Asset & Liability Bank Management Seminar Ski

UNIVERZITY OF SARAJEVO

ALM-Asset & Liability bank management

Subject: Banking managementMentor: Prof. dr. Fikret HadžićStudents: Karalić Amila 68 169 Genjac Amra 67 728 Omanović Selma 68 135

SARAJEVO, March 23,2011.

ALM-ASSET & LIABILITY BANK MANAGEMENTMarch 23,

2011

C O N T E N T:

INTRODUCTION 2

Asset-liabilities management strategies 4

Risk 6

Risk in ALM 6

Interest rate risk 8

Types of interest rate risk 10 Measurement of interest rate 11

Components of interest rate 13

The banker's responses to the interest rate risk 15

The main objective in managing interest rate risk 15

Interest sensitive gap management 16

Methods for determining the Gap 19

Aggressive interest sensitive Gap management 18

Duration Gap management 20

CONCLUSION 23

LITERATURE 24

INTRODUCTION

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Over the last few years the Indian financial markets have witnessed wide ranging changes at

fast pace. Intense competition for business involving both the assets and liabilities, together

with increasing volatility in the domestic interest rates as well as foreign exchange rates, has

brought pressure on the management of banks to maintain a good balance among spreads,

profitability and long-term viability. These pressures call for structured and comprehensive

measures and not just ad hoc action. The Management of banks has to base their business

decisions on a dynamic and integrated risk management system and process, driven by

corporate strategy. Banks are exposed to several major risks in the course of their business -

credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity

risk and operational risks. This note lays down broad guidelines in respect of interest rate and

liquidity risks management systems in banks which form part of the Asset-Liability

Management (ALM) function. The initial focus of the ALM function would be to enforce the

risk management discipline viz. managing business after assessing the risks involved. The

objective of good risk management programmers should be that these programmers will

evolve into a strategic tool for bank management.

Asset and Liability bank management is an integral part of the financial management process

of any bank. Asset and Liability bank management is concerned with strategic balance sheet

management involving risks caused by changes in the interest rates, exchange rates and the

liquidity position of the bank. While managing these three risks forms the crux of ALM,

credit risk and contingency risk also form a part of the ALM.

ALM can be termed as a risk management technique designed to earn an adequate return

while maintaining a comfortable surplus of assets beyond liabilities. It takes into

consideration interest rates, earning power, and degree of willingness to take on debt and

hence is also known as Surplus Management. ALM is defined as, the process of decision –

making to control risks of existence, stability and growth of a system through the dynamic

balances of its assets and liabilities. The text book definition of ALM is a risk management

technique designed to earn an adequate return while maintaining a comfortable surplus of

assets beyond liabilities. It takes into consideration interest rates, earning power and degree of

willingness to take on debt. It is also called surplus- management.

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Management techniques that are called assets and liabilities is the defensive system of

financial institutions when it comes to business cycles and seasonal pressures, as well as a

powerful tool that influences the formation of a portfolio of assets and liabilities in a manner

that contributes to the achievement goals of the institution.

The purpose of asset and liability management is to formulate and undertake activities that

shape the balance of the bank as a whole. The main objectives of asset and liability

management are:

maximize, or at least stabilize the bank margin (the difference between interest income

and expense)

maximize, or at least to protect the value (stock price) of a bank with an acceptable

level of risk

The aim is to be in position to pay benefits whenever they fall due and always have sufficient

equity to coves value fluctuations in assets and liabilities.

