Fundamentals of Banking Institutions

Topic 3: Interest Rate Risk (IRR) and Net Interest Income (NII)

Agenda

 Introductory comments

 IRR concepts and some numerical examples

 Analysis of NII and IRR disclosures

 Summary of takeaways

Fundamentals of Banking Institutions by Prof. Liang 2

 Introductory Remarks

IRR AND NII ANALYSIS

Fundamentals of Banking Institutions by Prof. Liang 3

Introductory Comments

 Interest Rate Risk (IRR) is one of the two main risks for most banks

 IRR is well understood theoretically

 Banks’ disclosures of NII and IRR are better than for any other type of income or
risk
 though NII primarily is based on amortized cost accounting

 Analysis of NII and IRR is both important and feasible

Fundamentals of Banking Institutions by Prof. Liang 4

 Interest Rates for various maturities: different borrowers
 Interest rates are prices to borrow money for a period of time
 Interest rates reflect: - real rates, - inflation rates, - credit risk premium

adjustable rate: hybrid, first 10 years fixed, afterwards change every 6month

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Interest Rates at various maturities: fixed versus variable

 Each of these components varies over time, yielding gains and losses on fixed-
rate and imperfectly floating-rate exposures

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 increase decresae

same same

same same

decresae increase

Implicit in value variability as a measure of IRR is the idea that liquidity is a primary
concern.

Accordingly, a financial institution can reduce IRR via to ways:

1. Hold only short-term or floating-rate assets and liabilities;
2. Match the amount and timing of its cash inflows on fix-rate assets with cash
outflows of its fixed-rate liabilities. Relatedly, the institution can use derivatives,
such as interest rate swaps, to eliminate or mitigate any remaining mis-match.
 INCOME VARIABILITY VIEW

Fundamentals of Banking Institutions by Prof. Liang 8

Income Variability view of IRR

 Financial Assets or Liabilities “Reprice” from time to time

 Reported interest income depends on assets and liabilities repricing in current
reporting period

interest rates more assets reprice more liabilities reprice

assets reprice more than liability

rise spread widens spread narrows

fall spread narrows spread widens

 This view is a good way to think about net interest income but ignores changes in
the value of instruments repricing in future periods.

Fundamentals of Banking Institutions by Prof. Liang 9

 Banks Balance Sheet: Liabilities

 Financial Liabilities Repricing? Liabilities and Equity (Sources of

 Interest rate insensitive: Core deposits funds) 69.2%

transactional deposits
Non-core, large time-deposit, foreign 18.2%
 Sensitive: savings, large time-
deposit, overnight repo Secured Borrowing
 Long-term debt: depend on Repurchase Agreements (Repos) 1.4%
repricing and maturity schedule Net federal funds purchased (sold) and CPs 0.6%

Equities (Preferred, Common, etc.) 10.5%

Total Liability Portion which reprices in
Today (t)
t t+1 t+2 …
Lt = Ltt + Ltt+1 + Ltt+2 …

Fundamentals of Banking Institutions by Prof. Liang 10

Banks Balance Sheet: Assets

Assets
Liabilities and (use
Equityof(Sources
funds)of
 Financial Assets Repricing? Core deposits funds)
Net loans and leases 69.2%
63.0%
 Loans and Leases Non-core, large time-deposit, foreign 18.2%
 Commercial and Industrial (C&I) Securities 17.8%
 Real Estate Secured Borrowing
 Consumer BalancesAgreements
Repurchase at Fed and(Repos)
other banks 1.4%
 Securities NetInterest-bearing
federal funds purchased (sold) and CPs 7.2%
0.6%

 Balances at other banks Non-interest-bearing 1.1%

Equities (Preferred, Common, etc.) 10.5%

Total Assets Portion which reprices in

All other (non-financial) assets 11.0%
Today (t)
t t+1 t+2 …
At = Att + Att+1 + Att+2 …

Fundamentals of Banking Institutions by Prof. Liang 11

 Conceptual Derivation of change in NII (∆NII)

Interest-bearing Assets Interest-bearing Liabilities

 Suppose interest rate for period t  Suppose interest rate for period t changes
changes from from

 So the INCREMENTAL interest income =  So the INCREMENTAL interest expense =

-
Fundamentals of Banking Institutions by Prof. Liang 12

NII Disclosures (SEC Industry Guide 3)

