Interest Rate Risk Management by Indian Scheduled Commercial Banks: Evidence Using Linear Programming Problem and Panel Data Analysis

Abstract

This paper intends to explore one of the relatively less highlighted area viz. interest rate risk management by Indian banks with a view to providing an innovative edge to the specific area in the Indian context. Firstly, the paper aims at building empirical relationships between the average yields on assets and liabilities of Indian banks - taking one at a time on the one side - and short-term and long-term interest rates taken one at a time on the other side. Secondly, this paper estimates the impact of (i) slope of the yield curve and (ii) changes in market interest rates on the banks’ net interest margins. Thirdly, the paper attempted to optimise the level of net interest margins of Scheduled Commercial Banks of India with respect to (i) short-term interest rate and (ii) long-term interest rate. The panel data on average yields on assets and liabilities and net interest margins of 64 Scheduled Commercial Banks of India has been undertaken for the study period starting from March 2002 to March 2011. The time series on short and long-term interest rates are also collected for the same period. This paper uses the panel cointegration tests and shows that average yields on assets and liabilities of Indian banks are closely tied to long-term interest rate. The fixed-effects regression analysis highlights that change in long-term interest rate significantly impacts net interest margins of Indian SCBs, implying that Indian banks are exposed to interest rate risk. Finally the study achieves its main objective by solving a linear programming problem with the help of simplex method and determines the maximum level of net interest margin of Indian SCBs, which comes out to be 5.734 per cent over the studied period, if long-term interest rate would have been 11.781 per cent.