INTEREST RATE RISK MANAGEMENT IN KRISHNA GRAMEENA BANK

CHAPTER-IV INTEREST RATE RISK MANAGEMENT IN KRISHNA GRAMEENA BANK xxi

CHAPTER-IV INTEREST RATE RISK MANAGEMENT IN KRISHNA GRAMEENA BANK 4.1 Introduction Interest Rate Risk denotes the changes in interest income and consequent possibility of loss due to changes in the rate of interest. The management of interest risk is fundamental to sound practice. If poorly managed, a bank can experience earnings, liquidity and ultimately capital adequacy problems. Traditionally, bankers and bank regulators have focused on the impact on earnings from changes in interest rates. A change in interest rates affects not only earnings but also the market values of all fixed rate instruments. Whether these changes manifest themselves immediately in earnings depends on accounting rules. It merely because, such changes may be buried in historic cost accounting does not mean that they do not matter 1. Deregulation of interest rates has exposed the banks to the adverse impact of interest rate risk. Interest rate risk is the risk where unexpected change in the market interest may impact on the Net Interest Income (NII) and Net Interest Margin (NIM). Any mismatches in the cash flows (fixed assets or liabilities) or re-pricing dates (floating assets or liabilities), expose bank s Net Interest Income or Net Interest Margin to variations. The earnings of assets and cost of liabilities are closely related to market interest rate volatility. Interest rate risk may take the form of gap or mismatch risk, basis risk, embedded option risk, yield risk, price risk 2. The interest rate risk can thus be viewed from two different but complimentary perspectives. One perspective is the traditional accounting perspective which focuses on the sensitivity of earnings to rate movements. The other is the economic perspective which focuses on the sensitivity of 99

the market values of all financial instruments, whether they are assets, liabilities or off-balance sheet contracts. The economic perspective focuses on the market values of the bank s capital accounts which is often referred to as the market value of portfolio equity. The sensitivity of the market value of portfolio equity to changes in interest rate is a good, complimentary indicator of the level of interest rate risk inherent in an institution s current position and a leading indicator of future earnings trends. 4.2 Sources of interest Rate Risk 3 risk in bank. The following are the various sources and dimensions of interest rate 1. Repricing Risk As financial intermediaries banks encounter interest rate risk in several ways. The primary and most often discussed form of Interest Rate Risks arise from timing differences in maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance sheet positions. While such re-pricing mismatches are fundamental to the business of banking. They can expose a bank s income and underlying economic value to unanticipated fluctuation as interest rates vary. 2. Yield Curve Risk Re-pricing mismatches can also expose a bank to changes in the slope and shape on the yield curve. As the economy moves through business cycles the Yield Curve changes rather more frequently. The Yield Curve Risk arises when unanticipated shifts of the Yield Curve have adverse effects on a bank s income or underlying economic value. For instance, the underlying economic value of a long position in ten year government bonds hedged by a short position in five year government 100

bonds could decline sharply if the Yield Curve steepens, even if the position is hedged against parallel movements in the Yield Curve. 3. Rate Level Risk This refers to the possibility of changes in the level of interest rate. The general change in the level of interest rates is a key factor in the choice of fixed/floating mix, maturity and hedging decisions. During a given period the interest rate levels are to be restructured either due to the market conditions or due to regulatory intervention. In the long run, rate level risks affect decisions regarding the type and the mix of assets/ liabilities to be maintained and their maturing period. The Reserve Bank of India has been lowering the statutory Cash Reserve Ratio (CRR) for banks in a phased manner from 12 per cent since the year 1996 onwards. The decrease in CRR increases the liquidity of banks which further results in lowering the PLR/interest rates. For all new deposits the revised interest rates will be applicable which will result in low marginal cost of funds. 4. Basis Risk Another important source of interest rate risk commonly referred to as basis risk which arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. Even when assets and liabilities are properly matched in terms of repricing risk the banks are often exposed to Basis Risk. When interest rates change these differences can give rise to unexpected changes in the cash flows and earning Spreads between assets, liabilities and off-balance sheet instruments of similar maturities or repricing frequencies. 5. Embedded Option Risk An additional and increasingly important source of Interest Rate Risk arises from the options embedded in many bank assets, liabilities and off- 101

balance sheet (OBS) portfolios. Big changes in the level of interest encourage premature withdrawal of deposits on the liability side or prepayment of loans on the asset side and it creates a mismatch and gives rise to repricing risk. When funds are raised by the issue of bonds/securities it may include call/put options and these two options are exposed to a risk when the interest rates fluctuate. Bonds with put and call option may be redeemed before their original maturity as the holder will like to exercise put option in an increasing interest rate scenario while the issuer will exercise call option if interest rates have fallen. 6. Volatility Risk In deciding on the mix of the assets and liabilities the short-term fluctuations in the pricing policies are to be considered in addition to the long run implication of the interest rate changes. In a highly volatile market, the risk will acquire serious proportions as the impact will be felt on the cash flows and profits. The volatility witnessed in the Indian call money market in 1994 explains the presence and the impact of the volatility Risk. While some banks defaulted in maintenance of CRR, many banks borrowed funds at high rates which had substantially reduced their profits. 4.3 Effects of Interest Rate Risk Changes in interest rates can have adverse effects both on a bank s earnings and its economic values. Such effects of interest rate risk in bank are shown below. 4.3.1 Earnings Perspective This is the traditional approach to Interest Rate Risk assessment taken by many banks. In the earning perspective the focus of analysis is the impact of changes in interest rates on accrual or reported earning. As reduced earning or outright losses can threaten the financial stability of an institution by undermining its capital adequacy and by reducing market 102

