14
Evaluating Commercial
Loan Requests
1
Evaluating Commercial Loan
Requests and Managing Credit Risk
 Important Questions Regarding Commercial Loan
Requests
1.
2.
3.
4.
5.
What is the character of the borrower and quality
of information provided?
What are the loan proceeds going to be used for?
How much does the customer need to borrow?
What is the primary source of repayment, and
when will the loan be repaid?
What is the secondary source of repayment; that
is, what collateral, guarantees, or other cash
inflows are available?
2
Fundamental Credit Issues
 There are two types of loan errors
 Type

Making a loan to a customer who will
ultimately default
 Type

I Error
II Error
Denying a loan to a customer who
would ultimately repay the debt
3
Fundamental Credit Issues
 Character of the Borrower and Quality
of Data Provided
 The
most important issue in assessing
credit risk is determining a borrower’s
commitment and ability to repay debts
in accordance with the terms of a loan
agreement

The best indicators are the borrower’s
financial history and personal
references
4
Fundamental Credit Issues
 Character of the Borrower and Quality of
Data Provided

Audited financial statements are preferred
in determining the quality of the data
because accounting rules are well
established so that an analyst can better
understand the underlying factors that
affect the entries

But just because a company has audited
financial statements, however, does not
mean the reported data are not
manipulated
5
Fundamental Credit Issues
 Use of Loan Proceeds
 Loan proceeds should be used for
legitimate business operating
purposes, including seasonal and
permanent working capital needs, the
purchase of depreciable assets,
physical plant expansion, acquisition
of other firms, and extraordinary
operating expenses
 Speculative asset purchases and debt
substitutions should be avoided
6
Fundamental Credit Issues
 How Much Does the Borrower Need?
The Loan Amount
 Borrowers
often request a loan before
they clearly understand how much
external financing is actually needed
and how much is available internally

The amount of credit required depends
on the use of the proceeds and the
availability of internal sources of funds
7
Fundamental Credit Issues
 How Much Does the Borrower Need? The
Loan Amount
For a shorter-term loan, the amount might
equal the temporary seasonal increase in
receivables and inventory net of that
supported by increased accounts payable
 With term loans, the amount can be
determined via pro forma analysis which
is the projecting or forecasting of a
company’s financial statements into the
future

8
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 Loans
are repaid from cash flows:
Liquidation of assets
 Cash flow from normal operations
 New debt issues
 New equity issues

9
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 Specific
sources of cash are generally
associated with certain types of loans

Short-term, seasonal working capital
loans are normally repaid from the
liquidation of receivables or reductions
in inventory
10
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 Specific
sources of cash are generally
associated with certain types of loans

Term loans are typically repaid out of
cash flows from operations, specifically
earnings and noncash charges in
excess of net working capital needs
and capital expenditures needed to
maintain the existing fixed asset base
11
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 The
primary source of repayment on
the loan can also determine the risk of
the loan

The general rule is not to rely on the
acquired asset or underlying collateral
as the primary source of repayment
12
Fundamental Credit Issues
 Secondary Source of Repayment:
Collateral
 Collateral
1.
must exhibit three features
Its value should always exceed the
outstanding principal on a loan
 The lower the loan-to-value (LTV) ratio, the
more likely a the lender can sell the
collateral for more than the balance due
and reduce loses
 Borrowers are “upside-down” on a loan if
the value of the collateral is less than the
outstanding loan balance
13
Fundamental Credit Issues
 Secondary Source of Repayment:
Collateral

Collateral must exhibit three features
2.
3.
The lender should be able to easily take
possession of the collateral and have a
ready market for its sale
A lender must be able to clearly mark the
collateral as its own


Careful loan documentation is required to
“perfect” the bank’s interest in the collateral
If collateral is not readily available, a
personal guarantee may be required
14
Fundamental Credit Issues
 Secondary Source of Repayment:
Collateral
The borrower’s cash flow is the preferred
source of loan repayments
 Liquidating collateral is secondary

There are significant transactions costs
associated with foreclosure
 Bankruptcy laws allow borrowers to retain
possession of the collateral long after they
have defaulted
 When the bank takes possession of the
collateral, it deprives the borrower of the
opportunity to salvage the company

15
Evaluating Credit Requests: A
Four-Part Process
1. Overview of management, operations,
and the firm’s industry
2. Common size and financial ratio
analysis
3. Analysis of cash flow
4. Projections and analysis of the
borrower’s financial condition
16
Evaluating Credit Requests: A
Four-Part Process
 Overview of Management, Operations,
and the Firm’s Industry
 Gather
background information on the
firm’s operations
 Write a Business and Industry Outlook
report
 Examine the nature of the borrower’s
loan request and the quality of the
financial data provided
17
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Common
size ratio comparisons are
valuable because they adjust for size
and thus enable comparisons across
firms in the same industry or line of
business
18
19
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Most
analysts differentiate between at
least four categories of ratios:

Liquidity ratios
 Indicate a firm’s ability to meet its shortterm obligations and continue operations.

Activity ratios
 Signal how efficiently a firm uses assets to
generate sales
20
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Most
analysts differentiate between at
least four categories of ratios:

Leverage ratios
 Indicate the mix of the firm’s financing
between debt and equity and potential
earnings volatility

Profitability ratios
 Provide evidence of the firm’s sales and
earnings performance
21
22
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Liquidity

Ratios
Current Ratio
 CA / CL

Quick Ratio
 (Cash + A/R) / CL
23
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Activity

Ratios
Days Cash
 Cash/Average Daily Sales

Days Inventory on Hand
 Inventory/Average Daily Cost of Goods
Sold

Inventory Turnover
 COGS / Average Inventory
24
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Activity

Ratios
Days Accounts Receivable Collection
Period
 A/R / Average Daily Sales

Days Cash-to-Cash Cycle
 Days Cash + Days A/R + Days Inventory on
Hand
25
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Activity

Ratios
Days Accounts Payable Outstanding
 A/P / Average Daily Purchases
 Purchases COGS + ΔInventory

Sales-to-Asset Ratio
 Sales/Net Fixed Assets
26
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis

Leverage Ratios

Debt to Tangible Net Worth
 Total Liabilities/Tangible Net Worth

Debt to Total Assets
 Total Debt/Total Assets

Times Interest Earned
 EBIT/Interest Expense

EBIT
 Earnings Before Taxes + Interest Expense
27
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Leverage

Ratios
Fixed Charge Coverage
 (EBIT + Lease Payments)/(Interest Expense
+ Lease Payments)

Net Fixed Assets to Tangible Net Worth
 Net Fixed Assets/Tangible Net Worth

Dividend Payout
 Cash Dividends Paid/Net Income
28
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Profitability

Analysis
Profit Margin (PM)
 Net Income/Sales
 1 – Expenses/Sales
 1 – (COGS/Sales) – (Operating
Expenses/Sales) – (Other Expenses/Sales)
– (Taxes/Sales)
29
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Profitability

Analysis
Asset Utilization (AU)
 Sales/Total Assets

Return on Assets
 Net Income/Total Assets
 PM × AU
30
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Profitability

Analysis
Equity Multiplier (EM)
 Total Assets/Equity

Return on Equity (ROE)
 Net Income/Equity
 ROA × EM

Sales Growth
 Demonstrates whether a firm is expanding
or contracting
31
32
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Based

Income Statement
Modified form of a direct statement of
cash flows
33
34
35
36
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Operations Section
 Income statement items and the change in
current assets and current liabilities
(except bank debt)

Investments Section
 The change in all long-term assets
37
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Financing Section
 Payments for debt and dividends, the
change in all long-term liabilities, the
change in short-term bank debt, and any
new stock issues

Cash Section
 The change in cash and marketable
securities
38
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow
n
Statement Format
m
 A   L
i 1
i
j1
j
 NW
where:
 Ai = the dollar value of the ith type of
asset (A)
 Lj = the dollar value of the jth type of
liability (L)
 NW = the dollar value of net worth

