Managing Interest Rate Risks: GAP and Earnings

Sensitivity

Syllabus
Measuring interest rate risk with GAP: traditional static GAP
analysis, determinants of rate sensitivity, factors affecting net
interest income, rate volume and mix analysis, rate sensitivity
report-- periodic GAP versus Cumulative GAP and GAP ratio,
and earnings sensitivity analysis, income statement GAP; and
Managing the GAP and earnings sensitivity risk
 Interest Rate Risk
• Interest Rate Risk
– The potential loss from unexpected changes in interest rates which can
significantly alter a bank’s profitability and market value of equity.
• When a bank’s assets and liabilities do not re-price at the same time, the
result is a change in net interest income.
– The change in the value of assets and the change in the value of
liabilities will also differ, causing a change in the value of stockholder’s
equity
• Banks typically focus on either:
– Net interest income or
– The market value of stockholders' equity
– The ALCO coordinates the bank’s strategies to achieve the optimal
risk/reward trade-off.
• GAP Analysis
– A static measure of risk that is commonly associated with net interest
income (margin) targeting
• Earnings Sensitivity Analysis
– Earnings sensitivity analysis extends GAP analysis by focusing on changes
in bank earnings due to changes in interest rates and balance sheet
composition
 Two Types of Interest Rate Risk
• Spread Risk (reinvestment/refinancing risk)
– Changes in interest rates will change the bank’s cost of
funds as well as the return on their invested assets.
They may change by different amounts.
– Static GAP Analysis considers the impact of changing
rates on the bank’s net interest income.
• Price Risk
– Changes in interest rates may change the market values
of the bank’s assets and liabilities by different amounts.
– Duration GAP considers the impact of changing rates
on the market value of equity.
 Measuring Interest rate Risk with GAP
• GAP: It is the difference between the amount of interest rate
sensitive assets(RSA) and Interest rate sensitive liabilities(RSL)
• RSA: Assets whose interest income changes with the change in
market interest rate. (eg: short term securities, short term loans,
long term variable rate loans etc)
• RSL: Liabilities whose interest expenses changes with the changes
in market interest rate (eg: Money market deposits, short term
savings, short term borrowings etc)
• Non rate sensitive assets and liabilities: Whose interest income
and do not vary with the change in market interest rate.
GAP = RSA-RSL
 Definition of Rupee GAP

• Difference between RSA and RSL is called

Rupee Gap.
GAP = RSA-RSL
• Relative GAP: Is a rupee GAP as a Fraction of
total assets.
Relative GAP Ratio = GAP/Total assets
• Interest Sensitive ratio = RSA/RSL
 Measuring interest rate risk with GAP

• Why will a bank's Net interest Income (NII) changes from

one period to next?
– Unexpected changes in interest rates
– Changes in the mix or composition of assets and liabilities
– Changes in the volume of earning assets and the volume of
interest bearing liabilities.
• GAP and earning sensitivity analysis represent the
measure of risk.
 Approaches in Managing Interest Rate risk
• On Balance adjustment
– The adjustment in bank's assets and liabilities in the balance sheet to
reduce the impact of interest rate changes.
– Adjustment may be Pricing and payment schedule of assets and
liabilities.
– Shifting from fixed rate loan to floating rate loan, shifting from short
term deposit to long term deposit etc.
• Off Balance sheet adjustment
– Interest rate SWAP: A contractual agreement between a bank and
another party to exchange payment. In this contract a bank agrees to
make a payments to another party on a fixed interest and in turn the
another party agrees to pay to the bank on a floating interest.
– Interest rate futures: Financial derivatives with an interest bearing
instrument that gives their owners the right to earn interest at a given
rate, or the obligation to pay interest at a given rate. (eg: Treasury bill
futures, Treasury bond futures etc)
 Traditional Static GAP Analysis
• It focuses on managing NII in the short run.
• It measures how much interest rate risk a bank evidences at a fixed point
in time by comparing the RSA with RSL.
• Static GAP assumes that balance sheet not to changes only rate changes
that affect earnings.
Periodic GAP: It compares RSA and RSL within each signal time bucket.
Cumulative GAP: Cumulative GAP measures the difference between RSA and
RSL over a more extended period. It is the sum of incremental GAP. If
there is only one period of planning horizon, the incremental and the
cumulative GAP is the same.
Steps of Static GAP analysis
– Develop an interest rate forecast
– Select RSA and RSL with time interval
– Group RSA and RSL into time intervals
– Calculate GAP Forecast NII
"The magnitude of the GAP provides information regarding how much
NII may changes when interest rate changes."
 Interest Rate-Sensitivity Reports
Classifies a bank’s assets and liabilities into time intervals
according to the minimum number of days until each instrument is
expected to be repriced.

