Asset Liability Management in Banks

Session 09

Components of a Bank Balance sheet

Liabilities
1. 2. 3. 4. 5. Capital Reserve & Surplus Deposits Borrowings Other Liabilities

Assets
1. 2. 3. 4. 5. 6. Cash & Balances with RBI Bal. With Banks & Money at Call and Short Notices Investments Advances Fixed Assets Other Assets

Contingent Liabilities

Components of Liabilities 1.Capital:

Capital represents owners 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. II. III. IV. V. Statutory Reserves Capital Reserves Investment Fluctuation Reserve Revenue and Other Reserves Balance in Profit and Loss Account

Components of Liabilities
3. Deposits This is the main source of banks 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 Bank Deposits III. Term Deposits

Components of Liabilities
4. Borrowings (Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions) I. Borrowings in India i) Reserve Bank of India ii) Other Banks iii) Other Institutions & Agencies II. Borrowings outside India

Components of Liabilities
5. Other Liabilities & Provisions
It is grouped as under: I. II. III. IV. V. Bills Payable Inter Office Adjustments (Net) Interest Accrued Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital) Others(including provisions)

Components of Assets
1. Cash & Bank Balances with RBI
I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts

Components of Assets
2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE
I. In India 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. Outside India 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 banks balance sheet. Reflected under 6 buckets as under: I. Investments in India in : *
i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutions vi) Others (UTI Shares , Commercial Papers, COD & Mutual Fund Units etc.) II. Investments outside India in ** Subsidiaries and/or Associates abroad

Components of Assets
4. Advances
The most important assets for a bank.
A. i) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term Loans B. Particulars of Advances : i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured

Components of Assets
5. Fixed Asset
I. II. Premises Other Fixed Assets (Including furniture and fixtures)

6. Other Assets
I. II. III. IV. V. VI. Interest accrued Tax paid in advance/tax deducted at source (Net of Provisions) Stationery and Stamps Non-banking assets acquired in satisfaction of claims Deferred Tax Asset (Net) Others

Contingent Liability
Banks obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.

Banks Profit & Loss Account

A banks profit & Loss Account has the following components: Income: This includes Interest Income and Other Income. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

I. II.

Components of Income
1. INTEREST EARNED
I. II. III. IV. Interest/Discount on Advances / Bills Income on Investments Interest on balances with Reserve Bank of India and other inter-bank funds Others

Components of Income
2. OTHER INCOME
I. II. III. IV. V. VI. VII. Commission, Exchange and Brokerage Profit on sale of Investments (Net) Profit/(Loss) on Revaluation of Investments Profit on sale of land, buildings and other assets (Net) Profit on exchange transactions (Net) Income earned by way of dividends etc. from subsidiaries and Associates abroad/in India Miscellaneous Income

Components of Expenses
1. INTEREST EXPENDED
I. II. III. Interest on Deposits Interest on Reserve Bank of India / Inter-Bank borrowings Others

Components of Expenses
2. OPERATING EXPENSES
I. II. III. IV. V. VI. VII. VIII. IX. X. XI. XII. Payments to and Provisions for employees Rent, Taxes and Lighting Printing and Stationery Advertisement and Publicity Depreciation on Bank's property Directors' Fees, Allowances and Expenses Auditors' Fees and Expenses (including Branch Auditors) Law Charges Postages, Telegrams, Telephones etc. Repairs and Maintenance Insurance Other Expenditure

Analyzing Bank Performance

Return on equity (ROE = NI / TE)

the basic measure of stockholders returns ROE is composed of two parts:
Return on Assets (ROA = NI / TA),
represents the returns to the assets the bank has invested in

Equity Multiplier (EM = TA / TE),

the degree of financial leverage employed by the bank

Return on assets (ROA = NI / TA)

can be decomposed into two parts:
Asset Utilization (AU) income generation Expense Ratio (ER) expense control

ROA Where:

= =

AU (TR / TA)

ER - (TE / TA)

TR = total revenue or total operating income = Int. inc. + Non-int. inc. + SG and TE = total expenses = Int. exp. + Non-int. exp. + PLL + Taxes

ROA is driven by the banks ability to:

generate income (AU) and control expenses (ER)

Income generation (AU) can be found on the UBPR of US (page 1) as: Int. Inc. Non. int. Inc. Sec gains (losses) AU = + + TA TA TA
Expense Control (ER) can be found on the UBPR (page 1) as:

Int. Exp. Non int . Exp. PLL ER = + + TA TA TA

*

Note, ER* does not include taxes.

