COMMERCIAL BANK MANAGEMENT

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 Commercial Bank Management

CHAPTER 5

Risk management of commercial banks

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Learning Objectives

• Asset, Liability, and Funds management

• Market rates and interest-rate risk

• Interest-sensitive gap management

• Duration gap management

• The Use of Derivatives: Financial Futures, Options, Swaps, and Other Hedging Tools

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Chapter 5: Tools for managing and hedging against risk

5.1 Overview of bank risks and risk management

5.1.1 General risk management 5.1.2. Credit risk management
5.1.3. Interest rate risk management 5.1.4. Liquidity risk management
5.1.5. Operational risk management 5.1.6. Market risk management

5.2 Strategies and tools for interest rate risk management

5.2.1 Asset, liability, and funds management
5.2.2. Interest-sensitive gap management
5.2.3. Duration gap management
5.2.4. Tools for hedging: futures, options, swaps, and other tools

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Chapter 5: Tools for managing and hedging against risk

5.3 Strategies for liquidity risk management

5.3.1. Estimating liquidity needs

5.3.2. Liquidity management strategies
5.3.3. Legal reserves and money management

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5.1 Overview of bank risks and risk
management

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5.1.1. The role of risk-taking

• Main objective : Maximizing shareholders’ wealth by pursuing risky projects

• Trade-off between risk and returns. Banks must take risk to generate returns,
especially when competition is high
• However, there is risk levels that shareholders cannot tolerate. Excessive levels of
risk would be detrimental to shareholders’ wealth
• Thus, risk management aims to limit risk profiles of banks (or any other companies)
within acceptable risk levels

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5.1.1. Approaches to risk-return assessment

Hempel and Simonson (2008) suggest a three-step approach:

I. Evaluate risk-return decisions of comparable banks and banking groups.
II. Contrast the bank's performance with similar institutions.
III. Establish realistic objectives based on historical performance, peer benchmarks, and
external factors.
This approach is based on the following analysis:
• Assess stock market expectations (if bank is listed).
• Analyze past performance trends.
• Evaluate peers' performance trends, considering factors like business mix, technology,
and external environment.

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5.1.1. Main elements of bank risk management

Six fundamental principles of risk management:

o Risk identification: Identifying, analyzing and understanding potential risks
o Risk measuring: Assessment of risks’ likelihood and impacts
o Risk mitigation: Strategies and measures to mitigate potential impacts
o Risk monitoring: Continuously monitor the effectiveness of risk management strategies
o Risk communication: Communication between stakeholders about risk and related- strategies
o Risk review and evaluation: Periodic reviews and evaluation of risk management process and
make adjustment if needed.

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5.1.1. Factors affecting the quality of banking risk management

• Banking regulation: The emergence and continuous development regulatory

frameworks, such as Basel framework, improve the soundness of individual banks and
the whole banking systems in many countries
• Risk culture shared among employees in financial institutions. Tone at the top does
matter
• Compensation policies for top executives: some compensation components may affect
risk-taking behavior of CEO, CFO, CRO, etc.

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5.1.1. Common risks in banking businesses

Can you name common risks that banks may face in their daily
operation/ activities?

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5.1.2. Credit risk management

• Credit risk is the likelihood of a borrower or counterparty failing to meet agreed

terms, such as repaying loan principals, interests, or other committed amounts.
• The main goal: Optimize a bank's returns while keeping credit risk exposure in
check.
• Customer loans, especially corporate loans, can be very serious due to their size
and interconnectedness.

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5.1.2. Credit risk management

• Managing credit risk is vitally important, because:

(i) Loans are largest and most obvious source of risk.
(ii) Credit risk may arise from different activities, both on and off the balance sheet

• Credit risk management involves:

(i) Managing risk from individual loans and loan portfolio and other transactions (e.g.,
Swap, options, dividend repayments on bonds).
(ii)Managing the interaction between credit risk and other risks

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5.1.2. Credit risk measurement

• For individual loan:

Banks need to measure two dimensions:
(i) The quantity of risk (i.e., the amount that can be lost)
(ii)The quality of risk: this is captured by the probability of default and the
likelihood of loan recovery in the event of default. Third-party guarantees or collaterals
may help to improve loan quality.

• For portfolio of loans:

Concentration risk needs to be considered. Customers’ default events may correlate
with each other, thus amplifying the risk.

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5.1.2. Loan evaluation to manage credit risk

• Main source of credit risk is the information asymmetry between banks and borrowers,
including selection bias and moral hazard.
• Loan evaluation process helps to mitigate information asymmetry. The process requires
information on potential borrowers to evaluate their quality.
• The process involves: Credit checking and Credit scoring

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5.1.2. Credit checking

• Banks examine applicant entries on credit registers and credit agencies like Experian. In
Vietnam we have CIC [Link] (“Trung tâm thông tin tín dụng quốc gia Việt
Nam”)
• Collect factual information includes names, addresses, id number, and past credit
histories.
• Credit checks reveal county court judgments or defaults against individuals.
• The outcome of this process is known as credit reference of this borrower.

