Understanding and managing interest rate risk at banks

Banks in many countries hold significant quantity of bonds issued by their sovereign. This nexus of bank balance sheets with the sovereign debt can amplify in a two-way loop the effect of a rise in sovereign debt yields on banks and vice-versa. The rise in sovereign debt yields tends to be episodic, exhibiting conditional volatility, and banks need to manage this risk proactively to dampen the two-way loop. Lessons are drawn from this perspective for understanding and managing of interest rate (or ‘duration’) risk at Indian banks from their holdings of government securities. Moral hazard implications of regulatory forbearance policies when the two-way loop materializes are also discussed.