1. 1 COMMERCIAL BANK MANAGEMENT 2

2. 2 ASSET-LIABILITY MANAGEMENT THE COORDINATION OF MANAGEMENT DECISIONS REGARDING THE ALLOCATION OF FUNDS TO CERTAIN ASSETS AND THE INTEGRATION INTO THESE DECISIONS THE INFORMATION REGARDING THE SOURCE OF FUNDS BOTH DEPOSIT AND NONDEPOSIT IS REFERRED TO AS ASSET-LIABILITY MANAGEMENT.

3. 3 ASSET-LIABILITY MANAGEMENT STRATEGIES ASSET MANAGEMENT STRATEGY TRADITIONALLY BANKERS BELIEVED THAT THEIR SOURCES OF FUNDS MAINLY DEPOSITS WERE DETERMINED BY THEIR CUSTOMERS, AND THAT THE BANKER ONLY EXERCISED CONTROL OVER THE ASSETS, MAKING DECISIONS ON WHICH BORROWERS WOULD RECEIVE CREDIT AND HOW FUNDS NOT ALLOCATED TO LOANS WOULD BE USED.

4. 4 ASSET-LIABILITY MANAGEMENT STRATEGIES LIABILITY MANAGEMENT STRATEGY IN THE 1960s AND 1970s CONFRONTED WITH SOARING INTEREST RATES AND INTENSE COMPETITION FOR FUNDS, BANKERS BEGAN TO DEVOTE GREATER ATTENTION TO OPENING UP NEW SOURCES OF FUNDING AND MONITORING THE MIX AND COST OF THEIR DEPOSIT AND NONDEPOSIT LIABILITIES.

5. 5 ASSET-LIABILITY MANAGEMENT STRATEGIES FUNDS MANAGEMENT STRATEGY THE MATURING OF LIABILITY MANAGEMENT TECHNIQUES, COUPLED WITH MORE VOLATILE INTEREST RATES AND GREATER RISK, EVENTUALLY GAVE BIRTH TO THE FUNDS MANAGEMENT APPROACH, WHICH STRESSES SEVERAL KEY OBJECTIVES:

6. 6 ASSET-LIABILITY MANAGEMENT STRATEGIES FUNDS MANAGEMENT STRATEGY 1.MANAGEMENT SHOULD EXERCISE AS MUCH CONTROL AS POSSIBLE OVER THE VOLUME, MIX AND THE RETURN OR COST OF BOTH ASSETS AND LIABILITIES. 2.MANAGEMENT’S CONTROL OVER ASSETS MUST BE COORDINATED WITH ITS CONTROL OVER LIABILITIES. EFFECTIVE COORDINATION WILL HELP MAXIMISE THE SPREAD BETWEEN REVENUES AND COSTS AND CONTROL RISK EXPOSURE. 3.REVENUES AND COSTS ARISE FROM BOTH SIDES OF THE BALANCE SHEET. MANAGEMENT POLICIES NEED TO BE DEVELOPED THAT MAXIMIZE RETURNS AND MINIMIZE COSTS FROM SUPPLYING SERVICES.

7. 7 INTEREST RATE RISK NO FINANCIAL MANAGER CAN COMPLETELY AVOID ONE OF THE TOUGHEST AND POTENTIALLY MOST DAMAGING FORMS OF RISK THAT ALL BANKS FACE—INTEREST RATE RISK. CHANGING MARKET INTEREST RATES IMPACT BOTH THE BALANCE SHEET AND THE STATEMENT OF INCOME.

8. 8 FORCES DETERMINING INTEREST RATES ALTHOUGH INTEREST RATES ARE CRITICAL TO EVERY BANK, BANK MANAGERS CANNOT CONTROL EITHER THE LEVEL OR THE TREND IN MARKET INTEREST RATES. INTEREST RATES ARE DETERMINED BY THE FINANCIAL MARKETPLACE THROUGH THE SUPPLY AND DEMAND FOR FUNDS.

