Introduction

on
Asset-Liability and Risk
Management of Banks

Narendra Bista
 Components of a Bank Balance sheet

Liabilities Assets
1. Capital 1. Cash & Balances with
2. Reserve & Surplus Central Bank
3. Deposits 2. Bal. With Banks &
4. Borrowings Money at Call and
Short Notices
5. Other Liabilities
3. Investments
4. Advances
5. Fixed Assets
6. Other Assets
Contingent Liabilities
 Components of Liabilities
1. Capital:
- Capital represents owner’s contribution/stake in
the bank.
- It serves as a cushion for depositors and
creditors.
- It is considered to be a long term sources for
the bank.
 Components of Liabilities
2. Reserves & Surplus
Components under this head includes:
I. Statutory Reserves
II. Capital Reserves
III. Investment Fluctuation Reserve
IV. Revenue and Other Reserves
V. Balance in Profit and Loss Account
 Components of Liabilities
3. Deposits
This is the main source of bank’s funds. The
deposits are classified as deposits payable on
‘demand’ and ‘time’. They are reflected in
balance sheet as under:
I. Demand Deposits
II. Savings Deposits
III. Term Deposits
IV. Call deposit
V. Margin deposits
VI. Certificate of deposits
 Components of Liabilities
4. Borrowings:
• Refinance
• Borrowings from Central Bank,
• Inter-bank &
• other institutions
 Components of Liabilities
5. Other Liabilities & Provisions
It is grouped as under:

I. Bills Payable
II. Inter Office Adjustments (Net)
III. Interest Accrued (interest suspense)
IV. Unsecured Redeemable Bonds
(Subordinated Debt for Tier-II Capital)
V. Others(including provisions)
 Components of Assets
1. Cash & Bank Balances
I. Cash in hand
(including foreign currency notes)
II. Balances with Central Bank
 Components of Assets
2. BALANCES WITH BANKS AND MONEY AT
CALL & SHORT NOTICE
I. In Domestic Banks
i) Balances with Banks
a) In Current Accounts
b) In Other Deposit Accounts
ii) Money at Call and Short Notice
a) With Banks
b) With Other Institutions
II. Foreign Banks
a) In Current Accounts
b) In Other Deposit Accounts
c) Money at Call & Short Notice
 Components of Assets
3. Investments
A major asset item in the bank’s balance sheet.
Reflected under 6 buckets as under:
I. Investments in Domestic country:
i) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions
vi) Others (Commercial Papers, Mutual Fund Units etc.)
II. Investments in foreign country
Subsidiaries and/or Associates abroad
 Components of Assets
4. Advances
The most important assets for a bank.
i) Bills Purchased and Discounted
ii) Loans and advances
iii) Loan against collected bills
 Components of Assets
5. Fixed Asset
I. Premises
II. Other Fixed Assets (Including furniture and fixtures)

6. Other Assets
I. Interest accrued
II. Tax paid in advance/tax deducted at source
(Net of Provisions)
III. Stationery and Stamps
IV. Non-banking assets acquired in satisfaction of claims
V. Others
Capital & Liabilities of Nepalese
Banks
1 Capital Fund
2 Borrowings
3 Deposits
4 Bills Payable
5 Other Liabilities
6 Reconciliation A/c
7 Profit & Loss A/c
Assets of Nepalese Banks
1 Liquid Funds
a. Cash Balance
b. Bank Balance
2 Investment In Securities
3 Share & Other Investment
4 Loans & Advances
5 Fixed Assets
6 Other Assets
7 Expenses not Written off
8 Non Banking Assets
9 Reconciliation Account
10 Profit & Loss A/c
Asset Structure of Financial Sector
2%
8% 14%

14%

61%

Cash & Bank Investment Loan & Advances Fixed Assets Other Assets
 Asset Structure of a Good Bank

1% 4%
19%
39%

37%

Cash & Bank Investment Loan & Advances Fixed Assets Other Assets
Asset Structure of a Poor Financial Institution
1% 1%
6%
9%

83%

Cash & Bank Investment Loan & Advances Fixed Assets Other Assets
Capital & Liabilities Structure of
Financial Sector

