Interrest rate risk management a case study of saigon commercial bank

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS- HOCHIMINH CITY

TRẦN THIỆN DUY

MASTER’S THESIS

Ho Chi Minh City -2010


MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS- HOCHIMINH CITY

TRẦN THIỆN DUY

MASTER’S THESIS

In
Finance- Banking
Ology Code: 60.31.12
Supervisor
Ph.D NGUYỄN THỊ NGỌC TRANG

Ho Chi Minh City -2010


i

Acknowledgements
I would like to express my heartfelt gratitude and deepest
appreciation to my research supervisor, Ph.D Nguyen Thi Ngoc Trang

for

her

precious

guidance,

share

of

experience,

ceaseless

encouragement and valuable suggestion, advice and help. Without her,
this study could not have been completed.
Special thanks are sent to all instructors and staff at Postgraduate
Faculty, University of Economics Ho Chi Minh city (UEH) for their
support and valuable knowledge during my study in UEH. I also
express my appreciation to Professor Dr. Nguyen Dong Phong, UEH
deputy rector, for creating the MBA program in English.
I also wish to thank my colleagues from SCB, my friends in
Tinnghia bank, Vietbank, ACB, Saigonbank, LienViet bank, HDbank
to help me during colleting data as well as support me during doing
research. Specially, my thanks go to Mrs Hua Minh Dai University of
Phoenix in Arizona USA, and Mr Nguyen Huu Thu- banking specialistfor a lot of useful information and advice sent during my study.
Last but not least, the deepest and most sincere gratitude goes to
my beloved mother, elder brother and my wife Nguyen Vu Phuong

Giao for their boundless support and encouragement during my entire
study period.


ii

Abstract
Interest rate risk is one of important financial risks to banking
business as other financial intermediaries. The fluctuation of interest
rate risk affects directly the bank’s balance sheet issuances. The
changed structure of bank’s balance sheet causes the relative movement
of a bank’s earnings and net worth.
Many large banks have to set up their own process and principles
to manage interest rate risk which is based on the content guidelines of
Basel II as the standard procedure in terms of risk management in order
to manage interest rate risk.
To manage interest rate risk, many measurement techniques have
been used such as dollar gap, duration gap, simulation analysis, value at
risk analysis, and option adjusted spread analysis. Each method has its
strengths and weaknesses. Choosing an appropriate method depends on
the source of interest rate risk, the complexity of operation and
capability of that model. While some foreign banks in Vietnam such as
HSBC, ANZ use simulation and value at risk as main techniques for
interest rate risk measurement, a large number of Vietnamese banks
measure their interest rate risk by the maturity gap or dollar gap method
as fundamental analysis. Actually, some banks in Vietnam do not pay
attention to interest rate measurement seriously. Therefore, this paper
emphasizes current methods that Vietnamese banks have been using to
measure interest rate risk, and analyzes the advantages and
disadvantages of those methods. In reality, the current method that

Vietnamese banks use to calculate their interest rate risk is
inappropriate due to the interest rate fluctuation in recent years and it


iii

shall need being replaced. A more appropriate method, earning
simulation model or income simulation model, which can cover all
shortcomings of the dollar gap should be discussed and suggested to
apply for interest rate risk measurement in the context of Vietnam.
Basing on the analysis of real situations, this paper also proposes
some recommendations for the Vietnamese banking system to apply
such a model in real condition and as well for the government in
macroeconomic management.

Keywords: dollar gap; duration gap; income simulation model; interest
rate risk; spread.


iv

Table of contents
Acknowledgements ..................................................................................... i
Abstract ....................................................................................................... ii
Table of contents ....................................................................................... iv
List of figures ............................................................................................ vi
Abbreviations............................................................................................. vii
Chapter 1: Introduction
1.1 Rationale ............................................................................................1
1.2 Problem statement..............................................................................3

