Chapter 4: Asset/Liability Management

Asset/liability management
Decisions about composition of assets, liabilities and risk
Management of sources and uses of funds on and off the balance sheet
*Refers to the simultaneous management of both bank assets and liabilities for the purpose of maximizing profits, mitigating interest rate risk (IRR), providing liquidity, assuring its capital adequacy, and enhancing the market value of the bank
ALCO
Asset liability management committee
Net interest margin (NIM)
Difference between the interest and dividends earned on interest-bearing assets and interest paid to depositors and creditors, expressed as a percentage of average earning assets
Dollar gap
Deals with the measure the size of a bank’s interest income
The difference between rate-sensitive assets and rate-sensitive liabilities
Does not focus on shareholder value. Focuses on net interest income. If _______ is positive, if interest rates increase, will lead to increase in profits….so the bank is asset sensitive. If there is a negative _______, then an increase in interest rate will lead to a decrease in profits….liability sensitive.
-Banks tend to put assets and liabilities in maturity buckets
Net interest income
Interest income less interest expense
Change in _____= GAP*change in interest rate
Duration gap (DGAP)
Considers the affects of the changes on the dollar value of the balance sheet items
Compares the effects of changes in interest rates on the duration of a bank’s assets and liabilities to determine the economic value of stockholder’s equity
_____=DA-WDL
w=l/a
Economic value
Theoretical value of the bank’s equity, taking into account the duration of both the assets and liabilities
Change in Net Worth
-DGAP * (change in interest rates / (1+i)) * A
i=market interest rate OR original interest rate
Is a function of change in interest rates and size of duration gap
If DGAP is positive, interest rate increase will cause ____ to increase.
Core deposits
Defined as the sum of demand deposits, all negotiable orders of withdrawal (NOW), and automatic transfer service (ATS) accounts, money market deposit accounts (MMDA) savings, other savings deposits, and time deposits under $100,000
*Banks acts as a price setter
*Interest insensitive
*Low cost
*Stable
Price risk
Buying long-term debt securities because the price of the bonds declined.
Because of the difficulty of accurately forecasting interest rates, many investors prefer to invest in short-term securities to minimize their risk such as commercial paper.
Interest rate risk
The risk to earnings and capital that interest rates may change unfavorably based on bank’s balance sheet.
Therefore, banks tend to balance out assets and liabilities as it is very hard to predict interest rate direction
Money market instruments
Short-term debt securities, such as commercial paper
Capital market instruments
Long-term securities such as stocks and bonds
Brokered deposits
Deposits issued by a financial institution and purchased by an investors through a third-party intermediary
*Very rate sensitive
Purchased deposits
*Fed funds are most widely used source of liability management
*Euro dollars and CDs are widely used
*Hard to get if a bank is in trouble
*Banks acts as a price taker
UBPR Uniform Bank Performance Report
Standardized way for banks to report their performance provided by the regulators. This report shows that banks various finance ratios (such as liquidity ratios) break down of assets in various categories (for example, short term investments, core deposits, short term noncore funding). It also shows the data for peer groups to compare the performance of other banks. This also shows the percentile of the data compared to other banks.
Liquidity risk
Refers to the ability to liquidate an asset quickly with little or no loss in market value and the ability to raise funds through the sale of an asset or by borrowing
Balance sheet adjustments
Changing maturities of loans, CDs, sell mortgages. This is achieved by changing maturities of loans and CDs, mortgages, securitization, and tranches to have a minimum duration gap. Adjust asset and liability to manage net interest income because it is very hard to predict interest rate deduction.
Securitization
The packaging and selling of loans, such as mortgage and credit cards loans. These are asset-based securities.
Rate sensitivity
A function of how often an item is repriced, not a function of maturity
Relative GAP ratio
Used for comparing dollar gap in comparison to total assets because the value of dollar gap does not matter unless we know the underlying assets. For example, 1/2 a million dollar gap may not be a big deal for a Chase Manhattan bank versus Valley National Bank.
%GAP / Total assets
Interest sensitivity ratio
Rate sensitive asset $ amount / RSL $ amount.
This is typically greater than 1.
Balance Sheet Adjustment 2
There are two kinds of _______.
On Balance Sheet Adjustment
Adjustment in fixed versus variable pricing and maturities
For example, floating rate mortgage of asset side of BS or longer term CD on liability side.
Loan sales.
Off Balance Sheet Adjustment
Use of derivatives such as interest rate swaps and financial futures. Fixed rate mortgage could swap for floating rate payment stream. Bank could use interest rate future contracts to hedge a potential increase in interest rate and price effect in mortgage portfolio.
Sell/ short Treasury bond future contracts and if interest rate increases, then the value of the Treasury bond decreases so you profit from shorting. That will cover the losses in mortgage portfolio.
Defensive asset/liability management
Near $0 gap, or RSA=RSL (nearly). That does not mean passive. Stable net interest income from changes in interest rates does not rely on forecast of interest rates.
Aggressive asset/liability management
Nonzero dollar gap, RSA does not equal RSL. It is risky, requires a forecast of interest rate change, and net interest income will change as interest rate changes. You better know the direction of interest rates. The reality is many time, some gaps are driven by market demands and beyond banks control (for example, borrowers want long term loans and depositors want short term maturities).
Standardized gap
To manage the problems with dollar gap management with maturity gap, the solution is use of _______, that is variable rate asset whose interest rate has shown to be insensitive to market interest rate change/movement, might be considered as a fixed rate. The gap is calculated on the volatility of interest rate changes of asset class based on market interest rate change.
Points to Remember
For DGAP, not to add equity in calculating total liability. (Problem 5-9)
Immunization
Occurs when the duration of a bank’s assets and liabilities is equal to zero. Protects the value of equity from changes in market rates of interest.
Liquidity
Refers to the ability to liquidate an asset quickly with little or no loss in market value and the ability to raise funds through the sale of an asset or by borrowing
Repurchase agreements (repos)
Short-term contracts to sell and repurchase financial assets, such as Treasury securities, at a future date.
Reverse repo
From the point of view of the institution buying the security
Repo rate
The interest rate at which central banks, such as the Federal Reserve, repurchase government securities from banks