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Financial Institutions
10871412
Dr. Muath Asmar
AN-NAJAH
NATIONAL UNIVERSITY
Faculty of Economics and
Social Sciences
Department of Finance
Financial Markets and Institutions
Ninth Edition, Global Edition
Part 7 The Management of
Financial Institutions
Chapter 23
Risk Management in
Financial Institutions
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Chapter Preview (1 of 2)
• Managing financial institutions is not easy. Uncertainty in
the economic environment has increased, making the job
of the financial institution manager that much harder. In
this chapter, we examine how financial institutions manage
credit risk, default risk, etc.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Chapter Preview (2 of 2)
• Topics include:
– Managing Credit Risk
– Managing Interest-Rate Risk
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (1 of 9)
• The business of financial institutions is making loans.
• The risk with loans is the borrower will not repay.
• Credit risk is the risk that a borrower will not repay a loan
according to the terms of the loan, either defaulting entirely
or making late payments of interest or principal.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (2 of 9)
Once again, the concepts of adverse selection and moral
hazard will provide our framework to understand the
principles financial managers must follow.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (3 of 9)
• Adverse selection: Those with the highest credit risk have
the biggest incentives to borrow from others.
• Moral hazard: Once a borrower has a loan, she has an
incentive to engage in risky projects to produce the highest
payoffs.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (4 of 9)
• Solving Asymmetric Information Problems: financial
managers have a number of tools available to assist in
reducing or eliminating the asymmetric information
problem
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Risk (1 of 2)
1. Screening and Monitoring
 Collecting reliable information about prospective
borrowers. This has also lead some institutions to
specialize in regions or industries, gaining expertise in
evaluating particular firms or individuals.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Risk (2 of 2)
2. Screening and Monitoring
– Also involves requiring certain actions, or prohibiting
others, and then periodically verifying that the borrower
is complying with the terms of the loan contact.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (5 of 9)
• Specialization in Lending helps in screening. It is easier
to collect data on local firms and firms in specific
industries. It allows them to better predict problems by
having better industry and location knowledge.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (6 of 9)
• Monitoring and Enforcement also helps. Financial
institutions write protective covenants into loans contracts
and actively manage them to ensure that borrowers are
not taking risks at their expense.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (7 of 9)
Long-term Customer Relationships: past information
contained in checking accounts, savings accounts, and
previous loans provides valuable information to more easily
determine credit worthiness.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (8 of 9)
3. Loan Commitments: arrangements where the bank
agrees to provide a loan up to a fixed amount, whenever
the firm requests the loan.
4. Collateral: a pledge of property or other assets that must
be surrendered if the terms of the loan are not met ( the
loans are called secured loans).
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Credit Risk (9 of 9)
5. Compensating Balances: reserves that a borrower must
maintain in an account that act as collateral should the
borrower default.
6. Credit Rationing: (1) lenders will refuse to lend to some
borrowers, regardless of how much interest they are
willing to pay, or (2) lenders will only finance part of a
project, requiring that the remaining part come from
equity financing.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Interest-Rate Risk (1 of 2)
• Financial institutions, banks in particular, specialize in
earning a higher rate of return on their assets relative to
the interest paid on their liabilities.
• As interest rate volatility increased in the last 20 years,
interest-rate risk exposure has become a concern for
financial institutions.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Interest-Rate Risk (2 of 2)
• To see how financial institutions can measure and manage
interest-rate risk exposure, we will examine the balance
sheet for First National Bank (next slide).
