Interest Rate Risk Research Articles

Effect of operational risk on financial performance in banking industry IDX

Seeing the phenomenon of the COVID-19 pandemic, it has resulted in changes in the work patterns of many banks in Indonesia. The presence of COVID 19 is able to change the current pattern of bank operations in Indonesia. The financial performance of a company is a measure of the company's profits or losses in a certain period of time. Which could be issues related to banking risk management such as exchange rate risk, operational risk and interest rate risk. To raise arguments about how risk affects financial performance can reduce the probability of bankruptcy and provide greater stability of banking. This study aims to determine the effect of the dependent variable on financial performance as measured by return on assets and return on equity and the independent variable net interest income, average asset turnover, total operating expense, interest over years, exchange rate. The purpose of this study is to examine the effect of operational risk on financial performance in the banking industry listed on the IDX.

THE DEVELOPMENT OF METHODOLOGY OF BANKS’ FINANCIAL STABILITY ASSESMENT BY TAXONOMETRIC METHOD

Abstract. The article examines the methodology of assessing bank’s financial stability. It is researched scientific evolution of financial stability nature definition, discerning endogenous and exogenous approaches. It is proved that financial stability simultaneously feels effect from endogenous and exogenous factors and it should be taking into consideration while managing financial stability of a bank, as well as assessing its level. It is grounded a set of requirements while constructing methodological approach for assessing bank’s financial stability that are as follows: it is necessary to form a set of indicators that would allow to characterize the bank’s activity in complex; it is important to consider the dynamic nature of financial stability; it is significant to take into account how any indicator effects on the bank’s financial stability. It is proved taxonomy method as an effective technology of processing quantitative indicators of bank’s financial stability. We propose to normalize values of indicators by the Euclidean distance tool in order to figure out their deviation from the determined standard values. It is proposed to use a set of indicators for assessing the bank’s financial stability, that are grouped as follows: 1) the quality of capitalization; 2) the level of liquidity; 3) quality of assets; 4) risk-validity of business activity; 5) currency risk;6) credit risk; 7) profitability; 8) operational risk; 9) interest rate risk; 10) factors of the macroeconomic environment. In general, it is proposed to use thirty-eight indicators which are presented by point and dynamic ones. Practical approbation of the proposed methodological approach is carried out on the example of systemically important banks of Ukraine. The purpose of the article is to improve methodology of assessing bank’s financial stability using taxonomy approach. The proposed method, in contrast to the existing ones, provides: 1) flow method construction of a set of indicators; 2) implementation of point and dynamic indicators; indicators-stimulators / destimulators and of a mixed type; 3) indicative consideration of macroeconomic environment factors. The application of such an approach allows to comprehensively determine the level of bank’s financial stability and to quantify the impact of the macroeconomic environment on it. Keywords: bank’s financial stability, taxonomy method, dynamic indicator, integrated index of bank’s financial stability, normalization of indicators, indicator-stimulator, indicator-destimulator. JEL Classification C13, C81, D53, G21, G23 Formulas: 6; fig.: 1; tabl.: 2; bibl.: 32.

Central Banks policy under sanctions: critical assessment of the Central Bank of the Russian Federation experience

The article provides a critical assessment of The Central Bank of the Russian Federation policy in response to the sanctions of the US, the EU, the UK, Switzerland, Japan, South Korea and a number of other countries. The effect of sanctions on the Russian economy and its financial market is viewed through the prism of credit, interest rate, and currency risk, and the risk of a decline in business activity. Special attention is paid to the inflationary component and inflationary expectations of the Russian Federation, as well as to the forecasts for a decline in business activity in Russia. A critical assessment is given to the actions of the Central Bank of the Russian Federation and the economic bloc of the government of the Russian Federation as a whole in response to the sanctions of the civilized world, which disable the normal existence of the economy and the main purpose of which is not to destroy the economy of the Russian Federation but to ensure the end of hostilities on the European continent. The results of our study will be useful to everyone who studies the problems of the effect of economic sanctions on the resource-based economy and the processes of stimulating political decisions by economic methods.