39
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Cash Flow From Operations is defined
as:
m
n
j1
i 1
A1   L j   Ai  Stock + Surplus + NI - DIV
where:
 ΔA1 = ΔCash

40
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow
m
n
j1
i 1
Statement Format
A1   L j   A i  Stock + Surplus
+ Revenue  Expenses  Taxes - DIV
41
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Sources of Cash
 Increase in any liability
 Decrease in a non-cash asset
 New issue of stock
 Additions to surplus
 Revenues
42
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Uses of Cash
 Decrease in any liability
 Increase in a non-cash asset
 Repayments/Buy back stock
 Deductions from surplus
 Cash Expenses
 Taxes
 Cash Dividends
43
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis For Prism
Industries
 Cash
Flow From Operations
Recall Exhibits 14.1, 14.2, & 14.3
 Cash Purchases for 2008:

 Cash Purchases = -(COGS + ΔInventory –
ΔAccounts Payable)
44
Evaluating Credit Requests: A FourPart Process
 Cash-Flow Analysis For Prism
Industries
 Cash

Flow From Investing Activities
ΔNet Fixed Assets = ΔGross Fixed Assets
– ΔAccumulated Depreciation
 Or

ΔNet Fixed Assets = Capital
Expenditures – Depreciation
 where:
 Capital Expenditures = ΔNet Fixed Assets
45
+ Depreciation
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis For Prism
Industries
 Cash

Flow From Financing Activities
Although cash-flow statements group
payments for financing below the
investment section, this is somewhat
misleading because payments for
financing generally take precedence
over capital expenditures and
increases in long-term investments
46
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis For Prism
Industries
 Change

in Cash
Equals cash flow from operations
adjusted for discretionary
expenditures, cash used for
investments, payments for financing,
and external financing
47
48
49
50
51
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Pro
Forma projections of the
borrower’s condition reveal:
How much financing is required
 When the loan will be repaid
 Use of the loan

52
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Pro

Forma Assumptions
Salest+1 = Salest × (1 + gSales)
 where:
 gSales = Projected Sales Growth
COGSt+1 = Salest+1 × COGS % of Sales
 Accounts Receivablet+1 = Days A/R
Outstanding × Average Daily Salest+1
 Inventoryt+1 = COGSt+1/Inventory
Turnover

53
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Pro

Forma Assumptions
Accounts Payablet+1 = Days A/P
Outstanding × Average Daily
Purchasest+1
 Or

Accounts Payablet+1 = Days A/P
Outstanding × [(COGSt+1 +
ΔInventoryt+1)/365]
54
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Projecting

Notes Payable to Banks
Rarely will the balance sheet “balance”
in the initial round of pro forma
forecasts
 To reconcile this, there must be a
balancing item or “plug” figure
55
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Projecting
Notes Payable to Banks
When projected assets exceed
projected liabilities plus equity,
additional debt (assumed to be in the
form of notes payable) is required
 When projected assets are less than
projected liabilities plus equity, no new
debt is required and existing debt could
be reduced or excess funds invested in
marketable securities

56
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Sensitivity Analysis
 Best Case Scenario
 Assumes optimistic improvements in planned
performance and the economy are realized

Worst Case Scenario
 Assumes the environment with the greatest
potential negative impact on sales, earnings,
and the balance sheet

Most Likely Scenario
 Assumes the most reasonable sequence of
economic events and performance trends
57
Evaluating Credit Requests: A
Four-Part Process
 Risk-Classification Scheme
 After
evaluating the borrower’s risk
profile along all dimensions, a loan is
placed in a rating category ranked
according to the degree of risk
58
59
Credit Analysis Application:
Wade’s Office Furniture
 See Exhibits 14.5- 14.11
60
61
62
63
64
65
66
67
68
69
70
71
72
73
Managing Risk with Loan Sales
and Credit Derivatives
 Many financial institutions have
changed their business models,
switching to the originate-to-distribute
(OTD) model
 Under
the OTD model, firms make
loans and thereby collect fees, then
either sell parts of the loan through
participations or package the loans
into pools and sell them in the
marketplace
74
Managing Risk with Loan Sales
and Credit Derivatives
 Larger institutions also form loan
syndicates in which one firm serves as a
principal in negotiating terms with a
borrower who has significant credit
needs, but then engages other firms to
take part of the credit and thus share the
risk
 Lead Bank

The institution that actually underwrites
the original loan and sells the
participation
75
Managing Risk with Loan Sales
and Credit Derivatives
 There are several inherent risk in loan
participations or loan sales
General credit risks
 There is an inherent potential conflict
between the originating institution and
the investor


The loan originator might see the up-front
fees and premium to the loan value as an
excellent source of revenue that might not
be as attractive if these loans were
subsequently held in portfolio
76
Managing Risk with Loan Sales
and Credit Derivatives
 Underwriting Loan Sales,
Participations, and Syndications
 The
lead lending institution and the
participating investor are required to
underwrite the loans as if they were
making the loans themselves and
placing them on their own books
77
Managing Risk with Loan Sales
and Credit Derivatives
 Shared National Credits (SNC)
 Loan
or loan commitment of $20
million or more made generally by
three or more unaffiliated supervised
institutions under a formal lending
agreement

The various regulatory agencies
established the SNC program in 1977 to
monitor and review the risk structure of
large syndicated loans
78
Managing Risk with Loan Sales
and Credit Derivatives
 Shared National Credits (SNC)
79
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Can take many forms
 Key terms of credit enhancements
potentially include:
 Excess cash flow
 Many securitized assets are placed in pools in
which the required payments to investors are
less than the contractual payments of
borrowers
 Thus, even if some borrowers do not make
the required payments, there is sufficient
cash flow to continue to pay investors
80
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Key
terms of credit enhancements
potentially include:

Reserve accounts
 The originating institution creates a trust
for losses up to an amount allocated for a
reserve which is used to make up any
deficits in payments by borrowers

Collateralization
 One or more parties pledge collateral
against the loan
81
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Key terms of credit enhancements
potentially include:
 Loan guarantees
 One or more parties pledge personal or
business assets or are contractually bound to
meet the obligations of the borrower if that
party defaults

Credit insurance
 Any party can purchase credit insurance,
provided either privately or by a governmental
unit, for loans that provide payments for
losses stemming from default
82
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Key
terms of credit enhancements
potentially include:

Credit derivatives
 Instruments or contracts that derive their
value from the underlying credit risk of a
loan or bond
83
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
 CDS
contracts are relatively
unregulated derivative instruments
based on the underlying payments and
values of fixed-income securities

These contracts are privately
negotiated instruments between a
buyer and a seller and are traded in
over-the-counter markets
84
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
 The buyer pays a premium and thus the
CDS is similar to an insurance contract
 The buyer often owns the underlying debt
and uses the CDS as a hedge
 The seller of the CDS plays a role similar
to that of the insurance company
 Sellers generally do not own the debt and
provide longer-term protection
 If an adverse event occurs the seller pays
the buyer the change in value of the
underlying asset
85
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
86
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
 There are several credit events that potentially
trigger a payment from the seller of a CDS to the
buyer:
 Failure to pay principal and interest payments in a
timely manner
 Restructuring of the debt in such a way that the
lender (investor in the debt) is negatively affected
 Bankruptcy or insolvency in which the debt is not
paid
 Acceleration of the principal and interest
payments prior to the scheduled date(s)
 Repudiation or moratorium in which the debt
issuer rejects or refuses to pay the debt
87
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
 The
credit crisis of 2007–2008 caused
many sellers of credit default swaps to
make large and unexpected payments
for default
88
15
Evaluating Consumer
Loans
89
Evaluating Consumer Loans
 Today, many banks target individuals
as the primary source of growth in
attracting new business
 Consumer loans differ from
commercial loans
 Quality
of financial data is lower
 Primary source of repayment is current
income
Types of Consumer Loans
 Evaluating Consumer Loans
 An
analyst should addresses the same
issues discussed with commercial
loans:
The use of loan proceeds
 The amount needed
 The primary and secondary source of
repayment