• GAP values are reported a periodic and cumulative

basis for each time interval.
– Periodic GAP
• Is the Gap for each time bucket and measures the timing
of potential income effects from interest rate changes
– Cumulative GAP
• It is the sum of periodic GAP's and 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.
Advantages and Disadvantages of Static GAP Analysis

• Advantages
– Easy to understand
– Works well with small changes in interest rates
• Disadvantages
– Ex-post measurement errors
– Ignores the time value of money
– Ignores the cumulative impact of interest rate changes
– Typically considers demand deposits to be non-rate
sensitive
– Ignores embedded options in the bank’s assets and
liabilities
 What Determines the rate sensitivity?

• Considering a 0-90 day “time bucket,” RSAs and RSLs include:

– Maturing instruments or principal payments
• If an asset or liability matures within 90 days, the
principal amount will be re-priced
• Any full or partial principal payments within 90 days will
be re-priced
– Floating and variable rate instruments
• If the index will contractually change within 90 days,
the asset or liability is rate sensitive
• The rate may change daily if their base rate changes.
– Issue: do you expect the base rate to change?
 Earnings Sensitivity Analysis
• Allows management to incorporate the
impact of different spreads between asset
yields and liability interest costs when rates
change by different amounts.
Steps to Earnings Sensitivity Analysis
• Forecast future interest rates
• Identify changes in the composition of assets and
liabilities in different rate environments
• Forecast when embedded options will be exercised
• Identify when specific assets and liabilities will re-
price given the rate environment
• Estimate net interest income and net income
• Repeat the process to compare forecasts of net
interest income and net income across different
interest rate environments.
Managing the GAP and Earnings Sensitivity Risk

• Steps to reduce risk

– Calculate periodic GAPs over short time intervals.
– Fund re-priceable assets with matching re-
priceable liabilities so that periodic GAPs
approach zero.
– Fund long-term assets with matching
noninterest-bearing liabilities.
– Use off-balance sheet transactions to hedge.
 Adjust the Effective Rate Sensitivity of a Bank’s
Assets and Liabilities
Objective Approaches
Buy longer-term securities.
Reduce asset
Lengthen the maturities of loans.
sensitivity
Move from floating-rate loans to term loans.

Increase asset Buy short-term securities.

sensitivity Shorten loan maturities.
Make more loans on a floating-rate basis.
Pay premiums to attract longer-term deposit
Reduce liability
instruments.
sensitivity
Issue long-term subordinated debt.
Pay premiums to attract short-term deposit
Increase liability instruments.
sensitivity Borrow more via non-core purchased
liabilities.
 GAP Interest rate and profitability
• The effect of changing interest rate on profitability of a
financial institutions depend on the GAP position of the
financial institution.
• Managing interest rate risk with rupee GAPs
– The main objectives of assets liabilities management (ALM) is to
control the size of net interest income. For this, bank
management can adapt defensive or aggressive ALM
– Defensive ALM, emphasis is made to prevent NII from the
changes in market interest rate.
– Aggressive ALM, increase the size of NII by making adjustment
into assets and liability portfolios.
 The problem with GAP Management
Time horizon:
– Time horizon problem is related to the decision about the appropriate
time period when assets and liabilities are to be re-priced.
– It assumes that assets and liabilities are re-priced in the same day. But
this is not practical.
– The solution is to divide the assets and liabilities into incremental GAP
and manage each incremental GAP separately.
Correlation with market
– We assume that the interest income and interest expenses move in
the same direction and in the same magnitude with the market
interest rate. In real life that may not be happen.
– A bank can us standardize GAP as the solution to this problem.
Focus on interest rate
– Focus on net interest income rather than shareholders' wealth.
– If interest rate increases, equity value may decrease.
Effect of the change in interest rate on profitability
under different GAP position

