Chapter Seven

Risk Management for Changing Interest Rates: Asset-Liability

Management

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The purpose of this chapter is to explore the options bank/FIs have today for dealing with risk –

Especially the risk of loss due to changing interest rates

To see how management can coordinate the management of its assets with the management of its liabilities

Objective

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Evolution of Fund Management Strategies Asset Management

Baking's history prior to the 1960s, bankers tended to take their sources of funds – liabilities and equity – largely for granted

Key decision area of bank management was not deposits and other borrowings but assets

>Sources of funds>liabilities and equity –largely for granted >Public determined the amount of deposit>the rate and type

were regulated >Banker could exercise control over assets>loan

Liability Management The 1960 and 1970 ushered in dramatic

changes in bank management strategies; Confronted with soaring interest rates and

intense competition for funds, bankers began to devote greater attention to sources of funding and cost of their deposit and non-deposit liabilities - called liability management

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Fund Management

The maturing of liability management techniques, coupled with more volatile interest rates and greater banking risk, eventually gave birth to the funds management strategy, which dominates banking today.

This is a balanced approach to asset and liability management.

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Fund Management Strategies Target to…..

The balanced approach of Asset-Liability Management i.e. Fund Management stresses several key objectives:

• Control of management over the volume, mix, and return or cost of both assets and liabilities in order to achieve the bank’s short-run and long-run goals

• Coordination of Management’s control over assets with its control over liabilities to maximize the spread between bank revenues from earning assets and the costs of issuing liabilities

• To develop policies that maximize returns and minimize costs from bank services

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Bank/FIs Greatest Asset-Liability Management Challenge

Interest Rate RiskThe danger that shifting interest rate could adversely affect the banks’ net interest margin, assets, or equity……

Changing interest rates impact both a bank’s balance sheet and its statement of income and expenses.

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Determination of Interest Rate

Price of Loanable Fund

Quantity of Loanable Fund

Demand for loanable funds

Supply of loanable funds

Rate of interest

Volume of credit extended

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Determining Interest Rate by Banks• Individual banks can not control either the

level of or trend in market rates of interests.

•Most banks are price takers, and accept interest rates as a given and plan accordingly.

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Measuring Interest Rate

Yield to Maturity (YTM) is the discount rate that equalizes the current market value of a loan or security with the expected stream of future income that a loan or security will generate.

n

1tt

t

YTM) (1

CF PriceMarket

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Banks’ Response to Interest rate Risk

•Concentrate on those elements of the portfolio of assets and liabilities that are most sensitive to interest rate movement.

•Basically these include loans and investments on the asset side and interest bearing deposits and borrowings on the liability side.

•Management seeks to hold fixed the bank’s Net Interest Margin.

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It is important to protect NIM Ratio for Banks

•NIM =

Interest Income - Interest Expenses

Total AssetsX 100

This is not Banks’ profit; Non interest income to be added and Non-interest Expenses to be deducted to obtain profit .

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Hedging Strategy of Banks•On the way to protect NIM ratio, the most

popular Interest Rate Hedging strategy in use by banks today is called Interest Sensitive Gap Management.

•Gap management Techniques require management to perform an analysis of the maturities and repricing bank’s interest bearing assets and liabilities.

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Repriceable AssetsMainly the loans or investments that are about to mature or coming up for renewal. For example

•Short term securities issued by government and private borrowers [about to mature]

•Short-term loans made by the banks to customers [about to mature]

•Variable rate loans and securities

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Non- Repriceable Assets

•Cash held in the bank’s vault or deposited in the central bank [reserves]

•Long term loan made in a fixed interest rate

•Long term securities carrying fixed coupon rates

•Bank buildings, equipment and other non-earning assets

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Repriceable LiabilitiesMainly the deposits or borrowings that are about to mature or coming up for renewal. For example

•Short term savings account

•Borrowings of banks coming up for renewal

•Borrowing from money market

•Variable rate deposits

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Non-Repriceable Liabilities

•Demand deposit accounts [generally pay no interest rate]

