RMPG Learning Series ALM Workshop

TRAINING ON CORE RISK
MANAGEMENT FOR BANGLADESH BANK

Training Session 2:
Asset Liability Management

May 2011
Dhaka

ICRA Management Consulting Services Limited © IMaCS 2010
Printed 26-May-11
1

CONFIDENTIAL

All the contents of the presentation are confidential and should
not be published, reproduced or circulated without the written
consent of World Bank, Central Bank of Bangladesh and IMaCS

© IMaCS 2010
Printed 26-May-11
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Agenda of the presentation

 Understanding requirement for training on Asset
Liability Management

 Introducing key concepts and tools for Asset Liability
Management

 Outlining the current guidelines issued by Bangladesh
Bank and suggesting improvements, if any

© IMaCS 2010
Printed 26-May-11
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Agenda for Day 1

Introduction to Asset Liability Management

ALM basic concepts

Lunch Break

Liquidity Risk

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Agenda for Day 2

Liquidity risk Continued

Lunch Break



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Agenda for Day 3


Lunch Break


Interest rate risk

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Agenda for Day 4

Interest rate risk

Lunch Break

Interest rate risk continued

Interest rate risk continued

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Agenda for Day 5

Interest Rate risk Continued

Lunch Break

Interest Rate risk Continued

Basel Guidelines, current guidelines in
Bangladesh and wrap up session

© IMaCS 2010
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In this session, we will understand what constitutes assets and
liabilities in a Bank and why asset liability management is important

© IMaCS 2010
Printed 26-May-11
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Components of Balance Sheet

Balance Sheet of a Bank

Liabilities Assets

Capital Cash and Balances at Central Bank
Reserves and Surplus Balance w ith banks and money at call
Deposits and short notice
Borrow ings Investments
Other Liabilities and Provisions Advances
Contingent Liabilities Fixed Assets
Other Assets
© IMaCS 2009
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Components of Liabilities … 1

1. Capital:
Capital represents owner‟s contribution/stake in the bank.
- It serves as a cushion for depositors and creditors.
- It is considered to be a long term sources for the bank.

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2. Reserves & Surplus
Components under this head includes:
I. Statutory Reserves
II. Capital Reserves
III. Investment Fluctuation Reserve
IV. Revenue and Other Reserves
V. Balance in Profit and Loss Account

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3. Deposits
This is the main source of bank‟s funds. The deposits are
classified as deposits payable on „demand‟ and „time‟. They
are reflected in balance sheet as under:
I. Demand Deposits
II. Savings Bank Deposits
III. Term Deposits

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4. Borrowings
(Borrowings include Refinance / Borrowings from central
bank, Inter-bank & other institutions)
I. Borrowings in Bangladesh
i) Bangladesh Bank
ii) Other Banks
iii) Other Institutions & Agencies
II. Borrowings outside Bangladesh

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5. Other Liabilities & Provisions
It is grouped as under:

I. Bills Payable
II. Inter Office Adjustments (Net)
III. Interest Accrued
IV. Unsecured Redeemable Bonds
(Subordinated Debt for Tier-II Capital)
V. Others(including provisions)

© IMaCS 2009
Printed 26-May-11
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Components of Assets … 1

1. Cash & Bank Balances
I. Cash in hand
(including foreign currency notes)
II. Balances with Bangladesh Bank
In Current Accounts
In Other Accounts

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2. BALANCES WITH BANKS AND
MONEY AT CALL & SHORT NOTICE
I. In Bangladesh
i) Balances with Banks
a) In Current Accounts
b) In Other Deposit Accounts
ii) Money at Call and Short Notice
a) With Banks
b) With Other Institutions
II. Outside Bangladesh
c) Money at Call & Short Notice
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3. Investments
A major asset item in the bank‟s balance sheet. Reflected
under 6 buckets as under:
I. Investments in Bangladesh in:
i) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions
vi) Others (Commercial Papers, COD & Mutual Fund Units
etc.)
II. Investments outside Bangladesh in
Subsidiaries and/or Associates abroad

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4. Advances
The most important assets for a bank.
A. i) Bills Purchased and Discounted
ii) Cash Credits, Overdrafts & Loans repayable on demand
iii) Term Loans
B. Particulars of Advances :
i) Secured by tangible assets (including advances against
Book Debts)
ii) Covered by Bank/ Government Guarantees
iii) Unsecured
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5. Fixed Asset
I. Premises
II. Other Fixed Assets (Including furniture and fixtures)

6. Other Assets
I. Interest accrued
II. Tax paid in advance/tax deducted at source (Net of Provisions)
III. Stationery and Stamps
IV. Non-banking assets acquired in satisfaction of claims
V. Deferred Tax Asset (Net)
VI. Others

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Contingent Liability

Bank‟s obligations under LCs, Guarantees, Acceptances on
behalf of constituents and Bills accepted by the bank are
reflected under this heads.

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Banks Profit & Loss Account

A bank’s profit & Loss Account has the following
components:
I. Income: This includes Interest Income and Other
Income.
II. Expenses: This includes Interest Expended, Operating
Expenses and Provisions & contingencies.

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Components of Income … 1

1. INTEREST EARNED

I. Interest/Discount on Advances / Bills
II. Income on Investments
III. Interest on balances Central Bank and other inter-bank
funds
IV. Others

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Components of Income … 2

2. OTHER INCOME
I. Commission and Brokerage
II. Profit on sale of Investments (Net)
III. Profit/(Loss) on Revaluation of Investments
IV. Profit on sale of land, buildings and other
assets (Net)
V. Profit on exchange transactions (Net)
VI. Income earned by way of dividends etc. from
subsidiaries and Associates abroad/in Bangladesh
VII. Miscellaneous Income
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Components of Expenses … 1

1. INTEREST EXPENDED

I. Interest on Deposits
II. Interest on Central Bank of Bangladesh/ Inter-Bank
borrowings
III. Others

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Components of Expenses … 2

2. OPERATING EXPENSES

I. Payments to and Provisions for employees
II. Rent, Taxes and Lighting
III. Printing and Stationery
IV. Advertisement and Publicity
V. Depreciation on Bank's property
VI. Directors' Fees, Allowances and Expenses
VII. Auditors' Fees and Expenses (including Branch Auditors)
VIII. Law Charges
IX. Postages, Telegrams, Telephones etc.
X. Repairs and Maintenance
XI. Insurance
XII. Other Expenditure

