MANAGING INTEREST RATE

RISK: GAP AND EARNINGS

SENSITIVITY
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IMPORTANT INTEREST RATE RISK
TERMINOLOGY
 ALCO: Acronym for asset and liability management
committee.
 ALM: Acronym for asset and liability management.

 Base rate: Any interest rate used as an index to price

loans or deposits; quoted interest rates are typically set at
some mark-up, such as 0.25 percent or 1 percent, over
the base rate and thus change whenever the base rate
changes. Sample base rates include the Wall Street
Journal prime rate, London Interbank Offer Rate
(LIBOR) and a bank’s own prime rate.
 Cost of funds: Interest expense divided by the dollar
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volume of interest-bearing liabilities.
IMPORTANT INTEREST RATE RISK
TERMINOLOGY
 Duration: A measure of the approximate price sensitivity of an asset
or portfolio to a change in interest rates.
 Earnings change ratio (ECR): A percentage measure that indicates
how much of each type of a bank’s assets or liabilities will reprice
when some index rate changes. An earnings change ratio of 1
indicates that the underlying asset or liability changes in yield or cost
1-to-1 with changes in the index rate.
 Earning asset ratio: The dollar volume of a bank’s earning assets
divided by the dollar volume of total assets.
 Earnings sensitivity analysis: Conducting “what if” analysis by
varying factors that affect interest income and expense to determine
how changes in key factors affect a bank’s net interest income and net
interest margin. The output indicates how much net interest income
will change in dollars and in percentage terms under different interest 3
rate scenarios.
IMPORTANT INTEREST RATE RISK
TERMINOLOGY
 Effective GAP: The “true” measure of GAP that takes into account a
specific interest rate forecast and when embedded options will either
be exercised or will affect the actual repricing of an asset or liability.
 Embedded option: A specific feature of a bank’s asset, liability, or
off-balance sheet contract that potentially changes the cash flows of
the item when interest rates vary. Examples include early prepayment
of principal on loans, issuers calling outstanding bonds, and
depositors withdrawing funds prior to maturity.
 Floating rate: Assets or liabilities that carry rates tied to the prime
rate or other base rates such that the instrument reprices (the effective
rate rises or falls) whenever the base rate changes.
 GAP: The dollar volume of rate sensitive assets minus the dollar
volume of rate sensitive liabilities.
 GAP ratio: The dollar volume of rate sensitive assets divided by the 4
dollar volume of rate sensitive liabilities.
IMPORTANT INTEREST RATE RISK
TERMINOLOGY
 Gradual rate shock: An assumed change in interest rates that
occurs over time; a 1 percent annual increase in rates may
translate into a monthly increase of 8.3 basis points for 12
months.
 Hedge: To take a position or implement a transaction with the
objective to reduce overall risk associated with an existing
position.
 Instantaneous rate shock: An immediate increase or decrease in
all interest rates by the same amount; a parallel shift in the yield
curve.
 Net interest margin (NIM): Tax-equivalent net interest income
divided by earning assets.
 Net overhead (burden): Noninterest expense minus noninterest 5
income.
IMPORTANT INTEREST RATE RISK
TERMINOLOGY
 Non rate GAP Ratio: Noninterest-bearing liabilities plus
equity minus nonearning assets as a ratio of earning assets.
 Rate sensitive assets (RSAs): The dollar value of assets that
either mature or are expected to reprice within a selected
time period, such as 90 days.
 Rate sensitive liabilities (RSLs): The dollar value of
liabilities that either mature or are expected to reprice within
a selected time period, such as 90 days.
 Risk management committee: Central committee charged
with enterprise-wide risk management, measurement,
monitoring, and policies. Members typically set strategy
regarding market risk within the organization. 6
IMPORTANT INTEREST RATE RISK
TERMINOLOGY
 Simulation: An analysis of possible outcomes for net interest
margin resulting from selecting hypothetical values for key
variables that influence the repricing of assets, liabilities, and
off-balance sheet items’ and conducting forecasts to determine
the effects of changes in these variables on a bank’s net interest
income.
 Speculation: Taking a position or implementing a transaction
that increases risk in hopes of earning above-average returns.
The party that speculates is labeled a speculator.
 Spread: The interest yield on earning assets minus the interest
cost of interest-bearing funds.
 Variable rate: Assets or liabilities that automatically reprice at
regular intervals such that the effective rate potentially varies at 7
specific intervals.
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INTRODUCTION
 This chapter examines how banks measure and manage
interest rate risk when they focus on earnings.
 It examines the factors that can potentially cause NIM to
change over time, how to measure how much risk a bank
has taken, and strategies to alter a bank’s interest rate
risk profile over time.
 As part of the analysis, it examines the difficulty in
measuring risk associated with the many options
embedded in bank assets and liabilities. It also describes
how management might attempt to hedge, or reduce,
interest rate risk.
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INTRODUCTION
 Sensitivity to market risk (S) is one of the basic components of
a bank’s CAMELS rating.
 Interest rate risk refers to the potential for a bank’s earnings and
economic value of equity to change when interest rates change.
 Banks use two basic models to assess interest rate risk.

