Asset & Liability Management

Asset-Liability Management
Commercial Banking
 Historical View of
Asset-Liability Management
• Asset Management Strategy
• Liability Management Strategy
• Funds Management Strategy

A banker is a fellow who lends you his umbrella when the sun is
shining and wants it back the minute it begins to rain. - Mark Twain.
 Interest Rate Risk: Can we not
control it?
• Price Risk — When Interest Rates Rise, the
Market Value of the Bond and Loans falls
Why??
• Reinvestment Risk — When Interest Rates Fall,
the Coupon Payments on the Bond are
Reinvested at Lower Rates
Measurement of Interest Rates
Yield to Maturity (YTM)

Market Price =
n
CF t
∑
t =1 (1 + YTM) t
 example

A bond purchased today at a price of

Rs. 950 and promising an interest
payment of Rs.100 each year for the
next 3 years, when It will be
redeemed would fetch a price of Rs.
1000. Calculate Yield to Maturity of
this Bond.

Answer: 12.10 %
Measurement of Interest Rates
Banker’s Discount Rate (DR)
(FV - Purchase Price)
DR =
FV
X
360
# Days to Maturity
Where:
FV equals Face Value
 Market Interest Rates

Function of:
• Risk-free Real Rate of Interest
• Various Risk Premia
– Default Risk
– Inflation Risk
– Maturity Risk
– Marketability Risk
Can interest rates be negative ??
 Yield curves for Indian Bond Market

http://www.livemint.com/2011/06/21232545/Nearinverted-yield-curve-show.html
 Inverted yield curve for India

http://capitalmind.in/2011/04/warning-inverted-yield-curves-slowdown/
 Misinterpretation of yield curves

Case of First Bank of Minneapolis

--losses of around $500 M in US Government
Securities
 Goal of Interest Rate Hedging

One Important Goal is to Insulate the Bank’s

Profits from the Damaging Effects of Fluctuating
Interest Rates
 Net Interest Margin

Interest Income - Interest Expenses

NIM=
Total Earning Assets

Net Income after Expenses

=
Total Earning Assets

So how to manage it ??
 Technique: 1

Interest- Sensitive Gap Management

 Interest-Sensitive Assets

• Short-Term Securities Issued by the Government

and Private Borrowers (about to mature)
• Short-Term Loans Made by the Bank to
Borrowing Customers (about to mature)
• Variable-Rate Loans Made by the Bank to
Borrowing Customers
 Interest-Sensitive Liabilities
• Borrowings from Money Markets (repo
borrowings, CDs )
• Short-Term Interest bearing Accounts
• Money-Market Deposits (rate variable per day
basis )
 Interest-Sensitive Gap Measurements

Interest-Sensitive Gap = Interest-Sensitive Assets - Interest-

Sensitive Liabilities

IS Gap
Relative Interest-Sensitive Gap =
Bank Size( total Assets)

Interest-Sensitive Assets
Interest Sensitivity Ratio = Interest-Sensitive Liabilities
 If this Gap is Positive then
• Bank is called Asset Sensitive Bank
• Relative Interest-Sensitive Gap will be
positive
• Interest Sensitivity Ratio Greater
than One
 If this Gap is Negative then

• Bank is called Liability Sensitive Bank

• Negative Relative Interest-Sensitive Gap
• Interest Sensitivity Ratio Less than One
 If this Gap is zero then

• Bank is called interest insensitive

• Near impossible situation for a bank

There is nothing to manage…

 Asset-Sensitive Gap: Impact on NIM

• Interest Rates Rise

NIM Rises
• Interest Rates Fall
NIM Falls
Liability-Sensitive Gap: Impact on
NIM
• Interest Rates Rise
NIM Falls
• Interest Rates Fall
NIM Rises
 Zero Interest-Sensitive Gap

When Interest Rates Change in Either Direction,

NIM is Protected.
 Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.0% 600 4.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.08x500+0.11x350) - (0.04x600+0.06x220)

78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
 Lets Understand the impact of the following

1% increase in the level of all short-term rates.

1% decrease in spread between assets yields
and interest cost.

RSA increase to 8.5%

RSL increase to 5.5%

Proportionate doubling in size.