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1. ASSET-LIABILITY MANAGEMENT STRATEGIES:

1.1. Asset Management Strategy – financial institutions have not always possessed a

completely integrated view of their assets and liabilities. Through most of the history of

banking, for example, bankers tended to take their source of founds-liabilities and equity-

largely for granted. This so-called asset management view held that the amount and kinds

of deposits a bank held and the volume of other borrowed funds it was able to attack were

largely determined by its customers. Under this view, the public determined the relative

amounts of checkable deposits, saving accounts, and other source of funds available to

depository institutions. “The key decision area for management was not deposits and other

borrowing but assets. The banker could exercise control only over the allocation of

incoming funds by deciding who was to receive the scarce quantity of loans available and

what the terms on those loans would be. Indeed, there was some logic behind this asset

management approach because, prior to deregulation of the banking and thrift industries,

the types of deposits, the rates offered, and the non-deposit source of funds banks and

thrift could draw upon were closely regulated. Managers had only limited discretion in

reshaping their source of funds”1

1.2. Liability Management Strategy – the 1960s and 1970s ushered in dramatic changes in

asset-liability management strategies. Confronted with soaring interest rates and intense

competition for funds, bankers and many of their competitors began to devote greater

attention to opening up new source of funding and monitoring the mix ad cost of their

deposits and non-deposits liabilities. The new strategy we called liability management. Its

goal was simply to gain control over funds source comparable to the control financial

managers had long exercised over their assets. The key control lever was price, the

interest rate and other terms banks and their competitions could offer on their deposits and

borrowings to achieve the volume, mix and cost desired. Fro example, a bank faced with

heavy loan demand that exceeded its available funds could simply raise the offer rate on

its deposits and money market borrowings relative to its competitors. And funds would

flow in. on the other hand, a bank flush with funds but with few profitable outlets for

1 Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services, 197, Chapter 6

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those funds could leave its offer rate unchanged or even lower than price, letting

competitions out bid it for whatever funds were available in the marketplace.

1.3. Funds Management Strategy – the maturing of liability management techniques,

coupled with more volatile interest rates and greater risk, eventually gave birth to funds

management approach, which dominates banking and the activities for many competitors

today. This view is a much more balanced approach to asset-liability management that

stresses several key objectives:

- Management could exercise as much control as possible over volume, mix, and

return or cost of both assets and liabilities in order to achieve the financial

institution’s goals.

- Management’s control avers assets must be coordinated with over liabilities so

that asset management and liabilities management are internally consistent and

do not pull again cache other. Effective coordination in managing assets and

liabilities will help to maximize the spread between revenues and costs and

control risk exposure.

- Revenues and costs arise from both sides of the balance sheet. Management

policies need to be developed that maximize returns and minimize costs from

supplying services. Income and expenses arising from both sides of the balance

sheet the bank (and the assets and liabilities). Banks should develop policies

that will maximize return and minimize the costs of its services, which result in

the assets (credit) or liabilities (deposits of sales). The traditional view that all

the revenue that a bank achieves must arise from loans and investments giving

way to the opinion that the bank sells a portfolio of financial services-loans,

payments, savings, financial advice, etc. - and each of these services should

have a price to be cover the cost of their production. Income from fees derived

from the management of liabilities could affect the achievement of the

objectives of profitability and profitability, as well as revenues management of

bank loans and other assets.

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2. RISK

No banker can not be completely avoided one of the most awkward types of risks they must

face-bank interest rate risk. When the interest rates on financial market changes, changes

affecting the most important source of income for banks - interest income on loans and

securities - and the most important source of cost - the cost of interest on deposits and other

assets that the bank has lent. Changing interest rates also change the market value of assets

and liabilities of banks changing the bank's net worth, i.e. value of equity role in bank.

Risk management is the process by which managers satisfy these needs by identifying key

risks, obtaining consistent, understandable, operational risk measures, choosing which risks to

reduce and which to increase and by what means, and establishing procedures to monitor the

resulting risk position. The ALM or balance sheet can often be managed aggressively through

the use of derivative contracts. Funds transfer pricing mechanisms are used extensively to

create economic transparency and to immunize business units to risk.