Trading behavior of Swedish retirement investors during the COVID-19 pandemic

PurposeHow did investors in the Swedish Premium Pension System (PPS) react to the stock market shock ignited by the COVID-19 pandemic?Design/methodology/approachThe authors use fund-level data from the Swedish Pensions Agency on investment choices in the PPS. For each fund, the authors use monthly information on the number of investors and holdings' market value up to November 2020. The authors also use information on the total number of portfolio changes per day. For analyzing whether PPS investors reacted to the pandemic with claiming their pension, the authors use monthly data on the number of investors of a certain age group who initiate their public pension payment.FindingsTrades more than doubled, and shifted capital from equity funds to low risk interest funds. In economic terms, however, trading stayed at low levels–less than two percent of investors traded in March 2020 and there was no effect on pension withdrawals. The increased trading during the market tumult was disproportionately concentrated among investors in the top of the pension capital distribution.Research limitations/implicationsWith fund-level data, the authors cannot investigate what in particular made retirement investors stay calm in the midst of a severe market decline. Either, those investors have a long-term investment horizon as they save for their pension or particular features of the system's choice architecture induce inertia and discourage from trading. The sub-group analyses are more consistent with the explanation that PPS-induced inertia is responsible for the relatively small increase in trading activity, but future research could exploit individual level data to explore this in more detail.Practical implicationsThe often-criticized PPS choice architecture provided positive side effects in times of a severe market shock by shielding retail investors from committing trading mistakes when trying to outsmart the market.Originality/valueThe study complements previous evidence on the effects of COVID-19 on investor activity. The small response of PPS investors to COVID-19 is in line with earlier US findings on 401(k) accounts during the 2007 financial crisis (Tang et al., 2012) and industry reports about the COVID-19 period (see, e.g. Mitchell, 2020). The authors find no effects at all on public pension withdrawals in Sweden, while evidence from US 401(k) plans indicates a small share of workers taking COVID-related early withdrawals.

MEASURING EFFICIENCY IN ASSETS AND LIABILITIES MANAGEMENT PRACTICES IN DEPOSIT-TAKING NON-BANKING FINANCIAL COMPANIES IN INDIA: A CAMEL APPROACH

ALM technique is a strategic financial tool particularly focused on management of financial risks such as liquidity and interest rate risks only. In general, mismatch between assets and liabilities poses high risk (financial or non-financial risk) to the company’s capital. Therefore, company’s can protect their capital from various risks through proper management of assets and liabilities. Present study applied CAMEL technique to measure the efficiency of ALM practices of selected NBFCs-D in Tamilnadu for the period of 2011-2020. The study revealed that, SRTFL reported strongest level of financial soundness in the aspects of capital adequacy, management efficiency and earning efficiency whereas satisfactory level in liquidity and moderate/fair level in assets quality. Similarly, SRCUFL reported strong level in capital adequacy and earning efficiency, satisfactory level in assets quality and liquidity and fair level in management efficiency. Similarly, SFL has shown strongest level of performance in asset quality and earning efficiency, satisfactory in management efficiency, fair level in capital adequacy and marginal/poor level in liquidity. Similarly, SKFL reported satisfactory level in assets quality, fair level in capital adequacy and earning efficiency, marginal level in management efficiency and unsatisfactory/worst level in liquidity. Finally, NLOF has reported unsatisfactory/worst level of performance in all parameters except capital adequacy. This indicates high risk level/default level of the NLOFL during the study period.

Adjustable-rate mortgages in the era of global reflation: How to model additional default risk?

We investigate the problem of interest rate risk transforming into default risk of adjustable-rate mortgage loans in the EU. Bank regulation is strikingly not neutral in this aspect, it explicitly favors short-duration adjustable-rate loans over long-duration fixed-rate loans in the framework of the gap management. This asymmetry in the regulation creates perverse incentives both for banks and households, which can lead to aggressive risk-taking, over-indebtedness of unhedged households, high procyclicality of mortgage markets, and increased systemic risks. We present a stress test model to quantify potential losses stemming from this specific risk from the perspective of lender institutions. We estimate the average extra capital that is needed to cover the additional risk of adjustable-rate mortgage loans in the EU to be 0.53% of the value of the total mortgage portfolio and 1.97% of the value of the adjustable-rate mortgage portfolio. We propose introducing a stress test model as a new mandatory element into banks’ risk management framework.

