1. Asset Liability Management – Determining & Measuring Interest Rates

2. Asset – Liability Management
Banks and many of their financial service competitors today
are highly complex organizations, offering multiple financial
services through multiple departments and divisions.
Financial firms usually make the decisions about which
customers are to receive credit, which securities should be
added to or subtracted from the financial institution’s
portfolio, which terms should be offered to the public on
loans, deposits, investment advice and other services, and
which sources of capital the institution should drawn upon.

3. Asset-Liability Management
Today bankers and other financial service managers have
learned to look at their asset and liability portfolios as an
integrated whole. This type of coordinated and integrated
decision making is known today as asset-liability
management (ALM)
The principal goals of asset-liability management are:
To maximize, or at least stabilize, the bank’s margin or spread between interest revenues & interest expenses, &
To maximize, or at least protect, the value (stock price) of the bank, at an acceptable level of risk.

4. Asset-Liability Management Strategies
Asset Management Strategy: Control of the composition of a bank’s assets to provide adequate liquidity & earnings & meet other goals. The banker could exercise control only over the allocation of incoming funds by deciding who was to receive the scarce quantity of loans available & what the terms on those loans would be.
Liability Management Strategy: Its goal was simply to gain control over the bank’s funds sources comparable to the control bankers had long exercised over their assets. The key control lever was price, the interest rate & other terms banks could offer on their deposits & borrowings to achieve the volume, mix & cost desired.

5. Asset-Liability Management Strategies----contt..
Funds Management Strategy: The key objectives of fund management strategy are:
Bank management should exercise as much as control as possible over the volume, mix, & return or cost of both assets & liabilities to achieve the bank’s goals.
Management’s control over assets must be coordinated with its control over liabilities so that asset & liability management are internally consistent & do not pull against each other. Effective coordination will help to maximize the spread between revenues and costs and control risk exposure.
Revenues & costs arise from both sides of the bank’s balance sheet. Bank policies need to be developed that maximize reruns & minimize costs from supplying services.

6. Interest Rate Risk
When interest rate changes in the financial marketplace, the
sources of revenue banks receive- especially interest income on
loans and securities – and their most important source of
expenses- interest cost on deposit and other borrowings- must
also change.
Moreover, changing market interest rate also change the market
value of assets and liabilities.
The danger that shifting interest rates could adversely affect the
bank’s net interest margin, assets or equity.

7. Interest Rate Risk, cont…
Forces Determining Interest Rates:
The rate of interest on any particular loan or security is
ultimately determined by the financial marketplace where
suppliers of loanable funds (credits) interact with demanders of
loanable funds (credits) and the interest rates (price of credit)
tends to settle at the point where the quantities of loanable
funds (credits) demanded and supplied are equal.

8. Determination of Interest Rate
loanable funds (credit)
Supply of
Affect the rate of return on loans and securities and the borrowing costs from selling deposits and issuing nondeposit IOUs
(Interest rate on loans and securities)
Price of Credit
Rate of Interest
loanable funds (credit)
Demand for
of credit
extended
Volume
Quantity of loanable funds

9. Determining Interest Rates
As market interest rates move, bankers and their competitors
face at least two major kinds of interest rate risk-
Price risk, and
Reinvestment risk
Price risk: this risk arises when market interest rates rise,
causing the market values of most bonds and fix-rate loans to
fall. If a financial institution wishes to sell these financial
instruments in a rising rate period, it must be prepared to accept
capital losses.
Reinvestment risk: when market interest rates fall, forcing a
financial firms to invest incoming funds in lower-yielding
earnings assets, lowering its expected future income.

10. Measurement of Interest Rate
How are interest rates measured?
Interest rates are the price of credit, demanded by the lenders as
compensation for the use of borrowed funds.
One of the most popular measures is the Yield to Maturity
(YTM), another popular interest rate measure is the bank
discount rate (DR).
YTM: the discount rate that equalizes the current market value
of a loan or security with the expected stream of future
payments that the loan or security will generate.