2.1. Risks in ALM

2.1.1. Interest Rate risk - Risks of having a negative impact on a banks future earnings

and on the market value of its equity due to changes in interest rates. The phased

deregulation of interest rates and the operational flexibility given to banks in

pricing most of the assets and liabilities have exposed the banking system to

Interest Rate Risk. Interest rate risk is the risk where changes in market interest

rates might adversely affect a bank's financial condition. Changes in interest rates

affect both the current earnings (earnings perspective) as also the net worth of the

bank (economic value perspective). The risk from the earnings' perspective can be

measured as changes in the Net Interest Income (Nil) or Net Interest Margin

(NIM). In the context of poor MIS, slow pace of computerization in banks and the

absence of total deregulation, the traditional Gap analysis is considered as a

suitable method to measure the Interest Rate Risk. It is the intention of RBI to

move over to modern techniques of Interest Rate Risk measurement like Duration

Gap Analysis, Simulation and Value at Risk at a later date when banks acquire

sufficient expertise and sophistication in MIS. The Gap or Mismatch risk can be

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measured by calculating Gaps over different time intervals as at a given date. Gap

analysis measures mismatches between rate sensitive liabilities and rate sensitive

assets (including off-balance sheet positions). An asset or liability is normally

classified as rate sensitive if:

i) within the time interval under consideration, there is a cash flow;

ii) the interest rate resets/reprises contractually during the interval;

iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits,

advances up to Rs.2 laths, DRI advances, Export credit, Refinance, CRR

balance, etc.) in cases where interest rates are administered ;

iv) It is contractually pre-payable or withdrawal before the stated maturities.

2.1.2. Liquidity Risk - Risk of having insufficient liquid assets to meet the liabilities at a

given time. The main liquidity concern of the ALM unit is the funding liquidity

risk embedded in the balance sheet. The funding of long term mortgages and other

securitized assets with short term liabilities (the maturity transformation process),

has moved to centre stage with the contagion effect of the sub-prime debacle. Both

industry and regulators failed to recognize the importance of funding and liquidity

as contributors to the crisis and the dependence on short term funding created

intrinsic flaws in the business model. Banks must assess the buoyancy of funding

and liquidity sources through the ALM process. Measuring and managing liquidity

needs are vital activities of commercial banks. By assuring a bank's ability to meet

its liabilities as they become due, liquidity management can reduce the probability

of an adverse situation developing. The importance of liquidity transcends

individual institutions, as liquidity shortfall in one institution can have

repercussions on the entire system. Bank management should measure not only the

liquidity positions of banks on an ongoing basis but also examine how liquidity

requirements are likely to evolve under crisis scenarios. Experience shows that

assets commonly considered as liquid like Government securities and other money

market instruments could also become illiquid when the market and players are

unidirectional. Therefore liquidity has to be tracked through maturity or cash flow

mismatches. For measuring and managing net funding requirements, the use of a

maturity ladder and calculation of cumulative surplus or deficit of funds at selected

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maturity dates is adopted as a standard tool. The format of the Statement of

Structural Liquidity is given in Annexure I.

2.1.3. Forex Risk - Risk of having losses in foreign exchange assets and liabilities due to

exchanges in exchange rates among multicurrency’s under consideration. The risk

of an investment's value changing due to changes in currency exchange rates. The

risk that an investor will have to close out a long or short position in a foreign

currency at a loss due to an adverse movement in exchange rates. Also known as

"currency risk" or "exchange-rate risk". Forex risk management cannot simply be

left to chance. In the same way that you may well look at historical forex data to

plan out what to trade and when. You equally need to have strategies in place to

tell you when to let the profits in a trade run, and when to cut them short. And you

need to have these clearly established ahead of time, so that in the heat of the

trading battle you don’t fall prey to that little voice in your head that says that this

situation is somehow different from previous occasions, and so you should just

“Wing It” or “Go With Your Instinct”.

3. INTEREST RATE RISK

“No financial manager can completely avoid one of the toughest and potentially most

damaging forms of risk that all banks and many of they competitors must face-interest rate

risk. When interest rates change in the financial marketplace the source of revenue banks and

their closest competitors receives-especially interest income on loans and securities-and their

most important source of expenses-interest cost and deposits and other borrowings-must also

change. Moreover, changing market interest rates also change the market values of assets and

liabilities, there by changing financial institution's net worth-that is, the value of the owner's

investment in firm. Thus, changing market interest rate impacts both the balance sheet and the

statement of income and expense of bank and other financial-service institutions. When the

interest rates on financial market changes, changes affecting the most important source of

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income for banks - interest income on loans and securities - and the most important source of

cost - the cost of interest on deposits and other assets that the bank has lent. “2

Changing interest rates also change the market value of assets and liabilities of banks

changing the net value of the bank. 3

As it is, your credit worthiness is the most important factor in determining the interest rate,

which is going to be applicable to you. As it is, every body would like to pay as less as

possible. Yet most people end up paying huge sums of interests, mainly because, their credit

scores are not good enough. It is therefore; better to get your credit score in good shape.