Bank Performance Model

Returns to Shareholders ROE = NI / TE Interest INCOME Non Interest Return to the Bank ROA = NI / TA Interest

Rate Composition (mix) Volume Fees and Serv Charge Trust Other Rate Composition (mix) Volume

EXPENSES Overhead Degree of Leverage EM =1 / (TE / TA) Prov. for LL Taxes

Salaries and Benefits Occupancy Other

Expense ratio (ER = Exp / TA)

the ability to control expenses.
Interest expense / TA Cost per liability (avg. rate paid) Int. exp. liab. (j) / Rs amt. liab. (j) Composition of liabilities Rs amt. of liab. (j) / TA Volume of int. bearing debt and equity Non-interest expense / TA Salaries and employee benefits / TA Occupancy expense / TA Other operating expense / TA Provisions for loan losses / TA Taxes / TA

Asset utilization (AU = TR / TA):

the ability to generate income.
Interest Income / TA Asset yields (avg. rate earned) Interest income asset (i) / Rs amount of asset (i) Composition of assets (mix) Rs amount asset (i) / TA Volume of Earning Assets Earning assets / TA Noninterest income / TA Fees and Service Charges Securities Gains (Losses) Other income

Aggregate profitability measures

Net interest margin NIM = NII / Earning Assets (EA) Spread Spread = (Int Inc / EA) (Int Exp / Int bear. Liab.) Earnings base EB = EA / TA Burden / TA (Noninterest Exp. - Noninterest Income) / TA Efficiency ratio Non int. Exp. / (Net int. Inc. + Non-int. Inc.)

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.

Significance of ALM
Volatility Product Innovations & Complexities Regulatory Environment Management Recognition

Purpose & Objective of ALM

An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration. It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are: 1. Net Interest Income (NII) 2. Net Interest Margin (NIM) 3. TGA & DGA 4. EVE & Economic Equity Ratio

RBI DIRECTIVES
Issued draft guidelines on 10th Sept98. Final guidelines issued on 10th implementation of ALM w.e.f. 01.04.99. Feb99 for

To begin with 60% of asset &liabilities will be covered; 100% from 01.04.2000. Initially Gap Analysis to be applied in the first stage of implementation. Disclosure to Balance Sheet on maturity pattern on Deposits, Borrowings, Investment & Advances w.e.f. 31.03.01

RBI/2010-11/263 DBOD. No. BP. BC. 59 / 21.04.098/ 2010-11November 4, 2010

i) Banks shall adopt the DGA for interest rate risk management in addition to the TGA followed presently. ii) The framework, both DGA and TGA, should be applied to the global position of assets, liabilities and off-balance sheet items of the bank, which are rate sensitive. Banks should compute their interest rate risk position in each currency applying the DGA and TGA to the rate sensitive assets/ liabilities/ off balance sheet items in that currency, where either the assets, or liabilities are 5 per cent or more of the total of either the banks global assets or global liabilities. The interest rate risk position in all other residual currencies should be computed separately on an aggregate basis. (modified duration approach)

Liquidity Management
Banks liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.

Adequacy of liquidity position for a bank

a. b. c. d. e. f. g. h. Analysis of following factors throw light on a banks adequacy of liquidity position: Historical Funding requirement Current liquidity position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated asset quality Present and future earning capacity and Present and planned capital position

Funding Avenues
To satisfy funding needs, a bank must perform one or a combination of the following: Dispose off liquid assets Increase short term borrowings Decrease holding of less liquid assets Increase liability of a term nature Increase Capital funds

a. b. c. d. e.

Types of Liquidity Risk

Liquidity Exposure can stem from both internally and externally. External liquidity risks can be geographic, systemic or instrument specific. Internal liquidity risk relates largely to perceptions of an institution in its various markets: local, regional, national or international

Statement of Structural Liquidity

All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:
i. 1 to 14 days ii. 15 to 28 days iii. 29 days and up to 3 months iv. Over 3 months and up to 6 months v. Over 6 months and up to 1 year vi. Over 1 year and up to 3 years vii. Over 3 years and up to 5 years viii. Over 5 years

STATEMENT OF STRUCTURAL LIQUIDITY

Places all cash inflows and outflows in the maturity ladder as per residual maturity Maturing Liability: cash outflow Maturing Assets : Cash Inflow Classified in to 8 time buckets Mismatches in the first two buckets not to exceed 20% of outflows Shows the structure as of a particular date Banks can fix higher tolerance level for other maturity buckets.

An Example of Structural Liquidity Statement

1 1 -1 1 11 - 1 Days Days 1 1Days- 1Mths - 1Mths - 1 Year - 11Years - Over 1 1Month 1Mths 1 Year Years 1Years Years Total

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11 1 1 1 333 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11 1 1 11 1 1 1 1 1 1 1 1 11 1 1 11 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11 1 1 1 Loans BPLR Linked 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11 1 1 1 Others 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Total Inflow 1 1 1 1 1 1 1 1 11 1 1 1 1 1 1 1 1 1 1 1 11 1 1 11 1 1 1 Gap -111 -111 1 1 1 -11 -1111 1 -111 1 1 1 Cumulative Gap -111 -111 -111 -111 -111 -111 -111 1 1 -11 .11 -11 .11 1 11 . 1 -1 .11 -11 .11 11 . 1 -111 . 1 11 . 1 Gap % to Total Outflow Capital Liab-fixed Int Liab-floating Int Others Total outflow Investments Loans-fixed Int Loans - floating

ADDRESSING THE MISMATCHES

Mismatches can be positive or negative Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A. In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. For ve mismatch,it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

STRATEGIES
To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch. The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.

