Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 6th edition

Chapter Twenty-Two
Managing Interest Rate Risk and Insolvency Risk
on the Balance Sheet

I. Chapter Outline
1. Interest Rate and Insolvency Risk Management: Chapter Overview
2. Interest Rate Risk Measurement and Management
a. Repricing Model
b. Duration Model
3. Insolvency Risk Management
a. Capital and Insolvency Risk

II. Learning Goals

1. Define the repricing gap measure of interest rate risk.
2. Understand the weaknesses of the various interest rate risk models.
3. Define the duration gap measure of interest rate risk.
4. Discuss how capital protects against credit risk and interest rate risk.
5. Highlight the differences between the book value and market value of equity.

III. Chapter in Perspective

Providing maturity intermediation is a major function of FIs. Recall from Part I of the
text that institutions are intermediaries between ultimate borrowers and lenders. They
serve as asset transformers by providing claims designed to better meet the specific needs
of borrowers and lenders. The asset transformation function typically leaves the FI with
longer term assets than liabilities. Thus as interest rates change over time the spread
between a FI’s asset earnings and liability costs may increase or decrease, leading to
major changes in a FI’s profitability. Likewise, changes in the market value of the FI’s
assets and liabilities will not be the same when interest rates change. Changes in interest
rates can cause the value of assets to change more or less than the value of liabilities.
The FI’s equity value can thus fluctuate sharply as interest rates change because the
market value of equity is equal to the market value of assets minus the market value of
liabilities. This chapter discusses the measurement of profitability and present value risk
and discusses methods of manipulating the balance sheets to manage these risks. The
chapter concludes by reemphasizing the role of equity capital in limiting insolvency risk
and discussing the benefits of market value accounting.

IV. Key Concepts and Definitions to Communicate to Students

Gap CGAP

Repricing model CGAP Effects

Funding gap model Spread Effects

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Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 6th edition

Duration gap model Net effects of changing rates on NII

Net interest margin or net interest income Duration gap

Insolvency risk Duration gap and equity value

changes

Maturity buckets Market value of equity

Rate sensitive assets (RSAs) Book value of equity

Rate sensitive liabilities (RSLs) Immunization

Market to book ratio Maturity intermediation

Insolvency risk Mark to market accounting

Capital Purchase Program Refinancing risk

Reinvestment risk

V. Teaching Notes

1. Interest Rate And Insolvency Risk Management: Chapter Overview

The large interest rate movements of the 1980s illustrated the interest rate risk exposure
of many FIs as large numbers of lenders were bankrupted by the swings in interest rates
in the early 1980s coupled with regional problems in real estate loans.1

Changes in interest rates can impair a FI’s profitability and affect the market value of a
FI’s equity. The repricing model measures the effect of interest rate changes on
profitability; the duration model measures the predicted change in the market value of
equity. Once the exposures have been determined, it is possible to mitigate the effects of
interest rate changes by manipulating the balance sheet, or by using the off balance sheet
tools discussed in Chapter 23.

Insolvency occurs if the value of liabilities exceeds the value of assets resulting in
negative equity. Insolvency normally occurs because of liquidity risk, credit risk and/or
interest rate risk. Maintaining sufficient equity capital and prudently managing the risks
a FI faces provides the surest protection against insolvency. The financial crisis led to
large increases the number of failures. From 2008 to 2012, 465 depository institutions
1
Chapter 19 points out that interest rate risk and credit risk are interrelated. If rates begin to rise
precipitously once again, default rates will also rise, and an unhedged mortgage lender funding the loans
with short term liabilities will likely face some of the same problems that S&Ls faced in the 1980s.
Securitization allows DIs to largely avoid interest rate risk. Nonndiversified DIs engaging in mortgage
lending that do not securitize or otherwise hedge face potentially severe insolvency risk from rising
interest rates.

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(DIs) failed costing the FDIC $89 billion.

Fed policy strongly affects interest rates. In the summer of 2004 the Fed began a series
of interest rate increases to curb inflationary pressures in the economy. The Fed
increased interest rates 17 consecutive times, each time by 25 basis points. In 2007 and
2008 the Fed reversed the increases, rapidly bringing rates down as the subprime crisis
worsened. Rates were eventually lowered to near zero. As of June 2014 the Fed
continued to keep interest rates very low. However, the FDIC has recently issued
warnings to institutions to prepare for upcoming interest rate increases that may occur as
early as 2015.

