Asset-Liability and Risk

Management of Banks 1
 Components of a Bank Balance sheet

Liabilities Assets
1. Capital 1. Cash
2. Reserve & Surplus 2. B/B with Central Bank
3. Deposits 3. Bank B/L & Call money
4. Borrowings 4. Investments
5. Other Liabilities 5. Advances
6. Fixed Assets
7. Other Assets

Contingent Liabilities or Off balance sheet items 2

Components of Capital & Liabilities
- Capital represents owner’s
1. Capital contribution/stake in the
bank.

- It serves as a cushion for

depositors and creditors.

- It is considered to be a long
term resources for the bank.
3
2. Reserves & Surplus

I. General Reserves/ Statutory Reserve

II. Capital Reserves
III. Investment Fluctuation Reserve
IV. Exchange Fluctuation Reserve
V. Investment Adjustment Reserve
IV. Dividend Equalization Reserve
V. Deferred Tax Reserve
V. Other Reserves

4
3. Deposits: Main source of the bank's funds.

This is the main source of bank’s funds.

I. Demand Deposits
II. Savings Deposits
III. Term Deposits
IV. Call deposit
V. Margin deposits
VI. Certificate of deposits
VII.Recurring deposits

5
4. Borrowings

• Refinance
• Borrowings from Central Bank,
• Inter-bank &
• other institutions

6
5. Other Liabilities & Provisions

i. Bills Payable
ii. Inter Office Adjustments (Net)
iii. Interest Payable
iv. Interest suspense
v. Unsecured Redeemable Bonds
vi. Subordinated Debt for Tier-II Capital)
vii. Tax payable or Provision for Tax
viii. Others(including provisions)

7
 1. Cash & Bank Balances
1. I. Cash in hand
(including foreign currency notes)
II. Balances with Central Bank

8
2. BALANCES WITH BANKS AND MONEY AT
CALL & SHORT NOTICE
I. In Domestic Banks
i) Balances with Banks
a) In Current Accounts
b) In Other Deposit Accounts
ii) Money at Call and Short Notice
a) With Banks
b) With Other Institutions
II. Foreign Banks
a) In Current Accounts
b) In Other Deposit Accounts
c) Money at Call & Short Notice
9
3. Investments
A major asset item in the bank’s balance
sheet. Reflected under 6 buckets as under:
I. Investments in Domestic country:
i) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions
vi) Others (Commercial Papers, Mutual Fund Units
etc.)
II. Investments in foreign country
Subsidiaries and/or Associates abroad
10
4. Advances

The most important assets for a bank.

i) Bills Purchased and Discounted
ii) Loans and advances
iii) Loan against collected bills

11
5. Fixed Asset
I. Premises
II. Other Fixed Assets (Including furniture and fixtures)

6. Other Assets
i. Accrued Interest Receivable
ii. Tax paid in advance/tax deducted at source
(Net of Provisions)
i. Stationery and Stamps
ii. Non-banking assets
iii. Deferred Tax Assets
iv. Others

12
 Calculation of Deferred Tax Asset

Accounting Profit Tax Base

Income before Dep. 100 100
Depreciation 20 10
NPBT 80 90
Tax @ 30% 24 27
NPAT 56 63
Deferred Tax Asset 27 - 24 3
13
Calculation of Deferred Tax Asset Contd...

Year Deferred Tax Total Deferred Tax

1 3 3
2 3 6
3 3 9
4 3 12
5 3 15
Total 15
14
Calculation of Deferred Tax Asset Contd...

From 6 to 10 Yrs. Accounting Profit Tax Profit

Income before Dep. 100 100
Depreciation 0 10
NPBT 100 90
Tax @ 30% 30 27
NPAT 70 63
Deferred Tax Asset 27 - 30 -3
15
Calculation of Deferred Tax Asset Contd...

Year Deferred Tax Total Deferred Tax

B/L b/d 15
6 -3 12
7 -3 9
8 -3 6
9 -3 3
10 -3 0
Total -15
16
 Number of BFIs
100

90 91
84
80 79 79
76
70
67
64
60 60
53 53
50
45 47
40 42 40
37 38 36
30 31 30 30
26 27 28 28 28
25
20 21 21
17 18
13 11
10 10
5 7
2 3
2 2 4
3
0
1980 1985 1990 1995 200 2005 2010 2011 2014 2015 2016 2017 2018
CBs DBs FCs MFCs 17
Asset Structure of Financial Sector
2%
8% 14%

14%

61%

Cash & Bank Investment Loan & Advances Fixed Assets Other Assets
18
 Asset Structure of a Good Bank

1% 4%
19%
39%

37%

Cash & Bank Investment Loan & Advances Fixed Assets Other Assets
19
Asset Structure of a Poor Financial Institution
1% 1%
6%
9%

83%

Cash & Bank Investment Loan & Advances Fixed Assets Other Assets
20
Capital & Liabilities Structure of
Financial Sector

12.1% 9.6%
2.5%

75.8%

CAPITAL FUND BORROWINGS DEPOSITS Other Liabilities

21
Income Structure of Financial Sector
4.8%
3.6%

4.1%

87.5%

Interest income Commision & Discount

Other operating income Non-operating income
22
Income Structure of a Good Bank

2.8%
Interest
11.9% income

9.0% Commission
&Disc

Other
76.3% operating
Income
Nonoperatin
g income

23
Income Structure of Poor Bank

0.3% 2.7% Interest

income

Commission&
Disc

Other
operating
Income
97.0% Nonoperating
income

24
Asset Liability Management (ALM)

1. Major portion of Liability is Deposit (followed

by borrowing)

2. Major portion of Asset is Credit (followed by

Investment),

3. Normally, Deposits have shorter maturity and

Credit has longer.