Maturity Pattern of Select Assets & Liabilities of A Bank Liability/Assets Rupees (In Cr) 15200 8000 6700 230 270 450 180 00 150 120 8800 3400 3000 400 2000 5800 1300 300 900 3300 In Percentage

I. Deposits a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years II. Borrowings a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years III. Loans & Advances a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years Iv. Investment a. Up to 1 year b. Over 1 yr to 3 yrs c. Over 3 yrs to 5 yrs d. Over 5 years

100 52.63 44.08 1.51 1.78 100 40.00 0.00 33.33 26.67 100 38.64 34.09 4.55 22.72 100 22.41 5.17 15.52 56.90

STATEMENT OF INTEREST RATE SENSITIVITY

Generated by grouping RSA,RSL & OFFBalance sheet items in to various (8)time buckets.
RSA: MONEY AT CALL ADVANCES ( BPLR LINKED ) INVESTMENT RSL DEPOSITS EXCLUDING CD BORROWINGS

MATURITY GAP METHOD (IRS)

THREE OPTIONS: A) RSA>RSL= Positive Gap B) RSL>RSA= Negative Gap C) RSL=RSA= Zero Gap

SUCCESS OF ALM IN BANKS : PRE - CONDITIONS

1. Awareness for ALM in the Bank staff at all levelssupportive Management & dedicated Teams. 2. Method of reporting data from Branches/ other Departments. (Strong MIS). 3. Computerization-Full computerization, networking. 4. Insight into the banking operations, economic forecasting, computerization, investment, credit. 5. Linking up ALM to future Risk Management Strategies.

Interest Rate Risk Management

Interest Rate risk is the exposure of a banks financial conditions to adverse movements of interest rates. Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a banks earnings and capital base. Changes in interest rates also affect the underlying value of the banks assets, liabilities and off-balance-sheet item.

Interest Rate Risk

Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM). Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank.

Sources of Interest Rate Risk

Interest rate risk mainly arises from:
Gap Risk Basis Risk Net Interest Position Risk Embedded Option Risk Yield Curve Risk Price Risk Reinvestment Risk

Measurement of Interest Rate Risk

Gap Analysis- Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates. - If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII. - conversely, a positive gap (RSA>RSL) in a given time band, an decrease in market interest rates could cause a decline in NII.

Measurement of Interest Rate Risk

Duration Analysis: Duration is a measure of the percentage change in the economic value of a position that occur given a small change in level of interest rate.

Measuring Interest Rate Risk with Duration GAP

Economic Value of Equity Analysis

Focuses on changes in stockholders equity given potential changes in interest rates

Duration GAP Analysis

Compares the price sensitivity of a banks total assets with the price sensitivity of its total liabilities to assess the impact of potential changes in interest rates on stockholders equity.

Remember
Duration is a measure of the effective maturity of a security.
Duration incorporates the timing and size of a securitys cash flows. Duration measures how price sensitive a security is to changes in interest rates.
The greater (shorter) the duration, the greater (lesser) the price sensitivity.

Duration (Revision)
Duration of a bond that provides cash flow c i at time t i is
ti ci ey ti B i =1 n

where B is its price and y is its yield (continuously compounded) This leads to

B = D y B
52

How?
B=dB/dyy for small change in y. Using the bond pricing relationship B= cie-yti substituting dB/dy we get B= -BDy.

53

Example
Calculate the duration for a 3 year 10% coupon bond with a face value of 100. The yield on the bond is 12% per annum with continuous compounding. The coupons are paid every six months.

54

55

Calculation of Duration
Time 0.5 1.0 1.5 2.0 2.5 3.0 Total CF 5 5 5 5 5 105 130 PV 4.709 4.435 4.176 3.933 3.704 73.256 94.213 Wt. 0.050 0.047 0.044 0.042 0.039 0.778 1.000 T * Wt 0.025 0.047 0.066 0.083 0.098 2.333 2.653

Understanding Duration
For the bond considered the B=94.213 and D=2.653. Therefore B= -94.213 * 2.653y or B=-249.95 y thus when the yield increases by 0.1% the bond price goes down to 93.963. The same can be checked by using the conventional formula for price of the bond.
56

Duration Continued
When the yield y is expressed with compounding m times per year
BDy B = 1 +y m

The expression
D 1 +y m

is referred to as the modified duration

57

Example
What is the modified duration of the bond with price 94.213 and duration 2.653. The yield with semiannual compounding is 12.3673%.

58

Solution (Revision End)

D=(2.653)/(1.123673/2) =2.499.

