Financial Management

Strategic Moves for Today’s Challenges
Thomas A. Farin
Chairman , President and Chief Executive Officer
Farin and Associates, Inc.
1
Strategic Thinking for
Today’s Challenges
Tom Farin (800) 236-3724
www.farin.com
President
tfarin@farin.com
www.fpwrestle.com
Beginning Question
What is Asset-Liability Management?

 Working definition – management of the relationship between a
financial institution’s risk and its return.
Lets begin by identifying the issues that drive return.
 We’re willing to bet that some of the the risk management issues
come out as we go through the return issues.
Then lets look at the tools and techniques that allow us to
measure and manage risk
Along the way, we’ll develop a series of 10 financial
management rules for managing your shop in the
interesting times ahead of us.
Strategic Thinking © 2003 - Slide 3

Effective Financial
Management Keys
1. Understand the importance of (800) 236-3724

financial leverage in managing your www.farin.com
return.
Measuring Return
Traditional Measures
 Net income
 ROA
 ROE Our focus
 Earnings per share
 Total stockholder return
All incorporate net income
Financial institutions of all kind need to focus on ROE as the
primary measure of effectiveness of performance.
•Stock institutions – measures how effectively stockholders
capital is being used to produce income.
•Mutuals and credit unions – measures the grown rate of the
capital account which becomes a constraint on the
institution’s ability to grow assets.

ROE, ROA & Leverage
Management of financial
leverage (capital) is a key
Capital Risk to delivering an effective return.

C/A Management Tools
Increase C/A by: Reduce C/A by:

Slowing growth Increasing growth
Increasing ROA Reducing ROA
Reducing dividends Increasing dividends
Issuing stock Buying back stock
Not available to mutuals

Or credit unions.

Effective Financial
Management Keys
2. Focus in managing your (800) 236-3724

reoccurring sources of return. www.farin.com
ROA Tree
Net interest margins

Are declining – and
Will continue to decline
Forever.
Declines will need to be made up by

increasing non-interest income
or reducing non-interest expense.

Importance of Asset Growth
Institutions wishing to deliver ROE’s must grow over the long

term.
 How much? – assets must grow at least as quickly as capital
over the long term if financial leverage is to be maintained.
Capital growth rate = ROE x (1 – D)
 Non-interest expense/AA will continue to decline over long-term.
Two ways to do this
 Cut dollar operating expenses
 Grow assets
 Loans will outgrow deposits over long term
 Why? – Gen X, Y, and Boomers don’t look to CDs when
investing long-term
 This means some of your funding growth will need to come
from borrowed funds.

Effective Financial
Management Keys
3. Make sure your IRR measurement (800) 236-3724

system considers both interest www.farin.com
rate risk and option risk.
Interest Rate Risk
“Interest Rate Risk is the Risk

that a Change in Market Rates
Typical Will Affect An Institutions
Manager Income ... And The Market
Definition Value of Its Assets and
Liabilities.”
IRR Definitions
1. IAR – Income at Risk
2. VAR – Value at Risk Regulatory
• EVE, NPV, MVPE, Viewpoint
NEV

Duration – A way of looking at interest rate
risk
Measures An Instrument’s Price Sensitivity
 Weighted average of PV of an instrument’s cash flows
 Can be used in simple valuation formula
(chg MV = - D x chg MR)
Can Be Used To Measure Price Sensitivity Of:
 An instrument
 A portfolio of similar instruments
 A portfolio of dissimilar instruments

Duration - Teeter Totter Approach
Considers amortization, prepayment

1600 repricing, time value of money.
1400
1200
1000
800
600 N P V - C as h
Duration is weighted average
400 Of time of receipt of cash flows
-- 3 years
200
0
Y e ar Y ea r Y ear Y ear Y e ar Y ear
1 2 3 4 5 6 Strategic Thinking © 2003 - Slide 14
Duration To Price
Effect of Rate Changes on Price
$110
$105
Price
$100
Value
$95
$90
-3% -2% -1% 0% 1% 2% 3%
Rate Change (%)
Chg MV = - D x Chg MR
-6% = -3 x 2%