Increase in RSAs and decrease in RSL’s

RSA = 540, fixed rate = 310

RSL = 560, fixed rate = 260.
 1% Increase in Short-Term Rates
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 9.0% 600 5.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.09x500+0.11x350) - (0.05x600+0.06x220)

83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74%
GAP = 500 - 600 = -100
 1% Decrease in Spread
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.5% 600 5.5%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.085x500+0.11x350) - (0.055x600+0.06x220)

81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09%
GAP = 500 - 600 = -100
 Proportionate Doubling in Size
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 1000 8.0% 1200 4.0%
Fixed rate 700 11.0% 440 6.0%
Non earning 300 200
1840
Equity
160
Total 2000 2000

NII = (0.08x1000+0.11x700) - (0.04x1200+0.06x440)

157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200
 Increase in RSAs and Decrease
in RSLs
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 540 8.0% 560 4.0%
Fixed rate 310 11.0% 260 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.08x540+0.11x310) - (0.04x560+0.06x260)

77.3 - 38 = 39.3
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
 NIM Influenced By:

• Changes in Interest Rates Up or Down

• Changes in Spread Between Assets and
Liabilities
• Changes in the Volume of Interest-Sensitive
Assets and Liabilities
• Changes in the Mix of Assets and Liabilities
 Important Strategies Concerning IS
Gap
1. Management must choose the time period over which NIM
is to be managed.
2. Management must choose a target NIM.
3. To increase NIM management must either:
-Develop correct interest rate forecast; or
-Reallocate assets and liabilities to increase spread.
4. Management must choose volume of interest-sensitive
assets and liabilities.
Cumulative Gap
 Example of Cumulative Gap
A Bank has the portfolio in the different maturity
brackets as followed
Maturity Interest Interest Rs. In Crores
Brackets Sensitive Sensitive Size of Gap Cumulative
Assets Liabilities Gap
1 Day (next 40 30 +10 +10
24 hrs.)
Day 2-7 120 160 -40 -30
Day 8-30 85 65 +20 -10
Day 31-90 280 250 +30 +20
Day 91-120 455 395 +60 +80
- - - - -
- - - - -
 Interpretation
• For the next 24 hrs. bank has a positive gap; its earnings will benefit if interest rates
rise between today and tomorrow.

• However, a forecast of rising money market interest rates over the next week would
be bad news because cumulative gap for next 7days is negative. If interest rate
increase is expected to be substantial, management should consider taking
countermeasures to protect earnings.

• This countermeasure may include selling of longer term CDs right away so that to
hedge against the losses from rising interest rates in the coming week.

• Looking over the remainder of the table, it is clear that bank will fare much better
over the next several months if market interest rates rise, because its cumulative
gap eventually turns positive again.
 Aggressive Interest-Sensitive Gap
Management
Expected Change in Best Interest- Aggressive
Interest Rates Sensitive Gap Management’s
Position Likely Actions
Rising Market Positive Cumulative Increase in IS Assets
Interest Rates IS Gap Decrease in IS
Liabilities
Falling Market Negative Cumulative Decrease in IS
Interest Rates IS Gap Assets
Increase in IS
Liabilities
 Problems with Interest-Sensitive
Gap Management
• Ignores the Basis Risk
• Ignores the time value of money
• Ignores the early withdrawals, prepayment and
foreclosures
• Interest Rate Attached to Bank Assets and Liabilities
Do Not Move at the Same Speed as Market Interest
Rates (Interest Rates Paid on Liabilities Tend to Move Faster than
Interest Rates Earned on Assets )
• Interest-Sensitive Gap Does Not Consider Impact of
Changing Interest Rates on Equity Position( Net-
Worth)
Asset & Liability
Management

The Concept of Duration and

Managing A Bank’s Duration
Gap
The Concept of Duration

• 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.
• In effect, duration measures the average
time needed to recover the funds
committed to an investment.
To Calculate Duration
n
t x CFt
∑
t =1 (1 + YTM)
t
D= n
CFt
∑
t =1 (1 + YTM)
t

Where
D= Duration in years, t = period of time, CF = cash flows,
YTM = yield to maturity,
Example
Suppose that a bank grants a loan to one
of its customers for a term of 5 years. The
customer promises the bank an annual
interest payment of 10%. The face value of
the loan is Rs. 1000 which is also its
current market value or price. Calculate the
Duration of this loan.

Answer : 4.17 years

More Examples: Calculate
Duration
nn nn
Ctt(t) Ctt(t)
∑ (1 + r)tt ∑ (1 + r)tt
DUR = t=1
t=1
nn = t=1
t=1
Ctt PV of the Sec.
∑ (1 + r)tt
t=1
t=1

Examples:
1000 face value, 10% coupon, 3 year,
12% YTM
 Calculate Duration
nn nn
Ctt(t) Ctt(t)
∑ (1 + r)tt ∑ (1 + r)tt
DUR = t=1
t=1
nn = t=1
t=1
Ctt PV of the Sec.
∑ (1 + r)tt
t=1
t=1

