McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Twenty-three Managing Risk on the Balance Sheet III: Interest Rate and Insolvency Risk

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Interest Rate Risk Measurement Repricing or funding gap –the difference between those assets whose interest rates will be repriced or changed over some future period (RSAs) and liabilities whose interest rates will be repriced or changed over some future period (RSLs) Rate Sensitivity –the time to reprice an asset or liability –a measure of an FI’s exposure to interest rate changes in each maturity “bucket” –GAP can be computed for each of an FI’s maturity buckets Repricing or funding gap –the difference between those assets whose interest rates will be repriced or changed over some future period (RSAs) and liabilities whose interest rates will be repriced or changed over some future period (RSLs) Rate Sensitivity –the time to reprice an asset or liability –a measure of an FI’s exposure to interest rate changes in each maturity “bucket” –GAP can be computed for each of an FI’s maturity buckets

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Calculating GAP for a Maturity Bucket  NII i = (GAP) i  R i = (RSA i - RSL i )  R i where  NII i = change in net interest income in the ith maturity bucket GAP i = dollar size of the gap between the book value of rate-sensitive assets and rate- sensitive liabilities in maturity bucket i  R i = change in the level of interest rates impacting assets and liabilities in the ith maturity bucket  NII i = (GAP) i  R i = (RSA i - RSL i )  R i where  NII i = change in net interest income in the ith maturity bucket GAP i = dollar size of the gap between the book value of rate-sensitive assets and rate- sensitive liabilities in maturity bucket i  R i = change in the level of interest rates impacting assets and liabilities in the ith maturity bucket

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Simple Bank Balance Sheet and Repricing Gap Assets Liabilities_________ 1. Cash and due from $ 5 1. Two-year time deposits $ Short-term consumer Demand deposits 40 loans (1 yr. maturity) 3. Long-term consumer Passbook Savings 30 loans (2 yr. maturity) 4. Three-month T-bills Three-month CDs Six-month T-notes Three-month banker’s 20 acceptances 6. Three-year T-bonds Six-month commercial yr. Fixed-rate mort One-year time deposits yr. Floating-rate m Equity capital (fixed) Premises 5 $270 $270 Assets Liabilities_________ 1. Cash and due from $ 5 1. Two-year time deposits $ Short-term consumer Demand deposits 40 loans (1 yr. maturity) 3. Long-term consumer Passbook Savings 30 loans (2 yr. maturity) 4. Three-month T-bills Three-month CDs Six-month T-notes Three-month banker’s 20 acceptances 6. Three-year T-bonds Six-month commercial yr. Fixed-rate mort One-year time deposits yr. Floating-rate m Equity capital (fixed) Premises 5 $270 $270

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Additional Terminology Cumulative gap (CGAP): the cumulative GAP across various repricing categories or buckets Spread effect: the effect that a change in the spread between rates on RSAs and RSLs has on net interest income (NII) as interest rates change Cumulative gap (CGAP): the cumulative GAP across various repricing categories or buckets Spread effect: the effect that a change in the spread between rates on RSAs and RSLs has on net interest income (NII) as interest rates change

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Four Major Weakness in the Repricing Model It ignores market value effects of interest rate changes It ignores cash flow patterns within a maturity bucket It fails to deal with the problem of rate- insensitive asset and liability cash flow runoffs and prepayments It ignores cash flows from off-balance-sheet activities It ignores market value effects of interest rate changes It ignores cash flow patterns within a maturity bucket It fails to deal with the problem of rate- insensitive asset and liability cash flow runoffs and prepayments It ignores cash flows from off-balance-sheet activities

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Duration Model Duration gap - a measure of overall interest rate risk exposure for an FI D = _ %  in the market value of a security  R(1 + R) Duration gap - a measure of overall interest rate risk exposure for an FI D = _ %  in the market value of a security  R(1 + R)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Difficulties in Applying the Duration Model Duration matching can be costly Immunization is a dynamic problem Large interest rate changes and convexity Duration matching can be costly Immunization is a dynamic problem Large interest rate changes and convexity

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Insolvency Risk Management Net worth –a measure of an FI’s capital that is equal to the difference between the market value o its assets and the market value of its liabilities Book Value –value of assets and liabilities based on their historical costs Market value or mark-to-market value basis –balance sheet values that reflect current rather than historical prices Net worth –a measure of an FI’s capital that is equal to the difference between the market value o its assets and the market value of its liabilities Book Value –value of assets and liabilities based on their historical costs Market value or mark-to-market value basis –balance sheet values that reflect current rather than historical prices

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Effects of Changes in Loan Values and Interest Rates on the Balance Sheet Assets Liabilities Base case Long-term securities $ 80 Short-term floating $ 90 Long-term bonds 20 Net worth 10 $100 $100 After a major decline in value of loans Long-term securities $ 80 Liabilities $90 Long-term bonds 8 Net worth -2 $88 $88 After a rise in interest rates Long-term securities $ 75 Liabilities $90 Long-term loans 17 Net worth 2 $92 $92 Assets Liabilities Base case Long-term securities $ 80 Short-term floating $ 90 Long-term bonds 20 Net worth 10 $100 $100 After a major decline in value of loans Long-term securities $ 80 Liabilities $90 Long-term bonds 8 Net worth -2 $88 $88 After a rise in interest rates Long-term securities $ 75 Liabilities $90 Long-term loans 17 Net worth 2 $92 $92

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The Book Value of Shares The book value of capital usually comprises three components in banking –Par value of shares - the face value of the common shares issued by the FI time the number of shares outstanding –Surplus value of shares - the difference between the price the public paid for common shares and their par values –Retained earnings - the accumulated value of past profits not yet paid in dividends to shareholders Book value of its capital = Par value + Surplus + Retained earnings The book value of capital usually comprises three components in banking –Par value of shares - the face value of the common shares issued by the FI time the number of shares outstanding –Surplus value of shares - the difference between the price the public paid for common shares and their par values –Retained earnings - the accumulated value of past profits not yet paid in dividends to shareholders Book value of its capital = Par value + Surplus + Retained earnings

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The Discrepancy between the Market and Book Values of Equity The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of values –Interest Rate Volatility - the higher the interest rate, the greater the discrepancy –Examination and Enforcement - the more frequent the examinations and the stiffer the examiner’s standards, the smaller the discrepancy –Loan Trading - the more loans traded the easier to assess the true market value of the loan portfolio The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of values –Interest Rate Volatility - the higher the interest rate, the greater the discrepancy –Examination and Enforcement - the more frequent the examinations and the stiffer the examiner’s standards, the smaller the discrepancy –Loan Trading - the more loans traded the easier to assess the true market value of the loan portfolio

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Calculating Discrepancy Between Book Values (BV) and Market Values (MV) MV = Market value of equity ownership in shares outstanding Number of shares Par value of equity + Surplus value + BV = Retained earnings_ ________ Number of shares Market-to-book ratio A ratio that shows the discrepancy between the stock market value of an FI’s equity and the book value of its equity MV = Market value of equity ownership in shares outstanding Number of shares Par value of equity + Surplus value + BV = Retained earnings_ ________ Number of shares Market-to-book ratio A ratio that shows the discrepancy between the stock market value of an FI’s equity and the book value of its equity