1. Interest Rate Risk Management: ISGAP
Copyright 2014 by Diane S. Docking

2. Copyright 2014 by Diane S. Docking
Learning Objectives
Define the repricing gap measure of interest rate risk.
Understand the process of ISGAP management
Copyright 2014 by Diane S. Docking

3. Managing Interest Rate Risk
Changes in interest rates:
cause variability in net interest income (NII) and net interest margin (NIM)
impact value of financial assets, liabilities, and reinvestment returns
cause repricing of loans, securities, and deposits impacting NII
Copyright 2014 by Diane S. Docking

4. Interest Rate Risk Management aka: ALM
Purpose:
To Control a Bank’s Sensitivity to Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity
To formulate strategies and take actions that shape a bank’s balance sheet in a way that contributes to its desired goals.
To maximize the bank’s margin or spread.
To maximize the stock value at an acceptable level of risk.
Done by an Asset/Liability Committee (ALCO)
In general, a short-run management tool:
Construct a sources and uses of funds statement.
NIMs are controlled by this management.
Copyright 2014 by Diane S. Docking

5. Defn: Net Interest Margin & Net Interest Incomeor
where:
* Or Total Average Assets
Copyright 2014 by Diane S. Docking

6. Defn: Interest-Sensitive Assets (ISA or RSA*)
Interest rate is subject to change/repricing within a year:
Short-Term Securities and Loans
Variable-Rate Securities and Loans
Current portion of Fixed-Rate Securities and Loans to be received
*Interest or Rate sensitive
Copyright 2014 by Diane S. Docking

7. Defn: NON Interest-Sensitive Assets
Interest rate is NOT subject to change/repricing within a year:
Cash in vault
Reserves at Fed**
Fixed-rate L-T loans and securities (except current portion coming due next year if know this)
PP&E
Other non-earning assets: intangibles, accruals, prepaids, etc.
**Reserves at Fed currently earn %; began in 2008.
Copyright 2014 by Diane S. Docking

8. Defn: Interest-Sensitive Liabilities (ISL or RSL*)
Interest rate is subject to change/repricing within a year:
Borrowings from Money Markets
Short-Term Savings Accounts**
Adjustable rate Money-Market Deposits
Variable-Rate Deposits
*Interest or Rate sensitive
**% that is “core” is not rate sensitive
Copyright 2014 by Diane S. Docking

9. Defn: NON Interest-Sensitive Liabilities
Interest rate is NOT subject to change/repricing within a year:
DDA paying no interest
Deposits where interest rates cannot be adjusted within a year
Fixed-rate Long-term savings, CD’s IRAs
Fixed-rate Long-term debt
Copyright 2014 by Diane S. Docking

10. Copyright 2014 by Diane S. Docking
ISGAP
GAP = ISA - ISL
Positive GAP where ISA > ISL
Negative GAP where ISL > ISA
Copyright 2014 by Diane S. Docking

11. Copyright 2014 by Diane S. Docking
Portfolio Maturity Mismatch
Copyright 2014 by Diane S. Docking

12. Other Interest-Sensitive Gap Measurements
To compare 2 or more banks, or track a bank over time, use the:
Relative ISGAP ratio = Gap$/Total Assets or
Interest Sensitivity ratio = RSA$/$RSL$.
Copyright 2014 by Diane S. Docking

13. Example: Relative GAP Ratio
Relative GAP ratio - computes a standardized gap so you can compare different banks of different sizes.
Bank 1 Bank 2
TA $1 million $100 million
ISGAP $100,000 $ 5 million
But:
Relative Gap Ratio 10% 5%
Copyright 2014 by Diane S. Docking

14. Example: ISGAP Measures
RSA = $100 million
RSL = $70 million
TA = $300 million
therefore:
ISGAP = 100 – 70 = $ million
(positive)
Relative ISGAP = 30/300 = %
ISRatio = 100/70 =
(> 1)
An Sensitive Bank:
Positive Dollar Interest-Sensitive Gap
Positive Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Greater than One
RSA = $100 million
RSL = $140 million
TA = $300 million
therefore:
ISGAP = 100 – 140 = million
(negative)
Relative ISGAP = -40/300 = %
ISRatio = 100/140 =
(< 1)
A Sensitive Bank:
Negative Dollar Interest-Sensitive Gap
Negative Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Less than One
Copyright 2014 by Diane S. Docking

15. Measuring effect of interest rate changes
The change in the dollar amount of net interest income (NII) is:
If rates on assets and liabilities move the same:
$NII = ISGAP$ ( i)
If rates on assets and liabilities do not move the same:
$NII = RSA$ ( iA) - RSL$ ( iL)
Copyright 2014 by Diane S. Docking

16. Relationship Between ISGAP and Changes in NII
D i
D NII + -
Copyright 2014 by Diane S. Docking

17. Example: ISGAP Management
10% interest sensitive
20% interest sensitive
20% mature in 1 year
Copyright 2014 by Diane S. Docking
Risk Management Association home page

18. Solution to Example: ISGAP Management
Rate-Sensitive Assets =
RSA = ___________
Rate-Sensitive Liabs =
RSL = __________
GAP = RSA  RSL =
Copyright 2014 by Diane S. Docking

