gap ration

7/21/2019 Gap Ration

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William Chittenden edited and updated the PowerPoint slides for this edition.

Managing Interest Rate Risk:

GAP and Earnings Sensitivity

Chapter 5

Bank ManagementBank Management,6th edition.6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright 2006 by South-Western, a division of Thomson Learning


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Interest Rate Risk

Interest Rate RiskThe potential loss from ne!pected

chan"es in interest rates #hich can

si"nificantly alter a $ank%s profita$ilityand market &ale of e'ity.


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Interest Rate Risk: GAP & EarningsSensitivity

When a $ank%s assets and lia$ilities donot reprice at the same time, the resltis a chan"e in net interest income.

The chan"e in the &ale of assets andthe chan"e in the &ale of lia$ilities #illalso differ, casin" a chan"e in the&ale of stockholder%s e'ity


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Interest Rate Risk

(anks typically focs on either) *et interest income or The market &ale of stockholders+ e'ity

- -nalysis - static measre of risk that is commonly

associated #ith net interest income /mar"in0tar"etin"

1arnin"s Sensiti&ity -nalysis

1arnin"s sensiti&ity analysis e!tends -analysis $y focsin" on chan"es in $ankearnin"s de to chan"es in interest rates and$alance sheet composition


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Asset and Liability Management

Committee (ALCO

The -2C3%s primary responsi$ility isinterest rate risk mana"ement.

The -2C3 coordinates the $ank%sstrate"ies to achie&e the optimalrisk4re#ard tradeoff.


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!"o !y#es o$ Interest Rate Risk

Spread Risk /rein&estment rate risk0Chan"es in interest rates #ill chan"e

the $ank%s cost of fnds as #ell as the

retrn on their in&ested assets. Theymay chan"e $y different amonts.

rice Risk

Chan"es in interest rates may chan"ethe market &ales of the $ank%s assetsand lia$ilities $y different amonts.


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Interest Rate Risk:

Spread (Reinvestment Rate) Risk

If interest rates chan"e, the $ank #ill ha&eto rein&est the cash flo#s from assets orrefinancerolledo&er lia$ilities at a differentinterest rate in the ftre.

-n increase in rates, ceteris pari$s,increases a $ank%sinterest income $t alsoincreases the $ank%sinterest e!pense.

Static - -nalysis considers the impact ofchan"in" rates on the $ank%s net interestincome.


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Interest Rate Risk:

Price Risk

If interest rates chan"e, the market&ales of assets and lia$ilities alsochan"e.

The lon"er is dration, the lar"er is thechan"e in &ale for a "i&en chan"e ininterest rates.

Dration - considers the impact ofchan"in" rates on the market &ale ofe'ity.


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Meas%ring Interest Rate Risk "it GAP

1!ample)- $ank makes a 78,888 foryear car

loan to a cstomer at fi!ed rate of 9.5:.The $ankinitially fnds the car loan #itha oneyear 78,888 CD at a cost of ;.5:.The $ank%s initial spread is ;:.

What is the $ank%s riskocses on mana"in" net interest

income in the shortrn -ssmes a ?parallel shift in the yield

cr&e,% or that all rates chan"e at thesame time, in the same direction and $y

the same amont.Does this ever happen?


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!raditional Stati' GAP Analysis

Steps in GAP Analysis

De&elop an interest rate forecastSelect a series of @time $cketsA or

inter&als for determinin" #hen assets

and lia$ilities #ill repricerop assets and lia$ilities into these

@$ckets A

Calclate the - for each @$cket A>orecast the chan"e in net interest

income "i&en an assmed chan"e in

interest rates


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at )etermines Rate Sensitivity (Ignoring

Embedded O#tions*

-n asset or lia$ility is considered ratesensiti&ity if drin" the time inter&al) It matres

It represents and interim, or partial, principalpayment

It can $e repriced The interest rate applied to the otstandin"

principal chan"es contractally drin" theinter&al The otstandin" principal can $e repriced

#hen some $ase rate of inde! chan"es andmana"ement e!pects the $ase rate 4 inde! tochan"e drin" the inter&al


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at are RSAs and RSLs*

Considerin" a 8B8 day @time $cket,A RS-s andRS2s inclde) Matrin" instrments or principal payments

If an asset or lia$ility matres #ithin B8 days, theprincipal amont #ill $e repriced

-ny fll or partial principal payments #ithin B8days #ill $e repriced

>loatin" and &aria$le rate instrments If the inde! #ill contractally chan"e #ithin B8

days, the asset or lia$ility is rate sensiti&e The rate may chan"e daily if their $ase rate

chan"es. Issue: do you expect the base rate to change?


