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Management

Yoon K. Choi

ABSTRACT

I propose a duration gap measure, duration ratio, which measures a relative duration

gap between assets and liabilities. The new measure may be a true risk measure in the

sense that it captures not only the effect of interest rate changes, but also other

exogenous shocks, such as market risk and exchange rate risk.

This new approach provides us with a good proxy for the duration ratio based on

interest income and expenses, and U.S. large banks are examined for their risk

management based on the duration ratios.

Duration Ratio as a New Risk Measure in Bank Risk Management

Risk management has been a crucial element of success in the bank industry. However, with so many

hedging instruments and strategies, it becomes so difficult to measure risk and assess the quality of these

risk management techniques. This note proposes a new risk measure that would help investors and bank

monitors and regulators in assessing risk in the bank industry. I also empirically examine risk

management in the large banks in U.S. using this new approach.

2

1. Duration Gap and Immunization (Saunders, 2000)

The overall interest rate risk faced by bank owners whose equity is the

difference between assets and liabilities is normally defined as sensitivity of the value of

equity with respect to interest rate changes. In notation,

E / I = A / I - L / I, (1)

where E = equity, I = interest rate, A = assets, and L = liabilities.

The well-known duration model shows:

A / A = - D

A

* I / (1 + I), (2)

L / L = - D

L

* I / (1 + I), (3)

where D

A

and D

L

are the durations of the bank s asset and liability portfolio,

respectively.

From equations (2) and (3), we obtain

A = - D

A

* A * I / (1 + I), (4)

L = - D

L

* L * I / (1 + I). (5)

Following the Macauley duration model which assumes that the interest rate and its

shock are the same for both assets and liabilities,

E = - [D

A

* A - D

L

* L] * I / (1 + I). (6)

Rearranging terms, we get

E = - [D

A

- D

L

* k] * A * I / (1 + I), (7)

where k = L/A is a measure of the bank s leverage.

3

According to the traditional immunization strategy based on equation (7), managers

should structure the balance sheet so that D

A

= D

L

* k such that E = 0.

2. Duration Ratio as Elasticity between Assets and Liabilities

Instead of calculating the difference, dividing (2) by (3) leads to the following:

(A / A) / (L / L) = D

A

/ D

L

(8)

Now the duration ratio in equation (8) can be interpreted as the elasticity of the asset

value with respect to liability values. I attempt to provide an economic meaning to the

duration ratio in terms of the interaction between assets and liabilities. In general, bank

risk management involves a way to offset asset risk by liabilities risk (e.g., maturity or

duration matching), such that equity risk will be immunized from the source of risk.

Suppose that both assets and liabilities are stochastic, and bank managers monitor assets

and liabilities so as to generate riskless equities. Equity can be seen a portfolio of assets

and liabilities. In a mathematical term, E = A L.

And

VAR(E) = VAR(A) + VAR(L) 2 * COV(A, L). (11)

VAR and COV indicate variance and covariance, respectively.

For simplicity, assume VAR(A) = VAR(L). Then,

VAR(E) = 2 * VAR(A) * (1 - CORR(A, L)). (12)

Thus, equation (12) suggests that managers can hedge the total portfolio against any risk

by achieving a perfect correlation (e.g., CORR = 1) between assets and liabilities. Just

like elasticity, correlation is a statistical measure of a linear relationship between asset

and liabilities. Therefore, the duration ratio is interpreted to measure overall risks rather

than interest rate risk faced by banks.

4

Another important implication of equation (8) is that we can obtain a simple

proxy for the overall duration ratio: The ratio of the percentage change in the market

value of assets to that of liabilities. Since these variables are in market value, I use two

alternative variables in the balance sheet and income statement: book values of asset

and liabilities and interest revenues and expenses. I use these variables of the U.S. large

banks in order to determine its validity as a proxy for the duration ratio.

3. Other Issues: Convexity and Capital Ratio Requirement

3.1. Convexity and Duration

It is well known that the duration model assumes a linear relationship between

rate shocks and bond price changes. However, the actual bond price-yield relationship

exhibits a property called convexity rather than linearity. Specifically, the increase in

price due to a rate fall tends to be greater than as predicted by the duration model, while

the price falls more for rate increases. We can incorporate the convexity factor in the

duration model by adding the curvature parameter as follows:

A / A = - D

A

* I / (1 + I) + * C * (I )

2

, (9)

The second term on the right hand side of the equation indicates the curvature term.

Given the convexity property, we need to adjust the duration ratio accordingly

because we do not obtain the simple duration ratio as in equation (8), due to the

convexity factor. Therefore, we suggest a modified duration ratio as follows:

(A / A) / (L / L) = D

A

/ D

L

+ CV (10)

where CV is a convexity factor with a property being that greater curvature is

associated with higher CV. Of course the duration model implies CV = 0.

5

3.2. Capital Ratios and Immunization

The result in equation (8) has a very interesting implication for risk management

under capital ratio restriction. Regulators set minimum target ratios for a bank s net

worth, E. The simplest one is the ratio of bank capital to its assets, E/A. Suppose that a

bank wants to immunize against falling below this target ratio; that is (E/A) = 0.

Kaufman (1984) shows that in order to immunize the net worth to set (E/A) = 0, the

manager needs to set D

A

= D

L

, instead of setting D

A

= k * D

L

such that E = 0. This

implies, according to equation (8), that the percentage change in assets should be the

same as the percentage change in liability. Furthermore, the risk management approach

would be different depending on the bank s objective of risk management, including the

bank s capital ratio requirement.

4. Data and Empirical Results

4.1. Data

I collected the data on assets and liabilities for the top 100 largest bank holding

companies as of December 31, 1997. The data were from the National Information

Center of the Federal Financial Institutions Examination Council. Only 89 of the top

100 bank holding companies had the variables we use in the empirical investigation.