• We will develop two tools, (1) Income Gap Analysis and (2)
Duration Gap Analysis, to assist the financial manager in
this effort.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Balance Sheet for First National Bank
(1 of 2)
First National Bank
Assets Blank Blank Liabilities Blank
Reserves and cash items $5 million Blank Checkable deposits $15 million
Securities Blank Blank Money market Blank
Less than 1 year $5 million Blank deposit accounts $5 million
1 to 2 years $5 million Blank Savings deposits $15 million
Greater than 2 years $10 million Blank CDs Blank
Residential mortgages Blank Blank Variable rate $10 million
Variable rate $10 million Blank Less than 1 year $15 million
Fixed rate (30-year) $10 million Blank 1 to 2 years $5 million
Blank Blank Blank Greater than 2 years $5 million
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Balance Sheet for First National Bank
(2 of 2)
First National Bank
Assets Blank Blank Liabilities Blank
Commercial loans Blank Blank Fed funds $5 million
Less than 1 year $15 million Blank Blank Blank
1 to 2 years $10 million Blank Borrowings Blank
Greater than 2 years $25 million Blank Less than 1 year $10 million
Physical capital $5 million Blank 1 to 2 years $5 million
Blank Blank Blank Greater than 2 years $5 million
Blank Blank Blank Bank capital $5 million
Blank Blank Blank Blank Blank
Total $100 million Blank Total
$100
million
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Income Gap Analysis (1 of 2)
• Income Gap Analysis: measures the sensitivity of a bank’s
current year net income to changes in interest rate.
• Requires determining which assets and liabilities will have
their interest rate change as market interest rates change.
Let’s see how that works for First National Bank.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Income Gap Analysis: Determining Rate Sensitive Items
for First National Bank (1 of 2)
Assets
– assets with maturity less
than one year
– variable-rate mortgages
– short-term commercial loans
– portion of fixed-rate
mortgages (say 20%)
Liabilities
– money market deposits
– variable-rate CDs
– short-term CDs
– federal funds
– short-term borrowings
– portion of checkable
deposits (10%)
– portion of savings (20%)
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Income Gap Analysis: Determining Rate Sensitive Items
for First National Bank (2 of 2)
Rate-Sensitive Assets = $5m + $ 10m + $15m + 20% 
$20m
RSA = $32m
Rate-Sensitive Liabs = $5m + $25m + $5m + $10m +
10%  $15m
+ 20%  $15m
RSL = $49.5m
if i ↑ 5% 
Asset Income = +5%  $32.0m = +$ 1.6m
Liability Costs = +5%  $49.5m = +$ 2.5m
Income = $1.6m − $ 2.5 = −$ 0.9m
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Income Gap Analysis (2 of 2)
If RSL > RSA, i ↑ results in: NIM ↓, Income ↓
GAP = RSA − RSL
= $32.0m −$49.5m = −$17.5m
Income = GAP  i
= −$17.5m  5% = −$0.9m
This is essentially a short-term focus on interest-rate risk
exposure. A longer-term focus uses duration gap analysis.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (1 of 8)
• Owners and managers care about: interest rate exposure
on income, and the impact of interest rate changes on the
balance sheet / net worth.
• The concept of duration, which first appeared in chapter 3,
plays a role here.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (2 of 8)
• Duration Gap Analysis: measures the sensitivity of a
bank’s current year net income to changes in interest rate.
