Chapter 10: Funding the Bank

Chapter 10: Funding the Bank
© 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Average Historical Cost of Funds
Many banks incorrectly use the average historical costs in their pricing decisions. Primary problem with historical costs is they provide no information as to if future interest costs will rise or fall. When interest rates rise, average historical cost understates the actual cost of issuing new debt. When rates fall the opposite is true. Pricing decisions should be based on marginal costs compared with marginal revenues. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Marginal Cost of Funds
Marginal cost of debt: Measure of the borrowing cost paid to acquire one additional unit of investable funds. Marginal cost of equity: Measure of the minimum acceptable rate of return required by shareholders. Marginal cost of funds: The marginal costs of debt and equity. Especially useful in pricing decisions. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs of Independent Sources of Funds
Difficult to measure marginal costs precisely. Must include both interest and noninterest costs expected to be paid and identify which portion of the acquired funds can be invested in earning assets. Formula for measuring explicit marginal cost of a single source of bank liability: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs of Independent Sources of Funds
Example: Market interest rate = 0.2% Servicing costs = 2.8% of balances Acquisition costs = 0.15% of balances Deposit insurance costs = 0.25% of balances Investable balance = 85% (10% required reserves, 5% float) Estimated marginal cost of obtaining additional interest checking balances: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost of Debt Marginal cost of different types of debt varies according to the magnitude of each type of liability. High-volume transactions accounts have substantial servicing costs and highest reserve requirements and float. Purchased funds pay higher rates but smaller transaction costs and zero reserve requirements (greater investable balances). Cost of long-term non deposit debt equals effective cost of borrowing from each source. This is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost of Equity The marginal cost of equity equals the required return to shareholders. Not directly measurable because dividend payments are not mandatory but several methods are used: Dividend Valuation Model: The cost of equity equals the discount rate (required return) used to convert future cash flows to their present value equivalent. Capital Asset Pricing Model (CAPM): Required return to shareholders equals the riskless rate of return plus a risk premium on common stock reflecting nondiversifiable market risk. Targeted Return on Equity Model. Cost of debt plus a premium to evaluate the cost of equity. Assumes book value = market value. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost of Preferred Stock
Preferred stock has characteristics of debt and common equity. Claims are superior to those of common stockholders but subordinated to those of debt holders. Dividends may be deferred when earnings are low. Marginal cost can be approximated using the dividend valuation model except that dividend growth is zero. Trust preferred stock is a hybrid form of equity capital. Effectively pays dividends that are tax deductible. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Weighted Marginal Cost of Total Funds
Best cost measure for asset-pricing purposes. Recognizes both explicit and implicit costs associated with any single source of funds. Computed in three stages: Forecast desired dollar amount of financing to be obtained from each individual debt and equity sources. Estimate marginal cost of each source of funds. Combine the estimates to project the weighted cost: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources and Banking Risks
Banks face two fundamental problems in managing liabilities. They are uncertainty over: what rates they must pay to retain and attract funds. likelihood customers will withdraw money regardless of rates. Basic fear is vulnerability to a liquidity crisis from unanticipated withdrawals and depositors and lenders refusing to provide funds. Banks must have the capacity to borrow in financial markets to replace deposits outflows and remain solvent. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources: Liquidity Risk
Liquidity risk of deposit base is a function of: Number and location of depositors. Average size of accounts. Specific maturity and rate characteristics of each account. Competitive environment. Interest elasticity of customer demand for each funding source is equally important. How much can interest rates change before bank experiences deposit outflows? If a bank raises its rates, how many new funds will it attract? © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources: Interest Rate Risk
Many depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates change. Banks must offer premiums to lengthen maturities. Many banks have chosen not to pay premiums and reprice liabilities more frequently than in the past. One strategy is to aggressively compete for retail core deposits. Once a bank attracts deposit business, many will maintain those balances as long as bank provides good service. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources: Credit Risk
During financial crisis many failed banks relied on FHLB advances and jumbo CDs to fund operations. Many banks financed loan growth with wholesale funds. Did funding sources or choice of loans cause the failures? Inappropriate use of advances and CDs to fund overly speculative loans caused the problems. Link between funding sources and credit risk tied to reasonableness of business plans, credit analysis when making loans, and monitoring of credit risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 7: Managing Interest Rate Risk: GAP and Earnings Sensitivity

