BANK 501 ASSET AND LIABILITY MANAGEMENT

1. BANK 501ASSET AND LIABILITY MANAGEMENT WEEK 2 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques Rose and Hudgings (2010) Chp.7

2. Key Topics • Asset, Liability, and Funds Management • Market Rates and Interest-Rate Risk • The Goals of Interest-Rate Hedging • Interest-Sensitive Gap Management • Duration Gap Management • Limitations of Hedging Techniques

3. Introduction: Asset and liability management is the financial risk management of any financial institution. The asset-liability management formulates strategies and take actions that maximize the risk adjusted returns to shareholders over the long run. The Principal Goals of Asset Liability Management Are: • To maximize, or at least stabilize, the bank’s margin, or spread between interest revenues and interest expenses, and • to maximize, or at least protect, the value (stock price) of the bank, at an acceptable level of risk.

4. Asset-Liability Management Strategies • Asset Management Strategy Under this view, the public determined the amounts of deposits available to banks. Banks had no control over their deposits but they had full control over their assets, in other words, the allocation and terms of their credits. • Liability Management Strategy In the 1970s, after financial liberalization banks gained control over their deposit rates and terms of deposits. Depending on demand on their loans they offered high or low deposit rates to attract or discourage funds coming to their banks.

5. Funds Management Strategy This is a much more balanced approach and it dominates banking today. Its’ objectives are: • Volume, mix, and return, or cost of both assets and liabilities should be controlled • Control over assets must be coordinated with control over liabilities • Revenues and cost arise from both assets and liabilities. Banks should maximize returns and minimize costs of making loans and selling deposits.

6. Interest Rate Risk • When interest rates change, the change affects banks’ interest income on loans and securities, andinterest cost on deposits and other bank borrowings. • Changing interest rates also change the market value of a bank’s assets and liabilities, thereby changing the bank’s net worth (that is the value of the owners’ investment in the bank). • Thus, changing interest rates impact both a bank’s balance sheet and its statement of income and expenses.

7. Interest Rate Risk • Price Risk — When Interest Rates Rise, the Market Value of the Bond Falls • Reinvestment Risk — When Interest Rates Fall, the Coupon Payments on the Bond are Reinvested at Lower Rates

8. Measurement of Interest Rates Interest rates are the price of credit- what is demanded by lenders as compensation for the use of borrowed funds. • Yield to Maturity (YTM) One of the most popular rate measures (particularly in the bond market) is the yield to maturity (YTM) which is the discount rate that equalizes the current market value of a loan or security with the expected stream of future income payments that the loan or security will generate.

9. Example: PV = $950, FV = $1000, C = 10%, N = 3 i % = ? With financial calculator yield to maturity = 12.09% To watch how to calculate yield to maturity with Excel &TI BAII+ financial calculator. Please visit: www.youtube.com/watch?v=NV0S8pKvje8&feature=related

10. Bank Discount Rate (DR): Another popular interest rate measure is the bank discount rate, which is often quoted on short-term loans and money market securities. Where: FV equals Face Value of a security such as treasury bills.

11. Bank Discount Rate (DR): Example: FV = $100 Purchase price = $96 Number of days to maturity = 90 Bank discount rate (DR) = ? (100 –96) 360 DR = X = 0.16 = 16% 100 90

12. The Components of Interest Rates Market Interest Rates are a function of: • Risk-free Real Rate of Interest • Various Risk Premia • Default Risk (credit risk) • Inflation Risk • Maturity Risk (term risk) • Liquidity Risk • Call Risk

13. Yield Curves • Graphical Picture of how interest rates vary with different maturities of loans viewed at a single point in time is called yield curve. • We assume that all other factors, such as credit risk are held constant. Therefore, yield curves are generally Created With Treasury Securities to Keep Default Risk Constant.

14. Shape of the Yield Curve • Yield curves will display an upward slope (a rising yield curve) when long term interest rates exceed short term interest rates. This is the case when the economy is expected to expand. • Yield curves can also slope downward (a falling yield curve) with short term interest rates higher than long term rates. When the yield curve is sloped downward, the economy may soon head into a recession. • A horizontal yield curve exist when long term interest rates and short term interest rates are approximately at the same level. Horizontal yield curve suggest that interest rates may be stable for a time with little change

15. Net Interest Margin (NIM) In order to protect bank profits against adverse interest rate changes, then, management seeks to hold fixed the bank’s net interest margin (NIM): Int. income Int. expenses on from bank loans - deposits and other and investments borrowed funds NIM = Total earning assets Net interest income after expenses = Total earning assets

16. Goal of Interest Rate Hedging One Important Goal is to Insulate the Bank’s Profits from the Damaging Effects of Fluctuating Interest Rates

17. Market Interest Rates and Bank Profits

18. Example: bank’s Interest revenues = $ 4 billion bank’s Interest expenses = $ 2.6 billion bank’s earning assets = $ 40 billion 4 billion - 2.6 billion NIM = = . 035 = 3.5% 40 billion Note: This is not yet the bank’s profit from borrowing and lending funds because we have not considered no-ninterest expenses.