• Requires determining the duration for assets and liabilities,
items whose market value will change as interest rates
change. Let’s see how this looks for First National Bank.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Table 23.1 Duration of the First National Bank’s Assets and
Liabilities (1 of 4)
Blank
Amount
($ millions)
Duration
(years)
Weighted Duration
(years)
Assets Blank Blank Blank
Reserves and cash items 5 0.0 0.00
Securities Blank Blank Blank
Less than 1 year 5 0.4 0.02
1 to 2 years 5 1.6 0.08
Greater than 2 years 10 7.0 0.70
Residential mortgages Blank Blank Blank
Variable rate 10 0.5 0.05
Fixed rate (30-year) 10 6.0 0.60
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Table 23.1 Duration of the First National Bank’s Assets and
Liabilities (2 of 4)
Blank
Amount
($ millions)
Duration
(years)
Weighted Duration
(years)
Commercial loans Blank Blank Blank
Less than 1 year 15 0.7 0.11
1 to 2 years 10 1.4 0.14
Greater than 2 years 25 4.0 1.00
Physical capital 5 0.0 0.00
Average duration Blank Blank 2.70
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Table 23.1 Duration of the First National Bank’s Assets and
Liabilities (3 of 4)
Blank
Amount
($ millions)
Duration
(years)
Weighted Duration
(years)
Liabilities Blank Blank Blank
Checkable deposits 15 2.0 0.32
Money market deposit
accounts 5 0.1 0.01
Savings deposits 15 1.0 0.16
CDs Blank Blank Blank
Variable rate 10 0.5 0.05
Less than 1 year 15 0.2 0.03
1 to 2 years 5 1.2 0.06
Greater than 2 years 5 2.7 0.14
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Table 23.1 Duration of the First National Bank’s Assets and
Liabilities (4 of 4)
Blank
Amount
($ millions)
Duration
(years)
Weighted Duration
(years)
Fed funds 5 0.0 0.00
Borrowings Blank Blank Blank
Less than 1 year 10 0.3 0.03
1 to 2 years 5 1.3 0.07
Greater than 2 years 5 3.1 0.16
Average duration Blank Blank 1.03
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (3 of 8)
• The basic equation for determining the change in market
value for assets or liabilities is:
Value Change = − DUR × [Δi/(1+i)] × Original Value
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (4 of 8)
• Consider a change in rates from 10% to 11%. Using the
value from Table 23.1, we see:
• % Change in Asset Value: −2.7 × (0.01/1.01) = −2.5%
• % Change in Liability Value: −1.03 × (0.01/1.01) = −0.9%
• % Change in Net Worth: −2.5% − (−0.9%) = −1.6%
– Or a loss of $1.6 million
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (5 of 8)
• For a rate change from 10% to 11%, the net worth of First
National Bank will fall, changing by −$1.6m.
• Recall from the balance sheet that First National Bank has
“Bank capital” totaling $5m. Following such a dramatic
change in rate, the capital would fall to $3.4m.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (6 of 8)
• For First National Bank, with a rate change from 10% to
11%, these equations are:
DURgap = DURa − (L/A × DURl)
% Change in Net Worth = −DURgap × Δi / (1+i)
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (7 of 8)
• Another version of this analysis, which combines the steps
into two equations, is:
DURgap = DURa − (L/A × DURl)
= 2.7 − (95/100 × 1.03) = 1.72
% Change in Net Worth = −DURgap × Δi / (1+i)
= −1.72 × 0.01 / 1.01 = −1.6%
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis (8 of 8)
• The same analysis can be applied to other financial
institutions. For example, let’s look at a simple finance
company which makes consumer loans. The balance
sheet and duration worksheet for Friendly Finance Co.
follows.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Balance Sheet for Friendly Finance
Company (1 of 2)
Friendly Finance Company
Assets Blank Blank Liabilities Blank
Cash and deposits $3 million Blank Commercial paper
$40
million
Securities Blank Bank loans Blank
Less than 1 year $5 million Blank Less than 1 year $3 million
1 to 2 years $1 million Blank 1 to 2 years $2 million
Greater than 2 years $1 million Blank Greater than 2 years $5 million
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Balance Sheet for Friendly Finance
Company (2 of 2)
Friendly Finance Company
Assets Blank Blank Liabilities Blank
Consumer loans
Blank
Blank
Long-term bonds and
other long-term debt $40 million
Less than 1 year $50 million Blank Blank Blank
1 to 2 years $20 million Blank Capital $10 million
Greater than 2 years $15 million Blank Blank Blank
Physical capital $5 million Blank Blank Blank
Total $100 million Blank Total $100 million
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Table 23.2 Duration of the Friendly Finance Company’s
Assets and Liabilities (1 of 3)
Blank
Amount
($ millions)
Duration
(years)
Weighted Duration
(years)
Assets Blank Blank Blank
Cash and deposits 3 0 0
Securities Blank Blank Blank
Less than 1 year 5 0.5 0.03
1 to 2 years 1 1.7 0.02
Greater than 2 years 1 9 0.09
Consumer loans Blank Blank Blank
Less than 1 year 50 0.5 0.25
1 to 2 years 20 1.5 0.3
Greater than 2 years 15 3 0.45
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Table 23.2 Duration of the Friendly Finance Company’s
Assets and Liabilities (2 of 3)
Blank
Amount
($ millions)
Duration
(years)
Weighted
Duration (years)
Physical capital 5 0 0
Average duration Blank Blank 1.14
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Table 23.2 Duration of the Friendly Finance Company’s
Assets and Liabilities (3 of 3)
Blank
Amount
($ millions)
Duration
(years)
Weighted
Duration (years)
Liabilities Blank Blank Blank
Commercial paper 40 0.2 0.09
Bank loans Blank Blank Blank
Less than 1 year 3 0.3 0.01
1 to 2 years 2 1.6 0.04
Greater than 2 years 5 3.5 0.19
Long-term bonds and
other long term debt 40 5.5 2.44
Average duration Blank Blank 2.77
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Income Gap Analysis: Determining Rate
Sensitive Items for Friendly Finance Co.