2. Interest Rate Risk Measurement and Management

The repricing model (sometimes called the funding gap model) has historically been
the accepted method of measuring a FI’s interest rate risk and is used by the majority of
institutions. With the recent advances in computer technology and the ability to easily
generate more complex calculations, the duration gap model is now becoming a
supplemental measure of interest rate risk.

Teaching Tip: Both are still used. The repricing gap model is easier for bankers (and
students) to understand conceptually and is used at many smaller banks. Understanding
the duration gap model presented here requires an understanding of Chapter 3,
understanding the repricing model does not. Institutions that concentrate on long term
lending funded by short term deposits face greater interest rate risk. All DIs are now
required to measure and report interest rate risk. In addition the BIS proposed that all DIs
report the level of capital at risk from interest rate changes. Although this chapter
presents these models as means for DIs to limit risk, banks and others can (and do)
choose to take positions on interest rates in order to bolster profitability. A high level
committee usually called the “Asset and Liability Committee” or something similar
manages the institution’s interest rate risk. Members of the committee will normally
include the bank president and senior VPs.

a. The Repricing Model

The repricing model attempts to measure how a FI’s interest income will change relative
to interest expense over a given time period if interest rates change. The time periods
(called maturity buckets) typically include one day, 3 months, 6 months, 1 year, 5 years,
and greater than 5 years.2 The model classifies assets and liabilities as “fixed rate” or
“rate sensitive” based on whether the earnings or costs will change on these accounts
during the planning period if interest rates change. Rate sensitive accounts are those
where the cash inflows on an asset or outflows on a liability will change at some point
within the planning period if interest rates change. Accounts are classified as fixed rate if
the cash inflows on an asset or outflows on a liability will not change within the planning
period even if interest rates change. Conceptually one can then compare the rate
sensitivities of the two sides of the balance sheet and estimate how Net Interest Income
(NII) is likely to change if interest rates change.

2
Cumulative repricing gaps are then calculated across the maturity buckets. The text calls these CGAP.

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For example, a simple balance sheet has been classified for a 6 month maturity bucket
below:
Assets Liabilities
Rate Sensitive Assets (RSAs) $100 Rate Sensitive Liabilities (RSLs) $ 50
Fixed Rate Assets (FRAs) $206 Fixed Rate Liabilities (FRLs) $256
Nonearning Assets (NEAs) $ 34 Equity $ 34
Total $340 Total $340
Because we can think of every asset as financed by a liability or equity account we can
think of the individual asset categories as financed by a given liability or equity account.
Students can readily grasp that there is very little profit risk from an interest rate change
on the $34 of NEA financed by equity. Likewise there is little profit risk from the $206
FRAs financed by FRLs because the cash inflows and outflows on these accounts do not
change over the given maturity bucket. Notice that this pairing leaves $50 in FRLs not
yet accounted for. There should not be an excessive amount of risk for the amount of
RSAs financed by RSLs, because both are rates sensitive. For instance, if interest rates
rise, the earnings on RSAs and the costs on RSLs should both rise and the spread should
be roughly unchanged. If the spread changes this is termed a ‘spread effect’ (as described
below). There are $50 (out of the total $100) RSAs financed by RSLs. This leaves a
final category, the remaining $50 in RSAs that are financed by the remaining $50 in
FRA. This category is a major source of interest rate risk because one side (the assets) is
rate sensitive and the other side is not. This category is called the repricing gap. The
repricing model measures this ‘GAP’ or the difference in sensitivity of interest income
and interest expense in the given maturity bucket
If R = the general level of interest rates then we can predict the ΔNII resulting from a
given ΔR as follows:
where RSA and RSL are equal to the balance
sheet quantity of rate sensitive assets and liabilities respectively. The change in NII over
a given time period is a function of the size and sign of the gap and the size and sign of
the interest rate change. A negative repricing gap means the FI is exposed to
refinancing risk which means the institution will be hurt if interest rates increase
because funding costs will upward more quickly than asset returns, thus reducing the net
interest margin. A positive repricing gap implies the FI faces reinvestment risk, which
is the risk that interest rates fall and funds will have to be reinvested at lower rates while
more liabilities will retain the same interest rate cost.

Teaching Tip: When comparing the interest sensitivities of two or more institutions of
different size, or when comparing one institution to peer averages the percentage gap (=
dollar gap / Assets) is more useful than the dollar gap. Sometimes one also calculates the
Gap Ratio (= RSA / RSL) (see the text). This measure can lead to incorrect comparisons
about interest sensitivity if used to compare the interest sensitivity of a bank with a
positive dollar gap to a bank with a negative dollar gap. The bank with the ratio furthest
from 1 may not be the most interest sensitive. For this reason the percentage gap is a
better comparison tool than the gap ratio.

