Assumptions Total Assets = 50,000,000 Net Surpluses Received = 480,000 Net Surpluses Received in one Month = 40,000

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1 GAP ANALYSIS SACCO savers have an inherent preference for short-term liquid accounts, even when the interest rate in these accounts is subject to changes. Furthermore, borrowers have an inherent preference for fixed interest rates and long-term maturity in loans, thus in order to reduce uncertainty and maintain payments within their budget. These member preferences result in a structural imbalance in the SACCO s ability to change interest rates in assets and liabilities, according to how they are changing on the market; this is called GAP or break-even point. The SACCO s financial performance depends to a great degree on the nature and scope of the imbalance. Gap analysis is one of the most common methods for determining the repricing ability of a balance sheet. IMPACT OF GAP ON NET SURPLUS Example 1.1 Assumptions Total Assets = 50,000,000 Net Surpluses Received = 480,000 Net Surpluses Received in one Month = 40,000 Month #1 Month # Days Days Rate-Sensitive Assets (RSA) 12M 15M Rate-Sensitive Liabilities (RSL) 30M 30M GAP -18M -15M GAP/Total Assets -36% -30% What would happen if interest rates increased by 2 percentage points? Month #1 Impact on Net Surpluses Received Yearly Reduction:.02 x (-18M) = -360,000 Monthly Reduction: -360,000/12 = -30,000 New Net Surpluses Received Monthly 40,000-30,000 = 10,000

2 Month #2 Impact on Net Surpluses Received Yearly Reduction:.02 x (-15M) = -300,000 Monthly Reduction: -300,000 / 12 = -25,000 New Net Surpluses Received Monthly 40,000-25,000 = 15,000 The above figure shows numerically the impact of the imbalance or GAP, as it is called. As shown by the numbers, the SACCO in the example has assets of 50 million or a net surplus of 480,000. The revaluation structure of the assets and liabilities shall determine the stability (of volatility) of the net surpluses. The number of rate sensitive assets (RSA) and rate-sensitive liabilities (RSL) are included for the next two months. The difference between RSA and RSL is the GAP. To be able to put this amount in proper perspective, the GAP has a percentage of the total assets is also included. Let it be noted that in the first month, the GAP is -18 million, - 36% of the assets and in the second month the GAP of -15 million represents -30% of the assets. GAP INTERPRETATION When the GAP is negative, the SACCO has more liability subject to revaluation than assets in a particular period. If interest rates increase, the financial costs of the deposits will tend to increase more rapidly than the return generated by the asset. If interest rates drop, the financial cost of the deposits will tend to drop more quickly than the return on the assets. The impact of this pressure can be determined by using the example presented above. Any alteration of the exchange rates leads to a significant alteration of profitability. GAP AND ITS RELATIONSHIP TO PROFITABILITY One of the most important aspects of GAP management is the relationship that exists between GAP and profitability. This relationship is characterized in example 1.2. Example 1.2 Ratio Between GAP/Total Assets, Risks and Profitability Negative Zero Positive GAP GAP GAP -100% -50% 0% +50% +100% High Risk No Risk High Risk High Yield Moderate Yield Low Yield

3 It is well known that a high degree of risk is accompanied by a high level of expected profitability. The key word is expected. These high expectations are not always realized. If a high negative GAP is maintained when interest rates are low or stable, a high level of profitability may result because a negative GAP means that the SACCO is borrowing at a low cost and is lending at a long-term maturity at a high interest rate. When interest rates drop, profitability levels will increase even more. However, when interest rates increase and especially if the yield curve is inverted, the profitability margins are quickly eroded and losses may result. The risk described in example 1.1. may be minimal by reducing the GAP. As shown in example 1.2, the risk reduction is accompanied by low expected levels of profitability. However, let it be noted that when the SACCO moves toward a positive GAP, the risk increases and the expected profitability levels decrease. This comes from the fact that a positive GAP means that the SACCO is financing assets with low interest rates and with a short-term yield, with high rate assets and with long-term maturity. Therefore, a positive GAP is not desirable because the risk usually is not accompanied by high expected surpluses. In addition, this position is against the inherent preferences of the members, discussed above. The recommended GAP position for SACCO should be between -10% and -20%. BASIC RISK One of the major assumptions fundamental to GAP analysis is that the changes in interest rates on assets will be closely related to changes in the interest rates of liabilities. Unfortunately, this is not usually the case. In fact, under certain circumstances, the differential movement in asset returns and liability cost can result in a high interest rate risk, even when one is in a no risk GAP (Zero GAP) position. This results in great surprises and unexpected volatility in net surpluses. From the perspective of Asset and Liability Management, this problem is called basic risk and comes from different sources, discussed below. Differential Rate Movement In the financial markets, it is well recognized that when interest rates change, practically all rates directed by the market change in the same direction. Occasionally, this does not happen. More important, when rates change, the oscillations in short-term rates are usually higher than oscillations in long-term rates. Therefore, depending on the direction of changes in rates and the composition of the Balance Sheet, the differential rate movement can have a positive or negative significant effect in the SACCO s net surpluses.