12.1% 9.6%
2.5%

75.8%

CAPITAL FUND BORROWINGS DEPOSITS Other Liabilities

Income Structure of Financial Sector
4.8%
3.6%

4.1%

87.5%

Interest income Commision & Discount

Other operating income Non-operating income
Income Structure of a Good Bank

2.8%
Interest
11.9% income

9.0% Commission
&Disc

Other
76.3% operating
Income
Nonoperatin
g income
Income Structure of Poor Bank

0.3% 2.7% Interest

income

Commission&
Disc

Other
operating
Income
97.0% Nonoperating
income
Asset Liability Management (ALM)
• Major portion of Liability is Deposit (followed
by borrowing)
• Major portion of Asset is Credit (followed by
Investment),
• Normally, Deposits have shorter maturity and
Credit has longer.
• Both of these items are interest sensitive,
 Objectives of ALM
• The objective and function of ALM is to
measure and control three levels of financial
risk:
1. Interest rate risk: the price difference
between loans and deposits
2. Credit risk: the probability of loan default,
3. Liquidity risk: occurring when loans and
deposits have different maturities.
 Assets Liability Management
It is a dynamic process of Planning,
Organizing & Controlling of Assets &
Liabilities- their volumes, mixes,
maturities, yields and costs in order to
maintain liquidity and NII.
 Historical View of Asset-Liability
Management
First :Asset Management Strategy
– Refers to a strategy where it is assumed that management
has control over the allocation of bank assets (loans) but
little or no control over funds sources (deposits)
Then: Liability Management Strategy
– Strategy that focuses on new sources of funds and managing
the mix of deposit and non deposit sources of funds by
varying the price or interest rates offered
Now: Funds Management Strategy
– The concept of planning and control over both sides of the
balance sheet – assets and liabilities
 Four key building blocks of ALM
1. Measurement of dollar gaps on the basis of maturity
buckets (0-90 days, 91-180days, etc) to determine the
amount of assets and liabilities being re-priced.
2. Estimating the interest rate at which these funds will
be re-priced
3. Projecting future interest income and interest expense
(rate x volume)
4. Exploring alternative interest-rate scenarios to
estimate the bank's downside vulnerability.
 Asset Management Strategy
• Control of the composition of bank's assets to
provide adequate liquidity and earnings and
meet other goals.
• Greater degrees of liquidity in assets
portfolios are available only in lower-yielding
assets like T-Bills.
• Loans are considered to be high yielding
assets; but are less liquid.
• To assure liquidity, banks are forced to trade
off profitability.
 Liability Management Strategies
• Control over a bank's liabilities (usually through
changes in interest rate offered) to provide the
bank with adequate liquidity and meet other
goals.
• An objective of liability management is to gain
control over the bank's funds sources.
• A bank could attract and increase inward funds
flow by raising interest on deposits, if it
experiences heavy loan demand at limited
resources.
 Funds Management Strategies
1. The coordinated management of both bank's assets
and its liabilities to ensure an adequate level of
liquidity and meet other goals.
2. This consolidated funds management has several key
objectives:
• Bank management should exercise as much control
as possible over the volume, mix, and return or cost
of both assets and liabilities to achieve the bank's
goals.
• Management's control over assets must be
coordinated with its control over liabilities so that
asset and liability management are internally
consistent and do not pull against each other;
• Effective coordination in managing assets and
liabilities will help to maximize the spread between
bank revenues and costs and control risk exposure.
 Policy Statement
Asset Liability Management Policy
Wholesale Borrowing Guidelines
Medium Term Funding Ratio
Maximum Cumulative Outflow
Liquidity Contingency Plan
Credit to Deposit Ratio (CD Ratio)
Credit to Core Capital Deposit Ratio (CCD Ratio)
Cash Reserve Ratio
Statutory Liquidity Ratio
Local Regulatory Compliance
 Objectives of ALM Policy
• Outline the scope and responsibilities of ALCO
• Define, measure and manage the various risks
• Maximize NII/NIM, Earnings, ROA, ROE by
keeping liquidity, forex, and interest rate risk
within acceptable and controllable levels,
• Protect the organization from disastrous
financial consequences arising from liquidity,
foreign and interest rate risk
 Asset Liability Committee (ALCO)
The committee consists of the following key
personnel of a bank:
• Chief Executive Officer / Managing Director
• Head of Treasury / Central Accounts Department
• Head of Finance
• Head of Corporate Banking
• Head of Consumer Banking
• Head of Credit
• Chief Operating Officer / Head of Operations
 Functions of ALCO
• Develop an asset-liability mgmt strategy and
procedures,
• Decide on desired maturity profile, mix and funding
sources of liabilities and assets,
• Assist in product pricing for deposits and advances
• To establish a monitoring and reporting system,
• To establish broad framework for measuring,
monitoring and managing liquidity, interest rate and
forex risk,
• To deal with cost and use of borrowed funds
• To estimate the volume of liquid assets required for
unanticipated needs,
• To make better use of short-term financial resources,
 Risk in banking Business
• Market Risk (Foreign exchange rate risk, Interest rate risk)
• Credit Risk
• Liquidity Risk
• Operational Risk
 Market Risk
The market risk is the negatively changing market values
of bank assets, liabilities and equity bringing about loss.
Indicators -
• The ratio of a bank's book value assets to the
estimated market value of those same assets
• The ratio of book value equity capital to the market
value of a bank's equity capital
• The market value of bank's bond and other fixed
income assets relative to their value as recorded on the
bank's books
• The market value of a bank's common and preferred
stock per share, reflecting investor perceptions of the
bank's risk exposure and its earnings potentials
 Market Risk
Market risk includes:
• Foreign Exchange Rate Risk
• Interest Rate Risk
• Price Risk
• Reinvestment Risk

