Assets and liabilities management

Mismatching
• A bank with mismatched assets and liabilities can be badly hurt by
unexpected interest rate changes. In the 80’s, many Savings & Loan
associations went bankrupt owing to rates increases: since they had
borrowed short and lent long, both their income and their net worth had
become negative.
• Banks use the gap and the duration analyses to respectively evaluate
(not necessarily to eliminate) their exposure to income and to capital
risks.
• Gap analysis estimates the net effect on income of interest rate
changes (parallel shifts). Income risk is two forged: there is a
reinvestment risk when assets mature before liabilities (ex. when a bank
has financed a 6 months T-bill by issuing a 1 year fixed rate CD: when,
after 6 months, it cashes the T-bill, it may be unable to reinvest the
proceeds at a profitable rate. Please note that it is not unusual for a
bank to finance a 5-years floating rate loan by issuing a 3-years fixed
rate bond: also in this case it is exposed to a reinvestment risk). There
is also a refinancing risk when liabilities mature before assets (ex.
when a bank has financed a 1 year fixed rate asset by issuing a 6
months CD: when the liability will mature, the bank has to refinance its
position by issuing another 6 months CD. But, if interest rates have
increased, the bank will have to pay a higher rate).
• For the Gap analysis all items, on both sides of the balance sheet, are
classified into two categories: rate-sensitive and fixed-rate (non-
sensitive).

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 ASSETS LIABILITIES
Rate-sensitive: RSA Rate-sensitive:RSL
(variable-rate loans and (variable-rate deposits;
bonds; bills and short-term 40 short-term or variable-rate 30
securities) securities)
Fixed-rate: NSA Fixed-rate: NSL
(fixed-rate loans; fixed-rate (fixed-rate loans; fixed-rate
long-term bonds; reserves) 60 long-term bonds; net worth) 70

Gap = RSA –RSL = 40 – 30 = 10 million

• The (annual) income will change by the size of the gap multiplied by
the size of the interest rates change: if the rates increase by 2% (200
basis points), the annual income will increase by: 2%•(10 million) =
200,000 euro.
GAP>0 ⇒ The bank is asset sensitive: it benefits from interest rate
increases and suffers from decreases.
GAP<0 ⇒ The bank is liability sensitive: it gains when rates decrease
and loses when they increase.

• A positive gap (asset sensitive bank) is an implicit bet that interest rates
will increase; a negative one (liability sensitive bank) that they will fall.
When the gap is zero, the bank has no exposure to income risk: a
change in interest rates will not change the bank’s income. The relation
for the expected change in interest margin is given by:
E ( ∆IM ) = GapE ( ∆i )

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• Gap ratio: defined as RSA/RSL is frequently utilised to evaluate the
time-path of a bank Gap or to make comparisons with the Gap of other
banks.
• To reduce the gap to zero, the bank of the ex. can sell 10 mln of short-
term assets and buy 10 mln of long-term assets. Alternatively, it can
operate in derivatives , both symmetric and asymmetric. In the first
case, it can buy futures or it can sell interest rate swaps or FRAs in
order to transform 10 mln of its floating rate assets into fixed rate
assets, as we shall show later on. The case of asymmetric instruments
will be considered at the end of the course.

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 Duration analysis
• Estimates the effect on the bank’s net worth (capital gains and losses)
of an interest rate change (parallel shifts).

