Asset and Liability Management

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CHAPTER 6 ASSET-LIABILITY MANAGEMENT: DETERMINING AND MEASURING INTEREST RATES AND CONTROLLING INTEREST-SENSITIVE AND DURATION GAPS

Goals of This Chapter: The purpose of this chapter is to explore the options bankers have today for dealing with risk – especially the risk of loss due to changing interest rates – and to see how a bank’s management can coordinate the management of its assets with the management of its liabilities in order to achieve the institution’s goals.

Key Topic In This Chapter • • • • • • Asset, Liability, and Funds Management Market Rates and Interest Rate Risk The Goals of Interest Rate Hedging Interest Sensitive Gap Management Duration Gap Management Limitations of Hedging Techniques

Chapter Outline I. II. Introduction: The Necessity for Coordinating Bank Asset and Liability Management Decisions Asset/Liability Management Strategies A. Asset Management Strategy B. Liability Management Strategy C. Funds Management Strategy Interest Rate Risk: One of the Greatest Asset-Liability Management Strategy Challenges A. Forces Determining Interest Rates B. The Measurement of Interest Rates 1. Yield to Maturity 2. Bank Discount Rate C. The Components of Interest Rates 1. Risk Premiums 2. Yield Curves 3. The Maturity Gap and the Yield Curve D. The Response of Banks and Other Financial Firms to Interest Rate Risk One of the Goals of Interest-Rate Hedging A. The Net Interest Margin B. Interest-Sensitive Gap Management 1. Asset-Sensitive Position 2. Liability-Sensitive Position 3. Interest-Sensitive Gap

III.

IV.

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V.

VI.

VII. VIII.

4. Interest Sensitivity Ratio 5. Computer-Based Techniques 6. Strategies in Gap Management The Concept of Duration A. Definition of Duration B. Calculation of Duration C. Net Worth and Duration D. Price Risk and Duration E. Convexity and Duration Using Duration to Hedge Against Interest-Rate Risk A. Duration Gap 1. Dollar Weighted Duration of Assets 2. Dollar Weighted Duration of Liabilities 3. Positive Duration Gap 4. Negative Duration Gap B. Change in the Bank’s Net Worth The Limitations of Duration Gap Management Summary of the Chapter Concept Checks

6-1. What do the following terms mean: Asset management? Liability management? Funds management? Asset management refers to a banking strategy where management has control over the allocation of bank assets but believes the bank's sources of funds (principally deposits) are outside its control. Liability management is a strategy of control over bank liabilities by varying interest rates offered on borrowed funds. Funds management combines both asset and liability management approaches into a balanced liquidity management strategy. 6-2. What factors have motivated banks and many of their competitors to develop funds management techniques in recent years? The necessity to find new sources of funds in the 1970s and the risk management problems encountered with troubled loans and volatile interest rates in the 1970s and 1980s led to the concept of planning and control over both sides of a bank's balance sheet -- the essence of funds management. 6-3. What forces cause interest rates to change? What kinds of risk do bankers and other financial firms face when interest rates change? Interest rates are determined, not by individual banks, but by the collective borrowing and lending decisions of thousands of participants in the money and capital markets. They are also impacted by changing perceptions of risk by participants in the money and capital markets, especially the risk of borrower default, liquidity risk, price risk, reinvestment risk, inflation risk, term or maturity risk, marketability risk, and call risk.

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Bankers can lose income or value no matter which way interest rates go. Rising interest rates can lead to losses on bank security instruments and on fixed-rate loans as the market values of these instruments fall. Falling interest rates will usually result in capital gains on fixed-rate...
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