Lecture in Brief

Chapter Learning Objective:

Learning an integrated approach to managing assets, liabilities,
and equity that really works.

Contents:
• Assets and Liabilities Management
• Assets and Liability Management Strategies
• Interest Rate Risk
• Components and Measurement of Interest Rate
• Interest Rate Risk Hedging
• Gap Analysis
• Duration Analysis
• Changes in the Value of Equity

Chapter 7 from Bank Management and Financial Services- Peter S. Rose

 Asset-liability management (ALM)
 Banks are highly complex organizations. (why?)They offer multiple
financial services through multiple departments each staffed by
specialists in making different kinds of decisions.

 In a well-managed financial institution all the diverse management

decisions must be coordinated across the whole institution in order to
ensure they do not clash with each other, leading to inconsistent
actions that damage earnings and net worth.

 Today bank managers look at their asset and liability portfolios as an

integrated whole which is known as asset-liability management
(ALM).

 ALM helps to formulate strategies and take actions that shape a bank’s
balance sheet and protect the value of its assets, equity and net income
that promote each institution’s goals. (two goals: Maximize the spread
and share value)
 Asset-liability management (ALM)

Asset Management: Control of the composition of or

arrangement of or structure of a bank’s assets to provide
adequate liquidity and earnings and for meeting obligation
and other goals

Liabilities Management: Control over a bank’s liabilities

(usually through changes in interest rate offered) to provide
the bank with adequate liquidity and meet other goals
 Asset-liability management (ALM)

ALM refers the control of the Bank’s sensitivity to changes in

market interest rates to limit losses in its net income or equity.

The ALM provides the defensive weapons to handle business

cycle and seasonal pressure on deposits and loans and with the
offensive weapons to construct portfolios of assets that promote
the bank’s goal.
 Asset-liability management (ALM)

Usually the principle goals of ALM are

a) To maximize or at least stabilize, the bank’s margin or

spread between interest revenues and interest expense

b) To maximize or at least protect the value of the bank, at an

acceptable level of risk.
 Asset-liability management (ALM)

Therefore, the central theme of (ALM) is the management of

a bank’s entire balance sheet on continuous basis with a view to
ensure a proper balance between funds mobilization and their
deployment with respect to their maturity profiles, cost and
return as well as risk exposure so as to improve profitability,
ensure adequate liquidity, manage risks and ensure stable equity
 Asset-liability management (ALM)

Exhibit 7-1: Asset-Liability Management in Banking and Financial Services

 Asset-Liability Management Strategies

1. Asset Management Strategy

2. Liability Management Strategy

3. Funds Management Strategy

 Asset-Liability Management Strategies
Asset Management Strategy:
 Historically, bankers tended to take their sources of funds—liabilities and
equity—largely for granted. Under this view, the public determined the
relative amounts of deposits and other sources of funds available to
depository institutions. The key decision area for management was not
deposits and other borrowings but assets.

 Bank could exercise control only over the allocation of incoming funds by
deciding who was to receive the scarce quantity of loans available and
what the terms on those loans would be.

 Indeed, there was some logic behind this asset management approach
because, prior to recent deregulation of the industry.
 Asset-Liability Management Strategies
Liability Management Strategy:
 Confronted with fluctuating interest rates and intense competition for
funds, financial firms began to devote greater attention to opening up new
sources of funding and monitoring the mix and cost of their deposit and
non-deposit liabilities.

 The goal is simply to gain control over funds sources comparable to the
control financial managers had long exercised over their assets.

 The key control lever was price—the interest rate and other terms offered
on deposits and other borrowings to achieve the volume, mix, and cost
desired.
 Asset-Liability Management Strategies
Funds Management Strategy:
 The maturing of liability management techniques, coupled with more
volatile interest rates and greater risk, eventually gave birth to the funds
management approach, which dominates today. The views are:-
❖ Management should exercise as much control as possible over the volume,
mix, and return or cost of both assets and liabilities in order to achieve the
financial institution’s goals.
❖ Management’s control over assets must be coordinated with its control
over liabilities.
❖ Revenues and costs arise from both sides of the balance sheet.
 Banks carry out daily asset-liability management (ALM) activities through
an asset-liability committee (ALCO), usually composed of key officers
representing different departments of the firm.
 Interest Rate Risk
• Interest rate risk is the risk where changes in the market interest rates might
adversely affect a bank’s financial condition.