4. Both of these items are interest sensitive,

25
 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.
26
 Four key building blocks of ALM
1. Measurement of dollar gaps on the basis of maturity
buckets (0-90 days, 91-180days, etc) to determine
the amount of assets and liabilities being re-priced.
2. Estimating the interest rate at which these funds will
be re-priced and projecting future interest income
and interest expense.
3. Exploring alternative interest-rate scenarios to
estimate the bank's downside vulnerability.
4. Selecting the appropriate hedging tools to minimize
the risk.
27
 Historical View of Asset-Liability
Management
First :Asset Management Strategy
– Refers to a strategy where it is assumed that management
has control over the allocation of bank assets (loans) but
little or no control over funds sources (deposits)

Then: Liability Management Strategy

– Strategy that focuses on new sources of funds and managing
the mix of deposit and non deposit sources of funds by
varying the price or interest rates offered

Now: Funds Management Strategy

– The concept of planning and control over both sides of the
balance sheet – assets and liabilities

28
 Asset Management Strategy
1. Control of the composition of bank's assets
to provide adequate liquidity and earnings
and meet other goals.
2. Greater degrees of liquidity in assets
portfolios are available only in lower-yielding
assets like T-Bills.
3. Loans are considered to be high yielding
assets; but are less liquid.
4. To assure liquidity, banks are forced to trade
off profitability.
29
 Liability Management Strategies
1. Control over a bank's liabilities (usually through
changes in interest rate offered) to provide the
bank with adequate liquidity and meet other
goals.
2. An objective of liability management is to gain
control over the bank's funds sources.
3. A bank could attract and increase inward funds
flow by raising interest on deposits, if it
experiences heavy loan demand at limited
resources.
30
 Funds Management Strategies
1. The coordinated management of both bank's assets
and its liabilities to ensure an adequate level of
liquidity and meet other goals.
2. This consolidated funds management has several key
objectives:
• Bank management should exercise as much control
as possible over the volume, mix, and return or cost
of both assets and liabilities to achieve the bank's
goals.
• Management's control over assets must be
coordinated with its control over liabilities so that
asset and liability management are internally
consistent and do not pull against each other;
• Effective coordination in managing assets and
liabilities will help to maximize the spread between
bank revenues and costs and control risk exposure. 31
 Policy Statement
1. Asset Liability Management Policy
2. Wholesale Borrowing Guidelines
3. Risk Management Policy
4. Liquidity Contingency Plan
5. Credit to Deposit Ratio (CD Ratio)
6. Credit to Core Capital Deposit Ratio (CCD Ratio)
7. Cash Reserve Ratio
8. Statutory Liquidity Ratio
9. Local Regulatory Compliance
32
 Objectives of ALM Policy
1. Outline the scope and responsibilities of ALCO
2. Define, measure and manage the various risks
3. Maximize NII/NIM, Earnings, ROA, ROE by
keeping liquidity, forex, and interest rate risk
within acceptable and controllable levels,
4. Protect the organization from disastrous
financial consequences arising from liquidity,
foreign exchange and interest rate risk

33
Asset Liability Committee (ALCO)
The committee consists of the following key
personnel of a bank:
• Chief Executive Officer / Managing Director
• Head of Treasury / Central Accounts Department
• Head of Finance
• Head of Corporate Banking
• Head of Consumer Banking
• Head of Credit
• Chief Operating Officer / Head of Operations
34
 Functions of ALCO
1. Develop an asset-liability mgmt strategy and
procedures,
2. Decide on desired maturity profile, mix and funding
sources of liabilities and assets,
3. Assist in product pricing for deposits and advances
4. To establish a monitoring and reporting system,
5. To establish broad framework for measuring,
monitoring and managing liquidity, interest rate and
forex risk,
6. To deal with cost and use of borrowed funds
7. To estimate the volume of liquid assets required for
unanticipated needs,
8. To make better use of short-term financial resources,
35
Risk in banking Business
1. Market Risk (Forex risk, Interest Risk, Price Risk)

2. Credit Risk

3. Liquidity Risk

4. Operational Risk

5. Other Risk
36
 Market Risk
The market risk is the negatively changing market
values of bank assets, liabilities and equity bringing
about loss.
Indicators -
• The ratio of a bank's book value assets to the
estimated market value of those same assets
• The market value of bank's bond and other fixed
income assets relative to their value as recorded
on the bank's books
• The market value of a bank's common and
preferred stock per share, reflecting investor
perceptions of the bank's risk exposure and its
earnings potentials
37
 Forex Risk

Components Interest
Price Risk of Market Rate
Risk Risk

Re-Investment
Risk
38
 Foreign Exchange Rate Risk

Adverse effects on organization’s net

income due to the change of exchange rate
or
Possibility of losses due to adverse changes
in the relative value of foreign currencies.

39
Mitigations of Foreign Exchange Rate
Risk

• Forward Exchange Contract

1

• Zero Net Open Position

2

• Exchange Fluctuation Reserve

3

40
Price Risk
– When interest rates rise, the market value
of the bond or asset falls

Reinvestment Risk
– When interest rates fall, the coupon
payments on a bond or maturing loans are
reinvested at lower rates, future income will
falls.

41
 Interest Rate Risk
The interest rate risk is the danger that shifting
interest rates adversely affecting a bank's net
income, the value of its assets or equity.

Unexpected changes of interest rate so that:

• Interest costs exceeds interest earnings
• Decrease the value of earning assets
• Decrease the Net worth of FIs.

42
Indicators of Interest Rate Risk

• The ratios of interest sensitive

1 assets to interest sensitive
liabilities at a particular maturity

• High volume of corporate and

2 individual depositors.