 The first, GAP and earnings sensitivity analysis, emphasizes

income statement effects by focusing on how changes in
interest rates and the bank’s balance sheet affect NII and net
income.
 The second, duration gap and economic value of equity
analysis, emphasizes the market value of stockholders equity by
focusing on how these same types of changes affect the market
value of assets versus the market value of liabilities. 10
GAP AND EARNINGS SENSITIVITY
ANALYSIS
 The analysis initially introduces traditional measures of
interest rate risk associated with static GAP models.
 These models focus on GAP as a static measure of risk
and NII as the target measure of bank performance.
 Sensitivity analysis extends GAP analysis to focus on the
variation in bank earnings across different interest rate
environments.
 This NII simulation, or “What if?” forecasting, provides
information regarding how much NII potentially changes
when rates are alternatively assumed to rise and fall by
various amounts.
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BANK’S ASSET AND LIABILITY
MANAGEMENT COMMITTEE
 Interest rate risk management is extremely important
because no one can consistently forecast interest rates
accurately.
 A bank’s asset and liability management committee
(ALCO), or alternatively its risk management
committee, is responsible for measuring and monitoring
interest rate risk.
 It also evaluates pricing, investment, funding, and
marketing strategies to achieve the desired trade-off
between risk and expected return.

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MEASURING INTEREST RATE RISK
WITH GAP
 Why will a bank’s NII change from one period to the
next? In general, three factors potentially cause a bank’s
NII to rise or fall.
 These are:
 unexpected changes in interest rates
 changes in the mix, or composition, of assets and/or
liabilities, and
 changes in the volume of earning assets and the volume of
interest-bearing liabilities.

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MEASURING INTEREST RATE RISK
WITH GAP
 These factors are referred to as rate, composition (mix),
and volume effects, respectively. GAP and earnings
sensitivity analysis represent measures of risk.
 The basic performance target is NII (or net income).
Both measures presumably signal whether a bank is
positioned to benefit or lose from rising versus falling
rates and how big a change in earnings is possible.
 Importantly, interest rate changes may either raise or
lower NII depending on the characteristics of a bank’s
assets and liabilities and the existence of embedded
options.
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MEASURING INTEREST RATE RISK
WITH GAP
 Consider a bank that makes $10 million in three-year, fixed-rate
commercial loans with quarterly principal and interest
payments financed with $10 million of small-time deposits that
reprice monthly. Why might management choose this portfolio?
 The bank receives interest and principal payments on the loans
every three months (quarterly) and pays monthly interest on
deposits.
 If the loan rate is 5 percent and the deposit rate is 1 percent, the
initial spread is 4 percent. This initial spread should be large
enough to cover the cost of doing business (a portion of
overhead), the cost of default and potential losses from the
expected change in rates over the investment horizon, plus
provide for a reasonable profit. 15
MEASURING INTEREST RATE RISK
WITH GAP

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MEASURING INTEREST RATE RISK
WITH GAP
 What happens if interest rates change during the next
year?
 Because the commercial loans have an initial three-year
maturity, the 5 percent rate is fixed and only the deposit
rates will change during the year.
 For example, suppose that the one-month deposit rate
rises to 1.4 percent. Because the loan rate is fixed at 5
percent, the spread would fall to 3.6 percent.
 The opposite would occur if the one-month deposit rate
fell to 0.75 percent as the spread would then increase to
4.25 percent.
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MEASURING INTEREST RATE RISK
WITH GAP
 Rate changes are only one factor that affects earnings
because a bank will change the mix of assets it owns and
the mix of liabilities that fund assets.
 Finally, there are embedded options in the loans that will
likely alter the cash flows and eventual interest payments
and receipts if rates change.

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TRADITIONAL STATIC GAP ANALYSIS
 Traditional static GAP models attempt to measure how much
interest rate risk a bank evidences at a fixed point in time by
comparing the rate sensitivity of assets with the rate
sensitivity of liabilities.
 Static GAP focuses on managing NII in the short run.

 The objective is typically to measure expected NII and then

identify strategies to stabilize or improve it.
 Interest rate risk is measured by calculating GAPs over
different time intervals based on aggregate balance sheet data
at a fixed point in time—hence, the term static GAP.
 The balance sheet is assumed not to change so that only rate
changes affect earnings. GAP values are then examined to 19
infer how much NII will change if rates change.
BASIC STEPS TO STATIC GAP ANALYSIS
 There are several basic steps to static GAP analysis.
 1. Develop an interest rate forecast.