• Immediate impact would be on bank’s earnings by changing its Net Interest

Income, i.e. change affects mostly the interest income and interest expense

• Long term impact of changing interest rates would be on bank’s Net Worth, i.e.
change affects mostly the assets and liabilities

• Changing interest rates impact both the balance sheet and the statement
of income and expenses of financial firms.
 Interest Rate Risk
 The interest rate (price of credit) tends to settle at the point where the
quantities of loanable funds demanded and supplied are equal.
 Financial institutions are on the supply side of the loanable funds (credit)
market (in granting loans) and come into the demand side when they offer
deposit services to the public or issue non-deposit IOUs.
 Most financial managers must be price takers, not price makers, and must
accept interest rates as a given and plan accordingly.
 As market interest rates move, financial firms typically face at least two major
kinds of interest rate risk—price risk and reinvestment risk.
 Price risk arises when market interest rates rise, causing the market values of
most bonds and fixed-rate loans to fall (capital loss) and Reinvestment risk
rears its head when market interest rates fall, forcing a financial firm to invest
incoming funds in lower-yielding earning assets, lowering its expected future
income
 Interest Rate Risk

EXHIBIT 7–2 Determination of the Rate of Interest in the Financial Marketplace where the
Demand and Supply of Loanable Funds (Credit) Interact to Set the Price of Credit
 Interest Rate Measurement (YTM)
 Yield to Maturity (YTM) is the discount rate that equalizes the current
market value of a loan or security with the expected stream of future
income payments that the loan or security will generate.

Another Formula:
 Interest Rate Measurement (YTM)
Exercise:
A bond purchased today at a price of $950 and promising an interest
payment of $100 each year over the next three years, when it will be
redeemed by the bond’s issuer for $1,000. You will have a promised interest
rate, measured by the yield to maturity. What is the YTM?

Please try through alternative formula

 Interest Rate Measurement (Bank Discount Rate)
 Another popular interest rate measure is the bank discount rate.

 It is often quoted on short-term loans and money market securities (such

as Treasury bills).

 This refers the rate of return on a financial instrument calculated using

the instrument’s face value and assuming a 360-day year.

 Formula:
 Interest Rate Measurement (Bank Discount Rate)
Exercise:

 A money market security can be purchased for a price of $96 and has a
face value of $100 to be paid at maturity. If the security matures in 90 days,
what will be its interest rate measured by the DR?

 However, to convert a bank discount rate (DR) to the equivalent YTM, we

go through the following formula:
 The Components of Interest Rates
 An interest rate consists of multiple elements or building blocks.

 Risk-free real interest rate change over time with shifts in the demand and
supply for loanable funds.

 Risk premiums also change over time, causing market interest rates to
move up or down, often erratically.
 Risk Premiums
 The default-risk premium component of the interest rate charged a
risky borrower will increase, raising the borrower’s loan rate (all other
factors held constant).

 Inflation-risk premium compensates for their projected loss in

purchasing power.

 Maturity Risk Premium – Compensation on long-term bonds as they

fluctuate heavily in response to interest rate changes.

 Liquidity Risk Premium– Compensation for the possible difficulty in

selling the instruments

 Call Risk Premium – Compensation for the flexibility that borrowers

can pay the loan earlier
 Banker’s Response to Interest Rate Risk….
 Asset Liability Management under The professional guidance of
Asset Liability Committee (ALCO).
 Such a committee not only choose strategy to deal with interest rate
but also participates in both short and long range planning to handle
bank’s liquidity needs.
• ALCO decision making unit- Responsible for balance sheet
planning from risk return perspective
• Monitoring the market risk levels by ensuring adherence to the
various risk limits set by the bank
• Articulating the current interest rate view and a view on future
direction of interest rate movements
 Banker’s Response to Interest Rate Risk….
 Deciding the business strategy of the bank, consistent with the interest rate
view, budget and pre-determined risk management objectives

 Determining the desired maturity profile and mix of assets and liabilities
 Product pricing for both assets and liabilities side

 Deciding the funding strategy i.e. source and mix of liabilities or sale of
assets

 Reviewing implementation of decisions made in the previous meeting

 Composition of ALCO
The size of ALCO depends on size of institution, business mix
and organizational complexity

 CEO to head the Committee

 Chiefs of Investment, Credit, Resource Management, Funds

Management/ Treasury, Banking and Economic Research to be
members of the Committee

 Head of Technology Division be an invitee

 Some banks may have sub-committees and support groups

 Management committee to oversee and review

 Interest Rate Hedging
 In dealing with interest rate risk, one important goal is to insulate profits—net
income— from the damaging effects of fluctuating interest rates.

 To accomplish this goal, management must concentrate on those elements of

the institution’s portfolio of assets and liabilities that are most sensitive to
interest rate movements.

 In order to protect profits against adverse interest rate changes, then,

management seeks to hold fixed the financial firm’s net interest margin (NIM)
Net Interest Margin
 Net Interest Margin
 NIM is not this bank’s profit from borrowing and lending funds
because we have not considered noninterest expenses (such as
employee salaries and overhead expenses).

 If management does find a 3.5 percent net interest margin acceptable,

it will probably use a variety of interest-rate risk hedging methods to
protect this NIM value, thereby helping to stabilize net earnings.