Maximizing Capital Efficiency in US Defined Benefit Pension Plan Immunizing Portfolio Construction Using Derivatives and a Power Law Relationship

The author puts forth a framework for how to invest efficiently against the two dominant risk factors facing US pension plans—interest rates and credit spreads—as a function of the capital allocated to the asset–liability risk management function (the immunizing portfolio [IP]). The framework uses derivatives and other instruments to vary the nature of the hedge investments as a function of IP capital and seeks efficient use of that capital. The result is a glide path for the IP capital allocation that emphasizes interest rate risk management when IP capital is scarce while balancing interest rate and credit risk management when IP capital is plentiful.

Determinants of Islamic Bank Performance: An Assessment of Jaiz Bank Plc Nigeria

The paper assessed whether the bank-specific factors (internal) and economic (external factors) determine the financial performance of Jaiz bank Nigeria as an Islamic bank. Secondary data from the bank’s financial statements and world banks Development indicators were extracted for the period of 8 years (2011 to 2018). After description analysis, OLS regression was utilized to determine the effect of independent variables (GDP, Inflation, Interest, capital adequacy, credit risk, deposit ratio, and cost efficiency) have on the dependent variables (ROA, ROE, and ROI) financial performance. It was established that; GDP as an external factor has a significant positive association with financial performance, cost efficiency was discovered to have a weak positive relationship with the financial performance, while inflation rate, interest rate, capital adequacy, deposit ratio, and credit risk were found to have no significant effect on the bank’s financial performance. It was recommended that; Islamic banks need to give more consideration to the economic factors in their policies and programs as they may influence their profitability. More studies are also needed to compare the determinants of Islamic banks with that of Money Deposit Banks.

Enterprise Risk Management: Theory and Practice

The Chief Risk Officer of Nationwide Insurance teams up with a distinguished academic to discuss the benefits and challenges associated with the design and implementation of an enterprise risk management program. The authors begin by arguing that a carefully designed ERM program—one in which all material corporate risks are viewed and managed within a single framework—can be a source of long‐run competitive advantage and value through its effects at both a “macro” or company‐wide level and a “micro” or business‐unit level.At the macro level, ERM enables senior management to identify, measure, and limit to acceptable levels the net exposures faced by the company. By managing such exposures mainly with the idea of cushioning downside outcomes and protecting the firm's credit rating, ERM helps maintain the firm's access to capital and other resources necessary to implement its strategy and business plan.At the micro level, ERM adds value by ensuring that all material risks are “owned,” and risk‐return tradeoffs carefully evaluated, by operating managers and employees throughout the firm. To this end, business unit managers at Nationwide are required to provide information about the major risks associated with all new capital projects—information that can then be used by senior management to evaluate the marginal impact of the projects on the firm's total risk. And to encourage operating managers to focus on the risk‐return tradeoffs in their own businesses, Nationwide's periodic performance evaluations of its business units attempt to reflect their contributions to total risk by assigning risk‐adjusted levels of “imputed” capital on which project managers are expected to earn adequate returns.The second, and by far the larger, part of the article provides an extensive guide to the process and major challenges that arise when implementing ERM, along with an account of Nationwide's approach to dealing with them. Among other issues, the authors discuss how a company should assess its risk “appetite,” measure how much risk it is bearing, and decide which risks to retain and which to transfer to others. Consistent with the principle of comparative advantage it uses to guide such decisions, Nationwide attempts to limit “non‐core” exposures, such as interest rate and equity risk, thereby enlarging the firm's capacity to bear the “information‐intensive, insurance‐specific” risks at the core of its business and competencies.

Copula Modelling to Analyse Financial Data

Copula modelling is a popular tool in analysing the dependencies between variables. Copula modelling allows the investigation of tail dependencies, which is of particular interest in risk and survival applications. Copula modelling is also of specific interest to economic and financial modelling as it can help in the prediction of financial contagion and periods of “boom” or “bust”. Bivariate copula modelling has a rich variety of copulas that may be chosen to represent the modelled dataset dependencies and possible extreme events that may lie within the dataset tails. Financial copula modelling tends to diverge as this richness of copula types within the literature may not be well realised with the two different types of modelling, one being non-time-series and the other being time-series, being undertaken differently. This paper investigates standard copula modelling and financial copula modelling and shows why the modelling strategies in using time-series and non-time-series copula modelling is undertaken using different methods. This difference, apart from the issues surrounding the time-series component, is mostly due to standard copula modelling having the ability to use empirical CDFs for the probability integral transformation. Financial time-series copula modelling uses pseudo-CDFs due to the standardized time-series residuals being centred around zero. The standardized residuals inhibit the estimation of the possible distributions required for constructing the copula model in the usual manner.

