Asset-Liability

Management
Q. What is the purpose of ALM?

1. To Maximize or at least stabilize the banks margin, i.e.

maximize the spread between interest revenues and
interest expenses.

2. To Maximize or at least protect the value of the bank

(stock price) at an acceptable level of risk.
Asset Management Strategy
The amount and kinds of deposits and the borrowed funds a
bank was able to attract were largely determined by its
customers.
The key decision area for management was not deposits and
other borrowings but assets.
The financial manager can exercise control over the allocation
of incoming funds by determining who will take the loan and
what the terms of that loan will be.
Indeed, this is called asset management approach.
Liability Management Strategy
Liability management is about gaining control over the source
of funds compared to control over their assets.
The key control was price—the interest rate and other terms
offered on deposits and other borrowings to achieve the
volume, mix, and cost desired.
For example, a lender faced with heavy loan demand that
exceeded its available funds could simply raise the offer rate
on its borrowings relative to its competitors, and funds
would flow in, vice versa.
Funds Management Strategy

The maturing of liability management techniques, combined

with volatile interest rates and risk, management of its assets
is called the funds management approach.

This view is a more balanced approach to asset-liability

management that stresses several key objectives:

1. Management should exercise as much control as possible

over the volume, mix, and return or cost of both assets and
liabilities in order to achieve the financial institution’s goals.
2. Management’s control over assets must be coordinated
with its control over liabilities so that asset management
and liability management are internally consistent and do
not pull against each other.
3. Revenues and costs arise from both sides of the balance
sheet (i.e., from both asset and liability accounts) and
management policies need to be developed that maximize
returns and minimize costs from their services.
Forces Determining Interest Rates

Managers of financial institutions cannot control the level of

interest rates in the market or its trends.
The rate of interest on any particular loan or security is
ultimately determined by the financial marketplace where
suppliers of loanable funds (credit) interact with demanders
of loanable funds (credit) and
the interest rate (price of credit) tends to settle at the point
where the quantities of loanable funds demanded and
supplied are equal.
Determination of the Rate of Interest in the Financial Marketplace
The individual institution can only react to the level of and trend
in interest rates in a way that best allows it to achieve its
goals.

In other words, most financial managers must be price takers,

not price makers, and must accept interest rates as a given
and plan accordingly.
Q. As market interest rate moves banks face at least two kinds
of interest rate risks, what are those risks?
As market interest rates move, financial firms typically face at
least two major kinds of interest rate risk
-price risk and
-reinvestment risk.
Price risk arises when market interest rates rise, causing the
market values of most bonds and fixed-rate loans to fall.
If a financial institution wishes to sell these financial instruments
in a rising rate period, it must be prepared to accept capital
losses.
Reinvestment risk arises when market interest rates fall,
forcing a financial firm to invest incoming funds in lower-
yielding earning assets, lowering its expected future income.

A big part of managing assets and liabilities consists of finding

ways to deal effectively with these two forms of risk.
Interest-Sensitive Gap Management

The most popular interest rate hedging strategies in use today is

interest-sensitive gap management.

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒔𝒆𝒏𝒔𝒊𝒕𝒊𝒗𝒆 𝑮𝒂𝒑 =

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒔𝒆𝒏𝒔𝒊𝒕𝒊𝒗𝒆 𝒂𝒔𝒔𝒆𝒕𝒔
− 𝑰𝒏𝒕𝒆𝒓𝒔𝒕 𝒔𝒆𝒏𝒔𝒊𝒕𝒊𝒗𝒆 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Gap management techniques require management to perform
an analysis of the maturities and repricing opportunities
associated with interest-bearing assets and with interest-
bearing liabilities.

What is a repriceable asset (or I.S.A)? A repriceable liability()?

The most familiar examples of repriceable assets include loans
that are about to mature or will soon to come up for renewal
or repricing.
If interest rates have risen since these loans were first made, the
lender is likely to renew them only if it can get a rate of
return that approximates the higher yields currently expected
on other financial instruments of comparable quality.
Similarly, loans that are maturing will provide the lender with
newly released funds available to reinvest in new loans at
today's interest rates.
In contrast, repriceable liabilities include a depository
institution's certificates of deposit (CDs, FDR etc.) about to
mature or eligible to be renewed, where the financial firm
and its customer must negotiate new deposit interest rates
that capture current market conditions.
If interest-sensitive assets in each planning period (day, week,
month, etc.) exceed the volume of interest-sensitive
liabilities subject to repricing, the financial firm is said to
have a positive gap and to be asset sensitive.
Thus:
𝐼. 𝑆. 𝐺𝑎𝑝 = 𝐼. 𝑆. 𝐴 − 𝐼. 𝑆. 𝐿 > 𝑂 ⟹ +𝑣𝑒 𝐺𝑎𝑝
This is also called assets sensitive gap.
For example, a bank with interest-sensitive assets of $500
million and interest-sensitive liabilities of $400 million is
asset sensitive with a positive gap of $100 million.
In the opposite situation, suppose an interest-sensitive bank's
liabilities are larger than its interest-sensitive assets. This
bank then has a negative gap and is said to be liability
sensitive.
Thus:
𝐼. 𝑆. 𝐺𝑎𝑝 = 𝐼. 𝑆. 𝐴 − 𝐼. 𝑆. 𝐿 < 𝑂 ⟹ −𝑣𝑒 𝐺𝑎𝑝
This is also called liability sensitive gap.