Assets
– securities with a
maturity less than one
year
– consumer loans with a
maturity less than one
year
Liabilities
– commercial paper
– bank loans with a
maturity less than one
year
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Income Gap Analysis
• If rates increase 1%
GAP = RSA − RSL = $55m − $43m = $12 million
Change in Income = GAP × Δi = $12,000,000 × 1%
= $120,000
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Duration Gap Analysis
• If rates increase 1%
DURgap = DURa − (L/A × DURl)
= 1.16 − (90/100 × 2.77) = −1.33
% Change in Net Worth = −DURgap × Δi / (1+i)
= −(−1.33) × 0.01 / 1.01 = 1.2%
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Interest-Rate Risk (1 of 2)
• Problems with GAP Analysis
– Assumes slope of yield curve unchanged and flat
– Manager estimates % of fixed rate assets and liabilities
that are rate sensitive
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Managing Interest-Rate Risk (2 of 2)
• Strategies for Managing Interest-Rate Risk
– In example above, shorten duration of bank assets or
lengthen duration of bank liabilities
– To completely immunize net worth from interest-rate
risk, set DURgap = 0
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Chapter Summary
• Managing Credit Risk: basic techniques for managing
relationships and rationing credit were reviewed.
• Managing Interest-Rate Risk: the essential techniques of
measuring interest-rate risk for both income and capital
affects were presented.

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Chapter 23

  • 1. Financial Institutions 10871412 Dr. Muath Asmar AN-NAJAH NATIONAL UNIVERSITY Faculty of Economics and Social Sciences Department of Finance
  • 2. Financial Markets and Institutions Ninth Edition, Global Edition Part 7 The Management of Financial Institutions Chapter 23 Risk Management in Financial Institutions Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
  • 3. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Chapter Preview (1 of 2) • Managing financial institutions is not easy. Uncertainty in the economic environment has increased, making the job of the financial institution manager that much harder. In this chapter, we examine how financial institutions manage credit risk, default risk, etc.
  • 4. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Chapter Preview (2 of 2) • Topics include: – Managing Credit Risk – Managing Interest-Rate Risk
  • 5. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (1 of 9) • The business of financial institutions is making loans. • The risk with loans is the borrower will not repay. • Credit risk is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal.
  • 6. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (2 of 9) Once again, the concepts of adverse selection and moral hazard will provide our framework to understand the principles financial managers must follow.
  • 7. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (3 of 9) • Adverse selection: Those with the highest credit risk have the biggest incentives to borrow from others. • Moral hazard: Once a borrower has a loan, she has an incentive to engage in risky projects to produce the highest payoffs.
  • 8. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (4 of 9) • Solving Asymmetric Information Problems: financial managers have a number of tools available to assist in reducing or eliminating the asymmetric information problem
  • 9. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Risk (1 of 2) 1. Screening and Monitoring  Collecting reliable information about prospective borrowers. This has also lead some institutions to specialize in regions or industries, gaining expertise in evaluating particular firms or individuals.
  • 10. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Risk (2 of 2) 2. Screening and Monitoring – Also involves requiring certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact.