9. 9 FORCES DETERMINING INTEREST RATES

10. 10 THE COMPONENTS OF INTEREST RATES MARKET INTEREST RATE ON A RISKY LOAN OR SECURITY = RISK-FREE REAL INTEREST RATE (SUCH AS THE INFLATION-ADJUSTED RETURN ON GOVT BONDS) + RISK PREMIUMS TO COMPENSATE LENDERS WHO ACCEPT RISKY ASSETS

11. 11 THE COMPONENTS OF INTEREST RATES RISK PREMIUMS COVER THE FOLLOWING RISKS: 1.DEFAULT (CREDIT) RISK 2.INFLATION RISK 3.TERM OR MATURITY RISK 4.MARKETABILITY RISK 5.CALL RISK

12. 12 THE YIELD CURVE THE YIELD CURVE IS A GRAPH SHOWING HOW INTEREST RATES VARY WITH DIFFERENT MATURITIES. GENERALLY YIELD CURVES ARE “POSITIVE” THAT IS UPWARD SLOPING REFLECTING THE FACT THAT LONG-TERM INTEREST RATES ARE HIGHER THAN SHORT-TERM RATES. “INVERSE” YIELD CURVES OCCUR WHEN SHORT- TERM RATES ARE HIGHER THAN LONG-TERM RATES, “INVERSE” YIELD IS CAUSED BY THE MARKET EXPECTATION THAT INTEREST RATES WILL FALL.

13. 13 THE MATURITY GAP AND THE YIELD CURVE A “POSITIVE” YIELD CURVE IS MORE FAVORABLE FOR THE PROFITABILITY OF BANKS THAN AN “INVERSE” YIELD CURVE THIS IS BECAUSE THE ASSETS OF THE BANK LOANS AND SECURITIES TEND TO HAVE LONGER MATURITIES THAN THEIR SOURCES OF FUNDS, SUCH AS DEPOSITS AND MONEY-MARKET BORROWINGS THE DIFFERENCE BETWEEN THE AVERAGE MATURITY OF ASSETS AND LIABILITIES IS REFERRED TO AS THE “MATURITY GAP”

14. 14 THE RESPONSE OF BANKS TO INTEREST RATE RISK IN RECENT DECADES BANKERS HAVE AGGRESSIVELY SOUGHT WAYS TO INSULATE THEIR ASSET AND LIABILITY PORTFOLIOS AND THEIR PROFITS FROM THE RAVAGES OF CHANGING INTEREST RATES. MANY BANKS CONDUCT THEIR ASSET- LIABLITY MANAGEMENT STRATEGY UNDER THE GUIDANCE OF AN ASSET-LIABILITY COMMITTEE, WHICH USUALLY MEETS DAILY

15. 15 THE RESPONSE OF BANKS TO INTEREST RATE RISK IN ORDER TO INSULATE PROFITS FROM THE DAMAGING EFFECTS OF FLUCTUATING INTEREST RATES, BANK MANAGEMENT WILL SEEK TO HOLD THE “NET INTEREST MARGIN” FIXED REMEMBER THAT THE “NET INTEREST MARGIN” IS EQUAL TO THE NET INTEREST INCOME DIVIDED BY THE TOTAL EARNING ASSETS

16. 16 INTEREST-SENSITIVE GAP MANAGEMENT THE MOST POPULAR INTEREST RATE HEDGING STRATEGY IS CALLED “INTEREST-SENSITIVE GAP MANAGEMENT” THIS TECHNIQUE REQUIRES BANKERS TO ANALYSE THE MATURITIES AND REPRICING OPPORTUNITIES ASSOCIATED WITH INTEREST- BEARING ASSETS AND WITH DEPOSITS AND OTHER BORROWINGS THE AIM IS TO MATCH AS CLOSELY AS POSSIBLE THE VOLUME OF ASSETS THAT CAN BE REPRICED AS RATES CHANGE WITH THE VOLUME OF DEPOSITS AND OTHER LIABILITIES WHOSE RATES CAN ALSO BE ADJUSTED WITH MARKET CONDITIONS DURING THE SAME TIME PERIOD.

17. 17 INTEREST-SENSITIVE GAP MANAGEMENT ALTHOUGH THE AIM IS TO MATCH THE VOLUMES OF ASSETS AND LIABILITIES WHICH CAN BE REPRICED, IN REAL LIFE THIS IS SELDOM POSSIBLE MOST OF THE TIME THERE IS A GAP BETWEEN INTEREST-SENSITIVE ASSETS AND INTEREST-SENSITIVE LIABILITIES, WHICH İS REFERRED TO AS THE “INTEREST-SENSITIVE GAP”

18. 18 INTEREST-SENSITIVE GAP MANAGEMENT INTEREST-SENSITIVE GAP = INTEREST- SENSITIVE ASSETS – INTEREST-SENSITIVE LIABILITIES IF INTEREST-SENSITIVE ASSETS IN EACH PLANNING PERIOD (DAY, WEEK, MONTH, ETC.) EXCEED THE VOLUME OF INTEREST SENSITIVE LIABILITIES, THE BANK IS SAID TO HAVE A “POSITIVE GAP” AND TO BE “ASSET SENSITIVE” IN THE OPPOSITE SITUATION THE BANK WILL HAVE A “NEGATIVE GAP” AND BE “LIABILITY SENSITIVE”