19. Solution to Example: ISGAP Management
if i  5% 
Asset Income = +5%  $32.0m = +$ 1.6m
Liability Costs = +5%  $49.5m = +$ 2.5m
∆ NII = $1.6m  $ 2.5 = $0.9m OR
Since RSL > RSA, i  results in: NIM , NII 
∆ NII = GAP  ∆i= $17.5m  5% = $0.9m
Copyright 2014 by Diane S. Docking

20. Example 2: ISGAP management
Waller Bank has the following financial information:
Assets: Annual Income*
Cash $ 5 million $ 0
T-bill securities, $ 20 million $ 1.20 million
T-bonds, 5 8% $ 8 million $ 0.64 million
Loans, 10 year, $ 80 million $ 6.50 million
Other assets $ 7 million $
Total Assets $120 million $ 8.34 million
Liabilities & Equity Capital: Annual Expense*
Demand deposits, no interest $ 5 million $ 0
Time deposits, 4% $ 90 million $ 3.60 million
Time deposits, 5 6% $ 15 million $ 0.90 million
Total Liabilities $110 million $ 4.50 million
Total Equity Capital $ 10 million NII $ 3.84 million
$120 million
*Assume rollover at current rate of any S-T asset or liability.
Copyright 2014 by Diane S. Docking

21. Example 2: ISGAP management (cont.)
What is the bank’s NIM?
If interest rates rise 2% next year, what will be the NIM?
What if interest rates on assets increase only 90% the rate of liabilities?
Explain how the bank could “insulate” itself against changes in interest rates.
Copyright 2014 by Diane S. Docking

22. Solution for Example 2: ISGAP management
NIM = NII/TA = $3.84/$120 = _________
ISGAP = ISA- ISL
= 20 – 90 = _________________
$NII = ISGAP$ ( i) = -$70 million (+.02) = _____________________; therefore,
New NIM assuming TA do not change =
($ $1.4)/$120 = $2.44/$120 = _____
Copyright 2014 by Diane S. Docking

23. Solution for Example 2: ISGAP management (cont.)
c) If interest rates on assets increase only 1.8% then:
$NII = RSA$ ( iA) - RSL$ ( iL)
= [$20 (.018)] – [$90 (+.02)]
=.36 – 1.8 = _________________
New NIM assuming TA do not change =
($ $1.44)/$120 = $2.40/$120 = _____
Copyright 2014 by Diane S. Docking

24. Solution for Example 2: ISGAP management (cont.)
Needs to increase ______and/or decrease ______ to bring ISGAP = 0.
HOW?
Copyright 2014 by Diane S. Docking

25. Aggressive Interest-Sensitive Gap Management
If interest rates are expected to increase in the near future, the bank could
use a positive dollar gap as an aggressive approach to gap management.
If interest rates are expected to decrease in the near future, the bank could
use a negative dollar gap (so as rate fell, bank deposit costs would fall more than bank revenues, causing profit to rise).
Expected Change in Interest Rates
Best Interest-Sensitive Gap Position
Aggressive Management’s Likely Actions
Rising Market Interest Rates
________ IS Gap
Increase in ________
Decrease in _______
Falling Market Interest Rates
Copyright 2014 by Diane S. Docking

26. Measuring interest rate sensitivity and the dollar gap
Incremental gaps
Measure the gaps for different maturity buckets (e.g., 0-30 days, days, days, and days).
Cumulative gaps
Add up the incremental gaps from maturity bucket to bucket.
The total difference in dollars between those bank assets and liabilities which can be repriced over a designated time period.
Copyright 2014 by Diane S. Docking

27. Computer-Based Techniques and Maturity Buckets
7-27
Computer-Based Techniques and Maturity Buckets
Copyright 2014 by Diane S. Docking

28. Measuring interest rate sensitivity and the dollar gap
Defensive versus aggressive asset/liability management:
Defensively guard against changes in NII (e.g., near zero gap).
Aggressively seek to increase NII in conjunction with interest rate forecasts (e.g., positive or negative gaps).
Many times some gaps are driven by market demands (e.g., borrowers want long-term loans and depositors want short-term maturities.
Copyright 2014 by Diane S. Docking

29. Problems with Interest-Sensitive Gap Management
Time horizon problems related to when assets and liabilities are repriced. Dollar gap assumes they are all repriced on the same day, which is not true.
For example, a bank could have a zero 30-day gap, but with daily liabilities and 30-day assets NII would react to changes in interest rates over time.
A solution is to divide the assets and liabilities into maturity buckets (i.e., incremental gap).
Interest Rates Paid on Liabilities Tend to Move Faster than Interest Rates Earned on Assets
Interest Rate Attached to Bank Assets and Liabilities Do Not Move at the Same Speed as Market Interest Rates
Point at Which Some Assets and Liabilities Are Repriced is Not Easy to Identify
Copyright 2014 by Diane S. Docking

30. Problems with Interest-Sensitive Gap Management
Focus on net interest income rather than shareholder wealth.
Dollar gap may be set to increase NIM if interest rates increase, but equity values may decrease if the value of assets fall more than liabilities fall (i.e., the duration of assets is greater than the duration of liabilities).
Interest-Sensitive Gap Does Not Consider Impact of Changing Interest Rates on Equity Position
Financial derivatives could be used to hedge dollar gap effects on equity values.
Copyright 2014 by Diane S. Docking