Option Risk – You need to look at this too
Definition Examples of Imbedded Options

 The risk that the party to a  Prepayment Options in
financial instrument will Consumer Loans
exercise options imbedded in  Annual and Lifetime Caps in
the instrument that affect its ARMs
cash flow
 Early Withdrawal Options In CDs
The IRR Issue  Bump Rate CDs
 Imbedded options in many  Options To Convert From ARMs
financial instruments will cause to Fixed-rate Mortgages
their cash flows to vary with
rate environments, complicating  Step-up Bonds
the analysis of their IRR.  Derivative Mortgage-Backed
Securities
Convexity
 Callable Bonds and FHLB
 As a result of imbedded Advances
options, values track along a
curve rather than a straight line.

Comparative Price Changes
5 Year Treasury
7 Year Bond
1 Year Call 15 Year FR MBS

Convexity
1 25
1 15
1 05
C allable
Trea sur
95
Bond ge ts ca lled in falling
85 rate environm e nt shorte ning
Tre as D
D ura tion
75 Bond D =
-3 % -2 % -1% 0% 1% 2% 3%
Convexity
1 25
MBS prepayments increase in falling
1 15 rate environment – shortening duration
Treas D = MBS D
1 05
Tre
MB
95
MBS prepayments decrease in rising
85 rate environment – lengthening duration
75
-3% -2 % -1 % 0% 1% 2% 3%
Value at Risk (VAR) – Regulatory View of IRR
NPV, MVPE, EVE, NEV
Calculation Technique Advantages
 Calculate market value of all assets  Supported By Most AL Models
and liabilities on balance sheet.
 Economic value = MVA - MVL  Meets Most Regulatory
 Repeat calculations for variety of Requirements For
immediate and permanent changes in  OTS - Manditory
market rates. Cash flows are
recalculated for each rate  Banking & Credit Union
environment. Agencies – recommended for
 Value at risk equal to changes in shops with complex balance
economic value caused by rate
shocks. sheets
Application In IRR Management Disadvantages
 Used to evaluate effect of changes on  Assumption Intensive
rates on value of instruments over
remaining life. Control – Post-Shock economic value
 Sums to changes in economic value. and sensitivity

Value at Risk
Market Value
Book -200 0 200
Total Assets 350,000 367,803 356,422 341,656
Total Liabilities 317,100 321,272 314,153 308,507
Portfolio Equity 32,900 46,531 42,268 33,149
Portfolio Equity Ratio 9.40% 12.70% 11.78% 9.51%
Rate Sensitivity 0 93 0 -227
Equity Exposure 0.00% 10.09% 0.00% -21.57%
Post-Shock Interest Sensitivity Measure
NPV Ratio 0-100 bp 100-200 bp 200-400 bp Over 400 bp
OTS
guideline
for S in Over 12% Minimal (1) Minimal (1) Minimal (1) Moderate (2)
CAMELS 8% to 12% Minimal (1) Minimal (1) Moderate (2) Significant (3)
4% to 8% Minimal (1) Moderate (2) Significant (3) High (4)
Below 4% Moderate (2) Significant (3) High (4) High (4)
From TB 13-a
http://www.ots.treas.gov/bltn_thrift.html

Effective Financial
Management Keys
4. Use dynamic rather than static (800) 236-3724

tools to manage interest rate www.farin.com
risk – Income at Risk and Value
at Risk
Static vs. Dynamic IRR Measurement
Static Systems Dynamic Systems

 Measure IRR in Existing Measure IRR in Future Balance
Balance Sheet Sheet
 Fail To Consider Institution Consider Institution Strategy
Strategy Evaluate Risk/Return Tradeoffs
 Can’t Be Used to Evaluate Example - Computer Simulation,
Risk/Return Tradeoffs Dynamic VAR
 Regulatory Systems Are
Static
 Examples - Gap, Duration,
Current VAR

Income at Risk (IAR) Simulation
Definition Advantages
A computer model is used to  Model used for income at risk
project an institution’s financial analysis can be used for multiple
purposes.
statements based on a set of
 Budgeting
assumptions. The effect of
changes in rates on income can  Strategic Planning
be measured by running multiple  Interest Rate Risk Analysis
rate environments. Fluctuations  Measures what management is
in income under the different rate most concerned about over short
and medium term – the effect of
environments are income at risk
changes in rate on bottom line and
as measured by the model. performance measures driven off
the bottom line – ROA, ROE, EPS,
etc.
Disadvantages
 Cost
 Data and Time Intensive
 Ideally your plan must be in place
in model.

