Interest Rate Risk Management:
ISGAP
Copyright 2014 by Diane S. Docking
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Learning Objectives
 Define the repricing gap measure of
interest rate risk.
 Understand the process of ISGAP
management
Copyright 2014 by Diane S. Docking
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Managing Interest Rate Risk
 Changes in interest rates:
 cause variability in net interest income (NII)
and net interest margin (NIM)
 impact value of financial assets, liabilities,
and reinvestment returns
 cause repricing of loans, securities, and
deposits impacting NII
Copyright 2014 by Diane S. Docking
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Interest Rate Risk Management
aka: ALM
 Purpose:
 To Control a Bank’s Sensitivity to Changes in Market
Interest Rates and Limit its Losses in its Net Income or
Equity
 To formulate strategies and take actions that shape a
bank’s balance sheet in a way that contributes to its
desired goals.
 To maximize the bank’s margin or spread.
 To maximize the stock value at an acceptable level of risk.
 Done by an Asset/Liability Committee (ALCO)
 In general, a short-run management tool:
 Construct a sources and uses of funds statement.
 NIMs are controlled by this management.
Copyright 2014 by Diane S. Docking
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Defn: Net Interest Margin & Net Interest Income
NIM 
NII
T otal Earning Assets
or
NIM 
NII
T otal Assets *
where:
NII  interestincome  interestexpense
* Or Total Average Assets
Copyright 2014 by Diane S. Docking
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Defn: Interest-Sensitive Assets (ISA or RSA*)
 Interest rate is subject to
change/repricing within a year:
 Short-Term Securities and Loans
 Variable-Rate Securities and Loans
 Current portion of Fixed-Rate Securities
and Loans to be received
*Interest or Rate sensitive
Copyright 2014 by Diane S. Docking
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Defn: NON Interest-Sensitive Assets
 Interest rate is NOT subject to
change/repricing within a year:
 Cash in vault
 Reserves at Fed**
 Fixed-rate L-T loans and securities (except
current portion coming due next year if know
this)
 PP&E
 Other non-earning assets: intangibles,
accruals, prepaids, etc.
**Reserves at Fed currently earn 0 - .25%; began in 2008.
Copyright 2014 by Diane S. Docking
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Defn: Interest-Sensitive Liabilities (ISL or RSL*)
 Interest rate is subject to
change/repricing within a year:




