THE BUSINESS OF
BANKING
Chapter 11
Hong Kong Banking Industry
• Three Tier Structure
Link
Fully Licensed Banks
-21 Locally Incorporated
-164 Foreign Incorporated
Restricted License Banks: Securities Companies
- 20 RLB’s
Deposit Taking Corporations: Finance Companies
- 23 DTC’s
Licensed banks incorporated in Hong Kong
At 17 October 2014
BANK OF EAST ASIA, LIMITED (THE)
1
HONGKONG & SHANGHAI BANKING CORPORATION LIMITED (THE)
STANDARD CHARTERED BANK (HONG KONG) LIMITED
1
1
2
2
2
2
2
BANK OF CHINA (HONG KONG) LIMITED
3
CHINA CITIC BANK INTERNATIONAL LIMITED
3
CHINA CONSTRUCTION BANK (ASIA) CORPORATION LIMITED
3
3
3
4
4
4
4
4
4
4
4
SHANGHAI COMMERCIAL BANK LIMITED
CITIBANK (HONG KONG) LIMITED
DBS BANK (HONG KONG) LIMITED
OCBC WING HANG BANK LIMITED
PUBLIC BANK (HONG KONG) LIMITED
INDUSTRIAL AND COMMERCIAL BANK OF CHINA (ASIA) LIMITED
NANYANG COMMERCIAL BANK, LIMITED
CHIYU BANKING CORPORATION LIMITED
CHONG HING BANK LIMITED
DAH SING BANK LIMITED
FUBON BANK (HONG KONG) LIMITED
HANG SENG BANK, LIMITED
TAI SANG BANK LIMITED
TAI YAU BANK, LIMITED
WING LUNG BANK LIMITED
1. Modern Local
2. International
3. China State
4. Native
1.
2.
3.
4.
Historical Origins
Modern Local Banks: Pre-war banks. (HSBC, Bof
EA,).
International Banks –. (Citibank, StanChart, DBS)
Chinese State Banks – Chinese government set up
banks in HK in pre-war era. After the revolution,
these were taken over by PRC. Due to the isolation
of PRC, these banks were the main link between the
mainland and the world financial system (Bank of
China, Nanyang Commercial)
Native Banks – Banks that serviced the rapidly
growing retail markets for small deposits and loans
during the immediate post-war migration of
immigrants from the mainland (Hang Seng, Wing
Lung, Dao Heng and many others)
Transactions Costs
• Debt serves a useful purpose in matching those who currently have
greater income than consumption to those with greater consumption
than income.
• However, matching buyers and sellers involves some costs.
Institutions develop to reduce these costs.
1. Pooling Savings
2. Providing Liquidity
3. Reduce Information
Costs
•Take advantages of
economies of scale
•Diversify Risks
• Safekeeping of Assets
•Reduce transactions costs
by allowing depositors to
convert assets into cash.
•Ameliorate asymmetric
information
Licensed Banks Aggregate Balance Sheets
Licensed Banks
Assets (AS)
Notes and Coins
Amount Due from Authorized Inst in HK
Amount Due from Banks Abroad
Loans and Advances to Customers
NCDs
Negotiable Debt Instruments (NDI)
Investments in Shareholdings
Interest in Land and Buildings
Other Assets
Aug, 2014
$17,894,835
$30,666
$666,889
$4,370,821
$7,061,604
$260,990
$3,625,634
$205,224
$191,474
$1,481,533
Liabilities (LB)
Amount Due to Authorized Inst in HK
Amount Due to Banks Abroad
Deposits from Customers
NCD Outstanding
Other Debt Instruments Outstanding
Capital, Reserves and Other Liabilities
$17,894,835
$800,188
$4,032,018
$9,815,768
$906,941
$298,367
$2,041,553
Multiple Currency Deposits
• Hong Kong banks accept large amounts of foreign
currency deposits.
• Small market for Foreign currency loans in Hong Kong.
• HK banks lend money to banks overseas, multinational
banks lend money to firms overseas.
Link
Bank Assets
1.
2.
3.
4.
Cash Items Primary Reserves (Vault cash + Clearing Balances), Current
Balances at Other Banks.
Loans Interbank Lending, Advances to Customers
Securities Government Bonds, MBS, Corporate Debt, Large CD’s, Stocks.