Teaching Tip: The following paradigm can be used to measure the repricing gap for a
particular maturity bucket and simultaneously analyze the profitability of the two

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sensitivity classes:3
1. Classify each asset on the balance sheet as either:
RSA FRA NEA

2. Classify each liability/equity account:

RSL FRL Equity

3. Group assets and liabilities into the following groups:

RSAs financed by RSLs
FRAs financed by FRLs
NEA financed by Equity
Gap: Positive dollar RS Gap: Indicates that excess RSAs financed by remaining FRLs
Negative dollar RS Gap: Excess FRAs financed by remaining RSLs
The leftovers:
Whatever is leftover financed by equity OR Equity financing whatever is leftover
This analysis highlights the idea that the quantity of interest rate risk depends upon
the size of the gap.

4. Calculate the average annual % rate of return on each asset category and the average
annual % cost rate on each liability category and then calculate the spreads. Spreads
are the difference between the income rate and the cost rate per dollar invested in the
category.

5. Calculate the dollar contribution to profit from each category as the product of the
amount times the spread.

6. Add up the profits. The banker is now in a position to both understand the major
sources of profitability and compare pricing with other institutions. One can also
easily forecast changes in profitability for various projected changes in interest rates.

This method is illustrated in the example that follows.

The dollar gap for each maturity bucket is measured as the dollar quantity of rate
sensitive assets (RSAs) minus the dollar quantity of rate sensitive liabilities (RSLs). The
cumulative gap (CGAP) is calculated by adding the gaps for subsequent time periods.
 For a positive CGAP, rising interest rates over the maturity period will normally
increase profitability, all else equal, and falling interest rates will decrease
profitability. In other words, interest rates and profitability move in the same
direction if CGAP is positive.
 For a negative CGAP, rising interest rates will decrease profitability, all else equal,
and falling interest rates will increase profitability. Interest rates and profitability
move in opposite directions if the CGAP is negative.
 These effects are termed CGAP effects.

3
See Gardiner, Mills and Cooperman, Managing Financial Institutions: An Asset/Liability Approach,
Dryden Press, 2000.

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Unequal changes in rates on RSAs and RSLs

The repricing gap analysis is more complicated than previously indicated because
although the rates of return on RSAs and RSLs will generally move in the same direction
as interest rates change, they will only rarely move identically. Thus, the spread between
the interest income earned on the RSAs and the interest cost on the RSLs will normally
change as interest rates change.4 The change in income from this category as interest
rates change is called the Spread Effect.
 If the Spread Effect is positive, when interest rates either rise or fall the spread of
interest income earned on RSAs less the interest cost on RSLs tends to increase,
thereby contributing to higher NII.
 If the Spread Effect is negative, when interest rates rise or fall, the spread of interest
income earned on RSAs less the interest cost on RSLs tends to fall, thereby
contributing to lower NII.

Conclusions about CGAP and Spread Effects:

Dollar GAP Spread Effect R Direction of NII
Positive Positive Increase Increase
Negative Increase Ambiguous
Positive Decrease Ambiguous
Negative Decrease Decrease

Negative Positive Increase Ambiguous

Negative Increase Decrease
Positive Decrease Increase
Negative Decrease Ambiguous

The following tables contain a more detailed example of a calculation of the repricing
model for a 1 year maturity bucket.5

Assets ($ Mill) Liabilities & Equity

Investments under 1 year @ 5% $ 100 Deposits < 1 year @ 4% $ 900
Loans < 1 year @ 7% $ 350 All Long Term Liabilities @ 7% $ 500
Variable rate loans
(rate reset in 6 months) @ 6.5% $ 300 Equity $ 200
Fixed Rate Assets > 1 year Total $1,600
maturity @ 8% $ 850
Total $1,600

The percentages are the average interest rate earned or paid on the given account. All
assets and liabilities that mature in less than one year or have an interest rate reset within
one year are potentially rate sensitive because their income could change if interest rates
change.
4
Their correlation is less than +1 for reasons indicated below.
5
Detailed examples of this type (from which this example is drawn) can be found in the aforementioned
Gardiner, Mills and Cooperman, Managing Financial Institutions: An Asset Liability Approach, Dryden
Press. 2000. More realistic applications of both the repricing and duration gap models can be found in
Saunders, Financial Institutions Management: A Modern Perspective, Irwin, 1994.

