Chapter RISK MANAGEMENT FOR
CHANGING INTEREST RATES:
7 ASSET-LIABILITY
MANAGEMENT AND
DURATION TECHNIQUES
Rose, P. S., & Hudgins, S. C. (2013). Bank management and financial services.
McGraw-Hill companies.
INTRODUCTION
• A well-managed financial institution:
- Ensures harmony in decision-making processes to prevent conflicting actions.
- Aligns various management decisions to safeguard earnings and maintain the net
worth.
• Asset-liability management (ALM) - Financial service managers:
- Look at their asset and liability portfolios as an integrated whole.
- Consider how their institution's whole portfolio contributes to the firm's broad goals
of adequate profitability and acceptable risk.
ASSET AND LIABILITY MANAGEMENT
STRATEGIES
Asset Management Strategy
-Asset management view held that the amount and kinds of deposits a
depository institution held and the volume of other borrowed funds it was
able to attract were largely determined by its customers.
-Under this view, the public determined the relative amounts of deposits
and other sources of funds available to depository institutions. The key
decision area for management was not deposits and other borrowings but
assets.
-The financial manager 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.
ASSET AND LIABILITY MANAGEMENT
STRATEGIES
Liability Management Strategy
-Its goal was simply to gain control over funds sources comparable to the
control financial managers had long exercised over their assets. The key
control lever was price-the interest rate and other terms offered on
deposits and other borrowings to achieve the volume, mix, and cost
desired.
-For example, a lender faced with heavy loan demand that exceeded its
available funds could simply raise the offer rate on its borrowings relative
to its competitors, and funds would flow in.
ASSET AND LIABILITY MANAGEMENT
STRATEGIES
Funds Management Strategy
-The maturing of liability management techniques, coupled with more
volatile interest rates and greater risk, eventually gave birth to the funds
management approach, which dominates today. Objectives:
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
Forces Determining Interest Rates
- The rate of interest on any particular loan or security is ultimately
determined by the financial marketplace where suppliers of loanable funds
(credit) interact with demanders of loanable funds (credit) and the interest
rate (price of credit) tends to settle at the point where the quantities of
loanable funds demanded and supplied are equal (Exhibit 7-2).
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
Forces Determining Interest Rates
Role in the Loanable Funds Market
- Financial institutions on the supply side when granting loans
- Each institution is one of many suppliers
Dual Market Position
- Institutions act as demanders when seeking funds via deposit or non-
deposit borrowings
- Each institution is just one demander among many
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
Forces Determining Interest Rates
- Financial firms can be both suppliers and demanders simultaneously
- Unable to determine or predict interest rate levels or trends
Market Dynamics and Strategy
- Financial managers are price takers, not makers
- Must adapt to interest rate levels and trends to achieve institutional
goals
- Institutions must plan based on existing market interest rates
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
Forces Determining Interest Rates
-As market interest rates move, financial firms typically face at least two
major kinds of interest rate risk-price risk and reinvestment risk.
- Price risk arises when market interest rates rise, causing the market values of
most bonds and fixed-rate loans to fall.
- Reinvestment risk rears its head when market interest rates fall, forcing a
financial firm to invest incoming funds in lower-yielding earning assets, lowering
its expected future income.
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
The Measurement of Interest Rates
- When we use the term interest rates exactly what do we mean? How are
interest rates measured?
- One of the most popular rate measures is the yield to maturity (YTM) the
discount rate that equalizes the current market value of a loan or security
with the expected stream of future income payments that the loan or
security will generate.
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
The Components of Interest Rates
Risk premiums - Additional returns required to compensate for various
risks:
- Default risk
- Inflation risk
- Term or maturity risk
- Liquidity risk
- Call risk
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
The Components of Interest Rates
Yield Curve - The graphical representation of interest rates across
different maturities.
Implications:
- Upward Sloping: Suggests higher long-term rates, possibly indicating
economic expansion.
- Downward Sloping: May signal an impending recession.
- Horizontal: Indicates stable interest rates across maturities.
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
The Components of Interest Rates
The Maturity Gap and the Yield Curve
-Financial institutions often have a maturity gap—assets typically have
longer maturities than liabilities.
Yield curve impact on financial institutions:
-Upward Sloping: Tends to be favorable; long-term asset revenues outstrip
shorter-term liabilities.
-Downward Sloping or Horizontal: Can result in a smaller or negative net
interest margin, potentially signaling financial pressure.
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
Responses to Interest Rate Risk
Changes in market interest rates can damage a financial firm’s
profitability by increasing its cost of funds, by lowering its returns from
earning assets, and by reducing the value of the owners' investment (net
worth or equity capital).
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
💥 Impact of interest rate change on Financial Firms (e.g., Silicon Valley Bank - SVB):
1. Higher Cost of Funds:
•Customers demanded higher interest on deposits.
•Many moved their money to money market funds or Treasury securities, forcing banks to pay
more to retain deposits.
•For SVB, deposits fell rapidly, raising their funding costs.
2. Lower Returns from Existing Assets:
•SVB had invested heavily in long-term government bonds when rates were low.
•As rates rose, the market value of those bonds dropped sharply, and returns became less
competitive than new high-yield assets.
3. Reduction in Equity Value:
•The bank's assets (mainly long-term bonds) fell in value.
•Since these unrealized losses weren't hedged properly, it reduced the bank's net worth.
•When investors realized this mismatch, SVB suffered a bank run and eventually collapsed in
March 2023.
