Asset Liability Management – Determining & Measuring Interest Rates Chapter:07 Asset Liability Management – Determining & Measuring Interest Rates

Asset – Liability Management Banks and many of their financial service competitors today are highly complex organizations, offering multiple financial services through multiple departments and divisions. Financial firms usually make the decisions about which customers are to receive credit, which securities should be added to or subtracted from the financial institution’s portfolio, which terms should be offered to the public on loans, deposits, investment advice and other services, and which sources of capital the institution should drawn upon.

Asset-Liability Management Today bankers and other financial service managers have learned to look at their asset and liability portfolios as an integrated whole. This type of coordinated and integrated decision making is known today as asset-liability management (ALM) The principal goals of asset-liability management are: To maximize, or at least stabilize, the bank’s margin or spread between interest revenues & interest expenses, & To maximize, or at least protect, the value (stock price) of the bank, at an acceptable level of risk.

Asset-Liability Management Strategies Asset Management Strategy: Control of the composition of a bank’s assets to provide adequate liquidity & earnings & meet other goals. The banker could exercise control only over the allocation of incoming funds by deciding who was to receive the scarce quantity of loans available & what the terms on those loans would be. Liability Management Strategy: Its goal was simply to gain control over the bank’s funds sources comparable to the control bankers had long exercised over their assets. The key control lever was price, the interest rate & other terms banks could offer on their deposits & borrowings to achieve the volume, mix & cost desired.

Asset-Liability Management Strategies----contt.. Funds Management Strategy: The key objectives of fund management strategy are: Bank management should exercise as much as control as possible over the volume, mix, & return or cost of both assets & liabilities to achieve the bank’s goals. Management’s control over assets must be coordinated with its control over liabilities so that asset & liability management are internally consistent & do not pull against each other. Effective coordination will help to maximize the spread between revenues and costs and control risk exposure. Revenues & costs arise from both sides of the bank’s balance sheet. Bank policies need to be developed that maximize reruns & minimize costs from supplying services.

Interest Rate Risk When interest rate changes in the financial marketplace, the sources of revenue banks receive- especially interest income on loans and securities – and their most important source of expenses- interest cost on deposit and other borrowings- must also change. Moreover, changing market interest rate also change the market value of assets and liabilities. The danger that shifting interest rates could adversely affect the bank’s net interest margin, assets or equity.

Interest Rate Risk, cont… Forces Determining Interest Rates: The rate of interest on any particular loan or security is ultimately determined by the financial marketplace where suppliers of loanable funds (credits) interact with demanders of loanable funds (credits) and the interest rates (price of credit) tends to settle at the point where the quantities of loanable funds (credits) demanded and supplied are equal.

Determination of Interest Rate loanable funds (credit) Supply of Affect the rate of return on loans and securities and the borrowing costs from selling deposits and issuing nondeposit IOUs (Interest rate on loans and securities) Price of Credit Rate of Interest loanable funds (credit) Demand for of credit extended Volume Quantity of loanable funds

Determining Interest Rates As market interest rates move, bankers and their competitors face at least two major kinds of interest rate risk- Price risk, and Reinvestment risk Price risk: this risk arises when market interest rates rise, causing the market values of most bonds and fix-rate loans to fall. If a financial institution wishes to sell these financial instruments in a rising rate period, it must be prepared to accept capital losses. Reinvestment risk: when market interest rates fall, forcing a financial firms to invest incoming funds in lower-yielding earnings assets, lowering its expected future income.

Measurement of Interest Rate How are interest rates measured? Interest rates are the price of credit, demanded by the lenders as compensation for the use of borrowed funds. One of the most popular measures is the Yield to Maturity (YTM), another popular interest rate measure is the bank discount rate (DR). YTM: the discount rate that equalizes the current market value of a loan or security with the expected stream of future payments that the loan or security will generate.

Measurement of Interest Rate, cont.. Bank Discount Rate: the rate often quoted on short-term loans and money market securities. DR ignores the effect of compounding of interest and is based on a 360 day year. In addition, the DR uses the face value of a financial instrument to calculate its yield or rate of return. To covert a DR to the equivalent yield to maturity we can use the formula:

The Components of Interest Rates Market Interest Rate on risky loan or security = Risk-Free Real Interest Rate (inflation adjusted return on Govt. securities) + Risk Premium RFRIR changes over time with shifts in the demand & supply for loanable funds. RP changes over time due to “Inflation”, “Characteristics of the borrower”, ‘Marketability and Maturity of securities”.

Response to Interest Rate Risk Changes in market interest rates can damage a bank or other financial firm’s profitability by increasing its cost of funds, lowering its returns from earnings assets, and reducing the value of the owners’ investment. Bankers have aggressively sought ways to insulate their asset and liability portfolios and their profits from the ravages of changing interest rates.

Changes in Interest Rate affecting the NIM NIM = {interest income from bank loans & investments – interest expenses on deposits & other borrowed funds} / Total Earning Assets If the interest cost of borrowed funds rises faster than bank income from loans & securities, the bank’s NIM will be squeezed, with adverse effects on bank profits. If interest rate fall and cause income from loans and securities to decline faster than interest costs on borrowings, the NIM will again be squeezed.

Factors Affecting NIM Changes in the level of interest rates. Changes in the spread between asset yields & liability costs. Changes in the volume of interest-bearing assets. Changes in the volume of interest-bearing liabilities. Changes in the mix of assets & liabilities that the management of each bank draws upon as its shifts between floating & fixed-rate assets & liabilities, between shorter & longer maturity assets & liabilities, between assets bearing higher versus lower expected yields.