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Rearranging the assets and liabilities into the appropriate sensitivity categories based on
maturity and payment pattern results gives the following results:
Rate Sensitive Assets Rate Sensitive Liabilities
Amnt Income Amnt Cost
Investments under 1 year @ 5% $ 100 $ 5.00 Deposits < 1 year
@ 4% $ 900 $ 36.00
Loans < 1 year @ 7% $ 350 $24.50
Variable rate loans
(rate reset in 6 months) @ 6.5% $ 300 $19.50
Total RSAs $ 750 Total $ 900
Total Income $49.00 Total Cost $ 36.00
NII from this category $13.00
Average rate of return 6.533% Average cost rate 4.000%
Spread on RSAs financed by RSLs 2.533% (6.533% - 4%)
The spread indicates the contribution to profit from this category per dollar invested (ignoring
noninterest income and costs.) Note that some RSLs are used to finance something other than
RSAs since there are only $750 RSAs but $900 RSLs.
Dollar Gap = RSAs – RSLs = -$ 150 The negative dollar gap indicates that some
fixed rate assets are financed by rate sensitive
Percentage Gap = -$150 / $1,600 = -9.375%
liabilities.
Gap ratio = $750 / $900 = 0.833 The ‘gap’ indicates the imbalance in
sensitivities of the liabilities that are funding
the assets.

Fixed rate assets and liabilities

Fixed Rate Assets Fixed Rate Liabilities
Amnt Income Amnt Cost
Fixed Rate Assets > 1 year All Long Term
maturity @ 8% $ 850 $68.00 Liabilities @ 7% $ 500 $ 35.00
Total FRAs $ 850 Total $ 500
Total Income $68.00 Total Cost $ 35.00
NII from this category $33.00
Average rate of return 8.000% Average cost rate 7.000%
Spread on FRAs financed by FRLs = 1.000% (8% - 7%)
The spread indicates the contribution to profit from this category per dollar invested (ignoring
noninterest income and costs.) Note that only $500 of FRAs are actually financed by FRLs.
$200 FRAs are financed by equity and the remaining $150 FRAs are financed by RSLs.
Notice the GAP  FRAs – FRLs

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The profit calculations per category can be found as the product of the amount and the
spread:
Category Amount Spread $ Profit
RSAs financed by RSLs $ 750 2.533% $19.00
FRAs financed by FRLs $ 500 1.000% $ 5.00
6
FRAs financed by equity $ 200 8.000% $16.00
The Gap: FRAs financed by RSLs $ 150 4.000% $ 6.00
NII $46.00
Average rate of return per dollar invested 2.875%

The two categories that are subject to interest rate risk are the categories in bold type:
RSAs financed by RSLs and the Gap, which in this case is FRAs financed by RSLs.7 In
each case the spreads are calculated as the average rate of return for the given asset
category less the average cost rate for the liability category used to finance those assets.
Note that equity has a contractual cost rate of zero so the spread on that category is
simply the given asset rate of return. The spread on the gap is the rate of return on the
FRAs minus the cost rate on the RSLs. If the gap had been positive this spread would be
calculated differently (the rate of return on the RSAs less the cost of the FRLs). The
return on equity can be calculated by dividing NII by equity (ignoring noninterest income
and expenses).

Using the calculations: Suppose interest rates increase 100 basis points and the spread
effect is a negative 30 basis points:
Category Amount Spread $ Profit
RSAs financed by RSLs $ 750 2.233% $16.75
FRAs financed by FRLs $ 500 1.000% $ 5.00
8
FRAs financed by equity $ 200 8.000% $16.00
The Gap: FRAs financed by RSLs $ 150 3.000% $ 4.50
NII $42.25
Average rate of return per dollar invested 2.641%
The change in ROA is 2.641% - 2.875% = - 23 basis points.
If the spread effect had been positive the profit drop would have been smaller.

The bank could reduce the amount of RSLs and increase the amount of FRLs to minimize
the effect of the rising interest rates. The bank may also wish to focus on RSL accounts
that are not as interest sensitive and attempt to increase the interest sensitivity of the
RSAs to minimize the negative spread effect. A problem with balance sheet
manipulations of this type is that the customer will normally desire the opposite of what
6
FRAs financed by equity are not a part of the gap since the assets and liabilities in this category are both
fixed rate. Instructors please be aware that the profit table has to be constructed based on the size of the
given categories. For instance, one will not always include a line where FRA is financed by equity. If the
gap had been positive the third row would have been RSA financed by equity.
7
Had the gap been positive the gap would have been represented by RSAs financed by FRLs.
8
FRAs financed by equity are not a part of the gap because the assets and liabilities in this category are
both fixed rate. Instructors please be aware that the profit table has to be constructed based on the size of
the given categories, for instance, it will not always include a line where FRA is financed by equity. If
the gap had been positive the third row would have been RSA financed by equity.