INTEREST RATE RISK: ONE OF THE GREATEST
MANAGEMENT CHALLENGES
Responses to Interest Rate Risk
Asset-Liability Committee (ALCO)
Many banks now conduct their asset-liability management strategies
under the guidance of an asset-liability committee, or ALCO. A well-run
ALCO meets regularly ( quarterly, monthly, or even more frequently) to
manage the financial firm's interest rate risk (IRR) and other risk
exposures as well. Responsibilities:
-Sets specific numerical targets, e.g., ROA of 1.5% and equity-to-assets ratio of at least
10%
-Regularly updates the board of directors on financial condition and strategies to address
weaknesses
-Outlines funding plans, quality of loans, and limits to off-balance-sheet risk exposure
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
- In dealing with interest rate risk, one important goal is to insulate
profits-net income from the damaging effects of fluctuating interest
rates.
- No matter which way interest rates go, managers of financial
institutions want stable profits that achieve the level of profitability
desired.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Impact of Interest Rate Changes:
- If borrowing costs rise faster than income from loans and securities, NIM
is squeezed.
- If loan and security income falls faster than interest expenses, NIM is also
squeezed.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Interest-Sensitive Gap Management as a Risk-Management Tool
- Among the most popular interest rate hedging strategies in use today is
interest-sensitive gap management.
- Management performs an analysis of the maturities and repricing
opportunities associated with interest-bearing assets and with interest-
bearing liabilities.
- The goal is to align the volume of assets and liabilities that can be
repriced with changes in interest rates.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Interest-Sensitive Gap Management as a Risk-Management Tool
-Repriceable assets include loans that are about to mature or will soon to
come up for renewal or repricing, such as variable-rate business and
household loans (including credit card accounts and adjustable-rate home
mortgages (ARMs)).
-Repriceable liabilities include a depository institution's certificates of
deposit (CDs) about to mature or eligible to be renewed, where the
financial firm and its customer must negotiate new deposit interest rates
that capture current market conditions.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Positive Gap: Beneficial if interest rates rise.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Negative Gap: Beneficial if interest rates fall.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
- Actually, there are several ways to measure the interest-sensitive gap
(IS GAP).
- One method is called simply the Dollar IS GAP. For example, if interest-
sensitive assets (ISA) are $150 million and interest-sensitive liabilities
(ISL) are $200 million, then the Dollar IS GAP= ISA - ISL= $150 million
- $200 million= -$50 million.
- Clearly, an institution whose Dollar IS GAP is positive is asset sensitive,
while a negative Dollar IS GAP describes a liability-sensitive condition.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Interest-Sensitive Gap Management as a Risk-Management Tool
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Interest-Sensitive Gap Management as a Risk-Management Tool
Computer-Based Techniques
-Many institutions use computer-based techniques in which their assets
and liabilities are classified as due or repriceable today, during the coming
week, in the next 30 days, and so on.
-Management tries to match interest-sensitive assets with interest-
sensitive liabilities in each of these maturity buckets in order to improve
the chances of achieving the financial firm's earnings goals.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Interest-Sensitive Gap Management as a Risk-Management Tool
Computer-Based Techniques
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Problems with Interest-Sensitive GAP Management
- While interest-sensitive gap management works beautifully in theory,
practical problems in its implementation always leave financial
institutions with at least some interest-rate risk exposure.
- Changes in interest rates attached to assets and liabilities do not
necessarily move at the same speed as do interest rates in the open
market (e.g, deposit interest rates typically lag behind loan interest
rates).
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Problems with Interest-Sensitive GAP Management
- A weighted interest-sensitive gap approach takes into account the
tendency of interest rates to vary in speed and magnitude relative to
each other and with the up and down cycle of business activity.
- The interest rates attached to assets of various kinds often change by
different amounts and at different speeds than many of the interest
rates attached to liabilities - a phenomenon called basis risk.
ONE OF THE GOALS OF INTEREST RATE HEDGING:
PROTECT THE NET INTEREST MARGIN
Problems with Interest-Sensitive GAP Management
- Interest-sensitive gap management does not consider the impact of
changing interest rates on the owners' (stockholders') position in the
financial firm as represented by the institution's net worth.
- Effective asset-liability management demands that financial managers
work to achieve desirable levels of both net interest income and net
worth.
THE CONCEPT OF DURATION AS A RISK~ MANAGEMENT
TOOL
- Changing interest rates can also do serious damage to another aspect of
a financial firm's performance-its net worth, the value of the
stockholders' investment in the institution.
- This requires the application of yet another managerial tool - duration
gap management.
- Duration is a value - and time-weighted measure of maturity that
considers the timing of all cash inflows from earning assets and all cash
outflows associated with liabilities.
- This weighted average time helps investors understand how long it will
take, on an average and present-value-adjusted basis, to recoup their
investment in the bond, providing a more nuanced view of the bond's
interest rate risk than just looking at its maturity date.
THE CONCEPT OF DURATION AS A RISK~ MANAGEMENT
TOOL
THE CONCEPT OF DURATION AS A RISK~ MANAGEMENT
TOOL
THE CONCEPT OF DURATION AS A RISK~ MANAGEMENT
TOOL
THE CONCEPT OF DURATION AS A RISK~ MANAGEMENT
TOOL
- A financial firm with longer-duration assets than liabilities will suffer a
greater decline in net worth when market interest rates rise than a
financial institution whose asset duration is relatively short term or
one that matches the duration of its liabilities with the duration of its
assets.
THE CONCEPT OF DURATION AS A RISK~ MANAGEMENT
TOOL
Price Sensitivity to Changes in Interest Rates and Duration
THE CONCEPT OF DURATION AS A RISK~ MANAGEMENT
TOOL
- For example, consider a bond held by a savings institution that carries
a duration of four years and a current market value (price) of $1,000.
Market interest rates attached to comparable bonds are about 10
percent currently, but recent forecasts suggest that market rates may
rise to 11 percent. If this forecast turns out to be correct, what
percentage change will occur in the bond’s market value? The answer
is:
