UBFB3023 Commercial

Bank Management

Lecture 5: Asset
Liabilities Management
and Gap Management
Concept
Learning Goals

• Asset liability management concepts

• Gap management strategy
• Gap limitations
Asset and Liability Management
Committee (ALCO)
• The ALCO’s primary responsibility is interest rate
risk management.
• The ALCO coordinates the bank’s strategies to
achieve the optimal risk/reward trade-off.
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
reprice 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.
Interest Rate Risk

• Banks typically focus on either:

• Net interest income or
• The market value of stockholders' equity
• GAP Analysis (Rate sensitive assets - Rate
sensitive liabilities)
• A static measure of risk that is commonly associated
with net interest income (margin) targeting
Interest Rate Risk: Reinvestment Rate

• 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.
• 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 (all other things held constant),
increases a bank’s interest income but also
increases the bank’s interest expense.
Interest Rate Risk: Price

• Changes in interest rates may change the

market values of the bank’s assets and
liabilities by different amounts.
• 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.
Measuring Interest Rate Risk

• A bank makes a RM10,000 five-year personal

loan to a customer at fixed rate of 8%. The
bank initially funds the personal loan with a
one-year RM10,000 FD at a cost of 4%. The
bank’s initial spread is 4%.
5-year personal loan 8.00%
1-year fixed deposit 4.00%
4.00%
Measuring Interest Rate Risk

• Traditional Static GAP Analysis

GAPt = RSAt – RSLt
• RSAt
• Rate Sensitive Assets
• Those assets that will mature or reprice in a
given time period (t)
• Repriceable assets
Measuring Interest Rate Risk

• Traditional Static GAP Analysis

GAPt = RSAt – RSLt
• RSLt
• Rate Sensitive Liabilities
• Those liabilities that will mature or reprice in a
given time period (t)
• Repriceable liabilities
Measuring Interest Rate Risk

• What is the bank’s 1-year GAP?

• RSA1year = RM 0
• RSL1year = RM 10,000

• GAP1year = RM 0 – RM 10,000 = - RM 10,000

• The bank’s one year funding GAP is -10,000
• What happen if interest increase?
Measuring Interest Rate Risk

• Steps in GAP Analysis:

1. Develop an interest rate forecast
2. Select a series of “time buckets” or intervals for
determining when assets and liabilities will
reprice
3. Group assets and liabilities into these “buckets”
4. Calculate the GAP for each “bucket ”
5. Forecast the change in net interest income
given an assumed change in interest rates
What Determines Rate Sensitivity?

• An asset or liability is considered rate sensitive if

during the time interval:
• It matures
• It represents an interim or partial principal payment
• The interest rate applied to the outstanding principal
balance changes contractually during the interval
• The interest rate applied to the outstanding principal
changes when some base rate/index changes and
management expects the base rate/index to change
during the interval
What Determines Rate Sensitivity?
Factors Affecting Net Interest Income

1. Changes in the level of interest rates

2. Changes in the relationship between the
yields on earning assets and rates paid on
interest-bearing liabilities
3. Changes in the volume of earning assets
and interest-bearing liabilities outstanding
4. Changes in the composition of assets and
liabilities
 Factors Affecting Net Interest Income

• Consider theBalance
following balance sheet:
Sheet for Banana Bank
Assets (RM) 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
1000 1000
Factors Affecting Net Interest Income

NII = [(0.08 x 500) + (0.11 x 350)]

– [(0.04 x 600) + (0.06 x 220)]
= RM 41.3
NIM = 41.3 / 850
= 4.86%
GAP = 500 – 600
= -100
Factors Affecting Net Interest Income

a) A 1% increase in the level of all short-term

rates?
b) 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%?
c) A proportionate doubling in size of the bank?
d) Changes in the composition of assets and
liabilities
 Factors Affecting Net Interest Income – a)

Balance Sheet for Banana Bank

Assets (RM) 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
1000 1000
Factors Affecting Net Interest Income – a)

NII = [(0.09 x 500) + (0.11 x 350)]

– [(0.05 x 600) + (0.06 x 220)]
= RM 40.3
NIM = 40.3 / 850
= 4.74%
GAP = 500 – 600
= -100
 Factors Affecting Net Interest Income – b)

Balance Sheet for Banana Bank

Assets (RM) 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
1000 1000
Factors Affecting Net Interest Income – b)

NII = [(0.085 x 500) + (0.11 x 350)]

– [(0.055 x 600) + (0.06 x 220)]
= RM 34.8
NIM = 34.8 / 850
= 4.09%
GAP = 500 – 600
= -100
 Factors Affecting Net Interest Income – c)