Managing Interest Rate Risk: GAP and Earnings Sensitivity
Sensitivity to market risk (S) is one of the basic components of a bank’s CAMEL rating. For most financial institutions, interest rate risk is the primary contributor to market risk. Bank managers ask two questions: What interest rate “bet” is the bank making? How much risk is the bank taking (how big is the bet)? Interest rate risk arises from liabilities and assets that do not reprice coincidentally. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest yield and loan market value can vary much differently than interest cost and market value of liabilities. Result is a change in net interest income and economic value of stockholders’ equity. For large, complex organizations interest volatility is just a portion of overall market risk. During the financial crisis in , declines in the values of subprime loans, leveraged loans, collateralized debt and related instruments produced large losses. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banks use two basic models to assess interest rate risk. GAP and earnings sensitivity analysis emphasizes income statement effects by focusing on how changes in interest rates and the bank’s balance sheet effect net interest income and net income. Duration gap and economic value of equity analysis emphasizes the market value of stockholders’ equity by focusing on how these same changes affect the market value of assets vs. the market value of liabilities. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Analysis introduces traditional measures of interest rate risk associated with static GAP models. Models focus on GAP as a static measure of risk and net interest income as the target performance measure. Sensitivity analysis extends GAP analysis to focus on the variation in bank earnings across different interest rate environments and provides information about income changes when rates rise or fall. Interest rate risk management is important because no one can consistently forecast rates accurately. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measuring Interest Rate Risk with GAP
Three general factors potentially cause a bank’s net interest income to change. Rate Effects: Unexpected changes in interest rates. Composition (Mix) Effects: Changes in the mix, or composition, of assets and/or liabilities. Volume Effects: Changes in the volume of earning assets and interest-bearing liabilities. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bank makes $10 million in 3-year fixed commercial loans with quarterly payments, financed with deposits that reprice monthly. If the loan rate is 5% and the deposit rate is 1%, the initial spread is 4%. If deposit rates rise, the spread falls and if deposit rates fall, the spread rises. Choice of longer-term fixed rate assets financed by shorter-term deposits evidences specific interest rate bet. Describes the rate effect but ignores other effects. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Balance sheet is dynamic and changes constantly over time. Rate changes are only one factor that affects earnings because banks change their mix of assets and liabilities. There are imbedded options in loans that will likely alter cash flows if interest rates change. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Traditional Static GAP Analysis
Static GAP focuses on managing net interest income in the short run. Objective is to measure expected net interest income and identify strategies to stabilize or improve it. Interest rate risk is measured by calculating GAPs over different time intervals based on balance sheet data at a fixed point in time – static. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Steps in GAP Analysis: Develop an interest rate forecast. Select a series of sequential time intervals for determining what amounts of assets and liabilities are rate sensitive within each time interval. Group assets and liabilities into these time intervals or “buckets” according to time to first repricing. Calculate GAP. Forecast net interest income given the assumed interest rate environment and repricing characteristics of the underlying instruments. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

