Bank Management & Financial Services (6th Edition) by Rose & Hudgins Asset-Liability Management: Determining and Measuring Interest Rates and Controlling Interest-Sensitive and Duration Gaps Bank Management & Financial Services (6th Edition) by Rose & Hudgins G. M. Wali Ullah Lecturer Independent University, Bangladesh (IUB)

ASSET-LIABILITY MANAGEMENT The Purpose of Asset-Liability Management is to- Control a Bank’s Sensitivity to Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity

ASSET-LIABILITY MANAGEMENT NET INTEREST MARGIN INT REVENUE INT COSTS MKT VALUE OF ASSETS MKT VALUE OF LIABILITIES INVESTMENT VALUE, PROFITABILITY AND RISK Response to changing IR NET WORTH

Market Interest Rates Function of: Risk-Free Real Rate of Interest Various Risk Premiums Default Risk Inflation Risk Liquidity Risk Call Risk Maturity Risk

Yield Curves Graphical Picture of Relationship Between Yields and Maturities on Securities Generally Created With Treasury Securities to Keep Default Risk Constant Shape of the Yield Curve Upward – Long-Term Rates Higher than Short-Term Rates Downward – Short-Term Rates Higher than Long-Term Rates Horizontal – Short-Term and Long-Term Rates the Same

Yield Curves

Interest Rate Hedging To protect profits against adverse changes in interest rates, management tries to hold fixed the Net Interest Margin (NIM) Management aims to Insulate the Bank from the Damaging Effects of Fluctuating Interest Rates on Profits

Interest-Sensitive Gap Management  

Interest-Sensitive Gap Management Interest-Sensitive Assets: Interest-Sensitive Liabilities: 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 Borrowings from Money Markets Short-Term Savings Accounts Money-Market Deposits Variable-Rate Deposits

Interest-Sensitive Gap Management Asset-Sensitive Bank Liability-Sensitive Bank Interest Rates Rise NIM Rises Interest Rates Fall NIM Falls Interest Rates Rise NIM Falls Interest Rates Fall NIM Rises

Important Decision Regarding IS Gap Management Must Choose the Time Period Over Which NIM is to be Managed Management Must Choose a Target NIM To Increase NIM Management Must Either: Develop Correct Interest Rate Forecast Reallocate Assets and Liabilities to Increase Spread Management Must Choose Volume of Interest-Sensitive Assets and Liabilities

Aggressive Interest-Sensitive Gap Management Expected Change in Interest Rates Best Interest-Sensitive Gap Position Aggressive Management’s Likely Action Rising Market Interest Rates Positive IS Gap Increase in IS Assets Decrease in IS Liabilities Falling Market Interest Rates Negative IS Gap Decrease in IS Assets Increase in IS Liabilities

Eliminating Interest-Sensitive Gap IS GAP THE RISK POSSIBLE MANAGEMENT RESPONSE Asset sensitive Losses if interest rates fall (NIM will be reduced) Do nothing Extend asset maturities or shorten liability maturities Increase ISL or reduce ISA Liability sensitive Losses if interest rise (NIM will be reduced) Shorted asset maturities or lengthen liability maturities Decrease ISL or increase ISA

Problems with Interest-Sensitive Gap Management Interest Paid on Liabilities Tend to Move Faster than Interest Rates Earned on Assets Interest Rate 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 Interest-Sensitive Gap Does Not Consider the Impact of Changing Interest Rates on Equity Position