Chapter 7: Managing Interest Rate Risk: GAP and Earnings Sensitivity 1 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 7: Managing Interest Rate Risk: GAP and Earnings Sensitivity 2

Managing Interest Rate Risk: GAP and Earnings Sensitivity Sensitivity to market risk (S) is one of the basic components of a bank’s CAMEL rating. For most financial institutions, interest rate risk is the primary contributor to market risk. Bank managers ask two questions: – What interest rate “bet” is the bank making? – How much risk is the bank taking (how big is the bet)? Interest rate risk arises from liabilities and assets that do not reprice coincidentally. 3

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Managing Interest Rate Risk: GAP and Earnings Sensitivity Interest yield and loan market value can vary much differently than interest cost and market value of liabilities. – Result is a change in net interest income and economic value of stockholders’ equity. For large, complex organizations interest volatility is just a portion of overall market risk. – During the financial crisis in , declines in the values of subprime loans, leveraged loans, collateralized debt and related instruments produced large losses. 5

Managing Interest Rate Risk: GAP and Earnings Sensitivity Banks use two basic models to assess interest rate risk. – GAP and earnings sensitivity analysis emphasizes income statement effects by focusing on how changes in interest rates and the bank’s balance sheet effect net interest income and net income. – Duration gap and economic value of equity analysis emphasizes the market value of stockholders’ equity by focusing on how these same changes affect the market value of assets vs. the market value of liabilities. 6

Managing Interest Rate Risk: GAP and Earnings Sensitivity Analysis introduces traditional measures of interest rate risk associated with static GAP models. – Models focus on GAP as a static measure of risk and net interest income as the target performance measure. – Sensitivity analysis extends GAP analysis to focus on the variation in bank earnings across different interest rate environments and provides information about income changes when rates rise or fall. Interest rate risk management is important because no one can consistently forecast rates accurately. 7

Measuring Interest Rate Risk with GAP Three general factors potentially cause a bank’s net interest income to change. – Rate Effects: Unexpected changes in interest rates. – Composition (Mix) Effects: Changes in the mix, or composition, of assets and/or liabilities. – Volume Effects: Changes in the volume of earning assets and interest-bearing liabilities. 8

Measuring Interest Rate Risk with GAP Bank makes $10 million in 3-year fixed commercial loans with quarterly payments, financed with deposits that reprice monthly. – If the loan rate is 5% and the deposit rate is 1%, the initial spread is 4%. – If deposit rates rise, the spread falls and if deposit rates fall, the spread rises. – Choice of longer-term fixed rate assets financed by shorter-term deposits evidences specific interest rate bet. – Describes the rate effect but ignores other effects. 9

Measuring Interest Rate Risk with GAP Balance sheet is dynamic and changes constantly over time. Rate changes are only one factor that affects earnings because banks change their mix of assets and liabilities. There are imbedded options in loans that will likely alter cash flows if interest rates change. 10

Traditional Static GAP Analysis Static GAP focuses on managing net interest income in the short run. Objective is to measure expected net interest income and identify strategies to stabilize or improve it. Interest rate risk is measured by calculating GAPs over different time intervals based on balance sheet data at a fixed point in time – static. 11

Traditional Static GAP Analysis Steps in GAP Analysis: 1.Develop an interest rate forecast. 2.Select a series of sequential time intervals for determining what amounts of assets and liabilities are rate sensitive within each time interval. 3.Group assets and liabilities into these time intervals or “buckets” according to time to first repricing. 4.Calculate GAP. 5.Forecast net interest income given the assumed interest rate environment and repricing characteristics of the underlying instruments. 12

Traditional Static GAP Analysis GAP measures the relative principal mounts of assets or liabilities that management expects to reprice within the relevant time interval. Ignores expected interest income and expense. GAP = RSA t – RSL t, : rate sensitive assets and liabilities are identified within each time bucket. – Periodic GAP compares RSAs and RSLs within each single time bucket. – Cumulative GAP compares RSAs and RSLs over all time buckets from the present through the last day in each successive time bucket. 13

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What Determines Rate Sensitivity? First steps require identification and classification of rate sensitive assets and liabilities. Expected Repricing versus Actual Repricing: – An asset or liability is normally classified as rate sensitive within a time interval if: 1.It matures. 2.It represents an interim or partial principal payment. 3.The interest rate applied to the outstanding principal balance changes contractually during the interval. 4.The interest rate applied to the outstanding principal balance changes when some base rate or index changes and management expects the base rate/index to change during the time interval. 16

What Determines Rate Sensitivity? Maturity: – If any asset or liability matures within a time interval, the principal amount will be repriced. If an asset matures, bank must reinvest the proceeds. If a liability matures, bank must replace with new funding. – Question is what principal amount is expected to reprice. Interim or Partial Principal Payment: – Any loan principal payment is rate sensitive if it is expected to be received within the time interval. – Same is true for payments on a bank’s liabilities. 17