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Reclassification of liabilities
Liabilities/outflows
1&2. Capital funds
a) Equity capital, Non-redeemable or perpetual preference capital, Reserves, Funds and Surplus
b) Preference capital - redeemable/non-perpetual
3. Grants, donations and benefactions
4. Bonds and debentures
a) Plain vanilla bonds/debentures
b) Bonds/debentures with embedded call/put options (including zero-coupon/deep discount bonds)
5. Inter Corporate Deposits:
6. Borrowings
a) Short Term borrowings
b) Long Term Borrowings
7. Current liabilities and provisions:
a) Sundry creditors
b) Expenses payable (other than interest)
c) Advance income received, receipts from borrowers pending adjustment
d) Interest payable on bonds/deposits
e) Provisions for NPAs
f) Provision for Investments portfolio
g) Other provisions © IMaCS 2009
Printed 26-May-11
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Reclassification of Assets … 1
Inflows
1. Cash
2. Remittance in transit
3. Balances with banks (in Bangladesh only)
a) Current account
b) Deposit accounts/short term deposits
4. Investments (net of provisions)
a) Approved Trustee securities, government securities, bonds, debentures and other instruments
b) Unlisted securities (e.g. shares, etc.)
c) Unlisted securities having a fixed term maturity
d) Venture capital units
e) Equity shares, convertible preference shares, non-redeemable/perpetual preference shares, shares of
subsidiaries/joint ventures and units in open ended mutual funds and other investments.
5. Advances (performing)
a) Bill of Exchange and promissory notes discounted and rediscounted
b) Term loans (rupee loans only)
c) Corporate loans/short term loans

© IMaCS 2009
Printed 26-May-11
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Reclassification of Assets … 2
6. Non-performing loans
(May be shown net of the provisions, interest suspense held )
a) Sub-standard
i) All overdues and instalments of principal falling due during the next three years
ii) Entire principal amount due beyond the next three years
b) Doubtful and loss
i) All instalments of principal falling due during the next five years as also all overdues
ii) Entire principal amount due beyond the next five years
7. Assets on lease
8. Fixed assets (excluding leased assets)
9. Other assets
(a) Intangible assets and items not representing cash inflows.
(b)Other items (such as accrued income, other receivables, staff loans, etc.)
C. Contingent liabilities
(a) Letters of credit/guarantees (outflow through devolvement)
(b) Loan commitments pending disbursal (outflow)
(c) Lines of credit committed to/by other Institutions (outflow/inflow)
Overdue for less than one month.
Interest overdue for more than one month but less than seven months (i.e. before the relative amount
becomes NPA)
Principal installments overdue for 7 months but less than one year © IMaCS 2009
Printed 26-May-11
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In this session, we will understand
what constitutes assets and
liabilities in a Bank and why asset
liability management is important

 Asset Liability  Asset liability
management is a
Management is strategic management
tool to measure and
concerned with manage liquidity risk,
strategic balance interest rate risk and
interest rate risk faced
sheet management by Banks and Financial
Institutions. ALM is
involving risks about matching of the
caused by changes assets and liabilities of
the balance sheet based
in interest rates, on maturity or re-pricing
for liquidity risk and
exchange rate and interest rate risk
the liquidity respectively
position of bank

 ALM is the process  It is a dynamic
involving decision process of Planning,
making about the Organizing &
composition of assets Controlling of Assets
and liabilities & Liabilities- their
including off balance volumes, mixes,
sheet items of the maturities, yields and
bank / FI and costs in order to
conducting the risk maintain liquidity
assessment and NII

Globalization of financial markets.
_ Deregulation of Interest Rates.
_ Multi-currency Balance Sheet.
_ Prevalence of Basis Risk and Embedded Option Risk.
_ Integration of Markets – Money Market, FOREX Market,
Government Securities Market.
_ Narrowing NII / NIM
_ Mismatches in the maturity profile of assets and liabilities
_ Banks borrow short term and lend long term-basis of
profitability
_ Mismatches in interest rates

 Liquidity  May lead to
mismatch→ liquidation

 Interest rate  Affects
mismatch → profitability

 An effective Asset Liability
Management Technique aims to
manage the volume, mix, maturity, rate
sensitivity, quality and liquidity of
assets and liabilities as a whole so as to
attain a predetermined acceptable
risk/reward ration.

 An effective Asset Liability
Management Technique aims to
manage the volume, mix, maturity,
rate sensitivity, quality and
liquidity of assets and liabilities as
a whole so as to attain a
predetermined acceptable
risk/reward ration.

 It is aimed to stabilize short-term profits,
long-term earnings and long-term substance
of the bank. The parameters for stabilizing
ALM system are:

 Net Interest Income (NII)
 Net Interest Margin (NIM)

 Economic Equity Ratio

Liquidity Management

Bank’s liquidity management is the
process of generating funds to meet
contractual or relationship obligations
at reasonable prices at all times.

New loan demands, existing
commitments, and deposit withdrawals
are the basic contractual or relationship
obligations that a bank must meet.

FLOW APPROACH STOCK APPROACH
Measuring & Based on the level of
Managing net Assets & Liabilities as
funding requirement well as Off balance
Sheet exposures on a
Managing market particular date and
access calculating certain
ratios to assess the
Contingency planning liquidity position

COMPONENTS OF BALANCE SHEET

 Liabilities  Assets
 Capital  Cash and Balances
 Reserves and at Central Bank
Surplus  Investments
 Deposits
 Advances
 Borrowings
 Fixed Assets
 Other Liabilities
and Provisions  Other Assets
 Contingent
Liabilities


1. Capital:
Capital represents owner’s
contribution/stake in the bank.
- It serves as a cushion for
depositors and creditors.
- It is considered to be a long term
sources for the bank.

2. Reserves & Surplus
Components under this head
includes:
I. Statutory Reserves
II. Capital Reserves
III. Investment Fluctuation Reserve
IV. Revenue and Other Reserves
V. Balance in Profit and Loss
Account

3. Deposits

This is the main source of bank’s
funds. The deposits are
classified as deposits payable on
‘demand’ and ‘time’. They
are reflected in balance sheet as
under:
I. Demand Deposits
II. Savings Bank Deposits
III. Term Deposits


4. Borrowings
(Borrowings include Refinance /
Borrowings from RBI,
Inter-bank& other institutions)
I. Borrowings in India
i) Bangladesh Bank
ii) Other Banks
iii) Other Institutions & Agencies
II. Borrowings outside India

 5. Other Liabilities & Provisions
 It is grouped as under:
 I. Bills Payable

 II. Inter Office Adjustments (Net)

 III. Interest Accrued

 IV. Unsecured Redeemable Bonds

 (Subordinated Debt for Tier-II Capital)
 V. Others(including provisions)


1. Cash & Bank Balances
I. Cash in hand
(including foreign currency
notes)
II. Balances with Bangladesh
Bank
In Current Accounts
In Other Accounts


