Chapter 2

Asset-Liability Management: Determining and Measuring Interest rate and

controlling a bank Interest Sensitive GAP

( Book Chapter-6)

Q: What do the following terms mean: asset management? Liability management? Funds
management?

Asset management: Asset management refers to a banking strategy where management has control
over the allocation of bank assets but believes the bank's sources of funds (principally deposits) are
outside its control.

Liability management: Liability management is a strategy of control over bank liabilities by varying
interest rates offered on borrowed funds.

Funds management: Funds management combines both asset and liability management approaches
into a balanced liquidity management strategy.

Q: What forces cause interest rates to change? What kinds of risks do financial firms face when
interest rates change?

Interest rates are determined, not by individual banks, but by the collective borrowing and lending
decisions of thousands of participants in the money and capital markets. They are also impacted by
changing perceptions of risk by participants in the money and capital markets, especially the risk of
borrower default, liquidity risk, price risk, reinvestment risk, inflation risk, term or maturity risk,
marketability risk, and call risk. Bankers can lose income or value no matter which way interest rates go.

Rising interest rates can lead to losses on bank security instruments and on fixed-rate loans as the
market values of these instruments fall. Falling interest rates will usually result in capital gains on fixed-
rate securities and loans but a bank will lose income if it has more rate-sensitive assets than liabilities.
Rising interest rates will also cause a loss to bank income if a bank has more ratesensitive liabilities than
rate-sensitive assets.

Q: What is that a lending institution wishes to protect from adverse movements in interest rates?

A bank wishes to protect both the value of bank assets and liabilities and the revenues and costs
generated by both assets and liabilities from adverse movements in interest rates.
Q: Can you explain the concept of gap management?

Gap management involves determining the maturity distribution and the repricing schedule for a bank's
assets and liabilities. When more assets are subject to repricing or will reach maturity in a given period
than liabilities or vice versa, the bank has a GAP and is exposed to loss from adverse interest-rate
movements based on the gap's size.

Q: When is a financial firm asset sensitive? Liability sensitive?

Asset sensitive A financial institution is asset sensitive when it has more interest-rate sensitive assets
maturing or subject to repricing during a specific time period than rate-sensitive liabilities.

Liability sensitive : A liability sensitive position, in contrast, would find the financial institution having
more interest-rate sensitive deposits and other liabilities than rate-sensitive assets for a particular
planning period.

Q: How do you measure the dollar interest-sensitive gap? The relative interest-sensitive gap? What is
the interest sensitivity ratio?

The dollar interest-sensitive gap is measured by taking the repriceable (interest-sensitive) assets minus
the repriceable (interest-sensitive) liabilities over some set planning period. Common planning periods
include 3 months, 6 months and 1 year. The relative interest-sensitive gap is the dollar interest-sensitive
gap divided by some measure of bank size (often total assets). The interest-sensitivity ratio is just the
ratio of interest-sensitive assets to interest sensitive liabilities. Regardless of which measure you use, the
results should be consistent. If you find a positive (negative) gap for dollar interest-sensitive gap, you
should also find a positive (negative) relative interest-sensitive gap and an interest sensitivity ratio
greater (less) than one.

Q: First National Bank of Bannerville has posted interest revenues of $63 million and interest costs
from all of its borrowings of $42 million. If this bank possesses $700 million in total earning assets,
what is First National’s net interest margin? Suppose the bank’s interest revenues and interest costs
double, while its earning assets increase by 50 percent. What will happen to its net interest margin?

First National Bank of Bannerville has posted the following financial statement entries:

Interest revenues $63 million

Interest costs $42 million

Total earning assets $700 million

Q: First National Bank 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. Can you calculate the expected change in net
interest income that this thrift institution might experience? What change will occur in net interest
income if interest rates rise by one and a quarter percentage points?

Solution :

Q: 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?

Because interest-sensitive assets are larger than liabilities by $245 million the bank is asset sensitive.

If interest rates rise, the bank's net interest margin should rise as asset revenues increase by more than
the resulting increase in liability costs. On the other hand, if interest rates fall, the bank's net interest
margin will fall as asset revenues decline faster than liability costs.
 Chapter 2

Asset-Liability Management: The Concept of Duration and Managing a Bank

Duration GAP(Book Chapter -7)
Q: What is the duration?

 Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows

 Duration is a value-weighted and time-weighted measure of maturity that considers the timing
of all cash inflows from earning assets and all cash outflows associated with liabilities

Q: How is a financial institution’s duration gap determined?

A bank's duration gap is determined by taking the difference between the duration of a bank's assets
and the duration of its liabilities. The duration of the bank’s assets can be determined by taking a
weighted average of the duration of all of the assets in the bank’s portfolio. The weight is the dollar
amount of a particular type of asset out of the total dollar amount of the assets of the bank. The
duration of the liabilities can be determined in a similar manner.

Q: Limitations of Duration Gap Management?

1. Finding Assets and Liabilities of the Same Duration Can be Difficult

2. Some Assets and Liabilities May Have Patterns of Cash Flows that are Not Well Defined
3. Customer Prepayments May Distort the Expected Cash Flows in Duration
4. Customer Defaults May Distort the Expected Cash Flows in Duration
5. Convexity Can Cause Problems