confidence. Such earnings perspective focuses attention on net interest income (i.e., the difference between total interest income and total interest expense). However, as banks have expended increasingly into activities that generate fee-based and other non-interest income a broader focus on overall net income incorporating both interest and non-interest income and expenses has become more common. The non-interest income arising from many activities such as, loan servicing and various asset securitizations programmes can be highly sensitive to market interest rates. 4.3.2 Economic Value Perspectives Variation in market interest rates can also affect the economic value of a bank s assets, liabilities and Off Balance Sheet positions. It will ultimately impact the Market Value of Equity or the value of Net Worth of the bank. Thus the sensitivity of a bank s economic value to fluctuations in interest rates is particularly important consideration of shareholders, management and supervisors. The economic value of an instrument represents an assessment of the present value of its expected net cash flows discounted to reflect market rates. Since the Economic Value Perspective considers the potential impact of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of the potential long term effects of changes in interest rates than is offered by the Earning Perspective. The Earnings and Economic Value Perspectives focus on how future changes in interest rates may affect a bank s financial performance. The past interest rates may also have an impact on the future performance as instruments that are not marked to market may already contain embedded gains or losses due to past rate movements which may be reflected over time in the bank s earnings. 103

4.4 Interest Rate Risk Measurement in Bank Banks should have Interest Rate Risk Measurement system that capture all material sources of Interest Rate Risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions underlying the system should be clearly understood by risk managers and bank management. Mere identification of the presence of the Interest Rate Risk will not suffice. A system that quantifies the risk and manages the same should be put in place so that timely action can be taken. Any delay or lag in the follow-up action may lead to a change in the dimension of the risk i.e. lead to some other risks like Credit Risk, Liquidity Risk etc. and make the situation uncontrollable. Risk Measurement System should assess all material Interest Rate Risk associated with a bank s assets, liabilities and OBS positions utilize generally accepted financial concepts and risk measurement techniques and have well document assumptions and parameters. 4.5 Techniques of Measuring Interest Rate Risk in Bank Following are the various techniques or methods of measuring interest rate risk in banks commonly used. 4.5.1 Maturity Gap Method The simplest techniques for measuring a bank s Interest Rate Risk exposure begin with a maturity / repricing schedule that distributes interestsensitive assets, liabilities and OBS positions into time bands according to their maturity (if fixed rate) or time remaining to their next repricing (if floating rate). This technique which is referred to as Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) that mature or repriced during a particular period of time. The objective of this method is to stabilize / improve the Net Interest Income in the short run over discreet periods of time called the Gap periods. 104

The first step in Gap Analysis is to bifurcate the entire asset and liability portfolio into two distinct categories viz., rate sensitive assets and rate sensitive liabilities. All the RSAs and RSLs are grouped into maturity buckets based on the maturity and the time until the first possible repricing due to change in the difference between the Interest Rate Sensitive Assets (RSAs) and the Interest Rate Sensitive Liabilities (RSL). RSG = RSAs RSLs RSG = Rate Sensitive Gap based on maturity Gap Ratio = RSAs RSLs The bank can use the Gap to maintain / improve its Net Interest Income for changing interest rates, otherwise adopt a speculative strategy wherein by altering the Gap effectively depending on the interest rate forecast the Net Interest Income can be improved. During a selected Gap period the RSG will be positive when the RSAs are more than the RSLs, negative when the RSLs are in excess of the RSAs and zero when the RSAs and RSLs are equal. In order to tackle the rising/falling interest rate structures the Maturity Gap Method suggests various positions that the treasurer can take i.e. i. Maintain a positive Gap when the interest rates are rising. ii. iii. Maintain a negative Gap when the interest rates are on a decline. Maintain a zero Gap position for firms to ensure a complete hedge against any movements in the future interest rates. The objective of an Asset Liability Management policy will be to maintain the Net Interest Margin within certain limits by managing the risks and the bank should first decide the maximum and minimum levels for the NIM. The success or failure of the Maturity Gap Method depends to a large 105

extent on the accuracy level of the forecasts made regarding the quantum and the direction of the interest rate changes. The assumption in the Gap method that the change in the interest rates is immediately affecting all the RSAs and RSLs by the same quantum is not always true in reality. Another limitation of the Gap method is that the treasurer may not have the flexibility in managing the Gap so as to effectively produce the targeted impact on the net interest income. Simultaneously this model ignores the time value of money for the cash flows occurring during the Gap period which is an important factor to be considered. 4.5.2 Rate Adjusted Gap The Maturity Gap Approach assumes a uniform change in the interest rates for all assets and liabilities but this may not be the case in reality. The market perception towards a change in the interest rate may be different from the actual rise/fall in interest rates. Similarly irrespective of any amount of fluctuation in the interest rate of the bank the differential interest rate remains constant because of certain regulations. In the Rate Adjusted Gap techniques, all the rate sensitive assets and liabilities will be adjusted by assigning weights based on the estimated change in the rate for the different assets/liabilities for a given change in interest rates. 4.5.3 Duration Analysis Duration Analysis concentrates on the price risk and the reinvestment risk while managing the interest rate exposure. It studies the effect of rate fluctuation on the market value of the assets and liabilities and Net Interest Margin (NIM) with the help of duration. Frederick Macaulay observes that it is possible to blend information contained in the size and timing of all cash flows into one number called duration. Duration is the weighted average of time taken (in years) to receive all cash flows, the weights being the present values of the cash flows. The Rate Sensitive Gap calculated in Duration Analysis is based on the duration and not the 106