Foreign Exchange Rate Risk: Adverse effects on

organization’s net income due to the change of
exchange rate (through net open position)
 Market Risk
• Price Risk
– When interest rates rise, the market value
of the bond or asset falls

• Reinvestment Risk
– When interest rates fall, the coupon
payments on a bond or maturing loans are
reinvested at lower rates, future income will
falls.
 Interest Rate Risk
The interest rate risk is the danger that shifting
interest rates adversely affecting a bank's net
income, the value of its assets or equity.
• The interest rate risk could not be completely
avoided; bankers simply can control either the
level of or the trend in market rates of interest.
• banker must be price taker, not price maker or
the banker must accept interest rates as a given
and plan accordingly.
 Interest Rate Risk contd..

Measures:
• The ratios of interest sensitive assets to
interest sensitive liabilities at a particular
maturity

• High volume of corporate and individual

depositors.
 Liquidity Risk
The liquidity risk is the adverse situation of having
insufficient cash to meet a bank's obligations when due.
Measures of Liquidity Risks -
• Purchased funds (including Eurodollars, fed. funds,
large CDs and commercial papers) to total assets
• Net loans to total assets
• Cash and due from deposit balance held at other banks
to total assets
• Cash assets and government securities to total assets
 Credit Risk
Credit Risk is the default by a borrower to whom a bank
has extended credit. The probability that some of a
bank's assets, especially its loans will decline in value and
perhaps become worthless is known as a credit risk.

Indicators:
• the ratio of non performing assets to total loans and
advances
• the ratio of the annual provision for loan losses to total
assets or loans and advances
• the ratio of allowance for loan losses to total loans and
advances or to equity capital.
 Other Risks

• Solvency Risk
• Inflation Risk
• Political Risk
• Crime Risk, etc.
Forces Determining Interest Rates
• Interest rate is determined by the financial
marketplace where suppliers of loanable
funds interact with demanders of loanable
funds

• The interest rate tends to settle at the point

where the quantities of loanable funds
demanded and supplied are equal.
 Determination of interest rate
Supply of
Loanable funds
Price of credit, investment

Rate of interest
Volume of credit

Demand of
loanable funds

0 Quantity of loanable funds

 Or

n
CFt
Market Price  
t 1 (1  YTM)
t
 Example
A bond purchased today at a price Rs. 950 and
promising an interest payment of Rs. 100 each
year over the next three years. It will be
redeemed by the bonds issuer for Rs. 1000.
Measure the rate using YTM.
 Solution
• Current Market Price = Rs 950
• Period (n) = 3 yrs.
• Expected Cash Flow (CF) = Rs. 100 each year.
• Future Value or Redemption price of security
=Rs. 1000
• YTM = ?
 Using Excel
pv = 950
nper = 3
pmt = 100
fv = 1000
type = 0

=RATE(3,100,-950,1000,0)
=12.1%
 Bank Discount Rate (DR)
Another interest rate measure

FV - Purchase Price 360

DR  *
FV # Days to Maturity

Where: FV equals Face Value

 Example
Suppose a money market security can be
purchased for a price of Rs. 96 and has a face
value of Rs. 100 to be paid at maturity of 90
days. Calculate interest rate using DR method.