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5.1.2. Credit scoring

• Banks use a qualitative approach initially, asking potential borrowers financial and non-
financial questions.
• Responses are assigned points or weights based on relevance to creditworthiness criteria,
such as the 'five Cs': character, capacity, capital, collateral, and conditions.
• A quantitative approach replaces personal judgement, using applicant-provided data to
calculate default probability through statistical analysis.
• The quantitative approach may vary, can be very simple (linear model) to very complex
(neural network)
• Credit scoring systems award points based on predictive factors, generating a credit score
indicative of repayment likelihood. Higher score means lower probability of default

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5.1.2. Managing loan portfolio

• Heavy loan concentration can be devastating

• Banks need to diversify their lending to different sectors, geographical locations, industry,
maturities, products.
• To assess credit risk of the aggregate loan portfolio, bank managers need to:
(i) Measure expected loss
(ii) Measure unexpected loss
• Expected loss and unexpected loss are influenced by customers’ probability of default,
exposure at default, and loss given default.

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5.1.3. Interest risk management

• Interest rate risk is the exposure of a bank's financial condition to adverse movements in
interest rates.
• Future losses or gains from interest rate fluctuations make a bank’s earnings less predictable
• It stems from mismatching the maturities of assets and liabilities, typically through
issuing longer-term assets funded by short-term deposits.
• Market movements or regulatory changes or central bank policies altering interest rates can
significantly impact a bank's interest rate risk exposure.

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5.1.3. Why we manage interest risk?

• Interest rate risk can lead to fluctuations in a bank's net interest income, impacting profitability
• Banks face reinvestment risk when they must reinvest funds from maturing assets at lower
interest rates.
• Conversely, there's funding risk when the cost of borrowing increases for banks, affecting their
interest expenses.
• Changes in interest rates can influence consumer behavior, affecting demand for loans and
deposits
• Interest rate risk can also impact a bank's liquidity position, as sudden rate changes may
affect the ability to access funding or sell assets.

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5.1.3. Managing interest risk

• Traditionally managed within Asset and Liability Management (ALM) functions

• Two primary management approaches for measuring interest rate risk are "gap" and "duration"
analysis.
• Large banks utilize advanced techniques for interest rate risk measurement
• Simulation approaches
Simulations of future interest rate changes' impact on earnings and economic value.
Entail a breakdown of various categories of on- and off-balance-sheet positions to incorporate
specific assumptions about cash flows.

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5.1.3. Managing interest risk

Textbook exercises (Chapter 7 of Rose & Hudgins, 2012)

4. Farmville Financial reports a net interest margin of 2.75 percent in its most recent financial
report, with total interest revenue of $95 million and total interest costs of $82 million. What
volume of earning assets must the bank hold? Suppose the bank’s interest revenues rise by 5
percent and interest costs and earning assets increase 9 percent. What will happen to Farmville's
net interest margin?

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5.1.4 Liquidity risk management

Bank deposits requires high liquidity, while many bank assets (loans, property investment)
is highly illiquid

• A bank needs liquid funds to cover a possible surge in operating expenses and to satisfy
loan demand, especially when they play central role in the payment process
• For example: Unexpected large withdrawals by depositors exceed available cash reserves,
leading to potential insolvency if it cannot quickly obtain additional funds from selling
liquid assets.

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5.1.4. Demand for and Supply of Liquidity

Supplies of Liquid Funds Demands for Liquidity

• Incoming customer deposits • Customer deposit withdrawals
• Revenues from the sale of non-deposit • Credit requests from quality loan
services customers
• Customer loan repayments • Repayment of non-deposit borrowings
• Sales of bank assets • Operating expenses and taxes
• Borrowings from the money market • Payment of stockholder dividends

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5.1.4. Demand for and Supply of Liquidity

A Bank’s net liquidity position

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5.1.4 Liquidity risk management

• Liquidity risk refers to the potential inability of a bank to meet short-term obligations
due to a mismatch between the timing of its assets and liabilities, or an unexpected
drain on its cash reserves

• Consequences:
(i) Financial instability or insolvency
(ii) Impairment to reputational capital

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5.1.4 Liquidity risk management

• Types of Liquidity Risk:

(i) Day-to-day liquidity risk: predictable small daily withdrawals. Banks can cover shortage
of cash by borrowing funds from other institutions and capital markets.
(ii) Liquidity crisis: usually unpredictable, abnormally large withdrawals. Liquidity crisis
leads to elevated borrowing costs due to a lack of creditworthiness or unexpectedly large
need of cash.
Bank run is potential in this case if depositor demands aren't met and there is no
support from central banks and deposit insurance, thus escalating to solvency crisis.

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5.1.4 Liquidity risk management

• Mitigating liquidity risk:

 Increase cash and marketable assets, such as T-bills and other government securities
 Use longer-term liabilities to fund banks’ operations
 However, balancing liquidity with profitability is a challenge. Liquid assets yield no or small
returns, thus reducing banks’ profitability and vice versa.
• Monitoring liquidity risk
(i) Short-term securities to total deposits ratio.
(ii)Loan/deposits ratio.
For example, if a bank holds $50 million in 1-year Treasury bills and has total deposits of $500
million, the short-term securities to total deposits ratio = 10%

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5.1.5 Operational risk management

• Definition:
 Defined by Basel Committee as risk of loss from internal processes, people, systems, or
external events.
 Encompasses failures in bank systems, controls, and management.

• This definition also covers technology risk which is the potential loss due to
breakdowns in existing technology or back-office support systems.
• However, technology risk may be different from operational risk because it covers
failure of tech investments to produce expected cost savings or inefficiencies due to
new systems

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5.1.5 Operational risk management

Can you guess and provide examples of operational risk events?