2. BALANCES WITH BANKS AND
MONEY AT CALL & SHORT NOTICE
I. In Bangladesh
i) Balances with Banks
ii) Money at Call and Short Notice
a) With Banks
b) With Other Institutions
II. Outside Bangladesh
c) Money at Call & Short Notice

3. Investments
A major asset item in the bank’s balance sheet. Reflected
under 6 buckets as under:
I. Investments in Bangladesh in:
i) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions
vi) Others (Commercial Papers, COD & Mutual
Fund Units
etc.)
II. Investments outside Bangladesh in
Subsidiaries and/or Associates abroad

4. Advances
The most important assets for a bank.
A. i) Bills Purchased and Discounted
ii) Cash Credits, Overdrafts & Loans
repayable on demand
iii) Term Loans
B. Particulars of Advances :
i) Secured by tangible assets (including
advances against
Book Debts)
ii) Covered by Bank/ Government
Guarantees
iii) Unsecured

5. Fixed Asset
I. Premises
II. Other Fixed Assets (Including furniture
and fixtures)
6. Other Assets
I. Interest accrued
II. Tax paid in advance/tax deducted at
source (Net of Provisions)
III. Stationery and Stamps
IV. Non-banking assets acquired in
satisfaction of claims
V. Deferred Tax Asset (Net)
VI. Others

Bank’s obligations
under LCs,

Contingent
Guarantees,
Acceptances on

Liability
behalf of constituents
and Bills accepted
by the bank are
reflected under this
heads.

 1&2. Capital funds
 a) Equity capital, Non-  4. Bonds and
redeemable or debentures
perpetual preference  a) Plain vanilla
capital, Reserves, bonds/debentures
Funds and Surplus  b) Bonds/debentures
 b) Preference capital - with embedded
redeemable/non- call/put options
perpetual (including zero-
 3. Grants, donations coupon/deep discount
and benefactions bonds)
 5. Inter Corporate
Deposits:

 6. Borrowings  c) Advance income
 a) Short Term received, receipts
borrowings from borrowers
 b) Long Term pending
Borrowings adjustment
 7. Current  d) Interest payable
liabilities and on bonds/deposits
provisions:  e) Provisions for
 a) Sundry creditors NPAs
 b) Expenses  f) Provision for
payable (other than Investments
interest) portfolio
 g) Other provisions

 1. Cash
 2. Remittance in transit

 3. Balances with banks (in India
only)
 a) Current account

 b) Deposit accounts/short term
deposits

 4. Investments (net of provisions)
 a) Approved Trustee securities, government
securities, bonds, debentures and other
instruments
 b) Unlisted securities (e.g. shares, etc.)
 c) Unlisted securities having a fixed term
maturity
 d) Venture capital units
 e) Equity shares, convertible preference
shares, non-redeemable/perpetual preference
shares, shares of
 subsidiaries/joint ventures and units in open
ended mutual funds and other investments.

a) Bill of Exchange and
promissory notes discounted and
rediscounted
b) Term loans (rupee loans only)
c) Corporate loans/short term
loans

 6. Non-performing loans
 (May be shown net of the provisions, interest
suspense held )
 a) Sub-standard
 i) All overdues and instalments of principal
falling due during the next three years
 ii) Entire principal amount due beyond the
next three years
 b) Doubtful and loss
 i) All instalments of principal falling due
during the next five years as also all overdues
 ii) Entire principal amount due beyond the
next five years

 7. Assets on lease
 8. Fixed assets (excluding leased
assets)
 9. Other assets

 (a) Intangible assets and items not
representing cash inflows.
 (b)Other items (such as accrued
income, other receivables, staff
loans, etc.)

C. Contingent liabilities
(a) Letters of credit/guarantees (outflow through
devolvement)
(b) Loan commitments pending disbursal (outflow)
(c) Lines of credit committed to/by other Institutions
(outflow/inflow)
Overdue for less than one month.
Interest overdue for more than one month but less than
seven months (i.e. before the relative amount
becomes NPA)
Principal installments overdue for 7 months but less
than one year

Managing Currency risk is one more
dimension of Asset - Liability
Management. Mismatched currency
position besides exposing the
balance sheet to movements in
exchange rate also exposes it to
country risk and settlement risk.

It is the current or prospective risk to earnings and
capital arising from adverse movements in currency
exchange rates.
It refers to the impact of adverse movement in
currency exchange rates on the value of open foreign
currency.
The banks are also exposed to interest rate risk,
which arises from the maturity mismatching of foreign
currency positions. Even in cases where spot and
forward positions in individual currencies are
balanced, the maturity pattern of forward transactions
may produce mismatches. As a result, banks may
suffer losses due to changes in discounts of the
currencies concerned

Banks also face another risk called
time-zone risk, which arises out of time
lags in settlement of one currency in
one center and the settlement of
another currency in another time zone.
The forex transactions with counter
parties situated outside Bangladesh
also involve sovereign or country risk.

LIQUIDITY NET STABLE
COVERAGE RATIO FUNDING RATIO
Objective is to examine Objective is to ensure
short term resiliency of longer term resiliency
liquidity risk profile to by funding activities
ensure they have with more stable
sufficient high quality funding on an on going
resources to survive structural basis
one month in acute
stress condition

The liquidity coverage ratio identifies the
amount of unencumbered, high quality liquid
assets an institution holds that can be used to
offset the net cash outflows it would encounter
under an acute short-term stress scenario
specified by supervisors. The specified scenario
entails both institution-specific and systemic
shocks built upon actual circumstances
experienced in the global financial crisis

The scenario entails:
 • a significant downgrade of the institution’s
public credit rating;
 • a partial loss of deposits;
 • a loss of unsecured wholesale funding;
 • a significant increase in secured funding
haircuts; and
 • increases in derivative collateral calls and
substantial calls on contractual and
noncontractual off-balance sheet exposures,
including committed credit and liquidity
facilities.

The net stable funding (NSF) ratio measures the
amount of longer-term, stable sources of funding
employed by an institution relative to the liquidity
profiles of the assets funded and the potential for
contingent calls on funding liquidity arising from off-
balance sheet commitments and obligations.

The NSF ratio is intended to promote longer-term
structural funding of banks’ balance sheets, off-
balance sheet exposures and capital markets
activities.

Throughout the global financial crisis
which began in mid-2007, many banks
struggled to maintain adequate liquidity.
Unprecedented levels of liquidity support
were required from central banks in order
to sustain the financial system and even
with such extensive support a number of
banks failed, were forced into mergers or
required resolution.

