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Financial Institutions Management: A Risk Management Approach

SAUNDERS

CORNETT

MC GRAW

5TH CANADIAN EDITION

Chapter 8: Interest Rate Risk I Learning Outcomes

LO 1 Discuss the Bank of Canada’s role in setting monetary policy and influencing the level and movement of interest rates

LO2 Discuss the re-pricing model and apply it to the balance sheet of an FI.

LO3 Discuss the weaknesses of the re-pricing model.

Introduction: Net Worth

The value of an FI to its owners.

This is equal to the difference between the market value of assets and that of liabilities.

Level and Movement of Interest Rates

While many factors influence the level and movement of interest rates, it is the central bank’s monetary policy strategy that most directly underlies the level and movement of interest rates that, in turn, affect an FI’s cost of funds and return on assets.

Since 1991, the Bank of Canada, Canada’s central bank, has carried out monetary policy actions based on a target range for inflation.

Level and Movement of Interest Rates

Consumer Price Index (CPI) A measure of the cost of living tracked monthly by Statistics Canada based on changes in the retail prices of a basket of consumer goods and services.

Overnight Rate

The rate that major FIs charge on one-day funds borrowed and lent to each other. It is at the middle of the operating band.

Level and Movement of Interest Rates

Bank Rate

The rate charged by the Bank of Canada on overnight loans to FIs.

Operating Band

The range (0.5 percent wide) of the overnight rates charged by the Bank of Canada. The bottom of the band is the rate the Bank of Canada will pay on deposits. The top of the band is the rate charged by the Bank of Canada on loans (the bank rate).

Level & Movement of Interest Rates. (Figure 8-1)

The Re-pricing Model

Repricing or funding gap model based on book value.

Contrasts with market value-based maturity and duration models recommended by the Bank for International Settlements (BIS).

Rate sensitivity means time to repricing.

Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL.

Refinancing risk.

The Re-Pricing Gap

Commercial banks must report re-pricing gaps for assets and liabilities with maturities of:

One day.

More than one day to three months.

More than 3 three months to six months.

More than six months to twelve months.

More than one year to five years.

Over five years.

Re-pricing Gap Example (Table 8-1)

The Re-pricing Model

DNIIi = (GAPi) DRi = (RSAi - RSLi) DRi

Example I:

In the one day bucket, gap is -$10 million. If rates rise by 1%:

DNII(1) = (-$10 million) × .01 = -$100,000.

The Re-pricing Model

Example II:

If we consider the cumulative 1-year gap,

DNII = (CGAPone year) DR = (-$15 million)(.01)

= -$150,000.

The Re-pricing Model (Table 8-2)

Rate-Sensitive Assets

Examples from hypothetical balance sheet:

Short-term consumer loans. If re-priced at year-end, would just make one-year cutoff.

Three-month T-bills re-priced on maturity every 3 months.

Six-month T-notes re-priced on maturity every 6 months.

30-year floating-rate mortgages re-priced (rate reset) every 9 months.

Rate-Sensitive Liabilities

RSLs bucketed in same manner as RSAs.

Demand deposits and passbook savings accounts warrant special mention.

Generally considered rate-insensitive (act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities.

CGAP Ratio

May be useful to express CGAP in ratio form as,

CGAP/Assets.

Provides direction of exposure and scale of the exposure.

Example:

CGAP/A = $15 million / $270 million = 0.56, or 5.6 percent.

Equal Rate Changes on RSAs, RSLs

Example: Suppose rates rise 2% for RSAs and RSLs. Expected annual change in NII,

NII = CGAP ×  R

= $15 million × .01

= $150,000

With positive CGAP, rates and NII move in the same direction.

Change proportional to CGAP.

Equal Rate Changes on RSAs, RSLs (Table 8-3)

Unequal Changes in Rates

If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case,

NII = (RSA ×  RRSA ) - (RSL ×  RRSL )

Unequal Rate Change

Spread effect example:

RSA rate rises by 1.2% and RSL rate rises by 1.0%

NII =  interest revenue -  interest expense

= ($155 million × 1.2%) - ($155 million × 1.0%)

= $310,000

Example of a Change in Rates (Table 8-2)

Weaknesses of Re-pricing Model

Weaknesses:

Market Value Effects

Over aggregation

Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets can be substantial.

Ignores effects of runoffs

Bank continuously originates and retires consumer and mortgage loans. Runoffs may be rate-sensitive.

Ignores market value effects and off-balance sheet (OBS) cash flows.

The Over Aggregation Problem (Figure 8-3)

The Run-Off Problem

Runoff

Periodic cash flow of interest and principal amortization payments on long-term assets, such as conventional mortgages, that can be reinvested at market rates.

Off Balance Sheet Items

RSAs and RSLs used in the basic re-pricing model include only the assets and liabilities listed on the balance sheet. Changes in interest rates will affect the cash flows on many off-balance-sheet (OBS) instruments as well.

Chapter Summary

This chapter introduced a method of measuring an FI’s interest rate risk exposure: the repricing model. The repricing model looks at the difference, or gap, between an FI’s rate-sensitive assets and rate- sensitive liabilities to measure interest rate risk. The chapter showed that the repricing model has difficulty in accurately measuring the interest rate risk of an FI. In particular, the repricing model ignores the market value effects of interest rate changes. More complete and accurate measures of an FI’s exposure are duration and the duration gap, which are explained in the next chapter.