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5.1.5 Operational risk management
Risk event types Risk event types
Intentional misreporting of positions, employee theft, and insider
Internal fraud
trading on an employee’s own account.
Robbery, forgery, cheque kiting* and damage from computer
External fraud
hacking.
Workers’ compensation claims, violation of employee health and
Employment practices and
safety rules, organised labour activities, discrimination claims and
workplace safety
general liability.
Fiduciary breaches, misuse of confidential customer information,
Clients, products and business
improper trading activities on the bank’s account, money laundering
practices
and sale of unauthorised products.
Damage to physical assets Terrorism, vandalism, earthquakes, fres and floods
Business disruption and system Hardware and software failures, telecommunication problems and
failures utility outages
Data entry errors, collateral management failures, incomplete legal
Execution, delivery and process documentation, unapproved access given to client
management accounts, non-client counterparty mis-performance and vendor
disputes.

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5.1.5 Operational risk management

• Previously, Basel I only requires banks to allocate risk capital to absorb possible losses
of credit and market risks
• However, Basel II requires banks to allocate risk capital for operational risk
• Cyber risks in operational risk
 Cyber risks identified as top operational concerns in 2020, including IT disruption,
data compromise, theft, and fraud.
 Cyber risks differ from other operational risks in form and potential impact.
 Financial firms allocate approximately 12% of IT budget to cyber security

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5.1.6 Market risk management

• Market risk definition: the risk of losses from market price movements in on- and off-
balance-sheet positions.
• Basel I (in amendments), II, and III requires banks to hold capital to absorb potential losses
due to market risk
• Two types of market risk:
 Systematic market risk: a movement in the prices of all market instruments due to
macrofactors
 Specific market risk: situations where the price of distinctively fluctuates because of events
related to the issuer of the instrument

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5.1.6 Market risk management

• Market risk includes changes in interest rates, exchange rates, and securities' prices.
• Bonds and equity sensitive to market interest rates and currency prices, impacting
perception of risk and earnings potential.
• Some indicators of market risk:
 Book value of assets/estimated market value of those same assets
 Book value of equity capital/market value of equity capital
 Market value of bonds and other fixed-income assets/their fair value

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5.1.6 Measuring Market risk

• For large banks:

Value-at-Risk (VaR) analysis: Estimates likely maximum loss on a bank's portfolio under
normal condition over a specific time period, with a certain level of confidence  Helps
banks decide how much capital they need to hold to absorb potential losses.
Expected Shortfall (ES) analysis: average of potential losses exceeding VaR, addressing
VaR's shortcomings  Helps predict extreme losses beyond the confidence level, such as
during a financial crisis, where losses may be much larger.
• For small banks:
Sensitivity analysis assesses price sensitivity of assets/liabilities to changes in interest
rates, etc., impacting stockholders' equity.

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5.1.6 Measuring Market risk

Example of historical simulation VaR:

Given that the mean of daily return from trading activities is 1%. Standard deviation of daily return
is 1.5%. Assume that the return follows standard normal distribution. The portfolio value is $100m
At a 99% confidence level, the bank expects losses to exceed the calculated VaR only 1% of the
time.
VaR (99%) = 1% - (1.5% * 𝟗𝟗% ) = 1% - (1.5% x 2.33) = -2.495%

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5.2 Strategies and tools for interest rate risk
management

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5.2.1 Asset-Liability Management Strategies

• Asset-Liability Management:
o Definition: coordinated and integrated decision making in managing asset and liability
portfolios
o Purpose: controlling a bank’s sensitivity to changes in market interest rates and limit its
losses in its net income or net worth.

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5.2.1 Asset-Liability Management Strategies

• Historical strategies of asset-liability management:

o Asset management strategy (control assets – allocating funds in loans and investments;
no control over liabilities – taking the funds as solely determined by the public)
o Liability management strategy (control liabilities by changing rates and other terms)

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5.2.1 Asset-Liability Management Strategies

• Historical strategies of asset-liability management:

o ALM management strategy:
 Control over the volume, mix, and return or cost of both assets and liabilities
 Control over assets coordinated with control over liabilities to maximize the spread
between revenues and costs and control risk exposure
 Revenues and costs arising from both sides of the balance sheet (i.e., from both asset
and liability accounts)

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5.2.1 Asset-Liability Management Strategies

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5.2.1 Asset-Liability Management Strategies

• Asset and Liability Management Committee (ALCO):

o Composing of key officers representing different departments
o Primary responsibility: interest rate risk management
o Coordinating the bank’s strategies to achieve the optimal risk/reward trade-off.

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5.2.2. Market Rates and Interest Rate Risk

• Forces Determining Interest Rates

• Banks engage in both

supply and demand for
loanable funds
• Interest rates are
determined by the supply
& demand of the market
for loanable funds
• Interest rate risk: including
price risk & reinvestment
risk

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5.2.2. Market Rates and Interest Rate Risk

• The Components of Interest Rates:

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5.2.2. Market Rates and Interest Rate Risk

• Yield curves:
o Definition: graphical picture of relationship between yields and maturities on securities,
generally created with Treasury Securities to keep default risk constant

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5.2.2. Market Rates and Interest Rate Risk

• Yield curves:
o Shape of the yield curve
 Upward – long-term rates higher than short-term rates (economic expansion)
 Downward – short-term rates higher than long-term rates (economic recession)
 Horizontal – short-term and long-term rates the same

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5.2.2. Market Rates and Interest Rate Risk

• Yield curves:
o Shape of the yield curve and the maturity gap
 Typical maturity gap of a bank: longer maturities of assets (loans & securities) than
liabilities (deposits)
 Upward sloping yield curve benefits banks, generating positive net interest margin
 Downward and horizontal yield curve put negative pressure in bank earnings

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5.2.2. Market Rates and Interest Rate Risk

• Interest rate risk:

o Example:
A bank makes a $10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank
initially funds the car loan with a one-year $10,000 CD at a cost of 4.5%. The bank’s initial
spread is 4%. What is the bank’s risk?