43
 Interest Rate Risk Mitigation

• Interest Sensitive Gap Management

• Duration Gap management

• Use of Derivative Tools: Future, Forward, Options,

Swap, Floors, Caps, Collars etc.
44
 Liquidity Risk
The liquidity risk is the adverse situation of having
insufficient cash to meet a bank's obligations when due.
Measures of Liquidity Risks –

• Liquid assets to total assets

• Net loans to total assets
• Cash and due from deposit balance held at other banks
to total assets
• Cash assets and government securities to total assets
45
 Liquidity risk
 The role of banks in the maturity transformation of
short-term deposits into long-term loans makes banks
inherently vulnerable to liquidity risk
 Risk that a financial institution may not be able to pay
back its liabilities in a timely manner because of an
unexpectedly large amount of claims
 More realistically, it may be able to meet those
requests only by quickly selling (fire sale) large
amounts of assets, at a price that is below their
current market value, thereby suffering a loss
 Asset and liability mismatch generates not only
interest rate risk  liquidity risk  Reputational Risk
46
How to manage liquidity risk?
1. Hold cash and short-term assets on the
balance sheet and reserves at the central
bank
2. Ability to borrow in the interbank market
3. Ability to borrow from the central bank
under the discount window (“last resort”)
4. Matching asset liability maturity

47
 Credit Risk
Credit Risk is the default by a borrower to whom a
bank has extended credit. The probability that
some of a bank's assets, especially its loans will
decline in value and perhaps become worthless is
known as a credit risk.

Indicators:
Pass Loan

N
P
L
48
 Credit Risk
Borrower default to repay the loan or unable to
meet its obligations
Types of defaulter:
• Willful defaulter
• Non-willful defaulter

49
 Willful Defaulters
a. All borrowers who/which are out of contact for
one year after the loan has become overdue,
have not initiated for restructuring and
rescheduling of the loan and have made no
payment commitments;
b. Borrowers who/which despite the possibility to
sale the mortgaged property to repay the
outstanding loan but are unwilling to dispose
the collateral property or who/which create
situations to restrict such sale;
c. Borrowers who/which are operating more than
one business or industries but, not utilizing the
earnings from such business to repay the loan;
50
• Borrowers who/which have caused diversion
of fund by not utilizing the loan for the
intended purpose,
• Siphoned off the earnings other than utilizing
for repayment of the loan,
• Used for creating another assets in the
business,
• Use of the short term fund for long term
purpose in violation of the agreement and
using the fund in the subsidiary companies or
other firm/companies.
51
• Borrowers who/which have used the name of
another person or third party, for instance,
servant, own employees etc., in the business
or project controlled by him with an intention
to conceal one’s own involvement in the
business.
• Borrowers who/which have offered false
description with regard to collateral or
business.

52
• Borrowers who/which have obtained the loan in
collusion with the employees of the lending
Banks and Financial Institutions, by discouraging
or other using illegal means and found to have
created unwarranted pressure or lobbying or
offering benefits with an intention of not
repaying the loan.

53
 Non-Willful Defaulters
• Borrowers who have intention to pay the loan
but failed owing to the loss in business or
become problematic on account of prevalence
of situation beyond control;
• Borrowers who despite not being able to
repay the loan are in contact with the lending
Bank and Financial Institution and expressed
commitment to repay the loan under the
terms acceptable to the Bank and Financial
Institution through restructuring or
rescheduling of the loan.
54
 Credit Risk Mitigations
• Collateral (Fixed, movable, Gtee., etc.)
• Provisions
• Credit analysis (6Cs, SWOT)
• Credit monitoring
• Credit derivatives (Credit swap, securitization)
• Maintain adequate level of capital

(6Cs= Cash, Capacity, Collateral, Character, Condition, Control)

55
 Operational Risk

Risk of loss resulting from inadequate internal

process, people and system or from external
events.

56
 Operational Risks Include
• Internal Fraud.
• External Fraud.
• Employment Practices and Workplace Safety.
• Clients, Products and Business Practices.
• Damage to Physical Assets.
• Business Disruption and System Failures.
• Execution, Delivery and Process Management.

57
 Internal Fraud
• Unauthorized Activity.
– Transactions not reported.
– Transaction type unauthorized.
– Mismarking of position.
• Theft and Fraud.
– Fraud/credit fraud/worthless deposits.
– Theft/extortion/embezzlement/robbery.
– Misappropriation of assets.
– Forgery.
– Insider trading.
– Money laundering.
– Willful blindness.
58
 External Fraud
• Theft and Fraud.
– Theft/robbery.
– Forgery.
– Identity theft.

• Systems Security.
– Hacking damage.
– Theft of information (with monetary loss).

59
 Operational Risk Management

Employee training.
Close management oversight.
Segregation of duties.
Employee background checks.
Procedures and process.
Purchase of insurance.
Exiting certain businesses.
Using new technologies (CCTV).

60
Other Risks
Reputational Risk

Inflation Risk

Political Risk

Country Risk
61
 Reputational Risk
• Reputational risk is the potential that negative
publicity, whether true or not, will result in loss
of customers, severing of corporate affiliations,
decrease in revenues and increase in costs.
• All of a bank's activities and decisions can lead
to reputational risk, if they are perceived as
controversial by the bank's stakeholders
(clients, trading, counterparties, employees, suppliers,
regulators/governmental bodies, and investors).

62
Stakeholders’ Adverse Perceptions of the
Bank's Activities Lead to Reputational Risk

63
 Reputational Risk Management

 Processes for crisis management are planned and

documented.
 External perceptions of the bank are regularly measured.
 Reputational threats are systematically tracked.
 Employees are trained to identify and manage reputational
risks.
 Standards on environmental, human rights and labor practices
are set publically.
 Relationships and trust with pressure groups and other
potential critics are established.

