Chapter Seven

Risk Management for Changing Interest Rates: Asset-Liability Management

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Objective
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

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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 banks short-run and long-run goals Coordination of Managements 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 Risk The danger that shifting interest rate could adversely affect the banks net interest margin, assets, or equity Changing interest rates impact both a banks balance sheet and its statement of income and expenses.
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Determination of Interest Rate

Price of Loanable Fund
Rate of interest Demand for loanable funds Volume of credit extended
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Supply of loanable funds

Quantity of Loanable Fund

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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.

CFt Market Price t t 1 (1 YTM)

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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 banks Net Interest Margin.
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It is important to protect NIM Ratio for Banks

NIM =
Interest Income - Interest Expenses Total Assets X 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 banks interest bearing assets and liabilities.

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Repriceable Assets
Mainly 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 banks 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 nonearning assets
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Repriceable Liabilities
Mainly 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 banks 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 InterestInterest-Sensitive Assets Sensitive Gap = Interest Sensitive Liabilities Relative Dollar IS Gap Interest Bank Size Sensitive Gap Interest Sensitivity Ratio

InterestSensitive Assets InterestSensitive Liabilitie s

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Measures of Interest Sensitive Gap

Dollar InterestInterest Sensitive Assets Sensitive Gap = Interest Sensitive Liabilities 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.

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Measures of Interest Sensitive Gap

Relative InterestSensitive Gap

Dollar IS Gap Bank Size

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
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Measures of Interest Sensitive Gap

Interest Sensitivity Ratio

InterestSensitive Assets InterestSensitive Liabilitie s

The ratio of ISA and ISL; An ISR less than 1 indicates LSG while ISR more than 1 indicates ASG

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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 Rising Market Interest Rates Best InterestSensitive Gap Position Positive IS Gap Aggressive Managements Likely Action Increase in IS Assets Decrease in IS Liabilities Decrease in IS Assets Increase in IS Liabilities

Falling Market Interest Rates

Negative IS Gap

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Problems with InterestSensitive 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
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