Types of Consumer Loans
 Evaluating Consumer Loans
 Consumer
loans differ so much in
design that no comprehensive
analytical format applies to all loans
Types of Consumer Loans
 Installment Loans
 Require
the periodic payment of
principal and interest
Types of Consumer Loans
 Installment Loans
 Direct

Negotiated between the bank and the
ultimate user of the funds
 Indirect

Funded by a bank through a separate
retailer that sells merchandise to a
customer
Types of Consumer Loans
 Installment Loans
 Revenues
and Costs from Installment
Loans
Consumer installment loans can be
extremely profitable
 Costs $100 - $250 to originate loan
 Typically yield over 5% (loan income
minus loan acquisition costs,
collections costs and net charge-offs)

Types of Consumer Loans
 Credit Cards and Other Revolving
Credit
 Credit
cards and overlines tied to
checking accounts are the two most
popular forms of revolving credit
agreements
 In 2007, over 92% of households had
credit cards (average of 13 cards)
Types of Consumer Loans
 Credit Cards and Other Revolving
Credit
 Most
banks operate as franchises of
MasterCard and/or Visa

Bank pays a one-time membership fee
plus an annual charge determined by
the number of its customers actively
using the cards
Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Debit
Cards
Widely available
 When an individual uses the card, their
balance is immediately debited
 Banks prefer debit card use over
checks because debit cards have lower
processing costs

Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Smart
Card
Contains a memory chip which can
store information and value
 Programmable such that users can
store information and add or transfer
value to another smart card
 Only modest usage in the U.S.

Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Prepaid
Card
A hybrid of a debit card
 Customers prepay for services to be
rendered and receive a card against
which purchases are charged
 Use of phone cards, prepaid cellular,
toll tags, subway, etc. are growing
rapidly

Types of Consumer Loans
 Credit Card Systems and Profitability
 Card
issuers earn income from three
sources:
Cardholders’ annual fees
 Interest on outstanding loan balances
 Discounting the charges that
merchants accept on purchases

Types of Consumer Loans
 Credit Card Systems and Profitability
 Despite
high charge-offs, credit cards
are attractive because they provide
higher risk-adjusted returns than do
other types of loans
Types of Consumer Loans
 Overdraft Protection and Open Credit
Lines
 Overdraft
Protection Against Checking
Accounts

A type of revolving credit
 A bank authorizes qualifying individuals to
write checks in excess of actual balances
held in a checking account up to a prespecified limit
Types of Consumer Loans
 Overdraft Protection and Open Credit
Lines
 Open

Credit Lines
The bank provides customers with
special checks that activate a loan
when presented for payment
Types of Consumer Loans
 Home Equity Loans
 Grew
from virtually nothing in the mid1980s to over $350 billion in 2008
 They meet the tax deductibility
requirements of the Tax Reform Act of
1986, which limits deductions for
consumer loan interest paid by
individuals, because they are secured
by equity in an individual's home
Types of Consumer Loans
 Home Equity Loans
 Some
allow access to credit line by
using a credit card
 Borrowers pay interest only on the
amount borrowed, pay 1 to 2 percent of
the outstanding principal each month,
and can repay the remaining principal
at their discretion
Types of Consumer Loans
 Non-Installment Loans
 aka
Bridge Loan
Requires a single principal and interest
payment
 Typically, the individual’s borrowing
needs are temporary and repayment is
from a well-defined future cash inflow

Subprime Loans
 One of the hottest growth areas during
the early 2000s
 Subprime
loans are higher-risk loans
labeled “B,” “C,” and “D” credits
 They have been especially popular in
auto, home equity, and mortgage
lending
 Typically have the same risk as loans
originated through consumer finance
companies
Subprime Loans
 Many subprime lenders make loans to
individuals that a bank would not
traditionally make and keep onbalance sheet
 Subprime lenders charge higher rates
and have more restrictive covenants
Subprime Loans
 What Happens When Housing Prices
Fall
 Subprime
loans can be attractive when
housing values are rising
Individuals who are overextended and
cannot make their monthly payments,
can often sell the home or refinance
and withdraw equity to pay the debts if
the price increases are sufficiently high
 The opposite occurs when housing
prices fall

Subprime Loans
 What Happens When Housing Prices
Fall
 During
2007–2008, banks were forced
to charge-off historically high amounts
of mortgage loans as delinquencies
and foreclosures skyrocketed
Consumer Credit Regulations
 Equal Credit Opportunity
 Makes
it illegal for lenders to
discriminate on the basis of race,
religion, sex, marital status, age, or
national origin
Consumer Credit Regulations
 Prohibited Information Requests
 The
applicant's marital status
 Whether alimony, child support, and
public assistance are included in
reported income
 A woman's childbearing capability and
plans
 Whether an applicant has a telephone
Consumer Credit Regulations
 Credit Scoring Systems
 Acceptable
if they do not require
prohibited information and are
statistically justified
 Can use information about age, sex,
and marital status as long as these
factors contribute positively to the
applicant's creditworthiness
Consumer Credit Regulations
 Credit Reporting
 Lenders
must report credit extended
jointly to married couples in both
spouses' names
 Whenever lenders reject a loan, they
must notify applicants of the credit
denial within 30 days and indicate why
the request was turned down
Consumer Credit Regulations
 Truth In Lending
 Regulations
apply to all individual
loans up to $25,000 where the
borrower's primary residence does not
serve as collateral
Consumer Credit Regulations
 Truth In Lending
 Requires
that lenders disclose to
potential borrowers both the total
finance charge and an annual
percentage rate (APR)
 Historically, consumer loan rates were
quoted as:
Add-On Rates
 Discount Rates
 Simple Interest Rates

Consumer Credit Regulations
 Fair Credit Reporting
 Fair
Credit Reporting Act
Enables individuals to examine their
credit reports provided by credit
bureaus
 If any information is incorrect, the
individual can have the bureau make
changes and notify all lenders who
obtained the inaccurate data

Consumer Credit Regulations
 Fair Credit Reporting
 There
are three primary credit
reporting agencies:
Equifax
 Experian
 Trans Union

 Unfortunately,
the credit reports that
they produce are quite often wrong
Consumer Credit Regulations
 Fair Credit Reporting
 Credit
Score
Like a bond rating for individuals
 Based on several factors

 Payment History
 Amounts Owed
 Length of Credit History
 Types of Credit
 New Credit
Consumer Credit Regulations
 Community Reinvestment Act
 CRA
prohibits redlining and
encourages lenders to extend credit
within their immediate trade area and
the markets where they collect
deposits
Consumer Credit Regulations
 Community Reinvestment Act
 Financial
Institutions Reform, Recover,
and Enforcement Act of 1989 raised
the profile of the CRA by mandating
public disclosure of bank lending
policies and regulatory ratings of bank
compliance
Consumer Credit Regulations
 Community Reinvestment Act
 Regulators
must also take CRA
compliance into account when
evaluating a bank's request to charter
a new bank, acquire a bank, open a
branch, or merge with another
institution
Consumer Credit Regulations
 Bankruptcy Reform
 Individuals
who cannot repay their
debts on time can file for bankruptcy
and receive court protection against
creditors
Consumer Credit Regulations
 Bankruptcy Reform
 Individuals
can file for bankruptcy
under:

Chapter 7
 Individuals liquidate qualified assets and
distribute the proceeds to creditors