1.3 Research questions.............................................................................6
1.4 Research objectives............................................................................6
1.5 Significance........................................................................................6
1.6 Research methodology.......................................................................7
1.7 Structure of research ..........................................................................8
Chapter 2: Literature review
2.1 Asset/Liability Management..............................................................9
2.2 Interest rate risk ...............................................................................10
2.3 Interest rate risk structure.................................................................10
2.4 Interest rate risk measurement .........................................................11
2.5 Conclusion .......................................................................................20
Chapter 3: Methodology
3.1 Research design................................................................................21
3.2 Data collection .................................................................................22
3.2.1 Document collection...................................................................23
3.2.2 Personal interview ......................................................................23
3.3 Data analysis ....................................................................................25
3.4 Conclusion .......................................................................................25
Chapter 4: Analysis and findings
4.1 Introduction .....................................................................................26


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4.2 The findings of data analysis ...........................................................27
4.2.1 Measure interest rate risk in Vietnamese banks.........................27
4.2.2 Advantages and disadvantages of current methods ...................38
4.2.2.1 The advantages of current methods............................38
4.2.2.2 The disadvantages of current methods .......................39
4.2.3 Experience of measuring interest rate risk ................................40

4.2.4 Expectation of interest rate risk measurement ...........................42
4.2.5 Measuring interest rate risk with income simulation model ......43
4.2.6 Conclusion..................................................................................47
Chapter 5: Conclusion
5.1 Conclusions to research questions ..................................................49
5.2 Recommendations............................................................................51
5.2.1 Recommendations for Vietnamese banks ..................................51
5.2.2 Recommendations for the government ......................................53
5.3 Limitations of research ....................................................................54
References ..................................................................................................55
Appendixes ................................................................................................58


vi

List of figures
Figure 4.1 : Sample of gap report
Figure 4.2 : Sample graphic displays
Figure 4.3 : IRR measurement (for example 1% increase)
Figure 4.4 : Adjusted interest rate risk measurement
Figure 4.5 : Average mobilizing rate and lending rate 2008-2010
Figure 4.6 : Framework of income simulation model


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Abbreviations
ALCO

: Asset and Liability Management Committee

ALM

: Asset and Liability Management

CDs

: Certificate of deposits

CIC

: Credit information centre

GSO

: General statistic office

IRR

: Interest rate risk

RSA

: Interest rate sensitive asset

RSL

: Interest rate sensitive liability

SBV

: State Bank of Vietnam

VND

: Vietnam dong

WTO

: World trade organization


1

Chapter 1: Introduction
1.1 Rationale
At the end of 2007, Vietnam was confronted with the economy
overheating resulting from massive capital inflows. The government
had to push out VND to absorb approximately 10 billion US dollar and
increased monetary base in the economy resulting in double-digit
inflation appearance. At the same time, global financial crisis has been
occurred. The financial crisis, originating in the United States, affected
foreign demand and global financial market. The international prices of
commodities exported by Vietnam were on a declining trend, export
orders for garments and other industrial products collapsed, and a
slowdown in manufacturing became noticeable. The government
reacted swiftly to economic shock. Subsequent stimulus measures have
prevented a collapse of economic activity and have put the economy on
a recovery track. Vietnam had to raise massive of financial and
monetary polices to rebalance the economy. The government has

applied a tightened monetary policy which demonstrated the
government‘s resolution in maintaining the priority policy on inflation
control and growth. Some of those were issuance of central bank note,
increasing reserve requirement ratio and interest rate hikes to withdraw
money out off economy. SBV applied strict tightened monetary
policies through the prime rate adjustment. They increased prime rate
up to 12% in June 2008 and reached to 14% in July 2008, lasting until
December of 2008. In the last quarter of 2008, when the inflation was
in controllable situation, SBV changed their monetary policies in order
to accelerate for growth objective ahead. The government opened their


2

monetary supply basing on observation, control, and flexible reactions
to unforeseen outside impact. The State Bank of Vietnam greatly
relaxed monetary policy from November 2009 onwards, confirming a
trend cautiously initiated in June. They have implemented to bring
down the prime rate to 7% since the first quarter of 2009 and cut down
the required reserve ratio. Since that time, the government has
continuously followed flexible policies in order to stabilize economy.
The subsequences of financial crisis and substantial adjustment
of government policies have pushed commercial banks in Vietnam into
interest rate race which been lasted competitively. After SBV
deregulated ceiling deposit interest rate of 12% and boost basic interest
rate up by 12%, actually up by 14%, lending interest rate had been up
by 18% as well. Most of banks had increased mobilizing interest rate to
attract capital and borrowed from inter-bank market to meet liquidity
requirement for solving their difficulty situation. During to the crisis
period, inter-bank market rate had reached to peak of 20% and lending