As it is, there are several factors, which determine your interest rate, as well as your

creditworthiness. The following are some o the factors, which determine the interest rates

payable on your debt:

1. The first factor, which determines the interest rate, is whether you make timely

payment on your debt or not. Punctuality in payment is a very important factor in

deciding the interest rate applicable to you. Even if you do not belong to a fixed

income category, but if you’re past record boasts of timely and punctual payment, then

you can easily negotiate your way into availing the lowest interest rates for yourself.

2. Another important factor is that of the amount of payment that you are making. If you

are satisfied by paying just the minimum amount required, then it might not go down

too well with your credit rating, simply because, all the unpaid amount, which is due,

would add to the principle amount and you will have to pay interest on it as well. This

is likely to pose problems for you in future. If you make payments more that the

minimum amount, then you will do a great favor to your credit rating.

3. Along with this, it is also important as to how much of the credit limit offered to you,

is being utilized by you. So, if you are utilizing around thirty to forty percent of your

credit limit, then it creates an image of sensibility and responsible behavior on your

part. This too would be very effective in deciding the interest rate which would be

applicable to you.

4. Your source of income is also an important factor in determining your interest rates.

People with small and medium sized business are more likely to pay a higher rate of

interest, unlike people with fixed income.

2 Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services,198, Chapter 63 Rose, S. Peter, Menadžment komercijalnih banaka, MATE Zagreb 2003., str. 210

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The above aspects, if taken care of properly, would be quite helpful in availing the lowest

interest rates. As it is, it is always better to pay less. The factors that determine interest rates.

Although interest rates are critical for each bank, the bankers can not control any level or

trend in market interest rates. The interest rate of any loan or security is determined by the

financial market, and aims at placing the point where they are offered and the required

amount of credits equal. When lending bankers on the supply side, but each bank is only one

supplier of credit in international markets credit funds. Likewise, bankers to the financial

markets are as those who claimed credit funds, when offering services deposits of the public

or when non-depositary issue IOU (written documents that provide evidence of Indebtedness),

which provides resources for investments and various investments. However, each banks, no

matter how big, just a seeker of credit funds market. This means that the banker can not

determine the level or be safe in conjunction with the trend of market interest rates. Instead, a

bank can only react to the level and trend of interest rate so that the best way to realize the

achievement of its. Most banks must be the same that accepts the price.

How to market and interest rates move, banks are faced with two basic types of risk interest

rates - price risk and reinvestment risk. Price risk occurs when market interest rates growth.

This causes a decline in market value of most bonds and loans with a fixed rate. If a bank

wants to sell these financial instruments at a time when interest growth rates must be willing

to accept capital loss. When interest rates fall occurs the reinvestment risk. Then comes a

decrease in expected future income of the bank due forcing the bank to invest funds in it

converge in less profitable loans, bonds and other assets.

3.1. Types of interest rate risk

Price risk - market interest rates rise. The risk that the value of a security or portfolio of

securities will decline in the future. A price risk is the risk that an investor will invest in an

equity that will eventually be worth less than what they paid for it. There are ways to manage

price risk, but as long as there is some investment going on in unsecured products, there is no

way to totally eliminate it. Therefore, the question is often how to mitigate market price risk

and what to do when it starts to become a severe problem. The goal of any investment is to

make money. However, the risk associated with the practice of investing is real and will mean

there will always be some losers. The ultimate question is to determine how much price risk is

worth the potential rewards. This may be a little different for each investor and can even be

different for the same investor, depending on what their goals are with an investment project.

