Chapter Twenty-two

1. Chapter Twenty-two Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet McGraw-Hill/Irwin

2. Interest Rate Risk Measurement • Repricing or funding gap • Rate Sensitivity • the time to reprice an asset or liability • a measure of an FI’s exposure to interest rate changes in each maturity “bucket” • GAP can be computed for each of an FI’s maturity buckets McGraw-Hill/Irwin

3. Calculating GAP for a Maturity Bucket NIIi = (GAP)i Ri = (RSAi - RSLi) Ri where NIIi = change in net interest income in the ith maturity bucket GAPi = dollar size of the gap between the book value of rate-sensitive assets and rate- sensitive liabilities in maturity bucket i Ri = change in the level of interest rates impacting assets and liabilities in the ith maturity bucket McGraw-Hill/Irwin

4. Simple Bank Balance Sheet and Repricing Gap Assets Liabilities_________ 1. Cash and due from $ 5 1. Two-year time deposits $ 40 2. Short-term consumer 50 2. Demand deposits 40 loans (1 yr. maturity) 3. Long-term consumer 25 3. Passbook Savings 30 loans (2 yr. maturity) 4. Three-month T-bills 30 4. Three-month CDs 40 5. Six-month T-notes 35 5. Three-month banker’s 20 acceptances 6. Three-year T-bonds 60 6. Six-month commercial 60 7. 10-yr. Fixed-rate mort. 20 7. One-year time deposits 20 8. 30-yr. Floating-rate m. 40 8. Equity capital (fixed) 20 9. Premises 5 $270 $270 McGraw-Hill/Irwin

5. Additional Terminology • Cumulative gap (CGAP): the cumulative GAP across various repricing categories or buckets • Spread effect: the effect that a change in the spread between rates on RSAs and RSLs has on net interest income (NII) as interest rates change McGraw-Hill/Irwin

6. Four Major Weakness in the Repricing Model • Market value effects • Cash flow patterns within a maturity bucket • The problems of rate runoffs and prepayments • Cash flows from off-balance-sheet activities McGraw-Hill/Irwin

7. Duration Model Duration gap - a measure of overall interest rate risk exposure for an FI D = _ %  in the market value of a security R(1 + R) McGraw-Hill/Irwin

8. Difficulties in Applying the Duration Model • Duration matching can be costly • Immunization is a dynamic problem • Large interest rate changes and convexity McGraw-Hill/Irwin

9. Insolvency Risk Management • Net worth • Book Value • Market value or mark-to-market value basis McGraw-Hill/Irwin

10. Effects of Changes in Loan Values and Interest Rates on the Balance Sheet Assets Liabilities Base case Long-term securities $ 80 Short-term floating $ 90 Long-term bonds 20 Net worth 10 $100 $100 After a major decline in value of loans Long-term securities $ 80 Liabilities $90 Long-term bonds 8 Net worth -2 $88 $88 After a rise in interest rates Long-term securities $ 75 Liabilities $90 Long-term loans 17 Net worth 2 $92 $92 McGraw-Hill/Irwin

11. The Book Value of Capital • The book value of capital usually comprises three components in banking • Par value of shares • Surplus value of shares • Retained earnings • Book value of its capital and credit risk • Book value of capital and interest rate risk McGraw-Hill/Irwin

12. The Discrepancy between the Market and Book Values of Equity • The degree to which the book value of an FI’s capital deviates from its true economic market value depends on a number of values • Interest Rate Volatility • Examination and Enforcement • Loan Trading McGraw-Hill/Irwin

13. Calculating Discrepancy Between Book Values (BV) and Market Values (MV) MV = Market value of equity ownership in shares outstanding Number of shares Par value of equity + Surplus value + BV = Retained earnings_ ________ Number of shares Market-to-book ratio A ratio that shows the discrepancy between the stock market value of an FI’s equity and the book value of its equity McGraw-Hill/Irwin

14. Arguments against Market Value Accounting • Difficulty of implementation • Introduces unnecessary degree of variability into an FI’s net worth • FI’s are less willing to accept longer-term asset exposures McGraw-Hill/Irwin