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+a'tors A$$e'ting ,et Interest In'ome

Chan"es in the le&el of interest ratesChan"es in the composition of assets

and lia$ilities

Chan"es in the &olme of earnin"assets and interest$earin" lia$ilitiesotstandin"

Chan"es in the relationship $et#eenthe yields on earnin" assets and ratespaid on interest$earin" lia$ilities


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+a'tors A$$e'ting ,et Interest In'ome:

An Example

Consider the follo#in" $alance sheet)


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E-amine te im#a't o$ te $ollo"ing 'anges

- 7: increase in the le&el of all shorttermrates

There is no "eneral optimal &ale for a$ank+s - in all en&ironments.

enerally, the farther a $ank+s - is

from ero, the "reater is the $ank+srisk.

- $ank mst e&alate its o&erall risk

and retrn profile and o$ecti&es todetermine its optimal -


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GAP and 3ariability in Earnings

*either the - nor - ratio pro&ide direct

information on the potential &aria$ility in

earnin"s #hen rates chan"e.

Consider t#o $anks, $oth #ith 588 million in

total assets. (ank -) E mil in RS-s and F mil in RS2s.

- = 7 mil and - ratio = 7.5 mil

(ank () E88 mil in RS-s and F88 mil RS2s.

- e'als 788 mill and 7.5 - ratio.

Clearly, the second $ank assmes "reater interest

rate risk $ecase its net interest income #ill

chan"e more #hen interest rates chan"e.


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Link 4et"een GAP and ,et Interest Margin

Many $anks #ill specify a tar"et -to earnin" asset ratio in the -2C3

policy statements

ratesinterestin&hange'(xpe&ted

$%)*ted$%)*+(xpe&inChange'+!oabe

assets(arning

apTarget=


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Establising a !arget GAP: An E-am#le

Consider a $ank #ith 58 million inearnin" assets that e!pects to"enerate a 5: *IM.

The $ank #ill risk chan"es in *IMe'al to pls or mins F8: drin" theyear

Gence, *IM shold fall $et#een ;: and6:.


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Establising a !arget GAP: An E-am#le

('ontin%ed

If mana"ement e!pects interest rates to &ary p to; percent drin" the pcomin" year, the $ank%sratio of its 7year cmlati&e - /a$solte &ale0to earnin" assets shold not e!ceed F5 percent.

Tar"et -41arnin" assets = /.F80/8.850 4 8.8; = 8.F5

Mana"ement%s #illin"ness to allo# only a F8percent &ariation in *IM sets limits on the -,

#hich #old $e allo#ed to &ary from 7F.5 millionto 7F.5 million, $ased on 58 million in earnin"assets.


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S#e'%lating on te GAP

Many $ank mana"ers attempt to adstthe interest rate risk e!posre of a$ank in anticipation of chan"es in

interest rates.This is speclati&e $ecase it

assmes that mana"ement canforecast rates $etter than the market.


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Can a 4ank E$$e'tively S#e'%late on te GAP*

Difficlt to &ary the - and #in asthis re'ires consistently accrateinterest rate forecasts

- $ank has limited fle!i$ility inadstin" its -H e."., loan anddeposit terms

There is no adstment for the timin"of cash flo#s or dynamics of thechan"in" - position


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Earnings Sensitivity Analysis

-llo#s mana"ement to incorporate theimpact of different spreads $et#eenasset yields and lia$ility interest costs

#hen rates chan"e $y differentamonts.


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Ste#s to Earnings Sensitivity Analysis

>orecast ftre interest rates Identify chan"es in the composition of

assets and lia$ilities in different rateen&ironments

>orecast #hen em$edded options #ill $ee!ercised

Identify #hen specific assets and lia$ilities#ill reprice "i&en the rate en&ironment

1stimate net interest income and net income Repeat the process to compare forecasts of

net interest income and net income acrossdifferent interest rate en&ironments.


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Earnings Sensitivity Analysis and te

E-er'ise o$ Embedded O#tions

Many $ank assets and lia$ilitiescontain different types of options, $othe!plicit and implicit)

3ption to refinance a loanCall option on a federal a"ency $ond

the $ank o#ns

Depositors ha&e the option to #ithdra#fnds prior to matrity

Cap /ma!imm0 rate on a floatin"rateloan


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Earnings Sensitivity AnalysisRe'ogni2es tat )i$$erent Interest

Rates Cange by )i$$erent Amo%ntsat )i$$erent !imes It is #ell reco"nied that $anks are

'ick to increase $ase loan rates $tare slo# to lo#er $ase loan rates #henrates fall.