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Price risk management is meant to help lessen any potential impacts of devaluation. This may

be done with a standing order to a stock broker, for example. In this case, an investor may

have a broker sell a stock once its value drops to a certain level. Often, this order is given well

in advance of a price drop. This helps prevent any further losses, but will not recoup any loss

of value up to that point. If the value of the stock starts to increase, there may be a standing

order that dictates when to repurchase that stock.

Reinvestment risk - market interest rates are falling. This term is usually heard in the context

of bonds. This reinvestment risk is especially evident during periods of falling interest rates

where the coupon payments are reinvested at less than the yield to maturity at the time of

purchase. Many corporate bonds are callable. What that means is that the bond issuer reserves

the right to “call” the bond before maturity and pay off the debt. That can lead to reinvestment

risk. When interest rates are declining, investors have to reinvest their interest income and any

return of principal, whether scheduled or unscheduled, at lower prevailing rates.4

3.2. Measurement of interest rate

In the most general expression, the rate of interest expressed by the cost of using credit and

cash resources financial market. Interest rate is the proportion who receive compensation

when you have pay to obtain the right to use loans obtained by dividing the amount of the

loan. There are numerous methods for measuring interest rate, and one of the most popular is

the profit per maturity (YTM - Yield to maturity). This is the discount rate that equates the

current market value of loans or securities with the expected inflow of future revenues by the

same generate. It can be represented by the formula:

4 Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services, 200, Chapter 6

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For example, a bond purchased today at price of $950 and promising an interest payment of

$100 each over the next three years, when it will be redeemed by the bond’s issuer for $1,000,

will have a promised interest rate, measured by the yield to maturity, determined by :

Another popular method of measuring interest rate is the discount rate Bank (DR-discount

rate), which is often used for short-term loans and securities in the money market.

The formula for calculating the discount rate is as follows:

For example, suppose a money market loan or security can be purchased for price of $96 and

has a face value of $ 100 to be paid at maturity. If the loan or security matures in 90 days, its

interest rate measured by the bank DR must be

This interest rate measured ignores the effect of compounding of interest and is based on a

360-day year, unlike the yield to maturity measure, which assumes a 365-day year and

assumes as well that interest income is compounded at the calculated yield to maturity (YTM)

In addition to these two ways of measuring interest rates are a lot of other.5

5 Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services, 200, Chapter 6, Part two

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3.2. Components of interest rate

Any interest rate on the loan or bond, is composed of multiple elements:

Market interest rate = Risk-free real interest rate + Risk premium (related to the reskineson risky loans or security non-return and failing contractual obligations, inflation risk...)

Not only is the risk-free real interest rate changes over time with changes in supply and

demand for credit funds, but also the perceptions of donors and recipients of loans in the

financial market is also changing. This causes interest rates move up and down, often very

irregular. Also, the announcement of price increases of goods and services can boost the loan

provider on the expectation of the trend of increased inflation reducing the purchasing power

of income from interest, unless you request more premium related to inflation risk. Many

interest rates on loans and bonds include the risk premium because the marketability of some

of these financial instruments may be harder to sell loans to other providers at preferred rates,

and because of the risk of payment on demand, which occurs when the loan recipients have

the right to prepayment of loans, reducing So the expected rate of return. Another key

component of any portion of the interest ceiling is temporal or premium. Long-term loans or

bonds often have higher market interest rates than short-term loans and bonds, because of the

risk maturity, where there is a greater possibility of loss during the long-term placements.6

The various components are:

A real interest rate is the compensation, over and above inflation, that a lender demands to

lend his money. Inflation is by far the biggest enemy of a lender. Lenders want a return on

their money which compensates them for the inflation they expect and the risk that their

inflation expectation could be wrong. The Liquidity Risk Premium is the compensation that a

lender receives for investing funds in something that is difficult to sell. The old adage "risk is

having your money available when you need it applies. Credit Risk is the risk that the loan or

bond will not be repaid as scheduled, or at all .


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Graphically, changes in interest rates with different maturity dates of loans monitored through

a single point in time is called curve obtained. We can conclude that there is a close

correlation between risk and term structure of interest rates.