•Long-term savings accounts [Fixed deposit]

•Equity capital provided by bank’s owners

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When there would be Gap? When the amount of Repriceable assets does

not equal the amount of Repriceable liabilities A gap exist between the Interest Sensitive

Assets and Interest Sensitive Liabilities The gap is known as Interest Sensitive Gap

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Interest-Sensitive Gap Measurements

Dollar Interest-Sensitive Gap

Interest-Sensitive Assets – Interest Sensitive Liabilities

=

Relative Interest-

Sensitive Gap SizeBank

Gap ISDollar

Interest Sensitivity

RatiosLiabilitie SensitiveInterest

Assets SensitiveInterest

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Measures of Interest Sensitive Gap

▫Simply the absolute difference of Interest sensitive assets and liabilities;

▫when ISG is positive it is Asset Sensitive, and if ISG is Negative it is Liability Sensitive.

Dollar Interest-Sensitive Gap

Interest Sensitive Assets – Interest Sensitive Liabilities=

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Measures of Interest Sensitive Gap

▫The ratio of IS Gap and Bank Size [measured by Total Asset]

▫A RISG greater than zero means the bank is asset sensitive, while a negative RIGP describes a Liability Sensitive Gap

Relative Interest-

Sensitive Gap SizeBank

Gap ISDollar

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Measures of Interest Sensitive Gap

▫The ratio of ISA and ISL; An ISR less than 1 indicates LSG

▫while ISR more than 1 indicates ASG

Interest Sensitivity

Ratio sLiabilitie SensitiveInterest

Assets SensitiveInterest

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Asset Sensitive Gap• If Interest Sensitive Assets in each planning period

exceed the volume of interest sensitive liabilities subject to repricing, the bank is said to have a Positive Gap or to be Asset Sensitive.

•Asset Sensitive Gap [ASG]=

[Interest-sensitive Assets - Interest-sensitive Liabilities] > 0

• Positive Dollar Interest-Sensitive Gap• Positive Relative Interest-Sensitive Gap• Interest Sensitivity Ratio Greater Than One

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Liability Sensitive Gap

• If Interest Sensitive Liabilities in each planning period exceed the volume of Interest Sensitive Assets subject to repricing, the bank is said to have a negative Gap or to be Liability Sensitive.

•Liability Sensitive Gap [LSG]=

[Interest-sensitive Assets - Interest-sensitive Liabilities] < 0

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

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Gap Positions and the Effect of Interest Rate Changes on the Bank

• Asset-Sensitive Bank▫ Interest Rates Rise

NIM Rises>as interest earnings from assets will increase more than the cost of borrowed fund

▫ Interest Rates Fall NIM Falls> as interest revenue from assets drop

by more than interest expenses associated with liabilities

• Liability-Sensitive Bank▫ Interest Rates Rise

NIM Falls>as rising cost of borrowed fund exceeds interest revenue from assets

▫ Interest Rates Fall NIM Rises> as interest expenses associated with

liabilities will go down more than revenue from assets.

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Important Decision Regarding IS Gap

•Management Must Choose the Time Period Over Which NIM is to be Managed

•Management Must Choose a Target NIM•To Increase NIM Management Must Either:▫Develop Correct Interest Rate Forecast▫Reallocate Assets and Liabilities to Increase

Spread•Management Must Choose Dollar Volume

of Interest-Sensitive Assets and Liabilities

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Cumulative Gap

The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period

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Aggressive Interest-Sensitive Gap Management

Expected Change in

Interest Rates

Best Interest-Sensitive Gap

Position

Aggressive Management’

s Likely Action

Rising Market

Interest Rates

Positive IS Gap

Increase in IS Assets

Decrease in IS Liabilities

Falling Market

Interest Rates

Negative IS Gap

Decrease in IS Assets

Increase in IS Liabilities

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Problems with Interest-Sensitive Gap Management• Interest 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 the Impact of Changing Interest Rates on Equity Position