Balance Sheet for Banana Bank

Assets (RM) Yield (%) Liabilities Cost (%)
Rate sensitive 1000 8.0 1200 4.0
Fixed rate 700 11.0 440 6.0
Non-earning 300 200
1840
Equity
160
2000 2000
Factors Affecting Net Interest Income – c)

NII = [(0.08 x 1000) + (0.11 x 700)]

– [(0.04 x 1200) + (0.06 x 440)]
= RM 82.6
NIM = 82.6 / 1700
= 4.86%
GAP = 1000 – 1200
= -200
Factors Affecting Net Interest Income – d)

• Net interest income varies directly with changes

in the volume of earning assets and interest-
bearing liabilities, regardless of the level of
interest rates
• RSAs increase to $540 while fixed-rate assets
decrease to $310 and RSLs decrease to $560
while fixed-rate liabilities increase to $260
 Factors Affecting Net Interest Income – c)

Balance Sheet for Banana Bank

Assets (RM) Yield (%) Liabilities Cost (%)
Rate sensitive 540 8.0 560 4.0
Fixed rate 310 11.0 260 6.0
Non-earning 300 100
920
Equity
80
1000 1000
Factors Affecting Net Interest Income – c)

NII = [(0.08 x 540) + (0.11 x 310)]

– [(0.04 x 560) + (0.06 x 260)]
= RM 39.3
NIM = 39.3 / 850
= 4.62%
GAP = 540 – 560
= -20
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
Changes in Interest (Parallel shift)

• It is rare, however, when the yield curve shifts

parallel, NII will change by:

NII = GAP x I

• If rates do not change by the same amount and at

the same time, then net interest income may
change by more or less.
GAP vs NII
GAP Ratio

• Some asset and liability management (ALM)

programs focus on the GAP ratio when
evaluating interest rate risk.
GAP Ratio = RSA / RSL
• A ratio higher than 1 indicates a positive GAP
• A ratio less than 1 indicates a negative GAP
Optimal GAP

• There is no general optimal value for a bank's

GAP in all environments.
• Generally, the farther a bank's GAP is from
zero (GAP) one (GAP ratio), the greater is the
bank's risk.
• A bank must evaluate its overall risk and return
profile and objectives to determine its optimal
GAP
GAP vs Variability in Earnings

• Consider two banks, both with $500 million in

total assets.
• Bank A: $3 mil in RSAs and $2 mil in RSLs. GAP =
$1 mil and GAP ratio = 1.5
• Bank B: $300 mil in RSAs and $200 mil RSLs. GAP =
$100 mill and GAP ratio = 1.5
• Clearly, the Bank B assumes greater interest
rate risk because its net interest income will
change more when interest rates change.
GAP vs Variability in Earnings

• Neither the GAP nor GAP ratio provide direct

information on the potential variability in earnings
when rates change.
Earning Sensitivity Analysis

• Allows management to incorporate the impact

of different spreads between asset yields and
liability interest costs when rates change by
different amount.
• It is well recognized that banks are quick to
increase base loan rates buts slow to lower
base loan rates when rates fall.
Managing the GAP and Earnings
Sensitivity Risk
• Steps to reduce risk
1. Calculate periodic GAPs over short time intervals.
2. Fund repriceable assets with matching repriceable
liabilities so that periodic GAPs approach zero.
3. Fund long-term assets with matching noninterest-
bearing liabilities.
4. Use off-balance sheet transactions to hedge.
Managing the GAP and Earnings
Sensitivity Risk
Measuring Interest Rate Risk

• Duration GAP Analysis DGAP

• 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.
• Economic Value of Equity Analysis (EVE)
• Focuses on changes in stockholders’ equity given
potential changes in interest rates
Duration (D)

• Duration is a measure of the effective maturity

of a security that incorporates the timing and
size of a security’s cash flows.
• Duration measures how price sensitive a
security is to changes in interest rates.
Duration (D)

• The greater (shorter) the duration, the greater

(lesser) the price sensitivity.
• Market participants often use TWO (2) different
duration measures; Macaulay’s duration and
Modified duration.
Duration versus Maturity

• Duration as an Elasticity Measure

• Consider the cash flows for these two securities over
the following time line
Duration versus Maturity

• The maturity of both is 20 years

• Maturity does not account for the differences in
timing of the cash flows.
• What is the duration for both?
• The duration for first security is 20 years.
• The duration for second security is 2.9 years.
• Duration is different , it uses a weighted average
of the present values of the cash flows.
Duration / Macaulay Duration (D)

• Duration is a weighted average of the time until

the expected cash flows from a security will be
received, relative to the security’s price
Duration / Macaulay Duration (D)

• What is the duration of a bond with a $1,000 face

value, 10% annual coupon payments, 3 years to
maturity and a 12% YTM? The bond’s price is
$951.96.
Duration / Macaulay Duration (D)

• What … $951.96.