maturity of the assets and liabilities. Duration Gap recognizes that Interest Rate Risk arises when the timings of cash inflows and outflows differ even if the assets and liabilities are categorized as rate insensitive as per the conventional Gap technique. The Duration Gap (DGAP) is computed as the difference between the composite duration of bank assets and marked down composite duration of it liabilities. DGAP = DA K DL Where in, DGAP = Duration Gap DA= Duration of Bank Assets KDL=composite Duration Liabilities Here DA is the summation of each asset s duration weighted by its share in total assets whereas DGAP is the duration of bank equity. The impact on market value of equity due to interest rate movements can be summarized as: A bank can immunize the market value of its equity by setting DGAP = 0. In reality if a bank wants to perfectly hedge its equity value it has to set its asset duration slightly less than its liability duration to maintain positive equity. No. Nature of DGAP Change in Interest Rate 1 DA = K DL Increase No Change 2 DA = K DL Decrease No Change Change in Market Value of Equity 3 DA > K DL Increase Market Value Increases 4 DA > K DL Decrease Market Value Decreases 5 DA < K DL Increase Market Value Decreases 6 DA < K DL Decrease Market Value Increases The DGAP measure is more scientific and realistic but more sophisticated and complex in approach at the same time. A basic 107

precondition for the use of this tool as a hedge mechanism is that all the assets and liabilities of banks have to be positioned as marked to the market. But for many banks in India very low portions of their balance sheets are marked to the market. Therefore, the DGAP tool has less applicability in the Interest Rate Risk immunization of a bank s balance sheet. 4 4.5.4 Simulation Techniques Simulation techniques involve detailed assessment of the potential effects of changes in interest rates on earnings and economic value by simulating the future path of interest rates and their impact on cash flows. In static simulations, the cash flows arising solely from the bank s current on and off balance sheet positions are assessed and in a dynamic simulation approach, the simulation builds in more detailed assumptions about the future course of interest rates and expected changes in the bank s business activity over that time many banks (especially those using complex financial instruments or otherwise having complex risk profiles) employ more sophisticated Interest Rate Risk measurement system than those based on simple maturity repricing schedules. 4.5.5 Value-at-Risk Approach Value-at-Risk methodology is a risk control method which statistically predicts the maximum potential loss a bank s portfolio could experience over a specific holding period at a certain probability. Using this method it is possible to measure the amount of risk for each produce with a common yardstick. The Value-at-Risk methodology takes into consideration the sensitivity of the current position s marginal move in the risk factors like interest rates, foreign exchange rates etc., the standard deviation of the historical volatility of the risk factors and the correlation between the risk factors. The VaR is used to estimate the volatility of Net Interest Income (NII) and net portfolio with a desired level of confidence. The Value-at-Risk concept has been recommended by the Basle Committee 108

as a standard measure of risk. The Basle Committee on banking supervision has recommended that Value-at-Risk may be calculated as on 99 per cent confidence interval basis. The variety of the techniques range from calculation that rely simply on maturity and re-pricing charts, duration Gap analysis, static simulations based on current on balance sheet and off balance sheet positions, highly sophisticated dynamic modeling techniques that incorporate assumptions about the behaviour of the bank and its customers in response to changes in the interest rate environment. All those methods vary in their ability to capture the different forms of interest rate exposure. It is needless to mention that the usefulness of each technique depends on the validity of the underlying assumption and the accuracy of the basic methodologies used to model Interest Rate Risk exposure. 4.6 RBI Guidelines with regards to Interest Rate Risk Management in bank The RBI issued guidelines in the year 1999 to tackle the problem of short-term liquidity. As per the Prudential Norms set by the RBI every bank has to ensure that the net outgo of funds during the coming 28 days should not exceed 20 per cent of the total outflow of cash. The Reserve Bank has also adopted Maturity Ladder for a comparative study of future cash inflows and cash outflows and all banks have been directed to prepare Liquidity Statements on the pattern of Maturity Ladder at quarterly intervals starting from the June 1999. In constructing the Maturity Ladder, a bank has to allocate each cash inflow or outflow to a given calendar date from a starting point. A maturing asset will result in cash inflow while a maturing liability will amounts to cash outflow. For constructing the Maturity Ladder classification of available data is necessary. For example a five-year deposit with only three months left to 109

maturity will be classified as cash outflow likely to take place in three months time. Thus maturity profile could be used for measuring the future cash flows of banks in different time buckets. The time buckets, given the Statutory Reserve Cycle of the days, have been distributed as follows. (i) 1 to 14 days (ii) 15 to 28 days (iii) 29 days and above up to 3 months (iv) Over 3 months and up to 6 months (v) Over 6 months and up to 1 year (vi) Over 1 year and up to 3 years (vii) Over 3 years and up to 5 years (viii) Over 5 years. 5 Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches up to one year would be relevant since these provide early warning signals of impending liquidity problems. The main focus should be on the short term mismatches viz. 1-14 days and 15-28 days. Banks are expected to monitor their cumulative mismatches across all time buckets by establishing internal prudential limits with the approval of the Board/Management Committee. The mismatches (negative Gap) during 1-14 days and 15-28 days in normal course may not exceed 20 per cent of the cash outflows in each time bucket. If a bank in view of its current asset-liability profile and the consequential structural mismatches needs higher tolerance level it could operate with higher limit sanctioned by its Board/Management Committee giving specific reasons on the need for such higher limit. The discretion to allow a higher level was intended for a temporary period i.e. till 31 March, 2000. Indian banks with large branch network can afford to have larger tolerance levels in mismatches in the long term if their term deposit base is quite high. While 110