Interest rate risk and monetary policy normalisation in the euro area

A low interest rate environment is susceptible to sudden increases in policy rates and heightened interest rate risk (IRR). By using a sample of 81 euro area banks during the period 2014Q4-2018Q1 and a confidential supervisory measure of IRR, this paper identifies which bank-specific characteristics can amplify or weaken the impact of a 200 basis points positive shock in interest rates. We find that banks reliant on core deposits, that hold more floating-interest rate loans and that diversify their lending, either by sector or geography, are less exposed to a positive change in interest rates. Interestingly, we discover that banks that did not exploit the exceptional financing provided by the European Central Bank (ECB) reveal greater IRR exposure. These findings advance the debate on the impact of a possible return to a normalised monetary policy on the euro area banking sector.

Asset Liability Management of Longevity and Interest Rate Risks: Using Survival–Mortality Bonds

In this article, we propose to attach a mortality index to a conventional bond, called a survival–mortality (SM) bond. Its cash flow pattern is like a conventional bond but it can be separated into a survival (S) part and a mortality (M) part; the cash flow pattern in the former is like an annuity or a longevity bond and that in the latter is like a mortality–catastrophe bond. We further propose to split it into S, M, and SM zero-coupon STRIPS (Separate Trading Registered Interest and Principal Securities). We apply these S, M, and SM issues to hedging longevity risk and interest rate risk of 1-year and multiple-year annuity exposures for the asset liability management of an annuity provider by adopting mortality, interest, mortality–interest duration, and convexity matching strategies. Numerical illustrations show that using SM STRIPS rather than S STRIPS can be sufficient to hedge the risks embedded in 1-year annuity exposures, whereas for multiple-year annuity exposures using S issues is more effective to reduce longevity risk and interest rate risk than using SM issues. We can infer that mortality-linked bonds play an essential role in asset liability management; the proposed survival–mortality bonds will be a feasible way to develop an efficient market for longevity risk.

A Joint Model for the Term Structure of Interest Rates and Realized Volatility

Abstract This paper presents a term structure model for no-arbitrage bond yields and realized bond market volatility. Based on well-known results, realized yield curve covariation is linked to generalized autoregressive conditional heteroskedasticity (GARCH)-type conditional covariation. The model is tractable and its latent state variables can be filtered using an exact algorithm. In an empirical study of U.S. Treasury bond data, the model shows that conditional yield curve covariation is priced in long-term yields. Moreover, the model proves useful for multi-step ahead forecasting of realized covariation. Finally, I use the model to quantify interest-rate risk and risk compensation.

Reducing transaction costs for interest rate risk hedging with stochastic programming

Traditional methods for hedging interest rate risk do not take transaction costs into account as they aim to eliminate all risk. We propose a two-stage stochastic programming model for hedging interest rate risk where transaction costs are weighed against portfolio variance. High-quality measurements of term structures enable us to extract the systematic risk factors and make precise estimates of the perceived transaction costs. The hedging cost is weighed against the reduction in portfolio variance by using an adjustable hedging parameter. The hedging procedure is simulated on a daily basis in a realistic setting over an out-of-sample period from 2002 to 2018, and the results are compared to traditional hedging methods through detailed performance attribution. Using second-order stochastic dominance, we show that the proposed method is preferred by all risk-averse investors.

Pareto Optimal Pension Risk Allocations

We consider a funded pension system where collective risks, in a simple Black-Scholes financial market, are allocated to the retirement savings of individual participants. In particular, we consider an allocation in such a way that the relative effect on total retirement wealth, that is, the sum of financial wealth and human capital, is the same for each participant. We show that this allocation is Pareto efficient. This stylized life-cycle fact inspired the new Dutch retirement system. Subsequently, we extend the allocation rule to a setting that includes annuity risk. This risk can be a traded risk (e.g., interest rate risk) as well as a non-traded risk (e.g., longevity risk). From our closed-form solutions, we identify the similarities between our optimal allocation rule and the allocation rule in the new Dutch retirement system. A numerical example illustrates our findings.