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the bank wishes to offer them. That is, in a period of rising rates customers will desire
long term, fixed rate loans (bank FRAs) and short term or variable rate deposits (bank
RSLs) while the bank will desire to offer them short term, floating rate loans (bank
RSAs) and long term, fixed rate deposits (bank FRLs) to maximize the bank’s Net
Interest Margin (NIM) or equivalently, NII.

Problems with the repricing model include:

 It is not always clear which category an account belongs in. Demand deposits can
now pay interest, but most banks don’t pay interest on them. This would make
them a FRL. NOW accounts do pay interest but, along with demand deposits,
may act like core deposits which are long term sources of funds. Some would
argue that demand deposits should be included with RSLs because as interest
rates rise some holders will switch to higher paying accounts. Managers must
determine customer behavior on these accounts and categorize them accordingly.
 The repricing model (RPM) measures only short term profit changes, not
shareholder wealth changes. As such it suffers from the same problems as the
goal of maximizing profits. In particular the RPM ignores cash flows changes
that occur outside the maturity bucket and ignores the change in current value of
future cash flows as interest rates change.
 The maturity buckets are arbitrarily chosen and can be difficult to manage. It is
possible to have a positive 3 month RS gap, a negative 6 month RS gap and a
positive 1 year RS gap. Managing this requires detailed forecasts of interest rate
changes over the various arbitrarily chosen time periods.
 All assets and liabilities that mature within the maturity bucket are considered
equally rate sensitive. This is defacto not true if a spread effect exists.
 The RPM ignores runoffs. Runoffs are receipts of cash on FRA or payments due
on FRLs that occur during the maturity bucket period.9 This cash must be
reinvested by the intermediary and it is rate sensitive. Runoffs are not calculated
in the basic version of the RPM presented here.
 The RPM ignores prepayments. Prepayment patterns are affected by changing
interest rates and are difficult to predict. Prepayments increase with declining
rates so assets that were considered fixed rate may become rate sensitive by being
prepaid within the maturity bucket.
 The RPM ignores cash flows generated from off balance sheet activities. These
cash flows are also often sensitive to the level of interest rates, so the RPM
underestimates the interest rate sensitivity of the institution.

Teaching Tip: Many accounts do not have fixed maturities and the classification of RS or
FR must be based on historical turnover patterns and management’s subjective
evaluation. Investors’ desire for liquidity may change as interest rates change, and
accounts that were previously fixed rate may become rate sensitive or vice versa.

9
Payments on FRLs that require additional borrowing would result in a change in interest expense on a
given account, making it rate sensitive. Similarly, if the bank had to liquidate part of a fixed rate asset to
pay the liability, this would change the income on fixed rate assets.

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b. The Duration Model

Even if a bank could set the repricing gap for all maturity buckets to zero (and the model
had no deficiencies) so that the bank could ensure that a given level of profits would
occur no matter how interest rates changed, the bank could not ensure that the present
value of the given profits would be the same if interest rates changed. If rates increased
the present value of the given hedged future profit stream would decline. Equity value is
theoretically equal to the present value of future profits so in this case the market value of
equity would decline if rates rose and rise if interest rates fell. The market value of
equity is also equal to the market value of assets minus the market value of liabilities.
Banks can thus do a better job of managing stockholder risk and rate of return by
estimating how much the value of assets will change relative to how much the value of
liabilities will change when interest rates move. These values can be estimated by
measuring and comparing the duration of the asset portfolio (DA) and the duration of the
liability portfolio (DL). DA is the weighted average of the durations of each asset:
where Xi is the percentage of total assets invested in asset i and Di is
the duration of the ith asset. DL is calculated similarly.

The accounting identity states that A = L + E or E = A - L where E = Equity, A =

total assets and L = total liabilities.

The percentage change in A and L for a given change in rates is given by (from Chapter
3):
respectively.

Dollar changes in A and L are given by:

so that

If R and (1+R) are the same for assets and liabilities then E can be simplified as:
and by multiplying by A / A:

where k = L / A or the total debt ratio.