determining the tolerance level the banks may take into account all relevant factors based on their asset-liability base, nature of business, future strategy etc. In case the negative Gap exceeds the prudential limit of 20 per cent outflows (1-14 days and 15-28 days), the bank may show by way of footnote as to how it proposes to finance the Gap to bring the mismatch within the prescribed limits. The Gap can be financed from market borrowings, bills Rediscounting, repay and deployment of foreign currency resources after conversion into rupees etc. In the context of poor MIS, slow pace of computerization in banks and the absence of total deregulation, the Reserve Bank has decided to implement the simplest method of traditional Gap Analysis as a suitable method to measure the Interest Rate Risk. It is the intention of RBI to move over to the modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk over time when banks acquire sufficient expertise and sophistication in acquiring and handling MIS. The Gap or mismatch risk can be measured by calculating Gaps over different time intervals. Gap Analysis measures mismatches between rate sensitive liabilities and rate sensitive assets. An asset or liability is normally classified as rate sensitive if, (i) Within the time interval under consideration there is cash flow. (ii) The interest rate resets/reprices contractually during the interval. (iii) RBI changes the interest rates (interest rates on Savings Bank Deposits, DRI Advances, Export Credit, Refinance, and CRR balance etc.) in cases where interest rates are administered. (iv) It is contractually pre-payable or withdrawable before the stated maturities 6. 111

The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturity or next repricing period whichever is earlier. For determining rate sensitivity, all investments, advances, deposits, borrowings, purchased funds etc. that mature / reprice within a specified time frame are deemed interest rate sensitive. Any principle repayment of loan including final principle payment and interim instalments are also rate sensitive if the bank expects to receive it within the time horizon. Generally, certain assets and liabilities that receive / pay rates with a reference rate are repriced at pre-determined intervals and are rate sensitive at the time of repricing. While the interest rates on term deposits are fixed during their currency, the advances portfolio of the banking system is basically floating and the interest rates on advances could be repriced any number of occasions corresponding to the changes in PLR. Each bank should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The prudential limits should have a bearing on the total assets, earning assets or equity. The banks may workout earnings at risk (EaR) or Net Interest Margin (NIM) based on their views on interest rate movements and fixes a prudential level with the approval of the Board/Management Committee. 4.7 Maturity Gap analysis Technique in Krishna Grameena Bank There are various techniques of assessing interest rate risk management in bank like Maturity Gap analysis technique, Rate adjusted Gap, Duration Analysis, Simulation Technique, Value at Risk (VaR) and Derivatives etc. The Maturity Gap analysis technique of asset liability management is used to assess Interest Rate Risk in Krishna Grameena Bank for the period of seven accounting years from 2005-06 to 2011-12 and also efforts are made to study the effect of changes in interest rates on Net 112

Interest Income (NII) and on Net Interest Margin (NIM) and on Net Income of Bank. Gap analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. It measures at a given date the gaps between rate sensitive liabilities (RSL) and rate sensitive assets (RSA) (including off-balance sheet positions) by grouping them into time buckets according to residual maturity or next repricing period, whichever is earlier. An asset or liability is treated as rate sensitive if i) Within the time bucket under considerations, there is a cash flow; ii) The interest rate resets/ re-prices contractually during the time buckets; iii) Administered rates are changed and iv) It is contractually pre-payable or withdrawal allowed before contracted maturities. This gap is used as a measure of interest rate sensitivity. A bank benefits from a positive gap i.e., RSA>RSL, if interest rate rises. Similarly, a negative gap (RSA<RSL) is advantageous during the period of falling interest rate. The interest rate risk is minimized if the gap is near zero. 4.8 Determination of Rate Sensitive Assets and Rate Sensitive Liabilities Rate sensitive assets and liabilities are arrived by grouping only those assets and liabilities which come within the time bucket 1-14 days to 6 months-1 year. There should be constant resets and reprices of interest rates during the time buckets. There should be contractual prepayment and withdrawal. The total of assets and liabilities which satisfy the above conditions are taken as rate sensitive assets and rate sensitive liabilities. Thus the gap is given by 113

Gap = Rate Sensitive Assets- Rate Sensitive Liabilities Rate Sensitive Asset Gap Ratio = Rate Sensitive Liabilities After the computation of rate sensitive assets and rate sensitive liabilities uniform rate of interest has been assigned for rate sensitive assets and fixed rate assets. This has been followed for rate sensitive liabilities and fixed rate liabilities. formula, The interest rate for assets is to be calculated by using the following Interest rate for assets = Interest earned Total advances + Total investments + Total Foreign currency assets Non-earning assets x 100 The interest rate for assets has been arrived at by taking into account total advances, total investments, total foreign currency assets and non earning assets. The interest rate for liabilities is to be calculated by using the following formula: Interest rate for liabilities Interest expended = Total deposits + Total borrowings + Total foreign currency liabilities x 100 The interest rate for liabilities has been arrived at by taking into account the interest expended, total deposits, total borrowings and total foreign currency liabilities. 4.9 Computation of mix The portfolio mix for assets and liabilities have been computed. The mix for rate sensitive assets, fixed rate assets, non earning assets, rate 114