Other Assets Land, Buildings, etc.
ASSETS
Cash and balances with banks
Placings with and advances to banks
Trading assets
Financial assets designated at fair value
Derivative financial instruments
Loans and advances to customers
Financial investments
Interest in associates
Investment properties
Premises, plant and equipment
Intangible assets
Other assets
Total assets
33,294
131,363
31,996
6,987
6,646
586,240
282,845
2,062
10,918
21,000
7,974
22,405
1,143,730
1
2
3
3
3
2
3
4
4
4
4
4
Liabilities
1.
2.
3.
Checkable & Non Transactions Deposits: Checking
accounts, current accounts, demand deposits,savings
deposits, time deposits, certificates of deposit.
Borrowings: Discount window borrowing, borrowing in
interbank market.
Other Liabilities: Subordinated debt, deferred tax liabilities
LIABILITIES
Current, savings and other deposit accounts
Deposits from banks
Trading liabilities
Financial liabilities designated at fair value
Derivative financial instruments
Certificates of deposit and other debt securities in issue
Other liabilities
Liabilities to customers under insurance contracts
Current tax liabilities
Deferred tax liabilities
Subordinated liabilities
Total liabilities
824,996
11,826
62,117
489
5,246
8,601
20,467
85,844
692
3,850
11,824
1,035,952
1
2
2
2
1
3
3
3
3
Hong Kong Interbank Market
• Hong Kong deposit market dominated by big branch
networks many smaller banks raise funds by borrowing
from big banks.
• Until 2001, HK limited branch networks of foreign banks.
Foreign banks finance HK lending with loans from
overseas parent.
• HK banks accept many foreign currency deposits. Lend
that F.C. to banks overseas.
Bank Net Worth/Shareholder Funds:
Funds put at risk by the owners of the bank.
• Share Capital: Money raised by selling equity shares in
Primary Markets
• Retained Earnings : Profits not (yet) paid as dividends.
• Balance sheet typically includes some proposed dividend.
• For tax purposes, some retained earnings are classified as other
reserves
Profits of Banking:
Interest Income
• Banks collect retail deposits from savers and make loans
to borrowers.
• Profits are earned by banks when they are able to make
loans at higher interest rates than they pay depositors.
• Net Interest Income is the interest rate earned on assets
(mainly loans) minus the average interest paid on
liabilities (mainly deposits).
Mar, 1997
Aug, 1997
Jan, 1998
Jun, 1998
Nov, 1998
Apr, 1999
Sep, 1999
Feb, 2000
Jul, 2000
Dec, 2000
May, 2001
Oct, 2001
Mar, 2002
Aug, 2002
Jan, 2003
Jun, 2003
Nov, 2003
Apr, 2004
Sep, 2004
Feb, 2005
Jul, 2005
Dec, 2005
May, 2006
Oct, 2006
Mar, 2007
Aug, 2007
Jan, 2008
Jun, 2008
Nov, 2008
Apr, 2009
Sep, 2009
Feb, 2010
Jul, 2010
Dec, 2010
May, 2011
Oct, 2011
Mar, 2012
Aug, 2012
Jan, 2013
Jun, 2013
Nov, 2013
Apr, 2014
Net Interest Margin: Net Interest Income divided by
Interest Earning Assets.
Net Interest Margin: Local & Foreign Retail Bank
2.5
2
1.5
1
0.5
0
Investment Income, etc.
Changes in Value of Subsidiaries etc.
Capital Adequacy Management
•
•
•
Compared to non-financials, banks have low
capitalization.
Bank capital is the funds invested by the owners of
banks in the bank.
Three factors affect the decisions of bank owners to
finance with equity capital:
1.
2.
3.
Bank capital prevents bank failure.
Bank capitalization affects returns to shareholders
Government regulations affect capitalization (next chapter)
Bank Failure
• Bank failure occurs when a bank cannot pay its
depositors in full.
• Riskier and less liquid assets make bank failure more
likely.
• Banks with high levels of capital can have some negative
profits and still avoid failure.
• Bank owners need to invest their own funds to offset its
own moral hazard issues.
How Bank Capital Prevents Bank Failure
• Consider two banks with identical balance sheets
except that Bank A is well capitalized while bank
B is poorly capitalized.