4 year Car Loan 8.50%

1 Year CD 4.50%
4.00%

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5.2.2 Interest-Sensitive Gap Management

• Goal of interest rate hedging: to insulate the bank from the damaging effects of
fluctuating interest rates on profits.
o Must concentrate on those interest-sensitive assets (ISA) and liabilities (ISL)
o Management seeks to hold fixed the net interest margin (NIM):

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5.2.2 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o Analysis of the maturities and repricing opportunities associated with interest-bearing
assets & interest-bearing liabilities
o Zero gap:

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5.2.2 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap :

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5.2.2 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o A gap exits: the amount of repriceable assets is different from that of repriceable liabilities

Dollar
Interest-Sensitive = ISA - ISL
Gap (IS Gap)

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5.2.2 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o Asset-sensitive bank: having positive gap

 If interest increases: NIM increases; if interest decreases: NIM decreases

 To reduce risk: increase ISL and decrease ISA

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5.2.2 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o Liability-sensitive bank: having negative gap

 If interest increases/decreases: how will NIM change?

 How to reduce risk?

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5.2.2 Interest-Sensitive Gap Management

• Relative IS GAP ratio

 Relative IS GAP > 0: asset-sensitive bank

 Relative IS GAP < 0: liability-sensitive bank

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5.2.2 Interest-Sensitive Gap Management

• Interest Sensitivity Ratio (ISR): to compare the ratio of ISA to ISL

 ISR > 1: asset-sensitive bank

 ISR < 1: liability-sensitive bank

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5.2.2 Interest-Sensitive Gap Management

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5.2.2 Interest-Sensitive Gap Management

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

o Asset-sensitive bank o Liability-sensitive bank

 Interest rates rise: NIM rises  Interest rates rise: NIM falls
 Interest rates fall: NIM falls  Interest rates fall: NIM rises

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5.2.2 Interest-Sensitive Gap Management

• Example:

Calculate NIM and GAP?

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5.2.2 Interest-Sensitive Gap Management

• Example:
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 1,000 8.0% $ 1,200 4.0%
Fixed rate $ 700 11.0% $ 440 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000

NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200
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5.2.2 Interest-Sensitive Gap Management

• Zero Interest-Sensitive Gap

o Dollar Interest-Sensitive Gap is Zero
o Relative Interest-Sensitive Gap is Zero
o Interest Sensitivity Ratio is One
o When Interest Rates Change in Either Direction - NIM is Protected and Will Not Change

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5.2.2 Interest-Sensitive Gap Management

• Can a bank with zero gap completely hedge its NIM?

o No as practically the interest rates attached to assets and liabilities are not perfectly
correlated in the real world
 E.g: Loan interest rates tend to lag behind interest rates on many money market
borrowings.
 So interest revenues often tend to grow more slowly than interest expenses during
economic expansions, while interest expenses tend to fall more rapidly than interest
revenues during economic downturns.

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5.2.2 Interest-Sensitive Gap Management

• Important decisions under gap management:

o Choose the time period during which NIM is to be managed
o Choose a target level, i.e. freezing or increasing NIM.
o To Increase NIM Management must either: (i) Develop correct interest rate forecast or (ii)
Reallocate assets and liabilities to increase spread
o Determine the volume of ISA and ISL

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5.2.2 Interest-Sensitive Gap Management

• Factors affecting NIM:

o Changes in the level of interest rates
o Changes in the spread between assets and liabilities
o Changes in the volume of interest-sensitive assets and liabilities
o Changes in the mix of interest-sensitive assets and liabilities

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5.2.2 Interest-Sensitive Gap Management

• Steps in gap analysis:

o Develop an interest rate forecast
o Select a series of “time buckets” or intervals for determining when assets and liabilities will
re-price
o Group assets and liabilities into these “buckets”
o Calculate the GAP for each “bucket ”
o Forecast the change in net interest income given an assumed change in interest rates

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5.2.2 Interest-Sensitive Gap Management

• Cumulative gap: The total dollar difference ISA & ISL over a designated time period.
o E.g: ISA = $100m; ISL = $200m; subject to change each month over the next six months.
Cumulative gap =($100 million in ISA per month x 6) - ($200 million in ISL per month x 6) =
-$600 million.
o Suppose market interest rates suddenly rise by 1%, net interest income loss
= (+0.01) X (-$600 million) = -$6 million

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5.2.2 Interest-Sensitive Gap Management

• Cumulative gap: Based on cumulative gap concept, we can calculate approximately how NII
will be affected by an interest rate change.

