Bank Interest Rate Risk Measures, Gap and Duration.pptx

Bank Interest Rate Risk Measure
Lecture by; Dr. Lord Mensah

Objectives
• Discuss Monetary policy and why it serves as
key determinant of interest rate
• Analyze the simpler method use to measure
banks interest rate risk
– The repricing model or the funding gap
• The impact of interest rate changes on the Net
Interest Income (NII) of banks
• Identify the weakness of the repricing model
3/1/2024 Dr. Lord Mensah 2

The level and movement of interest rate
• Commonly used model to explain interest
rates and interest rate movements is the
loanable funds theory
• The loanable funds theory of interest rate
determination
– views the level of interest rates in financial
markets as resulting from factors that affect the
supply and demand for loanable funds.

Determinant of equilibrium rate

Determinant of equilibrium rate conti.
• The aggregate quantity of funds supplied is
positively related to interest
• Aggregate quantity of funds demanded is
inversely related to interest rates
• The equilibrium interest rate point E is only a
temporary equilibrium
• Changes in underlying factors that determine the
demand and supply of loanable funds can cause
– continuous shifts in the supply and/or demand curve
for loanable funds.

Monetary policy
• Market forces will react to the resulting disequilibrium with
a change in the equilibrium interest rate and quantity of
funds traded in that market
• Central bank’s monetary policy strategy most directly
underlies the level and movement of interest rates that
– in turn, affect Bank cost of funds and return on assets
• The central bank through its open market operations, such
as buying and selling Treasury bonds and Treasury bills,
– the Bank seeks to influence the money supply, inflation, and the
level of interest rates
• particularly short-term interest rates
• The changing interest rates impact economic decisions,
– such as whether to consume or save

Dynamics of T-bills rate Ghana
0
5
10
15
20
25
30
35
40
45
Jan-98
Jun-98
Nov-98
Apr-99
Sep-99
Feb-00
Jul-00
Dec-00
May-01
Oct-01
Mar-02
Aug-02
Jan-03
Jun-03
Nov-03
Apr-04
Sep-04
Feb-05
Jul-05
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May-06
Oct-06
Mar-07
Aug-07
Jan-08
Jun-08
Nov-08
Apr-09
Sep-09
Feb-10
Jul-10
Dec-10
Tbills
Inflation

Market Integration
• The increased level of financial market
integration over the last decade has also affected
interest rates
• Financial market integration increases the speed
with which interest rate changes and associated
volatility are transmitted among countries
• Measurement and management of interest rate
risk, a prominent concern facing many Bank
managers

The Repricing Model
• The repricing, or funding gap model is a simple
model used by small (thus mostly) Banks
• This model is essentially a book value accounting
cash flow analysis
• Repricing gap: difference between the interest
income earned on an FI’s Assets and the interest
expense paid on its Liabilities (or its net interest
income) over a particular period of time.

The Repricing Model conti.
• A bank reports the gaps in each maturity
bucket by calculating
– the rate sensitivity of each asset (RSA)
– the rate sensitivity of each liability (RSL) on its
balance sheet
• Rate sensitivity here means that the asset or
liability is repriced at or near current market
interest rates within a certain time horizon (or
maturity bucket)

The Maturity Buckets
• One day.
• More than one day to three months.
• More than three months to six months.
• More than six months to twelve months.
• More than one year to five years.
• More than five years

Pricing Gap ( Millions of Dollars)

Issues from the Table
• A negative gap (RSA < RSL), exposes the Bank
to refinancing risk
– rise in the short-term rates would lower the
Bank’s net interest income
– assuming equal changes in interest rates on RSAs
and RSLs
• interest expense will increase by more than interest
revenue

Issues from the Table conti.
• A positive gap (RSA > RSL) exposes the bank
to reinvestment risk
– a drop in rates over this period would lower the
Bank’s net interest income
– interest income will decrease by more than
interest expense

Formula representation

Example
• In the first bucket, if the gap is negative $10
million and short-term interest rates rise is 1
percent, the annualized change in the Bank’s
future net interest income is:
• That is, the negative gap and associated
refinancing risk resulted in a loss of $100,000
in net interest income for the Bank

Cumulative GAP
• The manager can also estimate cumulative
gaps (CGAPs) over various repricing categories
or buckets
• Example from the previous table, estimate
common cumulative gap of interest for the
one-year repricing gap

Identify rate Sensitive Assets and Liabilities

Rate Sensitive Assets
• Short-term consumer loans: $50 million. These
are repriced at the end of the year and just make
the one-year cutoff.
• Three-month T-bills: $30 million. These are
repriced on maturity (rollover) every three
months.
• Six-month T-notes: $35 million. These are
repriced on maturity (rollover) every six months
• 30-year floating-rate mortgages: $40 million.
These are repriced (i.e., the mortgage rate is
reset) every nine months

Rate Sensitive Liabilities
• Three-month CDs: $40 million. These mature in
three months and are repriced on rollover.
• Three-month bankers acceptances: $20 million.
These also mature in three months and are
repriced on rollover.
• Six-month commercial paper: $60 million. These
mature and are repriced every six months.
• One-year time deposits: $20 million. These get
repriced right at the end of the one year gap
horizon.

From Above:
• The four repriced liabilities ($40 + $20 + $60 +
$20) sum to $140 million, and the
• Four repriced assets ($50 + $30 + $35 + $40)
sum to $155 million.
• Cumulative one-year repricing gap (CGAP) for
the bank is:

• Often banks express interest rate sensitivity as a
percentage of assets ( A )
– typically called the gap ratio
• Expressing the repricing gap in this way is useful
since it tells us
– the direction of the interest rate exposure (positive or
negative CGAP)
– the scale of that exposure as indicated by dividing the
gap by the asset size of the Bank

Summary of Expressions
• Assume equal change in interest rate at both
sides of the BS
• FI
NB: Bank would want its CGAP to be negative when
interest rates are expected to fall.
– these relationships are referred to as CGAP effects.

Unequal changes in interest rates
• The assumption of the equal interest rate
change on assets and liabilities are not real
• Rate changes on RSAs generally differ from
those on RSLs
• As we consider the impact of rate changes on
NII
– we have a spread effect in addition to the CGAP
effects

Example
• Assume for a moment that RSAs equal RSLs
equal $155 million. Suppose that rates rise by
1.2 percent on RSAs and by 1 percent on RSLs
• The resulting change in NII is calculated as:

• In general, the spread effect is such that,
regardless of the direction of the change in
interest rates,
– a positive relation occurs between changes in the
spread (between rates on RSAs and RSLs) and
changes in NII.
– Whenever the spread increases (decreases), NII
increases (decreases).

Summary

Weakness of Repricing Model
• It ignores market value effects of interest rate
changes
• It is over aggregative
• It fails to deal with the problem of rate-
insensitive asset and liability runoffs and
prepayments
• It ignores cash flows from off balance-sheet
activities.

Bank Interest Rate Risk Measures, Gap and Duration.pptx

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Bank Interest Rate Risk Measures, Gap and Duration.pptx