Chapter Twenty-

Three
Managing Interest
Rate Risk and
Insolvency Risk on
the Balance Sheet

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 Interest Rate Risk

l Asset-transformation function performed by financial

institutions (FIs) often exposes them to interest rate risk via
the mismatching of asset and liability maturities
l FIs use two main methods to measure interest rate
exposure:
1. Repricing gap (i.e., funding gap) model examines the impact
of interest rate changes on an FI’s net interest income (NII)
2. Duration gap model incorporates the impact of interest rate
changes on the overall market value of an FI’s balance sheet
and ultimately on its owners’ equity or net worth
l Insolvency risk is the result, a consequence, or an outcome
of excessive amounts of one or more of the risks taken by
an FI (e.g., liquidity risk, credit risk, and interest rate risk)
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 Interest Rate Risk Measurement
and Management
l Federal Reserve’s monetary policy strategy is the most
direct influence on the level and movement of interest rates
l If the Fed wants to slow down the economy, it will tighten
monetary policy by taking actions that raise interest rates
l Results in a decrease in business and household spending
l If the Fed wants to stimulate the economy (i.e., expansionary
monetary policy), it allows interest rates to fall
l Promotes borrowing and spending
l Until recently, bank regulators based evaluations of bank
interest rate risk on the repricing gap model alone
l While the repricing gap model is still used to measure interest
rate risk in most FIs, it is increasingly being used in
conjunction with the duration gap model
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Repricing Model

l Repricing or funding gap is the difference between

those assets whose interest rates will be repriced or
changed over some future period (RSAs) and liabilities
whose interest rates will be repriced or changed over
some future period (RSLs)
l Simple model used by small FIs in the U.S.
l Model is essentially a book value accounting cash flow
analysis of the interest income earned on an FI’s assets
and the interest expense paid on its liabilities (or its net
interest income) over some particular period
l Using this approach, DIs report quarterly on their Call
Reports, interest-rate sensitivity reports which show the
repricing gaps for assets and liabilities with various
maturities
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Repricing Gaps for an FI

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 Repricing Model (Continued)

l Gap in each maturity bucket (or bin) is calculated by

estimated the difference between the rate-sensitive assets
(RSAs) and the rate-sensitive liabilities (RSLs)
l Rate sensitivity is the time to repricing of an asset or liability
l Repricing model measures the change in an FI’s net
interest income exposure (or profit exposure) to interest
rate changes in each different maturity bucket
l Negative gap (where RSA < RSL) exposes the FI to
refinancing risk, the risk that the cost of rolling over or
reborrowing funds will rise above the returns being earned on
asset investments
l A positive gap (where RSA > RSL) exposes the FI to
reinvestment risk, the risk that the returns on funds to be
reinvested will fall below the cost of the funds
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Change in Net Interest Income

l Change in net interest income in the ith maturity bucked

is calculated as follows:

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 Cumulative Gaps (CGAP)

l FI manager can also estimate cumulative gaps (CGAP)

over various repricing categories or buckets
l Common CGAP of interest is the one-year repricing gap
l Cumulative effect on a bank’s net interest income may be
estimated using:

l CGAP effect is the relation between changes in interest

rates and changes in net interest income
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Impact of Rate Changes on Net
Interest Income When CGAP is
Positive

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Spread Effect

l Spread effect is the effect that a change in the spread

between rates on RSAs and RSLs has on net interest
income (NII) as interest rates change

l In general, the spread effect is such that, regardless of the

direction of the change in interest rates, a positive relation
exists between changes in the spread (between rates on
RSAs and RSLs) and changes in NII
l When the spread increases (decreases), NII increases
(decreases)

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Impact of Spread Effect on Net
Interest Income

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 Weaknesses of the Repricing
Model
l Repricing model has four major weaknesses
1. It ignores market value effects of interest rate changes
l Repricing gap is only a partial and short-term measure of overall
interest rate exposure
2. It ignores cash flow patterns within a maturity bucket
l On average, liabilities may be repriced toward the end of the
bucket’s range and assets may be repriced toward the beginning
3. It fails to deal with the problem of rate-insensitive asset and
liability cash flow runoffs and prepayments
l FI receives runoff from its rate-insensitive portfolio that can be
reinvested at current market rates
4. It ignores cash flows from off-balance-sheet (OBS) activities
l Changes in interest rates will affect the cash flows on many OBS
instruments, as well as those listed on the balance sheet
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Duration Gap Model

l Duration measures the interest rate sensitivity of an asset

or liability’s value to small changes in interest rates

l Duration gap is a measure of overall interest rate risk

exposure for an FI
l To estimate the overall duration gap of an FI:
l Determine the duration of an FI’s asset portfolio (A) and the
duration of its liability portfolio (L)
l Calculate the market value weighted average of the duration
of the assets (or liabilities) in the portfolio

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 Duration Gap Model (Continued)

l The dollar change in the market value of the asset portfolio for a
change in interest rates is:

l Similarly, the dollar change in the market value of the liability

portfolio for a change in interest rates is:

l Rearranging and combining these equations results in a measure

of the change in the market value of equity:

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 Duration Gap Model (Concluded)

l Effect of interest rate changes on the market value of an

FI’s equity or net worth (∆E) breaks down into three effects:
1. Leverage-adjusted duration gap = DA – kDL
l Measured in years and reflects degree of duration mismatch in an
FI’s balance sheet
l The larger this gap in absolute terms, the more exposed the FI is
to interest rate risk
2. Size of the FI
l A measures the size of the FI’s assets; the larger the asset size,
the larger the dollar size of the potential net worth exposure from
any given interest rate shock
3. Size of the interest rate shock = ∆R/(1 + R)
l The larger the shock, the greater the FI’s exposure