 2. Select a series of sequential time intervals for determining what amount

of assets and liabilities are rate sensitive within each time interval.
 3. Group assets and liabilities into these time intervals, or “buckets,”
according to the time until the first repricing. The principal portion of the
asset or liability that management expects to reprice in each specific time
interval is classified as rate sensitive within that interval. The effects of any
off-balance sheet positions, such as those associated with interest rate swaps
and futures, are also added to the balance sheet position according to
whether the item effectively represents a rate sensitive asset (RSA) or rate
sensitive liability (RSL).
 4. Calculate GAP. A bank’s static GAP equals the dollar amount of RSAs
minus the dollar amount of RSLs for each time interval.
 5. Forecast NII given the assumed interest rate environment and assumed 20
repricing characteristics of the underlying instruments.
TRADITIONAL STATIC GAP ANALYSIS
 GAP measures balance sheet values. It represents the
relative principal amounts of assets or liabilities that
management expects to reprice within the relevant time
interval.
 Expected interest income and interest expense
components of cash flows are ignored in the GAP
measure.
 When appropriate, the notional amounts of off-balance
sheet items are included as either RSAs or RSLs.
Formally,

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TRADITIONAL STATIC GAP ANALYSIS
 where RSAs and RSLs are those identified within each
time bucket.
 As such, there is a periodic GAP and a cumulative GAP
for each time bucket. The periodic GAP compares RSAs
with RSLs within each single time bucket.
 The cumulative GAP compares RSAs with RSLs over all
time buckets from the present through the last day in
each successive time bucket.
 For example, the cumulative GAP through 90 days (0–90
days) equals the sum of the periodic GAPs for the two
time buckets, 0–30 days and 31–90 days.
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TRADITIONAL STATIC GAP ANALYSIS
 Consider the earlier example with three year fixed-rate loans financed with
small time deposits.
 Following the steps outlined in GAP analysis, assume that rates will rise over
the next year and use one year as the relevant time frame.
 In this case, the loans are not rate sensitive, whereas the small time deposits are.

 Thus, the bank’s one-year GAP equals −$10 million. The sign of GAP indicates
whether the bank is positioned to benefit or lose when rates increase or
decrease.
 In this example, the negative sign indicates that the bank has more RSLs than
RSAs.
 The magnitude of the GAP provides information regarding how much NII may
change when rates change. In this example, the amount of risk the bank takes
may be indicated by comparing the –$10 million to the bank’s asset base. A
bank with $50 million in assets and a −$10 million one-year GAP has much
greater risk, ceteris paribus, than a bank with $500 million in assets and a −$10
million one-year GAP. 23
WHAT DETERMINES RATE
SENSITIVITY?
 The first three steps in GAP analysis require the
identification and classification of the principal portions
of specific assets and liabilities that are rate sensitive
within specific time intervals.
 Other balance sheet items either carry fixed rates or do
not earn or pay interest. Interest payments are not
included directly because GAP is a balance sheet (plus
off-balance sheet) measure of risk.
 Management typically selects a variety of time buckets
that provide useful information, as outlined later in
Exhibit 7.5. The initial issue is to determine what
features make an asset or liability rate sensitive. 24
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EXPECTED REPRICING VERSUS
ACTUAL REPRICING
 Although the actual contractual repricing schedule of
assets and liabilities is important, using expected
repricing can often lead to more accurate estimates of an
institution’s interest rate risk.
 Consider a 0–90 day time interval. The key issue is to
identify what assets and liabilities listed on a bank’s
balance sheet will be repriced within 90 days given the
specific interest forecast.

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EXPECTED REPRICING VERSUS
ACTUAL REPRICING
 In general, an asset or liability is normally classified as
rate sensitive within a time interval if:
 It matures.
 It represents an interim or partial principal payment.
 The interest rate applied to the outstanding principal balance
changes contractually during the interval.
 The interest rate applied to the outstanding principal balance
changes when some base rate or index changes and
management expects the base rate/index to change during the
time interval.
 Note that any interest received or paid is not included in
the GAP calculation.
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FACTORS AFFECTING NET INTEREST
INCOME
 In addition to changes in the level of interest rates,
 changes in the composition (or mix) of assets and liabilities,
 changes in the volume of assets and liabilities outstanding,
and
 changes in the relationship between the yields on earning
assets and rates paid on interest-bearing liabilities will alter
NII from that expected.
 Some factors are at least partially controllable, while
others are not.

