©2007, The McGraw-Hill Companies, All Rights Reserved 22-1 McGraw-Hill/Irwin Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet

©2007, The McGraw-Hill Companies, All Rights Reserved 22-2 McGraw-Hill/Irwin Interest Rate Risk Measurement Repricing or funding gap 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved 22-3 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 22-4 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 22-5 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 22-6 McGraw-Hill/Irwin Four Major Weakness in the Repricing Model Market value effects Cash flow patterns within a maturity bucket The problems of rate runoffs and prepayments Cash flows from off-balance-sheet activities Market value effects Cash flow patterns within a maturity bucket The problems of rate runoffs and prepayments Cash flows from off-balance-sheet activities

©2007, The McGraw-Hill Companies, All Rights Reserved 22-7 McGraw-Hill/Irwin 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)

©2007, The McGraw-Hill Companies, All Rights Reserved 22-8 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 22-9 McGraw-Hill/Irwin Insolvency Risk Management Net worth Book Value Market value or mark-to-market value basis Net worth Book Value Market value or mark-to-market value basis

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The Book Value of Capital The book value of capital usually comprises three components in banking –Par value of shares –Surplus value of shares –Retained earnings Book value of its capital and credit risk Book value of capital and interest rate risk The book value of capital usually comprises three components in banking –Par value of shares –Surplus value of shares –Retained earnings Book value of its capital and credit risk Book value of capital and interest rate risk

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 –Examination and Enforcement –Loan Trading 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 –Examination and Enforcement –Loan Trading

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Arguments against Market Value Accounting Difficulty of implementation Introduces unnecessary degree of variability into an FI’s net worth FI’s are less willing to accept longer- term asset exposures Difficulty of implementation Introduces unnecessary degree of variability into an FI’s net worth FI’s are less willing to accept longer- term asset exposures