11. Measurement of Interest Rate, cont..
Bank Discount Rate: the rate often quoted on short-term loans
and money market securities.
DR ignores the effect of compounding of interest and is based
on a 360 day year. In addition, the DR uses the face value of a
financial instrument to calculate its yield or rate of return.
To covert a DR to the equivalent yield to maturity we can use
the formula:

12. The Components of Interest Rates
Market Interest Rate on risky loan or security = Risk-Free Real Interest Rate (inflation adjusted return on Govt. securities) + Risk Premium
RFRIR changes over time with shifts in the demand & supply for loanable funds.
RP changes over time due to “Inflation”, “Characteristics of the borrower”, ‘Marketability and Maturity of securities”.

13. Response to Interest Rate Risk
Changes in market interest rates can damage a bank or other
financial firm’s profitability by increasing its cost of funds,
lowering its returns from earnings assets, and reducing the
value of the owners’ investment.
Bankers have aggressively sought ways to insulate their asset
and liability portfolios and their profits from the ravages of
changing interest rates.

14. Changes in Interest Rate affecting the NIM
NIM = {interest income from bank loans & investments – interest expenses on deposits & other borrowed funds} / Total Earning Assets
If the interest cost of borrowed funds rises faster than bank income from loans & securities, the bank’s NIM will be squeezed, with adverse effects on bank profits. If interest rate fall and cause income from loans and securities to decline faster than interest costs on borrowings, the NIM will again be squeezed.

15. Factors Affecting NIM Changes in the level of interest rates.
Changes in the spread between asset yields & liability costs.
Changes in the volume of interest-bearing assets.
Changes in the volume of interest-bearing liabilities.
Changes in the mix of assets & liabilities that the management of each bank draws upon as its shifts between floating & fixed-rate assets & liabilities, between shorter & longer maturity assets & liabilities, between assets bearing higher versus lower expected yields.

16. Interest Rate Hedging Interest-Sensitive Gap Management
Gap management techniques require management to perform
an analysis of the maturities & re-pricing opportunities
associated with the bank’s interest-bearing assets, deposits, &
money market borrowings.
Interest-sensitive gap management is basically the control
over the difference between the volume of a bank’s interest
sensitive assets & the volume of the interest-sensitive
liabilities. Through Gap management bank wants to ensure
for each time period that the –
Dollar amount of re-priceable Dollar amount of re-priceable
(interest-sensitive) assets = (interest-sensitive) liabilities

17. Interest-Sensitive Gap Management, Cont..
Re-priceable Assets
Re-priceable Liabilities
Short-term securities issued by government & private borrowers (about to mature)
Borrowings from the money market.
Short-term loans made by the bank to borrowing customers (about to mature)
Short-term savings accounts
Variable-rate (floating or adjustable rate) loans & securities
Money-market deposits (whose interest rates often are adjustable every few days)
Variable rate (floating or adjustable rate deposits )

18. Interest-Sensitive Gap Management, Cont..
What happen when the amount of repriceable assets does not
equal the amount of repriceable liabilities?
If the amount of repriceable assets does not equal the amount
of repriceable liabilities, there is a gap exists. That is called
Interest Sensitive Gap.
The interest sensitivity gap is the portion of the balance sheet
affected by interest rate.
Interest sensitive gap = Interest sensitive assets – Interest sensitive liabilities

19. Interest-Sensitive Gap Management, Cont..
Positive gap or Asset-sensitive gap:
If interest sensitive assets exceed the interest sensitive liabilities
subject to repricing, the bank is said to have a positive gap and to
be asset sensitive.
Assets-sensitive (positive) gap = ISA – ISL >0
Effect:
If interest rate rise, this bank’s interest margin will increase
because the interest revenue generated by assets will increase
more than the cost of borrowed funds. The bank will experience
an increase in its net interest income. On the other hand, if
interest rates fall, this bank’s NIM will decline as interest revenue
from assets drop by more than interest expenses associated with
liabilities.

