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Asset/Liability Management III Instructor: Ernest Swift
Georgia Banking School Course #309
Objectives
Identify the concepts and terminology used in asset/liability management
Describe the importance of interest rate risk management to banks
Identify techniques to assess and manage the possible effects of interest rate movements on bank earnings
Explain how to calculate the effect of interest rate changes on the equity value of the bank
Discuss how to manage interest rate risk in BankExec
Page 2 of 3
Interest Rate Risk
Interest rate risk is the prospect that the bank’s
earnings or the value of its equity will be adversely
affected by market interest rate changes
Reinvestment and refinancing risk
– Rate changes can affect the yield on earning assets
and the bank’s cost of funds differently
Market Risk
– Rate changes can affect the values of the bank’s
assets and liabilities by different amounts
Page 3 of 3
Sources of Interest Rate Risk
Repricing risk: assets and liabilities take on new
rates at different times
Basis risk: changes in market rate differentials
used in pricing assets or liabilities
Yield curve risk: the position or slope of the yield
curve changes
Embedded options risk: customers alter the
bank’s cash flows via prepayments or
withdrawals
Page 4 of 3
Asset Liability Management
Purpose: Structure the size and composition of
the bank’s balance sheet to optimize earnings
and enhance equity value of bank
Manage and mitigate liquidity and interest rate
risk within pre-specified tolerance ranges
Plan, organize, and control asset and liability
volumes, mix, maturities and durations
Page 5 of 3
Asset-Liability Management
Earnings Focus
Managing a bank’s asset-related cash flows
relative to its liability-related cash flows
Management of a bank’s net interest income (or
margin) and its volatility
Valuation Focus
Management of the value of the bank’s equity
and its volatility
Page 6 of 3
ALM: An Earnings Focus
Net interest income (NII)
= Interest income minus interest expense
Net interest margin (NIM)
= Net interest income ÷ earning assets
Note
NII and NIM can and typically will
fluctuate due to changes in market
interest rates
Page 7 of 3
Determinants of NII/NIM
Individual rates on assets and liabilities
Volume of earnings assets
Composition of assets and liabilities
NII = NIM X Earning Assets
Page 8 of 3
Impact of Changing Rates
Are assets and liabilities “matched” from a
portfolio perspective?
Does the timing of cash-flow adjustments match
on both sides of the balance sheet?
GAP and Earnings Sensitivity Analysis are
measures of the amount of interest rate risk
(IRR)
Page 9 of 3
Steps in GAP Analysis
1) Select series of “time buckets” for determining
when assets and liabilities will reprice
2) Group assets and liabilities into these “buckets”
3) Calculate the GAP for each “bucket ”
4) Estimate the change in net interest income
given an assumed change in interest rates
Page 10 of 3
Rate Sensitivity Gap
Gap
= Rate sensitive assets – Rate sensitive liabilities
An asset or liability is rate sensitive over a given
time horizon if:
– It matures
– It is a variable-rate instrument
– It prepays or is withdrawn
Cumulative Gap: Sum of incremental gap buckets
Relative Gap = Gap/Total assets
Page 11 of 3
Rate Sensitivity Classification
Easy Cases
Fixed maturities and high costs for prepayment or withdrawal
Variable-rate instruments
Hard cases
High prepayment prospects
No specified maturity
Classify as to likelihood of
repricing, not capacity to reprice
Basic
Rule:
Page 12 of 3
GAP and NII
Change in NII = (Change in rate) X GAP
Assumes that GAP is correctly measured
Assumes that all rates move by same amount
– Parallel shift in yield curve
– Rates on individual assets and liabilities change by
like amounts
Page 13 of 3
GAP
GAP= 0 “immunizes” bank’s net interest income
to effects of interest rate changes
If GAP is positive:
– Rate increases result in higher NII
– Rate decreases result in lower NII
If GAP is negative:
– Rate increases result in lower NII
– Rate decreases result in higher NII
Page 14 of 3
Sample Bank Balance Sheet
GAP is -$100 million
Earning Assets Int. Bearing Liab.
Rate-sensitive 500 7% Rate-sensitive 600 3%
Non-sensitive 350 9% Non-sensitive 220 5%
Non-earning 150 Non-int. bearing Liab. 100
Equity 80
Total 1000 1000
GAP = 500 – 600 = -100
NII = (500 x 0.07 + 350 x 0.09) – (600 x 0.03 + 220 x 0.05) = 37.5
NIM = 37.5 / 850 = 4.41%
Page 15 of 3
Rates Up 1% From Base Case
NII falls by $1 million
(GAP X rate change) = – $100 mil X 1% = - $1 mil
Earning Assets Int. Bearing Liab.
Rate-sensitive 500 8% Rate-sensitive 600 4%
Non-sensitive 350 9% Non-sensitive 220 5%
Non-earning 150 Non-int. bearing Liab. 100
Equity 80
Total 1000 1000
GAP = 500 – 600 = -100
NII = (500 x 0.08 + 350 x 0.09) – (600 x 0.04 + 220 x 0.05) = 36.5
NIM = 36.5 / 850 = 4.29%
Page 16 of 35
Aggressive GAP Management
Aggressive GAP management
Can increase (or decrease) NIM
Increases risk associated with rate changes
The sign of the bank’s total gap (plus or minus) indicates
the direction of the interest rate “bet”
Size of the relative gap measures magnitude of risk
ALM policy will place limits the acceptable level of risk
Page 17 of 3
On Balance Sheet Actions to Affect GAP
Reduce asset sensitivity if Gap is positive
– Buy long-term securities; Lengthen loan maturities; Move
from floating-rate loans to fixed-rate loans
Increase liability sensitivity if Gap is positive
– Pay premiums to attract short-term deposit instruments;
More non-core purchased liabilities
Increase asset sensitivity if Gap is negative
– Buy short-term securities; Shorten loan maturities; Make
more loans on a floating-rate basis
Reduce liability sensitivity if Gap is negative
– Pay premiums to attract longer-term deposit instruments;
Borrow long-term from the Federal Home Loan Bank
Page 18 of 3
Off Balance Sheet
Derivatives Used to Manage Interest Rate Risk
Financial Futures Contracts
Forward Rate Agreements
Interest Rate Swaps
Options on Interest Rates
– Interest Rate Caps
– Interest Rate Floors
– Interest Rate Collars
Page 19 of 3
Using Swaps to Affect Gap in BankExec
If Gap is positive, choose “Fixed Rate Swap”
If Gap is negative, choose “Variable Rate Swap”
The size of the swap depends on the absolute
value of the gap figure
– If Gap equals $100m, a 50% hedge would mean a
$50m swap
Swaps are marked to market quarterly
Swaps can be sold in the secondary market
Page 20 of 3
Problems with GAP
Ignores the actual time at which interest rate-
sensitive assets and liabilities reprice within time
buckets
Assumes rates on individual assets and liabilities
will move in unison with market interest rates
Ignores exercise of embedded options
Page 21 of 3
Embedded Options
Some bank assets and liabilities contain options
that when exercised by bank customers adversely
affect cash flows
Option to repay a loan early
Call option on bonds
Option to withdraw funds prior to maturity
Cap on a floating-rate loan
Page 22 of 3
Conclusions
Interest rate changes can be harmless or
catastrophic for the bank
There are multiple ways to assess the bank’s
exposure to a bad outcome when rates change
Regulators require that the bank consider the
impact of rate changes on both earnings and the
value of equity
Excessive interest rate risk exposures can be
mitigated by restructuring the balance sheet of
hedging with derivative securities
Page 23 of 3