sensitive liabilities, fixed rate liabilities and non interest bearing liabilities have been calculated to suggest the appropriate mix for assets and liabilities. Mix of rate sensitive assets = Volume of rate sensitive assets Total/ Average of assets x 100 Mix of fixed rate assets = Volume of fixed rate assets Total/ Average of assets x 100 Mix of non-earning assets = Volume of non-earning assets Total/ Average of assets x 100 Mix rate of sensitive liabilities = Volume of rate sensitive liabilities Total/ Average of liabilities x 100 Mix of fixed rate liabilities = Volume of fixed rate liabilities Total/ Average of liabilities x 100 Mix of non-interest bearing liabilities = Volume of non-interest bearing liabilities Total/ Average of assets x100 4.10 Computation of performance measures The Net Interest Income (NII), Net Interest Margin (NIM), Net Income (NI) and gap are the measures used to gauge the performance of Bank with relation to the asset liability management. 4.10.1 Net Interest Income Net Interest Income = (Interest rate of RSA x Volume of RSA) + (Interest rate of FRA x Volume of FRA) (Interest rate of RSL x Volume of RSL) (Interest rate of FRL x Volume of FRL). 115

4.10.2 Net Interest Margin This ratio identifies core earning capacity of the bank and its interest differential income as a percentage of average total assets. An alternative calculation prescribes earning assets as the denominator based on the presumption that the interest margin applies to earning assets engaged in providing interest income. However, both non-earning assets and non-interest bearing liabilities have a powerful impact on the net interest margin. This is because non earning assets are a drag on income, particularly if they are financed with interest bearing liabilities, while non interest bearing deposits boost earnings, particularly if they are financing high interest bearing assets. The Standard ratio prescribed by the World Bank is 4.5%. 7 It can be calculated by using the following formula. Net interest income Net Interest Margin = Total performing assets x 100 4.10.3 Net Income Net Income is the difference between the net interest income and provisions and contingencies. It can be calculated by using the following formula. Net Income = Net interest income Provisions and contingencies The various formulas suggested above are used for drawing conclusions about the interest rate risk management in Krishna Grameena Bank. The results are calculated for KGB by using all the three parameters for seven years from 2005-06 to 2011-12. 116

4.11 Calculation of Rate Sensitive Asset and Rate Sensitive Liability, Gap, Net Interest Income, Net Interest Margin and Net Income in Krishna Grameena Bank Table-4.1: Residual Maturity pattern of assets and liabilities for the year 2005-06 Maturity patterns Deposits Advances Investments Borrowings Foreign currency assets Foreign currency liability 1 to 180 days 181 to 365 days 1 to 3 years 3 to 5 years 19932.15 19135.92 -- 454.59 -- -- 5537.58 10525.24 250.00 10656.78 -- -- 12575.36 10976.35 436.35 1019.76 -- -- 4625.92 7564.46 9617.67 788.85 -- -- Over 5 years 3612.54 5515.36 1457.49 6233.78 -- -- Source: Annual Report of KGB for the year 2005-06. Table-4.2: Break up of assets and liabilities based on Maturity Pattern for the year 2005-06 Items Volume (Rs. In lakhs) Interest Rate Mix (%) RSA 29911.16 9.67 38.93 FRA 35567.68 9.67 46.30 NEA 11340.25 -- 14.77 Total/ average 76819.09 6.44 100.00 RSL 36581.10 4.13 47.61 FRL 28856.21 4.13 37.56 NIBL 11381.78 -- 14.83 Total/ Average 76819.09 2.75 100.00 Figures computed from Annual Report of KGB for the year 2005-06 117

The above table 4.2 shows the break up of assets and liabilities in the year 2005-06. The table suggests that the RSA and RSL, which are Rate Sensitive Assets and Rate Sensitive Liabilities of balance sheet positions have been classified according to the residual maturity. Here the entire volume of Rate Sensitive Assets, Rate Sensitive Liabilities, Fixed Rate Assets, Fixed Rate Liabilities, non-earning assets and non-interest bearing liabilities has been calculated and the total amount comes around Rs.76819.09 lakhs. The interest rates for RSA, FRA, RSL and FRL shows that the total average of interest rate for assets comes around 6.44 and the average of interest rate for liabilities comes around 2.75. The mix for RSA, FRA, NEA, RSL, FRL and NIBL has been computed. The mix for assets i.e., RSA comes around 38.93, for FRA it is 46.30, for NEA it is 14.77. The mix for liabilities i.e., RSL comes around 47.61, for FRL it is 37.56 and for NIBL it is 14.83 %. It has been confirmed from the table 4.3 which shows that there is a negative gap i.e., RSA < RSL. This trend is advantageous during the period of falling interest rates. The interest rate risk is minimized if the gap is nearing to zero. Table-4.3: Summary of Performance Measures for the year 2005-06 Performance Measure Initial Position Change in interest rate 2% decrease in interest rate 2% increase in interest rate GAP (RSA-RSL) -6669.94-6669.94-6669.94 Net interest income 3629.24 3762.64 3495.84 Net interest margin (%) 5.79 6.00 5.57 Net income 3078.55 3211.95 2945.154 Figures computed from Annual Report of KGB for the year 2005-06. 118

The above table shows summary of performance measures can be arrived at by the calculation of net interest income, net interest margin (NIM) and net income (NI). It can be inferred that during the year 2005-06 the gap is negative and it comes around Rs. 6669.94 lakhs. The interest income is Rs 3629.24 Lakhs. The net interest margin is 5.79 % which is more than the standard norm prescribed by the World Bank and the net income comes around Rs 3078.55 lakhs. The above data is shown with the help of figure 4.1. Figure-4.1: Summary of Performance Measures for the year 2005-06 4000 3500 3000 2500 2000 1500 1000 500 0 Net interest income Performance Measure Net income Initial Position 2% decrease in interest rate 2% increase in interest rate When interest rate negative shock of 2% was applied, it increased the NII to Rs.3762.64 lakhs, NIM to 6%, and NI to Rs.3211.95 lakhs. However, when interest rate positive shock of 2% was applied, it reduced the NII to Rs.3495.84 lakhs, NIM to 5.57% and NI to Rs.2945.154 lakhs. It is concluded that decrease of 2% in interest rate has increased the net interest margin by 0.21% over the initial position. It is because of the negative Gap. 119