interest rate had increased up by 21%. Most of commercial banks had
fallen into difficult situation of facing interest rate risk when interest
rate has been moving in large spread and uncontrollable. They had to
adjust their profit plan and increase their capital adequacy for meeting
the safety requirement.
Various later analyses showed that one of reasons leading to
heavily impacts of financial crisis to Vietnamese banks is that a number
of Vietnamese banks have ignored risk management assignments,
especially in interest rate risk management which directly effects to
interest income of banks. Because they have been lack of interest rate
risk monitoring, measuring and controlling methods and business


3

contingency plan as well, so they have been bearing interest rate
passively
Therefore, a measurement of interest rate risk should be learned
and applied in order to limit the interest rate risk impacting to the
interest income in the condition of interest rate fluctuation,
unpredictable financial market problems and government policies for
oriented- market economy.
In order to meet the regulation of Basel II, principles for the
management and supervision of interest rate risk, 2004, Vietnamese
banks should not only establish rate management process including
business strategy, system of internal controls but also incorporate the
supervisory treatment of interest rate risk in the banking book. In
particular, Vietnamese banks should have got “effective interest rate
risk measurement, monitoring and controlling function within the
interest rate risk management process”

1.2 Problem statement
Vietnam has to open financial market in the rout of entering
WTO, so the requirement of risk management in the banking sector
becomes more necessary for integrating global financial business and
competing with foreign banks. The application of risk management
standard is not only essential for asset and liability management but
also helpful for raising capability of banking management.
The interest rate risk management is properly a part of asset and
liability management. An important purpose of asset and liability
management is that how to adjust the items on balance sheet and offbalance sheet in order to mitigate the effect of changing interest rate to


4

projected profit. Therefore, the problem is that how to measure the
interest rate risk for mitigating the impact of interest rate to interest
income.
According to interest rate risk measurement of a number of
banks in Vietnam, the interest rate risk has been measured by gap
analysis. The dollar-value gap analysis, the simple form measurement,
is the dollar value of those assets on a bank's balance sheet that are
sensitive to changes in interest rates, less the bank's liabilities that are
sensitive to interest rate changes in specific time band. The gap
between sensitive assets and sensitive liability reflect bank sensitivity
position. The changes in net interest income can be calculated by
multiply dollar volume gap with the changing of interest rate. However,
it is simple and do not meet the need of the interest rate risk
management.
To recover the weaknesses of the dollar gap analysis, duration
gap analysis, a more sophisticated form of interest rate risk

measurement, can be applied. The duration gap is a measure of an
asset’s or a liability's sensitivity to a given change in interest rates. A
bank's duration gap is the dollar-weighted duration of the bank's assets
less the dollar-weighted duration of the bank's liabilities. Banks with a
positive duration gap see net interest margins widen if interest rates
were to rise (or to see net interest margin erode if rates were to fall).
Banks with a negative gap would see net interest margin erode if rates
rise (or would see net interest margin widen if rates were to fall). The
duration gap is not only useful tool for measuring how net worth of a
bank will change if interest rate move up or down by 100 basic points,
but it also serves for hedging risk with derivatives. Basing on the


5

duration method, banks can manage and forecast the interest rate risk
that effects to their equity and capital. However, like the dollar gap, the
duration gap is also a statistic approach which maybe inflexible when
some factors in that model change.
An approach which should be studied and applied is simulation
model that is more dynamic and retrieve all weaknesses of dollar gap
and duration gap. Some large banks in the world use it as virtual
advanced method for measuring interest rate risk basing on historical
data and powerful analysis of computer. Simulation is a complicated
method and can forecast rather exactly what arise in future for each
economic scenario. Simulation analysis utilizes computers to measure
IRR and the impact of different funding or business strategies under
numerous interest rate scenarios. Simulation analysis combines an
institution’s current financial position with expected future events to
quantify the impact that changing interest rates would have on

projected earnings and market value of equity.
There are two types of simulation analysis that may be carried
out to evaluate IRR: income simulation and market value of equity
simulation. Because income simulation is useful, forward-looking
analysis and a considerable enhancement over the "static" analysis of
gap and duration techniques, it is suggested as main method in
Vietnamese banks which is used to forecast how net interest income, as
well as net income, changes in response to changes in interest rates.
Therefore, this study analyzes the weaknesses of recent interest
rate risk calculation as scientific bases to suggest income simulation to
measure interest rate risk and assesses institutions interest position for


