BNFN 501 ASSET AND LIABILITY MANAGEMENT

1
BNFN 501ASSET AND LIABILITY MANAGEMENT

• WEEK 1
• P. ROSE (1999), CHP. 6
• DETERMINING AND MEASURING INTEREST RATES AND
  CONTROLLING A BANKS INTEREST- SENSITIVE GAP

2

• 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 banks
  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.

3
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.

4

• 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.

5
Interest Rate Risk

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

6
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

7
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.

8
Example

• PV 950
• FV 1000
• C 10
• N 3
• i ?
• With financial calculator yield to maturity
  12.09

9

• 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
10
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

11
Market Interest Rates

• Function of
• Risk-free Real Rate of Interest
• Various Risk Premia
• Default Risk
• Inflation Risk
• Maturity Risk
• Marketability Risk

12
Net Interest Margin (NIM)

• In order to protect bank profits against adverse
  interest rate changes, then, management seeks to
  hold fixed the banks 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

13
Goal of Interest Rate Hedging

• One Important Goal is to Insulate the Banks
  Profits from the Damaging Effects of Fluctuating
  Interest Rates

14
Market Interest Rates and Bank Profits
15
Example

• banks Interest revenues 4 billion
• banks Interest expenses 2.6 billion
• banks earning assets 40 billion
• 4 billion - 2.6 billion
• NIM
  . 035 3.5
• 40 billion
• Note This is not yet the banks profit from
  borrowing and lending funds because we have not
  considered noninterest expenses.

16
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

17
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

18
Interest-Sensitive Liabilities

• Borrowings from Money Markets
• Short-Term Savings Accounts
• Money-Market Deposits
• Variable-Rate Deposits

19
Interest-Sensitive Gap Measurements

• If the amount of repriceable assets is not equal
  the amount of repriceable 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 gt0
• Liability-sensitive Interest sensitive
  interest sensitive
• (negative) gap assets
  liabilities lt 0

20
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

21

• 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 banks 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.

22
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

23

• 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 banks net
  interest margin, because the rising cost
  associated with interest-sensitive liabilities
  will exceed increases in interest revenue from
  banks 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.

24
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

25
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 banks gap is zero.

26
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.

27
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

28
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

29
Aggressive Interest-Sensitive Gap Management
30
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