Interest Rate Risk: The Repricing Model Chapter 7 Interest Rate Risk: The Repricing Model

Overview This chapter explains how a third model of measuring an FI’s exposure to interest rates, the repricing model, works. We will examine the particular strengths of the model. We will discuss the particular weaknesses of the model. We will gain an understanding of the relative merits of the repricing model for banks, compared to the maturity model and to the duration model. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Repricing Model Repricing model is also know as the funding gap model. Book value accounting cash flow analysis of the repricing gap between rate-sensitive assets and rate-sensitive liabilities. Contrasts with market value-based maturity and duration models recommended by the Bank for International Settlements (BIS). Rate sensitivity means time to repricing. Repricing gap: rate-sensitive assets – rate-sensitive liabilities. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Repricing Model US Federal Reserve requires US commercial banks to report repricing gaps for assets and liabilities with maturities of: 1 day. More than 1 day, up to 3 months. More than 3 months, up to 6 months. More than 6 months, up to 12 months. More than 1 year, up to 5 years. More than 5 years. No such requirement in Australia, but most banks use the repricing model as an interest rate measurement tool. Australian banks listed in the US have to comply with US regulations. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Repricing Model Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

∆NIIi = (GAPi)∆Ri = (RSAiRSLi) ∆Ri The Repricing Model Model can be used to estimate the change in the FI’s net interest income in a particular repricing bucket if interest rates change. ∆NIIi = (GAPi)∆Ri = (RSAiRSLi) ∆Ri Where: ∆NIIi = change in net interest income in the ith bucket, GAPi = the dollar size of the gap between the book value of assets and liabilities in maturity bucket i, ∆Ri = the change in the level of interest rates impacting assets and liabilities in the ith bucket. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Repricing Model Example: Consider the following repricing gaps (in $ million). Assets Liabilities Gaps 1 day $50 $25 1 day to 3 months 10 40 -30 3 to 6 months 50 80 6 to 12 months 30 60 1 to 5 years 70 +60 Over 5 years 5 +5 $220 If the overnight interest rate rises by 1%, then: ∆NIIi = (- $30 million) × 0.01 = - $300,000. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Repricing Model The Cumulative Gap (CGap): Estimation of the cumulative gap over various repricing periods, such as one year. ∆NIIi = (CGAPi)∆Ri Reconsider the previous table. Assets Liabilities Gaps CGap 1 day $50 $25 1 day to 3 months 10 40 -30 -5 3 to 6 months 50 80 -35 6 to 12 months 30 60 -65 1 to 5 years 70 +60 Over 5 years 5 +5 $220 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Repricing Model The one-year cumulative gap is -$65 million. Assume ∆Ri = 1% is the average rate change that affects assets and liabilities that can be repriced within a year. ∆NIIi = (CGAPi)∆Ri = (-$65 million) (0.01) = -$650,000. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Rate-Sensitive Assets Examples: Short-term loans. T-Notes (of various maturities). Floating-rate long-term loans. The question to ask is: Will or can this asset have its interest rate changed within a specified time? Yes? Rate-sensitive. No? Not rate-sensitive. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Rate-Sensitive Liabilities Examples: Term deposits (of various maturities). Bankers’ acceptances. Negotiable certificates of deposits (NCDs). The question to ask is: Will or can this liability have its interest rate changed within a specified time? Yes? Rate-sensitive. No? Not rate-sensitive. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Rate-Sensitive Liabilities Are cheque accounts or transaction accounts rate-sensitive liabilities? Against inclusion: Rates paid on these accounts are ‘sticky’, Many deposits act as core deposits, Implicit cost of accounts is close to zero. For inclusion: Runoffs in case of interest rate rises resulting in high opportunity cost for the FI. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The CGap as a Percentage of Assets The CGap can be expressed as a percentage of assets. CGap / A provides the following information: the direction of the interest rate exposure (positive versus negative CGap), the scale of that exposure. Example: Assume a bank’s total assets are $500 million. The one-year cumulative gap is $20 million. CGap / A = $20 m / $500 m = 0.04 = 4.00% Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Real-Life Example of One-Year Gaps as a Percentage of Total Assets The inclusion of off-balance sheet items will change the gaps. Off-balance sheet gaps might be positive, while on- balance-sheet gaps are negative, and vice versa. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

The Repricing Model Advantages: Information value, Simplicity. Weaknesses: Market value effects, Over-aggregation, Runoffs. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Weaknesses of the Repricing Model Market value effects: Interest rate changes can adversely affect the market value of assets and liabilities, and thus the net worth of an FI. As such, the repricing model is only a partial measure of interest rate risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Weaknesses of the Repricing Model Over-aggregation: Rate-sensitive assets and rate-sensitive liabilities might not be evenly distributed within a maturity bucket. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

Weaknesses of the Repricing Model Runoffs: Periodic cash flow of interest and principal amortisation payments on long-term assets that can be reinvested at market rates. This runoff component is rate-sensitive. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher