# Managing Interest Rate Risk: GAP and Earnings Sensitivity

FINC 4320 Fall 2004

Interest Rate Risk
First, some basic ideas: • Interest rate risk is defined to be potential variability in net interest income (NII) or market value of equity (MVE) due to changes in interest rates. • Why the concern? • Recall some interest rate/bond price fundamentals

Interest Rate Risk • Why do we care about interest rate exposure? Recall the fundamental nature of a bank’s balance sheet: – reinvestment risk – refinancing risk – price risk .

Interest Rate Exposure and Earnings • First we will to look at a model that focuses on the bank’s earnings stream. To do this.\$ Value or RSLt • where t = time bucket.g. of interest rate exposure. the GAP. • Method: – Group assets and liabilities into time "buckets” according to when they mature or are expected to re-price – Calculate GAP for each time bucket – Funding GAPt = \$ Value RSAt . we need to look at rate sensitive assets and rate sensitive liabilities. Here we will look at the effects of interest rate changes on interest income and interest expense. we will compute a dollar measure. 0-3 months .. Using these. e.

The GAP Model • Rate-Sensitive Assets – Short-Term Securities Issued by the Government and Private Borrowers – Short-Term Loans Made by the Bank to Borrowing Customers – Variable-Rate Loans Made by the Bank to Borrowing Customers • Rate-Sensitive Liabilities – – – – Borrowings from Money Markets Short-Term Savings Accounts Money-Market Deposits Variable-Rate Deposits .

) are added to the balance sheet position – Calculate GAP for each time bucket – Funding GAPt = \$ Value RSAt . 2. futures. Management develops an interest rate forecast Management selects a series of “time buckets” (intervals) for determining when assets and liabilities are rate-sensitive 3.\$ Value or RSLt 1.Traditional static GAP analysis 1. etc. Management forecasts NII given the interest rate environment . Group assets and liabilities into time "buckets" according to when they mature or re-price – The effects of any off-balance sheet positions (swaps.

Factors affecting NII • Changes in the level of interest rates ∆ NII = (GAP) * (∆ i exected) • Changes in the slope of the yield curve • Changes in the volume of assets and liabilities • Change in the composition of assets and liabilities .

• They separate changes over time to shifts in assets and liability composition and volume from changes associated with movements in interest rates.Rate. and Mix Analysis • Many banks publish a summary of how net interest income has changed over time. • The purpose is to assess what factors influence shifts in net interest income over time. . Volume.

680 156.463 71.960 3.636 23.622 47 -1.285 2000 Compared to 1999 Change Due to * Yield/ Net Rate Change Volume 161.276 787 -6.801 -1.676 32.570 -206 7.537 5.208 (\$13.461 -122.762 (\$30.744 -35.313 2.176 \$ 48 76 1.018 21.222 1.909 21.870 39.864 -369 -3.447 -113 170.244 -14.Rate/Volume Analysis For Synovus Bank 2001 Compared to 2000 Change Due to * Yield/ Net Rate Change Volume \$ 149.470 -6.536 6.046 74.390 197. net Taxable investment securities t Tax-exempt investment securities Interest earning deposits with Federal funds sold Mortgage loans held for sale Total interest income Interest paid on: Interest bearing demand deposits Money market accounts Savings deposits Time deposits Federal funds purchased and Other borrowed funds Total interest expense Net interest income 223 -176 406 -1.857 549 436 40.423 -117.433 6.339 6.542 -660 -67 -727 38.507 2.225 36.307 -3. net t Tax-exempt loans.311 210.986) \$49.015 -22.147 1.108 4.026 28 1.380 -36.148 15.410 2.824 32.812 71.661 1.612 -450 658 2.760 \$80.545 9.321 89.376 \$82.077 1.297 160.272 17.548 -916 74 32.229 2.165 -29.443 21.318 -4.121 34.074 -12.970 4.820 Interest earned on: Taxable loans.654 13.253 -108.373 -586 -5.888 18.517 -6.776 .547) \$68.745 7.629 -34.361 25.

• A Liability-Sensitive Bank Has: – Negative Dollar Gap…indicates a bank has more rate sensitive liabilities than rate sensitive assets. and that net interest income will generally rise (fall) when interest rates rise (fall).The GAP Model • An Asset-Sensitive Bank Has: – Positive Dollar Gap…indicates a bank has more rate sensitive assets than liabilities. . and that net interest income will generally fall (rise) when interest rates rise (fall).

Optimal value for a bank’s GAP? • There is no general optimal value for a bank's GAP in all environments. • Generally. or the ratio of RSAs to RSLs should fall between 0. • Many banks establish GAP policy targets to control interest rate risk by specifying that GAP as a fraction of earning assets should be plus or minus 15%. • The best GAP for a bank can be determined only by evaluating a bank's overall risk and return profile and objectives. the greater is the bank's risk.1. the farther a bank's GAP is from zero. .9 and 1.

4. To increase NIM management must either: a. 3. Management must choose a target NIM. Reallocate assets and liabilities to increase spread.Important Decisions in the GAP Model 1. Develop correct interest rate forecast. 2. Management must choose dollar volume of interest-sensitive assets and liabilities. Management must choose the time period over which NIM is to be managed. or b. .

Target NIM and GAP • A better risk measure relates the absolute value of a bank’s GAP to earning assets. the greater the interest rate risk – The ratio of GAP to earning assets has the additional advantage in that it can be directly linked to variations in NIM. – The greater is this ratio. – In particular. management can determine a target value for GAP in light of specific risk objectives stated terms of a bank’s target NIM: Target GAP (Allowable % change in NIM)(Expected NIM) = Earning assets Expected % change in interest rates .

.Advantages of the GAP model • The primary advantage of GAP analysis is its simplicity.

That is. • GAP further ignores the impact of embedded options. it ignores the time value of money. .Problems with GAP Management • Interest rates paid on liabilities tend to move faster than interest rates earned on assets • Interest rates 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 • GAP does not consider impact of changing interest rates on equity (capital) position.

both explicit and implicit: – Option to refinance a loan – Call option on a federal agency bond the bank owns – Depositors option to withdraw funds prior to maturity .Exercise of embedded options in assets and liabilities • Customers have different types of options.

000 = .00 .5% 4.000 Car loan 4 year Car loan at 1 year CD at Spread 8.\$10.5% 4.Interest rate risk and embedded options Example: \$10. .\$RSL In this example: GAP1y = \$0.0% But for how long? Funding GAP GAP = \$RSA .000 This is a negative GAP.\$10.

000 -2 +6. financed by a 1 yr CD  1 year GAP position: -3 -1.000 -2 -2.000 -10.000 -10.000 -1 base +1 +2 +3 -8.000 -1 +2. and less likely to “pull” CD’s People will “pull” the CD’s for higher returns .000 4yr loan.000 -10.Implied options: 10.000 +2 -3.000 +3 -6.000 -10.000 base 0 Gap +1 -1.000 Re-finance the auto loans.000 Gap All CD’s will mature Re-finance the auto loans  3 month GAP is zero by definition: -3 +8.

The implications of embedded options • Is the bank the buyer or seller of the option – Does the bank or the customer determine when the option is exercised? • How and by what amount is the bank being compensated for selling the option. or how much must it pay to buy the option? • When will the option be exercised? – Often determined by the economic and interest rate environment • Static GAP analysis ignores these embedded options .

. • It is well recognized that banks are quick to increase base loan rates but are slow to lower base loan rates when rates fall. • Shifts in the yield curve are rarely parallel.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.

and 6. Estimate net interest income and net income. .Earnings sensitivity analysis consists of six general steps: 1. Repeat the process to compare forecasts of net interest income and net income across rate environments. 3. Forecast future interest rates. 5. Forecast when embedded options will be exercised. 4. Identify when specific assets and liabilities will reprice given the rate environment. Identify changes in the composition of assets and liabilities in different rate environments. 2.

1.5 Change in NII (\$MM) 2 (.5) (3.0) (3.0) (2.0 .0) .5) (3.0) (1.0) (1.5) (2.0) (2.5) (2.5 2 Change in NII (\$MM) (.0 .5) (1.5) .300 Sensitivity of Earnings: Year One ALCO Guideline Boar Limit d -200 -100 ML +100 +200 Ramped Change in Rates from Most Likely (Basis Point) 1.300 ALCO Guideline Boar Limit d Sensitivity of Earnings: Year Two +300 -200 -100 ML +100 +200 Ramped Change in Rates from Most Likely (Basis Points) +300 .5) (1.

and the timing of repricings. . when embedded options will be exercised. the greater is the amount of risk assumed by a bank. • Demonstrates the potential volatility in earnings across these environments.Earnings at risk • …the potential variation in net interest income across different interest rate environments. given different assumptions about balance sheet composition. • The greater is the potential variation in earnings (earnings at risk).

• This model uses an all encompassing Earnings Change Ratio (ECR). – This ratio attempts to incorporate information on each asset and liability. and rate paid on each liability. one procedure is to use Income Statement GAP analysis. . – This ratio indicates how the yield on each asset. which is a simplified procedure that takes some of the factors into account. is assumed to change relative to a 1 percent drop in the prime rate.Income statement gap • For smaller banks with limited off-balance sheet exposure.

to hedge. • Use off-balance sheet transactions. such as interest rate swaps and financial futures. • Match fund long-term assets with noninterest-bearing liabilities. . • Match fund repriceable assets with similar repriceable liabilities so that periodic GAPs approach zero.Steps that banks can take to reduce interest rate risk • Calculate periodic GAPs over short time intervals.

Shorten loan maturities. Make more loans on a floating-rate basis. . Borrow more via non-core purchased liabilities. Increase asset sensitivity Reduce liability sensitivity Increase liability sensitivity Pay premiums to attract short-term deposit instruments. Buy short-term securities. Objective Reduce asset sensitivity Approaches Buy longer-term securities. Move from floating-rate loans to term loans. Lengthen the maturities of loans. Pay premiums to attract longer-term deposit instruments.Various ways to adjust the effective rate sensitivity of a bank’s assets and liabilities onbalance sheet. Issue long-term subordinated debt.