  • 11. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (5 of 9) • Specialization in Lending helps in screening. It is easier to collect data on local firms and firms in specific industries. It allows them to better predict problems by having better industry and location knowledge.
  • 12. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (6 of 9) • Monitoring and Enforcement also helps. Financial institutions write protective covenants into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense.
  • 13. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (7 of 9) Long-term Customer Relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness.
  • 14. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (8 of 9) 3. Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan. 4. Collateral: a pledge of property or other assets that must be surrendered if the terms of the loan are not met ( the loans are called secured loans).
  • 15. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Credit Risk (9 of 9) 5. Compensating Balances: reserves that a borrower must maintain in an account that act as collateral should the borrower default. 6. Credit Rationing: (1) lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or (2) lenders will only finance part of a project, requiring that the remaining part come from equity financing.
  • 16. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Interest-Rate Risk (1 of 2) • Financial institutions, banks in particular, specialize in earning a higher rate of return on their assets relative to the interest paid on their liabilities. • As interest rate volatility increased in the last 20 years, interest-rate risk exposure has become a concern for financial institutions.
  • 17. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Interest-Rate Risk (2 of 2) • To see how financial institutions can measure and manage interest-rate risk exposure, we will examine the balance sheet for First National Bank (next slide). • We will develop two tools, (1) Income Gap Analysis and (2) Duration Gap Analysis, to assist the financial manager in this effort.
  • 18. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Balance Sheet for First National Bank (1 of 2) First National Bank Assets Blank Blank Liabilities Blank Reserves and cash items $5 million Blank Checkable deposits $15 million Securities Blank Blank Money market Blank Less than 1 year $5 million Blank deposit accounts $5 million 1 to 2 years $5 million Blank Savings deposits $15 million Greater than 2 years $10 million Blank CDs Blank Residential mortgages Blank Blank Variable rate $10 million Variable rate $10 million Blank Less than 1 year $15 million Fixed rate (30-year) $10 million Blank 1 to 2 years $5 million Blank Blank Blank Greater than 2 years $5 million
  • 19. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Balance Sheet for First National Bank (2 of 2) First National Bank Assets Blank Blank Liabilities Blank Commercial loans Blank Blank Fed funds $5 million Less than 1 year $15 million Blank Blank Blank 1 to 2 years $10 million Blank Borrowings Blank Greater than 2 years $25 million Blank Less than 1 year $10 million Physical capital $5 million Blank 1 to 2 years $5 million Blank Blank Blank Greater than 2 years $5 million Blank Blank Blank Bank capital $5 million Blank Blank Blank Blank Blank Total $100 million Blank Total $100 million
  • 20. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Income Gap Analysis (1 of 2) • Income Gap Analysis: measures the sensitivity of a bank’s current year net income to changes in interest rate. • Requires determining which assets and liabilities will have their interest rate change as market interest rates change. Let’s see how that works for First National Bank.
  • 21. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Income Gap Analysis: Determining Rate Sensitive Items for First National Bank (1 of 2) Assets – assets with maturity less than one year – variable-rate mortgages – short-term commercial loans – portion of fixed-rate mortgages (say 20%) Liabilities – money market deposits – variable-rate CDs – short-term CDs – federal funds – short-term borrowings – portion of checkable deposits (10%) – portion of savings (20%)
  • 22. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Income Gap Analysis: Determining Rate Sensitive Items for First National Bank (2 of 2) Rate-Sensitive Assets = $5m + $ 10m + $15m + 20%  $20m RSA = $32m Rate-Sensitive Liabs = $5m + $25m + $5m + $10m + 10%  $15m + 20%  $15m RSL = $49.5m if i ↑ 5%  Asset Income = +5%  $32.0m = +$ 1.6m Liability Costs = +5%  $49.5m = +$ 2.5m Income = $1.6m − $ 2.5 = −$ 0.9m
  • 23. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Income Gap Analysis (2 of 2) If RSL > RSA, i ↑ results in: NIM ↓, Income ↓ GAP = RSA − RSL = $32.0m −$49.5m = −$17.5m Income = GAP  i = −$17.5m  5% = −$0.9m This is essentially a short-term focus on interest-rate risk exposure. A longer-term focus uses duration gap analysis.