(100 - 96) 360

DR    0.6or16 percent
100 90
 Interest Rates
Functions or Components of interest rates:
• Risk-Free Real Rate of Interest
• Various Risk Premiums
– Default Risk
– Inflation Risk
– Liquidity Risk
– Call Risk
– Maturity Risk
 Interest Rates
Simply, Interest means price of credit
Types of Interest Rate:
1. Simple Interest
2. Compounding Interest
3. Real Interest
4. Nominal Interest
5. Periodic Interest rate
6. Effective Interest rate
7. Yield to maturity
Economic Forces Affecting Interest Rate
• Economic Growth: increase the demand of
loanable funds which increase the interest
rate. In economic slowdown, interest rate
decrease.
• Inflation: Inflation cuts saving, decrease
loanable fund, interest rate increase,
in inflation period, business and household
wiling to borrow more which increase demand
of loanable fund, interest rate increase.
• Monetary policy: If monetary policy reduce
the money supply, reduce the supply of
loanble fund and interest rate goes up. And
vise versa.
• Budget deficit: High budget deficit (not
offsetting by govt. exp.), increase the demand
of loanable fund, increase Interest rate.
 Nominal Risk-free real
Risk premium
(published) interest rate
to compensate
market (such as the
lenders who
interest rate = inflation +
accept risk
on a risky adjusted return
inherent in the
loan or on government
business
security bond)
 Yield Curves
• Graphical Picture of Relationship Between Yields and
Maturities on Securities
• Shape of the Yield Curve determines the spread
between long term and short term interest rates. Has
profound influence on bank’s NIM
– Upward – Long-Term Rates Higher than Short-
Term Rates
– Downward – Short-Term Rates Higher than Long-
Term Rates
– Horizontal – Short-Term and Long-Term Rates the
Same
 Interest rate risk
• Financial institutions may lose either income or value
no matter which way interest rates go
• Rising rates can lead to losses on security
instruments and fixed rate loans as the value of
these instruments fall. Rising rates can also cause a
loss to income if the bank has more rate sensitive
liabilities than assets
• Falling interest rates can lead to capital gains but
could lead to losses if there are more interest rate
sensitive assets than liabilities
 Net Interest Margin
Interest Income - Interest Expenses
NIM 
Total Earnings Assets
For example: A bank records $ 4 billion in interest revenues from
its loans and security investments and $ 2.6 billion in interest
expenses paid. If the bank holds $ 40 billion in earning assets,
NIM?

$4 billion - $2.6 billion

NIM  100  3.50%
$ 40 billion
 Problem (Class work)
• If interest revenues are $63 million, interest
costs are $42 million, earning assets are 700
million. What is the NIM.

• In the above case, If interest costs and interest

revenues double while its earning assets
increase by 50% what will happen to NIM
 Solution

$ 63 million - $ 42 million
NIM  100  3.0%
$ 700 million

($ 63 million - $ 42 million)  2
NIM  100  4.0%
$ 700 million 1.5
 Concept of Gap
Normally, Assets = Liabilities
and ISA =ISL
But, in practice,
(Rs. in million)

91-180 181-270 271-365 Over 1 Total

Particulars 1-90 Days
Days Days Days Year Amount

Assets 6963 1305 1837 1489 2377 13972

Liability 2563 1071 1990 5205 1166 11995

Net Financial Assets 4400 235 -153 -3716 1212 1977

Cumulative NFA 4400 4634 4481 765 1977 0

 (Rs. in million)

1-90 91-180 181-270 271-365 Over 1 Total

Particulars Days Days Days Days Year Amount

Assets 26905 1141 2264 1264 36651 68225

Liabilities 15635 3049 3404 3116 37865 63069

Net Financial Assets 11271 -1908 -1140 -1852 -1214 5156

Cumulative NFA 11271 9362 8222 6370 5156 0

Interest-Sensitive Gap Measurements
Dollar
Interest Interest
Interest- -
= Sensitive Sensitive
Sensitive
Assets Liabilities
Gap
 Interest Sensitive GAP
Interest Sensitive Gap (IS GAP) = ISA – ISL
If, ISA > ISL, there is positive gap,
If, ISA<ISL, there is negative gap.
Or
The bank is said to have Asset (Positive) Sensitive
gap if ISA-ISL>0
And,
Liability (Negative) Sensitive gap if ISA-ISL<0
 Asset-Sensitive Bank Has
Positive Dollar Interest-Sensitive Gap

Liability Sensitive Bank Has

Negative Dollar Interest-Sensitive Gap
 Repriceable Assets
OR
Interest-Sensitive Assets
• Short term securities issued by governments
and private borrowers (about to mature)
• Short-term loans made by the banks to
borrowing customers (about to mature)
• Variable rate loans made by the bank to
customers
• Variable rate securities
 Repriceable Liabilities
or
Interest-Sensitive Liabilities
• Borrowings from the money market (such as
federal funds.
• Short-term savings accounts
• Money-market deposits (whose interest rates
are adjustable every few days)
• Variable-Rate Deposits
 Concept of Gap management
• Gap management involves the determining the
maturity distribution and the re-pricing schedule for
a bank’s assets and liabilities.
• When more assets are subject to re-pricing or will
reach maturity in a given period than liabilities or
vice versa, the Bank has a gap between assets and
liabilities and is exposed to loss from an adverse
movement in rates based on the gap’s size and
direction and period
 Goal of Interest Rate Hedging

One important goal of interest rate

hedging is to insulate the bank from the
damaging effects of fluctuating interest
rates on profits (NIM)
 Nonrepriceable Assets
• Cash in vault and deposits at the central banks
(legal reserve)
• Long-term loans made at a fixed interest rate
• Long-term securities carrying fixed rates
• Buildings and equipment.
 Nonrepriceable Liabilitis
• Demand deposits (which pay no interest rate
or a fixed interest)
• Long-term savings and retirement accounts
• Equity capital
 Measurement of IS GAP

