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

Asset-Liability Management Control of a bank’s sensitivity to changes in market interest rates to limit losses in its net income or equity. 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. M. Morshed

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. M. Morshed

Asset-Liability Management Strategies----Contd 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. 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. M. Morshed

Interest Rate Risk The danger that shifting interest rates could adversely affect the bank’s net interest margin (interest revenue and interest expense) and net worth (market value of assets and liabilities). There are different types of interest rate risk that affect earnings: Gap Risk Yield Curve Risk. Reinvestment & refunding risk. M. Morshed

Determination of Interest Rate Banks are price takers not price makers. Price risk (IR increase, asset value falls) and reinvestment risk (IR falls, lower future expected return). Price of Credit (Interest rate) Supply of loanable funds Rate of Interest Demand for loanable funds (credit) Volume of credit extended Quantity of loanable funds M. Morshed

Measurement of Interest Rate – Yield to Maturity The rate of discount applied to the expected earnings stream from a debt instrument that equalizes that stream’s present value with the instrument’s market price. Current Market Price = CF1 CF2 + (1 + YTM) (1 + YTM)2 CF3 Sale price of security or loan + -----------+ + (1 + YTM)n (1 + YTM)n M. Morshed

Measurement of Interest Rate – Discount Rate Often quoted on short term loans and money market securities. DR = (100 – Purchase price of loan or security/100) * (360/number of days to maturity) YTM equivalent = (100- PP/PP) * (365/days to maturity) M. Morshed

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 (via default risk premium, inflation risk premium, liquidity risk, call risk premium) changes over time due to “Inflation”, “Characteristics of the borrower”, ‘Marketability and Maturity of securities”. M. Morshed

Changes in Interest Rate affecting the NIM NIM = {interest income from bank loans & investments – interest expenses on deposits & other borrowed funds} / Total Earning Assets = Net interest income / 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 IR, income from loans will decline, NIM will be squeezed. M. Morshed

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. M. Morshed

Interest Rate Hedging Interest-Sensitive Gap Management Gap management techniques require management to perform an analysis of the maturities & repricing 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: M. Morshed

Interest-Sensitive Gap Management (continued) Dollar amount of repriceable (interest sensitive) bank assets = Dollar amount of repriceable (interest sensitive) bank liabilities. So, Interest Sensitive Gap = ISA – ISL IS GAP or Relative IS GAP (IS GAP/TA) could be positive (asset sensitive) or negative (liability sensitive) M. Morshed

Interest-Sensitive Gap Management………Contd Repriceable Assets Repriceable 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 ) M. Morshed

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. M. Morshed

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. M. Morshed

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. M. Morshed

Aggressive Interest-Sensitive Gap Management M. Morshed

Interest Rate Hedging Duration Gap Management M. Morshed