GAP Interest Rate Net Interest

income.
Positive Increase Increase
Positive Decrease Decrease

Negative Increase Decrease

Negative Decrease Increase

Zero Increase No change

Zero Decrease No change
 Chapter 4
Managing Interest Rate Risk(II):
Duration GAP and Economic Value of Equity

Syllabus
Concept and calculation of economic value of equity (EVE);
Measuring interest rate risk with duration GAP: duration, modified
duration and effective duration, duration gap model, a duration
application for banks; Economic value of equity sensitivity analysis;
and Earnings sensitivity analysis versus EVE sensitivity analysis.
Measuring Interest Rate Risk with Duration GAP

• Economic Value of Equity Analysis

– Focuses on changes in stockholders’ equity given
potential changes in interest rates
• Duration GAP Analysis
– Compares the price sensitivity of a bank’s total
assets with the price sensitivity of its total
liabilities to assess the impact of potential
changes in interest rates on stockholders’ equity.
 Duration GAP
• Duration GAP Model
– Focuses on either managing the market value of stockholders’
equity
• The bank can protect EITHER the market value of equity or net
interest income, but not both
• Duration GAP analysis emphasizes the impact on equity
– Compares the duration of a bank’s assets with the duration of the
bank’s liabilities and examines how the economic value
stockholders’ equity will change when interest rates change.
 Steps in Duration GAP Analysis
• Forecast interest rates.
• Estimate the market values of bank assets, liabilities
and stockholders’ equity.
• 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.
• Forecasts changes in the market value of
stockholders’ equity across different interest rate
environments.
 Weighted Average Duration of Bank Assets

• The weighted average time period required to

realize all cash flows from an investment.
• Duration GAP analysis.docx
Positive and Negative Duration GAPs
• Positive DGAP
– Indicates that assets are more price sensitive than
liabilities, on average.
• Thus, when interest rates rise (fall), assets will fall
proportionately more (less) in value than liabilities and
EVE will fall (rise) accordingly.
• Negative DGAP
– Indicates that weighted liabilities are more price
sensitive than weighted assets.
• Thus, when interest rates rise (fall), assets will fall
proportionately less (more) in value that liabilities and
the EVE will rise (fall).
 Economic Value of Equity Sensitivity Analysis

• Effectively involves the same steps as earnings

sensitivity analysis.
• In EVE analysis, however, the bank focuses on:
– The relative durations of assets and liabilities
– How much the durations change in different
interest rate environments
– What happens to the economic value of equity
across different rate environments
 Embedded Options
• Embedded options sharply influence the
estimated volatility in EVE
– Prepayments that exceed (fall short of) that
expected will shorten (lengthen) duration.
– A bond being called will shorten duration.
– A deposit that is withdrawn early will shorten
duration.
– A deposit that is not withdrawn as expected will
lengthen duration.
 Effective “Duration” of Equity

• By definition, duration measures the

percentage change in market value for a given
change in interest rates
– Thus, a bank’s duration of equity measures the
percentage change in EVE that will occur with a 1
percent change in rates:
Asset/Liability Sensitivity and DGAP
• Funding GAP and Duration GAP are NOT
directly comparable
– Funding GAP examines various “time buckets”
while Duration GAP represents the entire balance
sheet.
• Generally, if a bank is liability (asset) sensitive in the
sense that net interest income falls (rises) when rates
rise and vice versa, it will likely have a positive
(negative) DGAP suggesting that assets are more price
sensitive than liabilities, on average.
Strengths and Weaknesses: DGAP and EVE-Sensitivity
Analysis

• Strengths
– Duration analysis provides a comprehensive
measure of interest rate risk
– Duration measures are additive
• This allows for the matching of total assets with
total liabilities rather than the matching of
individual accounts
– Duration analysis takes a longer term view
than static gap analysis
Strengths and Weaknesses: DGAP and EVE-Sensitivity
Analysis

• Weaknesses
– 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
 Speculating on Duration GAP

• It is 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 vary GAP and DGAP and must
often sacrifice yield to do so