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5.2.2 Interest-Sensitive Gap Management

• Aggressive interest-sensitive gap management:

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5.2.2 Interest-Sensitive Gap Management

• Aggressive interest-sensitive gap management:

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5.2.2 Interest-Sensitive Gap Management

• Defensive interest-sensitive gap management:

Set interest-sensitive GAP as close to zero as possible to reduce the expected volatility of NII

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5.2.2 Interest-Sensitive Gap Management

• Problems with interest-sensitive gap management:

o Interest paid on liabilities tend to move faster than interest earned on assets
o Interest rate attached to bank assets and liabilities do not move at the same speed as market
interest rates
o Point at which some assets and liabilities are re-priced is not easy to identify
o Not considering the impact of changing interest rates on equity position

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5.2.2 Interest-Sensitive Gap Management

Exercises:
1. Commerce National Bank reports interest-sensitive assets of $870 million and interest-
sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive or
liability sensitive? What is likely to happen to the bank’s net interest margin if interest
rates rise? If they fall?
2. People’s Savings Bank , a thrift institutions, has a cumulative gap for the coming year of
+$135 million, and interest rates are expected to fall by two and a half percentage points.
Calculate the expected change in net interest income that this thrift institution might
experience. What will occur in net interest income if interest rates rise by one and a
quarter percentage points?

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5.2.3 Duration Gap Management

• Goal of interest rate hedging: protecting the bank from the damaging effects of
fluctuating interest rates on net worth (NW).

• As market interest rates change, the value of both assets and its liabilities will change,
resulting in a change in its NW:
o A rise in market rates of interest will cause the market value (price) of both fixed-rate
assets and liabilities to decline.
o The longer the maturity, the more the declination

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5.2.3 Duration Gap Management

• Duration (D):
o a value- and time-weighted measure of maturity that considers the timing of all cash
inflows & outflows
o In effect, duration measures the average time needed to recover the funds committed to
an investment
n n

 (1  YTM)
t * CF t
t  (1  YTM)
t * CF t
t
D  t 1  t 1
n Current Market Value or Price
 (1  YTM)
t 1
CF t
t

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5.2.3 Duration Gap Management

• Duration (D):
o Example: Suppose that a bank grants a loan to one of its customers for a term of five
years. The customer promises the bank an annual interest payment of 10 percent. The
face (par) value of the loan is $1,000, which is also its current market value (price). What
is this loan duration?

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5.2.3 Duration Gap Management

• Duration (D):
o Example:

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5.2.3 Duration Gap Management

• Duration (D):
o A bank with longer-duration assets than liabilities will suffer a greater decline in NW
when market interest rates rise (than a bank with short-term asset duration or matching
the duration of liabilities with assets)
o Equating asset and liability durations  immunize NW from interest rate risk.

• Convexity:
o The rate of change in an asset’s price or value varies with the level of interest rates or
yields

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5.2.3 Duration Gap Management

• Price Sensitivity to Changes in Interest Rates and Duration:

o The % change in the market price of an asset/liability is equal to its duration times the
relative change in interest rates attached to that particular asset or liability:

P i
 - D*
P (1  i)
o The interest-rate risk of financial instruments is directly proportional to their durations.
A financial instrument whose duration is 2 will be twice as risky (in terms of price
volatility) as one with a duration of 1.

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5.2.3 Duration Gap Management

• Price Sensitivity to Changes in Interest Rates and Duration:

o Example: a bond held by a savings institution with a duration of four years and a current
market value (price) of $1,000. Market interest rates attached to comparable bonds are
about 10% currently, but recent forecasts suggest 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?

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5.2.3 Duration Gap Management

• Dollar-weighted duration of asset portfolio:

n
DA   w i * D Ai
i 1

wi = the dollar amount of the ith asset divided by total assets

DAi = the duration of the ith asset in the portfolio

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5.2.3 Duration Gap Management

• Dollar-weighted duration of liability portfolio:

n
DL   wi * DLi
i 1

wi = the dollar amount of the ith liability divided by total assets

DAi = the duration of the ith liability in the portfolio

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5.2.3 Duration Gap Management

• Leverage adjusted duration gap:

TL
D  DA - DL *
TA
o TL = the total liabilities divided
o TA = the total assets
o The larger the leverage-adjusted duration gap, the more sensitive will be the net worth
to a change in interest rates

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5.2.3 Duration Gap Management

• Change in the value of a bank’s net worth:

 i   i 
NW  - DA * * A - - DL * * L
 (1  i)   (1  i) 

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5.2.3 Duration Gap Management

• Change in the value of a bank’s net worth:

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5.2.3 Duration Gap Management

• Change in the value of a bank’s net worth:

Example: A financial firm has an average duration in its assets of three years, an average
liability duration of two years, total liabilities of $100 million, and total assets of $120 million.
Interest rates were originally 10 percent, but suddenly they rise to 12 percent. What is the
impact on the bank’s NW?

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5.2.3 Duration Gap Management

• Impact of changing interest rates on a bank’s net worth:

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5.2.3 Duration Gap Management

• Aggressive duration gap management strategy:

• Defensive duration gap management strategy: zero leverage-adjusted duration gap

(portfolio immunization)

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5.2.3 Duration Gap Management

• Limitations of duration gap management

o Finding assets and liabilities of the same duration can be difficult
o Some assets and liabilities may have patterns of cash flows that are not well defined
o Customer prepayments may distort the expected cash flows in duration
o Customer defaults may distort the expected cash flows in duration
o Convexity can cause problems

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5.2.4 Tools for hedging: Futures, Options,
Swaps, and Other Tools

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5.2.4. Financial Futures Contracts

• Financial futures contract:

o Definition: an agreement reached today between a buyer and a seller that calls for
delivery of a particular security in exchange for cash at some future date.
o Purpose: shift the risk of interest-rate fluctuations from risk-averse investors, such as
banks and insurance companies, to speculators willing to accept and possibly profit from
such risks.