Examples:
1000 face value, 10% coupon, 3 year, 12% YTM
100 * 1 100 * 2 100 * 3 1000 * 3
11
+ 22
+ 33
+
(1.12) (1.12) (1.12) (1.12)33 2597.6
D= 33 = = 2.73 years
100 1000 951.96
∑ (1.12)tt +
(1.12)33
t=1
t=1
If YTM = 5%
1000 face value, 10% coupon, 3 year, 5%
YTM
100 * 1 100 * 2 100 * 3 1000 * 3
11
+ 22
+ 33
+
(1.05) (1.05) (1.05) (1.05)33
D=
1136.16
3127.31
D= = 2.75 years
1136.16
If YTM = 20%
1000 face value, 10% coupon, 3 year, 20%
YTM

2131.95
D= = 2.68 years
789.35
If YTM = 12% and Coupon = 0
1000 face value, 0% coupon, 3 year, 12%
YTM
1000
|-------|-------|-------|
0 1 2 3
11 00 00 00 ** 33
((11 .1
.1 22 ))33
D
D == 1 0 0 0 = 3 by definition (same as
1000
.1 22 ))33
((11 .1 maturity)
Impact of Duration on net worth
Net worth = Assets- Liabilities

∆ NW = ∆ A − ∆ L
The longer the maturity of a Bank’s assets and liabilities, the more they
will tend to decline in market value (price) when market interest rates
rise.
Thus change in net worth due to changing interest rates will vary
depending upon the relative maturities of a Bank’s Assets and Liabilities.
A Bank with longer duration assets than liabilities will suffer greater
decline in net worth when market interest rates rise.
By equating asset and liability durations, management can balance the
cash outflows associated with Liabilities with cash inflows associated
with assets. Thus duration analysis can be used to stabilize or
immunize the market value of a Bank’s Net Worth.
Price Sensitivity of a Security
∆P ∆i
≈ −D ×
P (1 + i )
The %age change in the market price of an asset or liability is equal
to its duration times the relative change in interest rates attached to
that particular asset or liability.

Consider a bond held by a bank that carries a duration

of 4yrs, and a current market value of Rs. 1000.
market interest rates attached to this bond is 10%. But
recent forecasts suggest that it may go up to a level of
11%. If this forecast turns out to be correct, what
%age change will occur in bond’s market value??
Answer= -3.64%
Think over it…

• Suppose the interest rate or yield

attached to a 30yr Bond held by a bank
decreases from 6.5% to 6%. Then this
Bond’s price will rise by about 8 points.
• In contrast, suppose the Bond’s interest
rate or yield falls from 10% to 9.5%;
then its market price will rise by just 4
points.
 Bond A has a higher convexity than Bond B,
Convexity which means that all else being equal, Bond A will
always have a higher price than Bond B as
interest rates rise or fall

In general, the higher the coupon rate, the lower

the convexity (or market risk) of a bond.

http://www.investopedia.com/terms/c/convexity.asp#axzz1Xm2n0NAy
Importance of convexity for a
Banker
If two bonds offer the same duration and yield but
one exhibits greater convexity, changes in interest
rates will affect each bond differently. A bond with
greater convexity is less affected by interest rates
than a bond with less convexity. Also, bonds with
greater convexity will have a higher price than bonds
with a lower convexity, regardless of whether interest
rates rise or fall.
Duration of an Asset Portfolio
n
DA = ∑i =1
=1
w i x D Ai
Where:
wi = the amount of the ith asset divided by
total assets
Dai = the duration of the ith asset in the
portfolio
Duration of a Liability Portfolio
n
DL = ∑i =1
=1
w i x D Li

Where:
wi = the amount of the ith liability divided by total
liabilities
Dli = the duration of the ith liability in the portfolio
 Technique 2: Using Duration to hedge against Interest Rate Risk

Duration Gap
D = DA - DL
Lets make this gap almost equal to zero

Levered Duration Gap

TL
D = DA - DL x
TA
This equation tells us that value of Liabilities must change slightly
more than the value of assets to eliminate a Bank’s overall risk
exposure.
Change in the Value of
a Bank’s Net Worth

∆NW =
 ∆i   ∆i 
- DA x (1+ i) x A - - DL x (1+ i) x L
   

The larger the levered-duration gap, the more

sensitive will be the net worth of a Bank to a
change in market interest rates.
Example
• Suppose that a bank has an average
duration in its assets of 3yrs, an
average liability duration of 2yrs, total
liabilities of Rs. 100 cr., and total assets
of Rs. 120 cr. Interest rates were
originally 10%, but suddenly they rise to
12%. Calculate the change in net
worth.
• Answer: Rs. -2.91cr. Clearly this Bank
faces substantial decline in net worth in
the wake of rising interest rates
Impact of Changing Interest Rates
on Bank’s Net Worth
Positive Gap Rise Decrease
Fall Increase
Negative Rise Increase
Gap Fall Decrease
Zero Gap Rise No
Change
Fall No
Change
So the Strategy is simply…
1) Calculate the average duration of a
Bank’s earning assets and liabilities
from the formula
2) Plan the acquisition of assets and
liabilities so that, as closely as possible
levered adjusted duration gap is zero,
this is called portfolio immunization
i.e. TL
D = DA - DL x ≈0
TA
1 Par Years Market
1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 14.00% 700 2.65
Treasury bond 200 12.00% 9 12.00% 200 5.97
Total Earning Assets 900 13.56% 900
Non-cash earning assets 0 0
Total assets 1000 12.20% 1000 3.05

