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BNFN 501ASSET AND LIABILITY

MANAGEMENT

WEEK 1

P. ROSE (1999), CHP. 6

DETERMINING AND MEASURING INTEREST RATES AND CONTROLLING A BANK’S INTEREST- SENSITIVE GAP

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Introduction:

Asset and liability management is the financial risk management of any financial institution. The asset-liability management formulates strategies and take actions that maximize the risk adjusted returns to shareholders over the long run.

The Principal Goals of Asset Liability Management Are:

a) To maximize, or at least stabilize, the bank’s margin, or spread between interest revenues and interest expenses, and

b) 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 StrategyUnder this view, the public determined the amounts of deposits available to banks. Banks had no control over their deposits but they had full control over their assets, in other words, the allocation and terms of their credits.

•Liability Management StrategyIn the 1970s, after financial liberalization banks gained control over their deposit rates and terms of deposits. Depending on demand on their loans they offered high or low deposit rates to attract or discourage funds coming to their banks.

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•Funds Management StrategyThis is a much more balanced approach and it dominates banking today. Its’ objectives are:

1. Volume, mix, and return, or cost of both assets and liabilities should be controlled

2. Control over assets must be coordinated with control over liabilities

3. Revenues and cost arise from both assets and liabilities. Banks should maximize returns and minimize costs of making loans and selling deposits.

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Interest Rate Risk• When interest rates change, the change affects

banks’ interest income on loans and securities, and interest cost on deposits and other bank borrowings.

• Changing interest rates also change the market value of a bank’s assets and liabilities, thereby changing the bank’s net worth (that is the value of the owners’ investment in the bank).

• Thus, changing interest rates impact both a bank’s balance sheet and its statement of income and expenses.

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Interest Rate Risk

• Price Risk — When Interest Rates Rise, the Market Value of the Bond Falls

• Reinvestment Risk — When Interest Rates Fall, the Coupon Payments on the Bond are Reinvested at Lower Rates

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Measurement of Interest Rates

Interest rates are the price of credit- what is demanded by lenders as compensation for the use of borrowed funds.

• Yield to Maturity (YTM) One of the most popular rate measures (particularly in the bond market) is the yield to maturity (YTM) which is the discount rate that equalizes the current market value of a loan or security with the expected stream of future income payments that the loan or security will generate.

n

1tt

t

YTM) (1

CF

Price Market

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Example:PV = $950

FV = $1000

C = 10%

N = 3

i % = ?

With financial calculator yield to maturity = 12.09%

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• Bank Discount Rate (DR):Another popular interest rate measure is the bank discount rate, which is often quoted on short-term loans and money market securities.

Maturity to Days #

360

XFV

Price) Purchase -(FVDR

Where:

FV equals Face Value

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Bank Discount Rate (DR):

Example:

FV = $100Purchase price = $96Number of days to maturity = 90Bank discount rate (DR) = ?

(100 –96) 360DR = X = 0.16 = 16% 100 90

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Market Interest Rates

Function of:

• Risk-free Real Rate of Interest

• Various Risk Premia– Default Risk– Inflation Risk– Maturity Risk– Marketability Risk

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Net Interest Margin (NIM)In order to protect bank profits against adverse interest rate changes, then, management seeks to hold fixed the bank’s net interest margin (NIM):

Int. income Int. expenses on

from bank loans - deposits and other

and investments borrowed funds

NIM =

Total earning assets

Net interest income after expenses

=

Total earning assets

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Goal of Interest Rate Hedging

One Important Goal is to Insulate the Bank’s Profits from the Damaging Effects of Fluctuating Interest Rates

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Market Interest Rates and Bank ProfitsYear US Banks’ Avg.

ROAYield on 6 mo. T-Bills

1985 0.71% 7.48%1986 0.62 5.981987 0.09 5.781988 0.81 6.671989 0.49 8.111990 0.47 7.501991 0.52 5.381992 0.92 3.431993 1.17 2.951994 1.13 4.641995 1.13 5.561996 1.14 5.08

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Example:

bank’s Interest revenues = $ 4 billion

bank’s Interest expenses = $ 2.6 billion

bank’s earning assets = $ 40 billion

4 billion - 2.6 billion

NIM = = . 035 = 3.5%

40 billion

Note: This is not yet the bank’s profit from borrowing and lending funds because we have not considered noninterest expenses.

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Interest –Sensitive Gap ManagementThis is one of the most popular interest-rate hedging strategy used by banks. Banks try to match the volume of bank assets that can be repriced with the volume of deposits and other liabilities whose rates can also be adjusted with market conditions during the same time period.