Dynamic Modeling
Income At Risk Comparison of Alternative Strategies
Income at Risk - ROE

Rate Env Pol Limit Stgy 1 Stgy 2 Stgy 3 Stgy 4
+300 bp -25% 7.2% 7.2% 9.6% 9.2%
Flat Maximum 12.0% 7.2% 11.4% 11.8%
-200 bp -25% 15.6% 7.2% 13.2% 13.8%
“Let’s Make as
Unacceptable Which of the Three
Much Money As
Strategy. ROE Acceptable
We Can While
Drops 40% Strategies Would
Betting No More from Flat to You Choose?
than 25% of the +300 bp.
Bottom Line.”

Setting Income At Risk Limits
Recommended Approach Example

Set a goal for primary ratio you ROE Goal = 16%
use to measure income statement Maximum bet, 25% of goal
performance (ROA, ROE, EPS) Policy limit, either
Once goal is set, ask yourself  25% of income
how much of that goal are you
willing to risk under adverse
 ROE of 12%
changes in rates.

Dynamic Value at Risk (VAR)
NPV, MVPE, EVE, NEV Today 3 Years
Calculation Technique
Rates
Static
 Run a computer simulation run VAR
of one or more management
strategies in a single rate
environment. Time
 Run a VAR Test on forecast
balance sheet
Application In IRR Management
Rates
 Used to evaluate effect of a Dynamic
strategy on future VAR. IAR
 Only effective way to test the
long-term effect of changes in
rates on a strategy. Time
 Can be used as tool in
comparing risk-return tradeoffs
of alternative strategies. Rates
Dynamic
VAR
Time
Dynamic Value at Risk Example
Book -200 bp Flat +2
Portfolio Equity - Strat 1 $39,510,000 $53,738,000 $51,831,000 $47
Portfolio Equity – Strat 2 $39,834,000 $57,305,000 $52,591,000 $43
Port Equity Ratio - Strat 1 10.90% 14.21% 13.84%
Port Equity Ratio – Strat 2 10.59% 14.51% 13.54%
Rate Sensitivity – Strat 1 0 36.6 0
Rate Sensitivity – Strat 2 97.6 0
OTS
guideline

Setting Value at Risk Limits
Suggested Approach
 Use OTS TB 13-a Sensitivity guidelines as a starting point.
 Ask yourself, “What is the lowest rating for S in sensitivity we are willing
to accept?”
 Set limits based on answer.

OTS
guideline
A top 10 credit union decided that because of their minimal liquidity and
credit risk, they could afford to go to a 2 rating for Sensitivity. As a result any
of the above post-shock/sensitivity combinations would be acceptable.

Effective Financial
Management Keys
5. Use dynamic rather than static (800) 236-3724

tools to manage liquidity risk www.farin.com
Liquidity Risk Defined
The risk that:

 Sources of funds
 Investments
 Deposit inflows
 Cash flows off loans
 Will be unable to supply adequate funds to meet institution
needs for funds.
 Deposit outflows
 Funding commitments for loans
 Funding new loans

Static vs Dynamic Liquidity
Static Measurement Dynamic Measurement

 Measures liquidity in existing  Measures liquidity in business
balance sheet plan
 Fail to consider institution’s  Considers loan and deposit
business plan pricing strategies
 Fail to consider role of deposit  Requires business plan – can’t
and loan pricing strategies be generated from call reports
 Only way to measure liquidity  Allows for evaluation of
using call report data sources and uses of funds
 Fails to consider borrowing
power
 Uses outdated ratios –
loan/deposit ratio, other
regulatory liquidity ratios