Citigroup Fiscal Year
NII Analysis (based on NII disclosure in MDNA) 2020 2019 2018 2017
Average Interest Bearing Assets management discussion and analysis 1,830,342 1,797,468 1,742,576 1,671,781
Average Non-interest Bearing Assets 329,799 181,341 177,654 203,657
Average Total Assets 2,160,141 1,978,809 1,920,230 1,875,438
Interest Bearing Liabilities 1,298,144 1,452,921 1,371,423 1,292,639
Non-interest Bearing Liabilities 610,007 329,550 349,260 353,953
Average Total Liabilities 1,908,151 1,782,471 1,720,683 1,646,592
Average SE 251,990 196,338 199,547 228,846
Average Total Liabilities and SE 2,160,141 1,978,809 1,920,230 1,875,438

Interest Income (FTE basis, not GAAP basis) 68,912 76,718 71,082 62,075
Yield on Avg Int-bearing Assets 3.76% 4.27% 4.08% 3.71%
Interest Expenses (Same as GAAP) 14,541 29,163 24,266 16,518
Yield on Avg Int-bearing Liab 1.12% 2.01% 1.77% 1.28%
Net Interest Spread (Yield on Avg Int-earing Assets - Yield on Avg
2.64% 2.26% 2.31% 2.44%
Int-bearing Liab)
compared to "yield on earnings assets" 2.97% 2.65% 2.69% 2.73%
compared to (r_A - r_L) spread based on Total Assets/Liab 2.00% 2.28% 2.32% 2.36%

Fundamentals of Banking Institutions by Prof. Liang 13

Indicate bank’s strategy for and historical performance generating NII
Banks must disclose for each major type of interest-earning asset and interest-paying liability
for the current and past two years
average book balance (BV)
average book yield (r)
For most fixed-rate instruments, book balances are amortized costs, book yields are
determined at inception (remember accounting for bonds?)

Interpretation issues
average balances are not ending balances, average yields are not ending yields
book values are not fair values, book yields are not current market yields
do not see true spread
certain bank decisions have opposite effects on NII in short and long runs
does not reflect associated non-interest costs

The Ryan text uses Golden West Financial disclosures as an example: shown as Exhibit 4.4 on
page 82-83 in the Ryan’s textbook, Golden West’s Analysis of NII disclosure is located in its
2005 10-K Table 18 on page 20 and is not disclosed in its 2005 annual report.
Repricing gap = book value of assets less book value of liabilities repricing in a time interval
positive gap if more assets reprice
negative gap if more liabilities reprice
Indicate exposure to changes in interest rates at various intervals, usually
0-1 years
1-5 years
>5 years
While overall repricing gap disclosures are voluntary, generally one can construct repricing
gap from piecemeal Industry Guide 3 disclosures of repricing and maturity for loans,
securities, deposits, and other liabilities or from quarterly Y-9C and call report disclosures.
 Repricing GAP for 0-1 year and NII sensitivity disclosure

 Many banks discloses next year NII sensitivity to interest rate

movements
 This allows analysts to infer banks’ 0-1 GAP using the following
approximate relation

ΔNII next year = Δr x 0-1 GAP

 some banks disclose %ΔNII

Fundamentals of Banking Institutions by Prof. Liang 16

Here is a typical NII risk disclosure (CITI FY2019)

 What can we learn from this?

626M=+1%* 0-1 GAP

0-1GAP =62.6B

Fundamentals of Banking Institutions by Prof. Liang 17

 VALUE VARIABILITY VIEW

Fundamentals of Banking Institutions by Prof. Liang 18

Value Variability view of IRR

 The value of an instrument varies with

 the time until cash is received or the instrument reprices

 maturity
 repricing interval
 Duration (the most general concept)

 the variability of interest rates

 yield curves

Fundamentals of Banking Institutions by Prof. Liang 19

 Numerical Example

 $100 nominal payment 10 years from now with current interest rate
r=10%
 Current value=$100/1.110=$38.55
 If r falls instantaneously to 8%, then value=$100/1.0810=$46.32
 If r rises instantaneously to 12%, then value=$100/1.1210=$32.20