The curves obtained are constantly changing, and at different speeds. Short-term interest rates

tend to increase faster than long-term interest rates, and also quickly fall, when all interest

rates in the market are pointing downwards.7

The above illustration shows a functional connection between interest rates and maturities,

where the three possible solutions: get a horizontal curve, increasing or decreasing the false

positive or false negative.

The curve obtained indicated as horizontal AA represents the state in terms of equality of

short-and long-term interest rates. Growing get BB curve shows that long-term interest rates

over the short term, while decreasing yield curve CC shows that the short-term interest rates

has found the level of interest rates.

3.3. The bankers responses to the interest rate risk

7 Ćurčić, Uroš N., Bankarski portfolio menadžment, FELJTON Novi Sad 2002., drugo prošireno i prerađeno izdanje, str. 547

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Changes in market interest rates may affect the profitability of the bank, it will increase its

cost of funds, reduce the return on assets income provides and reduce the value of equity

investments in bank. During the last two decades, bankers are looking for ways that will

insulate their property portfolios and the portfolios of liabilities from the influence variable

interest rate. Many banks now implement strategies of asset and liability management

committee under the leadership of the managed assets and liabilities. This committee selects a

strategy to manage interest rate risk, participating in the short and long term planning, and in

the preparation of strategies for managing the liquidity needs of banks and other business

tasks.8

3.4. The main objective in managing interest rate risk

In managing interest rate risk is the main goal is to isolate the bank's profits from the adverse

impact of fluctuating interest rates. To meet this goal the government must concentrate on

those elements of the portfolio of assets and liabilities that are most sensitive to interest rate

trends. This includes loans and investments from the part of bank assets and deposits of its

duty rates, and the borrowings from the money market. To protect the profits of the negative

interest rate changes, the administration tends to maintain a fixed net interest margin (NIM),

which is expressed as follows:

4. INTEREST - SENSITIVE GAP MANAGEMENT


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The most common strategy of hedging interest rates, which are often applied in practice called

interest - sensitive Gap management. If a bank applies management techniques

interest - sensitive Gap management, the Bank is obliged to constantly and thoroughly

analyzes the maturity and ability to re-establish price for assets sensitive to changes in interest

rates, deposits and other securities the money market. If the Management Board in the

exercise of the said analysis, finds that the bank is largely exposed to interest rate risk, will try

as much as possible to align the amount of funds that are re-bid may be formed depending on

the direction of movements in market interest rates, the amount of deposits and the remaining

portion liabilities whose value can also adjust in order to more adequately reflect the

developments in the market over the same period. The Bank may carry out hedging in relation

to changes in interest rates - regardless of the direction of interest rates - so you will ensure

that every moment is worth the equality shown a pattern 1:

Dollar amount of reprievable Dollar amount of reprievable

(interest-sensitive) = (interest- sensitive)

assets liabilities

In order to better understand what these categories we will carry the same conceptual

definition. Reprievable assets can be defined as the bank's assets, primarily loans, which is

subject to interest rate changes, whether at maturity or when they are re-determined price by

an index rate. (reference or market interest rate). Re-evaluation of these resources is limited or

crawled up or down depending on the fluctuation of published rate or index and the cost of

funds, such as a six-month Treasury bill, bank prime rate, and so on. Examples are variable

rate consumer loans, variable rate demand loans and adjustable rate mortgage. Repriceable

liabilities is presented as a short-term deposit which is subject to a floating rate, as opposed to

fixed interest rates. The gap is the portion of the balance sheet affected by interest rate risk:

table 1 - Examples of variable and fixed- banking assets and liabilities 9

Examples of Repriceable Assets and Liabilities and Nonrepriceable Assets and Liabilities

9 Peter S.Rose, Menadžment komercijalnih banaka, Mate, Zagreb, 2005. godine, 219 str.

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Repriceable

Assets

Short-term securities

issued by governments

and private borrowers

(about to mature)

Short-term loans made to

borrowing customers

(about to mature)