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Fannie Mae Duration Gap

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Difficulties in Applying the the
Duration Model to Real-World FI
Balance Sheets
l Duration matching can be costly
l Critics claim that restructuring the balance sheet can be time-
consuming and costly
l Note that this argument isn’t as true today as is has been in the
past, given the growth of purchased funds, asset securitization,
and loan sales markets have eased the speed and lowered the
transaction costs of major balance sheet restructurings
l Immunization is a dynamic problem
l The duration of assets and liabilities changes as they approach
maturity, and the rate at which their durations change through
time may not be the same on the asset and liability sides of the
balance sheet
l Large interest rate changes and convexity
l Convexity is the degree of curvature of the price-yield curve
around some interest rate level
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Duration Estimated versus True
Bond Price

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 Insolvency Risk Management

l To ensure survival, an FI manager must protect against the

institution against the risk of insolvency
l The primary means of protection against the risk of
insolvency and failure is an FI’s equity capital
l Capital is also a source of funds
l Capital is a necessary requirement for growth under existing
minimum capital-to-asset ratios set by regulators
l FI managers often prefer low levels of capital in order to
generate a higher return on equity (ROE) for stockholders
l The moral hazard problem of deposit insurance exacerbates
this tendency
l Strategy results in a greater chance of insolvency

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Insolvency Risk Management
(Continued)
l Capital Purchase Program, part of the Troubled Asset
Relief Program (TARP) of 2008-2009, was designed to
encourage U.S. FIs to build capital to increase the flow
of financing to U.S. businesses and consumers and to
support the U.S. economy
l Under the program, the Treasury purchased over $205
billion in senior preferred stock issued by FIs
l In addition to capital injections received as part of the
CPP, TARP provided additional emergency funding to
Citigroup ($25 billion) and Bank of America ($20 billion)
l Through December 2019, $245 billion of TARP capital
injections had been allocated to DIs, of which $239.8
billion had been paid back, along with a return of $35.8
billion in dividends and assessments
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Capital

l The economic meaning of capital is net worth, the

difference between the market value of an FI’s assets
and the market value of its liabilities
l Essentially a market value accounting concept
l The market value or mark-to-market value basis uses
balance sheet values that reflect current rather than
historical prices
l Regulatory- and accounting-defined capital and required
leverage ratios are based in whole or in part on
historical or book values (BV) accounting concepts
l Book value is the value of assets and liabilities based on
their historical costs
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 Market Value of Capital

l The market value of capital and credit risk

l Declines in current and expected future cash flows on assets
lowers the market value of the FI’s asset portfolio
l Decreases in the MVs of assets are charged directly against
the equity owners’ capital or net worth
l Liability holders are only hurt when losses on the asset
portfolio exceed FI’s net worth
l Capital acts as “insurance”, protecting liability holders against
insolvency risk
l The market value of capital and interest rate risk
l Rising interest rates reduce the market value of the FI’s long-
term securities and loans, while floating-rate instruments find
their market values largely unaffected if interest rates on such
securities are instantaneously reset
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The Book Value of Capital

l Book value (BV) of capital is the difference between the

BV of assets and the BV of liabilities
l BV of capital usually comprises the following three
components in banking:
l Par value of shares – the face value of the common shares
issued by the FI times the number of shares outstanding
l Surplus value of shares – the difference between the price
the public paid for common shares when originally offered
and their par values, times the number of shares outstanding
l Retained earnings – the accumulated value of past profits
not yet paid in dividends to shareholders
l Since these earnings could be paid in dividends, they are part of the
equity owners’ stake in the FI

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The Book Value of Capital
(Continued)

l Book value of capital and credit risk

l Managers of FIs may resist writing down the values of bad
assets as long as possible to try to present a more favorable
picture to depositors, shareholders, and regulators
l FI managers can selectively sell assets to inflate their
reported capital
l Only pressure from auditors and regulators may force loss
recognition and write-downs of the values of problem assets
l Book value of capital and interest rate risk
l Failure of BV accounting systems to recognize the impact of
interest rate risk is extreme relative to their partial and lagged
recognition of credit risk problems
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Discrepancy between the Market
and Book Values of Equity
l Degree to which the BV of an FI’s capital deviates from
its true economic market value depends on a number of
factors, especially:
l Interest rate volatility – the higher the interest rate
volatility, the greater the discrepancy
l Examination and enforcement – the more frequent are
on-site and off-site examinations and the stiffer the
examiner/regulator standards regarding charging off
problem loans, the small the discrepancy
l Asset trading – the more assets that are traded, the
easier it is to assess the true MV of the asset portfolio
l Market-to-book ratio shows the discrepancy between
the stock market value of an FI’s equity and the book
value of its equity
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Market-to-Book Value Ratios for
U.S. DIs

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 Arguments Against Market Value
Accounting
l Arguments against market value accounting include the
following:
l Difficult to implement
l Especially true for small commercial banks and thrifts with large
amounts of nontraded assets, such as small loans, in their balance
sheets
l When market prices or values for assets cannot be determined
accurately, marking to market may be done only with error
l Introduces unnecessary degree of variability into FI’s reported
earnings – and thus net worth – because paper capital gains
and losses on assets are passed through the income statement
l FIs are less willing to accept longer-term asset exposures if
these assets must be continually marked-to-market to reflect
changing credit quality and interest rates
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