Liquidity Risk Ratio: A Sources and Uses Liquidity Ratio
National Bank of Mount Washington

Liquidity Risk Ratio Report as of 12/00 Current Cash Flows by Quarter Ending
Balances in Millions Balance Jan-01 Mar-01 Jun-01 Sep-01
Sources of Funds
Investments
Cash and Due From Banks 4,181
Overnight Investments 2,388
AFS Investments
Short Term - Maturing Within One Year 1,294 1,618 1,618 1,618
Long-Term - Market/Book >= 100% 12,849
Long-Term - Market/Book < 100%
Amortization Cash Flows 77 77 77 77
Prepayment Cash Flows 129 129 129 129
HTM Investments
Short Term - Maturing Within One Year 0 0 0 0
Long Term
Prepayment Cash Flows 0 0 0 0
Loans
Short Term - Maturing Within One Year 3,148 1,540 1,540 1,540
Long Term
Prepayment Cash Flows 1,225 1,225 1,225 1,225

Deposits
Growth in Non-Maturity Deposits 1,826 1,826 1,826 1,826
Retention of Maturing Term Deposits 17,327 12,744 12,744 12,744
New Term Deposits 6,717 6,208 6,208 6,208
Retention of Maturing Brokered Deposits 0 0 0 0
New Brokered Deposits 0 0 0 0
Retention of Term Deposits >$100K 1,662 690 690 690
New Term Deposits >$100K 0 0 0 0
Borrowings
Increase In Overnight FHLB Borrowings 0 0 0 0
Increase In Overnight Other Borrowings 0 0 0 0
New FHLB Term Borrowings 0 0 0 0
New Other Term Borrowings 0 0 0 0
FHLB Unused Borrowing Capacity 27,806 27,806 27,806 27,806 27,806
Other Unused Borrowing Capacity 0 0 0 0 0
Non-Interest Bearing Accounts
Reduction in Non-Earning Assets 306 0 0 0
Increase in Non-Deposit NIB Liabilities 0 0 0 0
Capital
Retained Earnings 200 207 215 224
Capital Injections 0 0 0 0
Total Sources of Funds
By Period 47,224 71,538 63,949 64,050 64,151
Cumulative 47,224 118,762 182,712 246,762 310,912

Uses of Funds
Deposits
Outflow of Non-Maturity Deposits 0 0 0 0
Maturing Term Deposits 19,252 14,160 14,160 14,160
Maturing Brokered Deposits 0 0 0 0
Maturing Deposits > $100K 1,662 690 690 690
Borrowed Funds
Decrease in FHLB Overnight Borrowings 0 0 0 0
Decrease in Other Overnight Borrowings 0 0 0 0
FHLB Maturing Borrowed Funds 0 0 0 0
FHLB Debt Service on Amortizing Debt 0 0 0 0
Other Maturing Borrowed Funds 0 0 0 0
Other Debt Service on Amortizing Debt 0 0 0 0
Loans
New Loan Originations 0 0 0 0
Non-Interest Bearing Accounts
Increase in Non-Earning Assets 306 290 290 300
Decrease in Non-Deposit NIB Liabilities 0 0 0 0
Capital
Stock Repurchase 0 0 0 0
Total Uses of Funds
By Period 0 21,220 15,140 15,140 15,150
Cumulative 0 21,220 36,361 51,501 66,651

Excess (Shortage) of Sources Over Uses
By Period 47,224 50,317 48,809 48,910 49,001
Cumulative 47,224 97,542 146,351 195,261 244,262
By Period (Without Borrowing Capacity) 22,459 50,317 48,809 48,910 49,001
Cumulative (Without Borrowing Capacity) 22,459 72,777 121,586 170,496 219,497
Liquidity Risk Ratio 559.66% 502.50% 479.14% 466.48%

