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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. Here we will look at the
effects of interest rate changes on interest income and
interest expense. To do this, we need to look at rate
sensitive assets and rate sensitive liabilities. Using
these, we will compute a dollar measure, the GAP, of
interest rate exposure.
• 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 - $ Value or RSLt
• where t = time bucket; e.g., 0-3 months
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
Traditional static GAP analysis
1. Management develops an interest rate forecast
2. Management selects a series of “time buckets” (intervals) for
determining when assets and liabilities are rate-sensitive
3. Group assets and liabilities into time "buckets" according to
when they mature or re-price
– The effects of any off-balance sheet positions (swaps, futures,
etc.) are added to the balance sheet position
– Calculate GAP for each time bucket
– Funding GAPt = $ Value RSAt - $ Value or RSLt
1. Management forecasts NII given the interest rate environment
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


Rate, Volume, and Mix Analysis

• Many banks publish a summary of how net interest


income has changed over time.

• They separate changes over time to shifts in assets


and liability composition and volume from changes
associated with movements in interest rates.

• The purpose is to assess what factors influence shifts


in net interest income over time.
2001 Compared to 2000 2000 Compared to 1999
Change Due to * Change Due to *
Rate/Volume Analysis For Synovus Bank

Yield/ Net Yield/ Net


Volume Rate Change Volume Rate Change

Interest earned on:


Taxable loans, net $ 149,423 -117,147 32,276 161,222 36,390 197,612
Tax-exempt loans, net
t 1,373 -586 787 1,108 -450 658
Taxable investment securities -5,313 -916 -6,229 4,507 2,570 7,077
t
Tax-exempt investment securities 2,548 74 2,622 2,026 -206 1,820
Interest earning deposits with 223 -176 47 28 48 76
Federal funds sold 406 -1,745 -1,339 1,447 1,410 2,857
Mortgage loans held for sale 7,801 -1,680 6,121 -113 549 436
Total interest income 156,461 -122,176 34,285 170,225 40,311 210,536

Interest paid on:


Interest bearing demand deposits $ 6,074 -12,517 -6,443 1,537 5,433 6,970
Money market accounts 21,380 -36,244 -14,864 4,654 13,888 18,542
Savings deposits -369 -3,307 -3,676 -660 -67 -727
Time deposits 32,015 -22,545 9,470 38,824 32,812 71,636
Federal funds purchased and -6,165 -29,744 -35,909 23,148 15,870 39,018
Other borrowed funds 21,318 -4,272 17,046 21,960 3,361 25,321
Total interest expense 74,253 -108,629 -34,376 89,463 71,297 160,760
Net interest income $82,208 ($13,547) $68,661 $80,762 ($30,986) $49,776
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 rise (fall) when interest rates rise
(fall).
• 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 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.
• The best GAP for a bank can be determined only by
evaluating a bank's overall risk and return profile and
objectives.
• Generally, the farther a bank's GAP is from zero, the
greater is the bank's risk.
• 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%, or the ratio
of RSAs to RSLs should fall between 0.9 and 1.1.
Important Decisions in the GAP Model
1. Management must choose the time period over
which NIM is to be managed.
2. Management must choose a target NIM.
3. To increase NIM management must either:
a. Develop correct interest rate forecast; or
b. Reallocate assets and liabilities to
increase spread.
4. Management must choose dollar volume of
interest-sensitive assets and liabilities.
Target NIM and GAP
• A better risk measure relates the absolute
value of a bank’s GAP to earning assets.
– The greater is this ratio, 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.
– 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.
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. That is,
it ignores the time value of money.
• GAP further ignores the impact of embedded
options.
Exercise of embedded options in assets and
liabilities

• Customers have different types of options,


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
Interest rate risk and embedded options
Example: $10,000 Car loan
4 year Car loan at 8.5%
1 year CD at 4.5%
Spread
4.0%
But for how long?

Funding GAP
GAP = $RSA - $RSL
In this example:
GAP1y = $0.00 - $10,000 = - $10,000
This is a negative GAP.
Implied options:
10,000 4yr loan, financed by a 1 yr CD

 1 year GAP position:


-3 -2 -1 base +1 +2 +3
-1,000 -2,000 -8,000 -10,000 -10,000 -10,000 -10,000
Gap
Re-finance the auto loans All CD’s will mature

 3 month GAP is zero by definition:


-3 -2 -1 base +1 +2 +3
+8,000 +6,000 +2,000 0 -1,000 -3,000 -6,000
Gap
Re-finance the auto loans, and People will “pull” the CD’s for
less likely to “pull” CD’s higher returns
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
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.
• Shifts in the yield curve are rarely parallel.
• It is well recognized that banks are quick to increase
base loan rates but are slow to lower base loan rates
when rates fall.
Earnings sensitivity analysis consists of six
general steps:
1. Forecast future interest rates,
2. Identify changes in the composition of assets and
liabilities in different rate environments,
3. Forecast when embedded options will be exercised,
4. Identify when specific assets and liabilities will
reprice given the rate environment,
5. Estimate net interest income and net income, and
6. Repeat the process to compare forecasts of net interest
income and net income across rate environments.
1.0
Sensitivity of Earnings: Year One
.5
2
Change in NII ($MM)

(.5)
ALCO Guideline
(1.0)
Board Limit
(1.5)
(2.0)
(2.5)
(3.0)
(3.5)
- 300 -200 -100 ML +100 +200 +300
Ramped Change in Rates from Most Likely (Basis Point)

1.0
Sensitivity of Earnings: Year Two
.5
2
Change in NII ($MM)

(.5)
ALCO Guideline
(1.0)
Board Limit
(1.5)
(2.0)
(2.5)
(3.0)
- 300 -200 -100 ML +100 +200 +300
Ramped Change in Rates from Most Likely (Basis Points)
Earnings at risk

• …the potential variation in net interest income across


different interest rate environments, given different
assumptions about balance sheet composition, when
embedded options will be exercised, and the timing
of repricings.
• Demonstrates the potential volatility in earnings
across these environments.
• The greater is the potential variation in earnings
(earnings at risk), the greater is the amount of risk
assumed by a bank.
Income statement gap
• For smaller banks with limited off-balance sheet
exposure, one procedure is to use Income Statement
GAP analysis, which is a simplified procedure that
takes some of the factors into account.
• This model uses an all encompassing Earnings Change
Ratio (ECR).
– This ratio attempts to incorporate information on each asset
and liability.
– This ratio indicates how the yield on each asset, and rate paid
on each liability, is assumed to change relative to a 1 percent
drop in the prime rate.
Steps that banks can take to reduce interest rate risk

• Calculate periodic GAPs over short time intervals.


• Match fund repriceable assets with similar repriceable
liabilities so that periodic GAPs approach zero.
• Match fund long-term assets with noninterest-bearing
liabilities.
• Use off-balance sheet transactions, such as interest
rate swaps and financial futures, to hedge.
Various ways to adjust the effective rate
sensitivity of a bank’s assets and liabilities on-
balance sheet.
Objective Approaches
Reduce asset Buy longer-term securities.
sensitivity Lengthen the maturities of loans.
Move from floating-rate loans to term loans.

Increase asset Buy short-term securities.


sensitivity Shorten loan maturities.
Make more loans on a floating-rate basis.

Reduce liability Pay premiums to attract longer-term deposit instruments.


sensitivity Issue long-term subordinated debt.

Increase liability Pay premiums to attract short-term deposit instruments.


sensitivity Borrow more via non-core purchased liabilities.