GAP measures the relative principal mounts of assets or liabilities that management expects to reprice within the relevant time interval. Ignores expected interest income and expense. GAP = RSAt – RSLt ,: rate sensitive assets and liabilities are identified within each time bucket. Periodic GAP compares RSAs and RSLs within each single time bucket. Cumulative GAP compares RSAs and RSLs over all time buckets from the present through the last day in each successive time bucket. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Determines Rate Sensitivity?
First steps require identification and classification of rate sensitive assets and liabilities. Expected Repricing versus Actual Repricing: An asset or liability is normally classified as rate sensitive within a time interval if: It matures. It represents an interim or partial principal payment. The interest rate applied to the outstanding principal balance changes contractually during the interval. The interest rate applied to the outstanding principal balance changes when some base rate or index changes and management expects the base rate/index to change during the time interval. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Maturity: If any asset or liability matures within a time interval, the principal amount will be repriced. If an asset matures, bank must reinvest the proceeds. If a liability matures, bank must replace with new funding. Question is what principal amount is expected to reprice. Interim or Partial Principal Payment: Any loan principal payment is rate sensitive if it is expected to be received within the time interval. Same is true for payments on a bank’s liabilities. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Contractual Change in Rate: Some assets and deposit liabilities earn or pay rates that vary contractually with some index. These instruments are repriced whenever the index changes. If the index will contractually change within 90 days, the underlying asset or liability is rate sensitive within 0–90 days. Change in Base Rate or Index: Some loans and deposits interest rates are tied to indexes that change with unknown frequency. For the most meaningful GAP analysis, management must forecast when such rates will change. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Factors Affecting Net Interest Income
Rate, Composition (Mix) and Volume Effects: All affect net interest income. Changes in the Level of Interest Rates: The sign of GAP (positive or negative) indicates the nature of the bank’s interest rate bet. A negative (positive) GAP, indicates that the bank has more (less) RSLs than RSAs. When interest rates rise (fall) during the time interval, the bank pays higher (lower) rates on all repriceable liabilities and earns higher (lower) yields on all repriceable assets. If a bank has a zero GAP (virtually impossible), RSAs equal RSLs. Equal interest rate changes do not alter net interest income because changes in interest income = changes in interest expense. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in the Level of Interest Rates (cont’d): If there is a parallel shift in the yield curve then changes in Net Interest Income are directly proportional to the size of the GAP: ∆NIIEXP = GAP x ∆iEXP Yield curve rarely shifts parallel. If rates do not change by the same amount and at the same time, then net interest income may change by more or less. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in the Relationship Between Asset Yields and Liability Costs: Net interest income may differ from expected if the spread between earning asset yields and the interest cost of interest-bearing liabilities changes. The spread may change because of a nonparallel shift in the yield curve or because of a change in the difference between different interest rates (basis risk). © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in Volume: Net interest income varies directly with changes in the volume of earning assets and interest-bearing liabilities, regardless of interest rate levels. If a bank doubles in size without changing portfolio composition and interest rates, net interest income will double because the bank earns the same interest spread on twice the volume of assets. Changes in Portfolio Composition: Any variation potentially alters net interest income. There is no fixed relationship between changes in portfolio mix and net interest income. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Rate, Volume, and Mix Analysis
Many financial institutions publish a summary in their annual report of how net interest income has changed over time. Separate changes attributable to shifts in asset and liability composition and volume from changes associated with movements in interest rates. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Rate Sensitivity Reports
Managers use these reports to monitor risk position and potential net interest income changes. Reports classify a bank’s assets and liabilities as rate sensitive in selected time buckets through one year. Periodic GAP versus Cumulative GAP: Periodic GAP: Gap for each time bucket. Measures timing of potential income effects from interest rate changes. Cumulative GAP: The sum of periodic GAP's. Measures aggregate interest rate risk over the entire period Cumulative GAP is important since it directly measures a bank’s net interest sensitivity throughout the time interval. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strengths and Weaknesses of Static GAP Analysis
Easy to understand. Indicates relevant amount and timing of interest rate risk. Suggests magnitudes of portfolio changes to alter risk. Weaknesses: Ex-post measurement errors. Ignores the time value of money. Ignores the cumulative impact of interest rate changes. Considers demand deposits to be non-rate sensitive. Ignores embedded options in assets and liabilities. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

GAP Ratio: GAP Ratio = RSAs/RSLs A GAP ratio greater than 1 indicates a positive GAP. A GAP ratio less than 1 indicates a negative GAP. Neither GAP nor the GAP ratio provides direct information on the potential variability in earnings when rates changes. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

