McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Chapter Seven Asset-Liability Management: Determining and Measuring Interest Rates and Controlling Interest-Sensitive and Duration Gaps

7-2 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset-Liability Management The Purpose of Asset-Liability Management is to Control a Bank’s Sensitivity to Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity

7-3 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Historical View of Asset-Liability Management Asset Management Strategy Liability Management Strategy Funds Management Strategy

7-4 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Interest Rate Risk Price Risk –When Interest Rates Rise, the Market Value of the Bond or Asset Falls Reinvestment Risk –When Interest Rates Fall, the Coupon Payments on the Bond are Reinvested at Lower Rates

7-5 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Yield to Maturity (YTM)

7-6 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Discount Rate (DR) Where: FV equals Face Value

7-7 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Interest Rates Function of: Risk-Free Real Rate of Interest Various Risk Premiums –Default Risk –Inflation Risk –Liquidity Risk –Call Risk –Maturity Risk

7-8 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Yield Curves Graphical Picture of Relationship Between Yields and Maturities on Securities Generally Created With Treasury Securities to Keep Default Risk Constant Shape of the Yield Curve –Upward – Long-Term Rates Higher than Short-Term Rates –Downward – Short-Term Rates Higher than Long- Term Rates –Horizontal – Short-Term and Long-Term Rates the Same

7-9 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Net Interest Margin

7-10 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Goal of Interest Rate Hedging One Important Goal of Interest Rate Hedging is to Insulate the Bank from the Damaging Effects of Fluctuating Interest Rates on Profits

7-11 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Interest-Sensitive Gap Measurements Dollar Interest- Sensitive Gap Interest-Sensitive Assets – Interest Sensitive Liabilities = Relative Interest- Sensitive Gap Interest Sensitivity Ratio

7-12 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Interest-Sensitive Assets Short-Term Securities Issued by the Government and Private Borrowers Short-Term Loans Made by the Bank to Borrowing Customers Variable-Rate Loans Made by the Bank to Borrowing Customers

7-13 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Interest-Sensitive Liabilities Borrowings from Money Markets Short-Term Savings Accounts Money-Market Deposits Variable-Rate Deposits

7-14 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset-Sensitive Bank Has: Positive Dollar Interest-Sensitive Gap Positive Relative Interest-Sensitive Gap Interest Sensitivity Ratio Greater Than One

7-15 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Liability Sensitive Bank Has: Negative Dollar Interest-Sensitive Gap Negative Relative Interest-Sensitive Gap Interest Sensitivity Ratio Less Than One

7-16 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Gap Positions and the Effect of Interest Rate Changes on the Bank Asset-Sensitive Bank –Interest Rates Rise NIM Rises –Interest Rates Fall NIM Falls Liability-Sensitive Bank –Interest Rates Rise NIM Falls –Interest Rates Fall NIM Rises

7-17 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Zero Interest-Sensitive Gap Dollar Interest-Sensitive Gap is Zero Relative Interest-Sensitive Gap is Zero Interest Sensitivity Ratio is One –When Interest Rates Change in Either Direction - NIM is Protected and Will Not Change

7-18 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Important Decision Regarding IS Gap Management Must Choose the Time Period Over Which NIM is to be Managed Management Must Choose a Target NIM To Increase NIM Management Must Either: –Develop Correct Interest Rate Forecast –Reallocate Assets and Liabilities to Increase Spread Management Must Choose Volume of Interest-Sensitive Assets and Liabilities

7-19 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. NIM Influenced By: Changes in Interest Rates Up or Down Changes in the Spread Between Assets and Liabilities Changes in the Volume of Interest- Sensitive Assets and Liabilities Changes in the Mix of Assets and Liabilities

7-20 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Cumulative Gap The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period

7-21 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggressive Interest-Sensitive Gap Management Expected Change in Interest Rates Best Interest- Sensitive Gap Position Aggressive Management’s Likely Action Rising Market Interest Rates Positive IS GapIncrease in IS Assets Decrease in IS Liabilities Falling Market Interest Rates Negative IS GapDecrease in IS Assets Increase in IS Liabilities

7-22 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Problems with Interest-Sensitive Gap Management Interest 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 Interest-Sensitive Gap Does Not Consider the Impact of Changing Interest Rates on Equity Position

7-23 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Concept of Duration Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows

7-24 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. To Calculate Duration

7-25 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Sensitivity of a Security

7-26 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Convexity The Rate of Change in an Asset’s Price or Value Varies with the Level of Interest Rates or Yields

7-27 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Duration of an Asset portfolio Where: w i = the dollar amount of the ith asset divided by total assets D Ai = the duration of the ith asset in the portfolio

7-28 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Duration of a Liability Portfolio Where: w i = the dollar amount of the ith liability divided by total liabilities D Li = the duration of the ith liability in the portfolio

7-29 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Duration Gap

7-30 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Change in the Value of a Bank’s Net Worth

7-31 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Impact of Changing Interest Rates on a Bank’s Net Worth PositiveInterest Rate RiseNW Decrease GapInterest Rate FallNW Increase NegativeInterest Rate RiseNW Increase GapInterest Rate FallNW Decrease ZeroInterest Rate RiseNo Change GapInterest Rate FallNo Change

7-32 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Limitations of Duration Gap Management Finding Assets and Liabilities of the Same Duration Can be Difficult Some Assets and Liabilities May Have Patterns of Cash Flows that are Not Well Defined Customer Prepayments May Distort the Expected Cash Flows in Duration Customer Defaults May Distort the Expected Cash Flows in Duration Convexity Can Cause Problems