Assets
Liabilities
Assets
Liabilities
Reserves $10
Deposits $90
Reserves $10
Deposits $96
Loan $90
Capital $10
Loan $90
Capital $4
How Bank Capital Prevents Bank Failure
• Bad economic times cause borrowers to default
on $5 million in loans. This wipes out the capital
of the weakly capitalize bank but leave the highly
capitalized bank in business.
Assets
Liabilities
Assets
Liabilities
Reserves $10 Deposits $90
Reserves $10
Deposits $96
Loan $85
Loan $85
Capital -$1
Capital $5
USA
HK
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
n14
n13
n12
n11
n10
n09
n08
n07
n06
n05
n04
n03
n02
n01
Equity to Asset Ratio Commercial Banks
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
Equity Multiplier ROA/ROE
• This is assets relative to
ASSETS
EM 
EQUITY CAPITAL
shareholders equity (i.e.
net worth less loan capital)
PROFITS
• A measure of the returns
ROA 
earned on assets is Return
TOTAL ASSETS
on Assets
PROFITS
• Owners of equity are
ROE 
 ROA  EM
EQUITY CAPITAL
concerned with the pay-off
they earn per each dollar
originally invested in the
bank: Return on Equity
• Equity returns are a
Assets
1,143,730 EM
10.6119
positive function of ROA Liabilities 1,035,952 ROA
0.0233
and leverage
Net Worth 107,778 ROE
0.2475
Profits
26,678
Basil Capital Accords
• International Treaty sets minimum standards for bank
regulation. Committee meets under the auspices of the Bank
for International Settlements: the central bank of central
bankers.
• Treaty defines Capital Adequacy Ratio:
Capital
CAR 
Risk Adjusted Assets
• Basi requires HK banks to maintain a Capital Adequacy Ratio
of at least 8%
Risk Adjusted Assets
• The risk adjusted assets of a bank are a
weighted some of loans and other assets, with
the weights being an increasing function of
risk.
• A bank has n = 1, …, N assets. Asset n has a
dollar value of Ln.
• Total assets = L1 + L2 + ….LN
• Regulators assign a weight to each asset, wn,
that is increasing in the level of credit risk.
• Risk adjusted Assets = w1L1 + w2L2 +….wN L3
CAR
• Risk Adjusted Assets are weighted sum of assets with
higher weights for higher risk.
Original risk weight categories have become more
complicated
1.OECD Government. 0%
2.Banking. 20% (weight = .2)
3.Secured Residential Lending. 50% (weight = .5)
4.Commercial and consumer loans, corporate bonds.
100%-150% (weight = 1-1.5)
May, 2014
Jan, 2014
Sep, 2013
May, 2013
Jan, 2013
Sep, 2012
May, 2012
Jan, 2012
Sep, 2011
May, 2011
Jan, 2011
Sep, 2010
May, 2010
Jan, 2010
Sep, 2009
May, 2009
Jan, 2009
Sep, 2008
May, 2008
Jan, 2008
Sep, 2007
May, 2007
Jan, 2007
Sep, 2006
May, 2006
Jan, 2006
Sep, 2005
May, 2005
Jan, 2005
Sep, 2004
May, 2004
Jan, 2004
Sep, 2003
May, 2003
Jan, 2003
Sep, 2002
Capital Adequacy Ratio of HK Banks
All Locally Incorporated AIs: Capital Adequacy Ratio
18
16
14
12
10
8
6
4
2
0
Basel II
• Banks are required to have some share of their
operating income as capital.
• The new accord creates more sophisticated way
of measuring credit risk.
• Banks must keep capital depending on assets and
operating income increasing capital requirements.
• Banks to apply their own credit models (based on
statistical analysis and valuation of collateral and
hedging to their liabilities) This will likely reduce
capital needed.
Credit Risk:
•
•
•
Credit Risk: The risk arising from the possibility that the
borrower will default.
Financial Intermediaries in general and banks in
particular exist because of their efficiency in dealing with
credit risk.
Much of credit risk in financial markets occurs due to
asymmetric information and its associated phenomena,
adverse selection and moral hazard.
Managing Banks: Balance Risks and Returns
• Banks must take risks as part of their business.
• Often most profitable activities of a bank will generate
most risks for the banks.
