Chapter 4

Asset-Liability Management (ALM)

Required Readings: Peter S.Rose, Chapter 6, 7, 8
1

Chapter Contents
ALMs purpose How interest rate risk impact banks income? Interest rate risk: GAP and using GAP to measure interest rate risk to banks income Using Duration for ALM

Asset-Liability Management
Whats ALM?

Yield to Maturity (YTM)

CFt Market Price ! t t !1 (1  YTM)

4

Bank Discount Rate (DR)

FV - Purchase Price 360 DR ! * FV # Days to Maturity

Trong : FV equals Face Value
5

Conversion of DR into YTM

YTM equivalent yield =


(100 purchase price)/Purchase Price * (365/days to maturity)

Example
Suppose, a 100$ security is now sold on the market at price of $96 with days to maturity of 90 days. Whats DR, the YTM equivalent yield?

Example
DR = (100 96)/100 * 360/90 = 0.16 Equivalent YTM = (100 96)/96 *365/90 = 0.1690 Actual YTM =


PV = -96, FV = 100, N = 90/365, I = ?

I = 18%
8

Thu nh p t li rng (NII) v Thu nh p t li c n bin (NIM)

NII: Net interest income
Interestincome  Interest exp enses NIM ! Totalearningassets

Interest Rate Risk

Price Risk


When Interest Rates Rise, the Market Value of the Bond or Asset Falls When Interest Rates Fall, the Coupon Payments on the Bond are Reinvested at Lower Rates
10

Reinvestment Risk


Interest Rate Risk: Reinvestment Rate Risk

If interest rates change, the bank will have to reinvest the cash flows from assets or refinance rolled-over liabilities at a different interest rate in the future.


An increase in rates, ceteris paribus, increases a banks interest income but also increases the banks interest expense.

Static GAP Analysis considers the impact of changing rates on the banks net interest income.
11

Interest Rate Risk: Price Risk

If interest rates change, the market values of assets and liabilities also change.


The longer is duration, the larger is the change in value for a given change in interest rates.

Duration GAP considers the impact of changing rates on the market value of equity.

12

Interest Rate Risk

Banks typically focus on either:
 

Net interest income or The market value of stockholders' equity A static measure of risk that is commonly associated with net interest income (margin) targeting Earnings sensitivity analysis extends GAP analysis by focusing on changes in bank earnings due to changes in interest rates and balance sheet composition
13

GAP Analysis


Earnings Sensitivity Analysis



Rate sensitive Asset/Liabilities (RSAs vs RSLs) and Non rate sensitive (NRS)
RSAs/ RSLs are assets or liabilities whose interest return or cost vary with interest rate movements over the same time horizon. E.g; short term securities.


RSAt
Rate Sensitive Assets


Those assets that will mature or reprice in a given time period (t)

RSLt
Rate Sensitive Liabilities


Those liabilities that will mature or reprice in a given time period (t)

Non rate sensitive (NRS) are assets or liabilities whose interest return or cost vary with interest rate movements over the same time horizon. E.g; Vault cash
14

What Determines Rate Sensitivity?

An asset or liability is considered rate sensitivity if during the time interval:
  

It matures It represents and interim, or partial, principal payment It can be repriced

The interest rate applied to the outstanding principal changes contractually during the interval The outstanding principal can be repriced when some base rate of index changes and management expects the base rate / index to change during the interval
15

Example on RSAs/RSLs
Assets 1. Short term consumer loans (1 year maturity) 2. Long term consumer loans (2 year maturity) 3.Three-month Treasury Bills 4. Six-month Treasury Notes 5. Three year Treasury Bonds 6. 10 year, fixed rate mortgages 7. 30 year, floating rate mortgages (rate adjusted every nine months) Liabilities 50 Equity Capital (Fixed) 25 Demand deposits 30 Passbook savings 35 Three month CDs Three month Banker 70 acceptances 20 Six month CP One year time deposits 40 Two year time deposits 270 40 270 20 40 30 40 20 60 20

16 Within 1 year, Determine the RSAs =? RSLs = ? Hows about NRS for assets and liabilities?

Interest rate GAP/ Dollar GAP/ Funding GAP/ Maturity GAP)

GAP = RSAs RSLs Cummulative GAP (CGAP): measures the difference between RSA and RSL over a more extended period
(NII i ! (GAPi )(Ri ! ( RSAi  RSLi )(Ri

(NII i ! (CGAP ) (Ri

17

Example on Interest sensitive GAP

Days 1 day 2-30 days 31-90 days 91-180 days 181-365 1 year -5 years Assets maturing or Repricing within 20 30 70 90 40 10 260 Liabilities maturing or Repricing within 30 40 85 70 30 5 260
18

Increme ntal Gap -10 -10 -15 20 10 5

Cummul ative Gap -10 -20 -35 -15 -5 0

Example


A bank makes a $10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $10,000 CD at a cost of 4.5%. The banks initial spread is 4%.
4 year Car Loan 1 Year CD 8.50% 4.50% 4.00%

What is the banks one year gap?

19

Example
Traditional Static GAP Analysis


What is the banks 1-year GAP with the auto loan?

