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Investors’ Notebook – Rates changes’ impact on earnings

By Zororo Mukungunugwa

IN line with our indications in the previous article, changes in interest rates can result in some adverse effects both on a bank’s earnings as well as its economi

c value.

This has resulted in the advent of two separate but complementary perspectives of assessing a bank’s interest rate risk exposure.

Earnings perspective:

Under the earnings perspective, the focus of analysis is the impact of changes in interest rates on the bank’s reported earnings. This is the traditional approach to interest rate risk assessment and is being used by quite a number of financial institutions.

Variation in earnings is an important point of reference for interest rate risk analysis because reduced earnings or outright losses can threaten the financial stability of an institution by undermining its capital adequacy and also by reducing market confidence in the institution.

In this regard, the component of earnings that has traditionally received the most attention is net interest income, which is the difference between total interest income and total interest expenses. This focus reflects both the importance of net interest income on the bank’s overall earnings and its direct and easily understood link to changes in interest rates.

However, as banks have expanded increasingly into activities that generate fee-based and other non-interest income, a broader focus on overall net income – incorporating both interest and non-interest income and expenses – has become more common.

The non-interest income arising from many activities such as loan servicing and various asset securitisation programmes can be highly-sensitive to market interest rates. For example, some banks provide the servicing and loan administration function for mortgage loan pools in return for a fee based on the volume of assets it administers.

When interest rates fall, the servicing bank may experience a decline in its fee income as the underlying mortgages prepay. In addition, even traditional sources of non-interest income such as transaction processing fees are becoming more interest rate sensitive.

This increased sensitivity has led both bank management and supervisors to take a broader view of the potential effects of changes in market interest rates on bank earnings and to factor these broader effects into their estimated earnings under different interest rate environments and

Economic value perspective: variation in market interest rates can also affect the economic value of a bank’s assets and liabilities. Thus, the sensitivity of a bank’s economic value to fluctuations in interest rates is a particularly important consideration for shareholders, management and supervisors alike.

The economic value of an instrument represents an assessment of the present value of its expected net cashflows, discounted to reflect market rates.

In this sense, the economic value perspective reflects one view of the sensitivity of the net worth of the bank to fluctuations in interest rates.

Since the economic value perspective considers the potential impact of interest rate changes on the present value of all future cashflows, it provides a more comprehensive view of the potential long-term effects of changes in interest rates than is offered by the earnings perspective.

This comprehensive view is important since changes in near-term earnings – the typical focus of the earnings perspective – may not provide an accurate indication of the impact of interest rate movements on the bank’s overall positions.

Thus the ability to assess interest rate risk of a financial institution is critical as it allows appropriate risk management techniques to be adopted.

Some of the financial institutions collapsed due to poor risk management practices resulting in them being exposed to such risks as interest rate risk.

Zororo Mukungunugwa is the general manager (finance) for Imperial Asset Management Company and can be contacted on mukungunugwaz@imperialasset.co.zw

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