These circumstances and events were
preceded by several years of ample liquidity
in the financial system, during which
liquidity risk and its management did not
receive the same level of scrutiny and
priority as other risk areas. The crisis
illustrated how quickly and severely
liquidity risks can crystallise and certain
sources of funding can evaporate,
compounding concerns related to the
valuation of assets and capital adequacy.

Banks should have in place
contingency and business
continuity plans to ensure their
ability to operate as going
concerns and minimize losses
in the event of severe business
disruption.

does does management
management have procedures
have a strategy in place for
for handling a accessing funds in
an emergency?
crisis?

A contingency plan needs to spell
out procedures to ensure that
information flows remain timely
and uninterrupted, and that they
provide senior management with
the precise information it needs in
order to make quick decisions.

Another major element in the plan
should be a strategy for taking
certain actions to
alter asset and liability behaviours.

Other components of the
contingency plan involve
maintaining customer
relationships with liability-
holders, borrowers, and trading
and off-balance-sheet
counterparties.

Contingency plans should also include
procedures for making up cash flow
shortfalls in adverse situations. Banks have
available to them several sources of such
funds, including previously unused credit
facilities. The plan should spell out as
clearly as possible the amount of funds a
bank has available from these sources, and
under what scenarios a bank could use
them.

 The plan should spell out as clearly as
possible the amount of funds a bank has
available from these sources, and under
what scenarios a bank could use them.
 Holding readily marketable securities
(financial assets). The sub-prime crisis has
exposed the shortcomings in such a strategy
for coping with market wide liquidity crises.

Holding securities which can be
pledged as collateral for short term
borrowings. The repurchase (repo)
market has become an important tool for
liquidity management of this sort.
Having in place lines of credit or other
arranged borrowing facilities. The Having
in place lines of credit or other arranged
borrowing facilities.

Having at-call or short term loans
outstanding to other entities which can be
called to provide cash when needed. The
risk here is that such loans involve
counterparty risk – and calling such loans
may increase the likelihood of default if
there is widespread stress in the financial
market.

For banks, the ability to access
“Lender of Last Resort” loans or
use discount window facilities at
Central Banks provide further
potential

new issues of short- and long-
term debt instruments

new capital issues, the sale of
subsidiaries or lines of business

asset securitisation

 rapid asset growth, especially when
funded with potentially volatile
liabilities
 • growing concentrations in assets or
liabilities
 • increases in currency mismatches
 • a decrease of weighted average
maturity of liabilities

 • repeated incidents of positions
approaching or breaching internal or
regulatory limits
 • negative trends or heightened risk
associated with a particular product
line, such as rising delinquencies
 • significant deterioration in the bank’s
earnings, asset quality, and overall
 financial condition

 • negative publicity
 • a credit rating downgrade
 • stock price declines or rising debt
costs
 • widening debt or credit-default-swap
spreads
 • rising wholesale or retail funding
costs

 • correspondent banks that eliminate or
decrease their credit lines
 • increasing retail deposit outflows
 • increasing redemptions of CDs before
maturity
 • difficulty accessing longer-term
funding
 • difficulty placing short-term
liabilities (eg commercial paper)

All banks are CFP are liquidity
required to stress tests designed
to quantify the likely
produce a
impact of an event on
Contingency the balance sheet
Funding Plan and the net potential
(CFP). These cumulative gap over a
plans are to be 3-month period.
approved by
ALCO

 The bank's CFP  If a CFP results in
should reflect the a funding gap within
funding needs of a 3-month time
the bank frame, the ALCO
must establish an
 Reports of CFPs
action plan to
should be address this
prepared at least situation. The Risk
quarterly and Management
reported to ALCO Committee should
approve the action

 CFPs under each  Balance sheet
scenario must actions and
consider the impact incremental sources
of accelerated run off of funding should be
of large funds dimensioned with
providers. sources, time frame
 The plans must
and incremental
consider the impact
of a progressive,
marginal cost and
tiered deterioration, included in the CFPs
as well as sudden, for each scenario.
drastic events.

 Assumptions  The ALCO will
underlying the CFPs, implement the CFP,
consistent with each amending it necessary,
scenario, must be to meet changing
reviewed and approved conditions daily
by ALCO. reports are to be
 The Chief submitted to the
Executive/Chairman Treasury Head,
must be advised as comparing actual cash
soon as a decision has flows with the
been made to activate assumptions of the
or implement a CFP. CFP.

Risks
• Various sources of risk that investors are exposed to when investing in fixed income
securities
– Interest Rate Risk: Sensitivity of bond prices to changes in interest rates
– Yield Curve Risk: Changes in the shape of the yield curve will negatively impact bond values
– Call Risk: Bond redeemed (called) before maturity & have to reinvest at lower yields
– Prepayment Risk: Principal on amortizing securities is prepaid, and have to reinvest at lower yields
– Reinvestment Risk: Risk of reinvesting in new security with lower yields
– Credit Risk: The risk of default and the risk of decrease in bond value due to a downgrade
– Liquidity Risk: immediate sale of security will result in a price below fair value
– Exchange-Rate Risk: Foreign exchange value of the currency that a foreign bond is denominated in will fall
relative to the home currency of the investor.
– Inflation Risk: Higher inflation erodes the purchasing power of the cash flows from a fixed income security.
– Event Risk: Decrease in a security's value from disasters, corporate restructurings, or regulatory changes that
negatively impact the firm.
– Sovereign Risk: Govt. may repudiate debt, prohibit debt repayment by private borrowers, or impose general
restrictions on currency flows
– Credit spread risk: The default risk premium required in the market for a given rating can increase, even
while the yield on Treasury securities of similar maturity remains unchanged

© IMaCS 2009
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Basic Concepts-Bonds

 Fixed Income Securities (FIS): An investment that provides a return in the
form of fixed periodic payments and the eventual return of principal at
maturity. Eg. Bonds

 Bond Indenture: Contract that specifies all rights and obligations of issuer and
owners of FIS.