Dollar IS GAP  ISA - ISL

IS GAP
Relative IS GAP 
Size of financial institutio n (TA)

ISA
Interest Sensitivit y Ratio (ISR)  100
IRL
Maturity profile used to identify, measure,
manage and control risk
Maturity Assets liabilities Gap Cumulative
size gap
1 Day $40 $30 +10 +10

1 week 120 160 -40 -30

1 month 85 65 +20 -10

2 months 280 250 +30 +20

3 months 455 395 +60 +80

Gap Positions and the Effect of Interest
Rate Changes on the Bank

• Asset-Sensitive Bank • Liability-Sensitive

– Interest Rates Rise Bank
• NIM Rises – Interest Rates Rise
– Interest Rates Fall • NIM Falls
• NIM Falls – Interest Rates Fall
• NIM Rises
 Asset Sensitive Bank

$ 10%, 8% 12%,10% 8%,6%

ISA 1000 100.0 120.0 80.0

ISL 800 64.0 80.0 48.0

IS GAP/NIM 200 36.0 40.0 32.0

 Asset Sensitive Bank
45

40
40

36
35
32
30

25
ISA Rate
20 ISL Rate
NIM
15
12
10 10
10 8 8
6
5

Original Rate Rise Rate Falls

 Liability Sensitive Bank

$ 10%, 8% 12%,10% 8%,6%

ISA 800 80.0 96.0 64.0

ISL 900 72.0 90.0 54.0

IS GAP/NIM -100 8.0 6.0 10.0

 Liability Sensitive Bank
14

12
12

10 10 10
10

8 8 8
8
ISA Rate
6 6 ISL Rate
6
NIM

Original Rate Rise Rate Fall

 Liability Sensitive Bank
14

12

10

8
ISA Rate
ISL Rate
6
NIM

0
Original Rate Rise Rate Fall
 Zero Interest-Sensitive Gap

When Dollar Interest-Sensitive Gap is Zero,

Interest Rates Change in Either Direction NIM
is Protected and Will Not Change
 Zero Interest-Sensitive Gap

$ 10%, 8% 12%,10% 8%,6%

ISA 100 10.0 12.0 8.0

ISL 100 8.0 10.0 6.0

IS GAP/NIM 0 2.0 2.0 2.0

 Zero Interest-Sensitive Gap
14

12
12

10 10
10

8 8
8
ISA Rate
6 ISL Rate
6
NIM

2 2 2
2

Original Rate Rise Rate Falls

 Zero Interest-Sensitive Gap
14

12

10

8
ISA Rate
ISL Rate
6
NIM

Original Rate Rise Rate Falls

Excel Example
 IS Gap (Real Case 1)
(Rs. in million)

S.N. Particulars 1 - 90 91 - 180 181 - 270 271 - Over 1

days days days 365 days year Total
1 Interest Sensitive Assets 4,382 1,099 826 847 2,269 9,423

Interest Sensitive
2 1,495 867 974 4,562 971 8,869
Liabilities
3 Gap (1 - 2) 2,887 233 (148) (3,715) 1,298 555

4 Cumulative Gap 2,887 3,120 2,972 (743) 555

Adjusted Interest Rate

5 0.25% 0.25% 0.25% 0.25% 1.00%
Change (IRC)

Impact on Earnings 7 8 7 (2) 6 26

6
(Cumulative Gap x IRC)

Accumulated Earnings 7 15 22 20 26
7
Impact to date
 IS Gap (Real Case 2)
(Rs. in million)

S.N. Particulars 1 - 90 91 - 180 181 - 270 271 - Over 1

days days days 365 days year Total
1 Interest Sensitive Assets 16039 528 1493 920 32637 51617
Interest Sensitive
2 7885 2497 2647 2775 27983 43787
Liabilities
3 Gap (1 - 2) 8154 -1970 -1154 -1855 4654 7829

4 Cumulative Gap 8154 6184 5030 3175 7829

Adjusted Interest Rate

5 0.25% 0.25% 0.25% 0.26% 1.00%
Change (IRC)

Impact on Earnings
6 20 15 12 8 78 134
(Cumulative Gap x IRC)

Accumulated Earnings
7 20 35 48 56 134
Impact to date
 Important Decision Regarding IS Gap

• Management Must Choose the Time Period

Over Which NIM is to be Managed
• Management Must Choose a Target NIM
• To Increase NIM Management Must Either:
– Develop Correct Interest Rate Forecast
– Reallocate Assets and Liabilities to Increase Spread
• Management Must Choose Volume of
Interest-Sensitive Assets and Liabilities
 NIM Influenced By:

