Post on 28-Nov-2014
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 .
6 Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services, 201, Chapter 6, Part two
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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
8 Rose, S. Peter & Hudgins, C. Sylvia, Bank Management & Financial Services, 203, Chapter 6, Part two
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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:
17
Interest-sensitive gap
=
Interest-sensitive assets – Interest-sensitive liabilities
> 0
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Interest-sensitive gap (negative)
=
Interest-sensitive assets – Interest-sensitive liabilities
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.
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< 0
ALM-ASSET & LIABILITY BANK MANAGEMENTMarch 23,
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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ALM-ASSET & LIABILITY BANK MANAGEMENTMarch 23,
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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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ALM-ASSET & LIABILITY BANK MANAGEMENTMarch 23,
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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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ALM-ASSET & LIABILITY BANK MANAGEMENTMarch 23,
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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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ALM-ASSET & LIABILITY BANK MANAGEMENTMarch 23,
2011
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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ALM-ASSET & LIABILITY BANK MANAGEMENTMarch 23,
2011
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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