 Covenants: are the contracts provisions including both affirmative and
negative covenants
 Affirmative Covenants: (actions that borrower promises to perform)
1. Maintenance of certain financial ratios.
2. Timely payments of principal & interests.
 Negative Covenants: (prohibitions on the borrower)
1. Restrictions on assets sales
2. Negative pledge of collateral
3. Restrictions on additional borrowings

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Key terminologies
 Interest/coupon: The charge for the privilege of borrowing money, typically
expressed as an annual percentage rate.
 Frequency: The coupon frequency
 Principal: The original amount invested, separate from earnings.
 Maturity: The length of time until the principal amount of a bond must be
repaid.
 YTM: Yield to maturity is defined as the one discount rate at which all the
coupons needs to be discounted to arrive at the market price of the bond
 Day count: The number of days to be taken in a year for computation of
interest.
 Face Value: Value of bond stated in indenture (denominated in currency in
which payments will be made).
 Issue Price: Price at which security is issued in the market.
 Market Price: Price at which bond is traded in the market.
© IMaCS 2009
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Bonds

 Bonds: A debt investment in which an investor loans money to an
entity (corporate or governmental) that borrows the funds for a
defined period of time at a fixed interest rate.
 Types of bonds:
1. Zero Coupon Bonds -no periodic interest payments
2. Accrual bonds - interest payments at maturity
3. Step up notes -coupon rate increase over time at specified rate
4. Deferred coupon bonds- coupon payments starts after some specified
period
5. Floating Rate Securities- coupon payments varies based on specified
interest rate or index.
1. Inflation indexed bond
2. Caps, floors, collar

© IMaCS 2009
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Redemption Provisions

 Redemption Provisions: Refers to how, when, and under what
circumstances the principal will be repaid.
 Non Amortizing: Pay only interest until maturity, at which time the entire
par or face value is repaid
 Amortizing securities: Make periodic interest and principal payments over
the life of the bond.
 Prepayment options: Give the issuer/borrower the right to accelerate the
principal repayment on a loan.
 Call provisions: Give the issuer the right (but not the obligation) to retire
all or a part of an issue prior to maturity.
 Nonrefundable bonds: Prohibit the call of an issue using the proceeds
from a lower coupon bond issue.
 Sinking fund provisions: Provide for the repayment of principal through a
series of payments over the life of the issue

© IMaCS 2009
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Embedded Options
 Security owner options: gives additional value to the security, compared to
an otherwise-identical straight (option free) security.
 A conversion option: Right to convert the bond into a fixed number of common shares
of the issuer.
 Put provisions: Right to sell (put) the bond to the issuer at a specified price prior to
maturity.
 Floors: Set a minimum on the coupon rate for a floating-rate bond.

 Security issuer options: will be priced less (or with a higher coupon) than
otherwise identical option free securities.
 Call provisions: Right to redeem (payoff) the issue prior to maturity.
 Prepayment option: Right to prepay the loan balance prior to maturity, in whole or in
part, without penalty.
 Accelerated sinking fund provisions: Allow the issuer to (annually) retire a larger
proportion of the issue than is required by the sinking fund provision, up to a specified
limit.
 Caps: Set a maximum on the coupon rate for a floating-rate bond.

© IMaCS 2009
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Treasury Securities
Type Maturity Coupon payments
T bills Less than 1 yr Similar to Zero
(usually 4 weeks, 3, 6 months) coupon bonds
T Notes 2,3,5,10 yrs Semiannual coupons
Bonds 20 or 30 years Semiannual coupons
Treasury Inflation 5,10 year notes, 20 year bonds Semiannual coupons
Protected Securities (TIPS)
•TIPS : The par value is adjusted semiannually for changes in the Consumer Price Index.
•If there is deflation, the adjusted par value is reduced for that period.
•The fixed coupon rate is paid semiannually as a % of the inflation adjusted par value.
•TIPS coupon payment = (Inflation adjusted coupon value)*(stated coupon rate/2)

•On-the-run issues are the most recently auctioned Treasury issues.
•Off-the-run issues are older issues replaced by a more recently auctioned issue.

•STRIPS: Strip the coupons from the principal, repackage the cash flows, and sell them
separately as zero-coupon bonds, at discounts to par value.
•Coupon Strips: Created from coupon payments stripped from the original security
© IMaCS 2009
•Principal Strips: Bond and note principal payments with the coupons stripped off Printed 26-May-11
148

Contd.
 Medium-term notes (MTN):
 Issued periodically by corporations under a shelf registration
 Sold by agents on a best efforts basis
 Have maturities ranging from 9 months to over 30 years.
 Commercial paper :
 Short-term corporate financing vehicle
 Does not require registration with the SEC if its maturity is less than 270 days.
• Directly-placed paper-sold directly by the issuer
• Dealer-placed paper-sold to investors through agents/brokers.
 Negotiable CDs
 Issued in a wide range of maturities by banks
 Trade in a secondary market
 Are backed by bank assets.
 Bankers acceptances:
 Issued by banks to guarantee a future payment for goods shipped
 Sold at a discount to the future payment they promise
 Short term, and have limited liquidity
 Asset-backed securities :
 Debt that is supported by an underlying pool of mortgages, auto loans, credit card receivables
 Collateralized debt obligations (CDOs)
 Backed by an underlying pool of debt securities like corporate bonds, loans etc

© IMaCS 2009
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Yield Curve

 Yield Curve: curve depicting relation between yield on
bonds of same credit quality but different maturities.
 4 types of yield curves

© IMaCS 2009
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Theories of the Yield Curve
 The pure expectations theory
 Rates at longer maturities depend only on expectations of
future short-term rates
 Consistent with any yield curve shape.
 The liquidity preference theory
 Longer term rates reflect investors expectations about future
short-term rates as well as a liquidity premium
 Consistent with a downward sloping curve if an expected
decrease in short-term rates outweighs the term premium.
 The market segmentation theory
 Lenders and borrowers have preferred maturity ranges
 Shape of the yield curve is determined by the supply and
demand for securities within each maturity range,
independent of the yield in other maturity ranges.
 Consistent with any yield curve shape
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Bonds Valuation
 3 major steps in bonds valuations are
 Estimate the cash flows over the life of the security.
1. The coupon payments
2. The return of principal
Arbitrage-free valuation approach: discount each cash flow using spot rates.
 Determine the appropriate discount rate based on the risk of the receipt of
the estimated cash flows.
3 main kinds of discount rates used are
1. Yield to maturity: The rate of return anticipated on a bond if it is held until
the maturity
2. Spot rates : appropriate discount rates for individual future payments
3. Forward rates: current lending rates for loans to be made in future periods
 Calculate the present value of the estimated cash flows by multiplying the
bond„s expected cash flows by the appropriate discount factors.
© IMaCS 2009
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Price Volatility Characteristics of FIS

 Price/Yield relationship for option-free bonds
 Price of bond changes inversely to the change in yield
Yield % 8%/ 5-year
6 108.9826
7 104.3760
7.5 102.16
7.9 100.4276
7.99 100.0427
8 100
8.01 99.9574
8.1 99.57462
8.5 97.8944
9 95.8417