What Determines Rate Sensitivity? Contractual Change in Rate: – Some assets and deposit liabilities earn or pay rates that vary contractually with some index. These instruments are repriced whenever the index changes. If the index will contractually change within 90 days, the underlying asset or liability is rate sensitive within 0–90 days. Change in Base Rate or Index: – Some loans and deposits interest rates are tied to indexes that change with unknown frequency. For the most meaningful GAP analysis, management must forecast when such rates will change. 18

Factors Affecting Net Interest Income Rate, Composition (Mix) and Volume Effects: – All affect net interest income. Changes in the Level of Interest Rates: – The sign of GAP (positive or negative) indicates the nature of the bank’s interest rate bet. A negative (positive) GAP, indicates that the bank has more (less) RSLs than RSAs. When interest rates rise (fall) during the time interval, the bank pays higher (lower) rates on all repriceable liabilities and earns higher (lower) yields on all repriceable assets. If a bank has a zero GAP (virtually impossible), RSAs equal RSLs. Equal interest rate changes do not alter net interest income because changes in interest income = changes in interest expense. 19

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Factors Affecting Net Interest Income Changes in the Level of Interest Rates (cont’d): – If there is a parallel shift in the yield curve then changes in Net Interest Income are directly proportional to the size of the GAP: ∆NII EXP = GAP x ∆i EXP – Yield curve rarely shifts parallel. If rates do not change by the same amount and at the same time, then net interest income may change by more or less. 22

Factors Affecting Net Interest Income Changes in the Relationship Between Asset Yields and Liability Costs: – Net interest income may differ from expected if the spread between earning asset yields and the interest cost of interest-bearing liabilities changes. – The spread may change because of a nonparallel shift in the yield curve or because of a change in the difference between different interest rates (basis risk). 23

Factors Affecting Net Interest Income Changes in Volume: – Net interest income varies directly with changes in the volume of earning assets and interest-bearing liabilities, regardless of interest rate levels. If a bank doubles in size without changing portfolio composition and interest rates, net interest income will double because the bank earns the same interest spread on twice the volume of assets. Changes in Portfolio Composition: – Any variation potentially alters net interest income. – There is no fixed relationship between changes in portfolio mix and net interest income. 24

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Rate, Volume, and Mix Analysis Many financial institutions publish a summary in their annual report of how net interest income has changed over time. – Separate changes attributable to shifts in asset and liability composition and volume from changes associated with movements in interest rates. 27

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Rate Sensitivity Reports Managers use these reports to monitor risk position and potential net interest income changes. – Reports classify a bank’s assets and liabilities as rate sensitive in selected time buckets through one year. Periodic GAP versus Cumulative GAP: – Periodic GAP: Gap for each time bucket. Measures timing of potential income effects from interest rate changes. – Cumulative GAP: The sum of periodic GAP's. Measures aggregate interest rate risk over the entire period Cumulative GAP is important since it directly measures a bank’s net interest sensitivity throughout the time interval. 29

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Strengths and Weaknesses of Static GAP Analysis Strengths: – Easy to understand. – Indicates relevant amount and timing of interest rate risk. – Suggests magnitudes of portfolio changes to alter risk. Weaknesses: – Ex-post measurement errors. – Ignores the time value of money. – Ignores the cumulative impact of interest rate changes. – Considers demand deposits to be non-rate sensitive. – Ignores embedded options in assets and liabilities. 32

Strengths and Weaknesses of Static GAP Analysis GAP Ratio: – GAP Ratio = RSAs/RSLs A GAP ratio greater than 1 indicates a positive GAP. A GAP ratio less than 1 indicates a negative GAP. Neither GAP nor the GAP ratio provides direct information on the potential variability in earnings when rates changes. 33

Strengths and Weaknesses of Static GAP Analysis GAP Divided by Earning Assets as a Measure of Risk: – An alternative risk measure that relates the absolute value of a bank’s GAP to earning assets. – The greater this ratio, the greater the interest rate risk. – Banks may specify a target GAP-to-earning-asset ratio in their ALCO policy statements. – A target allows management to position the bank to be either asset sensitive or liability sensitive, depending on the outlook for interest rates. 34

Earnings Sensitivity Analysis Extends static GAP analysis by making it dynamic. – Model simulation or what-if analysis of all factors that affect net interest income across a wide range of potential interest rate environments. Steps to Earnings Sensitivity Analysis: 1.Forecast interest rates. 2.Forecast balance sheet size and composition given the assumed interest rate environment. 3.Forecast when embedded options in assets and liabilities will be in money and hence, exercised under the assumed interest rate environment. 35