Chapter 13
 An individual works out a repayment plan
with court supervision
Consumer Credit Regulations
 Bankruptcy Reform
 In
2005, Congress passed bankruptcy
reform legislation that made it more
difficult for individuals to completely
avoid repaying their debts

In particular, an individual whose
income exceeds the state median has
to file for Chapter 13 and will repay at
least a portion of his or her debts
Credit Analysis
 Objective of consumer credit analysis
is to assess the risks associated with
lending to individuals
Credit Analysis
 When evaluating loans, bankers cite
the Cs of credit:
 Character
 Capital
 Capacity
 Conditions
 Collateral
Credit Analysis
 Two additional Cs
 Customer

Relationship
A bank’s prior relationship with a
customer reveals information about
past credit experience
 Competition
Lenders periodically react to
competitive pressures
 Competition should not affect the
accept/reject decision

Credit Analysis
 Policy Guidelines
 Acceptable
Loans
Automobile
 Boat
 Home Improvement
 Personal-Unsecured
 Single Payment
 Cosigned

Credit Analysis
 Policy Guidelines
 Unacceptable
Loans
Loans for speculative purposes
 Loans secured by a second lien
 Other than home improvement or home
equity loans
 Any participation with a correspondent
bank in a loan that the bank would not
normally approve

Credit Analysis
 Policy Guidelines
 Unacceptable
Loans
Loans to a poor credit risk based on
the strength of the cosigner
 Single payment automobile or boat
loans
 Loans secured by existing home
furnishings
 Loans for skydiving equipment and
hang gliders

Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Judgmental
Subjectively interpret the information in
light of the bank’s lending guidelines
and accepts or rejects the loan
 Assessment can be completed shortly
after receiving the loan application and
visiting with the applicant

Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Credit

Scoring
Grades the loan request according to a
statistically sound model that assigns
points to selected characteristics of the
prospective borrower
Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Credit
Scoring
If the total points exceeds the accept
threshold, the officer approves the loan
 If the total is below the reject threshold,
the officer denies the loan

Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 In
both cases, judgmental and
quantitative, a lending officer collects
information regarding the borrower’s
character, capacity, and collateral
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 You
receive an application for a
customer to purchase a 2007 Jeep
Cherokee

Do you make the loan?
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The
Credit Score
At this bank, the loan is automatically
approved if the total score equals at
least 200
 The loan is automatically denied if the
total score is below 150
 Accept/Reject is indeterminate for
scores between 150 & 200

Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The credit decision rests on the loan
officer’s evaluation of the applicant’s
character and capacity to repay the
debt
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The loan officer has numerous grounds
for denying credit
 Limited credit history
 Local residence was established too
recently
 Employed too recently
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The loan officer sees some positive
things
 Applicant appears to be a hard worker who
is the victim of circumstances resulting
from her husband’s death
 It is unlikely that anyone who puts almost
30 percent down on a new model is going
to walk away from a debt
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The loan officer sees some positive
things
 The bank will likely lose Groome as a
depositor if it denies the application

What would you recommend?
Credit Analysis
 Your FICO Credit Score
 Summarizes
in one number an
individual’s credit history
Lenders often use this number when
evaluating whether to approve a
consumer loan or mortgage
 Many insurance companies consider
the score when determining whether to
offer insurance coverage and how to
price the insurance

Credit Analysis
 Your FICO Credit Score
 Summarizes
in one number an
individual’s credit history

The scores range from 300 to 850 with
a higher figure indicating a better credit
history
 The national average is 670
 The higher the score is, the more likely it is
a lender will see the individual as making
the promised payments in a timely manner
Credit Analysis
 Your FICO Credit Score
 An
individual’s credit score is based
on five broad factors:
Payment history 35%
 Amounts owed 30%
 Length of credit history 15%
 New credit 10%
 Type of credit in use 10%

Credit Analysis
 An Application: Indirect Lending
A
retailer sells merchandise and takes
the credit application

Because many firms do not have the
resources to carry their receivables,
they sell the loans to banks or other
financial institutions
Credit Analysis
 An Application: Indirect Lending
 These
loans are collectively referred to
as dealer paper
 Banks aggressively compete for paper
originated by well-established
automobile, mobile home, and
furniture dealers
Credit Analysis
 An Application: Indirect Lending
 Dealers
negotiate finance charges
directly with their customers

A bank, in turn, agrees to purchase the
paper at predetermined rates that vary
with the default risk assumed by the
bank, the quality of the assets sold, and
the maturity of the consumer loan
Credit Analysis
 An Application: Indirect Lending
A
dealer normally negotiates a higher
rate with the car buyer than the
determined rate charged by the bank
 This differential varies with competitive
conditions but potentially represents a
significant source of dealer profit
Credit Analysis
 An Application: Indirect Lending
 Most
indirect loan arrangements
provide for dealer reserves that reduce
the risk in indirect lending
 The reserves are derived from the
differential between the normal, or
contract loan rate and the bank rate,
and help protect the bank against
customer defaults and refunds
Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 The
attraction is two-fold:
Competition for commercial customers
narrowed commercial loan yields so
that returns fell relative to potential
risks
 Developing loan and deposit
relationships with individuals
presumably represents a strategic
response to deregulation

Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 Consumer
loan rates have been among
the highest rates quoted at banks in
recent years
 In addition to interest income, banks
generate substantial non-interest
revenues from consumer loans
Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 With
traditional installment credit,
banks often encourage borrowers to
purchase credit life insurance on
which the bank may earn a premium
Recent Risk and Return
Characteristics of Consumer Loans
 Consumer Loan Losses
 Losses
on consumer loans are
normally the highest among all
categories of bank credit
 Losses are anticipated because of
mass marketing efforts pursued by
many lenders, particularly with credit
cards
 Credit card losses and fraud amounted
to more than $12 billion in 2005
Recent Risk and Return
Characteristics of Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 The
majority of consumer loans are
priced at fixed rates
 New auto loans typically carry 4-year
maturities, and credit card loans
exhibit an average 15- to 18-month
maturity
Recent Risk and Return
Characteristics of Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 Bankers
have responded in two ways
to deal with the interest rate risk:
Price more consumer loans on a
floating-rate basis
 Commercial and investment banks
have created a secondary market in
consumer loans, allowing loan
originators to sell a package of loans

Managing Interest Rate
Risk: GAP and
Earnings Sensitivity
Managing Interest Rate Risk
 Interest Rate Risk
 The
potential loss from unexpected
changes in interest rates which can
significantly alter a bank’s profitability
and market value of equity
170
Managing Interest Rate Risk
 Interest Rate Risk
 When
a bank’s assets and liabilities do
not reprice at the same time, the result
is a change in net interest income
 The change in the value of assets and
the change in the value of liabilities will
also differ, causing a change in the
value of stockholder’s equity
171
Managing Interest Rate Risk
 Interest Rate Risk

Banks typically focus on either:



GAP Analysis


Net interest income or
The market value of stockholders' equity
A static measure of risk that is commonly
associated with net interest income (margin)
targeting
Earnings Sensitivity Analysis

Earnings sensitivity analysis extends GAP
analysis by focusing on changes in bank
earnings due to changes in interest rates and
balance sheet composition
172
Managing Interest Rate Risk
 Interest Rate Risk
 Asset
and Liability Management
Committee (ALCO)
The bank’s ALCO primary
responsibility is interest rate risk
management.
 The ALCO coordinates the bank’s
strategies to achieve the optimal
risk/reward trade-off

173
Measuring Interest Rate Risk with
GAP
 Three general factors potentially cause a
bank’s net interest income to change.

