1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 6 6 Asset-Liability Management: Determining and Measuring Interest Rates and Controlling a Bank’s Interest-Sensitive Gap The purpose of this chapter is to explore the options bankers have today for dealing with risk – especially the risk of loss due to changing interest rates – and to see how a bank’s management can coordinate the management of its assets with the management of its liabilities in order to achieve the institution’s goals.

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Historical View of Asset-Liability Management Asset Management Strategy Liability Management Strategy Funds Management Strategy

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest Rate Risk 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

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Yield to Maturity (YTM)

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Bank Discount Rate (DR) Where: FV equals Face Value

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Market Interest Rates Function of: Risk-Free Real Rate of Interest Various Risk Premiums Default Risk Inflation Risk Marketability Risk Call Risk Maturity Risk

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Net Interest Margin

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Goal of Interest Rate Hedging One Important Goal of Interest Rate Hedging is to Insulate the Bank from the Damaging Effects of Fluctuating Interest Rates

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Market Interest Rates and Bank Profits

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest-Sensitive Gap Measurements Dollar Interest- Sensitive Gap Interest-Sensitive Assets – Interest Sensitive Liabilities = Relative Interest- Sensitive Gap Interest Sensitivity Ratio

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest-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

14. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Interest-Sensitive Liabilities Borrowings from Money Markets Short-Term Savings Accounts Money-Market Deposits Variable-Rate Deposits

15. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Asset-Sensitive Bank Has: Positive Dollar Interest-Sensitive Gap Positive Relative Interest-Sensitive Gap Interest Sensitivity Ratio Greater Than One

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Liability Sensitive Bank Has: Negative Dollar Interest-Sensitive Gap Negative Relative Interest-Sensitive Gap Interest Sensitivity Ratio Less Than One

17. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Gap Positions and the Effect of Interest Rate Changes on the Bank Asset-Sensitive Bank Interest Rates Rise NIM Rises Interest Rates Fall NIM Falls Liability-Sensitive Bank Interest Rates Rise NIM Falls Interest Rates Fall NIM Rises

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Zero Interest-Sensitive Gap Dollar Interest-Sensitive Gap is Zero Relative Interest-Sensitive Gap is Zero Interest Sensitivity Ratio is One When Interest Rates Change in Either Direction - NIM is Protected and Will Not Change

19. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Dollar Volume of Interest- Sensitive Assets and Liabilities

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. NIM Influenced By: Changes in Interest Rates Up or Down Changes in the Spread Between Assets and Liabilities Changes in the Volume of Interest-Sensitive Assets and Liabilities Changes in the Mix of Assets and Liabilities

21. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Cumulative Gap The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period

22. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 GapIncrease in IS Assets Decrease in IS Liabilities Falling Market Interest Rates Negative IS GapDecrease in IS Assets Increase in IS Liabilities

23. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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