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Interest Rate Risk for Financial Institutions: A Simple Guide

Modified on January 16, 2019

Interest rate risk (IRR) for a financial institution is similar to changing raw material costs for a manufacturing organization. If a financial institution like bank, nonbanking finance company (NBFC) or housing finance company (HFC) is not able to manage interest rate risk properly, then it runs the risk of running into losses just like any manufacturing organization will do if it does not manage raw material costs properly.

Financial institutions (FIs) represent businesses where they borrow money from one counterparty and lend it to another counterparty. A financial institution may borrow money from depositors (current and savings account or fixed deposits) or investors in commercial papers (CPs) or debentures or corporate bonds etc. Thereafter, the financial institution lends this money to entities like individuals (home loans, consumer loans etc.) or corporates (working capital loans, project loans etc.)

Therefore, a financial institution pays a rate of interest to the depositors and receives a rate of interest from borrowers. If it receives a higher interest rate from its borrowers than what it pays to its depositors, then the financial institution makes a profit. Otherwise, it makes a loss.

If an investor compares it with a manufacturing organization, then the interest paid to the depositors is the cost of goods sold (COGS) or raw material cost for a financial institution. The interest rate received from the borrowers is the sales price of goods. If a manufacturing organization receives a sales price of goods, which is less than the cost of the raw material, then it will make a loss. Similarly, if a financial institution receives a lower interest rate from borrowers than what it has to pay to its depositors, then the financial institution will make a loss.

Many times, financial institutions raise money from depositors/investors for a short duration (a few months like CP or CASA) and then use this money to give long-term loans (many years like home loans). In such cases, the financial institution has to keep renewing its short-term borrowings from depositors/investors so that it can keep its long-term loans intact. This creates a situation of asset liability mismatch (ALM).

ALM is an important risk for any financial institution because the counterparties, which have given it short-term funds, may demand it back whereas the FI would not have money to pay them back because all its money would be stuck in long-term loans given by it. Investors may read more about asset liability mismatch in the following article:

Advised reading: Asset Liability Mismatch: Why do NBFCs & Banks knowingly create it?

Apart from asset liability mismatch, the habit of raising money from short term depositors/investors and lending it for long-term loans raises another risk for financial institutions, which is called interest rate risk (IRR).

Interest rate risk arises when the rate at which the loans are given by the financial institution is fixed whereas the rate at which it has raised money from depositors/investors is variable. If the depositors ask for a higher rate from the financial institution and it is not able to pass on this increased cost of funds to its borrowers, then the financial institution faces the risk of losses. This is called interest rate risk (IRR). Interest rate risk further increases in cases where the loans given by the financial institution with fixed interest rate are long-term loans and the deposits raised at variable interest rate are short-term deposits like commercial papers (CPs).

One of the readers of our website, Mahesh Desai, had sent us a query about interest rate risk for Banks, NBFCs and HFCs in which he has beautifully projected the case of interest rate risk for a housing finance company (HFC) showing the calculations on Microsoft Excel. We answered his query with the steps that financial institutions take to mitigate interest rate risk. The following query and its response serve as a good resource for investors to understand the interest rate risk in terms of its illustration and management.

 

Interest Rate Risk: How it affects banks, NBFCs and HFCs? How to mitigate it?

Readers’ query:

Thank you Dr. Vijay for giving an insight. Apart from this specific IL&FS case, do you think the interest-rate risk is also a big component in asset liability mismatch along with liquidity crisis? Especially in housing finance companies (HFCs), if they have variable-rate long-term borrowing linked to MIBOR, LIBOR etc. or any short-term borrowing compared to their 10+ years of fixed-rate housing loans.

I think this is what can happen to an HFC when interest rate rises.

Let us say there is an HFC, which borrows money and then lends for housing loans. To keep this simple, I will make a few assumptions. Please let me know if I need to correct them.