• Bank managers must manage risk return trade-offs.
Principles for Maximizing Returns while
dealing with credit risk
Diamonds in the rough
•
Banks try to find borrowers who will pay high interest rates but
who are unlikely to default.
•
Borrowers who are well known to be good credit risks will have
many sources of funds.
•
Banks need to find information about certain borrowers not
publicly available.
Strategies for Managing Credit Risk
Credit-Risk Analysis – A loan officer manages banks
relationship with borrowers and evaluate potential borrowers.
1.
•
•
2.
Loan officers may have some specialization with certain industries or
businesses.
Loan officers also use credit scoring systems which use statistical data
to measure default probabilities and charge interest rate
commensurate with risk.
Monitoring – Loan agreements may contain restrictions on
borrower behavior or value of assets. Loan officers
monitor behavior and may recall loans if covenants are
violated.
Strategies for Managing Credit Risk (cont.)
3. Collateral – Loans identify physical assets
which may be taken by the bank in case of
default.
4. Long-term Relationships – Banks often have
relationships with certain businesses which
reduces information problems. elationships
have value to businesses which they are
loathe to jeopardize by engaging in moral
hazard behavior.
Strategies for Managing Credit Risk (cont.)
5.
6.
•
Credit Rationing - Borrowers must seek
additional sources of finance for their projects
including equity.
Diversification – Banks can limit the likelihood of
default by reducing exposure to a particular
borrower or class of borrower.
Sometimes there is a trade-off between
diversification needs and strategies for finding
diamonds in the rough, such as specialization or
long-term relationships which may tend to reduce
Measures of Credit Risk
•
1.
2.
3.
Assessing a bank’s exposure to credit risk, we could
ask 3 questions:
What is the historical loss rates on loans and
investments?
What are the expected losses in the future?
How is the bank prepared to weather the losses?
Historical Loss Rate
• Loan losses/charge-offs are the loans written off as
uncollectible in any period.
• Releases & Recoveries refer to loans written off in the
past but collected or collateral repossessed.
• Net loan losses are gross loan losses less recoveries.
Expected Future Losses
Measures
• Past Due Loans: Borrowers have not made a scheduled
payment.
• Nonperforming Loans: Loans past due for 90 days are
more.
-1
Overdue > 3 month & Rescheduled Loan: Local & Foreign Retail Bk(LF)
Bad Debt Charge to Average Total Assets: Local & Foreign Retail Bank
Apr, 2014
Nov, 2013
Jun, 2013
Jan, 2013
Aug, 2012
Mar, 2012
Oct, 2011
May, 2011
Dec, 2010
Jul, 2010
Feb, 2010
Sep, 2009
Apr, 2009
Nov, 2008
Jun, 2008
Jan, 2008
Aug, 2007
Mar, 2007
Oct, 2006
May, 2006
Dec, 2005
Jul, 2005
Feb, 2005
Sep, 2004
Apr, 2004
Nov, 2003
Jun, 2003
Jan, 2003
Aug, 2002
Mar, 2002
Oct, 2001
May, 2001
Dec, 2000
Jul, 2000
Feb, 2000
Sep, 1999
Apr, 1999
Nov, 1998
Jun, 1998
Jan, 1998
Aug, 1997
Mar, 1997
Hong Kong Credit Performance
10
9
8
7
6
5
4
3
2
1
0
Net Chargeoff Rates by Loan Type
Source: FDIC Statistics on Banking
4.00%
3.50%
3.00%
2.50%
2004
2003
2.00%
2002
2001
1.50%
1.00%
0.50%
0.00%
Total loans & Total real estate Commercial &
leases
loans
industrial loans
Loans to
individuals
All other loans
& leases
(including farm)
Net Charge-off Rates by Loan Type
Source: USA FDIC Statistics on Banking Link
Net Chargeoff Rates
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
2013
Net loans and leases
2011
All real estate loans
2009
Commercial and industrial loans
2007
Loans to individuals
Dec, 1990
Sep, 1991
Jun, 1992
Mar, 1993
Dec, 1993
Sep, 1994
Jun, 1995
Mar, 1996
Dec, 1996
Sep, 1997
Jun, 1998
Mar, 1999
Dec, 1999
Sep, 2000
Jun, 2001
Mar, 2002
Dec, 2002
Sep, 2003
Jun, 2004
Mar, 2005
Dec, 2005
Sep, 2006
Jun, 2007
Mar, 2008
Dec, 2008
Sep, 2009
Jun, 2010
Mar, 2011
Dec, 2011
Sep, 2012
Jun, 2013
Mar, 2014
Loans in HK by Type
100%
90%
80%
70%
60%
50%
Financial Concerns
Other Individual
40%
Individual Residential
Construction&Development
Commercial&Industrial
30%
20%
10%
0%
Protection Against Future Losses
• Loan Loss Reserve (Allowances for Loan
Impairment): Quantity of gross value of loans
that have been recognized as being likely to not
be repaid.