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5.2.4. Financial Futures Contracts

• The Long Hedge in Futures:

o Used when market interest rates are expected to decline & cash inflow (e.g: new deposit)
is expected in the near future
o Management can use a long hedge to avoid opportunity loss from falling interest rates
(i.e., reduced potential earnings): Futures contracts can be purchased today and then
sold in like amount at approximately the same time deposits come flowing in.
o If interest rates do decline, security prices must rise. Therefore, the bank will be able to
sell futures contracts for a higher price because those contracts will rise in value.
o The resulting profit from trading in financial futures will offset some or all the loss in
revenue due to lower interest rates on loans

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5.2.4. Financial Futures Contracts

• Using Long and Short Hedges to Protect Income and Value:

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5.2.4. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o The objective is to offset the loss in NW due to changes in market interest rates with
gains from trades in the futures market.

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5.2.4. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Setting the change in NW equal to the change in the futures position value, we have:

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5.2.4. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Example: a financial-services provider has an average asset duration of four years, an
average liability duration of two years, total assets of $500 million, and total liabilities of
$460 million at a given point in time. Suppose, too, that the firm plans to trade in
Treasury bond futures contracts. The T-bonds named in the futures contracts have a
duration of nine years, and the T-bonds' current price is $99,700 per $100,000 contract.
What is the number of futures contracts needed to cover risk exposure?

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5.2.4. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Example: a financial-services provider has an average asset duration of four years, an
average liability duration of two years, total assets of $500 million, and total liabilities of
$460 million at a given point in time. Suppose, too, that the firm plans to trade in
Treasury bond futures contracts. The T-bonds named in the futures contracts have a
duration of nine years, and the T-bonds' current price is $99,700 per $100,000 contract.
What is the number of futures contracts needed to cover risk exposure?

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5.2.4. Interest-Rate Options

• The interest-rate options: grant a holder of securities the right to either

(1) place (put) those instruments with another investor at a prespecified exercise price
before the option expires; or
(2) take delivery of securities (call) from another investor at a prespecified price before
the option's expiration date.
• Option premium: the fee that the buyer must pay for the privilege of being able to put
securities to or call securities away from the option writer
• Exercise (strike) price: the price to put/call the security in the future, stated clearly in the
option contract

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5.2.4. Interest-Rate Options

• Types of option:
(1) Put Option: Gives the Holder of the Option the Right to Sell the Financial Instrument at
a Set Price
(2) Call Option: Gives the Holder of the Option the Right to Purchase the Financial
Instrument at a Set Price

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5.2.4. Interest-Rate Options

• Principal Uses of Option Contracts:

o Protection of a Security Portfolio
o Hedging Against Positive or Negative Gap Positions

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5.2.4. Interest-Rate Options

• Call Options to Offset Falling Interest Rates:

o A financial firm plans to purchase $50 million in Treasury bonds in a few days and hopes
to earn an interest return of 8 percent.
o Fearing the drop in market interest rates, the investment officer of the bank buys a call
option on Treasury bonds at a strike price of $95,000 for each $100,000 bond. The
investment officer had to pay the dealer a premium of $500 to write this call option.
o If market interest rates fall as predicted, the T-bonds’ market price may climb up to
$97,000 per $100,000 bond, permitting the investment officer to demand delivery
o of the bonds at the cheaper price of $95,000. The call option would then be "in the
money" because the securities' market price is above the option's strike price of $95,000

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5.2.4. Interest-Rate Options

• Call Options to Offset Falling Interest Rates:

o Before-tax profit on call option = Security market price - Strike price - Option premium
option = $97,000 - $95,000 - $500 = $1 ,500 per $100,000 bond
o The projected profit per bond will at least partially offset any loss in interest return
experienced on the bonds traded in the cash market if interest rates fall.
o If interest rates rise instead of fall, the option would likely have dropped "out of the
money" as Treasury bond prices fell below the strike price. In this case the T-bond option
would likely expire unused and the firm would suffer a loss equal to the option premium
o However, a call option could also be used to help avoid losses from falling interest
returns on loans.

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5.2.4. Interest-Rate Swaps

• An interest-rate swap: a contract between two parties to exchange interest payments in

an effort to save money and hedge against interest-rate risk
o E.g: converting from fixed to floating interest rates or from floating to fixed interest rates
and more closely match the maturities of their liabilities to the maturities of their assets.
o A bank can earns fee income (usually amounting to 0.25-0.5% of the amount involved)
for arranging a swap for a customer

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5.2.4. Interest-Rate Swaps

• Using interest-rate swaps for asset-liability management:

Firm A: Firm B:

Short-term assets with Long-term assets with fixed

flexible yields SWAP rates of return

Long-term liabilities carrying Shorter-term liabilities

fixed interest rates

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5.2.4. Interest-Rate Swaps

• Why use interest-rate swaps?

o Retiring old debt and issuing new securities with more favorable characteristics can be
expensive and risky. New borrowing may have to take place in an environment of higher
interest rates.
o Underwriting costs, registration fees, time delays, and regulations often severely limit
how far any business firm can go in attempting to restructure its balance sheet.
o Swaps can be negotiated to cover virtually any period of time desired, though most fall
into the 3-year to 10-year range. They are also easy to carry out, usually negotiated and
agreed to over the telephone or via e-mail through a broker or dealer.

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5.2.4. Caps, Floors, and Collars

• Interest-rate caps:
o Protecting its holder against rising market interest rates.
o Borrowers are assured that lenders cannot increase loan rate above the cap interest rate
by paying an upfront premium/fee.
o Alternatively, the borrower may purchase an interest-rate cap from a third party who
promises to reimburse borrowers for any additional interest beyond the cap.