ASSETS LIABILITIES
Rate-sensitive 40 Rate-sensitive 30
Fixed-rate Fixed-rate
*Zero coupon 5 years (83
*Reserves 10 mln, market value at 6%) 62
*Zero coupon 20 years (233
mln, market value at 8%) 50 *Net worth 8
Total 100 Total 100

• After a 200 bp increase in interest rates, we have:

ASSETS LIABILITIES
Rate-sensitive 40 Rate-sensitive 30
Fixed-rate Fixed-rate
*Zero coupon 5 years (83
*Reserves 10 mln, market value at 8%) 56,46
*Zero coupon 20 years (233
mln, market value at 10%) 34,64 *Net worth -1,82
Total 84,64 Total 84,64

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• The bank is bankrupt, notwithstanding its advantage of 0.2 mln in
interest income. The cause is a very large mismatching between assets
and liabilities duration:

DA = Assets average duration = 0 ⋅ ( 40 / 100) + 0 ⋅ ( 10 / 100) + 20( 50 / 100) = 10

DL = Liabilities average duration = 0 ⋅ ( 30 / 92) + 5 ⋅ ( 62 / 92) = 3.4
L 92
DG = Duration gap = DA − D L = 10 − 3.4 = 6.87
A 100

• 1st approximation:Duration gap

 L 
∆NW1 ≈ − D A − DL  A∆i = − DG A∆i
 A 
For an increase of 200 bp, DG gives an estimation of ∆NW1 = − 13.74 mln:
a poor approximation since the actual fall is 9.82 mln.

• 2nd approximation: Modified duration gap

 D L DL 
∆ NW2 ≈ −  A −  A∆ i = − MDG A∆ i
1 + iA A 1 + iL 
For MDG = 6.30, we have: ∆NW2 = − 12.6 mln.

• 3rd approximation: Modified duration gap and convexity gap

∆NW ≈ − MD A∆i +  C − C  A( ∆i ) =
1 L 2
3
 A
 2 A
A L

1
= − MD G A∆i + C G A( ∆i )
2

2
50 62
with: C = 100 C( 20 10% ) = 180.04 ; C = 92 C( 5
A L 8% ) = 17.93 , we have: ∆NW3 =
−9.45 mln: a not too bad approximation.

• Of course, all the approximations are better for smaller changes in

interest rates. For ∆i= 0.01, we obtain: ∆NW1 = − 6.87, ∆NW2 = − 6.30,
∆NW3 = − 5.51 as against an actual fall of 5.61 mln.

• A positive DG is an implicit bet that interest rates will fall; a negative

one that they will rise. To obtain DG = 0, in order to cover much of the
capital risk, the bank can:

1. sell 34.35 mln of its zeros and buy short-term bills, so as to have DA =
20(15.65) = 0.92DL;

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2. sell futures as we shall show later on;
3. buy swaps, becoming a fixed rate payer and floating rate receiver, as we
shall show later on;
4. buy FRAs, as we shall show later on.
5. take positions in asymmetric derivatives (options) as we shall see
towards the end of the course.

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 Hedging the interest margin with futures

• To fully protect the interest margin (i.e. to reduce the Gap

to zero), the following relation should hold:
∆ IM = − ∆ F
where ∆F is the cash flow generated by the futures
position. Now:
∆F = − DF N F PF Fn ∆i
where D is the modified duration of the underlying of the
F

futures. For parallel shifts the hedging relation is:

Gap ∆i = DF N F PF Fn ∆i
Hence we have:
Gap
NF =
DF PF F n
as we have already seen. Note that the numerator is Gap,
while before we had: DS PS Sn . But now the amount to cover
is Gap instead of PS S n and DS = 1 because we are considering
the annual change in the bank’s income.

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Banks’ hedging against capital risk with futures

• A positive DG is an implicit bet that interest rates will fall;

a negative one that they will rise. A bank can protect its
net worth by using futures, i.e. selling futures when it has
a DG>0 and buying futures when it has a DG<0 for a
number of contracts as indicated by the following
formula:
DG A
NF = −
D F PF Fn
as can be proved in this way: there is a full cover of the
capital risk if ∆ NW = − ∆ F i.e. if the change in the net worth
of the bank’s balance sheet is equal to the change of the
futures value with the sign changed. If we consider ∆NW 1

(the same applies also to the other approximations), in the

case of parallel shifts, we can write:
− DG A∆i = −( − DF N F PF Fn ∆i )
from which the result follows.