• Net Loans (which appears as an asset on
balance sheet) = Gross Loans – Loan Loss
Reserve.
• When banks add to their loan loss reserve, they
will deduct from profits.
• When banks charge-off bad loans, they deduct
from gross loans and loan loss reserve and net
assets are unchanged..
Credit Derivatives
Risk Management Tools Used to transfer risk from one
party to another.
• Credit Default Swaps (CDS) – A bank with credit risk
exposure will pay X basis points per year and counterparty will make payment if there is a pre-determined credit
“event” such as default or credit downgrade, etc.
Credit Default Swap
Bank A
Fee Payment
Payment if negative
credit event
Bank B
All counterparties (gross)
50000000
45000000
40000000
35000000
30000000
25000000
20000000
15000000
10000000
5000000
0
Source: BIS Derivative Statistics
Liquidity Management
•
Majority of Bank liabilities (deposits) are very Liquid.
1.
Banks provide payment mechanism to customers and
are able to raise funds at low interest as a result.
2.
Liquidity advantage of depositors helps overcome
asymmetric information advantage of bankers.
•
Most profitable bank assets, loans, are illiquid.
1. Banks particular expertise is in analyzing and monitoring
long-term investment projects. Often expertise about a
given project is specific to the bank itself and can’t be
transferred. Banks loan portfolios are highly illiquid.
Liquidity Risk: The possibility that depositors may collectively
decide to withdraw more funds than the bank has on
hand.
Liquidity Risk
• Most profitable bank assets, loans, are illiquid.
• Banks have a liquidity mismatch between assets and
liabilities.
Liquidity Risk: The possibility that depositors may
collectively decide to withdraw more funds than the bank
has on hand.
Maturity Mismatch
• No matter how well a bank is managed or how good
the credit quality of their loans, if all liquid deposits are
withdrawn at once, banks could not raise enough liquid
funds to pay all obligations.
• Banks have very illiquid assets (loans) and obligations
to repay their depositors in full at any time.
• If all of the depositors at a bank withdraw their funds at
the same time, the bank will have to sell their loans at a
discount, and they will not have enough funds to pay all
of their depositors.
• If all of their depositors keep their money in the bank,
most banks will be able to repay all of their depositors
with interest.
• Thus, the payoff to any individual depositor depends on
what other depositors decide to do.
Game Theory
• In many economic situations, agents returns depend on the
actions of other agents. In such a situation, agents must
think strategically. Economists use game theory to describe
such situations.
• John (“A Beautiful Mind”) Nash developed a concept called
the Nash equilibrium. A Nash equilibrium occurs when every
player in a game is playing their best strategy given the
strategy that the other players play.
• Economists believe that outcomes of strategic situations are
likely to be well-described by Nash equilibrium. Since every
individual in a Nash eq. is playing there best strategy given
the actions of others, no one has any incentive to change
their strategy individually.
Bank Run Game: Withdraw or Don’t Withdraw
•
•
•
Depositors each deposit $1000 at 10%
interest.
They can choose to withdraw their funds
before collecting interest or keep their funds
with the bank.
The right hand table shows pay-offs for each
decision under two possible situations.
2.
All other depositors keep their funds in the bank and
the bank survives.
All other depositors withdraw funds and the bank
•
must liquidate.
Payoffs
1.
1.
2.
3.
4.
Individual Depositors Decision
Withdraw
Don’t
Withdraw
Withdraw
Payoff:
$500
Payoff:
$0
Don’t
Withdraw
Payoff:
Payoff:
1100
All
If an individual keeps their funds with the bank and
everyone else does likewise, everyone gets their funds Other
with interest.