Rate Effects


Composition (Mix) Effects


Unexpected changes in interest rates
Changes in the mix, or composition, of
assets and/or liabilities
Volume Effects

Changes in the volume of earning assets
and interest-bearing liabilities
174
Measuring Interest Rate Risk with
GAP
 Consider a bank that makes a $25,000
five-year car loan to a customer at
fixed rate of 8.5%. The bank initially
funds the car loan with a one-year
$25,000 CD at a cost of 4.5%. The
bank’s initial spread is 4%.
 What
is the bank’s risk?
175
Measuring Interest Rate Risk with
GAP
 Traditional Static Gap Analysis
 Static GAP Analysis
GAPt = RSAt - RSLt
 RSAt
 Rate Sensitive Assets
 Those assets that will mature or reprice
in a given time period (t)

RSLt
 Rate Sensitive Liabilities
 Those liabilities that will mature or
reprice in a given time period (t)
176
Measuring Interest Rate Risk with
GAP
 Traditional Static Gap Analysis
 Steps in GAP Analysis
1.
Develop an interest rate forecast
2.
Select a series of “time buckets” or time
intervals for determining when assets
and liabilities will reprice
3.
Group assets and liabilities into these
“buckets”
4.
Calculate the GAP for each “bucket ”
5.
Forecast the change in net interest
income given an assumed change in
interest rates
177
Measuring Interest Rate Risk with
GAP
 What Determines Rate Sensitivity
 The initial issue is to determine what
features make an asset or liability rate
sensitive
178
Measuring Interest Rate Risk with
GAP

Expected Repricing versus Actual
Repricing

In general, an asset or liability is normally
classified as rate sensitive within a time
interval if:
 It matures
 It represents an interim or partial principal
payment
 The interest rate applied to the outstanding
principal balance changes contractually during
the interval
 The interest rate applied to the outstanding
principal balance changes when some base
rate or index changes and management
expects the base rate/index to change during
the time interval
179
Measuring Interest Rate Risk with
GAP
 What Determines Rate Sensitivity
 Maturity
 If any asset or liability matures within a
time interval, the principal amount will be
repriced
 The question is what principal amount is
expected to reprice

Interim or Partial Principal Payment

Any principal payment on a loan is rate
sensitive if management expects to
receive it within the time interval
 Any interest received or paid is not included in
the GAP calculation
180
Measuring Interest Rate Risk with
GAP
 What Determines Rate Sensitivity
 Contractual
Change in Rate
Some assets and deposit liabilities earn
or pay rates that vary contractually with
some index
 These instruments are repriced
whenever the index changes

 If management knows that the index will
contractually change within 90 days, the
underlying asset or liability is rate
sensitive within 0–90 days.
181
Measuring Interest Rate Risk with
GAP
 What Determines Rate Sensitivity
 Change in Base Rate or Index
 Some loans and deposits carry interest
rates tied to indexes where the bank has
no control or definite knowledge of when
the index will change.
 For example, prime rate loans typically
state that the bank can contractually
change prime daily
 The loan is rate sensitive in the sense that its
yield can change at any time
 However, the loan’s effective rate sensitivity
depends on how frequently the prime rate
actually changes
182
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Rate,
Composition (Mix) and Volume
Effects

All affect net interest income
183
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes

in the Level of Interest Rates
The sign of GAP (positive or negative)
indicates the nature of the bank’s
interest rate risk
 A negative (positive) GAP, indicates that
the bank has more (less) RSLs than RSAs.
When interest rates rise (fall) during the
time interval, the bank pays higher (lower)
rates on all repriceable liabilities and earns
higher (lower) yields on all repriceable
assets
184
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income

Changes in the Level of Interest Rates

The sign of GAP (positive or negative)
indicates the nature of the bank’s interest
rate risk
 If all rates rise (fall) by equal amounts at the
same time, both interest income and interest
expense rise (fall), but interest expense rises
(falls) more because more liabilities are
repriced
 Net interest income thus declines (increases),
as does the bank’s net interest margin
185
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes
in the Level of Interest Rates
If a bank has a zero GAP, RSAs equal
RSLs and equal interest rate changes
do not alter net interest income
because changes in interest income
equal changes in interest expense
 It is virtually impossible for a bank to
have a zero GAP given the complexity
and size of bank balance sheets

186
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
187
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes

in the Level of Interest Rates
GAP analysis assumes a parallel shift
in the yield curve
188
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income

Changes in the Level of Interest Rates

If there is a parallel shift in the yield curve
then changes in Net Interest Income are
directly proportional to the size of the
GAP:
∆NIIEXP = GAP x ∆iEXP
 It is rare, however, when the yield curve shifts
parallel. If rates do not change by the same
amount and at the same time, then net interest
income may change by more or less
189
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes

in the Level of Interest Rates
Example 1
 Recall the bank that makes a $25,000 fiveyear car loan to a customer at fixed rate of
8.5%. The bank initially funds the car loan
with a one-year $25,000 CD at a cost of
4.5%. What is the bank’s 1-year GAP?
190
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes in the Level of Interest Rates
 Example 1
 RSA1 YR = $0
 RSL1 YR = $25,000
 GAP1 YR = $0 - $25,000 = -$25,000
 The bank’s one year funding GAP is $25,000
 If interest rates rise (fall) by 1% in 1 year,
the bank’s net interest margin and net
interest income will fall (rise)
 ∆NIIEXP = GAP x ∆iEXP = -$25,000 x 1% =
-$250
191
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes

in the Level of Interest Rates
Example 2
 Assume a bank accepts an 18-month
$30,000 CD deposit at a cost of 3.75% and
invests the funds in a $30,000 6-month TBill at rate of 4.80%. The bank’s initial
spread is 1.05%. What is the bank’s 6month GAP?
192
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes in the Level of Interest Rates
 Example 2
 RSA6 MO = $30,000
 RSL6 MO = $0
 GAP6 MO = $30,000 – $0 = $30,000
 The bank’s 6-month funding GAP is $30,000
 If interest rates rise (fall) by 1% in 6
months, the bank’s net interest margin and
net interest income will rise (fall)
 ∆NIIEXP = GAP x ∆iEXP = $30,000 x 1% =
$300
193
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income

Changes in the Relationship Between
Asset Yields and Liability Costs
Net interest income may differ from that
expected if the spread between earning
asset yields and the interest cost of
interest-bearing liabilities changes
 The spread may change because of a
nonparallel shift in the yield curve or
because of a change in the difference
between different interest rates (basis risk)

194
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes in Volume
 Net interest income varies directly with
changes in the volume of earning assets
and interest-bearing liabilities, regardless
of the level of interest rates
 For example, if a bank doubles in size but
the portfolio composition and interest
rates remain unchanged, net interest
income will double because the bank
earns the same interest spread on twice
the volume of earning assets such that
NIM is unchanged
195
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Changes
in Portfolio Composition
Any variation in portfolio mix
potentially alters net interest income
 There is no fixed relationship between
changes in portfolio mix and net
interest income

 The impact varies with the relationships
between interest rates on rate-sensitive
and fixed-rate instruments and with the
magnitude of funds shifts
196
197
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example
Rate sensitive
Fixed rate
Non earning
Total
3.0
Balance Sheet
Assets
Yield
$
500
8.0%
$
350
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
4.0%
6.0%
198
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

3.0
Interest Income
 ($500 x 8%) + ($350 x 11%) = $78.50

Interest Expense
 ($600 x 4%) + ($220 x 6%) = $37.20

Net Interest Income
 $78.50 - $37.20 = $41.30
199
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

3.0
Earning Assets
 $500 + $350 = $850

Net Interest Margin
 $41.3/$850 = 4.86%

Funding GAP
 $500 - $600 = -$100
200
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if all rates increase by 1%?
Rate sensitive
Fixed rate
Non earning
Total
3.1
Balance Sheet
Assets
Yield
$
500
9.0%
$
350
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.0%
6.0%
201
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 3.1
 What if all rates increase by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP
∆NIIEXP

