Risk Management for Changing Interest Rates Asset-Liability Management
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Transcript of Risk Management for Changing Interest Rates Asset-Liability Management
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Chapter Seven
Risk Management for Changing Interest Rates: Asset-Liability
Management
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
Objective
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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 bank’s short-run and long-run goals
• Coordination of Management’s 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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank/FIs Greatest Asset-Liability Management Challenge
Interest Rate RiskThe danger that shifting interest rate could adversely affect the banks’ net interest margin, assets, or equity……
Changing interest rates impact both a bank’s balance sheet and its statement of income and expenses.
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Determination of Interest Rate
Price of Loanable Fund
Quantity of Loanable Fund
Demand for loanable funds
Supply of loanable funds
Rate of interest
Volume of credit extended
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
n
1tt
t
YTM) (1
CF PriceMarket
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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 bank’s Net Interest Margin.
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
It is important to protect NIM Ratio for Banks
•NIM =
Interest Income - Interest Expenses
Total AssetsX 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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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 bank’s interest bearing assets and liabilities.
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Repriceable AssetsMainly 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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Non- Repriceable Assets
•Cash held in the bank’s 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 non-earning assets
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Repriceable LiabilitiesMainly 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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Non-Repriceable Liabilities
•Demand deposit accounts [generally pay no interest rate]
•Long-term savings accounts [Fixed deposit]
•Equity capital provided by bank’s owners
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Interest-Sensitive Gap Measurements
Dollar Interest-Sensitive Gap
Interest-Sensitive Assets – Interest Sensitive Liabilities
=
Relative Interest-
Sensitive Gap SizeBank
Gap ISDollar
Interest Sensitivity
RatiosLiabilitie SensitiveInterest
Assets SensitiveInterest
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Measures of Interest Sensitive Gap
▫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.
Dollar Interest-Sensitive Gap
Interest Sensitive Assets – Interest Sensitive Liabilities=
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Measures of Interest Sensitive Gap
▫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
Relative Interest-
Sensitive Gap SizeBank
Gap ISDollar
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Measures of Interest Sensitive Gap
▫The ratio of ISA and ISL; An ISR less than 1 indicates LSG
▫while ISR more than 1 indicates ASG
Interest Sensitivity
Ratio sLiabilitie SensitiveInterest
Assets SensitiveInterest
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Aggressive Interest-Sensitive Gap Management
Expected Change in
Interest Rates
Best Interest-Sensitive Gap
Position
Aggressive Management’
s Likely Action
Rising Market
Interest Rates
Positive IS Gap
Increase in IS Assets
Decrease in IS Liabilities
Falling Market
Interest Rates
Negative IS Gap
Decrease in IS Assets
Increase in IS Liabilities
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Problems with Interest-Sensitive 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