RSA1yr = $0 RSL1yr = $10,000 GAP1yr = $0 - $10,000 = -$10,000
 

The banks one year funding GAP is -10,000 If interest rates rise (fall) in 1 year, the banks margin will fall (rise)
20

Other Gap Measurements

Relative Dollar IS Gap Interest! Bank Size Sensitive Gap Interest Sensitivity Ratio

Interest Sensitive Assets ! Interest Sensitive Liabilities

21

Asset-Sensitive Bank Has:

Positive Dollar Interest-Sensitive Gap Positive Relative Interest-Sensitive Gap Interest Sensitivity Ratio Greater Than One

22

Liability Sensitive Bank Has:

Negative Dollar Interest-Sensitive Gap Negative Relative Interest-Sensitive Gap Interest Sensitivity Ratio Less Than One

23

Factors Affecting Net Interest Income

Changes in the level of interest rates Changes in the composition of assets and liabilities Changes in the volume of earning assets and interest-bearing liabilities outstanding Changes in the relationship between the yields on earning assets and rates paid on interestbearing liabilities
24

Example
Consider the following balance sheet:
Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive $ 500 8.0% $ 600 4.0% Fixed rate $ 350 11.0% $ 220 6.0% Non earning $ 150 $ 100 $ 920 Equity $ 80 Total $ 1,000 $ 1,000 NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220) NII = 78.5 - 37.2 = 41.3 NIM = 41.3 / 850 = 4.86% GAP = 500 - 600 = -100

25

Examine the impact of the following changes

A 1% increase in the level of all short-term rates? A 1% decrease in the spread between assets yields and interest costs such that the rate on RSAs increases to 8.5% and the rate on RSLs increase to 5.5%? A proportionate doubling in size of the bank?
26

1% increase in short-term rates

Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive $ 500 9.0% $ 600 5.0% Fixed rate $ 350 11.0% $ 220 6.0% Non earning $ 150 $ 100 $ 920 Equity $ 80 Total $ 1,000 $ 1,000 NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220) NII = 83.5 - 43.2 = 40.3 NIM = 40.3 / 850 = 4.74% With a negative GAP, more GAP = 500 - 600 = -100 liabilities than assets reprice

higher; hence NII and NIM fall 27

1% decrease in the spread

Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive $ 500 8.5% $ 600 5.5% Fixed rate $ 350 11.0% $ 220 6.0% Non earning $ 150 $ 100 $ 920 Equity $ 80 Total $ 1,000 $ 1,000 NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220) NII = 81 - 46.2 = 34.8 NII and NIM fall (rise) with a NIM = 34.8 / 850 = 4.09% decrease (increase) in the GAP = 500 - 600 = -100

spread. Why the larger change?

28

Proportionate doubling in size

Expected Balance Assets Rate sensitive $ 1,000 Fixed rate $ 700 Non earning $ 300 Sheet for Hypothetical Bank Yield Liabilities Cost 8.0% $ 1,200 4.0% 11.0% $ 440 6.0% $ 200 $ 1,840 Equity $ 160 $ 2,000

Total

$ 2,000

NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440) NII = 157 - 74.4 = 82.6 NII and GAP double, but NIM = 82.6 / 1700 = 4.86% GAP = 1000 - 1200 = -200 stays the same.

NIM

What has happened to risk?

29

RSAs increase to $540 while fixed-rate assets decrease to $310 and RSLs decrease to $560 while fixed-rate liabilities increase to $260
Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive $ 540 8.0% $ 560 4.0% Fixed rate $ 310 11.0% $ 260 6.0% Non earning $ 150 $ 100 $ 920 Equity $ 80 Total $ 1,000 $ 1,000 NII = (0.08 x 540 + 0.11 x 310) NII = 77.3 - 38 = 39.3 NIM = 39.3 / 850 = 4.62% GAP = 540 - 560 = -20 - (0.04 x 560 + 0.06 x 260)

Although the banks GAP (and hence risk) is lower, 30 NII is also lower.

Changes in Portfolio Composition and Risk

To reduce risk, a bank with a negative GAP would try to increase RSAs (variable rate loans or shorter maturities on loans and investments) and decrease RSLs (issue relatively more longer-term CDs and fewer fed funds purchased) Changes in portfolio composition also raise or lower interest income and expense based on the type of change

31

Summary of GAP and the Change in NII

GAP Positive Positive Negative Negative Zero Zero Change in Interest Income Increase Decrease Increase Decrease Increase Decrease GAP Summary Change in Interest Income Increase > Decrease > Increase Decrease Increase Decrease < < = = Change in Interest Expense Increase Decrease Increase Decrease Increase Decrease Change in Net Interest Income Increase Decrease Decrease Increase None None

32

Exercise on IS GAP, NII

Assets Rate sensitive Non rate sensitive Non earning Total 200 (12%) 400 (11%) 100 700 Liabilities and Equities Rate sensitive 300 (6%) Non rate sensitive 300 (5%) Equity 100 Total 700

Q: Determining the GAP? Net interest income? Net interest margin? How much will net interest income change if interest rates fall by 2%? What changes in portfolio composition would you recommend to management if you expected interest rates to increase?
33

Three problems with IS GAP

Time Horizon Market value effects Focus on Net interest income

34

Duration GAP analysis

What is Duration and its measurement? Networth of the bank (NW) Duration GAP and hedging interest rate risk with duration Weaknesses of duration GAP

35

Duration and its measurement

ExpectedCF * t (1  YTM )t D ! t !1n ExpectedCF (1  YTM )t t !1
(P (i !  Dx P 1 i
n

A loan with annual interest payment @10% for 5 years, the loan principal is $1000. What is the Duration of the loan if the current market price is $1000? How is the loan price vary if the interest rates increase by 1%?

36

Net Worth of the bank

NW ! A  L
(NW ! (A  (L

37

Duration GAP
Duration GAP = Duration of asset portfolio Duration of bank liabilities The bank tries to manage duration gap approaching zero Positive duration gap Negative duration gap

Durationofeachassetxmarketvalue
AssetportfolioDuration !
i !1

Totalmarketvalueofallassets

38

Weaknesses of duration GAP?

39