Learning Objectives
Define the repricing gap measure of interest rate risk.
Understand the process of ISGAP management
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Managing Interest Rate Risk
Changes in interest rates: cause variability in net interest income (NII)
and net interest margin (NIM) impact value of financial assets, liabilities,
and reinvestment returns cause repricing of loans, securities, and
deposits impacting NII
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Interest Rate Risk Managementaka: ALM
Purpose: To Control a Bank’s Sensitivity to Changes in Market
Interest Rates and Limit its Losses in its Net Income or Equity
To formulate strategies and take actions that shape a bank’s balance sheet in a way that contributes to its desired goals.
To maximize the bank’s margin or spread. To maximize the stock value at an acceptable level of risk.
Done by an Asset/Liability Committee (ALCO) In general, a short-run management tool:
Construct a sources and uses of funds statement.NIMs are controlled by this management.
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Assets Earning Total NIM
NII
Defn: Net Interest Margin & Net Interest Income
or
where:
* Or Total Average Assets
expenseinterestincomeinterestNII
*Assets Total NIM
NII
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Defn: Interest-Sensitive Assets (ISA or RSA*)
Interest rate is subject to change/repricing within a year: Short-Term Securities and Loans Variable-Rate Securities and Loans Current portion of Fixed-Rate Securities
and Loans to be received
*Interest or Rate sensitive
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Defn: NON Interest-Sensitive Assets
Interest rate is NOT subject to change/repricing within a year: Cash in vault Reserves at Fed** Fixed-rate L-T loans and securities (except
current portion coming due next year if know this)
PP&E Other non-earning assets: intangibles,
accruals, prepaids, etc.**Reserves at Fed currently earn 0 - .25%; began in 2008.
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Defn: Interest-Sensitive Liabilities (ISL or RSL*)
Interest rate is subject to change/repricing within a year: Borrowings from Money Markets Short-Term Savings Accounts** Adjustable rate Money-Market Deposits Variable-Rate Deposits
*Interest or Rate sensitive**% that is “core” is not rate sensitive
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Defn: NON Interest-Sensitive Liabilities
Interest rate is NOT subject to change/repricing within a year: DDA paying no interest Deposits where interest rates cannot be
adjusted within a year Fixed-rate Long-term savings, CD’s IRAs Fixed-rate Long-term debt
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ISGAP
GAP = ISA - ISL Positive GAP where ISA > ISL Negative GAP where ISL > ISA
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To compare 2 or more banks, or track a bank over time, use the:
Relative ISGAP ratio = Gap$/Total Assets
or
Interest Sensitivity ratio = RSA$/$RSL$.
Other Interest-Sensitive Gap Measurements
Example: Relative GAP RatioRelative GAP ratio - computes a standardized gap so you
can compare different banks of different sizes.
Bank 1 Bank 2TA $1 million $100
millionISGAP $100,000 $ 5
million
But:Relative Gap Ratio 10% 5%
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Example: ISGAP Measures
RSA = $100 millionRSL = $70 millionTA = $300 million
therefore:ISGAP = 100 – 70 = $ million
(positive)Relative ISGAP = 30/300 = %
(positive)ISRatio = 100/70 =
(> 1)
An -Sensitive Bank:Positive Dollar Interest-Sensitive GapPositive Relative Interest-Sensitive GapInterest Sensitivity Ratio Greater than One
RSA = $100 millionRSL = $140 millionTA = $300 million
therefore:ISGAP = 100 – 140 = million
(negative)Relative ISGAP = -40/300 = %
(negative)ISRatio = 100/140 = (< 1)
A -Sensitive Bank:Negative Dollar Interest-Sensitive GapNegative Relative Interest-Sensitive GapInterest Sensitivity Ratio Less than One
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Measuring effect of interest rate changes
The change in the dollar amount of net interest income (NII) is:1. If rates on assets and liabilities move the same:
$NII = ISGAP$ ( i)
2. If rates on assets and liabilities do not move the same:
$NII = RSA$ ( iA) - RSL$ ( iL)
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Relationship Between ISGAP and Changes in NII
ISGAP D i D NII
+ +
+ -
- +
- -
0 +
0 -
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Example: ISGAP Management
Risk Management Association home pagehttp://www.rmahq.org
20% mature in 1 year
10% interest sensitive
20% interest sensitive
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Solution to Example: ISGAP Management
Rate-Sensitive Assets =
RSA = ___________
Rate-Sensitive Liabs =
RSL = __________
GAP = RSA RSL =
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Solution to Example: ISGAP Management
if i 5% Asset Income = +5% $32.0m = +$ 1.6mLiability Costs = +5% $49.5m = +$ 2.5m
∆ NII = $1.6m $ 2.5 = $0.9mOR
Since RSL > RSA, i results in: NIM , NII
∆ NII = GAP ∆i= $17.5m 5% = $0.9m
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Example 2: ISGAP managementWaller Bank has the following financial information:Assets: Annual
Income*Cash $ 5 million $ 0T-bill securities, 90-day @6% $ 20 million $ 1.20 millionT-bonds, 5 year @ 8% $ 8 million $ 0.64 millionLoans, 10 year, FR @8.125% $ 80 million $ 6.50 millionOther assets $ 7 million $ 0 .