59

Duration versus Maturity

Duration is an approximate measure of the price elasticity of demand
% Change in Quantity Demanded % Change in Price

Price Elasticity of Demand = -

Duration versus Maturity

The longer the duration, the larger the change in price for a given change in interest rates. P
Duration P i (1 + i)

i P - Duration P + i) (1

Measuring Duration
Duration is a weighted average of the time until the expected cash flows from a security will be received, relative to the securitys price
Macaulays Duration
n CFt (t) CFt (t) t t ( 1 + r) ( 1 + r) 1 t =1 D = t= = k CFt Price of the Security t ( 1 + r) t =1 k

Measuring Duration (Alternative)

Example
What is the duration of a bond with a Rs1,000 face value, 10% annual coupon payments, 3 years to maturity and a 12% YTM? The bonds price is Rs951.96.
1 1 1 1 1 1 1 1 1 1 1 1 11 , 1 1 1 + + + 11 , 1 11 . (111 . )1 (111 . )1 (111 . )1 (111 . )1 D= = = 11 . 1 years 1 1 1 1 3333 1 1 11 . 1 + t 1 ( 111 . ) ( 111 . ) t =1

Measuring Duration
Example
What is the duration of a bond with a Rs1,000 face value, 10% coupon, 3 years to maturity but the YTM is 5%?The bonds price is Rs1,136.16.
1 1 1 *1 1 1 1 *1 1 1 1 * 1 11 , 1 1 *1 + + + 1 1 1 11 , 1 11 . 1 (111 . ) (111 . ) (111 . ) (3 .33 )1 D= = = 11 . 1years 1 1 1 11 . 1 11 , 1 11 . 1

Measuring Duration
Example
What is the duration of a bond with a Rs1,000 face value, 10% coupon, 3 years to maturity but the YTM is 20%?The bonds price is Rs789.35.
1 1 1 *1 1 1 1 *1 1 1 1 * 1 11 , 1 1 *1 + + + 11 , 1 11 . 1 (111 . )1 (111 . )1 (111 . )1 (111 . )1 D= = = 3 .3 3 years 1 1 11 . 1 3 3 3 .3 3

 Example

Measuring Duration

What is the duration of a zero coupon bond with a Rs1,000 face value, 3 years to maturity but the YTM is 12%?
11 , 1 1 *1 11 , 1 11 . 1 (111 . )1 D= = =1 years 3 ,3 3 3 1 1 11 . 1 (111 . )1

By definition, the duration of a zero coupon bond is equal to its maturity

Duration and Modified Duration

The greater the duration, the greater the price sensitivity Modified Duration gives an estimate of price volatility:

Macaulay' s Duration Modified Duration = (1 + i)

P - Modified Duration i P

Effective Duration
Effective Duration
Used to estimate a securitys price sensitivity when the security contains embedded options. Compares a securitys estimated price in a falling and rising rate environment.

Effective Duration
Pi- - Pi+ Effective Duration = + P1(i - i )
Where:
Pi- = Price if rates fall Pi+ = Price if rates rise P0 = Initial (current) price i+ = Initial market rate plus the increase in rate i- = Initial market rate minus the decrease in rate

 Example

Effective Duration

Consider a 3-year, 9.4 percent semi-annual coupon bond selling for Rs10,000 par to yield 9.4 percent to maturity. Macaulays Duration for the option-free version of this bond is 5.36 semiannual periods, or 2.68 years. The Modified Duration of this bond is 5.12 semiannual periods or 2.56 years.

Effective Duration
Example
Assume, instead, that the bond is callable at par in the near-term .
If rates fall, the price will not rise much above the par value since it will likely be called If rates rise, the bond is unlikely to be called and the price will fall

Effective Duration
Example
If rates rise 30 basis points to 5% semiannually, the price will fall to Rs9,847.72. If rates fall 30 basis points to 4.4% semiannually, the price will remain at par

Rs11 ,111 -1 ,1 1 1 .1 1 Effective Duration = =1 .1 1 Rs11 ,111 (1 .11 -1 .1 1 1 )

Duration GAP
Duration GAP Model
Focuses on either managing the market value of stockholders equity
The bank can protect EITHER the market value of equity or net interest income, but not both Duration GAP analysis emphasizes the impact on equity

Duration GAP
Duration GAP Analysis
Compares the duration of a banks assets with the duration of the banks liabilities and examines how the economic value stockholders equity will change when interest rates change.

Two Types of Interest Rate Risk

Reinvestment Rate Risk
Changes in interest rates will change the banks cost of funds as well as the return on invested assets

Price Risk
Changes in interest rates will change the market values of the banks assets and liabilities

Reinvestment Rate Risk

If interest rates change, the bank will have to reinvest the cash flows from assets or refinance rolled-over liabilities at a different interest rate in the future
An increase in rates increases a banks return on assets but also increases the banks cost of funds

Price Risk
If interest rates change, the value of assets and liabilities also change.
The longer the duration, the larger the change in value for a given change in interest rates

Duration GAP considers the impact of changing rates on the market value of equity

Reinvestment Rate Risk and Price Risk

Reinvestment Rate Risk
If interest rates rise (fall), the yield from the reinvestment of the cash flows rises (falls) and the holding period return (HPR) increases (decreases).