64
Forces Determining Interest Rates

Interest rate is determined by the

financial marketplace where suppliers
of loanable funds interact with
demanders of loanable funds

The interest rate tends to settle at the

point where the quantities of loanable
funds demanded and supplied are
equal.
65
 Determination of interest rate
Supply of
Loanable funds
Price of credit, investment

Rate of interest
Volume of credit

Demand of
loanable funds

0 Quantity of loanable funds

66
Economic Forces Affecting Interest Rate

• Economic Growth: increase the demand of

loanable funds which increase the interest
rate. In economic slowdown, interest rate
decrease.
• Inflation: Inflation cuts saving, decrease
loanable fund, interest rate increase,
in inflation period, business and household
wiling to borrow more which increase demand
of loanable fund, interest rate increase.

67
• Monetary policy: If monetary policy reduce
the money supply, reduce the supply of
loanble fund and interest rate goes up. And
vise versa.
• Budget deficit: High budget deficit (not
offsetting by govt. exp.), increase the demand
of loanable fund, increase Interest rate.

Other Factors: Import/export, Exchange rate,

Public awareness, Operating cost, Investment
opportunity, Balance of payment, Political
situation, Regulation, etc. 68
 Interest Rates
Simply, Interest means price of credit
Types of Interest Rate:
1. Simple Interest
2. Compounding Interest
3. Real Interest
4. Nominal Interest
5. Periodic Interest rate
6. Annual Percentage Rate (APR)
7. Yield to maturity or Effective Interest rate or
Annual Percentage Yield (APY)
69
 Interest Rates
Components of interest rates:
• Risk-Free Real Rate of Interest
+
• Various Risk Premiums:
– Default Risk
– Inflation Risk
– Liquidity Risk
– Call Risk
– Maturity Risk

70
 Bank Discount Rate (DR)

FV - Purchase Price 360

DR  *
FV # Days to Maturity

Where: FV equals Face Value

71
 Example
Suppose a money market security can be
purchased for a price of Rs. 96 and has a face
value of Rs. 100 to be paid at maturity of 90
days. Calculate interest rate using DR method.

(100 - 96) 360

DR    0.16or16 percent
100 90

72
Annual Percentage Rate (APR)
• APR is the yearly cost of a loan expressed as a
percentage.

• The APR includes, as a percent of the principal,

not only the interest that has to be paid on a
loan, but also some other costs.

• If the interest per month is 1%, then APR is 12%

73
Annual Percentage Yield (APY)
• It is also known as Yield to maturity or Effective
Interest rate or effective annual return.
• It is compound interest rate.

74
Annual Percentage Yield (APY)
• If interest rate is 12% and compounded monthly,
then APY is 12.68%
C.I. =((1+0.12/12)^12)-1=0.1268

• If interest rate is 12% and compounded daily,

then APY is 12.75%

C.I. =((1+0.12/365)^365)-1 = 0.1275

75
76
 Or

n
CFt
Market Price  
t 1 (1  YTM)
t

77
 Example
A bond purchased today at a price Rs. 950 and
promising an interest payment of Rs. 100 each
year over the next three years. It will be
redeemed by the bonds issuer for Rs. 1000.
Measure the rate using YTM.

78
 Solution
• Current Market Price = Rs 950
• Period (n) = 3 yrs.
• Expected Cash Flow (CF) = Rs. 100 each year.
• Future Value or Redemption price of security
=Rs. 1000
• YTM = ?

79
 Using Excel
pv = 950
nper = 3
pmt = 100
fv = 1000
type = 0

=RATE(3,100,-950,1000,0)
=12.1%

80
 Yield Curves

A graphical Picture of how interest rates vary with

different maturities of securities as viewed at a
single point of time.

Simply,

Graphic picture of relationship between yields and

maturities on securities

81
82
 Yield Curves

• Shape of the yield curve determines the spread

between long term and short term interest
rates.
– Upward – long-term rates higher than short-
term rates (normally happens)
– Downward – short-term rates higher than
long-term rates

83
 Interest rate risk
• Financial institutions may lose either income or value
no matter which way interest rates go:

• Rising rates can lead to losses on security instruments

and fixed rate loans as the value of these instruments
fall. Rising rates can also cause a loss to income if the
bank has more rate sensitive liabilities than assets

• Falling interest rates can lead to capital gains but

could lead to losses if there are more interest rate
sensitive assets than liabilities
84
 Net Interest Margin

Interest Income - Interest Expenses

NIM 
Total Earning Assets
For example: A bank records $ 4 billion in interest revenues from
its loans and security investments and $ 2.6 billion in interest
expenses paid. If the bank holds $ 40 billion in earning assets,
NIM?

$4 billion - $2.6 billion

NIM  100  3.50%
$ 40 billion
85
 Problem (Class work)

• If interest revenues are $63 million, interest

costs are $42 million, earning assets are 700
million. What is the NIM.

• In the above case, If interest costs and interest

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

86
 Solution

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

($ 63 million - $ 42 million)  2
NIM  100  4.0%
$ 700 million 1.5

87
 Concept of Gap
Normally, Assets = Liabilities + Capital
and ISA =ISL (Interest rate risk free position)
But, in practice,
(Rs. in million)

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

Particulars 1-90 Days
Days Days Days Year Amount

Assets 6963 1305 1837 1489 2377 13972

Liability 2563 1071 1990 5205 1166 11995

Net Financial Assets 4400 235 -153 -3716 1212 1977

Cumulative NFA 4400 4634 4481 765 1977

88
 (Rs. in million)

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

Particulars Days Days Days Days Year Amount

Assets 26905 1141 2264 1264 36651 68225

Liabilities 15635 3049 3404 3116 37865 63069

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

Cumulative NFA 11271 9362 8222 6370 5156

89
 Interest Sensitive GAP

Interest Sensitive Gap (IS GAP) = ISA – ISL

If, ISA > ISL, there is positive gap,
If, ISA<ISL, there is negative gap.
Or
The bank is said to have Asset (Positive) Sensitive
gap if ISA-ISL>0
And,
Liability (Negative) Sensitive gap if ISA-ISL<0
90
 Asset-Sensitive Bank Has
Positive Dollar Interest-Sensitive Gap