• Changes in Interest Rates Up or Down

• Changes in the Spread Between Assets and
Liabilities
• Changes in the Volume of Interest-Sensitive
Assets and Liabilities
• Changes in the Mix of Assets and Liabilities
 Cumulative Gap

The Total Difference in Dollars Between

Those Bank Assets and Liabilities Which
Can be Repriced over a Designated Time
Period
Aggressive Interest-Sensitive Gap
Management
Expected Change Best Interest- Aggressive
in Interest Rates Sensitive Gap Management’s
Position Likely Action
Rising Market Positive IS Gap Increase in IS
Interest Rates Assets
Decrease in IS
Liabilities
Falling Market Negative IS Gap Decrease in IS
Interest Rates Assets
Increase in IS
Liabilities
 Problem
• If interest rate sensitive assets are $870 and
interest sensitive liabilities are $625 during
the next month. Is the bank asset sensitive or
liability sensitive. What happens to NIM if rate
rise? What happens to NIM if rates fall
 Solution
• As assets sensitive assets are larger the bank is
asset sensitive by $245
• If rates rise NIM increases. If rates fall NIM
decreases
 Problem
• If the gap for the one year period is $+ 135
million and rates fall by 2.5% then calculate
the expected change in NII. What would
happen if rates rise by 1.25%
 solution
• 135 million × (- .025) = - 3.38 million $
• 135 million × .0125 = + 1.69 $
 Problem
• Suppose interest sensitive assets are 570
million and interest rate sensitive liabilities are
685 million. What is the dollar interest
sensitive gap?
 Solution
• Dollar interest– sensitive gap = 570 – 685 = -
115
Interest-Sensitive Gap Management

IS Gap Expected Normal Aggressive

Position Change in IR Action Mgmt Action
Positive Rising Wait for gain Increase ISA
Decrease ISL
Falling Make gap Decrease ISA
Zero Increase ISL
Negative Rising Make gap Increase ISA
Zero Decrease ISL
Falling Wait for gain Increase ISL
Decrease ISA
 Problems with Interest-Sensitive Gap
Management
• Interest paid on liabilities tend to move faster than
interest rates earned on assets

• Interest rate attached to bank assets and liabilities do

not move at the same speed as market interest rates

• Point at which some assets and liabilities are repriced

is not easy to identify

• Interest-sensitive gap does not consider the impact

of changing interest rates on equity position
 The Concept of Duration
• IS GAP enables to combat the possibility
of losses of net interest margin or spread
due to changes in market interest rates.
• Changing interest rate also can damage
to net worth or value of firm.
 The Concept of Duration
Duration is the weighted average
maturity of a promised stream of future
cash flows.
 Duration gap measurement
• It is the difference between the duration of a bank’s
assets and the duration of its liabilities
• The duration of the banks assets can be determined
by taking the weighted average of the duration of all
assets in the portfolio
• The weight is the dollar amount of a particular type
of asset out of the total amount of assets
• The duration of liabilities can be determined in a
similar way
 To Calculate Duration
n
CF1  t1 CF2  t 2 CFn  tn
t 1 (1  YTM)
1

(1  YTM) 2
 ... 
(1  YTM) n
D n
CF1 CF2 CFn
t 1 (1  YTM)
1

(1  YTM) 2
 ... 
(1  YTM) n

n
CF1  t1 CF2  t2 CFn  tn
 (1  YTM) 1

(1  YTM) 2
 ... 
(1  YTM) n
D  t 1
CurrentMarket Pr ice
 In Summary

n
CFt

t 1 (1  YTM)
t
 Period (t )
D n
CFt
t 1 (1  YTM)
t
 Where,

n
CFt

t 1 (1  YTM )
t = Current Market Value or Price
 Finally

n
CFt

t 1 (1  YTM)
t
 Period (t )
D
CurrentMarket Pr ice
 Duration of a bank loan calculation
Loan term 5 years. Annual interest rate payment
is 10% ( or $ 100). The face value of the loan is
$1000 which is also its current value , because
the loan’s current yield to maturity is 10
percent.
• Loan’s duration?
 Duration (contd…)