Liquidity Risk Ratio Goal 110.00% 110.00% 110.00% 110.00%
Amount Liquidity Risk Ratio Exceeds Goal 449.66% 392.50% 369.14% 356.48%
Balance Sheet Mix Current Quarter Ending

Balance Jan-01 Mar-01 Jun-01 Sep-01
Cash & Due From 2.9% 3.0% 3.0% 3.0% 3.0%
Investments 24.5% 23.6% 22.8% 22.0% 21.4%
Loans 69.8% 70.8% 71.6% 72.4% 73.2%
Other Non-Earning Assets 2.7% 2.7% 2.6% 2.6% 2.5%
Total Assets 100.0% 100.0% 100.0% 100.0% 100.0%
Non-Volatile Deposits 88.2% 88.6% 89.0% 89.3% 89.6%
Deposits >$100K 3.7% 3.5% 3.4% 3.2% 3.1%
Brokered Deposits 0.0% 0.0% 0.0% 0.0% 0.0%
FHLB Advances 0.0% 0.0% 0.0% 0.0% 0.0%
Other Borrowings 0.5% 0.5% 0.5% 0.4% 0.4%
Non-Deposit NIB Liabilities 0.4% 0.4% 0.4% 0.4% 0.3%
Capital 7.2% 7.0% 6.8% 6.7% 6.5%
Total Liabilities and Capital 100.0% 100.0% 100.0% 100.0% 100.0%
Supplementary Key Ratios Current Quarter Ending

Balance Jan-01 Mar-01 Jun-01 Sep-01
Loans/Deposits 76.0% 76.8% 77.6% 78.3% 78.9%
FHLB Borrowings/FHLB borrowing Capacity 0.0% 0.0% 0.0% 0.0% 0.0%

Effective Financial
Management Keys
6. Understand the tradeoffs between (800) 236-3724

deposits and borrowings www.farin.com
Deposits vs. Borrowings
Deposits Borrowings
Largest portion of non-capital funding Smaller portion of non-capital funding
Creates franchise value when well Neutral to franchise value
priced No customer relationship
Customer relationship Generally can have as much volume
as you want at market rates – subject
Pricing is used to increase or to credit approval
decrease volume No origination and servicing cost
Costs money to originate and service May have interest rate risk and
May have interest rate risk and option risk
option risk Cost is generally higher
Cost is generally lower Considered by some to be an
Greatest value is in non-maturity undesirable source of funding
deposits because of rate and duration Common sources
 FHLB
 Bond Market
 Fed funds
 Repos
 Brokered CDs

Funding Strategy
 Use deposits whenever they can be raised at a marginal

cost below borrowings. Deposits build franchise value
while borrowings don’t.
 Use borrowings when:
 Marginal cost of deposits is too high – raising deposits above
borrowing rates erodes franchise value.
 You can’t raise the kind of funding you need from customers to
fund loans they are demanding.
 You need to match fund a lending or investment strategy in a
very specific way.
 Short-range liquidity problems develop that can’t be met by
investment portfolio.

Financially Sound Deposit Pricing Tools
 Benchmark rates
 Marginal cost
 Can be applied to individual account
(savings account example)
 Can be applied to a sector (CD
example)

Benchmarks - Is Account Well Priced?
Account beats wholesale funding benchmark by 263 bp

Marginal Cost – Single Account Example
Marginal Cost of Additional Funds

12.75%
Before Change
After Change
Difference
Assumes a 5% increase in volume.

Effective Financial
Management Keys
7. Have an effective process in place (800) 236-3724

for making deposit pricing www.farin.com
decisions.
Deposit Pricing - Divide Accounts into Sectors
You may want to start out with four funding sectors.

 Checking accounts
 Savings and MMDA
 Short-term CDs
 Long-term CDs

Develop a Pricing Strategy for Each Sector
What Is a Pricing Strategy?

 The account structure within the sector
 Example: ST CD Sector
 3 Month CD
 6 Month CDs
 12 Month CDs
 The rules for pricing the accounts within the
sector

What is a Pricing Rule?
The rules for pricing the accounts.