© IMaCS 2009
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Observation from graphs
 Relationship is not linear (its convex).
 Slope gives measure of sensitivity of price for variation in yield (Duration)
 Higher the market yield, lower the interest rate risk (curve less steep at higher
yields).
 As yield increases, price of option-free bond decreases.
 For discount and premium bonds, the price changes even if the yield remains the
same as we move towards maturity.
 Price of discount (premium) bond increases (decreases) as it moves towards
maturity, reaching at par value at maturity.
 Absolute dollar price change and absolute % price change are different for an
equal increase and decrease in yields
 Volatility can be measured in terms of dollar price change and percentage price
change . It depends on maturity, coupon rate, YTM

© IMaCS 2009
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Bonds with options

 Negative convexity in putable and callable bonds
 Price of callable bond can not exceed the call price (negative convexity).
 Value of callable bond = (value of option free bond - call premium)
 (Value of callable bond) < (value of option free bond)
 Value of putable bond cannot decline more than put price (negative convexity).
 Value of putable bond= (value of option free bond+ value of put)
 Value of putable bond > value of option free bond

© IMaCS 2009
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Debt Market in India

Distribution of securities Distribution of number of trades
1% 0% 1%
1% 2% 1%
1%
8%
14% A
A 10%
3% A-
A-
A+
A+
AA
17% AA
62% AA-
AA-
AA+ 79% AA+
AAA
AAA

60% of AAA securities accounted for 80% of the total trade in past 2 years
© IMaCS 2009
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Interest rate movement in India
10.00%

9.00%

8.00%

7.00% 3M
6M
6.00% 9M
12M
5.00%

4.00%

© IMaCS 2009
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Yield curve structure-India –current scenario
10.00%

9.50%

9.00%

8.50%

8.00%

7.50%

7.00%
0.25-0.5 0.5-1 1.0-2.0 2.0-3.0 3.0-4.0 4.0-5.0 5.0-6.0 6.0-8.0 8.0-10.0 >10.0

© IMaCS 2009
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Introduction to Interest rate risk

 Risk due to variation in financial condition of the Bank due to
variation in interest rates
 Reprising risk
 Yield curve risk
 Option risk
 Basis risk
 The immediate impact of variation in interest rates is on the
earning of the Bank
 A long term impact of change in interest rates is on the net
worth, since the economic value of assets and liabilities get
affected
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Types of interest rate risk … 1

 Re-pricing risk
 Risk due to timing difference in the maturity (for fixed rate) and
repricing (for floating rate) of assets and liabilities and off balance
sheet (OBS) position
 Banks usually have assets deployed at fixed rates (pre-determined at
the time of contract) and also at variable rates (changes with change in
benchmark interest rates), which get run down in the EMI structures
regularly.
 On the other hand the liabilities have varying structures that include
repayment in installments and bullets. This leads to reprising risk

© IMaCS 2009
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 Yield curve risk
 Yield curve risk is the risk of change in the shape or slope of the yield
curve

 Usually banks borrow short term and lend long term, thus flattening
of the yield curve increases the cost of funds, whereas the interest
earned does not increase proportionately. Thereby leading to pressure
on the profitability of the Bank

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Example of yield curve risk
10.00%

9.00%

8.00%

3M
7.00% 6M
9M
12M

6.00%

5.00%

4.00%
15-Feb-10 15-Mar-10 15-Apr-10 15-May-10 15-Jun-10 15-Jul-10 15-Aug-10 15-Sep-10 15-Oct-10 15-Nov-10

© IMaCS 2009
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 Basis risk
 Assets and liabilities are linked to different benchmark yield curves
 Movement in the benchmark yield curves are seldom same in
direction and magnitude
 Any variance in the direction and magnitude of different benchmark
yield curves would lead to volatility in the profitability of the bank
 The risk that value of assets and liabilities change by the same
magnitude by change in interest rates is termed as basis risk

© IMaCS 2009
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 Option risk
 Change in interest rate that could lead to funds being withdrawn by
the exercise of the option embedded with the product

 Also change in interest rate could lead to cash flows being received
earlier than expected as a result of options being exercised

 Thus option risk is the risk that a change in prevailing interest rates
will lead to an adverse impact on the earnings or capital by change in
timing of the cash-flows of assets or liabilities

© IMaCS 2009
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Reasons for interest rate risk

 On account of asset transformation

 Many deposits are used for one big loan

 Non-periodical review of assets and liabilities

 Due to mismatches between maturity / reprising dates as well

as maturity amounts between assets and liabilities

 Depositors and borrowers may pre-close their accounts

© IMaCS 2009
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Earnings vs. economic value

 Earnings perspective: It involves the impact of changes in
interest rates on accrual or reported earnings in the near term.
This is measured by measuring the changes in NII and NIM

 Economic value perspective: It involves the impact of interest
rates on the expected cash-flows on assets minus the expected
cash-flows on liabilities. It focuses on the risk to net worth
arising from all reprising mismatches and other interest rate
sensitive positions. It identifies the risk arising from long
term interest rate gaps

© IMaCS 2009
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Factors Affecting NII.

 Changes in the level of interest rates.

 Changes in the volume of assets and liabilities.

 Change in the composition of assets and liabilities.

 Changes in the relationship between asset yields and

liabilities. cost of funds.

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Example-impact of interest rate on profitability

Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.0% 600 4.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.08x500+0.11x350) - (0.04x600+0.06x220)
78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
© IMaCS 2009
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Exhibit 1

 1% increase in the level of all short-term rates.
 1% decrease in spread between assets yields and
interest cost.
 RSA increase to 8.5%
 RSL increase to 5.5%
 Proportionate doubling in size.
 Increase in RSAs and decrease in RSL‟s
 RSA = 540, fixed rate = 310
 RSL = 560, fixed rate = 260.

© IMaCS 2009
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1% Increase in Short-Term Rates

Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.09x500+0.11x350) - (0.05x600+0.06x220)
83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74%
GAP = 500 - 600 = -100
© IMaCS 2009
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1% Decrease in Spread

Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.085x500+0.11x350) - (0.055x600+0.06x220)
81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09%
GAP = 500 - 600 = -100
© IMaCS 2009
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Proportionate Doubling in Size

Rate sensitive 1000 8.0% 1200 4.0%
Fixed rate 700 11.0% 440 6.0%
Non earning 300 200
1840
Equity
160
Total 2000 2000

NII = (0.08x1000+0.11x700) - (0.04x1200+0.06x440)
157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200
© IMaCS 2009
Printed 26-May-11
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Increase in RSAs and Decrease in RSLs

Fixed rate 310 11.0% 260 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000

NII = (0.08x540+0.11x310) - (0.04x560+0.06x260)
77.3 - 38 = 39.3
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
© IMaCS 2009
Printed 26-May-11
175

There are four methods for measuring Interest
Rate Risk

Gap Analysis method
Duration and Convexity method
Simulation and Scenario analysis method
Value at Risk method

Each method has its advantages, disadvantages and
complexities which is explained subsequently. For this
workshop, we will limit our discussions to Gap method and
duration method.