Borrowings from Money Markets
Short-Term Savings Accounts**
Adjustable rate Money-Market Deposits
Variable-Rate Deposits
*Interest or Rate sensitive
**% that is “core” is not rate sensitive
Copyright 2014 by Diane S. Docking
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Defn: NON Interest-Sensitive Liabilities
 Interest rate is NOT subject to
change/repricing within a year:
 DDA paying no interest
 Deposits where interest rates cannot be
adjusted within a year
 Fixed-rate Long-term savings, CD’s IRAs
 Fixed-rate Long-term debt
Copyright 2014 by Diane S. Docking
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ISGAP
 GAP = ISA - ISL
 Positive GAP where ISA > ISL
 Negative GAP where ISL > ISA
Copyright 2014 by Diane S. Docking
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Portfolio Maturity Mismatch
Copyright 2014 by Diane S. Docking
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Other Interest-Sensitive Gap
Measurements
To compare 2 or more banks, or track a bank over
time, use the:
Relative ISGAP ratio = Gap$/Total Assets
or
Interest Sensitivity ratio = RSA$/$RSL$.
Copyright 2014 by Diane S. Docking
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Example: Relative GAP Ratio
Relative GAP ratio - computes a standardized gap so you
can compare different banks of different sizes.
TA
ISGAP
Bank 1
$1 million
$100,000
Bank 2
$100 million
$ 5 million
But:
Relative Gap Ratio
10%
5%
Copyright 2014 by Diane S. Docking
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Example: ISGAP Measures
RSA = $100 million
RSL = $70 million
TA = $300 million
therefore:
ISGAP = 100 – 70 = $
(positive)
million
Relative ISGAP = 30/300 =
(positive)
%
ISRatio = 100/70 =
(negative)
million
Relative ISGAP = -40/300 =
(negative)
%
ISRatio = 100/140 =
(> 1)
An
RSA = $100 million
RSL = $140 million
TA = $300 million
therefore:
ISGAP = 100 – 140 =
(< 1)
-Sensitive Bank:
Positive Dollar Interest-Sensitive Gap
Positive Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Greater than One
A
-Sensitive Bank:
Negative Dollar Interest-Sensitive Gap
Negative Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Less than One
Copyright 2014 by Diane S. Docking
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Measuring effect of interest rate changes
The change in the dollar amount of net
interest income (NII) is:
1. If rates on assets and liabilities move the same:
$NII = ISGAP$ ( i)
2. If rates on assets and liabilities do not move the
same:
$NII = RSA$ ( iA) - RSL$ ( iL)
Copyright 2014 by Diane S. Docking
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Relationship Between ISGAP
and Changes in NII
ISGAP
i
+
+
0
0
+
+
+
Copyright 2014 by Diane S. Docking
 NII
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Example: ISGAP Management
10%
interest
sensitive
20%
interest
sensitive
20% mature
in 1 year
Copyright 2014 by Diane S. Docking
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Risk Management Association home page
http://www.rmahq.org
Solution to Example: ISGAP Management
Rate-Sensitive Assets =
RSA
= ___________
Rate-Sensitive Liabs =
RSL
= __________
GAP
= RSA  RSL =
Copyright 2014 by Diane S. Docking
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Solution to Example: ISGAP Management
if i  5% 
Asset Income
Liability Costs
= +5%  $32.0m
= +5%  $49.5m
= +$ 1.6m
= +$ 2.5m
= $1.6m  $ 2.5
= $0.9m
∆ NII = GAP  ∆i= $17.5m  5%
= $0.9m
∆ NII
OR
Since RSL > RSA, i  results in: NIM , NII 
Copyright 2014 by Diane S. Docking
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Example 2: ISGAP management
Waller Bank has the following financial information:
Assets:
Cash
$ 5 million
T-bill securities, 90-day @6% $ 20 million
T-bonds, 5 year @ 8%
$ 8 million
Loans, 10 year, FR @8.125% $ 80 million
Other assets
$ 7 million
Total Assets
$120 million
Liabilities & Equity Capital:
Demand deposits, no interest
Time deposits, 30-day @ 4%
Time deposits, 5 year @ 6%
Total Liabilities
Total Equity Capital
$ 5 million
$ 90 million
$ 15 million
$110 million
$ 10 million
$120 million
Annual Income*
$0
$ 1.20 million
$ 0.64 million
$ 6.50 million
$0
.
$ 8.34 million
Annual Expense*
$0
$ 3.60 million
$ 0.90 million
$ 4.50 million
NII $ 3.84 million
*Assume rollover at current rate of any S-T asset or liability.
Copyright 2014 by Diane S. Docking
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Example 2: ISGAP management (cont.)
a)
b)
c)
d)
What is the bank’s NIM?
If interest rates rise 2% next year, what will be the
NIM?
What if interest rates on assets increase only 90%
the rate of liabilities?
Explain how the bank could “insulate” itself against
changes in interest rates.
Copyright 2014 by Diane S. Docking
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Solution for Example 2: ISGAP management
a) NIM = NII/TA = $3.84/$120 = _________
b) ISGAP = ISA- ISL
= 20 – 90 = _________________
$NII = ISGAP$ ( i) = -$70 million (+.02)
= _____________________; therefore,
New NIM assuming TA do not change =
($3.84 - $1.4)/$120 = $2.44/$120 = _____
Copyright 2014 by Diane S. Docking
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Solution for Example 2: ISGAP management
(cont.)
c) If interest rates on assets increase only 1.8%
then:
$NII = RSA$ ( iA) - RSL$ ( iL)
= [$20 (.018)] – [$90 (+.02)]
=.36 – 1.8 = _________________
New NIM assuming TA do not change =
($3.84 - $1.44)/$120 = $2.40/$120 = _____
Copyright 2014 by Diane S. Docking
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Solution for Example 2: ISGAP management
(cont.)
d) Needs to increase ______and/or decrease
______ to bring ISGAP = 0.
HOW?
Copyright 2014 by Diane S. Docking
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Aggressive Interest-Sensitive Gap Management
•If interest rates are expected to increase in the near future, the bank could
• use a positive dollar gap as an aggressive approach to gap
management.
•If interest rates are expected to decrease in the near future, the bank could
• use a negative dollar gap (so as rate fell, bank deposit costs would
fall more than bank revenues, causing profit to rise).
Expected Change
in Interest Rates
Best InterestSensitive Gap
Position
Aggressive
Management’s Likely
Actions
Rising Market
Interest Rates
________ IS Gap Increase in ________
Decrease in _______
Falling Market
Interest Rates
________ IS Gap Increase in ________
Copyright 2014 by Diane S. DockingDecrease in _______25
Measuring interest rate sensitivity and
the dollar gap
 Incremental gaps
 Measure the gaps for different maturity
buckets (e.g., 0-30 days, 30-90 days, 90-180
days, and 180-365 days).
 Cumulative gaps
 Add up the incremental gaps from maturity
bucket to bucket.
 The total difference in dollars between those
bank assets and liabilities which can be
repriced over a designated time period.
Copyright 2014 by Diane S. Docking
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7-27
Computer-Based Techniques and
Maturity Buckets
Copyright 2014 by Diane S. Docking
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Measuring interest rate sensitivity and
the dollar gap
 Defensive versus aggressive asset/liability
management:
 Defensively guard against changes in NII
(e.g., near zero gap).
 Aggressively seek to increase NII in
conjunction with interest rate forecasts
(e.g., positive or negative gaps).
 Many times some gaps are driven by
market demands (e.g., borrowers want
long-term loans and depositors want shortterm maturities.
Copyright 2014 by Diane S. Docking
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Problems with Interest-Sensitive Gap Management
1.
Time horizon problems related to when assets and
liabilities are repriced. Dollar gap assumes they are all
repriced on the same day, which is not true.





For example, a bank could have a zero 30-day gap, but with
daily liabilities and 30-day assets NII would react to changes
in interest rates over time.
A solution is to divide the assets and liabilities into maturity
buckets (i.e., incremental gap).
Interest Rates Paid on Liabilities Tend to Move Faster
than Interest Rates Earned on Assets
Interest Rate Attached to Bank Assets and Liabilities Do
Not Move at the Same Speed as Market Interest Rates
Point at Which Some Assets and Liabilities Are Repriced
is Not Easy to Identify
Copyright 2014 by Diane S. Docking
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Problems with Interest-Sensitive Gap Management
2.
Focus on net interest income rather than
shareholder wealth.


3.
Dollar gap may be set to increase NIM if interest rates
increase, but equity values may decrease if the value
of assets fall more than liabilities fall (i.e., the duration
of assets is greater than the duration of liabilities).
Interest-Sensitive Gap Does Not Consider Impact of
Changing Interest Rates on Equity Position
Financial derivatives could be used to hedge dollar
gap effects on equity values.
Copyright 2014 by Diane S. Docking
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