CF CF PV Time PV x t
period expected @10% period
1 100 90.91 1 90.91
2 100 82.64 2 165.29
3 100 75.13 3 225.39
4 100 68.30 4 273.21
5 100 62.09 5 310.4
5 1000 620.92 5 3104.61
Dur. = 4,169.87/1000
=4.17 years
 Example 1
• Suppose a bank finds that it holds a Treasury
$1000 par bond with 10 years to final
maturity, bearing a 10% coupon rate with a
current price of $900.
• Calculate duration.
period cf pv pv*p
1 100 90.9 90.91
2 100 82.6 165.29
3 100 75.1 225.39
4 100 68.3 273.21
5 100 62.1 310.46
6 100 56.4 338.68
7 100 51.3 359.21
8 100 46.7 373.21
9 100 42.4 381.69
10 1100 424 4240.98
1000 6759.02
Duration 7.51
 IS Gap vs. Duration Gap
• IS Gap only looks at impact of changes in
interest rates on net income
• Duration takes into account the impact of
interest rate changes on the market value of
the bank’s equity position
 Portfolio Theory
• Rate effect: A rise in market rates of interest
will cause the market value (price) of both
fixed-rate assets and liabilities to decline.
• Duration effect: The longer the maturity of a
financial firm’s assets and liabilities, the more
they will tend to decline in market value
(price) when market interest rates rise.
 Example 2
A bank has $100 million in negotiable CDs
outstanding on which it must pay its customers
a 6 percent annual yield over the next two
calendar years. The duration of these CDs will be
determined by the distribution of cash
payments made over the next two years in
present value terms. Calculate the Duration of
the CDs.
period cf pv pv*p
1 6 5.66 5.66
2 6 5.34 10.68
2 100 89.00 178.00
Total 100.00 194.34
Duration 1.943
Using Duration to Hedge against
Interest Rate Risk

Dollar Dollar
weighted
duration of
the asset
portfolio
≈ weighted
duration of
liabilities
 Using Duration to Hedge against
Interest Rate Risk

Dollar
Dollar
Dollar
Duration = weighted
duration of
the asset
- weighted
duration of
liabilities
gap portfolio
Using Duration to Hedge against
Interest Rate Risk

Dollar
Duration
gap ≈ 0
 Dollar Wt. Avg. Asset Portfolio
Duration


Market Value
Duration
of each asset
of each
asset in
× in the
portfolio
Dollar i 1 portfolio
Wt. Avg. = Total Market Value of all
Duration
assets
Duration of an Asset portfolio

n
D A   D Ai  wi
Where: i 1
wi = the dollar 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
D L   D Li  wi
Where: i 1
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio
 Example
Actual or Estimated Assets
Assets held Market Values of Assets ($ Duration
millions) (years)
Treasury Bonds 90.0 7.49
Commercial Loans 100.0 0.6
Consumer Loans 50.0 1.2
Real estate Loans 40.0 2.25
Municipal Bonds 20.0 1.5

Calculate dollar weighted average asset portfolio.

 w D
Actual or Estimated
Assets Duration
Assets held Market Values of W*D
(years)
Assets ($ millions)

Treasury Bonds 90.0 7.49 674.1

Commercial Loans 100.0 0.6 60.0

Consumer Loans 50.0 1.2 60.0

Real estate Loans 40.0 2.25 90.0

Municipal Bonds 20.0 1.5 30.0

300.0 914.1

Dollar Wt. Avg. Asset duration 3.047

 Leverage Adjusted Duration Gap
• Volume of assets usually exceeds the volume
of liabilities.
• Otherwise, the financial institution would be
insolvent.
• Leverage should be adjusted to minimize the
effects of interest rate fluctuations.
 Leverage Adjusted Duration Gap

Dollar Dollar Total

Leverage weighted weighted Liabilities
adjusted =
duration
of the
- duration × Total
Duration of
asset Assets
gap portfolio liabilities
 Duration Gap

TL
D  DA - DL 
TA
 Duration gap calculation
• Asset duration is 2.5 years, liability duration is 3
years, total assets = $560 million and total liabilities =
$467 million
 Solution
Duration gap = DA –DL × TL/TA
= 2.5 yrs – 3 yrs × (467/560)
= 2.5 – 2.5018
= - .018 years
 Price Sensitivity of a Security
P i
 -D
P (1  i)
Where,
• ΔP/P = %change in market price of an asset,
• Δi/(1+i) = relative change in interest rate associated with
the assets or liabilities,
• D = duration,
• Negative sign = market price and interest rate on
financial instruments move in opposite directions.
• Interest rate risk of financial instruments is directly
proportional to their duration.
 Example
Suppose, a bond carrying a duration of 4 years
has a current market value (price) of $ 1000.
Market interest rate attached to the bond is 10
percent currently, but recent forecast suggests
that market rates may rise to 11 percent. If this
forecast turns out to be correct, what
percentage change will occur in the bond’s
market value?
 Solution
• Duration= 4, and interest rates go up from 10
to 11 pct
• Change in price % = -D x Δ i/1+I
• -4 x .01/1+.10 = - 3.64%
• If rate go down from 10 to 9 pct then
• -4 x -.01/1+.10 = + 3.64%
Change in the Value of Bank’s Net Worth
NW = A – L
ΔNW = ΔA – ΔL (i)
We Know,
ΔP/P = -D × (Δi/(1+i))
Or
ΔA/A = -D × (Δi/(1+i))
Change in the Value of Bank’s Net Worth
ΔA/A = -D × (Δi/(1+i))
Or
ΔA = -D × (Δi/(1+i))× A
Similarly,
ΔL = -D × (Δi/(1+i))× L
Change in the Value of Bank’s Net Worth
Replacing the value of ΔA and ΔL in
equation (i),