Table-4.4: Period-wise Residual Maturity of assets and Items liabilities for the year 2005-06 1 to 180 days 181 to 365 days Advances 19135.92 10525.24 Investments -- 250.00 Foreign currency assets -- -- Deposits 19932.15 5537.58 Borrowings 454.09 10656.78 Foreign currency liabilities -- -- GAP -1250.32-5419.12 Source: Annual Report of KGB for the year 2005-06. It is evident from the above table that the residual maturity of the rate sensitive assets and rate sensitive liabilities from 1 day to 180 days and 181 days to 365 days for the year 2005-06. It is revealed that the time buckets of 1-180 days, 181-365 days are vulnerable paving way to negative gaps of high volume. Maturity patterns Table-4.5: Residual Maturity pattern of assets and liabilities for the year 2006-07 Deposits Advances Investments Borrowings Foreign currency assets Foreign currency liability 1 to 180 9523.00 34572.00 920.00 520.00 -- -- days 181 to 930.00 13605.00 -- 20352.00 -- -- 365 days 1 to 3 35004.00 8305.00 8312.00 3580.00 -- -- years 3 to 5 2555.00 6999.00 3946.00 1036.00 -- -- years Over 5 years 10474.00 3725.00 480.00 2404.00 -- -- Source: Annual Report of KGB for the year 2006-07 120

Table-4.6: Break up of assets and liabilities based on Items residual maturity pattern for the year 2006-07 Volume (Rs. In lakhs) Interest Rate Mix (%) RSA 49097.00 9.81 48.91 FRA 31767.00 9.81 31.64 NEA 19516.77 -- 19.45 Total/ average 100380.77 6.54 100.00 RSL 31325.00 3.95 31.20 FRL 55053.00 3.95 54.84 NIBL 14002.77 -- 13.96 Total/ Average 100380.77 2.63 100.00 Source: Figures computed from Annual Report of KGB 2006-07 The above table shows the break-up of assets and liabilities in the year 2006-07. It suggests that the RSA and RSL have been classified according to the residual maturity. Here, the entire volume of rate sensitive assets, rate sensitive liabilities, fixed rate assets, fixed rate liabilities have been calculated and the total comes around Rs.100380.77 lakhs. The interest rates for RSA, FRA, RSL and FRL have also been computed. The total average of interest rates for assets comes around 6.54 and the average of interest rate for liabilities comes around 2.63. The portfolio mix computation suggests that the asset mix i.e., RSA comes around 49 and for FRA it is around 32, for NEA around 19. Similarly, the liability mix i.e., RSL, comes around 31, for FRL around 55 and for NIBL comes around 14. The table 4.7 shows that there is a positive gap i.e., RSA > RSL. This trend is advantageous during the period of increasing interest rates. 121

Table-4.7: Summary of Performance Measures for the year 2006-07 Performance Measure Initial Position Change in interest rate 2% decrease in interest rate 2% increase in interest rate GAP (RSA-RSL) 17772 17772 17772 Net interest income 4520.82 4166.86 4877.74 Net interest margin (%) 5.81 5.36 6.27 Net income 3718.53 3364.57 4075.45 Figures computed from Annual Report of KGB for the year 2006-07. The performance measures such as Net Interest Income (NII), Net Interest Margin (NIM) and Net Income (NI) have been calculated. It can be inferred that in the year 2006-07 the GAP i.e., RSA-RSL is positive and it comes to Rs.17772 lakhs. The net interest income is Rs.4520.82. lakhs, the net interest margin is 5.81 which is also more than the standard norm prescribed by the World Bank and the net income comes to Rs.3718.53 lakhs. The summary of performance measure for the year 2006-07 is also shows with the help of figure 4.2. When interest rate negative shock of 2% was applied, it reduced the NII to Rs.4166.86 lakhs, NIM to 5.36% and NII to Rs.3364.57 lakhs, whereas, when interest rate positive shock of 2% was applied, it increased NII to Rs.4877.74, NIM to 6.27% and NI to Rs.4075.45 lakhs. When there is a positive gap (i.e., RSA > RSL) this trend is more advantageous during the period of increasing interest rates. 122

Figure-4.2: Summary of Performance Measures for the year 2006-07 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 Net interest income Performance Measure Net income Initial Position 2% decrease in interest rate 2% increase in interest rate Table-4.8: Period wise Residual Maturity of assets and liabilities for the year 2006-07 Items 1 to 180 181 to 365 days days Advances 34572 13605 Investments 920 -- Foreign currency assets -- -- Deposits 9523 930 Borrowings 520 20352 Foreign currency liabilities -- -- GAP 25449-7677 Source: Annual Report of KGB for the year 2006-07. The above table shows the residual maturity of the rate sensitive assets and rate sensitive liabilities from 1 to 180 days and 181 to 365 days for the year 2006-07. It revealed that the time buckets of 181 days to 365 days are vulnerable paving way to negative gaps of high volume. The negative gaps are due to the mismatch in the maturity pattern of assets and liabilities. 123