Financial Calculator?
Modified Duration (MD)

• Indicate how much the price of a security will

change in percentage terms for a given change
in interest rate.
• The greater the duration, the greater the price
sensitivity.
Duration GAP Analysis (DGAP)

• Focuses on 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.
Duration GAP Analysis (DGAP)

• Steps
1. Forecast interest rates.
2. Estimate the market values of bank assets, liabilities
and stockholders’ equity.
3. 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.
4. Forecasts changes in the market value of
stockholders’ equity across different interest rate
environments.
Weighted Average Duration (A & L)

• Weighted Average Duration of Bank Assets (DA)

and Bank Liabilities (DL)

1. wi = weightage of asset or liabilities i

2. Di = Macaulay’s duration of asset or liabilities i
3. n = number of different assets or liabilities
Duration GAP (DGAP) and net worth

• However, the volume of asset exceeds the

volume of liabilities.
• To minimise the effect of interest rate fluctuations,
bank need to adjust for leverage.
Duration GAP (DGAP) and net worth

Net worth:

1. y = the general level of interest rates

Duration GAP (DGAP) and net worth
Duration GAP (DGAP) and net worth

DA:($700/$1000)*2.69 + ($200/$1000)*4.99 = 2.88

DL:($620/$920)*1.00 + ($300/$920)*2.81 = 1.59
DGAP: 2.88 - (920/1000)*1.59 = 1.42 years

• The average duration of assets is greater than

the average duration of liabilities; thus asset
values change by more than liability values.
Duration GAP (DGAP) and net worth

• Assume 1 percentage points increase in all the

rates

In $
ΔNW = -1.42 x (0.01/1.10) x 1000 = -$ 14.10
In %
ΔNW = -1.42 x (0.01/1.10) = - 1.41%
Duration GAP (DGAP) and net worth

• Positive DGAP
• Indicates that assets are more price sensitive
than liabilities, on average.
• When interest rates rise (fall), assets will fall
proportionately more (less) in value than liabilities
and NW will fall (rise) accordingly.
Duration GAP (DGAP) and net worth

• Negative DGAP
• Indicates that liabilities are more price sensitive
than assets on average.
• When interest rates rise (fall), assets will fall
proportionately less (more) in value that liabilities
and the NW will rise (fall).
Duration GAP (DGAP) and net worth
Duration GAP (DGAP) and net worth

• If DGAP is positive, the bank’s net interest income

will decrease when interest rates decrease, and
increase when rates increase.
• If DGAP is negative, the relationship is reversed.
• Only when DGAP equals zero is interest rate risk
eliminated.
• Banks can use duration analysis to stabilize a
number of different variables reflecting bank
performance.
Duration GAP (DGAP) and net worth

• Effectively involves the same steps as earnings

sensitivity analysis (ESA).
• In NW analysis, 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 net worth across different rate
environments
Embedded Options vs Volatility in net
worth
• Embedded options influence the estimated
volatility in net worth
1. Prepayments that exceed (fall short of) that
expected will shorten (lengthen) duration.
2. A bond being called will shorten duration.
3. A deposit that is withdrawn early will shorten
duration.
4. A deposit that is not withdrawn as expected will
lengthen duration.
Interest Sensitivity GAP vs Duration GAP

• Interest Sensitivity GAP and Duration GAP are

NOT directly comparable.
• Interest Sensitivity GAP examines various “time
buckets” while Duration GAP represents the
entire balance sheet.
Interest Sensitivity GAP vs Duration GAP

• 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 to have a positive (negative) DGAP
suggesting that assets are more price sensitive
than liabilities, on average.
Strengths and Weaknesses: DGAP and NW-
Sensitivity Analysis
• Strengths:
1. Duration analysis provides a comprehensive
measure of interest rate risk
2. Duration measure are additive
• Allows for the matching of total assets with total liabilities
rather than the matching of individual accounts
3. Duration analysis take a longer term view than gap
analysis
Strengths and Weaknesses: DGAP and NW-
Sensitivity Analysis
• Weakness:
1. It is difficult to compute duration accurately.
2. “Correct” duration analysis requires that each future
cash flow be discounted by a distinct discount rate
3. A bank must continuously monitor and adjust the
duration of its portfolio
4. It is difficult to estimate the duration on assets and
liabilities that do not earn or pay interest
5. Duration measures are highly subjective