The continued downward movement of interest rates and the huge profits made by banks have started creating concerns in some circles. What if interest rates were to go up? What is the extent to which banks in India would be affected?

The traditional view of bankers looking at the impact of interest rate changes is to examine how movements in interest rates affect their net interest income. This 'earnings perspective' is, however, quite incomplete. It ignores, for instance, the impact of interest rate changes on the value of bonds held by the bank.

When RBI Governor Bimal Jalan was cutting the bank rate over the last couple of years, many bankers responded negatively, saying that this would affect their profits.

The rationale was that while the lending rate would go down, deposit rates would not fall correspondingly, and thus the move would push down the net interest income of banks. This would result in a decline in their profits.

What happened was quite the contrary. Banks holding portfolios of long dated government bonds saw a sharp increase in the value of these bonds. For every increase in interest rates by 100 bps, the price of a bond with a 10-year duration went up by nearly 10 per cent. Profits from sale of these bonds zoomed.

So, why did these bankers not get it right? The reason was that they were primarily focusing on the impact of interest rate changes on their net interest earnings. The impact on their trading books was not immediately obvious.

As distinct from the accountant's perspective, is the economist's perspective which suggests that banks should look at the impact on their net present value.

Bank of International Settlement guidelines propose that banks and their regulators should simulate the impact of changes in interest rates on both NII and NPV of banks.

RBI guidelines on interest rate risk exposure of banks are still evolving.

The current approach is based on an earnings perspective and requires banks to submit to RBI an Interest Rate Risk statement in which the bank classifies assets and liabilities in time buckets according to the time to re-price or reset interest rates.

A perusal of gaps of assets and liabilities in each time bucket gives an indication of the impact on earnings when interest rates change.

RBI also requires banks to hold an Investment Fluctuation Reserve.

This is intended to be 5 per cent of the banks investment portfolio held on its trading account. This requirement for holding capital is meant to protect banks in the event of a rise in interest rates.

This approach assumes that if two banks hold an equal amount of GOI bonds, their interest rate risk exposure is the same.

But this is not correct since banks are able to lay off a substantial fraction of the interest rate risk to their liabilities. If a bank has time deposits, which are long dated liabilities, then it can hold long dated bonds without bearing much interest rate risk.

In short, this suggests that it is not enough to just look at the gaps in time buckets from the perspective of imputing the impact on net interest income.

In addition, it is also not enough to look at the impact upon the net present value of only the asset side. It is important to measure the net present value of both assets and liabilities of a bank.

When interest rates change the NPV of both sides change. To some extent the change on the asset side would be offset by the change in the value of liabilities. The difference has to be absorbed by equity capital.

In a recent study, Ajay Shah and I measured interest rate risk exposure of Indian banks using the latter approach.

(Interest rate risk in the Indian banking system by Ila Patnaik and Ajay Shah, ICRIER Working Paper No. 92, December 2002 available at http://www.mayin.org/ajayshah/ PDFDOCS/PatnaikShah2002_banks_irates.pdf on the world wide web)

We find that in a sample of 42 banks, which account for 85 per cent of bank deposits, 25 banks stand to gain substantially when interest rates go down. In the event of a rise in interest rates, these banks are likely to make huge losses.

We simulate scenarios of higher interest rates, putting together the losses on the assets with gains in the liabilities, and measure the error between the two sides as the impact on equity capital.

The interest rate scenarios envisaged are based on BIS proposals. By implementing BIS proposals, we find that banks in India need to simulate the impact of a 320 basis point shift in the yield curve.

The imputation of interest rate risk is done using the latest data set of maturity statements publicly available in annual reports, i.e. for 31st March 2002. Our results show that only 10 banks in our sample of 42 are hedged. These include SBI, HDFC and ICICI Bank.

We find that another six banks in the sample have a reverse exposure, in the sense that they stand to lose between 25 and 60 per cent of their equity capital in the event of a 320 bps rise in interest rates.

In other words, our work suggests that a downward movement of interest rates would adversely affect them. These include Global Trust Bank, Centurion Bank and Canara Bank.

By this logic, if full marking to market were done, these banks should have suffered in the period after March 31, since interest rates fell over this period.

Among the 25 banks that stand to lose if interest rates go up, the impact on equity capital ranges from 25 per cent to 105 per cent. Many of these figure in the top 20 banks in the country in terms of deposits.

These include Bank of Baroda, Bank of India, Andhra Bank, Corporation Bank, Union Bank of India, Oriental Bank of Commerce, Indian Overseas Bank and the State Bank of Hyderabad.

The perception of the interest rate risk exposure measured using accounting data is further corroborated by evidence from the stock market. In the case of a number of banks with significant exposure, the stock price of the bond is found to be sensitive to movements in the long rate.

It is clearly time for bank managers, board members, supervisors and uninsured depositors to focus on the extent of interest rate risk in Indian banks. There is an urgent need for better skills, systems and supervisory capacity.

If interest rates go up, before sound ways of measuring and containing this risk are put in place, there could be a serious depletion of the equity capital in the Indian banking system.