 If the interest cost of borrowed funds rises faster than income from
loans and securities or if interest rates fall and cause income from loans
and securities to decline faster than interest costs on borrowings, the
NIM will again be squeezed.

 Management must struggle continuously to find ways to ensure that

borrowing costs do not rise significantly relative to interest income and
threaten the margin of a financial firm.
 Net Interest Margin
FN Bank has posted interest revenues of $63 million and interest costs
from all of its borrowings of $42 million. If this bank possesses $700
million in total earning assets, what is First National’s net interest
margin?
Suppose the bank’s interest revenues and interest costs double,
while its earning assets increase by 50 percent. What will happen to its
net interest margin?

Solution:
NIM = (Interest Income from bank Loans and investment – Interest expense on
deposits and other borrowed funds)/Total Earnings Assets

= ($63 - $42) million / $700 million = 3%

Therefore, NIM = ($63*2 - $42*2) million / $700*1.50 million = 4%

 Therefore, NIM increases from 3% to 4%.

 Interest-Sensitive Gap Management
• Interest-sensitive gap management is the most popular interest rate hedging
strategies in use today is

• It requires management to perform an analysis of the maturities and re-

pricing opportunities associated with interest-bearing assets and with
interest-bearing liabilities.

• If management feels its institution is excessively exposed to interest rate risk,

it will try to match as closely as possible the volume of assets that can be re-
priced as interest rates change with the volume of liabilities whose rates can
also be adjusted with market conditions during the same time period.

• A financial firm can hedge itself against interest rate changes—no matter
which way rates move—by making sure for each time period that the: -
Examples of Re-priceable Assets and Liabilities
and Nonrepriceable Assets and Liabilities
 Interest-Sensitive Gap Management
 When the amount of repriceable assets does not equal the amount of
repriceable liabilities, a gap then exists between these interest-
sensitive assets and interest-sensitive liabilities.

 The gap is the portion of the balance sheet affected by interest rate
risk:

Interest-sensitive gap: (Interest-sensitive assets) – (Interest -

sensitive liabilities)

 A positive gap is asset sensitive

 A negative gap is liability sensitive

 Other Ways to Measure IS Gap
Relative IS GAP

If a Relative IS gap greater than 0 then the bank is asset sensitive, and if
negative then liability sensitive bank.

Interest Sensitive Ratio

If ISR is less than 1 then liability sensitive and if equal to or greater than 1
then asset sensitive
 IS GAP Exercise
ABC Bank and Trust reports interest-sensitive assets of $570 million and
interest-sensitive liabilities of $685 million. What is the bank’s dollar interest-
sensitive gap? What is its relative interest-sensitive gap? Also, what is its
interest-sensitive ratio?

Solution:

Dollar IS GAP: $(570-685) Million = -$115 million

Relative IS GAP: (IS GAP/ Bank Size) = -$115/$570 million = -0.20

Interest-Sensitive Ratio: ISA/ISL = $570/$685 million = 0.83

 IS GAP Exercise
Suppose, XYZ is holding interest-sensitive assets of $500 million and
interest-sensitive liabilities of $400 million. Determine the following:

a. Dollar interest-sensitive gap

b. Relative interest-sensitive gap

c. Interest-Sensitive ratio

d. Is the bank asset-sensitive?

 Factors Influencing the NIM
1. Changes in the level of interest rates, up or down.

2. Changes in spread between assets yields and liability costs.

3. Changes in the volume of interest bearing assets of a bank holds.

4. Changes in the volume of interest bearing liabilities of a bank holds

5. Changes in the mix of assets and liabilities that the management of each
bank draws upon.
NIM Break-down
 Factors Influencing the NIM
 Suppose the yields on rate-sensitive and fixed assets average 10 percent
and 11 percent, respectively, while rate-sensitive and non-rate-sensitive
liabilities cost an average of 8 percent and 9 percent, respectively. During
the coming week the bank holds $1,700 million in rate-sensitive assets
(out of an asset total of $4,100 million) and $1,800 million in rate-sensitive
liabilities. Suppose, too, that these annualized interest rates remain
steady. Determine the bank’s net interest income on an annualized basis.

Solution:
NIM = (0.10* $1,700) + (0.11* [4,100 -1,700]) – (0.08*$1,800) –
(0.09*[4,100 – 1, 800])
= $83 million
 Duration Analysis
 Duration is a value- and time-weighted measure of maturity.
 It considers the timing of all cash inflows from earning assets and all cash
outflows associated with liabilities.
 It measures the average maturity of a promised stream of future cash
payments.
 In effect, duration measures the average time needed to recover the funds
committed to an investment.
 Formula:

 In abbreviation,
 Duration Analysis
Suppose that a bank grants a loan to one of its customers for a term of five
years. The customer promises the bank an annual interest payment of 10
percent (that is, $100 per year). The face (par) value of the loan is $1,000,
which is also its current market value (price) because the loan’s current yield
to maturity is 10 percent. What is this loan’s duration?