Table-4.9: Residual Maturity pattern of assets and liabilities for the year 2007-08 Maturity patterns Deposits Advances Investments Borrowings Foreign currency assets Foreign currency liability 1 to 180 days 181 to 365 days 1 to 3 years 3 to 5 years 1227.00 41824.00 253.00 5810.00 -- -- 119.00 16459.00 -- 6238.00 -- -- 4511.00 10046.00 10634.00 6118.00 -- -- 329.00 8467.00 5049.00 7555.00 -- -- Over 5 years 691.14 4506.00 1538.00 5596.00 -- -- Source: Annual Report of KGB for the year 2007-08 Table-4.10: Break up of assets and liabilities based on residual maturity pattern for the year 2007-08 Items Volume (R. in lakhs) Interest Rate Mix (%) RSA 58536 9.67 46.96 FRA 40240 9.67 32.28 NEA 25869.76 -- 20.76 Total/ average 124645.76 6.44 100.00 RSL 13394 4.35 10.74 FRL 93223 4.35 74.79 NIBL 18028.76 -- 14.47 Total/ Average 124645.76 2.90 100.00 Source: Figures computed from Annual Report of KGB for the year 2007-08 The above table reveals the break-up of assets and liabilities in the year 2007-08. It shows that the RSA and RSL which are rate sensitive 124

assets and rate sensitive liabilities of balance sheet positions have been classified according to the residual maturity. Here the entire volume of rate sensitive assets, rate sensitive liabilities, fixed rate assets, fixed rate liabilities, non-earning assets and non-interest bearing liabilities have been calculated and the total comes to Rs.124645.76 lakhs. The interest rates for RSA, FRA, RSL and FRL have also been calculated. The average of interest rate for assets comes to 6.44 and the average of interest rate for liabilities comes is 2.90. The portfolio mix computation suggests that the asset mix i.e., RSA comes around 47 and for FRA it is little over 32 %, for NEA around 21%. Similarly the liability mix i.e., RSL, comes around 11%, for FRL comes around 75 %and for NIBL 15%. The following table shows that there is a positive gap i.e., RSA > RSL. This trend is advantageous during the period of increasing interest rates. Table-4.11: Summary of Performance Measures for 2007-08 Performance Measure Initial Position Change in interest rate 2% decrease in interest rate 2% increase in interest rate GAP (RSA-RSL) 45142 45142 45142 Net interest income 4913.79 4010.96 5816.64 Net interest margin (%) 5.08 4.15 6.02 Net income 4091.31 3188.48 4994.16 Figures computed from Annual Report of KGB for the year 2007-08 125

The performance measures such as net interest income (NII), net interest margin (NIM) and net income (NI) have been calculated. From the above table it can be inferred that in the year 2007-08, the GAP i.e., RSA- RSL is positive and it comes to Rs.45142 lakhs. The net interest income is Rs.4913.79 lakhs, the net interest margin is 5.08 %. It is more than the standard ratio fixed by the World Bank. The net income comes to Rs.4091.31 Lakhs. The above data is shown with the help of figure 4.3. Figure-4.3: Summary of Performance Measures for the year 2007-08 6000 5000 4000 3000 2000 1000 0 Net interest income Performance Measure Net income Initial Position 2% decrease in interest rate 2% increase in interest rate When interest rate negative shock of 2% was applied, it reduced, NII to Rs.4010.96 lakhs, NIM to 4.15% and NI to Rs.3188.48 lakhs. However, when interest rate positive shock of 2% was applied, it increased NII to Rs.5816.64 lakhs, NIM to 6.02% and NI to Rs.4994.16 lakhs. The above table clearly exhibits that the change in interest rate affects on NII, NIM and NI. When the rate sensitive asset is more than the rate sensitive liabilities this trend is more advantageous during the period of increasing interest rates. 126

Table-4.12: Period wise Residual Maturity of assets and Items liabilities for the year 2007-08 1 to 180 days 181 to 365 days Advances 41824 16459 Investments 253 -- Foreign currency assets -- -- Deposits 1227 119 Borrowings 5810 6238 Foreign currency liabilities -- -- GAP 35040 10102 Source: Annual Report of KGB for the year 2007-08 The above table shows the residual maturity of the rate sensitive assets and rate sensitive liabilities from 1 to 180 days and 181 to 365 days for the year 2007-08 since there is a positive GAP of assets and liabilities from 1 to 180 days and 181 to 365 days. Maturity patterns Table-4.13: Residual Maturity pattern of assets and liabilities for the year 2008-09 Deposits Advances Investments Borrowings Foreign currency assets Foreign currency liability 1 to 180 8044.00 49840.00 9565.00 4125.00 -- -- days 181 to 4146.00 17860.00 2461.00 3266.00 -- -- 365 days 1 to 3 38681.00 9050.00 9050.00 3200.00 -- -- years 3 to 5 15091.00 7456.00 1999.00 450.00 -- -- years Over 5 years 29792.00 11680.00 30233.00 -- -- -- Source: Annual Report of KGB for the year 2008-09 127