Depositors
If an individual doesn’t withdraw, but everyone else
Decision
does, the bank will have nothing left to pay the
individual who gets nothing.
If the individual depositor withdraws but no one else
does, the depositor loses only interest.
If an individual depositor withdraws and everyone else
does, they have some chance of getting some funds
(say $500) back.
$1000
Bank Runs
• The phenomenon in which all depositors compete to
•
•
•
•
withdraw their funds at the same time is called a bank
run or a bank panic.
Depositors lack complete information about the value
of banks assets.
If depositors believe that there is a significant fraction
of loans which will not be repaid, depositors may have
an incentive to immediately withdraw funds.
Bank deposits are first come, first serve. If you
withdraw your funds before the bank declares losses
you may not suffer at all.
Further, even if you believe that banks assets are
sound you may have an incentive to immediately
withdraw, if you believe that other depositors will also
withdraw their funds.
Panic of 1965
• In 1964, there was a collapse in the property market.
• In January 1965, the Banking Commissioner closed Ming Tak bank
•
•
•
•
•
which suffered losses in property investment.
Two weeks later there was a run on deposits at Canton Trust which
also had property holdings. Canton Trust suspended business on
February 8.
On February 9, there were runs on deposits at many native banks
including Wing Lung, Dao Heng, and the strongest of the native
banks Hang Seng.
On April 9, Chinese newspapers published rumours that the head of
Hang Seng was being interviewed by the police.
By the end of the day, depositors had withdrawn half of the savings
and checking deposits at Hang Seng.
On April 10, Hongkong Bank took over Hang Seng.
Deposit Insurance
Hong Kong Deposit Protection
• Liquidity Crisis: Sudden
Board
• compensation limit is set at HK$500,000 per
•
•
•
•
deposit withdrawal
requires liquidation of
otherwise sound assets.
depositor per bank;
secured deposits are protected;
Hong Kong dollar, Renminbi and foreign
currency deposits are protected;
•
a DPS Fund with size of 0.25% of relevant
deposits will be built up through the collection of
contributions from Scheme members; and
differential contributions will be assessed based
on the supervisory ratings of individual
Scheme members.
Bank of East Asia,
2008 Link
Lender of Last Resort
• Banking system sufficiently important that gov’ts will usually
protect depositors and prevent mass bankruptcies.
• Liquidity Crisis: Lend at penalty rates against good collateral. Walter
Bagehot, 1840’s.
• Solvency Crisis: Recapitalize banks through gov’t purchase of equity,
diluting or destroying shareholder value.
Link
• Moral Hazard: Banks creditors and (sometimes owners) are
protected from consequences of risky behavior.
Managing Liquidity
• A bank faces withdrawals of $5 million.
Assets
Liabilities
Cash - $5
Checkable Deposits -$5
• This reduces liquidity. The bank can
Liabilities
restore liquidity by managing assets or Assets
liabilities. Liquidity can be restored by
Cash +$5
converting secondary reserves (market Securities -$5
securities) into primary reserves (cash).
• The bank can also engage more short-term liabilities by
increasing borrowings from other banks or central bank.
Assets
Liabilities
Cash +$5
Borrowings+$5
Liquidity Requirements
• Hong Kong licensed banks are required to keep a
Liquidity Ratio
liquidity ratio of 25% or More
Liquidity Ratio 
Liquifiable Assets  Assets with Maturity  1 month
Liabilities with Maturity  1 month
• Most banks are fairly liquid.
Core Deposits vs. Managed Liabilities
•
1.
2.
•
Bank Liabilities can be divided into two parts.
Core Deposits – Demand Deposits, Savings Accounts,
Small Time Deposits (Retail Funds)
Managed Liabilities – Borrowings from Other Banks,
Commercial Paper, Large CD’s and Time Deposits
(Wholesale Funds)
Retail funds have lower interest costs and are thought to be
more stable. They take much longer time to raise and have
greater non-interest costs.
Measuring Liquidity Risk
Loan to Deposit Ratio – Ratio of illiquid loans to liquid deposits.
High measure of loan-to-deposit ratio indicates high liquidity
risk.
