Page 43 - DMGT512_FINANCIAL_INSTITUTIONS_AND_SERVICES

Financial Institutions and Services

Notes
Example: In the 80's, many Savings & Loan associations in Europe went bankrupt owing
to rates increases: since they had borrowed short and lent long, both their income and their net
worth had become negative.
Asset Liability Management (ALM) is a strategic management tool to manage interest rate risk
and liquidity risk faced by banks, other financial services companies and corporations.

Banks manage the risks of asset liability mismatch by matching the assets and liabilities according
to the maturity pattern or the matching the duration, by hedging and by securitization. They use
the gap and the duration analyses to respectively evaluate (not necessarily to eliminate) their
exposure to income and to capital risks.

Gap Analysis

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.

Example: 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.
There is also a refinancing risk when liabilities mature before assets.

Example: 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).

Example:

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

Gap = RSA – RSL = 40 – 30 = 10 millions
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% of
10 millions = 200,000.

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.

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