Interest rate and financial sector problems

Source: Financial Gleaner, June 22, 2001

CAN INTEREST rate risk explain the profitability and solvency problems in the financial sector?

Why should we be so concerned about interest rate risk in 2001?

The crisis in the financial sector is winding down, the macro-economic environment has been stabilising, and interest rates are far less volatile now than in the 1990s. There are two basic answers; first if we fail to understand the past we are more likely to repeat history, and second, the government is issuing much more long term fixed rate instruments now than they did in the past.

Thus, if the financial institutions continue to invest in fixed rate government paper they could possible face greater interest rate exposure even if interest rates do not exhibit large jumps.

Financial institutions are special. They allow for the flow of funds between the providers of capital (households) and the users of capital (government and the productive sector). The level of economic activity is partially dependent on the efficient movement of capital within the economy. Thus, regulators and other market participants pay close attention to the stability of financial institutions in general and depository institutions in particular, especially in economies that have poorly developed capital markets. Therefore, tremendous amounts of research and analysis have been done in determining the appropriate way to regulate financial institutions to ensure that they operate efficiently and to minimise the risks that these institutions face.

Credit and interest rate risks are the two major risks financial institutions face. Techniques for assessing and controlling credit risks are well established and used by most financial institutions. These include adherence to strict underwriting rules, differential loan interest rate regimes, and collateralisation, Supervisors and regulators will use capital ratios (risk adjusted) to determine the institution's ability to withstand credit risk. Unfortunately, interest rate risk is much more elusive to manage than credit risk, as changes in interest rates are externalities, while credit risk is directly related to the institution's policies. Supervisors and regulators tend to use duration matching/duration gap and maturity matching analyses (these techniques are fairly complex and have some major drawbacks) to determine the financial institutions' exposure to interest rate risk.

Interest rate risk is defined as the sensitivity to the financial institution's income and equity to the changes in interest rates. Financial institutions are unique in the sense that they have both financial instruments on both the asset side (loans and investments) and the liability and equity side of the balance sheet (deposits, debentures and shareholders equity). The change in value of the assets will not generally match the change in value of the liabilities, as these changes are dependent on the duration of both the assets and liabilities. Thus, the value of the institution's equity can change whenever interest rate changes. If the value of the institution's equity declines substantially this can result in the institution becoming insolvent.

Studying interest rate risk in the financial institutions in Jamaica is important for several reasons. First, changes in interest rates tend to exhibit unpredictable "jumps" rather than gradual adjustments as interest rates are often used to support the value of the local currency and to mop-up excess liquidity in the economy. Even small changes in interest rates can produce relatively large changes in income and equity. Therefore, we expect that the large changes in interest rates as experienced by the Jamaican financial sector in 1990s could result in large swings in income and market value of equity. Second, during the 1990s the financial institutions were required to have fairly large proportions of their deposits in cash or near cash instruments. Holding large proportions of very short-term assets could possibly result in the duration (effective maturity) of the assets being different from the duration of the liability. The average maturity of the deposit instruments would not have been as short as the assets. This mis-match of the duration of the assets and liability serves to worsen the interest rate sensitivity of the institution's income and equity. Finally, the risk-adjusted capital requirements as laid out by the Basle Committee, do not capture interest rate risk. Thus, we need to measure and control this risk in addition to adhering to the international risk adjusted capital requirement.

Figure 1 plots the yield on 6-month treasury bills for the period June 1993 to December 1999. It is evident that the 6-month yields took wild swings in the early part of the period. The June 1993 bill was issued at a yield of 24.6 per cent pa, a similar issue in December 1993 was priced to yield 50 per cent pa and 15 months later the yields were down to 23 per cent pa. However, by mid 1998 the yields were less volatile and new issues were priced to yield about 20 per cent per annum. The 6-month treasury yield is an important benchmark in the economy. During this period, the majority of Local Registered Stocks (government medium term bonds) were issued as variable rate coupon bonds. The coupon payments are based on the average yield on 6-month treasury bills.

If these wide swings in interest rates are not anticipated these can create either windfall profits or unanticipated losses. For example, if interest rates rise rapidly over a very short period of time and investments would mature faster than deposits and liabilities, allowing the reinvestment of funds at higher rates of returns while enjoying the same cost of funds, thus, the financial institution will have larger than expected profits. The converse is true when rates are falling rapidly.

The value of the institution's assets will decrease as interest rates rises, however the value of its liabilities will decrease even more since the duration of the liabilities is longer. Thus, the value of the financial institution's equity will increase in rising interest rates. The converse will be true, that is, the value of the equity will decline during periods of falling interest rates when the maturity (duration) of the assets is shorter than the maturity of the liability.

This is not the entire story. Financial assets and liabilities have embedded options that complicate the analysis above. The embedded option in loans is the pre-payment option. Borrowers can always refinance their loans (incurring some transaction costs) if interest rates fall sufficiently, thus reducing the potential windfall profits that the institutions would have when liabilities re-price faster than assets.

On the other hand, when interest rates increase the financial institution may find it necessary to increase deposit rates to remain competitive. If loan and investment rates are fixed then the institution will see a reduction in its profits, as it may be unable to call the loan or investment and re-invest at the higher rates when rates are falling. We can now appreciate why financial institutions are loathe to issue fixed rate loans.

* This article was written by Dr. Twia-Mae Logan, a lecturer at the University of the West Indies and Nova South Eastern University, Florida. She will be a main presenter at the 2 day Executive Seminar for the Financial Sector being hosted by the Technology Innovation Centre, UTech in Collaboration with the University of New Orleans & Aikman Enterprises Inc. at the Hilton Kingston Hotel on June 25 and 26, 2001