Georgia Banking School Course #309 Asset/Liability Management III Instructor: Ernest Swift
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 Page 2 of 3
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 Page 3 of 3
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 Page 4 of 3
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 Page 5 of 3
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 Page 6 of 3
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 Page 7 of 3
Determinants of NII/NIM Individual rates on assets and liabilities Volume of earnings assets Composition of assets and liabilities NII = NIM X Earning Assets Page 8 of 3
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) Page 9 of 3
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 Page 10 of 3
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 Page 11 of 3
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 Basic Rule: Classify as to likelihood of repricing, not capacity to reprice Page 12 of 3
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 Page 13 of 3
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 Page 14 of 3
Sample Bank Balance Sheet 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% GAP is -$100 million Page 15 of 3
Rates Up 1% From Base Case 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% NII falls by $1 million (GAP X rate change) = $100 mil X 1% = - $1 mil Page 16 of 35
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 Page 17 of 3
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 Page 18 of 3
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 Page 19 of 3
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 Page 20 of 3
Problems with GAP Ignores the actual time at which interest ratesensitive 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 Page 21 of 3
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 Page 22 of 3
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 Page 23 of 3