Liability Sensitive Bank Has

Negative Dollar Interest-Sensitive Gap

91
 Re-priceable Assets
OR
Interest-Sensitive Assets
• Short term securities issued by governments
and private borrowers (about to mature)
• Short-term loans made by the banks to
borrowing customers (about to mature)
• Variable rate loans made by the bank to
customers
• Variable rate securities
92
 Repriceable Liabilities
or
Interest-Sensitive Liabilities
• Borrowings from the money market (such as
federal funds.
• Short-term savings accounts
• Money-market deposits (whose interest rates
are adjustable every few days)
• Variable-Rate Deposits
93
 Non-repriceable Assets
• Cash in vault and deposits at the central banks
(legal reserve)
• Long-term loans made at a fixed interest rate
• Long-term securities carrying fixed rates
• Buildings and equipment.

94
 Non-repriceable Liabilities

1. Demand deposits (which pay no interest rate

or a fixed interest)
2. Long-term savings and retirement accounts
3. Equity capital

95
 Measurement of IS GAP
Dollar IS GAP  ISA - ISL
IS GAP
Relative IS GAP 
Size of financial institutio n (TA)

ISA
Interest Sensitivit y Ratio (ISR)  100
ISL
96
Maturity profile used to identify, measure,
manage and control risk
Gap Cumulative
Maturity Assets liabilities
size gap
1 Day $40 $30 +10 +10

1 week 120 160 -40 -30

1 month 85 65 +20 -10

2 months 280 250 +30 +20

3 months 455 395 +60 +80

 Asset Sensitive Bank
Base
$ Interest
Increased Decreased

(@10%) (@12%) (@8%)

ISA 1000 100.0 120.0 80.0
(@8%) (@10%) (@6%)
ISL 800 64.0 80.0 48.0

IS GAP/NII +200 36.0 40.0 32.0

98
 Asset Sensitive Bank
45

40
40

36
35
32
30

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

Original Rate Rise Rate Falls

99
 Liability Sensitive Bank
Base
$ Interest
Increased Decreased

(@10%) (@12%) (@8%)

ISA 1000 100.0 120.0 80.0
(@6%) (@8%) (@4%)
ISL 1200 72.0 96.0 48.0

IS GAP/NII -200 28.0 24.0 32.0

100
 Liability Sensitive Bank
14

12
12

10 10 10
10

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

Original Rate Rise Rate Fall 101

 Zero Interest-Sensitive Gap

When Dollar Interest-Sensitive Gap is Zero,

Interest Rates Change in Either Direction NIM
is Protected and Will Not Change

102
 Zero Interest Sensitive Bank
Base
$ Interest
Increased Decreased

(@10%) (@12%) (@8%)

ISA 1000 100.0 120.0 80.0
(@6%) (@8%) (@4%)
ISL 1000 60.0 80.0 40.0

IS GAP/NII 0 40.0 40.0 40.0

103
 Zero Interest-Sensitive Gap
14

12
12

10 10
10

8 8
8
ISA Rate
6 ISL Rate
6
NIM

2 2 2
2

Original Rate Rise Rate Falls

104
Gap Positions and the Effect of Interest
Rate Changes on the Bank

Asset-Sensitive Bank Liability-Sensitive Bank

Interest Interest NII

NII
Rate Rate

Interest Interest
NII Rate NII
Rate

105
 IS Gap (Real Case 1)
(Rs. in million)

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

days days days 365 days year Total
1 Interest Sensitive Assets 4,382 1,099 826 847 2,269 9,423
Interest Sensitive
2 1,495 867 974 4,562 971 8,869
Liabilities
3 Gap (1 - 2) 2,887 233 -148 -3,715 1,298 555

4 Cumulative Gap 2,887 3,120 2,972 -743 555

Adjusted Interest Rate

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

Impact on Earnings
6 7.22 0.58 -0.37 -9.29 3.25 1.39
(Cumulative Gap x IRC)

Accumulated Earnings
7 7.22 7.80 7.43 -1.86 1.39
Impact to date 106
 IS Gap (Real Case 2)
(Rs. in million)

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

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

4 Cumulative Gap 8154 6184 5030 3175 7829

Adjusted Interest Rate

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

Impact on Earnings
6 20.39 (4.93) (2.89) (4.64) 11.64 19.57
(Cumulative Gap x IRC)

Accumulated Earnings
7 20.39 15.46 12.58 7.94 19.57
Impact to date 107
 1st Quarter
Amount

fg
0 3 months 1 year

Maturity Period
108
Important Decision Regarding IS Gap
• Management must choose the time period over
which NIM is to be managed

• Management must choose a target NIM

• To increase NIM management must :

– Develop correct interest rate forecast

– Reallocate assets and liabilities to increase spread

• Management must choose volume of interest-

sensitive assets and liabilities
109
 NIM Influenced By:
• Changes in interest rates up or down

• Changes in the spread between assets and

liabilities

• Changes in the volume of interest-sensitive

assets and liabilities

• Changes in the mix of assets and liabilities

110
 Problem
• If interest rate sensitive assets are $870 and
interest sensitive liabilities are $625 during
the next month. Is the bank asset sensitive or
liability sensitive. What happens to NIM if rate
rise? What happens to NIM if rates fall

111
 Solution
• As assets sensitive assets are larger the bank is
asset sensitive by $245
• If rates rise NIM increases. If rates fall NIM
decreases

112
 Problem
• If the gap for the one year period is $+ 135
million and rates fall by 2.5 percent point then
calculate the expected change in NII. What
would happen if rates rise by 1.25 percent
point ?

