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BNFN 501 ASSET AND LIABILITY MANAGEMENT

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Title: 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
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