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RATE SENSITIVITY REPORTS
 Many managers monitor their bank’s risk position and
potential changes in NII using a framework like that in
Exhibit 7.5.
 This report classifies Security Bank’s assets and liabilities
as rate sensitive in selected time buckets through one year.
 The last column lists the totals for all balance sheet items
as of year-end.
 Each earlier column of data reflects the dollar volume of
repriceable items within a distinct but sequential time
period.
 The column labeled “Non-Rate sensitive” indicates
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amounts that do not earn or pay interest.
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PERIODIC GAP VERSUS CUMULATIVE
GAP
 Two types of GAP measures are reported at the bottom
of the report.
 The periodic GAP compares RSAs with RSLs within each of
the different time buckets and is a measure of the relative
mismatches across time.
 The cumulative GAP, by contrast, measures the sum of the
periodic GAPs through the last day in each time interval and
measures aggregate interest rate risk exposure from the
present through this last day.

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STRENGTHS AND WEAKNESSES OF
STATIC GAP ANALYSIS
 The attraction of static GAP analysis is that it is easy to
understand.
 Periodic GAPs indicate the relevant amount and timing
of interest rate risk over distinct maturities and clearly
suggest magnitudes of portfolio changes to alter risk.
 When there is uncertainty over the frequency of base rate
changes, GAP measures reflect errors in allocating loans
differently than actual rate changes would require.
 To overcome this problem, a bank should evaluate the
statistical rate sensitivity of all base rates to selected
market indexes.
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STRENGTHS AND WEAKNESSES OF
STATIC GAP ANALYSIS
 Second, GAP analysis ignores the time value of money.
The construction of maturity buckets does not
differentiate between cash flows that arise at the
beginning of the period versus those at the end.
 One attraction of duration-based measures of interest
rate risk is that they incorporate the present value of all
cash flows.
 Interest rate changes also affect the value of fixed-rate
assets and liabilities and total risk beyond one year. The
GAP framework ignores these changes.

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STRENGTHS AND WEAKNESSES OF
STATIC GAP ANALYSIS
 As such, GAP analysis does not recognize any rate risk
associated with demand deposit flows, even though a
bank typically loses deposits when interest rates rise.
 When rates are expected to increase, more demand
deposits will be rate sensitive. It is extremely difficult,
however, to know the exact rate sensitivity of these
deposits.
 Finally, static GAP does not capture risk associated with
options embedded in the loans, securities, and deposits
that banks deal with.

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GAP RATIO

 When GAP is positive, the GAP ratio is greater than 1.

 A negative GAP, in turn, is consistent with a GAP ratio
of less than 1.
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GAP DIVIDED BY EARNING ASSETS AS
A MEASURE OF RISK
 A better risk measure relates the absolute value of a
bank’s GAP to earning assets.
 The greater this ratio, the greater the interest rate risk.

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EARNINGS SENSITIVITY ANALYSIS
 The analysis includes the following six steps:
 Forecast interest rates.
 Forecast balance sheet size and composition given the assumed
interest rate environment.
 Forecast when embedded options in assets and liabilities will be
exercised.
 Identify which assets and liabilities will reprice over different time
horizons, and by how much, under the assumed interest rate
environment. Identify off-balance sheet items that have cash-flow
implications under the assumed rate environment.
 Calculate (estimated) NII and net income under the assumed rate
environment.
 Select a new interest rate environment and compare the forecasts of
NII and net income across different rate environments versus the 42
base case.
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EXERCISE OF EMBEDDED OPTIONS IN
ASSETS AND LIABILITIES
 The most obvious include a customer’s option to
refinance a loan.
 Another option is the call option on a federal agency
bond.
 An option embedded in bank liabilities is a depositor’s
option to withdraw funds prior to final maturity.
 To accurately assess interest rate risk, managers must
identify the existence of these options, understand when
they are likely to be exercised, and model the impact of
option exercise on earnings.
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DIFFERENT INTEREST RATES CHANGE BY
DIFFERENT AMOUNTS AT DIFFERENT TIMES
 Earnings sensitivity analysis enables managers to
forecast different spreads between asset yields and
liability interest costs when rates change by different
amounts.
 Banks typically increase loan rates more than they
increase deposit rates in a rising-rate environment such
that the spread widens.
 The implication is that although the rate sensitivity of
different instruments might be nominally the same, the
impact is different due to different timing of rate changes
and different magnitudes of rate changes.
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MANAGING THE GAP AND EARNINGS
SENSITIVITY RISK
 Calculate periodic GAPs over short time intervals.
 Match fund repriceable assets with similar repriceable
liabilities so that periodic GAPs approach zero.
 Match fund long-term assets with Noninterest-bearing
liabilities.
 Use off-balance sheet transactions, such as interest rate
swaps and financial futures, to hedge.

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