113
 solution
• 135 million × (- .025) = - 3.38 million $
• 135 million × .0125 = + 1.69 $

114
 Problem
• Suppose interest sensitive assets are 570
million and interest rate sensitive liabilities are
685 million. What is the dollar interest
sensitive gap?

115
 Solution
• Dollar interest– sensitive gap = 570 – 685 = -
115

116
 Normal IS Gap Management

Expected Change Interest-Sensitive Management’s Likely

in Interest Rates Gap Position Action

Negative IS Gap Make IS Gap Zero

Rising Market
Interest Rates
Positive IS Gap Wait for Gain

Negative IS Gap Wait for Gain

Falling Market
Interest Rates
Positive IS Gap Make IS Gap Zero
 Aggressive IS Gap Management
Aggressive
Expected Change Interest-Sensitive
Management’s Likely
in Interest Rates Gap Position
Action
Negative IS Gap Make IS Gap Zero
Rising Market Widen Gap :
Interest Rates Positive IS Gap Increase IS Assets
Decrease IS Liabilities
Widen Gap:
Negative IS Gap Decrease IS Assets
Falling Market
Interest Rates Increase IS Liabilities

Positive IS Gap Make IS Gap Zero

 Interest-Sensitive Gap Management
(Re-call)
IS Gap Expected Normal Aggressive
Position Change in IR Action Mgmt Action

Waiting for gain Widening +ive

Rising Gap by

Positive I I
S
S
L
A
 Interest-Sensitive Gap Management
(Re-call)
IS Gap Expected Normal Aggressive
Position Change in IR Action Mgmt Action

Making Zero Gap Making -ive

Gap by
Falling

Positive I I
S
S
A
L
 Interest-Sensitive Gap Management
(Re-call)
IS Gap Expected Normal Aggressive
Position Change in IR Action Mgmt Action

Making Zero Gap Making +ive

Rising Gap by

Negative I I
S
S
L
A
 Interest-Sensitive Gap Management
(Re-call)
IS Gap Expected Normal Aggressive
Position Change in IR Action Mgmt Action

Waiting for gain Widening -ive

Gap by
Falling

Negative I I
S
S
A
L
Interest-Sensitive Gap Management
(Re-call)

IS Gap Expected Normal Aggressive

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

• Interest rate attached to bank assets and liabilities do

not move at the same speed as market interest rates

• Point at which some assets and liabilities are repriced

is not easy to identify

• Interest-sensitive gap does not consider the impact

of changing interest rates on equity position
124
 The Concept of Duration
• IS GAP enables to combat the possibility
of losses of net interest margin or spread
due to changes in market interest rates.

• Changing interest rate also can damage

to net worth or value of firm.

125
 The Concept of Duration
Duration is the weighted average
maturity of a promised stream of future
cash flows.

If a loan is disbursed to be repaid at the

end of one year in lump sum basis, then
duration is 1 year.

126
 The Concept of Duration
If a loan of Rs 1000 is disbursed to be repaid
in two installment (at the end of 1 year and 2
year) in installment basis, then duration is :
Installment Cash flow Duration Weight × Duration
(year)
1 500 1 500
2 500 2 1000
Total 1000 3.0 1500
Duration (yr.) =1500/1000 =1.5 yrs.
127
 The Concept of Duration
If a loan of Rs 1000 is disbursed to be repaid in two
installment (at the end of 1 year and 2 year) in
installment basis. The applicable market discount rate is
10%, then duration is :
PVF Duration Weight ×
Installment Cash flow Present Value
(@10%) (year) Duration

1 500 0.9091 454.55 1 454.55

2 500 0.8264 413.22 2 826.45

Total 1000 867.77 3.0 1280.99

Duration =1280.99/867.77 = 1.48 yrs.

128
 Assumptions of Duration Gap
• Cash flow stream of asset and liability is well
defined,
• All receipts and payments are done as
projected (Prepayment, default and pre
matured call are not held)
• Asset and liability having all types of maturity
profile are available easily for buying and
selling in the market,
• Interest rate do change as projected in the
same direction, speed, time and magnitude.

129
Steps for Calculating Duration Gap

1. Calculate the duration of each individual

asset and liability

2. Calculate Wt. Avg. duration of Asset portfolio

and liability portfolio

3. Calculate the Leverage Adjusted Duration

Gap

130
 Steps 1

Calculation of duration of each

individual asset and liability

131
 To Calculate Duration
n
CF1  t1 CF2  t 2 CFn  tn
t 1 (1  YTM)
1

(1  YTM) 2
 ... 
(1  YTM) n
D n
CF1 CF2 CFn
t 1 (1  YTM)
1

(1  YTM) 2
 ... 
(1  YTM) n

n
CF1  t1 CF2  t2 CFn  tn
 (1  YTM) 1

(1  YTM) 2
 ... 
(1  YTM) n
D  t 1
CurrentMarket Pr ice
132
 In Summary

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

133
 Where,

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

134
 Finally

n
CFt

t 1 (1  YTM)
t
 Period (t )
D
CurrentMarket Pr ice

135
 Example 1
Loan term 5 years. Annual interest rate payment
is 10% ( or $ 100). The face value of the loan is
$1000 which is also its current value , because
the loan’s current yield to maturity is 10
percent.
• Loan’s duration?

136
 Solution
CF
period CF PV @10% PV t PV x t

1 100 0.9091 90.91 1 90.91

2 100 0.8264 82.64 2 165.29
3 100 0.7513 75.13 3 225.39
4 100 0.6830 68.30 4 273.21
5 100 0.6209 62.09 5 310.46
5 1000 0.6209 620.92 5 3104.61
Total 1000 4169.87
Duration =4169.87/1000=5.17
 Solution
CF
period CF PV @10% PV t PV x t

1 100 0.9091 90.91 1 90.91

2 100 0.8264 82.64 2 165.29
3 100 0.7513 75.13 3 225.39
4 100 0.6830 68.30 4 273.21
5 100 0.6209 62.09 5 310.46
5 1000 0.6209 620.92 5 3104.61
Total 1000 4169.87
Duration =4169.87/1000=4.17
 Example 2
A bank has $100 million in negotiable CDs
outstanding on which it must pay its customers
a 6 percent annual yield over the next two
calendar years. The duration of these CDs will be
determined by the distribution of cash
payments made over the next two years in
present value terms. Calculate the Duration of
the CDs.