© IMaCS 2009
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What is a Gap?

Gap = Risk Sensitive Assets (RSA) - Risk Sensitive Liabilities (RSL)

1. Risk Sensitive Assets and Liabilities are those whose values are
affected by interest rate movement

2. For interest risk analysis, gap is calculated for each bucket
according to repricing or residual maturity, whichever earlier

3. If they do not have contractual maturity, behaviourial maturities
to be used

4. Gap analysis, though simple, forms the basis of calculations
based on which Asset-Liability Mismatch limits are set

© IMaCS 2009
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Gap Report: Key concepts

A gap report calculates the gap over different time intervals
and the cumulative gap of a period
 Gap report based on reprising maturities is used for analysis of Interest Rate
Risk
 Gap report based on actual maturities is used for analysis of Liquidity Risk

Gap reports can be Static or Dynamic:
 Static Gap report is based on actual data on assets, liabilities and hedges on
a particular day
 Dynamic Gap report is based on projections of assets, liabilities and hedges
on a particular day taking into account bank‟s business plans

© IMaCS 2009
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Bucketing

 1 to 14 days
 15 day to 30 / 31 days (one month)
 Over one month and up to 2 months
 Over 2 months and up to 3 months
 Over 3 months and up to 6 months
 Over 6 months and up to 1 year
 Over 1 year and up to 3 years
 Over 3 years and up to 5 years
 Over 5 years

© IMaCS 2009
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Bucketing of assets and liabilities
Liabilities
1. Capital Non-sensitive
a) Equity and perpetual preference
shares Non-sensitive
b) Non-perpetual preference shares Non-sensitive
2. Reserves & surplus Non-sensitive
3. Gifts, grants, donations &
benefactions Non-sensitive
4. Notes, bonds & debentures
Sensitive; reprice on the roll- over/repricing date should
be slotted in respective time buckets as per the
a) Plain vanilla bonds/debentures repricing dates.
Sensitive; could reprice on the exercise date of the
option particularly in rising interest rate scenario. To be
b) Bonds Debunture with placed in respective time buckets as per the next
embedded options exercise date.
Sensitive; reprice on maturity. To be placed in
respective time buckets as per the residual maturity of
c) Fixed rate notes such instruments.
© IMaCS 2009
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Bucketing of assets and liabilities(contd.)

5. Deposits
Sensitive: could reprice on the repricing date in case of
a) Term deposits from public floating or reprice on maturity if fixed
Sensitive; reprice on maturity. To be placed in respective
time buckets as per the residual maturity of such
b) ICDs instruments.
c) Certificate of Deposit instruments.
6.Borrowings
a) Term money borrowings from time buckets as per the residual maturity of such
Banks instruments.

b) From Bangladesh Bank, Govt., & Sensitive: could reprice on the repricing date in case of
others floating or reprice on maturity if fixed
c) Bank Borrowings in the nature of Sensitive: could reprise on the reprising date in case of
WCDL, CC etc floating or reprise on maturity if fixed

© IMaCS 2009
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7. Current Liabilities & provisions:
a) Sundry creditors Non-sensitive
b) Expenses payable (other than
interest) Non-sensitive
c) Advance income received, receipts
from borrowers pending adjustment Non-sensitive
d) Interest payable on bonds/deposits Non-sensitive
e) Provisions (other than for NPAs) Non-sensitive
8. Contingent Liabilities
a) Letters of credit/guarantees Non-sensitive
b) Loan commitments pending
disbursal (outflows) NA
c) Lines of credit committed to other
institutions (outflows) NA
d) Outflows on account of forward Sensitive: should be bucketed according to the maturity of
exchange contracts, rupee/dollar swap the contract
9. Commercial Paper floating or reprice on maturity if fixed
10. Others (Subordinate Debt) floating or reprice on maturity if fixed
© IMaCS 2009
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Assets
1. Cash Non-sensitive
2. Remittance in transit NA
3. Balances with banks
a) Current account Non-sensitive
b) Deposit /short-term deposits instruments.
4. Investments (net of provisions) floating or reprice on maturity if fixed
a)Bills of exchange and promissory time buckets as per the residual maturity of such
notes discounted & rediscounted instruments.
b) Term loans (only rupee loans) floating or reprice on maturity if fixed
c) Corporate loans/short term loans floating or reprice on maturity if fixed
© IMaCS 2009
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6. Non-performing loans Same as Bucketing criteria of SLG
Sensitive on cash flows. The amounts should be
distributed to the respective maturity buckets
7. Inflows from assets on lease corresponding to the cash flow dates.
8. Fixed assets (excluding assets on
lease) Non-sensitive
9. Other assets :
a) Intangible assets & other non-cash
flow items Non-sensitive
b) Interest and other income receivable floating or reprice on maturity if fixed
In respective maturity buckets as per the timing of the
c) Others cashflows.
10. Lines of credit committed by
other institutions (inflows) 1-14 day time bucket
11. Bills rediscounted (inflow) floating or reprice on maturity if fixed
12. Inflows on account of forward
exchange contracts, dollar/rupee In the respective time buckets as per the residual maturity
swaps of the underlying bills/transactions.
13. Others NA
© IMaCS 2009
Printed 26-May-11
184

Important points to be considered while auditing Gap
Statements for measuring interest rate risk
 Number of time buckets
 Choosing too few may not give meaningful results
 Choosing too many will be difficult to interpret
 5 to 12 time buckets may be ideal
 Length of time buckets may depend on maturity mix of assets and liabilities
 Length of bucket depends on the type of institution
 It depends on the how developed the market for asset and liabilities are across
maturities
 The first few buckets are generally shorter
 Buckets should not be too heavy or light under “normal” conditions
 A bucket having 30% or more of assets or liabilities should be split into two
buckets
 Buckets containing less than 5% of the assets or liabilities are considered light
and should be combined
© IMaCS 2009
Printed 26-May-11
185

Important points to be considered while auditing slotting
of assets and liabilities for measuring interest rate risk
 On and off- Balance sheet items are slotted into appropriate buckets as per
maturities. Maturities can be classified into three types:
 Repricing
 Contractual
 Remaining
For estimating interest rate risk repricing maturities may be used.

 For example: 5 year variable rate bond with a coupon of 6-months LIBOR will be
slotted in the 6-month bucket as the bond will reprice according to movements in
6-month LIBOR.

