Interest Rate Risk Management: ISGAP Copyright 2014 by Diane S. Docking

Copyright 2014 by Diane S. Docking Learning Objectives Define the repricing gap measure of interest rate risk. Understand the process of ISGAP management Copyright 2014 by Diane S. Docking

Managing Interest Rate Risk Changes in interest rates: cause variability in net interest income (NII) and net interest margin (NIM) impact value of financial assets, liabilities, and reinvestment returns cause repricing of loans, securities, and deposits impacting NII Copyright 2014 by Diane S. Docking

Interest Rate Risk Management aka: ALM Purpose: To Control a Bank’s Sensitivity to Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity To formulate strategies and take actions that shape a bank’s balance sheet in a way that contributes to its desired goals. To maximize the bank’s margin or spread. To maximize the stock value at an acceptable level of risk. Done by an Asset/Liability Committee (ALCO) In general, a short-run management tool: Construct a sources and uses of funds statement. NIMs are controlled by this management. Copyright 2014 by Diane S. Docking

Defn: Net Interest Margin & Net Interest Income or where: * Or Total Average Assets Copyright 2014 by Diane S. Docking

Defn: Interest-Sensitive Assets (ISA or RSA*) Interest rate is subject to change/repricing within a year: Short-Term Securities and Loans Variable-Rate Securities and Loans Current portion of Fixed-Rate Securities and Loans to be received *Interest or Rate sensitive Copyright 2014 by Diane S. Docking

Defn: NON Interest-Sensitive Assets Interest rate is NOT subject to change/repricing within a year: Cash in vault Reserves at Fed** Fixed-rate L-T loans and securities (except current portion coming due next year if know this) PP&E Other non-earning assets: intangibles, accruals, prepaids, etc. **Reserves at Fed currently earn 0 - .25%; began in 2008. Copyright 2014 by Diane S. Docking

Defn: Interest-Sensitive Liabilities (ISL or RSL*) Interest rate is subject to change/repricing within a year: Borrowings from Money Markets Short-Term Savings Accounts** Adjustable rate Money-Market Deposits Variable-Rate Deposits *Interest or Rate sensitive **% that is “core” is not rate sensitive Copyright 2014 by Diane S. Docking

Defn: NON Interest-Sensitive Liabilities Interest rate is NOT subject to change/repricing within a year: DDA paying no interest Deposits where interest rates cannot be adjusted within a year Fixed-rate Long-term savings, CD’s IRAs Fixed-rate Long-term debt Copyright 2014 by Diane S. Docking

Copyright 2014 by Diane S. Docking ISGAP GAP = ISA - ISL Positive GAP where ISA > ISL Negative GAP where ISL > ISA Copyright 2014 by Diane S. Docking

Copyright 2014 by Diane S. Docking Portfolio Maturity Mismatch Copyright 2014 by Diane S. Docking

Other Interest-Sensitive Gap Measurements To compare 2 or more banks, or track a bank over time, use the: Relative ISGAP ratio = Gap$/Total Assets or Interest Sensitivity ratio = RSA$/$RSL$. Copyright 2014 by Diane S. Docking

Example: Relative GAP Ratio Relative GAP ratio - computes a standardized gap so you can compare different banks of different sizes. Bank 1 Bank 2 TA $1 million $100 million ISGAP $100,000 $ 5 million But: Relative Gap Ratio 10% 5% Copyright 2014 by Diane S. Docking

Example: ISGAP Measures RSA = $100 million RSL = $70 million TA = $300 million therefore: ISGAP = 100 – 70 = $ million (positive) Relative ISGAP = 30/300 = % ISRatio = 100/70 = (> 1) An -Sensitive Bank: Positive Dollar Interest-Sensitive Gap Positive Relative Interest-Sensitive Gap Interest Sensitivity Ratio Greater than One RSA = $100 million RSL = $140 million TA = $300 million therefore: ISGAP = 100 – 140 = million (negative) Relative ISGAP = -40/300 = % ISRatio = 100/140 = (< 1) A -Sensitive Bank: Negative Dollar Interest-Sensitive Gap Negative Relative Interest-Sensitive Gap Interest Sensitivity Ratio Less than One Copyright 2014 by Diane S. Docking

Measuring effect of interest rate changes The change in the dollar amount of net interest income (NII) is: If rates on assets and liabilities move the same: $NII = ISGAP$ ( i) If rates on assets and liabilities do not move the same: $NII = RSA$ ( iA) - RSL$ ( iL) Copyright 2014 by Diane S. Docking

Relationship Between ISGAP and Changes in NII D i D NII + - Copyright 2014 by Diane S. Docking

Example: ISGAP Management 10% interest sensitive 20% interest sensitive 20% mature in 1 year Copyright 2014 by Diane S. Docking Risk Management Association home page http://www.rmahq.org

Solution to Example: ISGAP Management Rate-Sensitive Assets = RSA = ___________ Rate-Sensitive Liabs = RSL = __________ GAP = RSA  RSL = Copyright 2014 by Diane S. Docking

