Interest Rate Risk Basics Enterprise Risk Management Project

Transcription

1 Interest Rate Risk Basics Enterprise Risk Management Project July 23, 2014 Graduate School of Banking at Colorado Timothy W. Koch University of South Carolina

2 Steps in GAP Analysis 1. Determine an interest rate forecast (driver rate & rate relationships) 2. Select a series of time intervals (time buckets) for determining the rate sensitivity of assets and liabilities 3. Assign assets and liabilities to the respective time intervals based on their expected rate sensitivity 4. Calculate periodic and cumulative GAPs 5. Forecast net interest income and net income GAP = Rate sensitive assets - Rate sensitive liabilities

3 What Makes an Asset or Liability Rate Sensitive? Rate sensitivity is a balance sheet concept. Thus, it is the principal amount of any cash flow that is characterized as rate sensitive. 1. Maturity or sale value 2. Partial principal payment 3. Principal amount that is priced off of a base rate, and the base rate is expected to change within the time interval 4. Principal amount associated with the exercise of embedded options

4 Interest Rate Risk Policy Guidelines A. GAP-Based Policy Targets 1. 1-Year cumulative GAP as a fraction of earning assets 2. GAP Ratio - 15% < GAP < + 15% Earning Assets B. Earnings Sensitivity Policy Targets 0.90 < RSAs < 1.10 RSLs 1. A parallel shift in the yield curve of +/- 2% should not lower net interest income by more than 5% from the base case forecast. 2. A gradual change in rates of +/- 2% should not lower net interest income by more than 3% from the base case forecast.

5 Steps in Earnings Sensitivity Analysis 1. Determine an interest rate forecast (driver rate & rate relationships) 2. Select a series of time intervals (time buckets) for determining the rate sensitivity of assets and liabilities 3. Select a base case interest rate environment 4. Assign assets and liabilities to the respective time intervals based on their expected rate sensitivity given the underlying rate environment. Incorporate the estimated exercise of embedded options. 5. Forecast the growth in loans, securities, core deposits and non-core liabilities; forecast net interest income and net income 6. Select a new interest rate environment and repeat steps #4 & #5. 7. Examine the range of forecast changes in net interest income and net income compared to the base case interest rate environment.

6 What is Each Bank s Bet? Which Bank Has the Greatest IRR? Interest Rate Estimated Net Percentage Change in Environment Interest Income Net Interest Income City Bank Valley Bank +3% $ 910,000-9% [+13.2%] +2% $ 960,000-4% [+7.8%] +1% $ 985, % [+2.9%] Base Case $ 1,000, % $ 1,024, % [-2.1%] -2% $ 1.050,000 +5% [-4.4%] -3% $ 1,055, % [-6.9%] Is these banks asset sensitive or liability sensitive?

7 The Effective Rate Sensitivity of Assets and Liabilities Overview: Many bank assets and liabilities carry embedded options. As such, principal payments are triggered when interest rates change. Thus, contractual payments may arise sooner or later than normally expected and the effective rate sensitivity of the underlying contract may differ sharply from that anticipated when the asset or liability was booked. A. Embedded options in bank assets and liabilities 1. Borrowers can prepay (refinance) loans 2. Issuers of callable bonds can call the bonds prior to final maturity 3. Depositors can withdraw funds prior to final maturity 4. Loans may have caps or floors that become binding when interest rates change 5. FHLB advances may be called by the FHLB or put back to the FHLB by the bank when rates change

8 The Effective Rate Sensitivity of Assets and Liabilities (Cont.) B. Embedded options are exercised (triggered) when interest rates change across different economic environments 1. When rates fall a. borrowers refinance/prepay loans b. issuers call bonds held by the bank c. floors on loans and deposits may be binding 2. When rates rise a. depositors withdraw funds prior to maturity b. FHLBs may call advances (demand payoff prior to maturity) c. caps on loans and deposits may be binding C. Rates Do Not Change by the Same Amount at the Same Time 1. When rates rise, banks increase the prime rate more than they increase core deposit rates 2. Banks raise the prime rate sooner when short-term rates are rising compared to when the lower the prime rate when short- term rates are falling

9 Macaulay s Duration Duration Principles 1. Duration is a measure of price elasticity. It indicates how much the price of a security or portfolio will change for a given change in the underlying interest rate. For option-free securities, it is measured in units of time. 2. The greater (lesser) is duration, the greater (lesser) is price sensitivity. Modified Duration 1. Modified duration indicates what percentage change in price will result from a one percent change in interest rates. 2. % D Price = - Modified duration x D rate

10 Steps in EVE Sensivity Analysis 1. Management develops an interest rate forecast. 2. Management estimates the market value of bank assets, liabilities and stockholders equity. 3. Management estimates the weighted duration of assets and weighted duration of liabilities. The effects of both on- and off-balance sheet items are incorporated. These estimates are used to calculate duration gap. 4. Management forecasts changes in the economic value of stockholders equity across different interest rate environments.

11 Rate Shock Analysis and EVE at Risk for Victory State Bank as of June 30, 2014 (Millions of $) Base Case: Interest Rates Assumed to Remain Constant: Rate Shocks are Instantaneous Item Interest Rate Environment -4% -3% -2% -1% Base Case +1% +2% +3% +4% Market Values Assets Liabilities EVE EVE at Risk % Change vs Base