GAP Divided by Earning Assets as a Measure of Risk: An alternative risk measure that relates the absolute value of a bank’s GAP to earning assets. The greater this ratio, the greater the interest rate risk. Banks may specify a target GAP-to-earning-asset ratio in their ALCO policy statements. A target allows management to position the bank to be either asset sensitive or liability sensitive, depending on the outlook for interest rates. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Earnings Sensitivity Analysis
Extends static GAP analysis by making it dynamic. Model simulation or what-if analysis of all factors that affect net interest income across a wide range of potential interest rate environments. Steps to Earnings Sensitivity Analysis: Forecast interest rates. Forecast balance sheet size and composition given the assumed interest rate environment. Forecast when embedded options in assets and liabilities will be in money and hence, exercised under the assumed interest rate environment. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Steps to Earnings Sensitivity Analysis: Identify when specific assets and liabilities will reprice given the rate environment. Estimate net interest income and net income under the assumed rate environment. Repeat the process to compare forecasts of net interest income and net income across different interest rate environments versus the base case. The choice of base case is important because all estimated changes in earnings are compared with the base case estimate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managers can estimate the impact of rate changes on earnings while allowing for: Interest rates to follow any future path. Different rates to change by different amounts at different times. Expected changes in balance sheet mix and volume. Embedded options to be exercised at different times and in different interest rate environments. Effective GAPs to change when interest rates change. Bank does not have a single static GAP, but will experience amounts of RSAs and RSLs that change when rates change. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exercise of Embedded Options in Assets and Liabilities
Most common embedded options at banks: Refinancing of loans Prepayment (even partial) of principal on loans Bonds being called Early withdrawal of deposits prior to final maturity Caps on loan or deposit rates Floors on loan or deposit rates Call or put options on FHLB advances Exercise of loan commitments by borrowers © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exercise of Embedded Options in Assets and Liabilities
Three issues of embedded options: Does the bank or its customer determine when the option is exercised? How and by what amount is the bank being compensated for selling the option, or how much must it pay to buy the option? Bank should forecast when the option will be exercised. Involves forecasting how much interest rates will change, when the loan will be prepaid when the bond will be called, and when the depositor will withdraw funds early. Will depend on the assumed rate environment. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Different Interest Rates Change by Different Amounts at Different Times
Earnings sensitivity analysis allows incorporation of the impact of different competitive markets with alternative pricing strategies. Enables forecast of different spreads between yields and interest costs when rates change by different amounts. Banks are quick to increase base loan rates when interest rates increase but slow to lower base loan rates when rates fall. Although rate sensitivity of different instruments might be nominally the same, impact is different due to different timing and magnitude of rate changes. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Earnings Sensitivity Analysis: An Example
Consider the rate sensitivity report on the next slide for First Savings Bank (FSB) as of year-end 2013. Report is based on the most likely interest rate scenario. FSB is a $1 billion bank that bases its analysis on forecasts of the federal funds rate and ties other rates to this overnight rate. As such, the federal funds rate serves as the bank’s benchmark interest rate. FSB uses a base case interest rate forecast that is drawn from market implied forecast rates. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Explanation of Sensitivity Results
Demonstrates importance of understanding impact of exercising embedded options and pricing lags. Framework uses federal funds rate as the benchmark rate such that rate shocks indicate how much the funds rate changes. Loan rates move more contemporaneously with the federal funds rate than do FSB deposit rates. FSB has a large prepayment risk because many of the assets are longer term and carry fixed rates. When rates fall, customers will typically exercise options. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

FSB’s earnings sensitivity results reflect the impacts of rate changes on a bank with this profile. There are two basic causes or drivers behind the estimated earnings changes. First, other market rates change by different amounts and at different times relative to the federal funds rate. Second, embedded options potentially alter cash flows when the options go in the money. Combined impact is that FSB’s effective GAP is different in each rate shock environment, as is the spread. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