Assumptions:

  • HFC borrows ₹10,000 Cr 1-year or 3-years floating-rate loan from banks on April 1, 2020. Let us assume that the floating rate is 8.95% for 2020.
  • HFC gives out housing loans for 20 years duration at a fixed rate on April 1, 2020.
  • Let us assume that the HFC has only one liability on balance sheet consisting of only one bank loan of ₹ 10,000 Cr from only one bank and no equity.
  • HFC has 10% operating cost to gross income ratio meaning that it has to spend 10% of its income on operating costs.

Now let us assume that RBI increases repo rate by 2% for each of the next 2 years. 10.95% & 12.95% in 2021 & 2022 respectively.

 

HFC with a one-year loan from Banks:

Here is how the interest rate risk in the financials of an HFC with 1-year bank loan looks like. The HFC needs to renew the bank loan at the end of every year or it needs to find a different source of borrowing. Either way, the HFC will end up paying new interest rate, which as per our assumptions is 2% increased rate in 2021 and another 2% increased rate in 2022.

Interest Rate Risk For Bank NBFC HFC Projected Financials One Year Loan From Banks

 

HFC with a three-year loan from Banks:

Here is how the interest rate risk in the financials of an HFC with 3-year bank loan looks like. The HFC needs to renew the loan every 3 years.

Interest Rate Risk For Bank NBFC HFC Projected Financials Three Year Loan From Banks

As we can see, the HFC starts making losses as interest rate increases roughly beyond 2%. It may or may not be similar to what happened in 2007-2008 housing crash when the US Federal Reserve increased rates by 4% in 2 years.

Interest Rate Risk For Bank NBFC HFC Fed Rates 2000 2010

In that case, even floating-rate lending to the consumer can cause an issue. As interest rate increases, the existing consumer needs to pay more equated monthly instalment (EMI) and eventually, she will start defaulting if a proper credit check is not done by the HFC before giving her the loan. Even new consumers will hesitate to take housing loans at a higher interest rate.

Therefore, I would say that if an HFC does not manage its assets-liability (short term & long term borrowing & lending with fixed & floating interest rate) properly, then it could suffer from interest rate risk.

This is just my thinking. I would love to hear your thoughts on it.

Regards,

Mahesh Desai

 

Author’s Response:

Hi Mahesh,

Thanks for writing to us and elaborating your thoughts on the interest rate risk faced by HFCs. The situation is similar for most of the financial institutions (FI).

It is correct that if any financial institution (FI) like a bank, nonbanking financial institution (NBFC) or a housing finance company (HFC) lends at a fixed interest rate and borrows at floating/variable interest rate, then whenever, its borrowing interest rates rise beyond a point, then the FI will start making losses.

Financial institutions use a few strategies to avoid such a circumstance.

Strategies to manage Interest Rate Risk:

  1. Lend at floating/variable interest rates so that they can pass on the impact of increasing borrowing rates to customers and thereby avoid losses.
  2. Whenever financial institutions lend at fixed interest rates, then they keep the interest rate differential/premium high for such customers so that the FI can bear a higher increase in its borrowing costs before it starts to make losses. E.g. if the borrowing cost of the FI is 10% and let us assume that it usually keeps an interest margin of 2% for the floating rate customers i.e. gives out floating rate loans at 12%. Then whenever any customer asks it for a fixed rate loan, then it keeps a higher interest margin, assume 4%, and quotes a fixed rate loan at 14%. In this manner, the FI builds an additional cushion to bear the impact of its rising borrowing costs in case of fixed interest rate loans.
  3. Even when financial institutions give loans at fixed interest rate loans, in the terms and conditions, they incorporate provisions that if the interest rates rise beyond a limit, then the FIs keep the right to increase the interest rates even on these fixed interest rate loans.
  4. If in a rare scenario, borrowing costs of the FIs increase drastically e.g. from the original assumed rate of 10% in point (2) above, the borrowing cost rises to 20%, then as rightly suggested by you, many good customers will also start to default. Moreover, in such a situation, the increase in defaults will be across the entire industry. In such cases, the entire financial industry will approach the Reserve Bank of India (RBI) for a bailout to allow them to restructure the loans of their customers who are now facing difficulties in making payments.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S.

 

DISCLAIMER

Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above

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