Total Assets $120 million $ 8.34 million
Liabilities & Equity Capital: Annual Expense*Demand deposits, no interest $ 5 million $ 0Time deposits, 30-day @ 4% $ 90 million $ 3.60 millionTime deposits, 5 year @ 6% $ 15 million $ 0.90 million
Total Liabilities $110 million $ 4.50 million
Total Equity Capital $ 10 million NII $ 3.84 million
$120 million
*Assume rollover at current rate of any S-T asset or liability.
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Example 2: ISGAP management (cont.)
a) What is the bank’s NIM?b) If interest rates rise 2% next year, what will be the
NIM?c) What if interest rates on assets increase only 90%
the rate of liabilities?d) Explain how the bank could “insulate” itself against
changes in interest rates.
Solution for Example 2: ISGAP management
a) NIM = NII/TA = $3.84/$120 = _________
b) ISGAP= ISA- ISL= 20 – 90 = _________________
$NII = ISGAP$ ( i) = -$70 million (+.02) = _____________________; therefore,
New NIM assuming TA do not change = ($3.84 - $1.4)/$120 = $2.44/$120 = _____
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Solution for Example 2: ISGAP management (cont.)
c) If interest rates on assets increase only 1.8% then:$NII = RSA$ ( iA) - RSL$ ( iL)
= [$20 (.018)] – [$90 (+.02)] =.36 – 1.8 = _________________
New NIM assuming TA do not change = ($3.84 - $1.44)/$120 = $2.40/$120 = _____
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Solution for Example 2: ISGAP management (cont.)
d) Needs to increase ______and/or decrease ______ to bring ISGAP = 0.
HOW?
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Aggressive Interest-Sensitive Gap Management
• If interest rates are expected to increase in the near future, the bank could
• use a positive dollar gap as an aggressive approach to gap management.
• If interest rates are expected to decrease in the near future, the bank could
• use a negative dollar gap (so as rate fell, bank deposit costs would fall more than bank revenues, causing profit to rise).Expected Change
in Interest RatesBest Interest-Sensitive Gap
Position
Aggressive Management’s Likely
Actions
Rising Market Interest Rates
________ IS Gap Increase in ________Decrease in _______
Falling Market Interest Rates
________ IS Gap Increase in ________Decrease in _______
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Measuring interest rate sensitivity and the dollar gap
Incremental gaps Measure the gaps for different maturity
buckets (e.g., 0-30 days, 30-90 days, 90-180 days, and 180-365 days).
Cumulative gaps Add up the incremental gaps from maturity
bucket to bucket. The total difference in dollars between those
bank assets and liabilities which can be repriced over a designated time period.
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Measuring interest rate sensitivity and the dollar gap
Defensive versus aggressive asset/liability management: Defensively guard against changes in NII
(e.g., near zero gap). Aggressively seek to increase NII in
conjunction with interest rate forecasts (e.g., positive or negative gaps).
Many times some gaps are driven by market demands (e.g., borrowers want long-term loans and depositors want short-term maturities.
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Problems with Interest-Sensitive Gap Management
1. Time horizon problems related to when assets and liabilities are repriced. Dollar gap assumes they are all repriced on the same day, which is not true. For example, a bank could have a zero 30-day gap, but with
daily liabilities and 30-day assets NII would react to changes in interest rates over time.
A solution is to divide the assets and liabilities into maturity buckets (i.e., incremental gap).
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
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Problems with Interest-Sensitive Gap Management
2. Focus on net interest income rather than shareholder wealth.
Dollar gap may be set to increase NIM if interest rates increase, but equity values may decrease if the value of assets fall more than liabilities fall (i.e., the duration of assets is greater than the duration of liabilities).
Interest-Sensitive Gap Does Not Consider Impact of Changing Interest Rates on Equity Position
3. Financial derivatives could be used to hedge dollar gap effects on equity values.