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Understanding the Repricing Gap: Impact on Net Interest Income in Financial Institutions

This section explores the concept of the repricing gap within financial institutions, detailing how assets and liabilities are analyzed over different time horizons to understand exposure to interest rate changes. It provides examples of cumulative gaps over periods from one day to over five years, illustrating potential net interest income (NII) changes based on varying interest rates. Furthermore, it discusses the strengths and weaknesses of the repricing model, including its limitations in considering market value effects and mismatches in asset-liability durations.

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Understanding the Repricing Gap: Impact on Net Interest Income in Financial Institutions

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  1. Part B Covers pages 201-205

  2. Repricing Gap Example AssetsLiabilitiesGapCum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0

  3. Applying the Repricing Model • Example II: If we consider the cumulative 1-year gap, DNII = (CGAPone year) DR = (-$15 million)(.01) = -$150,000.

  4. Equal Rate Changes on RSAs, RSLs • Example: Suppose rates rise 1% for RSAs and RSLs. Expected annual change in NII, NII = CGAP ×  R = -$15 million × .01 = -$150,000 • With positive CGAP, rates and NII move in the same direction. • Change proportional to CGAP

  5. Unequal Changes in Rates • If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case, NII = (RSA ×  RRSA ) - (RSL ×  RRSL )

  6. Repricing Gap Example AssetsLiabilitiesGapCum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 210225 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0

  7. Unequal Rate Change Example • Spread effect example: RSA rate rises by 1.0% and RSL rate rises by 1.0% NII =  interest revenue -  interest expense = ($210 million × 1.0%) - ($225 million × 1.0%) = $2,100,000 -$2,250,000 = -$150,000

  8. Unequal Rate Change Example Spread effect example: RSA rate rises by 1.2% and RSL rate rises by 1.0% NII =  interest revenue -  interest expense = ($210 million × 1.2%) - ($225 million × 1.0%) = $2,520,000 -$2,250,000 = $270,000

  9. Unequal Rate Change Example Spread effect example: RSA rate rises by 1.0% and RSL rate rises by 1.2% NII =  interest revenue -  interest expense = ($210 million × 1.0%) - ($225 million × 1.2%) = $2,100,000 -$2,700,000 = -$600,000

  10. Repricing Model – 1 Year Cum Gap Analysis

  11. Repricing Model – 1 Year Cum Gap Analysis

  12. Difficult Balance Sheet Items • Equity/Common Stock O/S • Ignore for repricing model, duration/maturity = 0 • Demand Deposits • Treat as 30% repricing over 5 years/duration = 5 years 70% repricing immediately/duration = 0 • Passbook Accounts • Treat as 20% repricing over 5 years/duration = 5 years 80% repricing immediately/duration = 0 • Amortizing Loans • We will bucket at final maturity, but really should be spread out in buckets as principal is repaid. Not a problem for duration/market value methods

  13. Difficult Balance Sheet Items • Prime-based loans • Adjustable rate mortgages • Put in based on adjustment date • Repricing/maturity/duration models cannot cope with life-time cap • Assets with options • Repricing model cannot cope • Duration model does not account for option • Only market value approaches have the capability to deal with options • Mortgages are most important class • Callable corporate bonds also

  14. Prime Rate Vs Fed Funds 1955-2009

  15. Prime Rate Vs Fed Funds 1997-2009

  16. Prime Rate Vs Fed Funds 2007-2009

  17. Repricing Model – 1 Year Cum Gap Analysis

  18. Repricing Model – 1 Year Cum Gap Analysis

  19. Repricing Model – 1 Year Cum Gap Analysis

  20. Repricing Model – 1 Year Cum Gap Analysis

  21. Repricing Model – 1 Year Cum Gap Analysis

  22. Comparison of 1980 Bank vs S&L

  23. Comparison of 1980 Bank vs S&L

  24. Restructuring Assets & Liabilities • The FI can restructure its assets and liabilities, on or off the balance sheet, to benefit from projected interest rate changes. • Positive gap: increase in rates increases NII • Negative gap: decrease in rates increases NII • The “simple bank” we looked at does not appear to be subject to much interest rate risk. • Let’s try restructuring for the “Simple S&L”

  25. Weaknesses of Repricing Model • Weaknesses: • Ignores market value effects and off-balance sheet (OBS) cash flows • Overaggregative • Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets can be substantial. • Ignores effects of runoffs • Bank continuously originates and retires consumer and mortgage loans and demand deposits/passbook account balances can vary. Runoffs may be rate-sensitive.

  26. A Word About Spreads • Text example: Prime-based loans versus CD rates • What about libor-based loans versus CD rates? • What about CMT-based loans versus CD rates • What about each loan type above versus wholesale funding costs? • This is why the industry spreads all items to Treasury or LIBOR

  27. *The Maturity Model • Explicitly incorporates market value effects. • For fixed-income assets and liabilities: • Rise (fall) in interest rates leads to fall (rise) in market price. • The longer the maturity, the greater the effect of interest rate changes on market price. • Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates.

  28. Maturity of Portfolio* • Maturity of portfolio of assets (liabilities) equals weighted average of maturities of individual components of the portfolio. • Principles stated on previous slide apply to portfolio as well as to individual assets or liabilities. • Typically, maturity gap, MA - ML > 0 for most banks and thrifts.

  29. *Effects of Interest Rate Changes • Size of the gap determines the size of interest rate change that would drive net worth to zero. • Immunization and effect of setting MA - ML = 0.

  30. *Maturities and Interest Rate Exposure • If MA - ML = 0, is the FI immunized? • Extreme example: Suppose liabilities consist of 1-year zero coupon bond with face value $100. Assets consist of 1-year loan, which pays back $99.99 shortly after origination, and 1¢ at the end of the year. Both have maturities of 1 year. • Not immunized, although maturity gap equals zero. • Reason: Differences in duration** **(See Chapter 9)

  31. *Maturity Model • Leverage also affects ability to eliminate interest rate risk using maturity model • Example: Assets: $100 million in one-year 10-percent bonds, funded with $90 million in one-year 10-percent deposits (and equity) Maturity gap is zero but exposure to interest rate risk is not zero.

  32. Modified Maturity Model Correct for leverage to immunize, change: MA - ML = 0 to MA – ML& E = 0 with ME = 0 (not in text)

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