Survey_GRW_2003

Abstract

We develop a model that captures the essential characteristics of a universal bank. In order to reduce the complexity of the model its focus is limited to interest rate products either belonging to the banking book or to the trading book and to the interest rate risk management. Other products and other risks can be included in extensions of the model. The model bank can be described as a set of two portfolios, the banking book and the trading book. The portfolio of the banking book consists of loans, bonds, own bond issues, term deposits and interest rate swaps, while the portfolio of the trading book consists of bonds, interest rate swaps and term deposits. In order to optimise the bank’s activities in the financial markets, interest rate swaps are only traded externally out of the trading book and internally between the trading book and the banking book. Term deposits, on the other hand, are only traded externally out of the banking book and internally between the banking book and the trading book. Bonds are directly bought into and sold out of both the banking and trading book. Two banking strategies will be analysed. Under the first strategy, the bank is fully hedged against any movements of interest rates. Obviously, we expect no gains or losses from changing interest rates in the economic performance as well as in the financial accounting results under an appropriate set of accounting rules. Under the second strategy, the bank hedges only partially against changing interest rates. Here we expect gains or losses directly correlating to changing interest rates in the economic performance and financial accounting results. Under both strategies we apply micro hedges to reduce the interest rate risk from fixed rate assets to short term interest rate exposure. The short term interest rate exposure is hedged on a portfolio level by term deposits, which also provide the funding of the assets. The individual transactions of the model bank under both banking strategies are displayed in Table 1 for a scenario of decreasing interest rates using actual market data from the period 1994 to 1998. The same transactions are used under the scenario of increasing interest rates, however, with different interest rate coupons due to different market rates, again based on actual market data from the period 1987 to 1991. The number of transactions for each product category is kept to a minimum so that the differences resulting from applying different sets of accounting rules can be more easily identified. For each transaction, the nominal volume is displayed in Table 1 together with the nominal rate of interest and the maturity in parentheses. All transactions are contracted at market rates, no product has a premium or discount.