 Non-interest sensitive items like capital are slotted into the last time bucket.

© IMaCS 2009
Printed 26-May-11
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Group Exercise : Slotting of cash flows
The bonds with following maturity details should be classified under which time
bucket. Options are: (a) Less than 1 month, (b) 1 to 3 months, (c) 3 to 6
months, (d) 6 months to 1 year, (e) 1 to 3 years and (f) 3 to 5 years

i. Today: 1st February, 2005
ii. Issue Date: 1st January, 2000
iii. Maturity Date: 30th June,
2005
iv. Bond reprices on 1st January

© IMaCS 2009
Printed 26-May-11
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Other important points to be considered while auditing slotting of
assets and liabilities for estimating interest rate risk
Principal vs. The principal to be slotted in the contractual
Cash Flows
maturity
Accrued interest, if shown in balance sheet, should
be slotted in the bucket it will be actually received

Amortizing Loans Calculate payments and segregate the principal and
interest components
Slot only the principal in the bucket

Liabilities Liabilities with non-contractual maturities

• Core vs. Volatile
• Trend, seasonal and cyclical components

© IMaCS 2009
Printed 26-May-11
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Gap report
Residual Impact of 1%
Time Buckets RSA RSL GAP Period change in
(Mid Point) Interest Rate
A B C=A-B D 1%*C*D/12

1 to 14 days 797 390 407 0.25 0.08

14 days to 30 / 31 days (one 297 349 -52 0.75 -0.03
month)
Over one month to 2 months 202 168 34 1.50 0.04

Over 2 months to 3 months 1309 1240 69 2.50 0.14

Over 3 months and up to 6 618 1051 -433 4.50 -1.63
months
Over 6 months and up to 1 year 1381 900 481 9.00 3.61

Total 4604 4098 506 2.22 © IMaCS 2009
Printed 26-May-11
189

Different types of Gap

Periodic Gap
Gap for each time bucket
Measures the income effects from interest rate changes

Cumulative Gap
– Sum of periodic Gaps
– Measures aggregate interest rate risk over the entire
period

© IMaCS 2009
Printed 26-May-11
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Types of Gap: Positive Gap & Negative Gap

A negative gap for a particular time A positive gap for a particular time
bucket is when the Rate Sensitive bucket is when the Rate Sensitive Assets
Liabilities exceed Rate Sensitive Assets exceed Rate Sensitive Liabilities

Liabilities reprice faster than assets Assets reprice faster than liabilities

Long term assets funded with shorter Short term assets funded with Long term
term liabilities Liabilities

An increase in interest rate leads to an An increase in interest rate leads to a
decrease in NII increase in NII

© IMaCS 2009
Printed 26-May-11
191

Illustration: A liability sensitive gap

Gap and Cumulative Gap
1.Since there are more liabilities at the
150
shorter end, the institution is
100
50 borrowing short and lending long.
0
-50
-100 2. Therefore liabilities reprise faster
-150
-200 than assets
-250
1 2 3 4 5 6 7
3. Increase in interest rates leads to a
Period 1 2 3 4 5 6 7 decrease in the Net interest income.
Assets 20 50 60 40 80 100 150
Liabilities 90 160 70 60 50 40 30 4. This is called a negative gap.
Gap -70 -110 -10 -20 30 60 120
Cum. Gap -70 -180 -190 -210 -180 -120 0

© IMaCS 2009
Printed 26-May-11
192

Illustration: An asset sensitive gap

Gap and Cumulative Gap
1.Since there are more assets at the
250
200
shorter end, the institution is
150
100
borrowing long and lending short
50
0
-50 2. Therefore assets reprice faster than
-100
-150 liabilities
1 2 3 4 5 6 7

3. Increase in interest rates leads to an
Period 1 2 3 4 5 6 7 increase in the Net interest income.
Assets 100 150 70 60 50 50 30
Liabilities 30 50 60 40 80 100 150
4. This is called a positive gap
Gap 70 100 10 20 -30 -50 -120
Cum. Gap 70 170 180 200 170 120 0

© IMaCS 2009
Printed 26-May-11
193

Management of gaps

 Management should cap the gap for each time bucket and the
cumulative gap based on
 Regulatory requirement
 Risk appetite of the Bank
 The gap can be adjusted to positive or negative based on the
interest rate perception of the bank
 Should have more rate sensitive assets in case of interest rates are
perceived to go up
 Should have more rate sensitive liabilities in case interest rates are
perceived to go down

© IMaCS 2009
Printed 26-May-11
194

Group Exercise

Bank’s asset liability maturity profile is given below:
Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 months
Total assets 97967 502495 71691 11519 44840 18937
Total liabilities 203567 285347 285302 30967 4513 3070

1. Does the Bank have a positive gap or a negative gap?

2. Find the interest rate sensitivity of the bank‟s NII to a 5% increase
in interest rates for (a) Quarter (b) Half year (c) Year

Assume all assets and liabilities as fixed rate.

Hint: If interest rates change and we are noticing the impact for a quarter, only the cash flows
relevant up to the quarter will be effected and for a quarter only

© IMaCS 2009
Printed 26-May-11
195

Help guide for Exercise

 Step 1: Calculate the Net Gap

 Step 2: Calculate duration for repricing

 Step 3: Calculate the impact of 5% rise in interest rate on the
NII by using the following formula:
[(Net Gap) * (duration for repricing) * (period/12) * (change in interest
rate)]

© IMaCS 2009
Printed 26-May-11
196

Solution : Impact of 5% increase in interest rate for
one Quarter
 Step 1: Calculate the Net Gap
Total assets 97967 502495 71691 11519 44840 18937
Total liabilities 203567 285347 285302 30967 4513 3070
Gap -105600 217148 -213611 -19448 40327 15867

 Step 2: Calculate duration for reprising
= [(3 months/ 12) – (Reprising after how much time)]
0.000 0.042 0.167 0.375 0.625 0.875

 Step 3: Calculate the impact of 5% rise in interest rate on the
NII by using the following formula:
= [(.25*-105600*.25*5%) + (.208*217148*.25*5%) + (.083*-
213611*.25*5%) ]
= 12.98
© IMaCS 2009
Printed 26-May-11
197

Solution: Impact of 5% increase in interest
rate for half year and full year

 For a quarter- 12.98

For half year- 0.500 0.458 0.333 0.125
x x 0. 5 x 5%= -672.7
-105600 217148 -213611 -19448

For whole year-
1.000 0.958 0.833 0.625 0.375 0.125
x x 1 x 5%= -3528
-105600 217148 -213611 -19448 40327 15867

© IMaCS 2009
Printed 26-May-11
198

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