Interest Rate Risk: Income Side
•
•
•
•
Interest Rate Risk – The risk to an institution's
income resulting from adverse movements in
interest rates
Many bank liabilities are of very short maturity
(such as saving deposits) whose interest
changes with market interest rates.
Many bank assets are long-term and interest
income may not change as market interest rate
rises.
When market interest rates rise, NIM will decline.
Interest Rate Risk: Balance Sheet Perspective
• An asset (or a liability) represents a set of payments that
must be made at times in the future.
• Define PVT as the present value of a future payments made
to an asset or a set of assets in T periods.
• Useful Approximation
FACE
T
100
100
100
100
100
1
2
3
4
5
PV
i= .1
90.90909
82.64463
75.13148
68.30135
62.09213
FACE
PV 
(1  i)T
I = .11
90.09009
81.16224
73.11914
65.8731
59.34513
PV
i
 T 
PV
1 i
ΔPV
ΔPV/PV ΔPV/PV/Δi/(1+i)
Δi/(1+i)
0.009091
-0.819 -0.00901 -0.99099
0.009091 -1.48238 -0.01794 -1.97305
0.009091 -2.01234 -0.02678 -2.94627
0.009091 -2.42825 -0.03555 -3.91072
0.009091
-2.747 -0.04424 -4.86648
Duration Measure of Interest Rate Risk
• Define market value, MV, of an
T
asset or a set of assets as the sum
MV

PV

t
of present values derived from
t 1
payments made in each future
period.
• Define the duration of an asset as
d
T
PVt
d  t 
MV
t 1
• The % change of the market value
of an asset to a change in the
interest rate is approximately
proportional to the duration of an
asset.
MV
i
 d 
MV
1 i
Measuring Interest Exposure
• Calculate the duration of a
banks assets, dA.
Calculate the duration of a
banks liabilities, dL.
• An increase in the interest
rate will have the following
effect on assets and
liabilities.
• Calculate the GAP as a
function of duration of
assets and liabilities.
A
i
 d A 
A
1 i
L
i
 d L 
L
1 i
L

D  GAP   d A  d L 
A

An increase in interest rates changes the
value of a banks assets and liabilities.
NW A L A L L




A
A
A
A
L A
i
i L
L  i

 d A
 dL
   d A  d L 
1 i
1 i A
A  1 i

NW NW NW
i


 GAP

A
NW
A
1 i
NW
i
  EM  GAP 
NW
1 i
Managing Interest Rate Risk
• A bank which has a large stock of assets which
will pay a fixed interest rate may face losses if
market interest rates rise.
• Since deposits must be redeemed at any time,
the bank must offer market interest rates. If
market interest rates rise, loan spreads will be cut.
• Banks may use asset and liability management to
match the sensitivity of assets and liabilities to
interest rates.
Floating Rate Loans
• Fixed payment loans have a constant payment based on a
fixed interest rate.
• Floating rate loan payments are based on an interest rate that
changes as some benchmark interest rate changes
• Floating rate loans protect NIM from interest rate margins.
Swaps
• Basic (plain vanilla) interest rate swap is agreement by
two parties to exchange interest rate payments on a
notional principal.
• One party pays a fixed interest rate for a pre-determined
period of time. Another party pays a floating rate
equivalent to some benchmark interest rate (LIBOR, etc.)
Swaps and Hedging
• If a bank has long-term fixed rate assets and short-term
liabilities, they face interest rate risk. Solution: Swap
income from fixed rate assets for floating rate from dealer.
• A pension fund with long-term obligations may like to lock
in fixed income at a higher rate than LT treasuries. They
may also swap income from floating rate assets for fixed
income from a dealer.
Interest Rate Swaps are Quickly Growing in
Importance
Total contracts Billions US$
700000
600000
500000
400000
300000
200000
100000
0
Source: BIS International Financial Statistics http://www.bis.org/statistics/derstats.htm
Banks as Risk Taking Institutions
•
Banks may specialize in ameliorating effects of
asymmetric information.
•
But there is still asymmetric information
between banks and depositors.
Banks info advantages are offset in at least 2
ways.
1. Bank Capital – Owners of banks put some of
their own funds into banks and these funds are
at risk.
2. Liquidity Advantage of Depositors – Depositors
can withdraw funds very quickly from banks.