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Numerical Example

100

80
Present Value

60 8%
10%
40
12%
20

0
10 9 8 7 6 5 4 3 2 1
Years rem aining

• There is more fair value volatility (movement along y axis) the

• longer the time to maturity
• more variable are interest rates

Fundamentals of Banking Institutions by Prof. Liang 21

 Duration in a simple setting

 Duration is the weighted-average time until fixed cash flows are realized or
instruments reprice
 the weights are the relative present values

 Assuming a flat yield curve, duration (D) is

 CF1   CF 2   CF 3   CF n 
  1    2    3      n
 1  r 
  (1  r ) 2   3   n 
D0    (1  r )   (1  r ) 
V0

 CFs=the fixed cash flow in period s

 V0=the net present value of all future cash flows
 r=constant interest rate (flat yield curve)
Fundamentals of Banking Institutions by Prof. Liang 22

Duration Example (a loan)

 Example: duration of a fixed-rate (10%) loan that pays $x in each of

the next three periods is
 x   x   x 
  1     2     3 
 1  10 %   (1  10 %)   (1  10 )
2 3
1 . 92  
 x   x   x 
      
2  3 

 1  10 %   (1  10 %)   (1  10 ) 

Intuition check: why duration < 2?

Fundamentals of Banking Institutions by Prof. Liang 23

 Duration Examples (loans and bonds)

Durations of loans and bonds of various maturities

bonds
n loan rc=0% rc=10% rc=20%

1 1 1 1 1
2 1.48 2 1.91 1.85
3 1.92 3 2.74 2.58
5 2.81 5 4.17 3.80
10 4.73 10 6.76 5.99
30 9.18 30 10.37 9.79
100 10.99 100 11 11

Intuition check: Why are the durations of a loan and a coupon bond
approximately equal if n is large?
Fundamentals of Banking Institutions by Prof. Liang discount back many times, results will be small 24

Using Duration to approximate value changes

 Duration fully captures IRR associated with small changes in flat yield curves
 For small change in r (equation 4.5 on page 72 in Ryan text)

 V  r
  D
V 1  r
 Duration of 10 implies ~10% reduction of value for 1% upward shift in a flat yield
curve
 “Convexity” results from duration changing with r

Fundamentals of Banking Institutions by Prof. Liang 25

 Convexity

Actual and Equation-4.5-estimated effects of parallel shifts in the yield curve on

the value of a 10-year loan

Actual change in value to parallel shift in yield Estimated change in value

curve of to ±1% parallel shift in
yield curve from Equation 4.5

Interest Value Dura -3% -2% -1% +1% +2% +3%

Rate -tion
2% 8.98 5.34 -- 1.02 .49 -.45 -.87 -1.26 ±.47

4% 8.11 5.18 1.36 .87 .42 -.39 -.75 -1.09 ±.40

6% 7.36 5.02 1.17 .75 .36 -.34 -.65 -.94 ±.35

8% 6.71 4.87 1.01 .65 .31 -.29 -.57 -.82 ±.30 -4.87*(+-1%)/(1+8%)

10% 6.14 4.73 .88 .57 .27 -.26 -.49 -.72 ±.26

20% 4.19 4.07 .47 .30 .15 -.14 -.27 -.39 ±.14

Fundamentals of Banking Institutions by Prof. Liang 26

Convexity
Projected vs. Actual % Value Change

25.00%

20.00%

15.00%

10.00%
% Change in Value

5.00%
Projected Change
Actual Change
0.00%
-6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6%

-5.00%

-10.00%

-15.00%

-20.00%
% Changes Interest Rate (from 7% )

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 Duration of a portfolio

 The duration of any portfolio is the weighted-average of the durations of its components
 The duration of a bank’s net assets (A-L=E) is

VA V V
DE  DA   D L  L  D A  L D A  D L 
VE VE VE
VA  V 
  D A  L D L 
VE  VA 
 DA-DL is “duration gap”
 DA-(VA/VL)DL is “leverage-adjusted duration gap”

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Duration of a (highly) leveraged portfolio

 Assume DA=3, DL=1, VA=10, and VL=9, then the duration of the bank’s
net assets is

21=3+ (9/1) x (3-1)

 Due to their high leverage, banks do not need to have a very large
duration gap to have high IRR

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 Yield Curves

 Plot yield to maturity (YTM) against maturity for a set of instruments

comparable on
 cash flow configuration (e.g., zero-coupon vs. coupon)

 credit risk

 Yield curves usually slope upwards

 longer duration instruments have more IRR (value volatility)

 spread of 30-year Treasury Bonds over Treasury Bills typically is about

2%, though it varies considerably.