Someone can simply utilize a table for the duration calculation [next page].
Duration Analysis
 Duration Analysis and Net Worth
 Net worth (NW) is owner’s investment in the institution.
 The NW of any bank is equal to the value of its assets less the value of its
liabilities. [NW= A-L]
 As market interest rates change, the value of both a financial institution’s
assets and its liabilities will change, resulting in a change in its NW.
Change in NW = Change in A – Change in L

 Portfolio theory teaches us that

1. A rise in market rates of interest will cause the market value (price) of both
fixed-rate assets and liabilities to decline.
2. The longer the maturity of a financial firm’s assets and liabilities, the more
they will tend to decline in market value (price) when market interest rates
rise.
 Role of Duration Analysis
 A financial firm with longer-duration assets than liabilities will suffer a
greater decline in net worth when market interest rates rise than a
financial institution whose asset duration is relatively short term or one
that matches the duration of its liabilities with the duration of its assets.

 By equating asset and liability durations, management can balance the

average maturity of expected cash inflows from assets with the average
maturity of expected cash outflows associated with liabilities.

 Thus, duration analysis can be used to stabilize, or immunize, the market

value of a financial institution’s net worth (NW).
 Price Sensitivity to Changes in Interest Rates and Duration

 The important feature of duration from a risk-management point of view

is that it measures the sensitivity of the market value of financial
instruments to changes in interest rates.
 The percentage change in the market price of an asset or a liability is equal
to its duration times the relative change in interest rates attached to that
particular asset or liability.
 Formula:
 Duration Analysis
 Consider a bond held by a savings institution that carries a duration of
four years and a current market value (price) of $1,000. Market interest
rates attached to comparable bonds are about 10 percent currently, but
recent forecasts suggest that market rates may rise to 11 percent. If this
forecast turns out to be correct, what percentage change will occur in the
bond’s market value?

 Solution:

Change = New –Old

= 11%-10%
= 1%
 Duration for Hedging Against Interest Rate Risk

 A financial-service provider is interested in fully hedging against interest

rate fluctuations wants to choose assets and liabilities such that:

The dollar-weighted duration of the asset portfolio = The dollar-

weighted duration of liabilities

 Therefore, the duration gap is as close to zero as possible.

Duration gap = Dollar-weighted duration of asset portfolio - Dollar-
weighted duration of liability portfolio

 However, in reality the duration gap could be positive (asset sensitive)

or negative (liability sensitive)
Changes in a Value of a Bank’s Net Worth (NW)
 Changes in a Value of a Bank’s Net Worth (NW)
Suppose that a financial firm has an average duration in its assets of three
years, an average liability duration of two years, total liabilities of $100
million, and total assets of $120 million. Interest rates were originally 10
percent, but suddenly they rise to 12 percent. Now, determine the change in
the value of the bank’s net worth?

Solution:
 Dollar-weighted Asset Portfolio Duration
 Weighting each asset duration by its associated dollar volume, we
calculate the duration of the asset portfolio as follows:
 Dollar-weighted Asset Portfolio Duration
Exercise:

Calculate the dollar-weighted asset portfolio duration of this bank.

 Dollar-weighted Asset Portfolio Duration
Solution:
Management Interpretation
 Concluding Remarks

The above formula reminds us that the impact of interest rate changes on
the market value of net worth depends upon three crucial size factors:

 The size of the duration gap (DA-DL), with a larger duration gap
indicating greater exposure of a financial firm to interest rate risk.

 The size of a financial institution (A and L), with larger institutions

experiencing a greater change in net worth for any given change in
interest rates.

 The size of the change in interest rates, with larger rate changes
generating greater interest rate risk exposure.
 Task
Ex-1:
Twinkle Savings Association has interest-sensitive assets of $325 million,
interest-sensitive liabilities of $325 million, and total assets of $500
million. What is the bank’s dollar interest-sensitive gap? What is
Twinkle’s relative interest-sensitive gap? What is the value of its interest
sensitivity ratio? Is it asset sensitive or liability sensitive? Under what
scenario for market interest rates will Twinkle experience a gain in net
interest income? A loss in net interest income?
Ex-2:
Watson Thrift Association reports an average asset duration of 7 years and
an average liability duration of 3.25 years. In its latest financial report, the
association recorded total assets of $1.8 billion and total liabilities of $1.5
billion. If interest rates began at 6 percent and then suddenly climbed to
7.5 percent, what change will occur in the value of Watson’s net worth? By
how much would Watson’s net worth change if, instead of rising, interest
rates fell from 6 percent to 5 percent?
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