 How the accounts are priced relative to each other
and to competitive and wholesale rates.
Example
 Price all CDs in this sector in the range of 40 bp
below the average rate in the market based on
survey data.

Applying Marginal Cost - Pay the Best Rates
Benchmark rate = 2.60%
Pricing rules
 Current – All accounts priced at midpoint of market
 Proposed – All accounts priced at top of market
Pay the Best Rate, Not the Best Rates –
Offensive Special
Saves 136.3 pb at margin

vs. 4.591%
Pricing rules Saves $28,504

 Current – All accounts priced at midpoint of market vs. $135,039 on $2.9 mm
 Proposed – CD special priced at top of market
Pay the Best Rate, Not the Best Rates –
Defensive Special
Saves 53 pbs at margin

vs. 3.228%
Pricing rules
 Current – All accounts priced at midpoint of market
 Proposed – CD special priced at top rate offered under previous strategy
Effective Financial
Management Keys
8. Understand the tradeoffs between (800) 236-3724

investments and loans www.farin.com
Investments vs. Loans
Loans Investments
Represents largest % of earning Smaller % of earning assets
assets
Neutral to franchise value
Creates franchise value when
well priced Does not lead to a customer
Cornerstone of many customer relationship
relationships Generally less credit risk
Can have significant credit risk Generally more liquid
Generally less liquid Requires less capital to fund
Requires more capital to fund Generally you can have as much
Pricing used to increase and volume as you want at market
decrease volume rates.
Costs money to originate and No origination and servicing cost
service
May have interest rate risk and
May have interest rate risk and
option risk option risk
Generally a higher yield given Generally a lower yield given
risks and costs risks and costs.

Securitization Process
Originates Purchases
Mortgage Mortgages
Loans for Sale From Institution
Financial Fannie
Institution Mae
Purchases Issues Securities

Securities for To Fund Loans
Investment Backed by
Portfolio Loans as Collateral
Note: While the example illustrates mortgage securitization,

Virtually any type of loan being made by financial institutions
Is being securitized and sold in the secondary markets.

Effective Financial
Management Keys
9. Have an effective process in place (800) 236-3724

for making loan pricing www.farin.com
decisions.
Financially Sound Loan Pricing Tools
 Benchmark rates – based on investment

alternative
 Marginal yield
 Can be applied to individual accounts
 Can be applied to a sector (risk based
pricing example)

Developing a Wholesale Equivalent Rate
15 Year Fixed-Rate Mortgage
Component of a Security’s
Price
Risk Free Return – 1 Month
Treasury Strip – from market
Duration Matched Return – 5
Year Treasury – from market
Difference – Interest Rate
Risk Adjustment - subtraction
Duration Matched Return –
Comparable Security – from
market
At the 5.651% wholesale equivalent rate, the 15 year
fixed-rate MBS is providing enough yield to: Difference – Option Risk
•Provide a risk free return. Adjustment - subtraction
•Hedge the interest rate risk in the transaction
•Hedge the option risk in the transaction.

Developing the Retail Equivalent Rate
Adjusting for Credit Risk &
Servicing Cost
Wholesale Equivalent Rate
Credit Risk Adjustment – From
Loss Experience
CR Adjusted Rate – Calculated
Servicing Cost Adjustment –
From Cost Model or Source –
Marginal Cost
Retail Equivalent Rate -
Calculated
By adjusting the 5.651% wholesale equivalent rate,

by 25 bp, the retail equivalent rate has also adjusted for:
•Credit risk
•Servicing cost

Using The Retail Equivalent Rate
Assumptions
You don’t set your market’s rate,
Includes rate and
rather you react to competitor rate
amortized fees
initiatives
The funding is in place – you are
trying to determine how to invest.
Capital is not a constraint.
Decision Tool
If comparing loans to
Origination rate is 34.9 bp above the retail
investments, make the loan if
equivalent. Conclusion: Originate the loan.
origination rate is above retail
equivalent rate.