On the Diversification of Fixed Income Assets

This article introduces a new approach for dealing with the diversification/concentration risk of fixed income assets. Because Government bonds, corporate bonds, and mortgage backed securities constitute a large proportion of the assets of institutional investors in most countries, it is important to be able to determine the number of lines/issuers of such assets, not only for portfolio management but also for risk management purposes. The approach that I introduce shows the dependence of the critical number of lines of fixed income assets on the main interest rate risk and credit risk drivers. Specifically, I examine the importance of volatility risk, force of mean reversion, default risk, recovery risk, and default dependence risk on the critical number of assets in a fixed income portfolio. The methodology in this paper relies on the use of the coefficient of variation for the computation of the critical number of credit-sensitive securities in a fixed income portfolio. To the best of my knowledge, this paper is the first to develop such an approach.

Mixed models for optimal saving with labor income risk and interest-rate risk.

In this paper, optimal saving models with two risk components are studied: the labor income risk and the interest rate risk. These risks can be modeled probabilistically by random variables or possibilistically by fuzzy numbers. In mixed models, one of the components is probabilistic and the other one is possibilistic. After the construction of two mixed models of optimal saving, several notions of precautionary saving are defined. These measure the variation in optimal saving level when moving from one model to another (usually by adding a risk component). The main results of the paper establish necessary and sufficient conditions on the positivity of different precautionary savings. (This means that the presence of new risks generates extra-saving.)

Risk Management and Agency Theory: Role of the Put Option in Corporate Bonds

This study sets out a new methodology to exemplify, through a set of risk metrics called the Greeks, impact of a bond’s structured provisions (e.g., call, put, and conversion options) on its risk characteristics and its propensity for agency conflicts. The methodology is assessed by applying it to a sample of 159 non-convertible bonds, with time-scheduled call and put provisions issued between 1977 and 2005. A structural contingent-claims valuation model is used to value the bonds and estimate the Greeks. The methodology is used to assess the impact of the call and put provisions on the bond’s credit risk and interest-rate risk, as well as the provisions’ ability to mitigate the agency conflict associated with over-investment, under-investment, asset-substitution, and information asymmetry about the firm’s true risk among stakeholders. The main findings of this study are that the put option plays a key role in reducing credit risk, mitigating agency conflict, and protecting against volatility shocks; conversely, the call option plays a key role in reducing interest-rate risk. The methodology is sufficiently general to apply to bonds and preferred stock with any set of structured provisions.

Capital Structure Priority Effects in Durations, Stock-Bond Comovements, and Factor Pricing Models

Abstract We show theoretically and empirically that the durations of corporate securities are monotonically related to their capital structure priority, with equity often having a negative duration. The magnitude of this effect increases with firm leverage. We use these insights to challenge existing results on stock-bond comovements and factor pricing. For example, though overlooked, higher leverage and lower priority reduce the correlation between corporate security and government bond returns, and these variables explain time-series and cross-sectional variation in correlations; traditional market model regressions significantly understate corporate bond betas; and regressions on standard term and default factors dramatically overstate interest rate and default risk. (JEL G12, G13)

Measurement and Management of Interest Rate Risk of Commercial Banks: Based on VaR-GARCH Model of a Case Study of SHIBOR

With the acceleration of financial liberalization in China and the tremendous changes in the international financial situation, China’s commercial banks face considerable interest rate risks. The profitability and solvency of commercial banks have been impacted, leading to increased operational uncertainty and even systemic risks. The Shanghai Interbank Offered Rate, launched in 2007, tends to approach the benchmark interest rate in the financial market. Therefore, this paper selects The Shanghai Interbank Offered Rate (SHIBOR) overnight lending rate from January 2017 to July 2021 as a sample and adopts a method combining the VaR and GARCH models. Through empirical analysis, this paper establishes a GARCH model to eliminate the heteroscedasticity phenomenon in the data. The results show that the SHIBOR series has the characteristics of stationary, non-normal distribution, serial autocorrelation, and heteroscedasticity. The GARCH (2,2) model under the generalized error distribution (GED) is the most effective for measuring interest rate risk. Based on this, this article puts forward suggestions that commercial banks should enhance their awareness of interest rate risk management and should actively use financial derivatives to hedge interest rate risks.