{DA – kDL} is termed the duration gap.

Example calculation: Suppose a bank with $500 million in assets has an average asset
duration of 3 years, and an average liability duration of 1 year. The bank also has a total
debt ratio of 90%. R may be thought of as the required return on equity (see Gardner and
Mills) or perhaps as the average interest rate level. If R is 12% and the bank is expecting
a 50 basis point increase in interest rates, by how much will the equity value change?

Equity Value Change

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E = – [3 – (0.901)] $500 million  (0.0050 / 1.12) = –$4,687,500.

To find the percentage change in equity, divide both sides of the equation by E:
E = $500 million (1-0.90) or E = $50 million so that:
E/E = – [3 – (0.901)] ($500 million/$50 million)  (0.0050 / 1.12) = – 9.375% or
E/E may be more simply found as -$4,687,500 / $50,000,000 = -9.375%.

Changes in the value of equity for different duration gaps

Recall that duration measures the value change of the assets or liabilities for a given
interest rate change. If we assume similar rate changes for assets and liabilities then the
following generalizations can be made:

Interest Rate Biggest Value Equity

Duration Gap Change Change Value
Increase Assets Decreases
Positive
Decrease Assets Increases

Increase Liabilities Increases

Negative
Decrease Liabilities Decreases

Both asset and liability values for fixed income contracts increase when rates fall and
decrease when rates rise. However, for a positive duration gap the absolute value of the
change in value of the assets is greater than the change in value of the liabilities when
interest rates change. With a negative duration gap the change in value of the liabilities
will be larger in absolute terms than the change in value of the assets.

Teaching Tip: The duration of a variable rate contract may be thought of as the time until
the rate reset. This will typically be much shorter than the maturity. Thus, a 30 year
mortgage with a rate adjustment due in 6 months has a 6 month duration. Contracts with
a maturity of 3 months or less may be thought of as having a duration equal to their
maturity without substantively affecting the analysis. This simplifies the duration
calculations for many accounts.

If the bank has a positive duration gap and is forecasting rising rates, they may wish to
switch to shorter term assets and/or variable rate assets and try to lengthen the duration of
the liability portfolio. Alternatively, the off balance sheet tools discussed in Chapter 23
could be used. If the leverage adjusted duration gap is zero, the equity value will be
approximately unchanged for small changes in interest rates.

Problems with the duration model include:

 Duration matching can be time consuming and costly. Although this is still true,
with today’s computing power this criticism is less valid than in the past.
 Immunization (setting and keeping the duration gap at zero) is a dynamic
process. The durations of the assets and liabilities will change every time interest
rates change and will change at uneven rates over time (the duration formula is
not linear with respect to time). This implies that maintaining a given duration
gap requires frequent on or off balance sheet adjustments, and implies that trading

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costs have to be weighed against the benefits of duration management.

 Immunization does not provide protection for large interest rate changes due to
convexity because duration predicts a linear price change with respect to interest
rates. In actuality the capital loss associated with a given percentage interest rate
increase is less than the capital gain associated with a given interest rate decrease.
Duration thus overpredicts capital losses and underpredicts capital gains because
of convexity.

Teaching Tip: The duration model can cause bankers to become complacent about the
interest rate risk they face. Aside from convexity, which can be a significant problem in
an abnormal market, the duration model suffers from many of the same problems as the
RPM. For instance, the effects of defaults, prepayments, and call features of securities
are difficult to include in the duration calculations. This can lead to the belief that the
bank precisely knows its risk level when in fact a large interest rate move that changes
investor behavior is not incorporated into the model.10

3. Insolvency Risk Management

a. Capital and Insolvency Risk
Equity is the FI’s main cushion against insolvency. It also serves as a source of funds
and as a requirement for growth given the minimum capital to asset requirements in force
for DIs. Equity can be thought of as either the book value of assets minus the book value
of liabilities, with some adjustments allowed by regulators, or as the market value of
assets minus the market value of liabilities. Book values are only rarely accurate
representations of market values.

Teaching Tip: Book values are not necessarily good representations of liquidation values
either. It is not clear to this author exactly what book value of equity actually measures.
It is roughly the sum of past decisions on asset acquisitions less the face amount
borrowed. As such it appears to be roughly a measure of net sunk costs by managers. It
has the advantage of being calculated according to a set of rules that limit management’s
ability to manipulate equity value, and it provides a fairly predicable number on a day to
day basis. For those who remember their economics training, this very stability implies
that the book value of equity cannot be a fair representation of the ongoing day to day
value of the firm in a dynamic marketplace.