When rates increase, asset yields assumed to increase more than liability costs such that spreads widen. Opposite occurs when rates fall. FSB owns many fixed-rate mortgages subject to prepayment risk. As rates decline, borrowers will refinance. When rates rise, there are fewer rate sensitive assets. Different effective GAP for each rate scenario. Sometimes referred to as earnings-at-risk or net interest margin simulation. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income Statement GAP Interest rate risk model which modifies the standard GAP model to incorporate different speeds and repricing of specific assets and liabilities given an interest rate change. Balance Sheet GAP: Reflects contractual repricing. Earnings Change Ratio (ECR): A ratio calculated for each asset or liability that estimates how the yield on assets or rate paid on liabilities is assumed to change relative to a 1 percent change in the base rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing the GAP and Earnings Sensitivity Risk
Steps to reduce risk in effective GAP management: Calculate periodic GAPs over short time intervals. Match fund repriceable assets with similar repriceable liabilities so that periodic GAPs approach zero. Match fund long-term assets with non-interest-bearing liabilities. Use off-balance sheet transactions, such as interest rate swaps and financial futures, to hedge. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing the GAP and Earnings Sensitivity Risk

Chapter 8: Managing Interest Rate Risk: Economic Value of Equity

GAP and Earnings Sensitivity versus Duration GAP and EVE Sensitivity

Managing Interest Rate Risk: Economic Value of Equity (EVE)
Duration gap analysis represents an application of duration concepts to a bank’s entire balance sheet. Builds on Macaulay’s duration applied to single securities. Parallels static GAP and earnings sensitivity analysis as both duration gap and EVE are measures of risk. Analysis is dynamic in that it incorporates the impact of potential rate changes and recognizes the exercise of embedded options will affect a bank’s true risk exposure depending on how interest rates change. Analytical procedure is similar to earnings sensitivity analysis. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Interest Rate Risk: Economic Value of Equity (EVE)
EVE analysis is essentially a liquidation analysis. Uses market value accounting. The value of EVE is a residual figure equal to the difference between the market value of assets and the market value of equity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measuring Interest Rate Risk with Duration GAP
Duration GAP analysis: Compares the price sensitivity of bank’s total assets with the price sensitivity of total liabilities to assess whether the market value of assets or liabilities changes more when rates change. Any differential impact will indicate how the bank’s economic value of equity will change. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Duration, Modified Duration, and Effective Duration
Macaulay’s Duration (D): where P* is the initial price, i is the market interest rate, and t is equal to the time until the cash payment is made © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measure of price sensitivity in the approximate price elasticity relationship where P refers to the price of the underlying security: Modified duration indicates the price change of a security in percentage for a given change in interest rates: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Effective duration estimates how price sensitive a security is when it contains embedded options: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Assume a three-year 9.4% coupon bond selling for $10,000 par and callable at par. Effective duration for a 30 base-point (0.3 percent) semiannual move in rates: Demonstrates possibility of negative duration: Can happen when the price of a security in a falling-rate environment falls below the price in a rising-rate environment making the numerator negative. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Duration GAP (DGAP) Model
Focuses on managing net interest income or the economic value of stockholders’ equity. Focuses on price sensitivity (how the price will change when interest rates change) rather than rate sensitivity (the ability to reprice when interest rates change). Measure of bank’s aggregate portfolio interest rate risk that compares the weighted average duration of assets with the weighted average duration of liabilities. Management can adjust to hedge or accept interest rate risk by speculating on future interest rate changes. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Steps in Duration GAP Analysis: Forecast interest rates. Estimate the market values of bank assets and liabilities. Estimate the weighted average duration of assets and the weighted average duration of liabilities. Incorporate the effects of both on- and off-balance sheet items. These estimates are used to calculate duration gap. Forecast changes in EVE across different interest rate environments. Account for differential changes in rates and the exercise of embedded options. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Weighted Average Duration of Bank Assets (DA): © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Weighted Average Duration of Bank Liabilities (DL): © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ΔEVE = ΔMVA – ΔMVL ΔEVE = [DA – (MVL/MVA)DL][Δy/(1 + y)]MVA Duration GAP = DGAP = DA – (MVL/MVA)DL then ΔEVE = -DGAP[Δy/(1+y)]MVA DA and DL account for present value of all cash flows. Approximate estimate of the sensitivity of EVE to changes in the general level of interest rates. Interest (y) typically a weighted-average. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