Liabilities
Interest bearing liabs.
Time deposit 520 9.00% 1 9.00% 520 1.00
Certificate of deposit 400 10.00% 4 10.00% 400 3.49
Tot. Int Bearing Liabs. 920 9.43% 920
Tot. non-int. bearing 0 0
Total liabilities 920 9.43% 920 2.08
Total equity 80 80
Total liabs & equity 1000 1000
1 Par Years Market
1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 14.00% 700 2.65
Treasury bond 200 12.00% 9 12.00% 200 5.97
Total Earning
98Assets
× 1 98900 × 1 98 × 3 13.56%
700 ×3 900
Non-cash earning assets
1
+ 02 + 3
+ 0
Total dur
assets (1 .14 ) (1.14
1000) (1.14 ) 1.14)3
(12.20% 1000 3.05
=
Liabilities
700
Interest bearing liabs.
Time deposit 520 9.00% 1 9.00% 520 1.00
Certificate of deposit 400 10.00% 4 10.00% 400 3.49
Tot. Int Bearing Liabs. 920 9.43% 920
Tot. non-int. bearing 0 0
Total liabilities 920 9.43% 920 2.08
Total equity 80 80
Total liabs & equity 1000 1000
Calculating DGAP

DA = (700 / 1000) * 2.65 + (200 / 1000) * 5.97 = 3.05

DL = (520 / 920) * 1.00 + (400 / 920) * 3.48 = 2.08

DGAP = 3.00 - (920 / 1000) * 2.06 = 1.14 years

What does 1.14 mean?

The average duration of assets > liabilities, hence asset values

change by more than liability values.
What is the Bank’s Strategy
here…?

To eliminate the risk of changes in the Net
Worth NW, what do we have to change
DA or DL and by what quantity?
Change DA = -1.14
Change DL = +1.14/u = 1.24
Where u=weight of liability i.e. 920/1000
2 Par Years Market
1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 15.00% 684.02 2.64
Treasury bond 200 12.00% 9 13.00% 189.74 5.89
Total Earning Assets 900 14.57% 873.75
Non-cash earning assets 0 0
Total assets 1000 13.07% 973.75 3.00

Liabilities
Interest bearing liabs.
Time deposit 520 9.00% 1 10.00% 515.27 1.00
Certificate of deposit 400 10.00% 4 11.00% 387.59 3.48
Tot. Int Bearing Liabs. 920 10.43% 902.86
Tot. non-int. bearing 0 0
Total liabilities 920 10.43% 902.86 2.06
Total equity 80 70.891
Total liabs & equity 1000 973.75
2 Par Years Market
1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 15.00% 684.02 2.64
Treasury bond 200 12.00% 9 13.00% 189.74 5.89
Total Earning Assets 900 14.57% 873.75
Non-cash earning
3 assets 0 0
98 1000700
PV = ∑
Total assets
t
+ 13.07% 973.75 3.00

Liabilities t=1 (1.15 ) (1.15)3

Interest bearing liabs.
Time deposit 520 9.00% 1 10.00% 515.27 1.00
Certificate of deposit 400 10.00% 4 11.00% 387.59 3.48
Tot. Int Bearing Liabs. 920 10.43% 902.86
Tot. non-int. bearing 0 0
Total liabilities 920 10.43% 902.86 2.06
Total equity 80 70.891
Total liabs & equity 1000 973.75
Calculating DGAP

DA = (684 / 974) * 2.64 + (189 / 974) * 5.89 = 3.00

DL = (515 / 903) * 1.00 + (387 / 903) * 3.48 = 2.06

DGAP = 3.00 - (903 / 974) * 2.06 = 1.09 years

What does 1.09 mean?

The average duration of assets > liabilities, hence asset values
change by more than liability values.

Work out the Bank’s strategy in this case…

Limitations of
Duration Gap Management

Finding Assets and Liabilities of the
Same Duration Can be Difficult

Some Assets and Liabilities May Have
Patterns of CFs Not Well Defined (e.g.
Demand Deposits, Passbook Savings Accounts)

Customer Prepayments May Distort the
Expected Cash Flows in Duration

Not a Linear Relationship Between
Prices and Interest Rates (problem of
Convexity)