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5.2.4. Caps, Floors, and Collars

• Interest-rate caps:
o Typical conditions when a bank buy interest-rate caps:
 When it has fixed-rate assets with floating-rate liabilities
 When it possesses longer-term assets than liabilities
 When it holds a large portfolio of bonds that will drop in value when market interest
rates rise.

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5.2.4. Caps, Floors, and Collars

• Interest-rate floors:
o Guaranteeing minimum rate of return for lenders/investors, used in periods of falling
interest rates
o Banks use interest-rate floors most often when their liabilities have longer maturities
than their assets or when they are funding floating-rate assets with fixed-rate debts.

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5.2.4. Caps, Floors, and Collars

• Interest-rate collars:
o An agreement combining a rate floor and a rate cap
o E.g: a customer who has just received a $100 million loan may ask the lender for a collar
on the loan's prime rate between 11 percent and 7 percent. In this instance, the lender
will pay its customer's added interest cost if prime rises above 11 percent, while the
customer reimburses the lender if prime drops below 7 percent.
o In effect, the collar's purchaser pays a premium for a rate cap while receiving a premium
for accepting a rate floor.

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5.3 Liquidity and reserves management:
Strategies and Policies

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5.3.1. Estimating Liquidity Needs

Methods of estimating liquidity needs

 Sources and uses of funds approach

 Structure of funds approach

 Liquidity indicator approach

 Signals from the marketplace

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5.3.1. Estimating Liquidity Needs

 Sources and Uses of funds approach

The sources and uses of funds method for estimating liquidity needs begins with two simple facts:
1. In the case of a bank, for example, liquidity rises as deposits increase and loans decrease.
2. Alternatively, liquidity declines when deposits decrease and loans increase.

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5.3.1. Estimating Liquidity Needs

 Sources and Uses of funds approach

The key steps in the sources and uses of funds approach, using a bank as an example, are:
1. Loans and deposits must be forecast for a given planning period.
2. The estimated change in loans and deposits must be calculated for that same period.
3. The liquidity manager must estimate the net liquid funds' surplus or deficit for the planning period by
comparing the estimated change in loans (or other uses of funds) to the estimated change in deposits
(or other funds sources).

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5.3.1. Estimating Liquidity Needs

 Sources and Uses of funds approach

A somewhat simpler approach for estimating future deposits (or other funds sources) and loans (or other
funds uses) is to divide the forecast of future deposit and loan growth into three components:
1. A trend component, estimated by constructing a trend (constant-growth) line using as reference points
year-end, quarterly, or monthly deposit and loan totals established over at least the last 10 years (or
some other base period sufficiently long to define a trend growth rate).
2. A seasonal component, measuring how deposits (or other funds sources) and loans (or other funds uses)
are expected to behave in any given week or month due to seasonal factors, as compared to the most
recent year-end deposit or loan level.
3. A cyclical component, representing positive or negative deviations from a bank's total expected deposits
and loans (measured by the sum of trend and seasonal components), depending upon the strength or
weakness of the economy in the current year.

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5.3.1. Estimating Liquidity Needs

 Structure of Funds Approach

• Another approach to estimating a financial firm's liquidity requirements is the structure of
funds method. As an illustration, we might divide a bank's deposit and non-deposit liabilities
into three categories:

1. “Hot money" liabilities (often called volatile liabilities)-deposits and other borrowed funds (such
as federal funds borrowings) that are very interest sensitive or that management is sure will be
withdrawn during the current period.
2. Vulnerable funds-customer deposits of which a substantial portion, perhaps 25 to 30 percent,
will probably be withdrawn sometime during the current time period.
3. Stable funds (often called core deposits or core liabilities)-funds that management con- siders
unlikely to be removed (except for a minor percentage of the total).

• Liquidity manager set aside liquid funds according to some operating rule

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5.3.1. Estimating Liquidity Needs

 Structure of Funds Approach

• Example: The manager may decide to set up a 95 percent liquid reserve behind all hot money funds (less
any required legal reserves held behind hot money deposits). Vulnerable deposits and non-deposit
liabilities are to hold a fixed percentage of their total amount (30%) in liquid reserves. For stable (core)
funds sources, a liquidity manager may decide to place a small proportion-perhaps 15 % or less- of their
total in liquid reserves. Thus, the liquidity reserve behind deposit and non-deposit liabilities would be:

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5.3.1. Estimating Liquidity Needs

 Structure of Funds Approach

• Many financial firms like to use probabilities in deciding how much liquidity to hold. Under this
refinement of the structure of funds approach, the liquidity manager will want to define the best and the
worst possible liquidity positions his or her financial institution might find itself in and assign
probabilities to each.

1. The worst possible liquidity position

2. The best possible liquidity position

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5.3.1. Estimating Liquidity Needs

 Liquidity indicator approach

Many financial-service institutions estimate their liquidity needs based upon experience and
industry averages. This often means using certain liquidity indicators.
• Cash Position Indicator = Cash and deposits due from depository institutions/total assets
(positive liquidity indicator)
• Liquid Security Indicator = U.S. government securities/total assets (positive liquidity
indicator)
• Net Federal Funds Position = (Federal funds sold and reverse repurchase agreements -
Federal funds purchased and repurchase agreements)/Total assets (positive liquidity
indicator)
• Capacity Ratio = Net loans and leases/total assets (negative liquidity indicator)
• Pledged Securities Ratio = Pledged securities/total security holdings (negative liquidity
indicator)

Where positive liquidity indicator means the higher the ratio, the better liquidity of the bank.