$ 83.50
$ 43.20
$ 40.30
4.74%
$ (100)
$ (1.00)
With a negative GAP, interest income
increases by less than the increase in
interest expense. Thus, both NII and NIM
fall.
202
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if all rates fall by 1%?
Rate sensitive
Fixed rate
Non earning
Total
3.2
Balance Sheet
Assets
Yield
$
500
7.0%
$
350
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
3.0%
6.0%
203
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 3.2
 What if all rates fall by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP
∆NIIEXP

$ 73.50
$ 31.20
$ 42.30
4.98%
$ (100)
$ 1.00
With a negative GAP, interest income
decreases by less than the decrease in
interest expense. Thus, both NII and NIM
increase.
204
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

3.3
What if rates rise but the spread falls by
1%?
Rate sensitive
Fixed rate
Non earning
Total
Balance Sheet
Assets
Yield
$
500
8.5%
$
350
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.5%
6.0%
205
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 3.3
 What if rates rise but the spread falls by
1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 81.00
$ 46.20
$ 34.80
4.09%
$ (100)
Both NII and NIM fall with a decrease in the
spread. Why the larger change?
 Note: ∆NIIEXP ≠ GAP x ∆iEXP Why?
206
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

3.4
What if rates fall but the spread falls by
1%?
Rate sensitive
Fixed rate
Non earning
Total
Balance Sheet
Assets
Yield
$
500
6.5%
$
350
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
3.5%
6.0%
207
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 3.4
 What if rates fall and the spread falls by
1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 71.00
$ 34.20
$ 36.80
4.33%
$ (100)
Both NII and NIM fall with a decrease in the
spread.
 Note: ∆NIIEXP ≠ GAP x ∆iEXP
208
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates rise and the spread rises
by 1%?
Rate sensitive
Fixed rate
Non earning
Total
3.5
Balance Sheet
Assets
Yield
$
500
10.0%
$
350
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.0%
6.0%
209
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 3.5
 What if rates rise and the spread rises by
1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 88.50
$ 43.20
$ 45.30
5.33%
$ (100)
Both NII and NIM increase with an increase
in the spread.
 Note: ∆NIIEXP ≠ GAP x ∆iEXP
210
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates fall and the spread rises
by 1%?
Balance Sheet
Rate sensitive
Fixed rate
Non earning
Total
3.6
Assets
$
500
$
350
$
150
$ 1,000
Yield
7.0%
11.0%
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
2.0%
6.0%
211
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 3.6
 What if rates fall and the spread rises by
1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 73.50
$ 25.20
$ 48.30
5.68%
$ (100)
Both NII and NIM increase with an increase
in the spread.
 Note: ∆NIIEXP ≠ GAP x ∆iEXP
212
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if the bank proportionately
doubles in size?
Rate sensitive
Fixed rate
Non earning
Total
3.7
Balance Sheet
Assets
Yield
$ 1,000
8.0%
$
700
11.0%
$
300
$ 2,000
Liabilities
$ 1,200
$
440
$
200
$ 1,840
Equity
$
160
$ 2,000
Cost
4.0%
6.0%
213
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 3.7
 What if the bank proportionately doubles
in size?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 157.00
$ 74.40
$ 82.60
4.86%
$ (200)
Both NII doubles but NIM stays the same.
Why? What has happened to the bank’s
risk?
214
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example
Rate sensitive
Fixed rate
Non earning
Total
4.0
Balance Sheet
Assets
Yield
$
600
8.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
450
$
370
$
100
$
920
Equity
$
80
$ 1,000
Cost
4.0%
6.0%
215
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example
4.0
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 75.50
$ 40.20
$ 35.30
4.15%
$
150
Bank has a positive GAP
216
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates increase by 1%?
Rate sensitive
Fixed rate
Non earning
Total
4.1
Balance Sheet
Assets
Yield
$
600
9.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
450
$
370
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.0%
6.0%
217
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 4.1
 What if rates increase by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP
∆NIIEXP

$ 81.50
$ 44.70
$ 36.80
4.33%
$
150
$ 1.50
With a positive GAP, interest income
increases by more than the increase in
interest expense. Thus, both NII and NIM
rise.
218
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates decrease by 1%?
Rate sensitive
Fixed rate
Non earning
Total
4.2
Balance Sheet
Assets
Yield
$
600
7.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
450
$
370
$
100
$
920
Equity
$
80
$ 1,000
Cost
3.0%
6.0%
219
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 4.2
 What if rates decrease by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP
∆NIIEXP

$ 69.50
$ 35.70
$ 33.80
3.98%
$
150
$ (1.50)
With a positive GAP, interest income
decreases by more than the decrease in
interest expense. Thus, both NII and NIM
fall.
220
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates rise but the spread falls by
1%?
Balance Sheet
Rate sensitive
Fixed rate
Non earning
Total
4.3
Assets
$
600
$
250
$
150
$ 1,000
Yield
8.5%
11.0%
Liabilities
$
450
$
370
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.5%
6.0%
221
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 4.3
 What if rates rise but the spread falls by
1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 78.50
$ 46.95
$ 31.55
3.71%
$
150
Both NII and NIM fall with a decrease in
the spread. Why the larger change?
 Note: ∆NIIEXP ≠ GAP x ∆iEXP Why?
222
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates fall and the spread falls by
1%?
Rate sensitive
Fixed rate
Non earning
Total
4.4
Balance Sheet
Assets
Yield
$
600
6.5%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
450
$
370
$
100
$
920
Equity
$
80
$ 1,000
Cost
3.5%
6.0%
223
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 4.4
 What if rates fall and the spread falls by
1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP
$ 66.50
$ 37.95
$ 28.55
3.36%
$
150
Both NII and NIM fall with a decrease in the
spread.
 Note: ∆NIIEXP ≠ GAP x ∆iEXP

224
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates rise and the spread rises
by 1%?
Rate sensitive
Fixed rate
Non earning
Total
4.5
Balance Sheet
Assets
Yield
$
600
10.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
450
$
370
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.0%
6.0%
225
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 4.5
 What if rates rise and the spread rises
by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP
$ 87.50
$ 44.70
$ 42.80
5.04%
$
150
Both NII and NIM increase with an
increase in the spread.
 Note: ∆NIIEXP ≠ GAP x ∆iEXP

226
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates fall and the spread rises
by 1%?
Rate sensitive
Fixed rate
Non earning
Total
4.6
Balance Sheet
Assets
Yield
$
600
7.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
450
$
370
$
100
$
920
Equity
$
80
$ 1,000
Cost
2.0%
6.0%
227
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 4.6
 What if rates fall and the spread rises
by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP
$ 69.50
$ 31.20
$ 38.30
4.51%
$
150
Both NII and NIM increase with an
increase in the spread.
 Note: ∆NIIEXP ≠ GAP x ∆iEXP

228
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if the bank proportionately
doubles in size?
Rate sensitive
Fixed rate
Non earning
Total
4.7
Balance Sheet
Assets
Yield
$ 1,200
8.0%
$
500
11.0%
$
300
$ 2,000
Liabilities
$
900
$
740
$
200
$ 1,840
Equity
$
160
$ 2,000
Cost
4.0%
6.0%
229
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 4.7
 What if the bank proportionately doubles
in size?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 151.00
$ 80.40
$ 70.60
4.15%
$
300
Both NII doubles but NIM stays the same.
Why? What has happened to the bank’s
risk?
230
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example
Rate sensitive
Fixed rate
Non earning
Total
5.0
Balance Sheet
Assets
Yield
$
600
8.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
4.0%
6.0%
231
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example
5.0
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 75.50
$ 37.20
$ 38.30
4.51%
$
-
Bank has zero GAP
232
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates increase by 1%?
Rate sensitive
Fixed rate
Non earning
Total
5.1
Balance Sheet
Assets
Yield
$
600
9.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.0%
6.0%
233
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 5.1
 What if rates increase by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 81.50
$ 43.20
$ 38.30
4.51%
$
-
With a zero GAP, interest income
increases by the amount as the increase in
interest expense. Thus, there is no
change in NII or NIM!
234
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates fall and the spread falls by
1%?
Rate sensitive
Fixed rate
Non earning
Total
5.2
Balance Sheet
Assets
Yield
$
600
6.5%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
3.5%
6.0%
235
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example 5.2
 What if rates fall and the spread falls by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 66.50
$ 34.20
$ 32.30
3.80%
$
-
Even with a zero GAP, interest income
falls by more than the decrease in interest
expense. Thus, both NII and NIM fall with
a decrease in the spread. Note: ∆NIIEXP ≠
GAP x ∆iEXP
236
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Example

