FIN 6002 – Session 14

Pradeepta Sethi
TAPMI
 Group Project
• Part A –
• Summary of the paper -
Understanding of the topic in
your own words
• Part B-
• Comments/viewpoints/critique -
Connecting with the underlying
theory/concept
• Part C-
• Suggestions/Recommendations/F
uture outlook - Your view on the
probable future situation
• Max (Min) word limit – 2500 (1200)
• Hand written hardcopy
• Submission to Mr. Vijith
 Interest
Assets Yield rates Liabilities costs
Rate-
sensitive 500 6% 600 2%
Fixed rate 350 9% 220 4%
Base Case Non
earning 150 0 100 0
Equity 80
Factors Total 1000 1000

affecting NII • NII = 0.06(500)+0.09(350)-0.02(600)-0.04(220) =

40.70
• NIM = 40.70/850=4.79%
Parallel Shift • GAP = 500-600= -100
• All market rates are assumed to increase /
decrease by 1 %
• ∆ "#$%&'$ "#()*% = ± 0.01 500 = 5 ||(−5)
• ∆ "#$%&'$ %56%#'% = ± 0.01 600 = 6 || (-6)
• ∆ 899 = −1|| 1, 39.70 || 41.70
• NIM = 39.70/850 = 4.67%,|| 41.70/850 = 4.90
 • The following relationship summarizes
this framework

• ∆"##$%& = ()*×∆,$%&

Factors • ∆"##$%& = (./) − ./1)×∆,$%&

affecting NII
• Where ∆344567 is the expected change in
NII over a period of time from some base
Changes in amount.
level of
interest rate • GAP = GAP through the end of the period
of time (time bucket).

• ∆i9:; the expected change in the level of

interest rates
 Interest
Assets Yield rates Liabilities costs
Rate-
sensitive 500 6.5% 600 3.5%
Fixed rate 350 9% 220 4%
Non
earning 150 0 100 0
Factors Equity 80

affecting NII Total 1000 1000

• Nonparallel shift in the yield curve – when

interest rates on similar securities with different
Changes in maturities change by different amounts

spread • NII = 0.065(500)+0.09(350)-0.035(600)-

0.04(220) = 34.20
• NIM = 34.20/850=4.02%
• GAP = 500-600= -100
• 1% decrease in spread NII declines.
• Spread increase – NII increase
 Interest
Assets Yield rates Liabilities costs
Rate-
sensitive 1000 6% 1200 2%
Fixed rate 700 9% 440 4%
Non
earning 300 0 200 0

Factors Equity
Total 2000
160
2000
affecting NII
• NII varies directly with changes in the volume of
earning assets and interest-bearing liabilities,
Changes in regardless of the level of interest rates
• NII = 0.06(1000)+0.09(700)-0.02(1200)-
volume 0.04(440) = 81.40
• NIM = 81.40/1700=4.79%
• GAP = 1000-1200= -200
• NII doubles because the bank earns the same
interest spread on twice the volume of earning
assets such that NIM is unchanged.
 Interest
Assets Yield rates Liabilities costs
Rate-
sensitive 540 6% 560 2%
Fixed rate 310 9% 260 4%
Non
earning 150 0 100 0

Factors Equity
Total 1000
80
1000
affecting NII

Changes in • There is no fixed relationship between changes

in portfolio mix and NII
composition • NII = 0.06(540)+0.09(310)-0.02(560)-0.04(260)
= 38.70
• NIM = 38.70/850=4.55%
• GAP = 540-560= -20
 • Rate sensitivity report classifies bank’s
assets and liabilities as rate sensitive in
selected time buckets through one year.

• The periodic GAP compares RSAs with

Rate RSLs within each of the different time
buckets and is a measure of the relative
Sensitivity mismatches across time.

Reports • The cumulative GAP - measures the sum

of the periodic GAPs through the last day
in each time interval and measures
aggregate interest rate risk exposure from
the present through this last day.
 Sr. no. Interest rate sensitivity – Time buckets
1 1-28 days
2 29 days and up to 3 months
3 Over 3 months and up to 6 months

Rate 4
5
Over 6 months and up to 1 year
Over 1 year and up to 3 years
Sensitivity 6 Over 3 years and up to 5 years
Reports 7 Over 5 years and up to 7 years
8 Over 7 years and up to 10 years
9 Over 10 years and up to 15 years
10 Over 15 years
11 Non-sensitive
 • The primary advantage of GAP analysis
is its simplicity.

• The primary weakness is that it ignores

the time value of money.

• It ignores the cumulative impact of

interest rate changes on a bank’s
position.

Gap Critique • Liabilities that pay no interest are often

ignored in rate sensitivity comparisons.

• GAP further ignores the impact of

embedded options.

• For this reason, most banks conduct

earnings sensitivity analysis, or pro forma
analysis, to project earnings and the
variation in earnings under different
interest rate environments
 • It extends static GAP analysis by making
it dynamic.
• It does this by model simulation or “what
if” analysis of all the factors that affect NII
across a wide range of potential interest
rate environments.
• The analysis essentially repeats static
Earning GAP analysis assuming different interest
sensitivity rate environments and compares
expected NII between the different
analysis environments
• It allows managers to assess how much
NII might vary across a wide range of
interest rates.
• The typical comparison looks at seven
different interest rate environments
beginning with a base case, or most
likely, scenario.
 • Forecast interest rates.
• Forecast balance sheet size and composition
given the assumed interest rate environment.
• Forecast when embedded options in assets
and liabilities will be in the money and, hence,
exercised such that prepayments change,
securities are called or put, deposits are
withdrawn early, or rate caps and rate floors are
exceeded under the assumed interest rate
Earning environment.
• Identify which assets and liabilities will reprice
sensitivity over different time horizons, and by how much,

analysis under the assumed interest rate environment.

Identify off-balance sheet terms that have cash-
flow implications under the assumed rate
environment.
• Calculate (estimated) NII and net income under
the assumed rate environment.
• Select a new interest rate environment and
compare the forecasts of NII and net income
across different rate environments versus the
base case
 Earning sensitivity output with interest rate shocks

Interest rate environment Estimated NII % change in NII

Bank X Bank Y
3% 910 -9% 13.2%
2% 960 -4% 7.8%
1% 985 -1.5% 2.9%
Base case 1000
-1% 1024 2.4% -2.1%
-2% 1050 5% -4.4%
-3% 1055 5.5% -6.9%
 • Bank X and Bank Y operate in the same trade
area and with the same general business
strategy.
• The base case interest rate forecast is that all
rates will remain constant at current levels.
• The data indicate the estimated impact on
each bank’s NII when interest rates are
shocked 1%, 2%, and 3% higher and lower
Earning relative to the base case.

sensitivity • Bank X’s earnings rise as rates fall, but fall as

rates rise. The bank’s “bet” is that it is
analysis positioned to benefit in a falling rate
environment and lose in a rising interest rate
environment.
• Hence it is a liability sensitive bank because it
is consistent with having a negative GAP
through one year.
• Bank Y’s NII increases when rates rise, but
decreases when rates fall. So bank Y is asset
sensitive.
 Managing the Gap

Objective Approach

Reduce asset sensitivity • Buy long-term securities

• Lengthen the maturities of loan
• Move from floating to fixed rate loans
• Put floors on loan rates

Increase asset sensitivity • Buy short-term securities

• Shorten loan maturities
• Make more loans on floating rate basis

Reduce liability sensitivity • Pay premiums to attract longer-term deposit

instruments
• Issue long-term subordinated debt
• Put caps on deposit rates

Increase liability sensitivity • Pay premiums to attract short-term deposit

instruments
• Borrow more