6

managing interest rate risks. Relying on that analysis, the banker can
make their decision about trading securities, investment or lending
activities every day effectively.
1.3 Research questions
The research problems defined above lead to following research
questions:
How do Vietnamese banks measure interest rate risk?
What are the advantages and disadvantages of current
interest rate risk methods?
How is interest rate risk measured by income simulation
model in context of Vietnam?
1.4 Research objectives
In solving research problems, this study has research objectives:
To identify appropriate method for measuring interest rate
risk

To contribute some knowledge to interest rate risk
management
1.5 Significance
Vietnamese banks can use income simulation as principal
measurement to manage asset and liability on balance sheet and offbalance sheet to ensure that their interest income moving in guideline.
Income simulation can be learn as an appropriate measurement
which the bank need to deal with under Pillar 2 of Basel II, particularly
represented in Principles 12 to 15


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1.6 Research Methodology
Zikmund (1997) discusses three types of business research:
exploratory, descriptive and causal research. Exploratory research is
conducted to clarify and define the nature of problem. Descriptive
research is designed to describe the characteristics of population or
phenomenon. Causal research is conducted to identify cause-and-effect
relationship among variables where the research problem has been
narrowly defined.
Choosing a type of research depends upon research questions
that research wants to answer. This research study is to analyze what
Vietnamese banks do to measure interest rate risk, evaluates the
performance of recent methods and apply earning simulation model
into interest rate risk calculation. Therefore, “Exploratory” is the
appropriate type of research.
Selecting research design is the next step after choosing type of
research. There are four types of research design: survey; experiments;
observation and secondary data Zikmund (1997). Basing on the
advantage and disadvantage of each research design, survey method is

used in this research.
Survey was chosen in this research to investigate the
performance of Vietnamese banks in terms of interest rate measurement
and identify the advantage and disadvantage of recent method. A
questionnaire was designed and directly asked to interviewees to collect
data related to the performance of their bank in terms of interest rate
risk calculation, how they do to measure interest rate risk and the


8

information form the survey maybe more appropriate in case lack of
secondary data.
For the purpose of illustrating clearly viewpoint of researcher,
secondary data such as financial statement, interest rate and relative
items available from website or collecting directly from Vietnamese
banks was used in this study.
1.7 Structure of research
This study consists of five chapters. Chapter 1 introduces the
research including the rationale of study, the problem of research,
research questions, research objectives and significance of study. The
second chapter overviews some theories of interest risk management.
Chapter 3 reviews the methodology of research. Chapter 4 analyses
data and presents the findings of research. The last Chapter points out
the conclusions of research and recommendations.


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Chapter 2: Literature review

2.1 Asset/Liability Management
Asset liability management is a common name for the complete
set of techniques used to manage risk within a general enterprise risk
management framework. Asset/Liability Management is defined as the
set of technique to control value creation and risks in a bank, J. Demine
(2002).
As define of Asset/Liabilities Management, Beton E.Gup (2005),
chapter 5, the process of making daily decision such as making loan,
buying and selling securities, investing or lending activities about
composition of asset and liabilities and the risk management is know as
Asset/Liabilities Management. Risk management is also a part of ALM.
Hence, the purpose of ALM is partially to control the size of bank’ net
interest income and also to consider the affects of the change on the
value of balance sheet items.
Peter Rose (1999) expressed that Asset and liability management
is the financial risk management of any financial institution. The assetliability management formulates strategies and takes actions that
maximize the risk adjusted returns to shareholders over the long run.
Following the viewpoint of Peter Rose (1999) in his book Asset and
Liabilities Management, the principal goals of asset and liability
management are to maximize, or at least stabilize, the bank’s margin,
or spread between interest revenues and interest expenses, and to
maximize, or at least protect, the value (stock price) of the bank, at an
acceptable level of risk


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2.2 Interest rate risk
As defined in Basel II (2004), “interest rate risk is the exposure
of a bank’s financial condition to adverse movements in interest rate.”