What if rates rise and the spread rises
by 1%?
Rate sensitive
Fixed rate
Non earning
Total
5.3
Balance Sheet
Assets
Yield
$
600
10.0%
$
250
11.0%
$
150
$ 1,000
Liabilities
$
600
$
220
$
100
$
920
Equity
$
80
$ 1,000
Cost
5.0%
6.0%
237
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income

Example 5.3

What if rates rise and the spread rises by 1%?
Interest Income
Interest Expense
Net Interest Income
Net Interest Margin
Funding GAP

$ 87.50
$ 43.20
$ 44.30
5.21%
$
-
Even with a zero GAP, interest income rises
by more than the increase in interest expense.
Thus, both NII and NIM increase with an
increase in the spread. Note: ∆NIIEXP ≠ GAP x
∆iEXP
238
Measuring Interest Rate Risk with
GAP
 Factors Affecting Net Interest Income
 Summary
NII
NIM

of Base Cases
Positive
$35.30
4.15%
GAP
Zero
Negative
$38.20
$41.30
4.51%
4.86%
If a Negative GAP gives the largest NII
and NIM, why not plan for a Negative
GAP?
239
Measuring Interest Rate Risk with
GAP
 Rate, Volume, and Mix Analysis
 Many
financial institutions publish a
summary in their annual report of how
net interest income has changed over
time
 They separate changes attributable to
shifts in asset and liability composition
and volume from changes associated
with movements in interest rates
240
241
Measuring Interest Rate Risk with
GAP
 Rate Sensitivity Reports
 Many
managers monitor their bank’s
risk position and potential changes in
net interest income using rate
sensitivity reports

These report classify a bank’s assets
and liabilities as rate sensitive in
selected time buckets through one year
242
Measuring Interest Rate Risk with
GAP
 Rate Sensitivity Reports
 Periodic

GAP
The Gap for each time bucket and
measures the timing of potential
income effects from interest rate
changes
243
Measuring Interest Rate Risk with
GAP
 Rate Sensitivity Reports
 Cumulative
GAP
The sum of periodic GAP's and
measures aggregate interest rate risk
over the entire period
 Cumulative GAP is important since it
directly measures a bank’s net interest
sensitivity throughout the time interval

244
245
Measuring Interest Rate Risk with
GAP
 Strengths and Weaknesses of Static
GAP Analysis
 Strengths
Easy to understand
 Works well with small changes in
interest rates

246
Measuring Interest Rate Risk with
GAP
 Strengths and Weaknesses of Static GAP
Analysis

Weaknesses
Ex-post measurement errors
 Ignores the time value of money
 Ignores the cumulative impact of interest
rate changes
 Typically considers demand deposits to
be non-rate sensitive
 Ignores embedded options in the bank’s
assets and liabilities

247
Measuring Interest Rate Risk with
GAP
 GAP Ratio
 GAP
Ratio = RSAs/RSLs
A GAP ratio greater than 1 indicates a
positive GAP
 A GAP ratio less than 1 indicates a
negative GAP

248
Measuring Interest Rate Risk with
GAP
 GAP Divided by Earning Assets as a Measure
of Risk
 An alternative risk measure that relates the
absolute value of a bank’s GAP to earning
assets
 The greater this ratio, the greater the interest
rate risk
 Banks may specify a target GAP-to-earningasset ratio in their ALCO policy statements
 A target allows management to position the
bank to be either asset sensitive or liability
sensitive, depending on the outlook for
interest rates
249
Earnings Sensitivity Analysis
 Allows management to incorporate the
impact of different spreads between
asset yields and liability interest costs
when rates change by different
amounts
250
Earnings Sensitivity Analysis
 Steps to Earnings Sensitivity Analysis
1. Forecast interest rates.
2. Forecast balance sheet size and
composition given the assumed interest
rate environment
3. Forecast when embedded options in
assets and liabilities will be exercised
such that prepayments change,
securities are called or put, deposits are
withdrawn early, or rate caps and rate
floors are exceeded under the assumed
interest rate environment
251
Earnings Sensitivity Analysis
 Steps to Earnings Sensitivity Analysis
4.
5.
6.
Identify when specific assets and liabilities
will reprice given the rate environment
Estimate net interest income and net
income under the assumed rate
environment
Repeat the process to compare forecasts of
net interest income and net income across
different interest rate environments versus
the base case

The choice of base case is important because
all estimated changes in earnings are
compared with the base case estimate
252
Earnings Sensitivity Analysis
 The key benefits of conducting earnings sensitivity
analysis are that managers can estimate the impact
of rate changes on earnings while allowing for the
following:





Interest rates to follow any future path
Different rates to change by different amounts at
different times
Expected changes in balance sheet mix and volume
Embedded options to be exercised at different times
and in different interest rate environments
Effective GAPs to change when interest rates change
 Thus, a bank does not have a single static GAP, but
instead will experience amounts of RSAs and RSLs
that change when interest rates change
253
Earnings Sensitivity Analysis
 Exercise of Embedded Options in Assets and
Liabilities
 The most common embedded options at
banks include the following:








Refinancing of loans
Prepayment (even partial) of principal on
loans
Bonds being called
Early withdrawal of deposits
Caps on loan or deposit rates
Floors on loan or deposit rates
Call or put options on FHLB advances
Exercise of loan commitments by borrowers
254
Earnings Sensitivity Analysis
 Exercise of Embedded Options in Assets and
Liabilities
 The implications of embedded options



Does the bank or the customer determine
when the option is exercised?
How and by what amount is the bank being
compensated for selling the option, or how
much must it pay to buy the option?
When will the option be exercised?
 This is often determined by the economic and
interest rate environment

Static GAP analysis ignores these embedded
options
255
Earnings Sensitivity Analysis
 Different Interest Rates Change by
Different Amounts at Different Times
 It
is well recognized that banks are
quick to increase base loan rates but
are slow to lower base loan rates when
rates fall
256
Earnings Sensitivity Analysis
 Earnings Sensitivity: An Example
 Consider the rate sensitivity report for
First Savings Bank (FSB) as of year-end
2008 that is presented on the next slide
 The report is based on the most likely
interest rate scenario
 FSB is a $1 billion bank that bases its
analysis on forecasts of the federal funds
rate and ties other rates to this overnight
rate
 As such, the federal funds rate serves as
the bank’s benchmark interest rate
257
258
259
260
Earnings Sensitivity Analysis
 Explanation of Sensitivity Results
 This example demonstrates the
importance of understanding the impact
of exercising embedded options and the
lags between the pricing of assets and
liabilities.
 The framework uses the federal funds
rate as the benchmark rate such that rate
shocks indicate how much the funds rate
changes
 Summary results are known as Earningsat-Risk Simulation or Net Interest Income
Simulation
261
Earnings Sensitivity Analysis
 Explanation of Sensitivity Results
 Earnings-at-Risk

