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Chapter:07

Asset Liability Management – Determining & Measuring

Interest Rates

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Asset-Liability Management

Control of a bank’s sensitivity to changes in market interest rates to limit losses in its net income or equity. The principal goals of asset-liability management are:

– To maximize, or at least stabilize, the bank’s margin or spread between interest revenues & interest expenses, &

– To maximize, or at least protect, the value (stock price) of the bank, at an acceptable level of risk.

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Asset-Liability Management Strategies Asset Management Strategy: Control of the composition

of a bank’s assets to provide adequate liquidity & earnings & meet other goals. The banker could exercise control only over the allocation of incoming funds by deciding who was to receive the scarce quantity of loans available & what the terms on those loans would be.

Liability Management Strategy: Its goal was simply to gain control over the bank’s funds sources comparable to the control bankers had long exercised over their assets. The key control lever was price, the interest rate & other terms banks could offer on their deposits & borrowings to achieve the volume, mix & cost desired.

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Asset-Liability Management Strategies----Contd

Funds Management Strategy: The key objectives of fund management strategy are:– Bank management should exercise as much as control

as possible over the volume, mix, & return or cost of both assets & liabilities to achieve the bank’s goals.

– Management’s control over assets must be coordinated with its control over liabilities so that asset & liability management are internally consistent & do not pull against each other.

– Revenues & costs arise from both sides of the bank’s balance sheet. Bank policies need to be developed that maximize reruns & minimize costs from supplying services.

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Interest Rate Risk

The danger that shifting interest rates could adversely affect the bank’s net interest margin, assets or equity. There are different types of interest rate risk that affect earnings:

1. Gap Risk

2. Yield Curve Risk.

3. Reinvestment & refunding risk.

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Determination of Interest Rate

Rate of Interest

Demand for loanable funds (credit)

Supply of loanable funds

Volumeof creditextended

Quantity of loanable funds

Price ofCredit(Interestrate)

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Measurement of Interest Rate –Yield to Maturity

The rate of discount applied to the expected earnings stream from a debt instrument that equalizes that stream’s present value with the instrument’s market price.

Current Market Price = CF1 CF2

CF3Sale price of security or loan

(1 + YTM) (1 + YTM)2+

(1 + YTM)n+ -----------+

(1 + YTM)n+

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Measurement of Interest Rate –Discount Rate

Discount rate and YTM equivalent yield

Page 211-212

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The Components of Interest Rates Market Interest Rate on risky loan or security

= Risk-Free Real interest rate (inflation adjusted return on Govt. securities) + Risk Premium

RFRIR changes over time with shifts in the demand & supply for loanable funds.

RP changes over time due to “Inflation”, “Characteristics of the borrower”, ‘Marketability and Maturity of securities”.

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Changes in Interest Rate affecting the NIM

NIM = {interest income from bank loans & investments – interest expenses on deposits & other borrowed funds} / Total Earning Assets

= Net interest income / Total

Earning Assets If the interest cost of borrowed funds rises faster

than bank income from loans & securities, the bank’s NIM will be squeezed, with adverse effects on bank profits.

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Factors Affecting NIM1) Changes in the level of interest rates.2) Changes in the spread between asset yields &

liability costs.3) Changes in the volume of interest-bearing assets.4) Changes in the volume of interest-bearing

liabilities.5) Changes in the mix of assets & liabilities that the

management of each bank draws upon as its shifts between floating & fixed-rate assets & liabilities, between shorter & longer maturity assets & liabilities, between assets bearing higher versus lower expected yields.

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Interest Rate HedgingInterest-Sensitive Gap Management

Gap management techniques require management to perform an analysis of the maturities & repricing opportunities associated with the bank’s interest-bearing assets, deposits, & money market borrowings. Interest-sensitive gap management is basically the control over the difference between the volume of a bank’s interest-sensitive assets & the volume of the interest-sensitive liabilities. Through Gap management bank wants to ensure for each time period:

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Interest-Sensitive Gap Management (continued)

Dollar amount of repriceable (interest sensitive) bank assets = Dollar amount of repriceable (interest sensitive) bank liabilities.

So, Interest Sensitive Gap = ISA – ISLIS GAP or Relative IS GAP (IS GAP/TA)

could be positive (asset sensitive) or negative (liability sensitive)

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Interest-Sensitive Gap Management………Contd

Repriceable Assets Repriceable Liabilities

Short-term securities issued by government & private borrowers (about to mature)

Borrowings from the money market.

Short-term loans made by the bank to borrowing customers (about to mature)

Short-term savings accounts

Variable-rate (floating or adjustable rate) loans & securities

Money-market deposits (whose interest rates often are adjustable every few days)

Variable rate (floating or adjustable rate deposits )

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Defensive Interest-Sensitive Gap Management

The strategy here is to achieve the following-

IS Gap = 0 or ISA = ISL or IS Ratio (ISA/ISL) = 1

Then, changes in NIM will be zero (page 221)

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Eliminating a Bank’s Interest-Sensitive Gap by using Defensive Strategy

With Positive Gap

The Risk Possible Management Responses

Interest-sensitive

assets > Interest-sensitive liabilities (asset sensitive)

Losses if interest rates fall because the bank’s net interest margin will be reduced.

1. Do nothing.

2. Extend asset maturities or shorten liability maturities.

3. Increase interest-sensitive liabilities or reduce interest-sensitive assets.

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Eliminating a Bank’s Interest-Sensitive Gap by using Defensive Strategy --Contd

With Negative Gap

The Risk Possible Management Responses

Interest-sensitive

assets < Interest-sensitive liabilities (liability sensitive)

Losses if interest rates rise because the bank’s net interest margin will be reduced.

1. Do nothing.

2. Shorten asset maturities or lengthen liability maturities.

3. Decrease interest-sensitive liabilities or increase interest-sensitive assets.

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Aggressive Interest-Sensitive Gap

Management

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Interest Rate HedgingDuration Gap Management