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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

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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

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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

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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

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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

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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

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Determinants of NII/NIM

Individual rates on assets and liabilities

Volume of earnings assets

Composition of assets and liabilities

NII = NIM X Earning Assets

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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)

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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

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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

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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:

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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

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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

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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%

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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%

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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

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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

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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

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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

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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

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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

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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

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