The Impact of Interest Rate Risk on the Profitability and Efficiency of Banks

THE IMPACT OF INTEREST RATE RISK ON THE PROFITABILITY AND EFFICIENCY OF BANKS

ONKUNDI VINCENT D33S/CTY/9150/2010

RESEARCH SUBMITTED TO THE DEPARTMENT OF ACCOUNTING AND FINANCE IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE DEGREE OF BACHELOR OF COMMERCE OF KENYATTA UNIVERSITY

DECLARATION

This proposal is my original work and has not been presented for a degree in any other university

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This proposal has been submitted for examination with my approval as the university supervisor

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TABLE OF CONTENTS

DECLARATION...............................................................

ABSTRACT.....................................................................

TABLE OF CONTENTS.....................................................

LIST OFTABLES.............................................................

LIST OF FIGURES...........................................................

ACCRONYMS.................................................................

DEFINITION OF TERMS..................................................

CHAPTER ONE................................................................ 1INTRODUCTION.............................................................

1.1 Background..................................................................

Types of interest rate risk.................................................

Basic risk..................................................................

Yield curve risk...........................................................

Re-pricing risk............................................................

Option risk..................................................................

Model risk...................................................................

1.2 Statement of the problem.....................................................

1.3 Objectives........................................................................

1.3.1 Specific objectives............................................................

1.4 Research questions............................................................

1.5 Justification.....................................................................

1.6 Scope..............................................................................

1.7 Limitation........................................................................

CHAPTER ONE

INTRODUCTION

1.1 Background of the study

Interest rate risk is the risk variability in value borne by an interest-bearing asset, such as a loan or a bond due to variability of interest rate. As rates rise, the price of fixed rate bond will fall and vice versa.

Types of interest rate risk that Banks face:

Basis risk

This is the risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.

Yield curve risk

This is the risk presented by the differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money at lower rates and investing in long-term assets at higher rates. But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses.

Repricing risk

This is the risk presented by assets and liabilities that re-price at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.

Option risk

This is the risk presented by optionalities embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.

Model risk

This risk is presented by mathematical models used to price asset and liabilities not directly quoted on the market. Interest rate pricing models are based on reasonable assumptions about the behaviour of interest rates that may fail in particular market conditions. Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they impact liability costs. This is because substantial amounts of bank funding are not affected, or are just minimally affected, by changes in interest rates. Banks earn more money when interest rates are high, and they earn less money when interest rates are low. This relationship often breaks down in very large banks that rely significantly on funding sources other than traditional bank deposits. Large

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