Earnings Sensitivity Analysis Steps to Earnings Sensitivity Analysis: 4.Identify when specific assets and liabilities will reprice given the rate environment. 5.Estimate net interest income and net income under the assumed rate environment. 6.Repeat the process to compare forecasts of net interest income and net income across different interest rate environments versus the base case. The choice of base case is important because all estimated changes in earnings are compared with the base case estimate. 36

Earnings Sensitivity Analysis Managers can estimate the impact of rate changes on earnings while allowing for: – Interest rates to follow any future path. – Different rates to change by different amounts at different times. – Expected changes in balance sheet mix and volume. – Embedded options to be exercised at different times and in different interest rate environments. – Effective GAPs to change when interest rates change. Bank does not have a single static GAP, but will experience amounts of RSAs and RSLs that change when rates change. 37

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Exercise of Embedded Options in Assets and Liabilities Most common embedded options at banks: – Refinancing of loans – Prepayment (even partial) of principal on loans – Bonds being called – Early withdrawal of deposits prior to final maturity – Caps on loan or deposit rates – Floors on loan or deposit rates – Call or put options on FHLB advances – Exercise of loan commitments by borrowers 39

Exercise of Embedded Options in Assets and Liabilities Three issues of embedded options: – Does the bank or its customer determine when the option is exercised? – How and by what amount is the bank being compensated for selling the option, or how much must it pay to buy the option? – Bank should forecast when the option will be exercised. Involves forecasting how much interest rates will change, when the loan will be prepaid when the bond will be called, and when the depositor will withdraw funds early. Will depend on the assumed rate environment. 40

Different Interest Rates Change by Different Amounts at Different Times Earnings sensitivity analysis allows incorporation of the impact of different competitive markets with alternative pricing strategies. – Enables forecast of different spreads between yields and interest costs when rates change by different amounts. – Banks are quick to increase base loan rates when interest rates increase but slow to lower base loan rates when rates fall. – Although rate sensitivity of different instruments might be nominally the same, impact is different due to different timing and magnitude of rate changes. 41

Earnings Sensitivity Analysis: An Example Consider the rate sensitivity report on the next slide for First Savings Bank (FSB) as of year-end – Report is based on the most likely interest rate scenario. FSB is a $1 billion bank that bases its analysis on forecasts of the federal funds rate and ties other rates to this overnight rate. – As such, the federal funds rate serves as the bank’s benchmark interest rate. FSB uses a base case interest rate forecast that is drawn from market implied forecast rates. 42

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Explanation of Sensitivity Results Demonstrates importance of understanding impact of exercising embedded options and pricing lags. Framework uses federal funds rate as the bench-mark rate such that rate shocks indicate how much the funds rate changes. – Loan rates move more contemporaneously with the federal funds rate than do FSB deposit rates. FSB has a large prepayment risk because many of the assets are longer term and carry fixed rates. – When rates fall, customers will typically exercise options. 49

Explanation of Sensitivity Results FSB’s earnings sensitivity results reflect the impacts of rate changes on a bank with this profile. There are two basic causes or drivers behind the estimated earnings changes. – First, other market rates change by different amounts and at different times relative to the federal funds rate. – Second, embedded options potentially alter cash flows when the options go in the money. – Combined impact is that FSB’s effective GAP is different in each rate shock environment, as is the spread. 50

Explanation of Sensitivity Results When rates increase, asset yields assumed to increase more than liability costs such that spreads widen. Opposite occurs when rates fall. FSB owns many fixed-rate mortgages subject to prepayment risk. – As rates decline, borrowers will refinance. – When rates rise, there are fewer rate sensitive assets. Different effective GAP for each rate scenario. Sometimes referred to as earnings-at-risk or net interest margin simulation. 51

Income Statement GAP Interest rate risk model which modifies the standard GAP model to incorporate different speeds and repricing of specific assets and liabilities given an interest rate change. Balance Sheet GAP: Reflects contractual repricing. Earnings Change Ratio (ECR): A ratio calculated for each asset or liability that estimates how the yield on assets or rate paid on liabilities is assumed to change relative to a 1 percent change in the base rate. 52

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Managing the GAP and Earnings Sensitivity Risk Steps to reduce risk in effective GAP management: – Calculate periodic GAPs over short time intervals. – Match fund repriceable assets with similar repriceable liabilities so that periodic GAPs approach zero. – Match fund long-term assets with non-interest- bearing liabilities. – Use off-balance sheet transactions, such as interest rate swaps and financial futures, to hedge. 55

Managing the GAP and Earnings Sensitivity Risk 56

Chapter 7: Managing Interest Rate Risk: GAP and Earnings Sensitivity 57 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.