Implications of the interest rate liberalization for financial institutions and interest rate risk management

Abstract

It is widely accepted what the interest rate policy plays an important role in achieving both an internal and external balance and ensuring efficient allocation of financial resources in an economy. Interest rates influence the demand and supply of investible resources and the decisions of economic agents invest and consume. They are at the center of any policies that the monetary authorities may choose to undertake to influence business conditions and economic activity. For a long time, the interest rates in India were under the administered regime of the Reserve Bank of India and the government if India. However, in the recent pasts, some actions have been taken to liberalize the structure of the interest rates for banks and developmental financial institutions. The Chakravarty committee in 1985, the Vagul Committee in 1987 and the Narasimham committee in 1991 has played an important role in setting on the liberalization movement. The late 80s and the beginning of the 90s have witnessed various reforms in the financial sector. Interest rate liberalization being one of them. There has now been a movement from the rigidly administered interest rate policies – with multiple complex structures – to a simpler, partial free market rates. The recent liberalization measures symbolize the winds of change in the interest rate policy in India and the likelihood of the arrival of the free market forces in determination of interest rates. The pace of reforms seems to continue. Financial institutions operations are very much dependent on the structures and policies in interest rates. The spread between the deposit and the lending rates is the only playground for financial institution to control their profitability. The interest rates in a market determined environment are bound to increase. Thus, cost of mobilization of resources for financial institutions will go up, hampering the resource mobilization and profitability of these institutions. The free market rates will also have an impact on the economy – changing the investment pattern in the industrial sector, the financing choices and the investment trend of the investors. Liberalization has to be aided with suitable regulatory policies for smooth and efficient functioning of the financial sector. The Reserve bank of India needs to ensure a healthy competition among the operators in banking sector by making available market based instrument of monetary control, speedy and reliable accounting procedures, settlement arrangements and policy research. With the market determined structure, interest rates will invariably become more volatile. Thus, the risk due to interest rate fluctuation has an additional importance. The unexpected changes in market interest rates affect the act interest income and the market value of financial instruments, resulting in unanticipated losses. Therefore, to manage the risk due to interest rates, some of the techniques like the duration approach, the gap model, the interest rate swaps, options and futures, and simulation play a very important role in financial institution management. Although the interest rates have been partially deregulated, the deregulated will continue and widen in the coming years. It is high time that the financial institutions in India adopt these techniques to protect their balance sheet operations from the variation in the interest rates.