Title: BNFN 501 ASSET AND LIABILITY MANAGEMENT
1BNFN 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.
3Asset-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.
5Interest 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.
6Interest 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
7Measurement 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.
8Example
- 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
10Bank 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
11Market 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
13Goal of Interest Rate Hedging
- One Important Goal is to Insulate the Banks
Profits from the Damaging Effects of Fluctuating
Interest Rates
14Market Interest Rates and Bank Profits
15Example
- 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.
16Interest 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
17Interest-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
18Interest-Sensitive Liabilities
- Borrowings from Money Markets
- Short-Term Savings Accounts
- Money-Market Deposits
- Variable-Rate Deposits
19Interest-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
20Interest-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.
22Asset-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.
24Liability-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
25Zero 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.
26Important 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.
27NIM 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
28Cumulative 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
-
29Aggressive Interest-Sensitive Gap Management
30Problems 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