Fundamentals of Banking Institutions by Prof. Liang 30

Treasury Yield Curves (2006-2023)

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 Duration, Flat Yield Curves, and IRR

 Duration fully explains IRR for small parallel shifts of flat yield curves
 and is a good approximation for small parallel shifts of non-flat yield curves

 But yield curves may not move in parallel

 may change slope (more or less steep)

 may change shape (more convex or concave)

Fundamentals of Banking Institutions by Prof. Liang 32

Non-flat Yield Curves and IRR

 In general, bank analysts must assess a bank’s IRR based on its

exposures in each time interval and possible movements in spot interest
rates

 General rule: the net present value of the fixed cash flow in an interval is
inversely related to the spot interest rate for that interval, so

spot interest rate Fixed cash inflows Fixed cash outflows

rises bank is hurt bank benefits

falls bank benefits bank is hurt

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 Non-flat Yield Curves and IRR

 Assuming a normal upwards-sloping, concave yield curve, what

exposures are most helped and hurt by the following yield curve
movements:
 a parallel upward shift
 a flattening resulting from
 short-term rates rising

 long-term rates falling

 a convexification resulting from both short-term and long-term rates rising

 a concavification resulting from medium-term rates rising

Fundamentals of Banking Institutions by Prof. Liang 34

Non-flat Yield Curve: an example

 Assume a bank holds these fixed-rate assets and liabilities, which pay no interest or principal until they
mature
 $10 of 1-year assets paying 5% ($10.50 in year 1)
 $20 of 2-year liabilities paying 7% (-$22.90 in year 2)
 $12 of 3-year assets paying 8% ($15.12 in year 3)
 Assume these spot interest rates are current market rates, but they instantaneously change to one of these
three sets of values:
yield curve shift 1-year rate 2-year rate 3-year rate
parallel up 6% 8% 9%
convexify 6% 6% 9%
flatten 8% 8% 8%

Fundamentals of Banking Institutions by Prof. Liang 35

 Non-flat Yield Curve: an example

 Calculation of net present values

1-year 2-year 3-year net
assets liabilities assets assets
at original rates (5%, 7%, 8%) 10 -20 12 2
parallel up (6%, 8%, 9%) 9.91 -19.63 11.67 1.95
convexify (6%, 6%, 9%) 9.91 -20.38 11.67 1.20
flatten (8%, 8%, 8%) 9.72 -19.63 12 2.09
 Duration of bank’s net assets=3=(10/2)1-(20/2)2+ (12/2)3
 For 1% upward parallel shift in yield curve, the duration-based estimate
of value change is pretty good: – 3×1%/(1.06)×$2= – $0.056

Fundamentals of Banking Institutions by Prof. Liang 36

Here is a typical NII risk disclosure (CITI FY2019)

 What can we learn from this?

Fundamentals of Banking Institutions by Prof. Liang 37

•Issues in analyzing repricing gap disclosures
•broad time intervals
•includes total book values of instruments repricing in each interval
•core deposits with no fixed term are “sticky”
•repricing gap is static
•does not describe options (e.g., prepayment) well
•can change quickly

The Ryan Text uses Golden West Financial repricing gap disclosures as an example:
Shown as Exhibit 4.6 on page 89 in the Ryan’s textbook, Golden West’s Repricing
Gap disclosure is located in its 2005 10-K Table 47 on page 48 and is also disclosed in
its 2005 annual report on page 73 as a part of MDNA.
Column “Reprice within ONE year” information, except the row ”Short-term
borrowings”, is given by Schedule HC-H reported in FR Y-9C reporting Form.
Retrievable at https://www.ffiec.gov/npw/Institution/TopHoldings

Row “Short-term borrowings” information is given by Citi’s GAAP balance sheet;

Column “Total” information is given by Citi’s GAAP balance sheet; The total
$amount of “Interest-earning assets” is imputed by Total assets minus {other assets,
intangible assets, Goodwill, and Cash and due from banks}