  • 24. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (1 of 8) • Owners and managers care about: interest rate exposure on income, and the impact of interest rate changes on the balance sheet / net worth. • The concept of duration, which first appeared in chapter 3, plays a role here.
  • 25. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (2 of 8) • Duration Gap Analysis: measures the sensitivity of a bank’s current year net income to changes in interest rate. • Requires determining the duration for assets and liabilities, items whose market value will change as interest rates change. Let’s see how this looks for First National Bank.
  • 26. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Table 23.1 Duration of the First National Bank’s Assets and Liabilities (1 of 4) Blank Amount ($ millions) Duration (years) Weighted Duration (years) Assets Blank Blank Blank Reserves and cash items 5 0.0 0.00 Securities Blank Blank Blank Less than 1 year 5 0.4 0.02 1 to 2 years 5 1.6 0.08 Greater than 2 years 10 7.0 0.70 Residential mortgages Blank Blank Blank Variable rate 10 0.5 0.05 Fixed rate (30-year) 10 6.0 0.60
  • 27. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Table 23.1 Duration of the First National Bank’s Assets and Liabilities (2 of 4) Blank Amount ($ millions) Duration (years) Weighted Duration (years) Commercial loans Blank Blank Blank Less than 1 year 15 0.7 0.11 1 to 2 years 10 1.4 0.14 Greater than 2 years 25 4.0 1.00 Physical capital 5 0.0 0.00 Average duration Blank Blank 2.70
  • 28. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Table 23.1 Duration of the First National Bank’s Assets and Liabilities (3 of 4) Blank Amount ($ millions) Duration (years) Weighted Duration (years) Liabilities Blank Blank Blank Checkable deposits 15 2.0 0.32 Money market deposit accounts 5 0.1 0.01 Savings deposits 15 1.0 0.16 CDs Blank Blank Blank Variable rate 10 0.5 0.05 Less than 1 year 15 0.2 0.03 1 to 2 years 5 1.2 0.06 Greater than 2 years 5 2.7 0.14
  • 29. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Table 23.1 Duration of the First National Bank’s Assets and Liabilities (4 of 4) Blank Amount ($ millions) Duration (years) Weighted Duration (years) Fed funds 5 0.0 0.00 Borrowings Blank Blank Blank Less than 1 year 10 0.3 0.03 1 to 2 years 5 1.3 0.07 Greater than 2 years 5 3.1 0.16 Average duration Blank Blank 1.03
  • 30. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (3 of 8) • The basic equation for determining the change in market value for assets or liabilities is: Value Change = − DUR × [Δi/(1+i)] × Original Value
  • 31. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (4 of 8) • Consider a change in rates from 10% to 11%. Using the value from Table 23.1, we see: • % Change in Asset Value: −2.7 × (0.01/1.01) = −2.5% • % Change in Liability Value: −1.03 × (0.01/1.01) = −0.9% • % Change in Net Worth: −2.5% − (−0.9%) = −1.6% – Or a loss of $1.6 million
  • 32. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (5 of 8) • For a rate change from 10% to 11%, the net worth of First National Bank will fall, changing by −$1.6m. • Recall from the balance sheet that First National Bank has “Bank capital” totaling $5m. Following such a dramatic change in rate, the capital would fall to $3.4m.
  • 33. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (6 of 8) • For First National Bank, with a rate change from 10% to 11%, these equations are: DURgap = DURa − (L/A × DURl) % Change in Net Worth = −DURgap × Δi / (1+i)
  • 34. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (7 of 8) • Another version of this analysis, which combines the steps into two equations, is: DURgap = DURa − (L/A × DURl) = 2.7 − (95/100 × 1.03) = 1.72 % Change in Net Worth = −DURgap × Δi / (1+i) = −1.72 × 0.01 / 1.01 = −1.6%
  • 35. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis (8 of 8) • The same analysis can be applied to other financial institutions. For example, let’s look at a simple finance company which makes consumer loans. The balance sheet and duration worksheet for Friendly Finance Co. follows.
