Central Bank & Interest Rate Risk Federal Reserve Bank: U.S. central bank Open market operations influence money supply, inflation, and interest rates Oct-1979 to Oct-1982, nonborrowed reserves target regime – did not work Implications of reserves target policy: Increases importance of measuring and managing interest rate risk. Effects of interest rate targeting. Lessens interest rate risk Greenspan view: Risk Management Focus on Federal Funds Rate Simple announcement of Fed Funds increase, decrease, or no change.

Repricing Model Repricing or funding gap model based on book value. 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 is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL. Refinancing risk

Maturity Buckets Commercial banks must report repricing gaps for assets and liabilities with maturities of: One day. More than one day to three months. More than 3 three months to six months. More than six months to twelve months. More than one year to five years. Over five years.

Repricing Gap Example Assets Liabilities Gap Cum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0

Repricing Gap Dollar GAP Spread Effect R Direction of NII Positive Increase Negative Ambiguous Decrease

Applying the Repricing Model DNIIi = (GAPi) DRi = (RSAi - RSLi) Dri Example: In the one day bucket, gap is -$10 million. If rates rise by 1%, DNII(1) = (-$10 million) × .01 = -$100,000.

Applying the Repricing Model Example II: If we consider the cumulative 1-year gap, DNII = (CGAPone year) DR = (-$15 million)(.01) = -$150,000.

Repricing Model

May be useful to express CGAP in ratio form as, CGAP/Assets. CGAP Ratio May be useful to express CGAP in ratio form as, CGAP/Assets. Provides direction of exposure and Scale of the exposure. Example: CGAP/A = $15 million / $270 million = .056, or 5.6 percent.

Unequal Changes in Rates If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case, NII = (RSA ×  RRSA ) - (RSL ×  RRSL ) Spread effect example: RSA=RSL=$155m RSA rate rises by 1.2% and RSL rate rises by 1.0% NII =  interest revenue -  interest expense = ($155 million × 1.2%) - ($155 million × 1.0%) = $310,000

Restructuring Assets & Liabilities The FI can restructure its assets and liabilities, on or off the balance sheet, to benefit from projected interest rate changes. Positive gap: increase in rates increases NII Negative gap: decrease in rates increases NII Example: State Street Boston Good luck? Or Good Management?

Problems with model: Repricing Model measures only short-term profit changes not shareholder wealth changes maturity buckets are arbitrarily chosen assets and liabilities within a bucket are considered equally rate sensitive ignores runoffs ignores prepayments ignores CFs gnerated from off balance sheet activities

Explicitly incorporates market value effects. The Maturity Model Explicitly incorporates market value effects. For fixed-income assets and liabilities: Rise (fall) in interest rates leads to fall (rise) in market price. The longer the maturity, the greater the effect of interest rate changes on market price. Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates.

Maturity Model Example FI issues a one-year CD to a depositor that has a face value of $100 and an interest rate promised to depositors of 15%. (On maturity at year end, the FI has to repay $115.) Suppose FI lends $100 for one year to a corporate borrower at 15% annual interest (so $A=$L). However, the FI contractually requires half of the loan ($50) to be repaid after 6 months and the last half to be repaid at the end of the year. Note that although the maturity of the loan equals the maturity of the deposit and the loan is fully funded by the deposit liabilities, the CFs on the loan may be greater or less than the $115 required to pay off depositors, depending on what happens to interest rates over the one year period.

Maturities and Interest Rate Exposure If MA - ML = 0, is the FI immunized? Extreme example: Suppose liabilities consist of 1-year zero coupon bond with face value $100. Assets consist of 1-year loan, which pays back $99.99 shortly after origination, and 1¢ at the end of the year. Both have maturities of 1 year. Not immunized, although maturity gap equals zero. Reason: Differences in duration* *(See Chapter 9)

Maturity Model Leverage also affects ability to eliminate interest rate risk using maturity model Example: Assets: $100 million in one-year 10-percent bonds, funded with $90 million in one-year 10-percent deposits (and equity) Maturity gap is zero but exposure to interest rate risk is not zero.