DGAP as a Measure of Risk The sign and size of DGAP provide information about whether rising or falling rates are beneficial or harmful and how much risk the bank is taking. If DGAP is positive, an increase in rates will lower EVE, while a decrease in rates will increase EVE. If DGAP is negative, an increase in rates will increase EVE, while a decrease in rates will lower EVE. The closer DGAP is to zero, the smaller is the potential change in EVE for any change in rates. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Duration Application for Banks

Implications of DGAP > 0: The value of DGAP at 1.42 years indicates the bank has a substantial mismatch in average durations of assets and liabilities. Since the DGAP is positive, the market value of assets will change more than the market value of liabilities if all rates change by comparable amounts. In this example, an increase in rates will cause a decrease in EVE, while a decrease in rates will cause an increase in EVE. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Duration GAP Summary © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

When DGAP > 0 : Banks benefit when rates fall (EVE rises) and loses when rates rise (EVE falls). When DGAP < 0: Banks benefit when rates rise (EVE falls) and loses when rates fall (EVE rises). The greater the absolute value of DGAP, the greater the interest rate risk. A bank that is perfectly hedged will have a DGAP of zero. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

DGAP As a Measure of Risk Can be used to approximate expected change in economic value of equity for a given change in rates. The farther DGAP is from zero, the greater the potential impact on EVE and hence the greater risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

An Immunized Portfolio
Objective: Reduce Interest Rate Risk with DGAP > 0: Shorten asset durations by: Buying short-term securities and selling long-term securities. Making floating-rate loans and selling fixed-rate loans. Lengthen liability durations by: Issuing longer-term CDs. borrowing via longer-term FHLB advances. obtaining more core transactions accounts from stable sources. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Objective: Reduce Interest Rate Risk with DGAP > 0: Lengthen asset durations by: Buying long-term securities and selling short-term securities. Buying securities without call options. Making fixed rate loans and selling floating-rate loans. Shorten liability durations by: Issuing shorter-term CDs. Borrowing via shorter-term FHLB advances. Using short-term purchased liability funding from federal funds and repurchase agreements. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banks may choose to target variables other than the market value of equity in managing interest rate risk Many banks are interested in stabilizing the book value of net interest income. This can be done for a one-year time horizon, with the appropriate duration gap measure as shown on the next slide. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

DGAP* = MVRSA(1 − DRSA) − MVRSL(1 − DRSL) MVRSA = cumulative market value of rate-sensitive assets (RSAs) MVRSL = cumulative market value of rate-sensitive liabilities (RSLs) DRSA = composite duration of RSAs for the given time horizon DRSL = composite duration of RSLs for the given time horizon © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

DGAP* > 0: Net interest income will decrease (increase) when interest rates decrease (increase). DGAP* < 0: Net interest income will decrease (increase) when interest rates increase (decrease). DGAP* = 0: Interest rate risk eliminated. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Value of Equity Sensitivity Analysis
Consists of conducting “what if” analysis of the all factors that effect EVE across a wide range of interest rate environments. Repeats static DGAP analysis under different assumed interest rates. Important component is rate shock analysis incorporating projections of when embedded options will be exercised and what different values assets and liabilities might take. The greater potential volatility in EVE, the greater the risk. The greater potential reduction in EVE, the greater the risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Value of Equity Sensitivity Analysis
Estimating the timing of cash flows and subsequent durations of assets and liabilities is complicated by: Prepayments that exceed (fall short of) those expected with shorten (lengthen) duration. A bond being called will shorten duration. A deposit that is withdrawn early or not withdrawn as expected with shorten (lengthen) duration. An interest rate cap that becomes binding will generally reduce cash flows and lower duration. An interest rate floor that becomes binding will generally increase cash flows and increase duration. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