Table 1 shows the summary statistics of our sample. The average asset size (AA) over

the sample period ranges from 6.19 billion to 281 billion dollars, with a mean of about

33 billion dollars. On average, the interest revenue doubled interest expenses, indicating

a profitable performance in 1997. Tier I capital ratio is about 7.5% on average, which is

well above the 5% benchmark rate for well-capitalization according to the category

defined by the 1991 FDIC Improvement Act. In fact, the minimum Tier I leverage ratio

in our sample was 5.03%.

6

4.2. Duration ratio in changes in assets and liabilities in book value

Although we use the book value in calculating duration ratios using assets and

liabilities (DR1), the ratio may capture the current market value changes since we use

the recent percentage changes in assets and liabilities instead of the levels. The average

duration ratio based on assets and liabilities was 0.919 close to 1, which implies

successful hedging strategies used in our sample banks. However, if we examine the

results carefully, the duration ratio may not be reliable for some individual banks. I find

a few negative sign, sometimes with a very high number (e.g., -6.2), and this is not

acceptable because the duration ratio is supposed to be positive.

4.3. Duration ratio in interest revenues and expenses (DR2)

Since the price changes in assets and liabilities in banks are accurately reflected

in interest revenues and expenses, we may obtain the duration ratio using interest

revenues and expense changes instead. Table 2 shows that the duration ratio is again

very close to 1.0. DR2 seems to measure the duration ratio more accurately, since the

standard deviation (0.06) of the measure is much smaller than DR1. Furthermore, all

duration ratios calculated in this sample are positive, which is another indication of its

reliability for the proxy for the duration ratio.

4.4. Two Alternative Risk Management: D

A

= D

L

vs. D

A

= k * D

L

The previous section discussed two different risk management objectives: D

A

=

D

L

vs. D

A

= k * D

L

. If management wants to hedge the level of equity against risks

(e.g., E = 0), then the manager needs to set D

A

= k * D

L

(Strategy I). In this case, the

duration ratio is close to the leverage ratio. If the manager wants to hedge the capital

ratio instead (e.g., (E/A) = 0), he needs to set D

A

= D

L

(Strategy II). Here, the

duration ratio is close to one. Table II shows summary statistics for the two different

sets of banks, based on these strategies. There are 17 banks whose immunization

strategy is to D

A

= k * D

L

so as to keep the level of equity stable. These banks seem to

be larger in size and produce less interest revenues than those banks using Strategy II.

7

Finally, the capital leverage ratio for the banks using Strategy I seems to be lower than

the banks using Strategy II.

5. Summary and Conclusion

We examine two proxies for the duration ratio. One is based on assets and

liabilities; the other is based on interest revenues and expenses. Given the calculated

duration ratios of the well-capitalized large U.S. banks, the second measure based on

interest revenues and expenses seems to be a more reliable proxy. The underlying

assumption is that these U.S. banks in our sample are engaged in successful risk

management. We find that an interesting pattern exists among our sample banks in

terms of immunization strategies. Those banks using Strategy I seem to be larger in size,

have lower capital leverage ratios, and produce less interest revenues than those banks

using Strategy II.

Several extensions are in order.

1. We can extend our analysis with much longer time-series data. We may observe

how duration ratio evolves over time.

2. We may examine smaller banks of different capital ratios to see whether different

duration ratios are associated with these banks in a systematic way.

8

References

Kaufman, G. Measuring and Managing Interest Rate Risk: A Primer. Federal Reserve

of Chicago, Economic Perspectives, 1984, p. 16-29.

Saunders, A. Financial Institution Management: A Modern Perspective, McGraw-Hill

Co. 2000.

9

Table I

Summary Statistics of the Sample

This table contains the summary statistics of the major variables considered for 1997.

INTREV is the interest income per average assets, INTEXP is the interest expense per

average assets, AA is the average asset size in millions of dollars. CAP is the ratio of

Tier I capital ratio. DURAT_1 ((A / A) / (L / L)) is the first proxy for duration ratio.

DURAT_2 is the second proxy, defined as (int rev / int rev) / (int exp / int exp).

____________________________________________________________________

Variables Mean Minimum Maximum Std Dev.

____________________________________________________________________

INTREV (%) 7.5% 3.55% 14.15% 1.74%

INTEXP (%) 3.55% 1.83% 5.32% 0.66%

AA (Million) 32,907 6,190 281,678 52,346

CAP (%) 7.53% 5.03% 15.92% 1.9%

DURAT_1 0.9196 -6.169 2.215 0.8

DURAT_2 1.0011 0.8846 1.291 0.06

____________________________________________________________________

Table II

Immunization Strategies

This table contains the summary statistics of the major variables considered for 1997 for

the banks with different immunization strategies. INTREV is the interest income per

average assets, INTEXP is the interest expense per average assets, AA is the average

asset size in millions of dollars. CAP is the ratio of Tier I capital ratio. L/A is the

leverage ratio. D

A

/ D

L

is the duration ratio. Strategy I is to set D

A

= k * D

L

, while

Strategy II is to set D

A

= D

L

.

____________________________________________________________________

Strategy I Strategy II

Variables Mean Median Mean Median

____________________________________________________________________

INTREV (%) 6.89% 6.97% 7.64% 7.43%

INTEXP (%) 3.34% 3.35% 3.59% 3.51%

AA (Million) 46,302 15,532 29,743 13,340

CAP (%) 6.5% 6.36% 7.77% 7.24%

D

A

/ D

L

93.4% 94.2% 101.7% 99.9%

L / A 93.5% 93.6% 92.2% 92.7%

____________________________________________________________________

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