The Capital Purchase Program (CPP) was part of the TARP funding in 2008-2009. The
Treasury purchased over $200 billion of senior preferred equity under the program.
These purchases qualified as Tier 1 capital for FIs. Citigroup and Bank of America
received additional special funding under this program totaling $25 billion and $20
billion respectively. The CPP was designed to help FIs increase their capital with the aim
of increasing lending to the general public. Lending fell in 2008, 2009 and 2010, so in
this sense the program was a failure, although presumably lending would have fallen
even farther without it and more failures may have occurred. The program came with
stipulations on maximum executive pay, golden parachutes and clawback provisions on

10
This is a false precision problem. VAR suffers from similar criticisms, as the failure of Long Term
Capital Management showed.

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executive pay based on earnings and limits on tax deductions associated with executive
compensation.

Capital and credit risk:

Loan losses are written off against capital. As loans are marked to market, capital is
reduced. When enough loan losses eliminate all the existing equity, the institution is
insolvent.

Capital and interest rate risk:

Realized losses in value of securities and loans are also written off against capital. If
losses due to rising interest rates (net of the reduced value of liabilities) are large enough
to wipe out the FI’s capital, the institution becomes insolvent.

Market value accounting and insolvency

If regulators closed an institution as soon as its market value of capital became zero,
theoretically no liability holders or taxpayers would suffer any losses and the FDIC’s DIF
would never be required. This is not the case if regulators wait until the book value of
equity is zero to close the institution. Book value of equity is composed of par value +
surplus + retained earnings + loan and lease loss reserves. It is not automatically adjusted
downward as credit or interest rate losses occur. For instance, under GAAP, FI managers
do not have to recognize loans as ‘bad’ and write them off in the year in which payment
problems develop. Managers may also sell other assets that have gains in value (these are
marked to market when sold) and inflate the book value of capital even though losses on
other loans and securities have not been recognized. This practice is called ‘gains
trading’ and can be used to postpone insolvency (while generating larger losses).11 The
use of book value does not recognize losses due to interest rate risk either. As interest
rates rise, an institution with a positive duration gap suffers losses to the market value of
equity. The book value of equity is unchanged until the assets and liabilities are marked
to market. This explains why over half of all S&Ls were insolvent in the early 1980s
under market value accounting but were allowed to continue to operate. The insolvent
S&Ls went on to generate even larger losses that eventually bankrupted the industry’s
insurer, the FSLIC. Examinations help limit the difference between book value and
market value of capital by forcing FIs to recognize its true losses. Loan and security
sales also reduce the difference. However, in times of high credit losses and high interest
rate volatility, the difference between the book and market value of equity can become
quite large. One can attempt to measure this difference by examining an institution’s
market to book ratio. The market to book ratio is the market value of equity divided by
the book value of equity. In a small sample of large banks, the market to book ratios
ranged from a low of 0.849 for Deutsche Bank to as high as 3.312 for Bank of New York
Mellon.12
In summary, using book value accounting increases the government’s potential
liability to depositors and other claimants.

11
New market value accounting rules should help minimize gains trading.
12
The text data includes thrifts.

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Predictably, the industry is against implementing market value accounting. The reasons
usually cited are:
1. Banks and thrifts maintain that implementing market value accounting is difficult and
burdensome, particularly for smaller institutions that have many nontraded assets for
which it would be difficult to obtain a market value. However, it seems fairly easy to
impute a market value for financial assets and liabilities, so this argument does not
seem particularly relevant except perhaps for very small institutions.