ΔNW= [-D×(Δi/(1+i))×A]-[-D×(Δi/(1+i))×L]
or

 i   i 
NW  - D A   A - - D L   L
 (1  i)   (1  i) 
 Duration gap calculation
• Asset duration is 3.25 years and liability
duration is 1.75 years. The liabilities amount
to $485 million while assets total $512 million.
Interest rates rise form 7 to 8 per cent.
• Calculate duration gap. What happens to the
net worth.
 solution
• First calculate duration gap.
• Duration gap = 3.25 yrs – 1.75 yrs *485/512 =
+ 1.5923
• The change in net worth due to the increase in
interest rates is = {-3.25yrsx .01/(1+.07) x
$512} – {-1.75 yrs x .01/(1+.07) x $485 mill } =
-7.62
 Example
Average
Market Interst
Assets Duration
value ($) Rate (%)
(Yrs)
Treasury bills 90.0 10.00 7.490
Municipal bonds 20.0 6.00 1.500
Commercial loans 100.0 12.00 0.600
Consumer loans 50.0 15.00 1.200
Real estate loans 40.0 13.00 2.250
Total 300.0
 Average
Market Interst
Liabilities Duration
value ($) Rate (%)
(Yrs)
Negotiable CDs 100.0 6.00 1.9430
Other time deposits 125.0 7.20 2.7500
Subordinated notes 50.0 9.00 3.9180
Total Liabilities 275.0
Equiti capital 25.0
Total 300.0
 Calculation of Wt. Average Duration
of Assets
Average
Market
Assets Duration Wt.*P
value ($)
(Yrs)
Treasury bills 90.0 7.490 2.247
Municipal bonds 20.0 1.500 0.100
Commercial loans 100.0 0.600 0.200
Consumer loans 50.0 1.200 0.200
Real estate loans 40.0 2.250 0.300
Total 300.0 3.047
Wt. Average
Duration of Assets 3.047
 Calculation of Wt. Average Duration
of Liabilities
Average
Market
Liabilities Duration Wt.*P
value ($)
(Yrs)

Negotiable CDs 100.0 1.9430 0.707

Other time deposits 125.0 2.7500 1.250
Subordinated notes 50.0 3.9180 0.712
Total Liabilities 275.0 2.669
Wt. Average Duration
of Liabilities 2.669
 Change in Value of Net Worth
 i   i 
NW  - D A   A  - - D L   L
 (1  i)   (1  i) 
Suppose interest rate on both assets and liabilities rise
from 8 to 10 percent. The filling in the asset and
liabilities figures from the example above gives this
result.
 (0.02)   (0.02) 
NW  - 3.047yrs.   $300m - - 2.669yrs.   $275m
 (1  0.08)   (1  0.08) 

= -$3.34 million
Interpretation: Net worth would fall by $3.34 million if interest rate
increase by 2 percent points.
Suppose interest rate on both assets and liabilities fall
from 8 to 6 percent. What would happen to the value of
the above example?

Substituting the value in the same formula:

 (0.02)   (0.02) 
NW  - 3.047yrs.   $300m - - 2.669yrs.   $275m
 (1  0.08)   (1  0.08) 

= +$3.34 million
Interpretation: Net worth would rise by $3.34 million if interest rate
fall by 2 percent points.
Calculation of leverage adj. Duration Gap
TL
D  DA - DL 
TA
=3.047 yrs - 2.669 yrs X$275/$300

= +0.60 years
Interpretation:
The positive duration gap of +0.60 years means that the bank’s net
worth will decline if interest rates rise and increase if interest rates
fall.
 Impact of Changing Interest Rates on a
Bank’s Net Worth
If the FIs’ Leverage Adj. If Interest NW will
Duration Gap is: Rate
Rise Decrease
Positive (DA>DL×L/A)
Fall Increase

Negative (DA<DL×L/A) Rise Increase

Fall Decrease
Zero (DA=DL×L/A) Rise No Change
Fall No Change
 Limitations of Duration Gap
Management
• Finding assets and liabilities of the same duration can
be difficult
• Some assets and liabilities may have patterns of cash
flows that are not well defined
• Customer prepayments may distort the expected cash
flows in duration
• Customer defaults may distort the expected cash flows
in duration
 Issues for Discussion
• When market interest rate increase, price of
long-term assets decrease. Why?
• What about re-priceable assets?