19. Interest –Sensitive Gap Management This is one of the most popular interest-rate hedging strategy used by banks. Banks try to match the volume of bank assets that can be repriced with the volume of deposits and other liabilities whose rates can also be adjusted with market conditions during the same time period. Dollar amount of repriceable Dollar amount of repriceable (interest-sensitive) bank assets = (interest-sensitive) bank liabilities repriceable assets: loans that are about to mature or renewed repriceable liabilities: deposits that are about to mature or renewed

20. Interest-Sensitive Assets • Short-Term Securities Issued by the Government and Private Borrowers • Short-Term Loans Made by the Bank to Borrowing Customers • Variable-Rate Loans Made by the Bank to Borrowing Customers

21. Interest-Sensitive Liabilities • Borrowings from Money Markets • Short-Term Savings Accounts • Money-Market Deposits • Variable-Rate Deposits

22. Interest-Sensitive Gap Measurements If the amount of repriceable assets is not equal the amount of re-priceable liabilities, a gap exist between these interest-sensitive assets and interest-sensitive liabilities. This gap can be negative or positive. Interest-sensitive gap = (Interest-sensitive assets) – (Interest-sensitive liabilities) Asset-sensitive Interest sensitive interest sensitive (positive) gap = assets – liabilities >0 Liability-sensitive Interest sensitive interest sensitive (negative) gap = assets – liabilities < 0

23. Interest-Sensitive Gap Measurements Dollar Interest-Sensitive Gap = Interest-Sensitive Assets - Interest-Sensitive Liabilities Relative Dollar IS Gap Interest-Sensitive Gap = Bank Size Interest Sensitive Assets Interest Sensitivity Ratio = Interest Sensitive Liabilities

24. Asset- Sensitive Gap : An Example Interest sensitive assets = $500 million Interest sensitive liabilities = 400 million This bank is asset sensitive with a positive gap of 100 million dollars. • If the interest rates rise, the bank’s net interest margin will increase, I.e. bank will experience an increase in its net interest income. • If the interest rates fall, when the bank is asset sensitive, the banks NIM will decline as interest revenues from assets drop by more than interest expenses associated with liabilities. • The bank with a positive gap will lose net interest income if interest rates fall.

25. Asset-Sensitive Bank Has: • Positive Dollar Interest-Sensitive Gap • Positive Relative Interest-Sensitive Gap • Interest Sensitivity Ratio Greater than One Asset-Sensitive Gap: • Interest Rates Rise NIM Rises • Interest Rates Fall NIM Falls

26. Liability-sensisitve gap: An Example: • Interest sensitive assets = 150 million interest sensitive liabilities = 200 million This bank is liability sensitive with a negative gap of 50 million dollars. • Rising interest rates will lower the bank’s net interest margin, because the rising cost associated with interest-sensitive liabilities will exceed increases in interest revenue from bank’s interest sensitive assets. • Falling interest rates will generate a higher interest margin and probably greater earnings as well, because borrowing costs will decline by more than interest revenues.

27. Liability-Sensitive Bank Has: • Negative Dollar Interest-Sensitive Gap • Negative Relative Dollar Interest-Sensitive Gap • Interest Sensitivity Ratio Less than One Liability-Sensitive Gap • Interest Rates Rise NIM Falls • Interest Rates Fall NIM Rises

28. Zero Interest-Sensitive Gap If interest-sensitive assets and liabilities of a bank are equal, this bank is relatively insulated from interest rate risk. In this case interest revenues and funding cost will change at the same rate. The bank’s gap is zero.

29. Important Decisions Concerning IS Gap 1. Management must choose the time period over which NIM is to be managed. 2. Management must choose a target NIM. 3. To increase NIM management must either: a. Develop correct interest rate forecast; or b. Reallocate assets and liabilities to increase spread. 4. Management must choose dollar volume of interest-sensitive assets and liabilities.

30. NIM Influenced By: • Changes in Interest Rates Up or Down • Changes in Spread Between Assets and Liabilities • Changes in the Volume of Interest-Sensitive Assets and Liabilities • Changes in the Mix of Assets and Liabilities between floating and fixed rate assets and liabilities, between shorter and longer maturity assets and liabilities, and between assets bearing higher versus lower expected yields

31. Cumulative Gap Cumulative Gap is The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced Over a Designated Time Period. Maturity IS Assets IS Liabilities Size of Gap Cumulative Gap 24 hours $40 $30 +10 +10 7 days $120 160 -40 -30 30 days 85 65 20 -10 90 days 280 250 30 +20 120 days 455 395 60 +80

32. Aggressive Interest-Sensitive Gap Management

33. Problems with Interest-SensitiveGap Management • Interest Rates 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 Impact of Changing Interest Rates on Equity Position