Price risk
If interest rates rise (fall), the price falls (rises). Thus, if you sell the security prior to maturity, the HPR falls (rises).

Reinvestment Rate Risk and Price Risk

Increases in interest rates will increase the HPR from a higher reinvestment rate but reduce the HPR from capital losses if the security is sold prior to maturity. Decreases in interest rates will decrease the HPR from a lower reinvestment rate but increase the HPR from capital gains if the security is sold prior to maturity.

Reinvestment Rate Risk and Price Risk

An immunized security or portfolio is one in which the gain from the higher reinvestment rate is just offset by the capital loss. For an individual security, immunization occurs when an investors holding period equals the duration of the security.

Steps in Duration GAP Analysis

Forecast interest rates. Estimate the market values of bank assets, liabilities and stockholders equity. Estimate the weighted average duration of assets and the weighted average duration of liabilities.
Incorporate the effects of both on- and off-balance sheet items. These estimates are used to calculate duration gap.

Forecasts changes in the market value of stockholders equity across different interest rate environments.

Weighted Average Duration of Bank Assets

Weighted Average Duration of Bank Assets (DA)

Where

i wi = Market value of asset i divided by the market value of all bank assets

DA = w iDai

Dai = Macaulays duration of asset i n = number of different bank assets

Weighted Average Duration of Bank Liabilities

Weighted Average Duration of Bank Liabilities (DL)

DL = z jDl j
Where
j

zj = Market value of liability j divided by the market value of all bank liabilities Dlj= Macaulays duration of liability j m = number of different bank liabilities

Duration GAP and Economic Value of Equity

Let MVA and MVL equal the market values of assets and liabilities, respectively. If: EVE = MVA MVL and

Duration GAP
Then:

DGAP = DA - (MVL/MVA)DL
y EVE = - DGAP MVA + y) (1

where y = the general level of interest rates

Duration GAP and Economic Value of Equity

To protect the economic value of equity against any change when rates change , the bank could set the duration gap to zero:
y EVE = - DGAP MVA + y) (1

Hypothetical Bank Balance Sheet

1 Assets Cash 1 1 1 .1 1 Earning assets 1 -yr Commercial loan 1 1 1 .1 1 1 1 .1 1 % 1 -yr Treasury bond 1 1 1 .1 1 1 .1 1 % Total Earning Assets 1 1 1 .1 1 Non-cash earning assets 1 1 .1 11 Total assets 1 ,1 1 1 .1 1 Liabilities Interest bearing liabs. 1 -yr Time deposit 1 -yr Certificate of deposit Tot. Int Bearing Liabs. Tot. non-int. bearing Total liabilities Total equity Total liabs & equity Par 1 ,1 1 1 .1 1 % Coup Years Mat. YTM Market Value 1 1 1 .1 1 1 1 1 1 .1 1 % 1 .1 1 % 1 1 .1 1 % 1 1 1 .1 1 1 1 1 .1 1 1 1 1 .1 1 1 1 .1 1 1 1 .1 1 % 1 ,1 1 11 . 1 1 .1 1 1 .1 1 Dur.

1 1 1 1 1 1 1 1 1 1 1 1 1 + + + 1 (1 .1 1 ) (1 .1 1 ) (1 .1 1 ) (1 .1 1 ) D= 1 1 1
1 1 1 .1 1 1 1 1 .1 1 1 1 1 .1 1 1 .1 1 1 1 1 .1 1 1 1 .1 1 1 ,1 1 1 .1 1 1 .1 1 % 1 .1 1 % 1 1 1 .1 1 % 1 .1 1 % 1 .1 1 %

1 .1 1

1 1 1 .1 1 1 1 1 .1 1 1 1 1 .1 1 1 .1 1 1 .1 1 % 1 1 1 .1 1 1 1 .1 1 1 ,1 1 11 . 1

1 .1 1 1 .1 1

1 .1 1

 DA DL

Calculating DGAP

(Rs700/Rs1000)*2.69 + (Rs200/Rs1000)*4.99 = 2.88 (Rs620/Rs920)*1.00 + (Rs300/Rs920)*2.81 = 1.59

DGAP
2.88 - (920/1000)*1.59 = 1.42 years
What does this tell us?
The average duration of assets is greater than the average duration of liabilities; thus asset values change by more than liability values.

1 percent increase in all rates.

Par 1 ,1 1 1 .1 1 % Coup Years Mat. YTM

Market Value 1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 1 1 1 .1 1 11 . 1 1 1 11 . 1

Dur.