Solution to Example: ISGAP Management if i  5%  Asset Income = +5%  $32.0m = +$ 1.6m Liability Costs = +5%  $49.5m = +$ 2.5m ∆ NII = $1.6m  $ 2.5 = $0.9m OR Since RSL > RSA, i  results in: NIM , NII  ∆ NII = GAP  ∆i= $17.5m  5% = $0.9m Copyright 2014 by Diane S. Docking

Example 2: ISGAP management Waller Bank has the following financial information: Assets: Annual Income* Cash $ 5 million $ 0 T-bill securities, 90-day @6% $ 20 million $ 1.20 million T-bonds, 5 year @ 8% $ 8 million $ 0.64 million Loans, 10 year, FR @8.125% $ 80 million $ 6.50 million Other assets $ 7 million $ 0 . Total Assets $120 million $ 8.34 million Liabilities & Equity Capital: Annual Expense* Demand deposits, no interest $ 5 million $ 0 Time deposits, 30-day @ 4% $ 90 million $ 3.60 million Time deposits, 5 year @ 6% $ 15 million $ 0.90 million Total Liabilities $110 million $ 4.50 million Total Equity Capital $ 10 million NII $ 3.84 million $120 million *Assume rollover at current rate of any S-T asset or liability. Copyright 2014 by Diane S. Docking

Example 2: ISGAP management (cont.) What is the bank’s NIM? If interest rates rise 2% next year, what will be the NIM? What if interest rates on assets increase only 90% the rate of liabilities? Explain how the bank could “insulate” itself against changes in interest rates. Copyright 2014 by Diane S. Docking

Solution for Example 2: ISGAP management NIM = NII/TA = $3.84/$120 = _________ ISGAP = ISA- ISL = 20 – 90 = _________________ $NII = ISGAP$ ( i) = -$70 million (+.02) = _____________________; therefore, New NIM assuming TA do not change = ($3.84 - $1.4)/$120 = $2.44/$120 = _____ Copyright 2014 by Diane S. Docking

Solution for Example 2: ISGAP management (cont.) c) If interest rates on assets increase only 1.8% then: $NII = RSA$ ( iA) - RSL$ ( iL) = [$20 (.018)] – [$90 (+.02)] =.36 – 1.8 = _________________ New NIM assuming TA do not change = ($3.84 - $1.44)/$120 = $2.40/$120 = _____ Copyright 2014 by Diane S. Docking

Solution for Example 2: ISGAP management (cont.) Needs to increase ______and/or decrease ______ to bring ISGAP = 0. HOW? Copyright 2014 by Diane S. Docking

Aggressive Interest-Sensitive Gap Management If interest rates are expected to increase in the near future, the bank could use a positive dollar gap as an aggressive approach to gap management. If interest rates are expected to decrease in the near future, the bank could use a negative dollar gap (so as rate fell, bank deposit costs would fall more than bank revenues, causing profit to rise). Expected Change in Interest Rates Best Interest-Sensitive Gap Position Aggressive Management’s Likely Actions Rising Market Interest Rates ________ IS Gap Increase in ________ Decrease in _______ Falling Market Interest Rates Copyright 2014 by Diane S. Docking

Measuring interest rate sensitivity and the dollar gap Incremental gaps Measure the gaps for different maturity buckets (e.g., 0-30 days, 30-90 days, 90-180 days, and 180-365 days). Cumulative gaps Add up the incremental gaps from maturity bucket to bucket. The total difference in dollars between those bank assets and liabilities which can be repriced over a designated time period. Copyright 2014 by Diane S. Docking

Computer-Based Techniques and Maturity Buckets 7-27 Computer-Based Techniques and Maturity Buckets Copyright 2014 by Diane S. Docking

Measuring interest rate sensitivity and the dollar gap Defensive versus aggressive asset/liability management: Defensively guard against changes in NII (e.g., near zero gap). Aggressively seek to increase NII in conjunction with interest rate forecasts (e.g., positive or negative gaps). Many times some gaps are driven by market demands (e.g., borrowers want long-term loans and depositors want short-term maturities. Copyright 2014 by Diane S. Docking

Problems with Interest-Sensitive Gap Management Time horizon problems related to when assets and liabilities are repriced. Dollar gap assumes they are all repriced on the same day, which is not true. For example, a bank could have a zero 30-day gap, but with daily liabilities and 30-day assets NII would react to changes in interest rates over time. A solution is to divide the assets and liabilities into maturity buckets (i.e., incremental gap). 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 Copyright 2014 by Diane S. Docking

Problems with Interest-Sensitive Gap Management Focus on net interest income rather than shareholder wealth. Dollar gap may be set to increase NIM if interest rates increase, but equity values may decrease if the value of assets fall more than liabilities fall (i.e., the duration of assets is greater than the duration of liabilities). Interest-Sensitive Gap Does Not Consider Impact of Changing Interest Rates on Equity Position Financial derivatives could be used to hedge dollar gap effects on equity values. Copyright 2014 by Diane S. Docking