新西兰Finance作业：How banks manage risk by monetary loan policy a(2)

2.3.2 Causes of basis risk

There are many reasons for basis risk. The frequent adjustment of the benchmark interest rate by the Chinese government is an important reason (Chen, Wei, Zhang & Shi, 2013). For example, since 2012, interest rate cuts have been carried out seven times in a row. The maximum spread between RMB deposits and loans for a one-year period is 3.6, and the minimum is 1.8 percentage points (Chen, Matousek & Wanke, 2018). Continuing interest rate cuts led to a serious shortage of interest reserves for domestic commercial banks. The situation was specially serious in the banks in which three-year and five-year regular savings deposits accounted for a particularly high proportion, and their negative impact continued until 2020 (Tan & Floros, 2018). In the process of interest rate liberalization in China in future, fierce market competition among banks will lead to increased interest rate volatility. When commercial banks adjust the deposit and loan interest rate according to changes in the benchmark interest rate, the interest rate basis risk will be greater, which will inevitably affect the banks’ normal interest income (Aydemir & Ovenc, 2016).

2.3.3 Causes of yield curve risk

The interest rate of China’s current issuance of treasury bonds is higher than that of bank deposits during the same period (Chen, Wei, Zhang & Shi, 2013). There is room for interest rate spreads between interest rates of treasury bonds and interest rates of deposits of the central bank. Banks have used the loan that was originally used for enterprises to purchase a large amount of national debt to obtain interest income. Not only the revenue increases substantially, but also the risk is zero. In recent years, the proportion of bond assets in total assets in commercial banks has been increasing. In the short term, this can bring considerable opportunistic gains to banks, but in the long term, if the central bank raises the interest rate, in the situation that the turnover rate in the secondary market of bonds is low, commercial banks have to bear greater interest rate risk (Chen, Matousek & Wanke, 2018).

2.3.4 Causes option risk

Potential risk of option risk interest rate refers to changes in commercial banks’ net interest income caused by depositors’ advance withdrawal of time deposits or borrowers’ returning loans in advance when there are changes in interest rates (Gopalan & Rajan, 2017). In China, many of banks’ deposit and loan businesses have options features (Aydemir, R., & Ovenc, 2016). Holders of options always exercise their power when they are beneficial and it is unfavorable to the sellers. Therefore, commercial banks in China will face varying degrees of potential options risks. Regardless of whether the real interest rate change is positive or negative, as long as the nominal interest rate changes, it may prompt borrowers to pay in advance unexpired loans or depositors to withdraw unexpired deposits in advance (Chi & Li, 2017). In particular, when customers repay loans in advance, and banks do not receive relevant income to make up for the risks that the banks bear, and the bank systems have accumulated a large number of option-type risks. The gradual release of interest rates will undoubtedly make it more difficult for banks to control potential options.

China has lowered interest rates on deposits and loans for seven times since 2012, many companies have repaid unscheduled loans in advance to ask for loans at lower interest rates to reduce financing costs; at the same time, individual customers’ interest-rate risk awareness has increased, and they have also repaid unexpired loans and ask for a loan with lower interest rates, coupled with a lack of policy restrictions for China's current default behaviors for customers' early repayment, therefore, option risk is increasingly prominent in China's commercial banks (Tan & Floros, 2018).

3.0 Conclusion

Interest rate risk is currently one of the major risks faced by Chinese banks. The interest rate risks faced by banks in China include four categories: repricing risk, basis risk, yield curve risk, and option risk. The risk of repricing is related to structural mismatches in the maturity period of assets and liabilities that are common in China's banks. Basis analysis is related to the frequent regulation of interest rates by the Chinese government. Yield curve risk is related to the large number of Chinese banks’ purchase of government bonds to earn interest income. Option risk is related to the lack of policy restrictions on the current default behaviors of customers’ early repayment. Finally, the author proposes suggestions on how banks in China use monetary loan policy and derivatives to effectively reduce and manage interest rate risks, the suggestions include optimizing investment portfolios, improving interest rate development strategies, using interest rate derivatives to manage interest rate risks and asset securitization.

4.0 Recommendation

Based on relevant literatures and the author's work experience in XX Bank, the author made the following recommendations for how XX Bank manages interest rate risk.

4.1 Monetary loan policy

4.1.1 Optimizing investment portfolio

Optimizing investment portfolio strategies helps to manage and control repricing risk and yield curve risk (Tan, 2016). The most direct way to change interest rate sensitivity gap is to adjust the time from the interest rate adjustment date for certain items in the assets or liabilities. If the interest rate sensitivity gap is positive, that is, the interest rate sensitivity asset is greater than the interest rate sensitivity liability, then banks can sell the short maturity bonds held by the banks and then purchase long-term bonds. Conversely, if the gap is negative, it can adjust long-term bonds to short-term bonds. Of course, in every decision to change investment decisions, decision makers must be aware of how the decisions will affect the matching of assets and liabilities and the impact on the trend of the sensitivity gap. Using simulation software to assist in decision-making is a more feasible method. Commercial banks often face the problem of income loss when they use investment portfolio strategies (Chi & Li, 2017). After selling bonds, they face the risk of reinvestment, such as the sale of long-term bonds with higher interest rates. At this time, market interest rates are low. After buying short-term bonds, it will have a greater impact on the next year's revenue, this situation is often difficult to be accepted by banks, and it needs to find other ways to solve the interest rate risk problem.

4.1.2 Strategies to improve interest rate formulation

Strategies of improving the interest rate system help to manage and control basis risk and option risk (Tan & Floros, 2018). Pricing directly affects the size, structure, and maturity of assets and liabilities, it can prevent interest rate risk by changing the pricing level and method of a commercial bank. On the one hand, banks can change their scale by raising or lowering the deposit and loan interest rates for certain periods. For example, by increasing the three-year and five-year deposit rates, attracting depositors to choose more long-term deposits; on the other hand, by changing interest rate adjustment methods to directly change the maturity period, such as determining the medium and long-term loan interest rates yearly, makes long-term loans become interest-rate sensitive assets.

There is a major shortcoming in changing banks' interest rate risk by formulating new interest rate strategies. It is that it takes a considerable period of time before banks’ total interest rate risk cash changes significantly. Of course, in order to speed up the effects of interest rate policy changes, banks can provide deposit rates above the market level and loan interest rates below the market level. In addition, banks can also relax credit standards for new borrowers in order to facilitate the expansion of new loan activities. Of course, with these measures, managers must also consider the results of reduction in interest rates and increased credit risk.

4.1.3 Asset securitization

Using asset securitization helps to solve repricing risk, basis risk and option risk.

Asset securitization mainly refers to the reorganization of credit assets (such as bank deposits, corporate accounts receivables, etc.) that are less illiquid but have future cash flows to form asset pool and use them as a basis for the issuance of securities (Délèze & Korkeamäki, 2018). As a structured financing method, asset securitization is through the joint participation of various stakeholders to enable various contracts (such as transfer contracts, guarantee contracts, etc.) established by their respective commitments to support each other and restrict each other, ultimately achieving the results of risk sharing and getting what they need. Assets in balance sheets are transferred to the capital market in the form of securitization and traded. In effect, the interest rate risk is transferred from banks to investors in the capital market, making interest rate risk be avoided. Advantages of asset securitization are not only the transfer of interest rate risk, but also increase of the liquidity of assets.

4.2 Using interest rate derivatives to manage interest rate risks

4.2.1 Interest rate swap

For banks in China, since the source of funds is mainly residents’ deposits and the deadline is short, the issue of medium- to long-term fixed-rate loans will generate a large interest rate gap (Hou, Wang & Zhang, 2014). It is urgently necessary to sign a fixed-rate loan contract with customers to achieve interest rate risk hedge in the interest rate swap market. The RMB interest rate swap is an action that the two parties agree to exchange cash flow according to the agreed amount of RMB principal within a certain period of time in the future. One party's cash flow is calculated based on the floating interest rate, and the other party's cash flow is calculated based on the fixed interest rate. When different market players judge the interest rate trends differently, they exchange transactions. This is the most effective tool for sharing the market risk among the participating entities. At present, China's banking system has accumulated a huge interest rate risk and has laid down hidden risks for financial stability (Tan & Floros, 2018). The efficient hedge function of interest rate swaps is conducive to commercial banks’ evading the interest rate risk for huge debt assets, and it is also conducive to resolving the risks caused by mismatching the maturity of commercial banks' asset liabilities through interest rate swap transactions.