19. 19 INTEREST-SENSITIVE GAP MANAGEMENT GAPPING METHODS REQUIRE THE FINANCIAL MANAGERS TO MAKE SOME IMPORTANT DECISIONS: 1.THE TIME PERIOD OVER WHICH NIM IS TO BE MANAGED MUST BE CHOSEN 2.A TARGET LEVEL OF NIM MUST BE CHOSEN 3.IF THE WISH IS TO INCREASE NIM, EITHER A CORRECT INTEREST RATE FORECAST MUST BE DEVELOPED OR WAYS MUST BE FOUND TO REALLOCATE EARNING ASSETS AND LIABILITIES TO INCREASE THE SPREAD BETWEEN INTEREST INCOME AND INTEREST EXPENSE 4.THE DOLLAR VOLUME OF INTEREST-SENSITIVE ASSETS AND INTEREST-SENSITIVE LIABILITIES TO BE HELD MUST BE DETERMINED.

20. 20 INTEREST-SENSITIVE GAP MANAGEMENT THE NET INTEREST MARGIN IS INFLUENCED BY MULTIPLE FACTORS: 1.CHANGES IN THE LEVEL OF INTEREST RATES, UP OR DOWN 2.CHANGES IN THE SPREAD BETWEEN ASSET YIELDS AND LIABILITY COSTS (OFTEN REFLECTED IN THE CHANGING SHAPE OF THE YIELD CURVE) 3.CHANGES IN THE OVERALL VOLUME OF INTEREST-BEARING ASSETS AND INTEREST- BEARING LIABILITIES A BANK HOLDS AS IT EXPANDS OR SHRINKS ITS BALANCE SHEET 4.CHANGES IN THE MIX OF ASSETS AND LIABILITIES THAT MANAGEMENT DRAWS UPON AS IT SHIFTS BETWEEN FLOATING AND FIXED- RATE ASSETS AND LIABILITIES.

21. 21 DURATION GAP MANAGEMENT DURATION IS A VALUE- AND TIME- WEIGHTED MEASURE OF MATURITY THAT CONSIDERS THE TIMING OF ALL CASH INFLOWS FROM EARNING ASSETS AND ALL CASH OUTFLOWS ASSOCIATED WITH LIABILITIES. IN EFFECT, DURATION MEASURES THE AVERAGE TIME NEEDED TO RECOVER THE FUNDS COMMITTED TO AN INVESTMENT

22. 22 DURATION GAP MANAGEMENT DURATION GAP MANAGEMENT SEEKS TO BALANCE THE DOLLAR-WEIGHTED DURATION OF THE ASSET PORTFOLIO WITH THE DOLLAR-WEIGHTED DURATION OF THE LIABILITIES THE DIFFERENCE BETWEEN THESE IS REFERRED TO AS THE “DURATION GAP”

23. 23 THE LIMITATIONS OF DURATION GAP MANAGEMENT FINDING ASSETS AND LIABILITIES OF THE SAME DURATION THAT FIT INTO A BANK’S PORTFOLIO IS OFTEN A FRUSTRATING TASK FOR FINANCIAL INSTRUMENTS PAYING OUT GRADUALLY OVER TIME, DURATION IS ALWAYS LESS THAN CALENDER MATURITY DEMAND DEPOSITS HAVE A PATTERN OF CASH FLOWS THAT IS NOT WELL DEFINED, MAKING THE CALCULATION OF DURATION DIFFICULT CUSTOMER EARLY PAYMENTS OF LOANS AND ALSO CUSTOMER DEFAULTS ON LOAN REPAYMENTS DISTORT THE EXPECTED CASH FLOWS FROM LOANS

24. 24 ASSIGNMENT 5 Chapter 6 Question 1. A government bond is currently selling for $900 and pays $80 per year in interest for five years when it matures. If the redemption value of this bond is $1000, what is its yield to maturity if purchased today for $900? Chapter 6 Question 5. If a bank’s net interest margin, which was 2.85%, doubles and its total assets, which originally stood at $545 million, rise by 40%, what change will occur in the bank’s net interest income? To be submitted by e-mail to taltuner@hotmail.com not later than 20th April 2009.taltuner@hotmail.com