Variable-rate loans and

securities

Repriceable

Liabilities

Borrowings from the money

market (such as federal funds or

RP borrowings)

Short-term savings accounts

Money-market deposits (whose

interest rate are adjustable every

few days)

Nonrepriceable

Assets

Cash in the vault and

deposits at the Central

Bank (legal reserves)

Long-term loans made

at a fixed interest rate

Long-term securities

carrying fixed rates

Buildings and

equipment

Nonrepriceable

Liabilities

Demand deposits

(which pay no rate or a

fixed interest rate)

Long-term saving and

retirement account

Equity capital provided

by the financial

institution's owners

If at any planned period (daily, weekly, monthly, quarterly, etc.), the amount of assets

susceptible to interest rate sensitive liabilities exceeds the amount on which interest is subject

to the re-formation rates, it is believed that such financial institution has a positive gap and

that is sensitive to the assets. Sensitivity of the bank assets can be represented by the

following form:

Interest-sensitive gap (positive)

=

Interest-sensitive assets – Interest-sensitive liabilities

Otherwise, if at all planned period (daily, weekly, monthly, quarterly, etc.), the amount of

liabilities

sensitive

to interest

rate sensitive

assets exceeds

the amount

on which interest is subject to the re-formation rates, it is believed that such financial

institution has a negative gap and to be sensitive the liabilities. Therefore is valid:

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Interest-sensitive gap

=


> 0


2011

Interest-sensitive gap (negative)

=


There are several ways to measure the gap sensitive to interest. One of most used

method in practice is called simply the dollar IS GAP19. It means the absolute amount of

money which is the difference between assets and liabilities sensitive to interest:

Dollar GAP IS = ISA20 - ISL21

If IS GAP assumes positive values, a banking institution is sensitive to the assets, and

if the values which are associated with GAP IS in the negative range the bank is vulnerable to

liabilities. After calculating the dollar IS GAP, it is possible to determine the coefficient of

relative IS GAP-a

Relative GAP IS greater than zero means that the institution-sensitive assets, while negative

relative GAP IS indicates the sensitivity of financial institutions liabilities.

If we have available data on the total amount interest-sensitive assets and data on

the size of liabilities sensitive to interest rate, we calculate the indicator of interest and

sensitivity:

table 2 -. Indicators to the sensitivity of bank on assets and liabilities10

Bank-sensitive assets Bank-sensitive liabilities

10

? Peter S.Rose, Menadžment komercijalnih banaka, Mate, Zagreb, 2005. godine, 219 str.

18

< 0


2011

IS GAP > 0

Dollar IS GAP > 0

Relativni IS GAP > 0

Interest sensitivity ratio(ISR) > 1

IS GAP < 0

Dollar IS GAP < 0

Relativni IS GAP < 0

Interest sensitivity ratio(ISR) < 1

4.1. Methods for determining the Gap

All methods require financial managers to make important decisions:

1. Management must choose the time period during which the net interest margin (NIM) is to

be managed to achieve some desired value ant the length of sub periods into witch the

planning period is to be dividend

2. Management must choose a target level for the net interest margin-that is, whether to freeze

the margin roughly where it is or perhaps increase the NIM

3. If management wishes to increase the NIM, it must either develop a correct interest rate

forecast or find ways to relocate earning assets and liabilities to increase the spread between

interest revenues and interest expenses.

4. Management must determine the dollar volume of interest-sensitive assets and interest-

sensitive liabilities it wants the financial firm to hold.

4.2. Aggressive interest sensitive Gap management

Aggressive management interest sensitive Gap is based on predicting the administration of

the tendencies of future trends in market interest rates. If the administration believes will

follow a fall in interest rates during the current planning period, will allow you to interest

sensitive liabilities exceed assets interest sensitive.

If the real events in the market coincides with the predictions of administration, costs

obligations reducers are more than income and NIM banks will increase. Predicting increases

in interest rates will result in an increase interest sensitive assets because such a situation will

cause the increase of income of the bank more in interest costs. Such an aggressive strategy

implies greater risks for the bank.