Considering Marginal Yield
Volume doubles Rates dropped 25 bp

Assumptions
You are contemplating modifying
the rate in an attempt to modify
volume.
When you are cutting loan rates
to increase volume, you are giving
up the rate change on loan
volume at the old rate to gain
additional volume at the higher
Income before and after rate.
Decision Tool
It makes sense to reduce rate to
Marginal yield equals increase volume when the
change in income marginal yield on the additional
Marginal yield is
divided by change in volume volume is above the retail
below retail equivalent
57.5 / 1,000 = 5.75% equivalent rate.
– bad pricing decision.

Risk-Based Loans
Situation – Institution wishes to use pricing to increase auto

loan originations.

Marginal Yield Calculation
Strategy: drop rates to increase volume.
Marginal Yield = Chg Inc / Chg Balances

= 551.32 / 8,500 = 6.486%
Bad decision as marginal yield 94 bp below breakeven

Risk-Based Loans
Credit Class A B C Av
Credit Adjustment 0.2 0.5 2.5 0
Borrowers Segmented into credit class (A, B, C)

Credit adjustment is annual charge off experience by credit class

Risk-Based Loans
A Credit Consumer Loans Break Even & Spread
A credits are extremely profitable

As their loss experience is well
below the 0.75% average for this
Kind of loan.

Risk-Based Loans
B Credit Consumer Loans Break Even & Spread
B credits are profitable as their

loss experience is below the
0.75% average for this
Kind of loan.

Risk-Based Loans
C Credit Consumer Loans Break Even & Spread
C credits are unprofitable as

their loss experience is well
above the 0.75% average for
this kind of loan.

Risk-Based Loans
Risk Based Pricing Marginal Yield
6.846%
Without
segmentation
Marginal yield is higher as rate is dropped for only rate sensitive customers (A’s)

Effective Financial
Management Keys
10. Develop the expertise to use (800) 236-3724

SWAPs and CAPs as interest www.farin.com
rate risk management tools
What is a SWAP?
Definition – an off-balance sheet How it Works

transaction that swaps the Three parties
obligation to make payments on  Party – makes fixed-rate
variable rate funding with the payment, receives
obligation to make payments on variable-rate payment
fixed-rate funding (or vice versa).  Counter-party – makes
Characteristics include: variable-rate payment,
Fixed-rate index receives fixed-rate
Floating rate index payment
 Intermediary – puts
Notional Principal
together and guarantees
Term the transaction
Fee – can be built into rate Institution can be either the party
received. or the counter-party.

Using a SWAP as a Hedge
Situation – Institution has used Interest rate SWAPs are executed

short-term CDs and MMDAs to with institution receiving short-term
fund fixed-rate mortgages. They payments and paying long-term
are vulnerable to a rise in rates payments
and want to hedge their risk.
Fixed-Rate Mortgage Yield Fixed-Rate Mortgage Yield
Yield/Cost
Yield/Cost
Institution makes long-term
CD & MMDA Cost Treasury interest payments
CD & MMDA Cost covered with short-term
Treasury interest payments
0 +100 +200 +300 +400 +500 0 +100 +200 +300 +400 +500
Rates -- > Rates -- >
Using a SWAP to Minimize Funding Costs
5
Situation – Customers prefer 4.5
short-term CDs. They require a
4
significant rate inducement to
move CDs to 5-7 years. Institution 3.5 Swap
needs 5-7 year funding for fixed- 3 Curv
rate mortgage lending. Here are 2.5
2 CD
two options:
Pay a the premium customers 1.5 Curv
demand for 5-7 year CDs. 1
Accept ‘cheap’ short-term 0.5
funding from customers and Swap 0
to 5-7 years.
Yr
Yr
M
7
1

What is a CAP?
Definition - Synthetic instrument

with following characteristics.
Income
Price
Term
Index
0
Strike point
Notional principal
0 +100 +200 +300 +400 +500
How it works:
You pay a price for the cap. The Rates -- >
price is generally amortized over Amortized price Income accelerates
the life of the instrument. after strike point is
When the index rises past the reached.
strike point, you receive income
equal to the difference between Speculative use – Use an
the index and the strike point times investment in an interest rate cap
the notional principal. to bet on rising rates.