A financial institution holding interest-sensitive assets of $150

million and interest sensitive liabilities of $200 million is liability
sensitive, with a negative gap of $50 million.
Suppose an interest-sensitive bank's liabilities are equal to its
interest-sensitive assets.
This bank then has a no gap or zero gap.

𝐼. 𝑆. 𝐺 = 𝐼. 𝑆. 𝐴 − 𝐼. 𝑆. 𝐿 = 𝑂
In this case, interest revenues from assets and funding costs will
change at the same rate.
The interest-sensitive gap is zero, and the net interest margin is
protected regardless of which way interest rates go.
The Relative IS GAP ratio

A Relative IS GAP greater than zero means the institution is

asset sensitive, while a negative Relative IS GAP describes a
liability-sensitive financial firm.
We can compare the ratio of ISA to ISL, called the Interest
Sensitivity Ratio (ISR).
An Asset-Sensitive Financial Firm Has:
• Positive Dollar IS GAP
• Positive Relative IS GAP
• Interest Sensitivity Ratio greater than one

A Liability-Sensitive Financial Firm Has:

• Negative Dollar IS GAP
• Negative Relative IS GAP
• Interest Sensitivity Ratio less than one
Q. What happens when the amount of repriceable assets
equal/unequal with the repriceable liabilities, if interest rates
changes?
Consider 3 situations.
Situation: 1
Given 𝐼𝑆𝐴 = $500𝑚, 𝐼𝑆𝐿 = $400𝑚
Then, 𝐴𝑠𝑠𝑒𝑡𝑠 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝑔𝑎𝑝 = $500𝑚 − $400𝑚 = $100𝑚

Let interest rate is 10%, then 𝑖𝑛𝑐𝑜𝑚𝑒 = $(50 − 40)𝑚 = $10𝑚.

If interest goes to 20% then, 𝑖𝑛𝑐𝑜𝑚𝑒 = $(100 − 80)𝑚 = $20𝑚.
If interest decrease to 5% then, 𝑖𝑛𝑐𝑜𝑚𝑒 = $(25 − 20)𝑚 = $5𝑚.
Which situation is good for bank?
In this situation, if interest rate rises, the bank net interest
margin will increase, because the interest revenue generated
by bank assets will increase more than the cost of borrowed
funds, i.e. raise the net interest margin (vice versa and
ceteris paribus).
In other words, if bankers believe that, in near future interest
will rise then they try to increase the assets sensitive gap.
To increase +ve gap, ease the terms and condition on short term
loans and other securities (like decrease interest rate on
loans etc.) and tighten the terms condition against on short
term deposits and other borrowings (like decrease interest
on deposits etc.).
Situation: 2
In the opposite situation,
𝐼𝑆𝐴 = $400𝑚, 𝐼𝑆𝐿 = $500𝑚
So, 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝑔𝑎𝑝 = $400𝑚 − $500𝑚 = −$100𝑚

If interest rate is 10%, then 𝑖𝑛𝑐𝑜𝑚𝑒 = $ 40 − 50 𝑚 = −$10𝑚.

If interest goes to 20% then, 𝑖𝑛𝑐𝑜𝑚𝑒 = $ 80 − 100 𝑚 =
− $20𝑚.
If interest goes to 5% then, 𝑖𝑛𝑐𝑜𝑚𝑒 = $ 20 − 25 𝑚 = −$5𝑚.

Which situation is good for bank?

Rising interest rate will lower the bank’s interest margin, because
the rising interest cost associated with interest sensitive
liabilities will exceed increase in interest revenue in bank’s
interest sensitive assets (vice versa and ceteris paribus).

Again, decrease interest rate will increase the bank’s interest

margin, because the decrease interest cost associated with
interest sensitive liabilities will exceed decrease in interest
revenue in bank’s interest sensitive assets.
In other words, if bankers believe that, in near future interest
will decrease then they try to increase the liabilities sensitive
gap.

To increase -ve gap, tighten the terms and condition on short

term loans and other securities (like increase interest rate on
loans etc.) and ease the terms condition against on short
term deposits and other borrowings (like increase interest on
deposits to attract depositors etc.).
Situation: 3
Given 𝐼𝑆𝐴 = $400𝑚, 𝐼𝑆𝐿 = $400𝑚
Then, 𝐴𝑠𝑠𝑒𝑡𝑠 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝑔𝑎𝑝 = $400𝑚 − $400𝑚 = 0

Let interest rate is 10%, then 𝑖𝑛𝑐𝑜𝑚𝑒 = $(40 − 40)𝑚 = 0.