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Re'all te o%r e-am#le $rom be$ore:

-7Ir= 8 78,888 = 78,888What if rates increaseded>nds >orecast &s. Implied >or#ard Rates; 58


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Interest Rate

+ore'asts

Most 2ikely>orecast andRate RampsDec. F885

ercent

6

5

;

E

F

8

77 7 F886E 5 B 77 7 F88E 5 B 7F

Time /month0

>ed>ndsRate:

;.58

;.F5

;.88

E.5

E.58

E.F5

E.887 E 5 B 77 7E

Market Implied Rates

Most 2ikely>orecast

75 7 7B F7 FE

.0S iti it f ( i 9 1


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2

+./*

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!LC1 uideine

oard Limit+.0*

+./*

Changein$%%

+3))*

+2.0*

+2./*

+4.0*

-400 -200 -00 500 5200 5400)Lamped Change in ates from )ost Li7ey +asis "oints*

Sensitivity of (arnings8 9ear To

./

2

!LC1 uideine

oard Limit+.0*

+./*

+./*

Changein$%%+3))*

+2.0*

+2./*

+4.0*

+4./*

-400 -200 -00 500 5200 5400)Lamped Change in ates from )ost Li7ey +asis "oint*

Sensitivity of (arnings8 9ear 1ne

E

arnings

sensitiv

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ndtwo

yearsve

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ikelyrat

escenario


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Earnings Sensitivity Analysis Res%lts

>or the $ank)The em$edded options can potentially

alter the $ank%s cash flo#s

Interest rates chan"e $y differentamonts at different times

Smmary reslts are kno#n as

1arnin"satRisk or *et InterestIncome Simlation


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Earnings Sensitivity Analysis

1arnin"satRisk The potential &ariation in net interest income

across different interest rate en&ironments,"i&en different assmptions a$ot $alancesheet composition, #hen em$edded options

#ill $e e!ercised, and the timin" of repricin"s. Demonstrates the potential &olatility in

earnin"s across these en&ironments The "reater is the potential &ariation in

earnin"s /earnin"s at risk0, the "reater is theamont of risk assmed $y a $ank, or

The "reater is the ma!imm loss, the "reateris risk


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In'ome Statement GAP

Income Statement ->orecasts the chan"e in net interest

income "i&en a 7: rise or fall in the$ank%s $enchmark rate o&er the ne!tyear.

It con&erts contractal - data tofi"res e&idencin" the impact of a 7:

rate mo&ement. Income statement - is also kno# in

the indstry as (eta - analysis

In'ome Statement GAP Ad?%sts te


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In'ome Statement GAP Ad?%sts te

4alan'e Seet GAP to In'or#orate te

Earnings Cange Ratio

The 1arnin"s Chan"e Ratio

This ratio indicates ho# the yield oneach asset and rate paid on eachlia$ility is assmed to chan"e relati&eto a 7 percent mo&e in the $enchmarkrate.


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In'o

meState

mentGA

P

M i t GAP d E i S iti it


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Managing te GAP and Earnings Sensitivity

Risk

Steps to redce riskCalclate periodic -s o&er short

time inter&als.

>nd repricea$le assets #ith matchin"repricea$le lia$ilities so that periodic-s approach ero.

>nd lon"term assets #ith matchin"noninterest$earin" lia$ilities.

Lse off$alance sheet transactions tohed"e.

Ad? t t E$$ ti R t S iti it $


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Ad?%st te E$$e'tive Rate Sensitivity o$ a

4ank>s Assets and Liabilities

Ob?e'tive A##roa'es

Redce assetsensiti&ity

(y lon"erterm secrities.2en"then the matrities of loans.Mo&e from floatin"rate loans to term loans.

Increase assetsensiti&ity

(y shortterm secrities.Shorten loan matrities.Make more loans on a floatin"rate $asis.

Redce lia$ility

sensiti&ity

ay premims to attract lon"erterm depositinstrments.

Isse lon"term s$ordinated de$t.

Increase lia$ilitysensiti&ity

ay premims to attract shortterm depositinstrments.

(orro# more &ia noncore prchasedlia$ilities.

Bank ManagementBank Management 6th edition6th edition


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Managing Interest Rate Risk:

GAP and Earnings Sensitivity

Chapter 5

Bank ManagementBank Management,6th edition.6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright 2006 by South-Western, a division of Thomson Learning

gap ration

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