4 GAP MANAGEMENT STRATEGIES The Key Component of an effective ALM program requires management to establish a strategy to manage risk. A strategy provides management with the focus to conduct daily operations to reach long-term results. This facet of ALM is missing in many SACCOs. A strategy assigns a purpose to base management decisions. For example, officials may desire to increase loan volume to promote member services. However, a liquidity shortfall may be projected in the coming months. Therefore, a one-year signature loan offered at a discount rate may provide the solution. Without recognizing risk, officials may have marketed a longer-term product not suitable for them at the given time. Adopting an ALM strategy is also a key component of making intelligent investment decisions. A SACCO analyzing its investment needs will be able to seek suitable instruments rather than purchasing what is offered. For example, a SACCO projects ample liquidity for the coming year along with a falling rate cycle. A broker may offer the SACCO a 3-year Government Bond and an amortizing investment with a 3-year average life. If the SACCO understands its risk position, it would purchase the Bond and for it does not need the cash flow, and income will be maximized for more principal will stay invested at a higher rate (the amortizing bond s principal cash flows will be invested at the new rate. In trying to manage the GAP, various components are analyzed; Loan Portfolio An alternative for reducing the risk of an excessive negative GAP is to insist on loans with variable rates. However, members have a strong preference for loans with fixed rates and may accept a loan with a variable rate only if it is offered at a reduced rate. Therefore, the cost of reducing the risk by means of insisting on offering loans with variable rates, often means low income. An excessive position of positive GAP may be reduced by means of changing the emphasis on variable-term loans to fixed-term loans, which usually do not have a long-term maturity, such as mortgage loans. Investment Portfolio When an excessive negative GAP margin exists, it can be diminished by means of reducing the investment due structure. However, when the strategy is evaluated, it is essential to consider the trade-off involved in a strategy to reduce risk. When the term structure of an investment portfolio is low, for example, this usually means low yield levels. Therefore, if a significant part of the portfolio is in long-term loans, i.e., greater than five years, the risk involved can be more significant than the reduction in income levels, usually associated with the reduction of the portfolio due-date distribution.

5 An alternative to the reduction of the term structure is to increase the amount of investments that are revalued on a monthly basis and by merely reinvesting the funds every month. A positive GAP is the result of a significant amount of loans with variable rates that are subject to revaluation within a very short time period. The risk associated with a positive GAP may be reduced by the increase in the maturity structure of the investments. On the surface, this strategy may seem viable because the interest rate risk will be reduced and the investment income will be increased, due to the long-term structure of the portfolio. However, the same effect may be obtained by putting more emphasis on loans with fixed rates. In addition, these loans are preferred by members. Checking Accounts and Savings Accounts Many SACCO have a negative GAP as a result of excess liabilities with sensitive rates, especially, ordinary savings accounts and in some cases, checking accounts. If a lower rate were paid on these accounts, by offering the members a short-term option in the form of a money market account and long-term certificates of deposit, the funds sensitive to market rates may be moved from ordinary savings accounts to the other accounts. What would remain in the ordinary savings accounts would be considered insensitive to market rates. Checking accounts with a high market-sensitive interest rate are particularly undesirable from the standpoint of Asset and Liability Management. The reasons are: 1) High finance costs; 2) Large balances together with a high interest rate and no restriction on maturity creates an account that is highly sensitive to the market; 3) High processing cost (since it is a transaction account), and; 4) The funds are reserved due to the fact that in large SACCO, a portion of the funds has to be held in the form of nonyielding reserves. Institutional Capital Position A SACCO s institutional capital is important from the point of view of Asset and Liability Management, because it represents funds that are permanent and not sensitive to the market. The source of institutional capital is capitalized net surpluses and, by their very nature, improvement in their position is usually a long-term objective. Reducing the Size of a SACCO If a SACCO has a high negative GAP position, inadequate institutional capital, weak net surpluses, an effective strategy would be to reduce its size. If the rates it is paying on its savings are reduced substantially, withdrawals can be induced. The low finance cost will

6 have an immediate and dramatic effect in yield. Eventually, this will increase institutional capital. The only problem with this strategy is that there must be sufficient liquidity to manage savings withdrawals. Minimizing the Basic Risk Diversification The risk that is created by the movement of rates between assets and liabilities that are subject to revaluation can be minimized by diversifying assets and liabilities over different months or quarters. Therefore, by extending assets and liabilities over different revaluation intervals, the basic-risk effects will be greatly minimized. Rate Revision Unlike the basic risk caused by external reasons, asset and liability rates perhaps do not move with the market, since management or the Board of Directors has been slow to respond to changing conditions. To minimize this internally induced basic risk, procedures should be established to provide for the frequency and the ongoing process of analyzing market conditions and rates on loans, savings and certificates of deposit. A frequent analysis of market conditions and the rates on products and services offered by SACCO is one of the responsibilities of the Asset and Liability Management Committee (ALM Committee). This does not mean that management has to change rates every time the market changes. On the contrary, it is wise to wait a while to determine whether the new market conditions or going to persist or are of a temporary nature. In some cases, a delayed reaction and increasing rates on liabilities, for example, may be necessary to improve the SACCO s profitability.

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