Chapter Five Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

Asset, Liability, and Funds Management Key Topics Asset, Liability, and Funds Management Market Rates and Interest Rate Risk Tools that Financial Managers use The Goals of Interest Rate Hedging (protection)

Introduction p. 133-134 As a financial institution takes on risk, it must protect the value of its net worth from going down, which could result in failure Financial-service managers have learned to look at their asset and liability portfolios (a bunch of different investments) as a group of investments that work together.

Asset-liability management Introduction p. 133-134 Asset-liability management Managers must consider how their bank’s whole portfolio contributes to the firm’s goals of profitability and acceptable risk Can protect against business cycles and ups and downs.

Asset-Liability Management Strategies p.134-135 Asset Management Strategy Control over assets, no control over liabilities Liability Management Strategy Control over liabilities by changing rates and other terms, introducing new products. Funds Management Strategy Works with both strategies

EXHIBIT 5–1 Asset-Liability Management in Banking and Financial Services p. 135

CONCEPT REVIEW WHAT ARE THE GOALS OF A FINANCIAL MANAGER? To consider how the bank’s portfolio contributes to it’s profitability and acceptable risk WHAT IS THIS KIND OF MANAGEMENT CALLED? Asset-Liability Management

CONCEPT REVIEW WHAT DO THESE TERMS MEAN – ASSET MANAGEMENT, LIABILITY MANAGEMENT, FUNDS MANAGEMENT? Asset management means the bank has control over assets but little to no control over liabilities. Liability Management is having control over liabilities by changing rates and introducing new products. Funds Management uses both tools

Interest Rate Risk: One of the Greatest Management Challenges. p Changing interest rates impact both the balance sheet and the statement of income and expenses of financial firms Price Risk When interest rates rise, the market value of the bond or asset falls Reinvestment Risk When interest rates fall, the coupon payments on the bond are reinvested at lower rates

EXHIBIT 5–2 Determination of the Rate of Interest in the Financial Marketplace Where the Demand and Supply of Loanable Funds (Credit) Interact to Set the Price of Credit p136

Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 Interest rates are the price of credit Demanded by lenders as their payment for the use of borrowed funds Expressed in percentage points and basis points (1/100 of a percentage point) Yield to Maturity (YTM) – Most common measurement of interest rates The expected rate of return on a bond until it matures. Based on the price, the coupon interest payments and final value at maturity.

Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 How to Calculate the Yield to Maturity

Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 Another popular interest rate measure is the bank discount rate (DR). To make calculations easier is based on a 360 day year. Often quoted on short-term loans and money market securities (such as Treasury bills)

Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 To convert a DR to the equivalent yield to maturity, we can use the formula

Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 138 Market interest rates are a function of various risk premiums which can cost the borrower extra money buying bonds. Default Risk – risky borrower. May not be able to get full bond value Inflation Risk – rising prices make bonds less valauable Liquidity Risk – difficult to sell quickly if cash is needed for better investments. Call Risk – borrower pays off loan early Maturity Risk – have higher interest rates due to greater opportunity for loss

CONCEPT CHECK INTEREST CAN BE CONSIDERED THE PRICE OF ______ Credit WHAT IS YIELD TO MATURITY? It is the measurement of interest rates The expected rate of return on a bond. This is based on price, the coupon or rate you get each year and the final value.

CONCEPT CHECK DESCRIBE THESE RISK PREMIUMS: Default risk Inflation risk Liquidity risk Call risk Default – borrower cannot pay back Inflation - rising prices Liquidity – bank may not be able to sell quickly at a good price Call – borrower pays off loan early

One of the Goals of Interest Rate Hedging: 躲闪 duǒshǎn Protect the Net Interest Margin p. 141 In order to protect profits against adverse interest rate changes, management seeks to hold fixed the financial firm’s net interest margin (NIM)

One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) A financial firm can hedge itself against interest rate changes – no matter which way rates move – by making sure for each time period that The gap is the portion of the balance sheet affected by interest rate risk

One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) p. 143 If interest-sensitive assets exceed the volume of interest- sensitive liabilities subject to repricing, the financial firm is said to have a positive gap and to be asset sensitive In the opposite situation, suppose an interest-sensitive bank’s liabilities are larger than its interest-sensitive assets

One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) p. 145 The net interest margin is influenced by multiple factors: Changes in the level of interest rates, up or down Changes in the spread (difference or margin) between asset yields and liability costs Changes in the volume of interest- earning assets (loans, securities) a bank has as it grows or lowers its activities

One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) p. 145 The net interest margin is influenced by multiple factors: 4. Changes in the volume of interest-bearing liabilities that are used to fund earning assets as a bank grows or shrinks in size 5. Changes in the mix of assets & liabilities a bank draws upon as it shifts between adjustible-rate and fixed-rate assets and liabilities, between shorter and longer maturity assets and liabilities, and between assets bearing higher versus lower expected returns.