Assets Cash 1 1 11 . 1 Earning assets 1 -yr Commercial loan 1 1 11 . 1 1 1 .1 1 % 1 1 11 . 1 % 1 -yr Treasury bond 1 1 11 . 1 11 . 1 % 1 11 . 1 % Total Earning Assets 1 1 11 . 1 1 11 . 1 % 1 1 1 1 1 1 Non-cash earning assets . 1 PV =11 + t 1 t = 1 Total assets 11 , 1 11 . 1 1 11 .1 1 % 1 .1 1 1 .1

1 .1 1 11 . 1

11 . 1

Liabilities Interest bearing liabs. 1 -yr Time deposit 1 -yr Certificate of deposit Tot. Int Bearing Liabs. Tot. non-int. bearing Total liabilities Total equity Total liabs & equity

1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 11 . 1 1 1 11 . 1 1 11 . 1 11 , 1 11 . 1

11 . 1 % 11 . 1 %

1 1

11 . 1 % 11 . 1 % 11 . 1 % 11 . 1 %

1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 11 . 1 1 1 11 . 1 1 11 . 1 1 1 11 . 1

11 . 1 11 . 1

11 . 1

 DA DL

Calculating DGAP

(Rs683/Rs974)*2.68 + (Rs191/Rs974)*4.97 = 2.86 (Rs614/Rs906)*1.00 + (Rs292/Rs906)*2.80 = 1.58

DGAP
2.86 - (Rs906/Rs974) * 1.58 = 1.36 years
What does 1.36 mean?
The average duration of assets is greater than the average duration of liabilities, thus asset values change by more than liability values.

Change in the Market Value of Equity

y EVE = - DGAP[ ]MVA (1 + y)
In this case: .1 1 EVE = - 3 .3 3 [ ]Rs1 ,1 1 1 = Rs3 3 .1 1 1 .1 1

Positive and Negative Duration GAPs Positive DGAP

Indicates that assets are more price sensitive than liabilities, on average.
Thus, when interest rates rise (fall), assets will fall proportionately more (less) in value than liabilities and EVE will fall (rise) accordingly.

Negative DGAP
Indicates that weighted liabilities are more price sensitive than weighted assets.
Thus, when interest rates rise (fall), assets will fall proportionately less (more) in value that liabilities and the EVE will rise (fall).

DGAP Summary
DGAP Summary DGAP Positive Positive Negative Negative Zero Zero Change in Interest Assets Liabilities Equity Rates Increase Decrease > Decrease Decrease Decrease Increase > Increase Increase Increase Decrease Increase Decrease Decrease < Decrease Increase Increase < Increase Decrease Decrease = Decrease Increase = Increase None None

An Immunized Portfolio
To immunize the EVE from rate changes in the example, the bank would need to:
decrease the asset duration by 1.42 years or increase the duration of liabilities by 1.54 years DA / ( MVA/MVL) = 1.42 / (Rs920 / Rs1,000) = 1.54 years

Immunized Portfolio
1 Assets Cash 1 1 11 . 1 Earning assets 1 -yr Commercial loan 1 1 11 . 1 1 1 .1 1 % 1 -yr Treasury bond 1 1 11 . 1 11 . 1 % Total Earning Assets 1 1 11 . 1 Non-cash earning assets 11 . 1 Total assets 11 , 1 11 . 1 Liabilities Interest bearing liabs. 1 -yr Time deposit 1 1 11 . 1 11 . 1 % 1 -yr Certificate of deposit 1 1 11 . 1 11 . 1 % 1 -yr Zero-coupon CD* 1 1 11 . 1 11 . 1 % Tot. Int Bearing Liabs. 11 , 1 11 . 1 Tot. non-int. bearing 11 . 1 Total liabilities 11 , 1 11 . 1 Total equity 1 11 . 1 Par Years 1 , 1 1 1 .1 1 % Coup Mat. YTM Market Value 1 1 11 . 1 1 1 1 11 . 1 % 11 . 1 % 1 11 . 1 % 1 11 . 1 % 1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 11 . 1 11 , 1 11 . 1 1 .1 1 11 . 1 Dur.

11 . 1

1 1 1

11 . 1 % 11 . 1 % 11 . 1 % 11 . 1 % 11 . 1 %

1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 11 . 1 1 1 11 . 1 1 11 . 1

11 . 1 11 . 1 11 . 1

11 . 1

DGAP = 2.88 0.92 (3.11) 0

Immunized Portfolio with a 1% increase in rates

1 Par 1 ,1 1 1 .1 1 Years % Coup Mat. YTM Market Value 1 1 11 . 1 1 1 1 11 . 1 % 11 . 1 % 1 11 . 1 % 1 11 . 1 % 1 1 11 . 1 1 1 11 . 1 1 1 1. 1 1 11 . 1 1 1 11 . 1 1 .1 1 11 . 1 Dur.