Continuously accurately predicting future movements in interest rates is not possible, so

therefore the majority of bank managers rely on protection from changes in interest rates

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instead of constant predictions of the same. Interest rates are moving in the opposite direction

from predictions administration produce greater losses.

Most bank managers rely on protection from changes in interest rates of constant predications

of the same.

Opposite:

4.3. Duration Gap management

Duration is a measure of value and time period of maturity which includes aspects of all cash

inflows of revenue assets, as well as all cash outflows related liabilities. Duration is a measure

of the average maturity of the expected future cash payments. The duration has also measures

the average time it takes to charge the funds invested in one investment.

where D is the duration of an instrument by age, t is the time period in which to achieve cash

flow in a financial instrument, CF is the volume of each expected cash flow in each time

period (t), and the YTM is the current yield to maturity of an instrument.

Portfolio theory in finance means:

1. increase in market interest rates caused the decline in market value assets and

liabilities are fixed rate,

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2. the longer the maturity of assets and liabilities of banks, the greater the possibility of

declining market values of assets and liabilities, with the increase in market interest

rates.11

Using a life time to protect against interest rate risk

Bank or other financial institution that wants to completely protect against fluctuations in

interest rates, opting for the assets and liabilities to the following condition:

Life of the asset = life of the passive

And that the gap life as close as possible to zero. A bank that seeks to divide her life must be

zero to provide the following:

Since a longer life means greater sensitivity to interest rate changes, this equation tells us that

the value of bank liabilities has changed little over the value of active banks in order to

eliminate the bank's overall exposure to interest rate risk. If the lifetime of active banks is not

aligned with a life of its obligations, the bank is exposed to interest rate risk. What is the life

of a larger gap, it is the equity of the bank vulnerable to interest rate changes.

For example, if we assume that the lifetime of assets exceeds the lifetime commitment. In this

case we have a positive gap life:

Positive gap life = life of the asset – life of the liabilities >0

As a result we have a situation where the value of liabilities less change, upward or

downward, but the value of assets. In this case, the increase in market interest rates will lead

to a reduction of equity capital, since the value of the assets falls more than the value of

liabilities. Equity in the bank will be reduced in terms of market value.

The reverse situation is when the liabilities have a longer lifetime than the bank's assets:

Negative gap life = life of the asset – life of the liabilities <0

11 Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services, 215, Chapter 6,

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In this case, changes in market interest rates will result in a greater change in the value of

liabilities, rather than changing the value of assets. If interest rates fall, bank liabilities will

increase by a greater amount of its assets, and equity will be reduced. If interest rates rise, the

value of liabilities will be reduced faster than the value of assets and equity of the bank will

increase.

Conclusion

From the previous presentations, we can conclude that the bank now focuses primarily on risk

management, which requires the coordination of decisions on the asset's decision on the

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liability side. One of the major risk factors to which the bank is constantly facing the risk of

interest rates. Interest rates are beyond the control of banks. Therefore, banks need to

successfully react to changes in market interest rates, to protect and controlled interest earning

income and expenses, and net interest margin of banks. Today, one of the most popular means

of managing interest rate risk management is gap. This technique focuses on protecting and

maximizing the net interest margin of banks, but is severely limited. The choice of time

intervals for analysis is very arbitrary, and management interest sensitive gap does not protect

the value of bank assets - in particular its net worth. It requires the application of other

techniques, management gap life, which shows the total exposure to interest rate risk, taking

into account the time of all cash inflows from income assets and all cash outflows related

liabilities. The most popular means of managing interest rate risk management is interest-

sensitive gap management or duration gap management.

Literature:

1. Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services

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2. Ćurčić, Uroš N., Bankarski portfolio menadžment, FELJTON Novi Sad 2002., drugo

prošireno i prerađeno izdanje

3. Rose, S. Peter, Menadžment komercijalnih banaka, MATE Zagreb 2003.,

4. Website:

- www.cbbih.ba

- www.sie.arizona.edu/SPX/tutorial_slides/mitra_doc.pdf

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Documents

Asset & Liability Bank Management Seminar Ski