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5.3.1. Estimating Liquidity Needs

 Liquidity indicator approach

Many financial-service institutions estimate their liquidity needs based upon experience and
industry averages. This often means using certain liquidity indicators.
• Hot Money Ratio = Money market (short-term) assets/volatile liabilities= (Cash and due
from deposits held at other depository institutions + holdings of short-term securities +
Federal funds loans+ reverse repurchase agreements)/(large CDs+ Eurocurrency deposits+
Federal funds borrowings+ repurchase agreements) (positive liquidity indicator)
• Deposit Brokerage Index = Brokered deposits/total deposits (negative liquidity indicator)
• Core Deposit Ratio = Core deposits/total assets (positive liquidity indicator)
• Deposit Composition Ratio = Demand deposits/Time deposits (negative liquidity indicator)
• Loan Commitment Ratio = Unused loan commitments/total assets (negative liquidity
indicator)

Where positive liquidity indicator means the higher the ratio, the better liquidity of the bank.

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5.3.1. Estimating Liquidity Needs

 Signals from the Marketplace

Many analysts believe there is one ultimately sound method for assessing a financial institution’s
liquidity needs and how well it is fulfilling them. This method centers on the discipline of the
financial marketplace. No financial service provider can tell for sure if it has sufficient liquidity until
it has passed the market's test.

• Public confidence
• Stock price behavior
• Risk premiums on CDs
• Loss sales of assets
• Meeting commitments to creditors
• Borrowings from the central bank

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5.3.2. Liquidity Management Strategies

 Asset Liquidity Management or Asset Conversion Strategy

 Borrowed Liquidity or Liability Management Strategy

 Balanced Liquidity Strategy

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5.3.2. Liquidity Management Strategies

 Asset Liquidity Management or Asset Conversion Strategy

Storing liquidity in assets, predominantly in cash and marketable securities.

What is a liquid asset?

• A liquid asset has a ready market so it can be converted into cash without delay.
• It has a reasonably stable price so that, no matter how quickly the asset must be sold or how large the
sale is, the market is deep enough to absorb the sale without a significant decline in price.
• It is reversible, meaning the seller can recover his or her original investment (principal) with little
risk of loss.

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5.3.2. Liquidity Management Strategies

 Asset Liquidity Management or Asset Conversion Strategy

Options for Storing Liquidity Costs of Asset Liquidity Management

• Treasury Bills • Loss of future earnings on assets that must

• Fed Funds Sold to Other Banks be sold “opportunity cost”
• Purchasing Securities for Resale (Repos) • Transaction costs on assets that must be sold
• Deposits with Correspondent Banks • Potential capital losses if interest rates are
• Municipal Bonds and Notes rising
• Federal Agency Securities • May weaken appearance of balance sheet
• Negotiable Certificates of Deposits • Liquid assets generally have low returns
• Eurocurrency Loans

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5.3.2. Liquidity Management Strategies

 Borrowed Liquidity or Liability Management Strategy

This strategy calls for the bank to purchase or borrow from the money market to cover all of its liquidity
needs

Sources of Borrowed Funds

• Federal Funds Purchased

• Selling Securities for Repurchase (Repos)
• Issuing Large CDs (Greater than $100,000)
• Issuing Eurocurrency Deposits
• Securing Advance from the Federal Home Loan Bank
• Borrowing Reserves from the Discount Window of the Federal Reserve

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5.3.2. Liquidity Management Strategies

 Balanced Liquidity Strategy

The combined use of liquid asset holdings (asset management) and borrowed liquidity (liability
management) to meet liquidity needs

Guidelines for Liquidity Managers

• They should keep track of all fund-using and fund-raising departments

• They should know in advance withdrawals by the biggest credit or deposit customers
• Their priorities and objectives for liquidity management should be clear
• Liquidity needs must be evaluated on a continuing basis

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5.3.2. Liquidity Management Strategies

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5.3.3 Legal Reserves and Money Management

 The Money Position Manager

Management of a financial institution's liquidity position can be a harrowing job, requiring quick
decisions that may have long-run consequences for profitability. Nowhere is this more evident than
in the job of money position manager.

 Legal Reserves
• Assets that a central bank requires depository institutions to hold as a reserve behind their
deposits or other liabilities
• The manager of the money position is responsible for ensuring that his or her institution
maintains an adequate level of legal reserves-that is, those assets that law and central bank
regulation say must be held during a particular time period.

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5.3.3 Legal Reserves and Money Management

 Regulations on Calculating Legal Reserve Requirements

Reserve Computation
• under the current system of accounting
for legal reserves – called lagged
reserve accounting (LRA) – the daily
average amount of deposits and other
reservable liabilities are computed
using information gathered over a two-
week period stretching from a Tuesday
through a Monday two weeks later.
• This interval of time is known as the
reserve computation period. The
daily average amount of vault cash
each depository institution holds is
also figured over the same two-week
computation period.

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5.3.3 Legal Reserves and Money Management

 Regulations on Calculating Legal Reserve Requirements

Reserve Maintenance
After the money position manager
calculates daily average deposits and the
institution's required legal reserves, he or
she must maintain that required legal
reserve on deposit with the Federal
Reserve bank in the region (less the
amount of daily average vault cash held),
on average, over a 14-day period
stretching from a Thursday through a
Wednesday. This is known as the reserve
maintenance period.

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 Q&A session
Thank you for listening!

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