Interest Rate Hedging Interest-Sensitive Gap Management Gap management techniques require management to perform an analysis of the maturities & re-pricing opportunities associated with the bank’s interest-bearing assets, deposits, & money market borrowings. Interest-sensitive gap management is basically the control over the difference between the volume of a bank’s interest sensitive assets & the volume of the interest-sensitive liabilities. Through Gap management bank wants to ensure for each time period that the – Dollar amount of re-priceable Dollar amount of re-priceable (interest-sensitive) assets = (interest-sensitive) liabilities

Interest-Sensitive Gap Management, Cont.. Re-priceable Assets Re-priceable Liabilities Short-term securities issued by government & private borrowers (about to mature) Borrowings from the money market. Short-term loans made by the bank to borrowing customers (about to mature) Short-term savings accounts Variable-rate (floating or adjustable rate) loans & securities Money-market deposits (whose interest rates often are adjustable every few days) Variable rate (floating or adjustable rate deposits )

Interest-Sensitive Gap Management, Cont.. What happen when the amount of repriceable assets does not equal the amount of repriceable liabilities? If the amount of repriceable assets does not equal the amount of repriceable liabilities, there is a gap exists. That is called Interest Sensitive Gap. The interest sensitivity gap is the portion of the balance sheet affected by interest rate. Interest sensitive gap = Interest sensitive assets – Interest sensitive liabilities

Interest-Sensitive Gap Management, Cont.. Positive gap or Asset-sensitive gap: If interest sensitive assets exceed the interest sensitive liabilities subject to repricing, the bank is said to have a positive gap and to be asset sensitive. Assets-sensitive (positive) gap = ISA – ISL >0 Effect: If interest rate rise, this bank’s interest margin will increase because the interest revenue generated by assets will increase more than the cost of borrowed funds. The bank will experience an increase in its net interest income. On the other hand, if interest rates fall, this bank’s NIM will decline as interest revenue from assets drop by more than interest expenses associated with liabilities.

Interest-Sensitive Gap Management, Cont.. Negative gap or Liability-sensitive gap: If interest sensitive liabilities exceed the interest sensitive assets, the bank is said to have a negative gap and to be liability sensitive. Liability-sensitive (negative) gap = ISA – ISL < 0 Effect: Raising interest will lower this bank’s net interest margin, because the rising cost associated with interest sensitive liabilities will exceeds increases in interest revenue from interest sensitive assets. On the other hand, if interest rates fall, will generate higher interest margin, because borrowing cost will decline by more than interest revenues.

Interest-Sensitive Gap Management, Cont.. Ways to measure Interest sensitive gap: Dollar IS GAP = ISA – ISL If dollar IS GAP is positiev, then bank is assets sensitive, and if dollar IS GAP is negative, bank is liability sensitive. If Relative IS GAP is greater than zero, then the bank is assets sensitive, and if Relative IS GAP is negative, bank is liability sensitive.

Interest-Sensitive Gap Management, Cont.. Interest Sensitive Ratio (ISR), compare the ratio of ISA to ISL. If ISR is less than 1 tell us bank is liability sensitive, while an ISR greater than unity points to an assets sensitive institution. An Asset-Sensitive Financial Firm Has: An Liability-Sensitive Financial Firm Has: Positive Dollar IS GAP Positive Relative IS GAP Interest Sensitivity Ratio greater than one Negative Dollar IS GAP Negative Relative IS GAP Interest Sensitivity Ratio less than one

Interest-Sensitive Gap Management, Cont.. A zero gap does not eliminate all interest rate risk, because- The interest rates attached to assets and liabilities are not perfectly correlated in the real world. Loan interest rates, for example, tend to lag behind interest rates on many money market borrowings. Interest revenue often tend to grow more slowly than expenses during economic downturns. s

Interest-Sensitive Gap Management, Cont.. What ever the models are used to calculate interest sensitive gap, require financial managers to make some important decision: Management must choose the time period during which the net interest margin (NIM) is to be managed (e.g. six month, one year) to achieve some desire value and the length of sub-periods (“maturity buckets”) into which the planning period is to be divided. Management must choose a target level for the net interest margin- that is, whether to freeze the margin roughly where it is or perhaps increase the NIM.

Interest-Sensitive Gap Management, Cont.. If management wishes to increase the NIM, it must either develop a correct interest rate forecast or find ways to reallocate earnings assets and liabilities to increase the spread between interest revenues and interest expenses. Management must determined the dollar volume of interest sensitive assets and interest sensitive liabilities it wants the financial firm to hold.

Defensive Interest-Sensitive Gap Management The strategy here is to achieve the following- IS Gap = 0 or ISA = ISL or IS Ratio (ISA/ISL) = 1 Then, changes in NIM will be zero

Possible Management Responses Eliminating a Bank’s Interest-Sensitive Gap by using Defensive Strategy With Positive Gap The Risk Possible Management Responses Interest-sensitive assets > Interest-sensitive liabilities (asset sensitive) Losses if interest rates fall because the bank’s net interest margin will be reduced. Do nothing. Extend asset maturities or shorten liability maturities. Increase interest-sensitive liabilities or reduce interest-sensitive assets.

Possible Management Responses Eliminating a Bank’s Interest-Sensitive Gap by using Defensive Strategy --Contd With Negative Gap The Risk Possible Management Responses Interest-sensitive assets < Interest-sensitive liabilities (liability sensitive) Losses if interest rates rise because the bank’s net interest margin will be reduced. Do nothing. Shorten asset maturities or lengthen liability maturities. Decrease interest-sensitive liabilities or increase interest-sensitive assets.