CAP as a Micro-Hedge
Situation - You originate 1 year Solution – Buy a CAP that begins

ARMS to customers and fund with producing income when rates rise
1 year CDs. You wish to offer the 300 bp to offset risk from ARM
ARMs with 3% lifetime caps. cap. CAP Income
ARM Yield ARM Yield

Yield/Cost
Yield/Cost
CD plus CAP Cost
CD Cost CD Cost
0 +100 +200 +300 +400 +500 0 +100 +200 +300 +400 +500
Rates -- > Rates -- >

CAP as a Macro-Hedge
Situation – you are seeing Solution – You purchase series of

moderate changes in income with interest rate caps that begin
moderate rises in rates and severe producing income when rates rise
drops in income with rapid rises in between 200 and 300 basis points.
rates.
Income with CAP

Income
Income
On-balance sheet income On-balance sheet income
0 +100 +200 +300 +400 +500 0 +100 +200 +300 +400 +500

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Strategic Moves for Today’s Challenges

What is Asset-Liability Management?

Strategic Thinking © 2003 - Slide 3

1. Understand the importance of (800) 236-3724

Strategic Thinking © 2003 - Slide 5

Strategic Thinking © 2003 - Slide 6

Increase C/A by: Reduce C/A by:

Not available to mutuals

Strategic Thinking © 2003 - Slide 7

2. Focus in managing your (800) 236-3724

Net interest margins

Declines will need to be made up by

Strategic Thinking © 2003 - Slide 9

Institutions wishing to deliver ROE’s must grow over the long

Strategic Thinking © 2003 - Slide 10

3. Make sure your IRR measurement (800) 236-3724

“Interest Rate Risk is the Risk

Strategic Thinking © 2003 - Slide 12

Strategic Thinking © 2003 - Slide 13

Considers amortization, prepayment

Effect of Rate Changes on Price

Strategic Thinking © 2003 - Slide 15

Definition Examples of Imbedded Options

Strategic Thinking © 2003 - Slide 16

Strategic Thinking © 2003 - Slide 17

Strategic Thinking © 2003 - Slide 20

4% to 8% Minimal (1) Moderate (2) Significant (3) High (4)

Below 4% Moderate (2) Significant (3) High (4) High (4)

Strategic Thinking © 2003 - Slide 21

4. Use dynamic rather than static (800) 236-3724

Static Systems Dynamic Systems

Strategic Thinking © 2003 - Slide 23

Strategic Thinking © 2003 - Slide 24

Income at Risk - ROE

Strategic Thinking © 2003 - Slide 25

Recommended Approach Example

Strategic Thinking © 2003 - Slide 26

4% to 8% Minimal (1) Moderate (2) Significant (3) High (4)

Below 4% Moderate (2) Significant (3) High (4) High (4)

Strategic Thinking © 2003 - Slide 28

Post-Shock Interest Sensitivity Measure

4% to 8% Minimal (1) Moderate (2) Significant (3) High (4)

Below 4% Moderate (2) Significant (3) High (4) High (4)

Strategic Thinking © 2003 - Slide 29

5. Use dynamic rather than static (800) 236-3724

The risk that:

Strategic Thinking © 2003 - Slide 31

Static Measurement Dynamic Measurement

Strategic Thinking © 2003 - Slide 32

National Bank of Mount Washington

Strategic Thinking © 2003 - Slide 33

Strategic Thinking © 2003 - Slide 34

Strategic Thinking © 2003 - Slide 35

Liquidity Risk Ratio 559.66% 502.50% 479.14% 466.48%

Balance Sheet Mix Current Quarter Ending

Supplementary Key Ratios Current Quarter Ending

Strategic Thinking © 2003 - Slide 36

6. Understand the tradeoffs between (800) 236-3724

Strategic Thinking © 2003 - Slide 38

 Use deposits whenever they can be raised at a marginal

Strategic Thinking © 2003 - Slide 39

Strategic Thinking © 2003 - Slide 40

Account beats wholesale funding benchmark by 263 bp