20. Interest-Sensitive Gap Management, Cont..
Negative gap or Liability-sensitive gap:
If interest sensitive liabilities exceed the interest sensitive assets,
the bank is said to have a negative gap and to be liability
sensitive.
Liability-sensitive (negative) gap = ISA – ISL < 0
Effect:
Raising interest will lower this bank’s net interest margin,
because the rising cost associated with interest sensitive liabilities
will exceeds increases in interest revenue from interest sensitive
assets. On the other hand, if interest rates fall, will generate
higher interest margin, because borrowing cost will decline by
more than interest revenues.

21. Interest-Sensitive Gap Management, Cont..
Ways to measure Interest sensitive gap:
Dollar IS GAP = ISA – ISL
If dollar IS GAP is positiev, then bank is assets sensitive, and if
dollar IS GAP is negative, bank is liability sensitive.
If Relative IS GAP is greater than zero, then the bank is assets
sensitive, and if Relative IS GAP is negative, bank is liability
sensitive.

22. Interest-Sensitive Gap Management, Cont..
Interest Sensitive Ratio (ISR), compare the ratio of ISA to ISL.
If ISR is less than 1 tell us bank is liability sensitive, while an
ISR greater than unity points to an assets sensitive institution.
An Asset-Sensitive Financial Firm Has:
An Liability-Sensitive Financial Firm Has:
Positive Dollar IS GAP
Positive Relative IS GAP
Interest Sensitivity Ratio greater than one
Negative Dollar IS GAP
Negative Relative IS GAP
Interest Sensitivity Ratio less than one

23. Interest-Sensitive Gap Management, Cont..
A zero gap does not eliminate all interest rate risk, because-
The interest rates attached to assets and liabilities are not
perfectly correlated in the real world.
Loan interest rates, for example, tend to lag behind interest
rates on many money market borrowings.
Interest revenue often tend to grow more slowly than expenses during economic downturns. s

24. Interest-Sensitive Gap Management, Cont..
What ever the models are used to calculate interest
sensitive gap, require financial managers to make some
important decision:
Management must choose the time period during which the net interest margin (NIM) is to be managed (e.g. six month, one year) to achieve some desire value and the length of sub-periods (“maturity buckets”) into which the planning period is to be divided.
Management must choose a target level for the net
interest margin- that is, whether to freeze the margin roughly where it is or perhaps increase the NIM.

25. Interest-Sensitive Gap Management, Cont..
If management wishes to increase the NIM, it must either develop a correct interest rate forecast or find ways to reallocate earnings assets and liabilities to increase the spread between interest revenues and interest expenses.
Management must determined the dollar volume of interest sensitive assets and interest sensitive liabilities it wants the financial firm to hold.

26. Defensive Interest-Sensitive Gap Management
The strategy here is to achieve the following-
IS Gap = 0 or
ISA = ISL or
IS Ratio (ISA/ISL) = 1
Then, changes in NIM will be zero

27. Possible Management Responses
Eliminating a Bank’s Interest-Sensitive Gap by using Defensive Strategy
With Positive Gap
The Risk
Possible Management Responses
Interest-sensitive assets > Interest-sensitive liabilities (asset sensitive)
Losses if interest rates fall because the bank’s net interest margin will be reduced.
Do nothing.
Extend asset maturities or shorten liability maturities.
Increase interest-sensitive liabilities or reduce interest-sensitive assets.

28. Possible Management Responses
Eliminating a Bank’s Interest-Sensitive Gap by using Defensive Strategy --Contd
With Negative Gap
The Risk
Possible Management Responses
Interest-sensitive assets < Interest-sensitive liabilities (liability sensitive)
Losses if interest rates rise because the bank’s net interest margin will be reduced.
Do nothing.
Shorten asset maturities or lengthen liability maturities.
Decrease interest-sensitive liabilities or increase interest-sensitive assets.