139
 Solution
Period (t) cf pv pv*t
1 6 5.66 5.66
2 6 5.34 10.68
2 100 89.00 178.00
Total 100.00 194.34
Duration 1.943
140
 Example 3
A bank has invested Rs. 1,00,000 on 5 year bond
in 1st Shrawan, 2069. The coupon rate of the
bond is 8%. The current market yield is 10%
which is projected to be constant for coming 3
years. Today is 1st Shrawan, 2071.

Calculate the duration of the investment.

141
 Solution
Remaining Maturity 3 years
Face value 100000
Coupon rate (p.a.) 8%
Market Yield (i) 10%

n
CF1  t1 CF2  t 2 CFn  t n
 (1  i) 1

(1  i) 2
 ... 
(1  i) n
D  t 1
CurrentMarket Pr ice

C C (C  A)
P   ..... 
1  i1 (1  i2 ) 2 (1  it ) t

142
 Calculation of Duration

CF CF PVIF PV t PV x t
period @10%
1 8,000 0.9091 7,272.73 1 7,272.73
2 8,000 0.8264 6,611.57 2 13,223.14
3 8,000 0.7513 6,010.52 3 18,031.56
3 100,000 0.7513 75,131.48 3 225,394.4
Total 95,026.30 263,921.9
=263,921.9 /95,026.30
Duration
=2.777 yrs
 Steps 2

Calculation of Weighted Average

duration of Asset Portfolio

&

Weighted Average duration of Liability

Portfolio
144
Dollar Wt. Avg. Asset Portfolio Duration


Duration of Market Value of

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

145
 Duration of Asset portfolio

n
D A   D Ai  wi
Where: i 1
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio

146
 Duration of Liability Portfolio

n
D L   D Li  wi
Where: i 1
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio

147
 Example 3
Actual or Estimated Assets
Assets held Market Values of Assets Duration
($ millions) (years)
Treasury Bonds 90.0 7.49
Commercial Loans 100.0 0.6
Consumer Loans 50.0 1.2
Real estate Loans 40.0 2.25
Municipal Bonds 20.0 1.5

Calculate dollar weighted average asset portfolio.

148
 w D
Actual or Estimated
Assets Duration
Assets held Market Values of W*D
(years)
Assets ($ millions)

Treasury Bonds 90.0 7.49 674.1

Commercial Loans 100.0 0.6 60.0

Consumer Loans 50.0 1.2 60.0

Real estate Loans 40.0 2.25 90.0

Municipal Bonds 20.0 1.5 30.0

300.0 914.1

Dollar Wt. Avg. Asset duration 3.047 149

 Steps 3

Calculation of Leverage
Adjusted Duration Gap

150
 Duration Gap

Weighted Weighted
Duration
gap = duration
of asset - duration of
liabilities
portfolio Portfolio

151
 Duration gap measurement

• It is the difference between the duration of a bank’s

assets and the duration of its liabilities
• The duration of the banks assets can be determined
by taking the weighted average of the duration of all
assets in the portfolio
• The weight is the amount of a particular type of asset
out of the total amount of assets
• The duration of liabilities can be determined in a
similar way

152
Using Duration to Hedge against Interest
Rate Risk

Weighted
Weighted
duration of
duration of
the asset
portfolio
≈ liabilities
portfolio

Or

153
 Leverage Adjusted Duration Gap

• Volume of assets usually exceeds the volume

of liabilities.
• Otherwise, the financial institution would be
insolvent.
• Leverage should be adjusted to minimize the
effects of interest rate fluctuations.

154
 Leverage Adjusted Duration Gap

Dollar Dollar Total

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

155
 Duration Gap

TL
D  DA - DL 
TA

156
 Duration gap calculation

Suppose,
Asset duration = 2.5 years,
liability duration = 3 years,
total assets = $560 million
total liabilities = $467 million

Duration Gap = ?

157
 Solution
Duration gap = DA –DL × TL/TA
= 2.5 yrs – 3 yrs × (467/560)
= 2.5 – 2.5018
= - .018 years

158
 Portfolio Theory

• Rate effect: A rise in market rates of interest

will cause the market value (price) of both
fixed-rate assets and liabilities to decline.
• Duration effect: The longer the maturity of a
financial firm’s assets and liabilities, the more
they will tend to decline in market value
(price) when market interest rates rise.
 Price Sensitivity of a Security
P i
 -D
P (1  i)
Where,
• ΔP/P = %change in market price of an asset,
• Δi/(1+i) = relative change in interest rate associated with
the assets or liabilities,
• D = duration,
• Negative sign = market price and interest rate on
financial instruments move in opposite directions.
• Interest rate risk of financial instruments is directly
proportional to their duration. 160
 Example
Suppose, a bond carrying a duration of 4 years
has a current market value (price) of $ 1000.
Market interest rate attached to the bond is 10
percent currently, but recent forecast suggests
that market rates may rise to 11 percent. If this
forecast turns out to be correct, what
percentage change will occur in the bond’s
market value?