A bank can accept interest rate risk as a normal part of banking activity.
However, excessive interest rate risk can affect significantly to earning
and capital base.
Interest rate risk is also a concern of Asset and liability
management. When interest rates change, the changes affect banks’
interest income of loans and securities, and interest cost of deposits and
other bank borrowings. A fluctuation of interest rates also changes the
market value of a bank’s assets and liabilities, thereby changing the
bank’s net worth (that is the value of the owners’ investment in the
bank). Thus, the changes of interest rate affect both a bank’s balance
sheet and its statement of income and expenses.
2.3 Interest rate risk structure
As defined in the Basel paper, July 2004, the four types of
structural interest rate risk are repricing (mismatch), yield curve, basis
risk and optionality.
Repricing or mismatch risk is created when fixed rate loans are
funded by variable rate borrowings or when fixed rate deposits fund
variable rate loans. This type of risk generates the largest amount of
earnings variations.
Yield curve risk is the result of fixed rate loans being funded by
fixed rate deposits of a different term. Yield curve risk usually does
not affect earnings variation because the terms are beyond the 12-


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month earnings period.

Yield curve risk requires an equity-at-risk

measure.
Basis risk arises when variable rate loans are funded by variable
rate deposits that change rates at different speeds. When variable rates
move at different speeds, earnings variation rises.
Finally, optionality risk is formed from options embedded in
many products. Optionality risk changes the maturity or the payment
profile of products. As such, optionality can impact both the earnings
and equity measures
2.4 Interest rate risk Measurement
A question is raised that how to measure interest rate in risk
management. An effective risk management process is that how to
measure interest rate risk, control interest rate risk within prudent levels
in order to keep banking on safety and soundness.
To manage interest rate risk, banks have to measure how much it
affects bank income and net worth. As concern on The Management of
Risk, Beton E.Gup, Chapter 5, there are three technique of dealing with
interest rate risk. They are dollar gap, duration gap and simulation.
The traditional measure of interest rate risk is the dollar gap
(referred to as the funding gap or the maturity gap) between assets and
liabilities which based on the repricing interval of each component of
balance sheet. It is the earliest way and easiest to understand.
To compute dollar gap, assets and liabilities would be grouped
into interest rate sensitive or non interest rate sensitive. Interest rate
sensitive assets are those that reprice within some defined period and


12

interest rate sensitive liabilities are those that reprice in the same
period. With each category, the gap is expressed as dollar amount

minus liabilities.
So dollar gap is the different between the dollar amount of
interest rate sensitive assets (RSA) and the dollar amount of interest
rate sensitive liabilities (RSL)
Gap($)= RSA($)-RSL($)
The gap can have a positive value or negative value. A bank
would have a positive gap if its RSA were higher than RSL that is call
asset sensitive. In contrary, that bank is liabilities sensitive.
If bank is sensitive asset, their interest income will increase when
interest rate increases and vice versa.
The effects of changing interest rate on net interest income for
banks with different position can be calculation as followed formula:
NII= RSA.

I – RSL

I= Gap.

I

Where:
NII

is the expected change in the dollar amount of net

interest income
I

is the expected change in interest rate in percentage points.

The maturity gap suggests how a bank responds to a given
change in interest rate. For example, smaller banks and thrifts have had
longer average maturity on the asset side than the liability side. They
often use short-term deposits to fund long-term assets such as fix-rate
mortgage–loan. They would have a large negative maturity gap in
short-term brackets and large positive maturity gap in long-term


