Rate Level Risk - Type of Interest Rate

During a given period there is possibility for restructuring the interest rate levels either due to the market conditions or due to regulatory intervention. This phenomenon will, in the long run, affect decisions regarding the type and the mix of assets/liabilities to be maintained and their maturing periods.

The present interest rate restructuring taking place in the Indian markets is a very good example of this aspect. The Reserve Bank of India which is the apex body regulating the Indian monetary system, has been lowering the Statutory Cash Reserve Ratio for banks in a phased manner from 12% to 8% since 1996. Every time the CRR is lowered, there is an increase in the liquidity which further results in lowering of the interest rate levels. A 2% cut in the CRR from 10% to 8% in the Busy Season Credit Policy announced in October 1997 was immediately followed by a cut in the PLR/interest rates of Banks and FI’s. The risk that arises due to this reduction can be understood from the fact that the revised rates of interest will be applicable to all the new deposits, which will lower the marginal costs of funds. However, the affect will be seen on all the existing assets. Consequently the loss of interest income on assets is likely to be higher than the reduction in the interest cost of deposits leading to lower spreads.