  • 36. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Balance Sheet for Friendly Finance Company (1 of 2) Friendly Finance Company Assets Blank Blank Liabilities Blank Cash and deposits $3 million Blank Commercial paper $40 million Securities Blank Bank loans Blank Less than 1 year $5 million Blank Less than 1 year $3 million 1 to 2 years $1 million Blank 1 to 2 years $2 million Greater than 2 years $1 million Blank Greater than 2 years $5 million
  • 37. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Balance Sheet for Friendly Finance Company (2 of 2) Friendly Finance Company Assets Blank Blank Liabilities Blank Consumer loans Blank Blank Long-term bonds and other long-term debt $40 million Less than 1 year $50 million Blank Blank Blank 1 to 2 years $20 million Blank Capital $10 million Greater than 2 years $15 million Blank Blank Blank Physical capital $5 million Blank Blank Blank Total $100 million Blank Total $100 million
  • 38. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Table 23.2 Duration of the Friendly Finance Company’s Assets and Liabilities (1 of 3) Blank Amount ($ millions) Duration (years) Weighted Duration (years) Assets Blank Blank Blank Cash and deposits 3 0 0 Securities Blank Blank Blank Less than 1 year 5 0.5 0.03 1 to 2 years 1 1.7 0.02 Greater than 2 years 1 9 0.09 Consumer loans Blank Blank Blank Less than 1 year 50 0.5 0.25 1 to 2 years 20 1.5 0.3 Greater than 2 years 15 3 0.45
  • 39. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Table 23.2 Duration of the Friendly Finance Company’s Assets and Liabilities (2 of 3) Blank Amount ($ millions) Duration (years) Weighted Duration (years) Physical capital 5 0 0 Average duration Blank Blank 1.14
  • 40. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Table 23.2 Duration of the Friendly Finance Company’s Assets and Liabilities (3 of 3) Blank Amount ($ millions) Duration (years) Weighted Duration (years) Liabilities Blank Blank Blank Commercial paper 40 0.2 0.09 Bank loans Blank Blank Blank Less than 1 year 3 0.3 0.01 1 to 2 years 2 1.6 0.04 Greater than 2 years 5 3.5 0.19 Long-term bonds and other long term debt 40 5.5 2.44 Average duration Blank Blank 2.77
  • 41. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Income Gap Analysis: Determining Rate Sensitive Items for Friendly Finance Co. Assets – securities with a maturity less than one year – consumer loans with a maturity less than one year Liabilities – commercial paper – bank loans with a maturity less than one year
  • 42. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Income Gap Analysis • If rates increase 1% GAP = RSA − RSL = $55m − $43m = $12 million Change in Income = GAP × Δi = $12,000,000 × 1% = $120,000
  • 43. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Duration Gap Analysis • If rates increase 1% DURgap = DURa − (L/A × DURl) = 1.16 − (90/100 × 2.77) = −1.33 % Change in Net Worth = −DURgap × Δi / (1+i) = −(−1.33) × 0.01 / 1.01 = 1.2%
  • 44. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Interest-Rate Risk (1 of 2) • Problems with GAP Analysis – Assumes slope of yield curve unchanged and flat – Manager estimates % of fixed rate assets and liabilities that are rate sensitive
  • 45. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Managing Interest-Rate Risk (2 of 2) • Strategies for Managing Interest-Rate Risk – In example above, shorten duration of bank assets or lengthen duration of bank liabilities – To completely immunize net worth from interest-rate risk, set DURgap = 0
  • 46. Copyright © 2018 Pearson Education, Ltd. All Rights Reserved. Chapter Summary • Managing Credit Risk: basic techniques for managing relationships and rationing credit were reviewed. • Managing Interest-Rate Risk: the essential techniques of measuring interest-rate risk for both income and capital affects were presented.

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