Table-4.14: Break up of assets and liabilities based on Items residual maturity pattern for the year 2008-09 Volume (Rs. In lakhs) Interest Rate Mix (%) RSA 79726 9.43 51.62 FRA 39230 9.43 25.40 NEA 35483 -- 22.98 Total/ average 154439 6.28 100.00 RSL 19581 4.80 12.67 FRL 117447 4.80 76.04 NIBL 17411 -- 11.29 Total/ Average 154439 3.20 100.00 Source: Figures computed from Annual Report of KGB for the year 2008-09 The above table shows the break up of assets and liabilities in the year 2008-09. The data reveals that the RSA and RSL which is rate sensitive assets and rate sensitive liabilities of balance sheet positions have been classified according to the residual maturity. Here the entire volume of rate sensitive assets, rate sensitive liabilities, fixed rate assets, fixed rate liabilities, non-earning assets and non-interest bearing liabilities have been calculated and the total comes to Rs.154439 lakhs. The interest rates for RSA, FRA, RSL and FRL have also been computed. The average of interest rate for assets comes to 6.28 and the average of interest rate for liabilities comes to 3.2. The portfolio mix computation suggests that the asset mix i.e., RSA comes around 52 and for FRA around 25, for NEA around 23. Similarly, the liability mix i.e., RSL, comes around 13, for FRL 76 and for NIBL comes around 11. 128

The following table shows that there is a positive gap i.e., RSA>RSL. This trend is advantageous during the period of increasing interest rates. Table-4.15: Summary of Performance Measures for 2008-09 Performance Measure Initial Position Change in interest rate 2% decrease in interest rate 2% increase in interest rate GAP (RSA-RSL) 60145 60145 60145 Net interest income 4640.20 3437.30 5843.10 Net interest margin (%) 3.98 2.95 5.01 Net income 4140.51 2937.61 5343.41 Figures computed from Annual Report of KGB for the year 2008-09. The performance measures such as net interest income (NII), net interest margin (NIM) and net income (NI) have been calculated. From the above table it can be inferred that in the year 2008-09, the GAP i.e., RSA- RSL is positive and it comes around Rs.60145 lakhs. The net interest income is Rs.4640.20 lakhs, the net interest margin (NIM) is 3.98% which is very low when compared to the standard ratio prescribed by World Bank is 4.5% and the net income comes around Rs.4140.51 Lakhs. When 2% decrease in interest rate was applied, it decreased NII to Rs.3437.30, NIM to 2.95% and NI to Rs.2937.61 lakhs. On the other hand, when 2% increase in interest rate was applied, it increased NII to Rs.5843.10 lakhs, NIM to 5.015 and NI to Rs.5343.41 lakhs. The above table reveals that the increase in interest rate is more advantageous when there is a positive gap. The above data is shown with the help of figure 4.4. 129

Figure-4.4: Summary of Performance Measures for the year 2008-09 6000 5000 4000 3000 2000 1000 0 Net interest income Performance Measure Net income Initial Position 2% decrease in interest rate 2% increase in interest rate Table-4.16: Period wise Residual Maturity of assets and liabilities for the year 2008-09 Items 1 to 14 days 15 to 28 days 29 days to 3 months 3 to 6 months 6 months to 1 year Advances -- -- -- 49840.36 17860.78 Investments -- -- -- 9565.88 2461.00 Foreign currency assets -- -- -- -- -- Deposits -- -- -- 8044.59 4146.17 Borrowings -- -- -- 4125.00 3266.99 Foreign currency liabilities -- -- -- -- -- GAP -- -- -- 47236.65 12908.71 Source: Annual Report of KGB for the year 2008-09. 130

Table-4.17: Residual Maturity pattern of assets and liabilities for the year 2009-2010 Maturity patterns Deposits Advances Investments Borrowings Foreign currency assets Foreign currency liability 1 to 14 days 15 to 29 days 29 days to 3 months 3 to 6 months 6 months to 1 year 1 to 3 years 3 to 5 years 5600 11200 -- -- -- -- 5500 11000 -- -- -- -- 6800 24000 -- -- -- -- 15400 20000 -- 1500 -- -- 21000 19800 -- 5115 -- -- 24000 12500 9666 2400 -- -- 12500 10000 16836 1000 -- -- Over 5 years 18722 5803 2352 30119 -- -- Source: Annual Report of KGB for the year 2009-10. The above table shows the residual maturity of the rate sensitive assets and rate sensitive liabilities from 90 days-180 days to 181 days 365 days for the year 2008-09. The difference between rate sensitive assets and rate sensitive liabilities of 3 months to 6 months and 6 months to 1 year shows the positive Gap. The above table shows the break up of assets and liabilities in the year 2009-10. The table suggests that the RSA and RSL which are rate sensitive assets and rate sensitive liabilities of balance sheet positions have 131

been classified according to the residual maturity. Here, the entire volume of rate sensitive assets, rate sensitive liabilities, fixed rate assets, fixed rate liabilities, non-earning assets and non-interest bearing liabilities have been calculated and the total comes to Rs.169102 Lakhs. Table-4.18: Break up of assets and liabilities based on residual maturity pattern for the year 2009-10 Items Volume (Rs. In lakhs) Interest Rate Mix (%) RSA 86000 9.36 50.85 FRA 57157 9.36 33.80 NEA 25855 -- 15.35 Total/ average 169102 6.24 100.00 RSL 60915 4.94 36.02 FRL 88741 4.94 52.47 NIBL 19446 -- 11.51 Total/ Average 169102 3.29 100.00 Source: Figures computed from Annual Report of KGB for 2009-10. The interest rates for RSA, FRA, RSL and FRL have also been computed. The average of interest rate for assets comes around 6.24 and the average of interest rate for liabilities comes around 3.29. The portfolio mix computation suggests that the assets mix i.e., RSA comes around 51 and for FRA it is around 34, for NEA around 15. Similarly, the liability mix i.e., RSL, comes around 36, for FRL around 52 and for NIBL comes around 12. The table 4.19 confirmed that there is a positive GAP i.e., RSA>RSL. This trend is advantageous during the period of increasing interest rates. 132