Chapter Twentytwo Managing Interest Rate Risk and Insolvency

Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet Mc. Graw-Hill/Irwin 1 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Interest Rate Risk Measurement • Repricing or funding gap • Rate Sensitivity – the time to reprice an asset or liability – a measure of an FI’s exposure to interest rate changes in each maturity “bucket” – GAP can be computed for each of an FI’s maturity buckets Mc. Graw-Hill/Irwin 2 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Calculating GAP for a Maturity Bucket NIIi = (GAP)i Ri = (RSAi - RSLi) Ri where NIIi = change in net interest income in the ith maturity bucket GAPi = dollar size of the gap between the book value of rate-sensitive assets and ratesensitive liabilities in maturity bucket i Ri = change in the level of interest rates impacting assets and liabilities in the ith maturity bucket Mc. Graw-Hill/Irwin 3 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Simple Bank Balance Sheet and Repricing Gap Assets 1. Cash and due from 2. Short-term consumer loans (1 yr. maturity) 3. Long-term consumer loans (2 yr. maturity) 4. Three-month T-bills 5. Six-month T-notes 6. Three-year T-bonds 7. 10 -yr. Fixed-rate mort. 8. 30 -yr. Floating-rate m. 9. Premises Mc. Graw-Hill/Irwin Liabilities_____ $ 5 50 1. Two-year time deposits 2. Demand deposits 25 3. Passbook Savings 30 35 4. Three-month CDs 5. Three-month banker’s acceptances 6. Six-month commercial 7. One-year time deposits 8. Equity capital (fixed) 60 20 40 5 $270 $ 40 40 30 40 20 60 20 20 $270 4 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Additional Terminology • Cumulative gap (CGAP): the cumulative GAP across various repricing categories or buckets • Spread effect: the effect that a change in the spread between rates on RSAs and RSLs has on net interest income (NII) as interest rates change Mc. Graw-Hill/Irwin 5 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Four Major Weakness in the Repricing Model • Market value effects • Cash flow patterns within a maturity bucket • The problems of rate runoffs and prepayments • Cash flows from off-balance-sheet activities Mc. Graw-Hill/Irwin 6 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Duration Model Duration gap - a measure of overall interest rate risk exposure for an FI D = _ % in the market value of a security R(1 + R) Mc. Graw-Hill/Irwin 7 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Difficulties in Applying the Duration Model • Duration matching can be costly • Immunization is a dynamic problem • Large interest rate changes and convexity Mc. Graw-Hill/Irwin 8 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Insolvency Risk Management • Net worth • Book Value • Market value or mark-to-market value basis Mc. Graw-Hill/Irwin 9 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Effects of Changes in Loan Values and Interest Rates on the Balance Sheet Assets Base case Long-term securities Long-term bonds Liabilities $ 80 20 $100 Short-term floating Net worth $ 90 10 $100 After a major decline in value of loans Long-term securities Long-term bonds $ 80 8 $88 Liabilities Net worth $90 -2 $88 Liabilities Net worth $90 2 $92 After a rise in interest rates Long-term securities Long-term loans Mc. Graw-Hill/Irwin $ 75 17 $92 10 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

The Book Value of Capital • The book value of capital usually comprises three components in banking – Par value of shares – Surplus value of shares – Retained earnings • Book value of its capital and credit risk • Book value of capital and interest rate risk Mc. Graw-Hill/Irwin 11 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

The Discrepancy between the Market and Book Values of Equity • The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of values – Interest Rate Volatility – Examination and Enforcement – Loan Trading Mc. Graw-Hill/Irwin 12 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Calculating Discrepancy Between Book Values (BV) and Market Values (MV) MV = Market value of equity ownership in shares outstanding Number of shares BV = Par value of equity + Surplus value + Retained earnings_ ____ Number of shares Market-to-book ratio A ratio that shows the discrepancy between the stock market value of an FI’s equity and the book value of its equity Mc. Graw-Hill/Irwin 13 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved

Arguments against Market Value Accounting • Difficulty of implementation • Introduces unnecessary degree of variability into an FI’s net worth • FI’s are less willing to accept longerterm asset exposures Mc. Graw-Hill/Irwin 14 © 2007, The Mc. Graw-Hill Companies, All Rights Reserved