Assets Cash 1 1 11 . 1 Earning assets 1 -yr Commercial loan 1 1 11 . 1 1 1 .1 1 % 1 -yr Treasury bond 1 1 11 . 1 11 . 1 % Total Earning Assets 1 1 11 . 1 Non-cash earning assets 11 . 1 Total assets 11 , 1 11 . 1 Liabilities Interest bearing liabs. 1 -yr Time deposit 1 1 11 . 1 11 . 1 % 1 -yr Certificate of deposit 1 1 11 . 1 11 . 1 % 1 -yr Zero-coupon CD* 1 1 11 . 1 11 . 1 % Tot. Int Bearing Liabs. 11 , 1 11 . 1 Tot. non-int. bearing 11 . 1 Total liabilities 11 , 1 11 . 1 Total equity 1 11 . 1

11 . 1

1 1 1

11 . 1 % 11 . 1 % 11 . 1 % 11 . 1 % 11 . 1 %

1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 1 1 11 . 1 11 . 1 1 1 11 . 1 1 11 . 1

11 . 1 11 . 1 11 . 1

11 . 1

Immunized Portfolio with a 1% increase in rates

EVE changed by only Rs0.5 with the immunized portfolio versus Rs25.0 when the portfolio was not immunized.

Stabilizing the Book Value of Net Interest Income

This can be done for a 1-year time horizon, with the appropriate duration gap measure
DGAP* MVRSA(1- DRSA) - MVRSL(1- DRSL) where:
MVRSA = cumulative market value of RSAs MVRSL = cumulative market value of RSLs DRSA = composite duration of RSAs for the given time horizon
Equal to the sum of the products of each assets duration with the relative share of its total asset market value

DRSL = composite duration of RSLs for the given time horizon

Equal to the sum of the products of each liabilitys duration with the relative share of its total liability market value.

Stabilizing the Book Value of Net Interest Income

If DGAP* is positive, the banks net interest income will decrease when interest rates decrease, and increase when rates increase.
If DGAP* is negative, the relationship is reversed.

Only when DGAP* equals zero is interest rate risk eliminated.

Banks can use duration analysis to stabilize a number of different variables reflecting bank performance.

Economic Value of Equity Sensitivity Analysis

Effectively involves the same steps as earnings sensitivity analysis. In EVE analysis, however, the bank focuses on:
The relative durations of assets and liabilities How much the durations change in different interest rate environments What happens to the economic value of equity across different rate environments

Embedded Options
Embedded options sharply influence the estimated volatility in EVE
Prepayments that exceed (fall short of) that expected will shorten (lengthen) duration. A bond being called will shorten duration. A deposit that is withdrawn early will shorten duration. A deposit that is not withdrawn as expected will lengthen duration.

All Indian Bank Economic Value of Equity

Assets

Market Value/Duration Report as of 03/31/12 Most Likely Rate Scenario-Base Strategy

Book Value Market Value 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1

Book Yield Duration* 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 %

Loans

Prime Based Ln Equity Credit Lines Fixed Rate > I yr Var Rate Mtg 1 Yr 1 1 -Year Mortgage Consumer Ln Credit Card Total Loans Loan Loss Reserve Net Loans

1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 -11 ,111 .11 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 ,1 1 1 .1 1 1 1 1 ,1 1 1 .1 1

1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1

Investments
Eurodollars CMO Fix Rate US Treasury Total Investments Fed Funds Sold Cash & Due From Non-int Rel Assets Total Assets

All Indian Bank Economic Value of Equity

Liabilities

Market Value/Duration Report as of 03/31/12 Most Likely Rate Scenario-Base Strategy

Book Value

Market Value Book Yield Duration* 1 1 1 ,1 1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 ,1 1 1 ,1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 % 1 .1 1 %

Deposits

MMDA Retail CDs Savings NOW DDA Personal Comm'l DDA Total Deposits TT&L L-T Notes Fixed Fed Funds Purch NIR Liabilities Total Liabilities Equity Total Liab & Equity Off Balance Sheet lnt Rate Swaps Adjusted Equity

1 1 1 ,1 1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 1 1 ,1 1 1 1 1 ,1 1 1 1 ,1 1 1 ,1 1 1 1 1 ,1 1 1

1 .1 1 % 1 .1 1 % 1 .1 1 %

1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1

Notional 1 .1 1 1 ,1 1 1 1 .1

Duration Gap for All Indian Bank EVE

Market Value of Assets

Rs1,001,963

Duration of Assets
2.6 years

Market Value of Liabilities

Rs919,400

Duration of Liabilities
2.0 years

Duration Gap for All Indian Bank EVE

Duration Gap
= 2.6 (Rs919,400/Rs1,001,963)*2.0 = 0.765 years

Example:
A 1% increase in rates would reduce EVE by Rs7.2 million = 0.765 (0.01 / 1.0693) * Rs1,001,963
Recall that the average rate on assets is 6.93%