161
 Solution
• Duration= 4, and interest rates go up from 10
to 11 pct
• Change in price % = -D x Δ i/(1+i)
• -4 x .01/(1+.10) = - 3.64%
• If rate go down from 10 to 9 pct. then
• -4 x -.01/(1+.10) = + 3.64%

162
 Net worth
Liabilities Assets
1. Paid up Capital 1. Cash
2. General Reserve 2. B/B with Central Bank

Net worth
3. Retained Earnings 3. Bank B/L & Call money
4. P/L Account 4. Investments
5. Share premium 5. Advances
6. Proposed dividends 6. Fixed Assets
7. Free reserves 7. Goodwill
8. Redeemable debenture 8. Other Assets
9. Deposits
10. Borrowings
11. Interest suspense
12. Other Liabilities 163
Change in the Value of Bank’s Net Worth

NW = A – L
ΔNW = ΔA – ΔL (i)
We Know,

ΔP/P = -D × (Δi/(1+i))
Or
ΔA/A = -D × (Δi/(1+i)) 164
Change in the Value of Bank’s Net Worth

ΔA/A = -D × (Δi/(1+i))

Or
ΔA = -D × (Δi/(1+i))× A

Similarly,
ΔL = -D × (Δi/(1+i))× L
165
Change in the Value of Bank’s Net Worth

Replacing the value of ΔA and ΔL in

equation (i),

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

or
 i   i 
NW  - D A   A - - D L   L
 (1  i)   (1  i) 
166
Change in the Value of Bank’s Net Worth
 i   i 
NW  - D A   A - - D L   L
 (1  i)   (1  i) 
OR

 L  i
NW  - D A - D L    A
 A  (1  i)
Where,
A = Market value of Asset
L = Market value of Liability
167
 Duration gap calculation

• Asset duration is 3.25 years and liability

duration is 1.75 years. The liabilities amount
to $485 million while assets total $512 million.
Interest rates rise form 7 to 8 per cent.
• Calculate duration gap. What happens to the
net worth.

168
 solution
• First calculate duration gap.
• Duration gap = 3.25 yrs – 1.75 yrs *485/512 =
+ 1.5923
• The change in net worth due to the increase in
interest rates is = {-3.25yrsx .01/(1+.07) x
$512} – {-1.75 yrs x .01/(1+.07) x $485 mill } =
-7.62

169
 Example
Average
Market Interst
Assets Duration
value ($) Rate (%)
(Yrs)
Treasury bills 90.0 10.00 7.490
Municipal bonds 20.0 6.00 1.500
Commercial loans 100.0 12.00 0.600
Consumer loans 50.0 15.00 1.200
Real estate loans 40.0 13.00 2.250
Total 300.0 170
 Average
Market Interst
Liabilities Duration
value ($) Rate (%)
(Yrs)
Negotiable CDs 100.0 6.00 1.9430
Other time deposits 125.0 7.20 2.7500
Subordinated notes 50.0 9.00 3.9180
Total Liabilities 275.0
Equiti capital 25.0
Total 300.0 171
Calculation of Wt. Average Duration of
Assets

Average
Market
Assets Duration Wt.*P
value ($)
(Yrs)
Treasury bills 90.0 7.490 2.247
Municipal bonds 20.0 1.500 0.100
Commercial loans 100.0 0.600 0.200
Consumer loans 50.0 1.200 0.200
Real estate loans 40.0 2.250 0.300
Total 300.0 3.047
Wt. Average
Duration of Assets 3.047
172
 Calculation of Wt. Average Duration of
Liabilities

Average
Market
Liabilities Duration Wt.*P
value ($)
(Yrs)

Negotiable CDs 100.0 1.9430 0.707

Other time deposits 125.0 2.7500 1.250
Subordinated notes 50.0 3.9180 0.712
Total Liabilities 275.0 2.669
Wt. Average Duration
of Liabilities 2.669
173
 Change in the Value of Net Worth
 i   i 
NW  - D A   A  - - D L   L
 (1  i)   (1  i) 
Suppose interest rate on both assets and liabilities rise
from 8 to 10 percent. Putting the value of all variables in
the above equation, we find:

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

= -$3.34 million
Interpretation: Net worth would fall by $3.34 million if interest rate
increase by 2 percent points. 174
Suppose interest rate on both assets and liabilities fall from 8
to 6 percent. What would happen to the value of the above
example?

Substituting the value in the same formula:

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

= +$3.34 million
Interpretation: Net worth would rise by $3.34 million if interest rate
fall by 2 percent points.

175
Calculation of leverage adj. Duration Gap
TL
D  DA - DL 
TA
=3.047 yrs - 2.669 yrs X$275/$300

= +0.60 years
Interpretation:
The positive duration gap of +0.60 years means that the bank’s net
worth will decline if interest rates rise and increase if interest rates
fall.

176
Impact of Changing Interest Rates on a
Bank’s Net Worth
If the FIs’ Leverage Adj. If Interest
NW will
Duration Gap is: Rate
Rise Decrease
Positive (DA>DL×L/A)
Fall Increase
Rise Increase
Negative (DA<DL×L/A)
Fall Decrease
Rise No Change
Zero (DA=DL×L/A)
Fall No Change
+ IS GAP NIM Interest Rate
- IS GAP NIM Interest Rate
0 IS GAP NIM Interest Rate
+ IS GAP NIM Interest Rate Net Worth -Duration Gap
- IS GAP NIM Interest Rate Net Worth +Duration Gap
0 IS GAP NIM Interest Rate Net Worth 0 Duration Gap
 IS Gap vs. Duration Gap

• IS Gap only looks at impact of changes in

interest rates on net income
• Duration takes into account the impact of
interest rate changes on the market value of
the bank’s equity position

184
Limitations of Duration Gap Management

• Finding assets and liabilities of the same duration can

be difficult
• Some assets and liabilities may have patterns of cash
flows that are not well defined
• Customer prepayments may distort the expected cash
flows in duration
• Customer defaults may distort the expected cash flows
in duration
• Interest rate attached to bank assets and liabilities do
not move at the same speed, magnitude and direction
as market interest rates
185