One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) p. 147 We calculate a firm’s net interest income to see how it will change if interest rates rise Net interest income can be derived from the following formula

Chapter Summary 1. Managers of banks focus on the management of risk – controlling possible loss due to changes in market rates on interest, borrowers not paying their loans, regulation changes. 2. Focus of this chapter was to show you the tools that managers can use. 3. Early banking history focused on asset management because liabilities are controlled by customers. .

Chapter Summary (cont) 4. Liability management became popular when managers realized they could have more control by changing interest rates. 5. Funds management is using tools from both. 6. Managers have to deal with interest-rate risk every day, since the market is always changing. 7. Protecting the net interest margin, or the SPREAD between interest revenues and interest costs, managers use interest sensitive gap management tools

Chapter Concept Checks 5-1 What do the following terms mean: Asset management? Liability management? Funds management? P. 134-135 5-3. What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates change? P. 135-136, 138 5-4 What makes it so difficult to correctly forecast or predict interest rate changes? P.138 5-7 What is the goal of hedging? P 141

Chapter Concept Checks 5-8. First National Bank of Bannerville has posted interest revenues of $63 million and interest costs from all of its borrowings of $42 million. If this bank possesses $700 million in total earning assets, what is First National’s net interest margin? Suppose the bank’s interest revenues and interest costs double, while its earning assets increase by 50 percent. What will happen to its net interest margin? See slide 18 or page 141

Chapter Concept Checks 5-11 Commerce National Bank reports interest-sensitive assets of $870 million and interest-sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive or liability sensitive? What is likely to happen to the bank’s net interest margin if interest rates rise? If they fall? p. 141-144

Chapter Concept Checks 5-1 What do the following terms mean: Asset management? Liability management? Funds management? P. 134-135 Asset management refers to a banking strategy where management has control over bank assets but believes the bank's sources of funds (principally deposits) are outside its control. The key decision area for management is not deposits and other borrowings but assets. The financial manager exercises control over the allocation of incoming funds by deciding who is granted loans and what the terms on those loans will be.  

Chapter Concept Checks Liability management is a where a bank has control of liabilities. This is done mainly by opening up new sources of funding and monitoring the volume, mix and cost of their deposits and non-deposit items.   Funds management combines both asset and liability management into a balanced management strategy. Effective coordination in managing assets and liabilities will help to maximize the spread (difference or margin) between revenues and costs and control risk exposure.

Chapter Concept Checks 5-3. What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates change? P. 135-136, 138 Interest rates are determined, not by individual banks, but by the borrowing and lending decisions of many people in the money and capital markets. They are also impacted by changing views of risk by participants in the money and capital markets, especially the risk of borrower default, liquidity risk, price risk, reinvestment risk, inflation risk, term or maturity risk, marketability risk, and call risk.

Chapter Concept Checks 5-4 What makes it so difficult to correctly forecast or predict interest rate changes? P 138 Interest rates cannot be set by an individual bank or even by a group of banks. They are determined by thousands of investors (the public, consumers like you and me) trading in the credit markets. Each market rate of interest has multiple parts— the risk-free real interest rate plus various risk costs. A change in any of these rate parts can cause interest rates to change. This makes it difficult to forecast interest rate changes.

Chapter Concept Checks 5-7 What is the goal of hedging? P 141   The goal of hedging in banking is to freeze (hold), or protect the spread between asset returns and liability costs and to offset declining values on certain assets by profitable transactions so that a target rate of return is assured.

Chapter Concept Checks The bank’s net interest margin is 3% computed as follows: p. 141 Net interest margin = $63 𝑚𝑖𝑙𝑙𝑖𝑜𝑛−$42 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 $700 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = 0.03 (3%) If interest revenues and interest costs double while earning assets grow by 50 percent, the net interest margin will change as follows: Net interest margin= 63 𝑚𝑖𝑙𝑙𝑖𝑜𝑛−42𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑥2 700 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑥 (1.50) = 0.04 (4%) Clearly the net interest margin increases—in this case by one third.

Chapter Concept Checks 5-11 Commerce National Bank reports interest-sensitive assets of $870 million and interest-sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive or liability sensitive? What is likely to happen to the bank’s net interest margin if interest rates rise? If they fall? Because interest-sensitive assets are larger than liabilities by $245 million, the bank is asset sensitive.  If interest rates rise, the bank's net interest margin should rise as asset revenues increase more than the resulting increase in liability costs. On the other hand, if interest rates fall, the bank's net interest margin will fall as asset revenues decline faster than liability costs.