Sensitivity of EVE versus Most Likely (Zero Shock) Interest Rate Scenario
C h a n g e in E V E (m illio n s o f d o lla r s ) 11 . 1 11 . 1 1 ( 11 . 1 ) ( 11 . 1 ) ( 11 . 1 ) ( 11 . 1 ) ( 11 . 1 ) - 111 - 111 - 111 1 + 111 + 111 + 111 A L C O G u id e lin e B o a r d L im it ( 1. 1) ( 11 . 1 ) 1. 1 11 . 1 1. 1

S h o c k s to C u rre n t R a te s

Sensitivity of Economic Value of Equity measures the change in the economic value of the corporations equity under various changes in interest rates. Rate changes are instantaneous changes from current rates. The change in economic value of equity is derived from the difference between changes in the market value of assets and changes

Effective Duration of Equity

By definition, duration measures the percentage change in market value for a given change in interest rates
Thus, a banks duration of equity measures the percentage change in EVE that will occur with a 1 percent change in rates:
Effective duration of equity 9.9 yrs. = Rs8,200 / Rs82,563

 Funding GAP and Duration GAP are NOT directly comparable

Funding GAP examines various time buckets while Duration GAP represents the entire balance sheet.
Generally, if a bank is liability (asset) sensitive in the sense that net interest income falls (rises) when rates rise and vice versa, it will likely have a positive (negative) DGAP suggesting that assets are more price sensitive than liabilities, on average.

Asset/Liability Sensitivity and DGAP

Strengths and Weaknesses: DGAP and EVESensitivity Analysis

Strengths
Duration analysis provides a comprehensive measure of interest rate risk Duration measures are additive
This allows for the matching of total assets with total liabilities rather than the matching of individual accounts

Duration analysis takes a longer term view than static gap analysis

Strengths and Weaknesses: DGAP and EVESensitivity Analysis

Weaknesses
It is difficult to compute duration accurately Correct duration analysis requires that each future cash flow be discounted by a distinct discount rate A bank must continuously monitor and adjust the duration of its portfolio It is difficult to estimate the duration on assets and liabilities that do not earn or pay interest Duration measures are highly subjective

Speculating on Duration GAP

It is difficult to actively vary GAP or DGAP and consistently win
Interest rates forecasts are frequently wrong Even if rates change as predicted, banks have limited flexibility in vary GAP and DGAP and must often sacrifice yield to do so

Gap and DGAP Management Strategies Example Cash flows from investing Rs1,000 either in a 2-year security yielding 6 percent or two consecutive 1-year securities, with the current 1-year yield equal to 5.5 percent. 1 1 1
Two-Year Security

$1 1 1
One-Year Security & then another One-Year Security

$1 1 1 1

$1 1

Gap and DGAP Management Strategies Example

It is not known today what a 1-year security will yield in one year. For the two consecutive 1-year securities to generate the same Rs120 in interest, ignoring compounding, the 1-year security must yield 6.5% one year from the present. This break-even rate is a 1-year forward rate, one year from the present:
6% + 6% = 5.5% + x so x must = 6.5%

Gap and DGAP Management Strategies Example

By investing in the 1-year security, a depositor is betting that the 1-year interest rate in one year will be greater than 6.5% By issuing the 2-year security, the bank is betting that the 1-year interest rate in one year will be greater than 6.5%

Yield Curve Strategy

When the U.S. economy hits its peak, the yield curve typically inverts, with short-term rates exceeding long-term rates.
Only twice since WWII has a recession not followed an inverted yield curve

As the economy contracts, the Federal Reserve typically increases the money supply, which causes the rates to fall and the yield curve to return to its normal shape.

Yield Curve Strategy

To take advantage of this trend, when the yield curve inverts, banks could:
Buy long-term non-callable securities
Prices will rise as rates fall

Make fixed-rate non-callable loans

Borrowers are locked into higher rates

Price deposits on a floating-rate basis Lengthen the duration of assets relative to the duration of liabilities

Interest Rates and the Business Cycle The general level of interest rates and the shape of the yield curve appear to follow the U.S. business cycle.

Peak

) t n e c r e P ( s Contraction e t Expansion a R In contractionary t s stages rates fall until e r they reach a trough e when the U.S. t n falls into Ieconomy recession.

In expansionary Short-TermRates stages rates rise until they reach a peak as the Federal Reserve Long-TermRates tightens credit availability.
Expansion
The inverted yield curve has predicted the last five recessions
DATE WHEN 1 -YEAR RATE LENGTH OF TIME UNTIL FIRST EXCEEDS 11 -YEAR RATE START OF NEXT RECESSION

Trough

Apr. 11 Mar. 11 Sept. 11 Sept. 11 Feb. 11 Dec. 11

1 1months (Dec. 1 1 ) 1months (Nov. 1 1 ) 1 1months (Jan. 1 1 ) 1 1months (July 1 1 ) 1 1months (July 1 1 ) 1 1 months (March 1 1 )

Tim e