13

brackets, meaning that short-term liability exceed short-term assets and
long –term assets exceed long-term liability. In this situation, a rise in
interest rate would lead to a higher cost of fund before loan rate could
adjust and lowering their profits.
However, this approach omits some factors including cash flow,
unequal interest rate on asset and liability and initial net worth.
Peter Rose (1999), Chapter 6, also concerned some problems
with dollar gap management. Firstly, interest rates paid on liabilities
tend to move faster than interest rates earned on assets. Secondly,
interest rate attached to bank assets and liabilities do not move at the
same speed as market interest rates. Thirdly, point at which some assets
and liabilities are repriced is not easy to identify. At last, interestsensitive gap does not consider impact of changing interest rates on
equity position.
Advantage theory for this problem is duration concept. This
concept, first introduced by Ferderick R. Macaulay in the pricing of
the interest sensitivity of bond, considers the timing of cash flows both
before and at present asset and liability maturities. Duration is defined
as present –value weighted time to maturity.
Macaulay duration was formulated in 1938. Macaulay duration
involves three simple calculations:

Determine the time remaining until the payment of receipt of
each cash flow from an instrument is determined.
Weight those time periods by multiplying each by the ratio of the
present value of that cash flow to the instrument's total present
value.


14

Calculate the sum of the weighted time periods.
Macaulay duration = ∑t =1
n

Modified Duration =

PV (CFt )
xt
TPV

Macaulay' s Duration
(1 + i)

∆P
≅ - Modified Duration × ∆ i
P

Modified Duration gives an estimate of price volatility
t = the number of periods remaining until the receipt of cash flow
CFt = the cash flow received in period t
PV = the present value function 1/(1+r)t

TPV = total present value of all future cash flows
n = the number of periods remaining until maturity
However, the Macaulay duration is accurate only if the yield curve is
flat and the shifts in the yield curve are parallel.
Duration gap is based on Macaulay’s concept duration. The
excellence introduction about duration theory are provided by George
G.Kaufman (1985), and French (1988), and on more academic plane,
Grove (1974). Gerald O Bierwag (1987) also researched in detail about
duration gap in his book Duration analysis: Managing interest rate
Risk. Beirwag and G.Kaufman (1985) attempt to clarify duration for
financial institutions by providing several single-factor duration gap
equation because different duration gap equation should be adopted for


15

alternative “target” account which would be immunized by the
institution.
Shaffer (1991) also concerned over the restrictive condition of
flat yield curve in using Macaulay’s duration and added that change in
interest rate must be small for immunization to be effective. He
concluded that the restrictive conditions were one reason why many
financial institutions had been hesitant to adopt duration gap as means
of controlling interest rate risk.
Cherin and Hanson (1997) examined the immunization strategy
of matching the duration of a fixed income portfolio with investment
horizon. They pointed out that most illustration had been concentrated
on the duration of principal payments but ignored the duration of
accumulated interest payments. More specifically, these illustrations
presented a change in principal value when interest rates change, but

did not show a similar change in the value of accumulated interest. So
they suggested that a more compatible treatment would be assume both
principal and accumulated interest are in bonds that are duration
matched to the investment horizon, thus resulting in an increasing in
the value of both principal and accumulated interest when interest rate
declines.
Kristin L Beck, Elizabeth F. Goldreyer and Louis J. D’Antonio
(2000) demonstrate that the yield and duration of a portfolio of fixed
income instrument are not necessarily equal to the weighted average of
the yields and duration of each individual asset. The yield and duration
of bank’s portfolio of fixed income would be determined by portfolio’


16

cash flow. In addition, they directly integrated both fund management
and capital adequacy with portfolio.
Beton E .Gup and James W Kolari. 3th,(2005) also introduced
his theory in commercial banking. Duration is defined as the weighted
average time to received all cash flows from a financial instrument. The
duration gap is the difference between the duration of assets and
liabilities. It is a measure of interest rate sensitivity to show how
interest rate affect the market value of bank assets and liabilities and its
net worth or equity. The net worth is the difference between assets and
liabilities. Therefore, the changing in market value of assets and
liabilities will change the value of net worth or equity.
By using duration, net worth of bank can be calculated as formula
NW= A-L
NW=

A–

L

Market Value of equity should be the gap between the present value of
assets and the present value of liabilities
NWMV = APV – LPV
APV: present value of assets
LPV: the present value of liabilities
As mentioning above, To calculate the duration of asset
n

DA = ∑wi * DAi
i =1

Calculation the duration of liabilities
n

D L = ∑ w i * D Li
i =1