2. Managers do not want unrealized (paper) gains and losses to be reflected in income,
claiming this would excessively destabilize earnings and equity. Accounting theory
tells us that the purpose of income as it is measured is to smooth out fluctuations in
cash flows through time to provide a better picture of value than short term, highly
variable cash flows. Accruals adjustments supposedly give a truer picture of the cash
flow potential of the firm over the long term. Stock prices appear to more closely
follow income than short term cash flows or EVA adjusted cash flow measures.
Managers claim they hold many of their assets and liabilities to maturity and marking
them to market would simply distort the value of the bank to shareholders. Moreover,
the FDIC claims that marking to market could cause them to have to close an
institution that might otherwise survive simply because of a short term interest rate
movement. Both arguments have some validity but are incorrect theoretically. The
managers’ claim that we should not update values as market conditions change
implies that equity should measure something other than present value of expected
future cash flows.13 An economic variable that measures future prospects must be
unstable if those prospects are changing. Bankers and accountants don’t think this
way though. They want a measure of value that is stable and encourages
accountability. The FDIC’s argument forgets that during the 1980s the FSLIC went
bankrupt (and the FDIC came close) because book value accounting allowed
institutions to build large losses which the insurer eventually had to pay. There is
also an implicit assumption in their argument that an interest rate change will be
reversed in time to restore profitability to the institution. I doubt the validity of that
argument, but more importantly, I would counter that if a short term interest rate
move can put an institution under then the regulators need to bring about a change in
management at that institution anyway.
3. FIs also maintain that they would be less likely to engage in long term lending and
investing if these accounts were regularly marked to market. This statement itself is
very revealing as it indicates that FI managers recognize that the current accounting
rules allow managers to take on more risk than they could otherwise. There
might be disruptions in the short run, but in a free capital system, other new lenders
would emerge if banks refused to make these loans. They may not make as many, or
they may increase the price of the loans, or they may simply hedge more. This
appears to be a disingenuous argument.
4. The industry argues the lack of liquidity in the recent crisis led to unrealistically low
market values of assets and marking to market imposed excessive losses on
13
Alternatively managers may be implicitly implying that the maturity of their investments is the proper
time horizon over which value should be measured, but equity does not mature when their investments
do so they are ignoring reinvestment risk over the longer time horizon, the value of which is better
captured by current market values.

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institutions. Consequently the Financial Accounting Standards Board (FASB) allows

management to rely on internal estimates of cash flows to estimate fair value. This is
referred to as ‘marking to model’ rather than ‘marking to market.’ This makes sense
in a non-functioning market environment but it still allows FIs to not update the value
of assets and liabilities to current market conditions and adds subjectivity that is
likely to be manipulated by management.
5. As of April 2009 FASB allows DIs to not recognize losses in earnings and regulatory
capital on accounts that are a) designated as held for investment rather than sale and
b) temporarily impaired in value due to market conditions rather than underlying
credit deterioration. The losses must be accounted for and revealed separately. This
again adds subjectivity that can be used to hide losses. The new rules imply that
regulators will be able to evaluate these issues and will be willing to do so.

This discussion is part of a larger debate between accountants and bankers who favor
book value and rules based measures and financial economists who favor letting the
market determine value. Accounting rules are designed to provide a stable measure of
historical value that minimizes managerial manipulations and preserves management
accountability. However, in a dynamic world where value is determined as the present
worth of expected future firm prospects, book value cannot possibly accurately measure
daily fluctuations in economic firm value. If you believe that firm value is the
aggregation of the past and current decisions of the firm’s management, then you will
probably prefer book value measures of equity. If you instead believe that firm value is
properly an estimate of the value of the current and future prospects of the firm then you
should prefer market value.

VI. Web Links

http://www.federalreserve.gov/ Website of the Board of Governors of the Federal

Reserve

http://www.fdic.gov/ The Federal Deposit Insurance Corporation website

has net charge off rates for banks and thrifts.

http://www.fasb.org/ FASB webpage with full text and summaries of

FASB statements

http://www.americanbanker.com/ ABA website.

http://www.wsj.com/ Website of the Wall Street Journal Interactive

edition. The web version of the well known
financial newspaper can be personalized to meet
your own needs. Instructors can also receive via e-
mail current events cases keyed to financial market
news complete with discussion questions.

VII. Student Learning Activities

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1. Go to the FDIC website and find the Quarterly Banking Profile. How has the
average duration gap been changing at institutions? Are the banks currently more or
less vulnerable to rising or falling interest rates? Explain why.

2. Go to the FDIC website and find the Quarterly Banking Profile. What has
been happening to the book value of equity capital? Why have these changes
occurred? Has the number of problem banks increased or decreased recently?
Ascertain why. Find an index of bank stocks. What has been happening to the market
value of equity capital? Are the changes similar? Why or why not?

3. Go to http://www.fasb.org/ and find the summary of FASB statement No. 114,

“Accounting by Creditors for Impairment of a Loan.” According to this statement
how should lenders value problem loans? Why are all loans not valued this way?
Explain.

4. Find the FDIC DOS Manual of Examination Policies: Market Risk, Section
7.1 on the web. What are the primary goals of examiners when they evaluate a bank’s
interest rate risk (IRR)? What are the ‘earnings approach’ and EVE? How do they
differ? What is the FDIC looking for in its IRR measurement system review?

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