EVE Sensitivity Analysis: An Example
First Savings Bank: Average duration of assets equals 2.6 years Market value of assets equals $1,001,963 Average duration of liabilities equals 2 years Market value of liabilities equals $919,400 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Duration Gap: 2.6 – ($919,400/$1,001,963) × 2.0 = years A 1% increase in rates would reduce EVE by $7.2 million: ΔMVE = -DGAP[Δy/(1+y)]MVA ΔMVE = (0.01/1.0693) × $1,001,963,000 This estimate ignores the impact of interest rates on embedded options, the effective duration of assets and liabilities and interest rate swaps. Higher interest rates are associated with a decline in EVE and lower rates are associated with an increase in EVE. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Previous slide shows that FSB’s EVE will change by $8.2 million if rates change by 1%. Effective “Duration” of Equity: Recall, duration measures the percentage change in market value for a given change in interest rates. A bank’s duration of equity measures the percentage change in EVE that will occur with a 1 percent change in rates: Effective duration of equity = $8,200 / $82,563 = 9.9 years © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest Rate Risk at Freddie Mac and Fannie Mae

Strengths and Weaknesses: DGAP and EVE Sensitivity Analysis
Duration analysis provides a comprehensive measure of interest rate risk for the total portfolio. Duration measures are additive so that total assets may be matched with total liabilities rather than matching of individual accounts. Duration analysis takes a longer-term view and provides managers with greater flexibility in adjusting rate sensitivity because they can use a wide range of instruments to balance value sensitivity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strengths and Weaknesses: DGAP and EVE Sensitivity Analysis
It is difficult to compute duration accurately. “Correct” duration analysis requires that each future cash flow be discounted by a distinct discount rate. A bank must continuously monitor and adjust the duration of its portfolio. It is difficult to estimate the duration on assets and liabilities that do not earn or pay interest. Duration measures are highly subjective. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Critique of Strategies for Managing Earnings and EVE Sensitivity
GAP and DGAP Management Strategies: Banks do accept some interest rate risk. Difficult to actively vary GAP or DGAP and consistently win. Interest rates forecasts are frequently wrong. Even if rates change as predicted, banks have limited flexibility in changing GAP and DGAP. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest Risk Management: An Example Consider the case where a liability sensitive bank decides to reduce risk by marketing 2-year, 6% time deposits rather than 1-year deposits paying 5.5%. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest Rate Risk: An Example For the two consecutive 1-year securities to generate the same $120 in interest, ignoring compounding, the 1-year security must yield 6.5% one year from the present. 6% + 6% = 5.5% + ? so ? must = 6.5% By investing in the 1-year security, depositor is betting the 1-year interest rate in one year will be greater than 6.5%. By issuing the 2-year security, the bank is betting that the 1-year interest rate in one year will be greater than 6.5%. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Yield Curve Strategies
Analysts typically view business cycle effects in terms of how the 10-year (long term) Treasury yield varies relative to the 1-year (short term) yield. Expansionary and peak economic activity periods: Strong consumer spending, growing loan demand and limited bank liquidity. Federal Reserve slows money growth out of fear that inflation will get out of control. Peak is followed by a contractionary period as spending and loan demand declines. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

When growth has slowed too much, reserves and money supply are expanded. Intent behind monetary policy actions during the financial crisis to keep interest rates low. Quantitative Easing involves the Federal Reserve buying large amounts of longer-term Treasury securities and mortgage-backed securities. At the trough or recession, Federal Reserve is providing ample liquidity but loan demand is low. Eventually low interest rates stimulate spending and growth. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

When U.S. economy hits its peak, yield curve inverts and economy falls into recession. To take advantage of this trend, when the yield curve inverts: Buy long-term non-callable securities. Make fixed-rate non-callable loans. Price deposits on a floating-rate basis. Follow strategies to become more liability sensitive and/or lengthen the duration of assets versus the duration of liabilities. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 10: Funding the Bank

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