Interest Rate Risk

 Interest Rate Risk

 Thepotential loss from unexpected
changes in interest rates which can
significantly alter a bank’s profitability
and market value of equity.
Interest Rate Risk: GAP & Earnings
Sensitivity
 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
 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
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.
Two Types of Interest Rate Risk

 Spread Risk (reinvestment rate 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.
 Price Risk
 Changes in interest rates may change
the market values of the bank’s assets
and liabilities by different amounts.
Interest Rate Risk:
Spread (Reinvestment Rate) Risk
 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, ceteris paribus,
increases a bank’s interest income but also
increases the bank’s interest expense.
 Static GAP Analysis considers the impact of
changing rates on the bank’s net interest
income.
Interest Rate Risk:
Price Risk
 If interest rates change, the market
values of assets and liabilities also
change.
 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 with GAP

 Traditional Static GAP Analysis

GAPt = RSAt -RSLt
 RSAt
 Rate Sensitive Assets
 Those assets that will mature or reprice in
a given time period (t)
 RSLt
 Rate Sensitive Liabilities
 Those liabilities that will mature or reprice
in a given time period (t)
Factors Affecting Net Interest Income

 Changes in the level of interest rates

 Changes in the composition of assets
and liabilities
 Changes in the volume of earning
assets and interest-bearing liabilities
outstanding
 Changes in the relationship between
the yields on earning assets and rates
paid on interest-bearing liabilities
Factors Affecting Net Interest Income:
An Example
 Consider the following balance sheet:
Expected Balance Sheet for Hypothetical Bank
Assets 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
Total $ 1,000 $ 1,000

NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)

NII = 78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
1% increase in short-term rates
Expected Balance Sheet for Hypothetical Bank
Assets 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
Total $ 1,000 $ 1,000

NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)

NII = 83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74% With a negative GAP, more
GAP = 500 - 600 = -100
liabilities than assets reprice
higher; hence NII and NIM fall
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 Net Interest Income are directly
proportional to the size of the GAP
 If there is a parallel shift in the yield
curve:
ΔNII exp  GAP  iexp
 It is rare, however, when the yield
curve shifts parallel
 Ifrates do not change by the same
amount and at the same time, then net
interest income may change by more
or less.
 Summary of GAP and the Change in NII

GAP Summary
Change in Change in Change in Change in
GAP Interest Interest Interest Net Interest
Income Income Expense Income
Positive Increase Increase > Increase Increase
Positive Decrease Decrease > Decrease Decrease

Negative Increase Increase < Increase Decrease

Negative Decrease Decrease < Decrease Increase

Zero Increase Increase = Increase None

Zero Decrease Decrease = Decrease None
 Measuring Interest Rate Risk with GAP
1-7 8-30 31-90 91-180 181-365 Over Not Rate
Days Days Days Days Days 1 year Sensitive Total
Assets
U.S. Treas & ag 0.7 3.6 1.2 0.3 3.7 9.5
MM Inv 1.2 1.8 3.0
Municipals 0.7 1.0 2.2 7.6 11.5
FF & Repo's 5.0 5.0
Comm loans 1.0 13.8 2.9 4.7 4.6 15.5 42.5
Install loans 0.3 0.5 1.6 1.3 1.9 8.2 13.8
Cash 9.0 9.0
Other assets 5.7 5.7
Total Assets 6.3 15.0 10.0 10.0 9.0 35.0 14.7 100.0
Liabilities and Equity
MMDA 5.0 12.3 17.3
Super NOW 2.2 2.2
CD's < 100,000 0.9 2.0 5.1 6.9 1.8 2.9 19.6
CD's > 100,000 1.9 4.0 12.9 7.9 1.2 27.9
FF purchased -
NOW 9.6 9.6
Savings 1.9 1.9
DD 13.5 13.5
Other liabilities 1.0 1.0
Equity 7.0 7.0
Total Liab & Eq. 5.0 11.0 30.3 24.4 3.0 4.8 21.5 100.0
Periodic GAP 1.3 4.0 -20.3 -14.4 6.0 30.2
Cumulative GAP 1.3 5.3 -15.0 -29.4 -23.4 6.8
Measuring Interest Rate Risk with
the GAP Ratio
 GAP Ratio = RSAs/RSLs
A GAP ratio greater than 1 indicates a
positive GAP
 A GAP ratio less than 1 indicates a
negative GAP
Speculating on the GAP

 Many bank managers attempt to adjust

the interest rate risk exposure of a
bank in anticipation of changes in
interest rates.
 This is speculative because it
assumes that management can
forecast rates better than the market.
Can a Bank Effectively Speculate on the GAP?

 Difficult to vary the GAP and win as

this requires consistently accurate
interest rate forecasts
 A bank has limited flexibility in
adjusting its GAP; e.g., loan and
deposit terms
 There is no adjustment for the timing
of cash flows or dynamics of the
changing GAP position