If interest goes to 20% then, 𝑖𝑛𝑐𝑜𝑚𝑒 = $(80 − 80)𝑚 = 0.
If interest decrease to 5% then, 𝑖𝑛𝑐𝑜𝑚𝑒 = $(20 − 20)𝑚 = 0.

Which situation is good for bank?

If bankers not able to forecast which way the interest rate will
go then they must follow zero gap management.
Here, net interest margin is protected regardless of which way
interest rates go.

As a practical matter zero gap doesn’t eliminate all interest risks,

because interest rates attached to bank’s assets and labilities
are not perfectly correlated in the real world.
Interest rates that move in the wrong direction can magnify
losses.
Financial managers to make some important decisions about
gap management:

1. Management must choose the time period during which the net
interest margin (NIM) is to be managed (e.g., six months or one year)
to achieve some desired value and the length of sub-periods
(“maturity buckets”) into which the planning period is to be divided.

2. Management must choose a target level for the net interest margin—
that is, whether to freeze the margin roughly where it is or perhaps
increase the NIM.
3. If management wishes to increase the NIM, it must either
develop a correct interest rate forecast or find ways to
reallocate earning assets and liabilities to increase the
spread between interest revenues and interest expenses.

4. Management must determine the volume of interest-

sensitive assets and interest-sensitive liabilities it wants the
financial firm to hold.
Net interest income also can be derived from the following formula:
For example, suppose the yields on rate-sensitive and fixed
assets average 10 percent and 11 percent, respectively, while
rate-sensitive and non-rate-sensitive liabilities cost an
average of 8 percent and 9 percent, respectively. During the
coming week the bank holds $1,700 million in rate-sensitive
assets (out of an asset total of $4,100 million) and $1,800
million in rate-sensitive liabilities. Suppose, too, that these
annualized interest rates remain steady.
Then this institution’s net interest income on an annualized basis
will be
0.10 × $1,700 + 0.11 × 4,100 − 1,700 − 0.08 × $1,800
− 0.09 × 4,100 − 1,800 = $83 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
However, if the market interest rate on rate-sensitive assets
rises to 12 percent and the interest rate on rate-sensitive
liabilities rises to 10 percent during the first week, this
liability-sensitive institution will have an annualized net
interest income of only
0.12 × %1200 + 0.11 × 4,100 − 1,700 − 0.10 × $1,800
− 0.09 × 4,100 − 1,800 = $81 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Therefore, this bank will lose $2 million in net interest income
on an annualized basis if market interest rates rise in the
coming week.
Management must decide whether to accept that risk or to
counter it with hedging strategies or tools.
The net interest margin of a financial-service provider is
influenced by multiple factors:

1. Changes in the level of interest rates, up or down.

2. Changes in the spread between asset yields and liability
costs (often reflected in the changing shape of the yield
curve between long-term rates and short-term rates).
3. Changes in the volume of interest-bearing (earning) assets a
financial institution holds as it expands or shrinks the overall
scale of its activities.
4. Changes in the volume of interest-bearing liabilities that are
used to fund earning assets as a financial institution grows
or shrinks in size.
5. Changes in the mix of assets and liabilities that
management draws upon as it shifts between floating and
fixed-rate assets and liabilities, between shorter and longer
maturity assets and liabilities,
and between assets bearing higher versus lower expected
yields (e.g., a shift from less cash to more loans or from
higher-yielding consumer and real estate loans to lower-
yielding commercial loans).
Cumulative gap concept:
A useful overall measure of interest rate risk exposure is the
cumulative gap, which is the total difference in takas
between those assets and liabilities that can be repriced
over a designated period of time.
Month I.S.A I.S.L I.S. GAP Cumulative gap
July 700 300 400 400
August 400 600 -200 200
September 600 500 100 300
October 100 400 -300 0
November 200 400 -200 -200
December 400 800 -400 -600
The cumulative gap concept is useful because, given any specific
change in market interest rates, we can calculate
approximately how net interest income will be affected by an
interest rate change.
The key relationship is this:
For example, suppose market interest rates suddenly rise by 1
full percentage point and cumulative gap is –600 million
taka.
Then the bank in the example given above will suffer a net
interest income loss of approximately
+0.01 × −600 = −𝑇𝑘 6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
If market interest rates suddenly falls by 1 full percentage
point. Then the bank in the example given above will gain
a net interest income of approximately
−0.01 × −600 = 𝑇𝑘 6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
In general, financial institutions with a negative cumulative
gap will benefit from falling interest rates but lose net
interest income when interest rates rise.
Institutions with a positive cumulative gap will benefit if
interest rates rise, but lose net interest income if market
interest rates decline.
Some financial firms shade their interest-sensitive gaps
toward either asset sensitivity or liability sensitivity,
depending on their degree of confidence in their own
interest rate forecasts.
This is often referred to as aggressive GAP management.
Many financial-service managers have chosen to adopt a
purely defensive GAP management strategy:

Defensive Interest-Sensitive GAP Management

Set interest-sensitive GAP as close to zero as
possible to reduce the expected volatility of
net interest income