Dollar amount of repriceable Dollar amount of repriceable(interest-sensitive) bank assets = (interest-sensitive) bank

liabilitiesrepriceable assets: loans that are about to mature or renewedrepriceable liabilities: deposits that are about to mature or renewed

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Interest-Sensitive Assets• Short-Term Securities Issued by the

Government and Private Borrowers

• Short-Term Loans Made by the Bank to Borrowing Customers

• Variable-Rate Loans Made by the Bank to Borrowing Customers

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Interest-Sensitive Liabilities

• Borrowings from Money Markets

• Short-Term Savings Accounts

• Money-Market Deposits

• Variable-Rate Deposits

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Interest-Sensitive Gap MeasurementsIf the amount of repriceable assets is not equal the amount of repriceable liabilities, a gap exist between these interest-sensitive assets and interest-sensitive liabilities. This gap can be negative or positive.

Interest-sensitive gap = (Interest-sensitive assets) –

(Interest-sensitive liabilities)

Asset-sensitive Interest sensitive interest sensitive

(positive) gap = assets – liabilities >0

Liability-sensitive Interest sensitive interest sensitive

(negative) gap = assets – liabilities < 0

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Interest-Sensitive Gap Measurements

Dollar Interest-Sensitive Gap = Interest-Sensitive Assets -

Interest-Sensitive Liabilities

Relative Dollar IS GapInterest-Sensitive Gap =

Bank Size

Interest Sensitive Assets Interest Sensitivity Ratio =

Interest Sensitive Liabilities

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Asset- Sensitive Gap : An Example Interest sensitive assets = $500 million Interest sensitive liabilities = 400 million This bank is asset sensitive with a positive gap of 100 million dollars.•If the interest rates rise, the bank’s net interest margin will increase, I.e. bank will experience an increase in its net interest income.•If the interest rates fall, when the bank is asset sensitive, the banks NIM will decline as interest revenues from assets drop by more than interest expenses associated with liabilities. •The bank with a positive gap will lose net interest income if interest rates fall.

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Asset-Sensitive Bank Has:• Positive Dollar Interest-Sensitive Gap• Positive Relative Interest-Sensitive Gap• Interest Sensitivity Ratio Greater

than One

Asset-Sensitive Gap:• Interest Rates Rise NIM Rises• Interest Rates Fall NIM Falls

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Liability-sensisitve gap: An Example:•Interest sensitive assets = 150 millioninterest sensitive liabilities = 200 million This bank is liability sensitive with a negative gap of 50 million dollars.

• Rising interest rates will lower the bank’s net interest margin, because the rising cost associated with interest-sensitive liabilities will exceed increases in interest revenue from bank’s interest sensitive assets.•Falling interest rates will generate a higher interest margin and probably greater earnings as well, because borrowing costs will decline by more than interest revenues.

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Liability-Sensitive Bank Has:

• Negative Dollar Interest-Sensitive Gap• Negative Relative Dollar Interest-Sensitive Gap• Interest Sensitivity Ratio Less than One

Liability-Sensitive Gap• Interest Rates Rise NIM Falls• Interest Rates Fall NIM Rises

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Zero Interest-Sensitive GapIf interest-sensitive assets and liabilities of a bank are equal, this bank is relatively insulated from interest rate risk. In this case interest revenues and funding cost will change at the same rate. The bank’s gap is zero.

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Important Decisions Concerning IS Gap

1. Management must choose the time period over which NIM is to be managed.

2. Management must choose a target NIM.

3. To increase NIM management must either:

a. Develop correct interest rate forecast; or

b. Reallocate assets and liabilities to increase spread.

4. Management must choose dollar volume of interest-sensitive assets and liabilities.

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NIM Influenced By:• Changes in Interest Rates Up or Down• Changes in Spread Between Assets and Liabilities • Changes in the Volume of Interest-Sensitive

Assets and Liabilities • Changes in the Mix of Assets and Liabilities

between floating and fixed rate assets and liabilities, between shorter and longer maturity assets and liabilities, and between assets bearing higher versus lower expected yields

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Cumulative Gap

Cumulative Gap is The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced Over a Designated Time Period.

Maturity IS Assets IS Liabilities Size of Gap Cumulative Gap

24 hours $40 $30 +10 +10

7 days $120 160 -40 -30

30 days 85 65 20 -10

90 days 280 250 30 +20

120 days 455 395 60 +80

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Aggressive Interest-Sensitive Gap Management

Expected Change inInterest Rates

Best Interest-Sensitive Gap

Position

AggressiveManagement’sLikely Actions

Rising MarketInterest Rates

Positive IS Gap Increase in ISAssets

Decrease in ISLiabilities

Falling MarketInterest Rates

Negative IS Gap Decrease in ISAssets

Increase in ISLiabilities

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Problems with Interest-SensitiveGap Management

• Interest Rates Paid on Liabilities Tend to Move Faster than Interest Rates Earned on Assets

• Interest Rate Attached to Bank Assets and Liabilities Do Not Move at the Same Speed as Market Interest Rates

• Point at Which Some Assets and Liabilities Are Repriced is Not Easy to Identify

• Interest-Sensitive Gap Does Not Consider Impact of Changing Interest Rates on Equity Position