The potential variation in net interest
income across different interest rate
environments, given different
assumptions about balance sheet
composition, when embedded options
will be exercised, and the timing of
repricings.
262
Earnings Sensitivity Analysis
 Explanation of Sensitivity Results
 FSB’s earnings sensitivity results reflect
the impacts of rate changes on a bank
with this profile
 There are two basic causes or drivers
behind the estimated earnings changes
 First, other market rates change by
different amounts and at different times
relative to the federal funds rate
 Second, embedded options potentially
alter cash flows when the options go in
the money
263
Income Statement GAP
 Income Statement GAP
 An
interest rate risk model which
modifies the standard GAP model to
incorporate the different speeds and
amounts of repricing of specific assets
and liabilities given an interest rate
change
264
Income Statement GAP
 Beta GAP
 The adjusted GAP figure in a basic
earnings sensitivity analysis derived
from multiplying the amount of ratesensitive assets by the associated beta
factors and summing across all ratesensitive assets, and subtracting the
amount of rate-sensitive liabilities
multiplied by the associated beta
factors summed across all ratesensitive liabilities
265
Income Statement GAP
 Balance Sheet GAP
 The effective amount of assets that
reprice by the full assumed rate change
minus the effective amount of liabilities
that reprice by the full assumed rate
change.
 Earnings Change Ratio (ECR)
 A ratio calculated for each asset or
liability that estimates how the yield on
assets or rate paid on liabilities is
assumed to change relative to a 1 percent
change in the base rate
266
267
Managing the GAP and Earnings
Sensitivity Risk
 Steps to reduce risk
 Calculate
periodic GAPs over short
time intervals
 Match fund repriceable assets with
similar repriceable liabilities so that
periodic GAPs approach zero
 Match fund long-term assets with noninterest-bearing liabilities
 Use off-balance sheet transactions to
hedge
268
Managing the GAP and Earnings
Sensitivity Risk
 How to Adjust the Effective GAP or
Earnings Sensitivity Profile
269
Managing Interest Rate
Risk: Economic Value
of Equity
270
Managing Interest Rate Risk:
Economic Value of Equity
 Economic Value of Equity (EVE)
Analysis
 Focuses
on changes in stockholders’
equity given potential changes in
interest rates
271
Managing Interest Rate Risk:
Economic Value of Equity
 Duration GAP Analysis
 Compares
the price sensitivity of a
bank’s total assets with the price
sensitivity of its total liabilities to
assess the impact of potential changes
in interest rates on stockholders’
equity
272
Managing Interest Rate Risk:
Economic Value of Equity
 GAP and Earnings Sensitivity versus
Duration GAP and EVE Sensitivity
273
Managing Interest Rate Risk:
Economic Value of Equity
 Recall from Chapter 6
 Duration
is a measure of the effective
maturity of a security
Duration incorporates the timing and
size of a security’s cash flows
 Duration measures how price sensitive
a security is to changes in interest
rates

 The greater (shorter) the duration, the
greater (lesser) the price sensitivity
274
Managing Interest Rate Risk:
Economic Value of Equity
 Market Value Accounting Issues

EVE sensitivity analysis is linked with the
debate concerning whether market value
accounting is appropriate for financial
institutions


Recently many large commercial and
investment banks reported large write-downs
of mortgage-related assets, which depleted
their capital
Some managers argued that the write-downs
far exceeded the true decline in value of the
assets and because banks did not need to sell
the assets they should not be forced to
recognize the “paper” losses
275
276
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Analysis
 Compares
the price sensitivity of a
bank’s total assets with the price
sensitivity of its total liabilities to
assess whether the market value of
assets or liabilities changes more
when rates change
277
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Macaulay’s
Duration (D)
 Cashflow t 
t 
t

n
(1  i )
D  t 

P*




where P* is the initial price, i is the
market interest rate, and t is equal to
the time until the cash payment is made
278
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Macaulay’s

Duration (D)
Macaulay’s duration is a measure of
price sensitivity where P refers to the
price of the underlying security:
ΔP
D

 Δi
P
(1  i)
279
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Modified

Duration
Indicates how much the price of a
security will change in percentage
terms for a given change in interest
rates
Modified Duration = D/(1+i)
280
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Example

Assume that a ten-year zero coupon
bond has a par value of $10,000,
current price of $7,835.26, and a market
rate of interest of 5%. What is the
expected change in the bond’s price if
interest rates fall by 25 basis points?
281
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Example

Since the bond is a zero-coupon bond,
Macaulay’s Duration equals the time to
maturity, 10 years. With a market rate
of interest, the Modified Duration is
10/(1.05) = 9.524 years. If rates change
by 0.25% (.0025), the bond’s price will
change by approximately 9.524 × .0025
× $7,835.26 = $186.56
282
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective
Duration
Used to estimate a security’s price
sensitivity when the security contains
embedded options
 Compares a security’s estimated price
in a falling and rising rate environment

283
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and Effective
Duration

Effective Duration
Pi- - Pi 
Effective Duration 
P0 (i  - i - )
where:
Pi- = Price if rates fall
Pi+ = Price if rates rise
P0 = Initial (current) price
i+ = Initial market rate plus the increase in
the rate
i- = Initial market rate minus the decrease
in the rate
284
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective

Duration
Example
 Consider a 3-year, 9.4 percent semi-annual
coupon bond selling for $10,000 par to
yield 9.4 percent to maturity
 Macaulay’s Duration for the option-free
version of this bond is 5.36 semiannual
periods, or 2.68 years
 The Modified Duration of this bond is 5.12
semiannual periods or 2.56 years
285
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective

Duration
Example
 Assume that the bond is callable at par in
the near-term .
 If rates fall, the price will not rise much
above the par value since it will likely
be called
 If rates rise, the bond is unlikely to be
called and the price will fall
286
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective

Duration
Example
 If rates rise 30 basis points to 5%
semiannually, the price will fall to
$9,847.72.
 If rates fall 30 basis points to 4.4%
semiannually, the price will remain at par
287
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective

Duration
Example
$10,000 - $9,847.72
Effective Duration 
 2.54
$10,000(0.05 - 0.044)
288
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Focuses
on managing the market value
of stockholders’ equity
The bank can protect EITHER the
market value of equity or net interest
income, but not both
 Duration GAP analysis emphasizes the
impact on equity and focuses on price
sensitivity

289
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model

Steps in Duration GAP Analysis



Forecast interest rates
Estimate the market values of bank assets,
liabilities and stockholders’ equity
Estimate the weighted average duration of
assets and the weighted average duration of
liabilities
 Incorporate the effects of both on- and off-balance
sheet items. These estimates are used to calculate
duration gap

Forecasts changes in the market value of
stockholders’ equity across different interest
rate environments
290
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Weighted
Average Duration of Bank
Assets (DA):
n
DA   w i Da i
where
i
wi = Market value of asset i divided by
the market value of all bank assets
 Dai = Macaulay’s duration of asset i
 n = number of different bank assets

291
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Weighted
Average Duration of Bank
Liabilities (DL):
m
where
DL   z jDl j
j
zj = Market value of liability j divided by
the market value of all bank liabilities
 Dlj= Macaulay’s duration of liability j
 m = number of different bank liabilities

292
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Let MVA and MVL equal the market values
of assets and liabilities, respectively
 If ΔEVE = ΔMVA – ΔMVL
and
 Duration GAP = DGAP = DA –
(MVL/MVA)DL
then
 ΔEVE = -DGAP[Δy/(1+y)]MVA
where y is the interest rate
293
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 To
protect the economic value of
equity against any change when rates
change , the bank could set the
duration gap to zero:
 y 
ΔEVE  - DGAP 
MVA

 (1  y) 
294
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model

DGAP as a Measure of Risk

The sign and size of DGAP provide
information about whether rising or falling
rates are beneficial or harmful and how much
risk the bank is taking
 If DGAP is positive, an increase in rates will lower
EVE, while a decrease in rates will increase EVE
 If DGAP is negative, an increase in rates will
increase EVE, while a decrease in rates will lower
EVE
 The closer DGAP is to zero, the smaller is the
potential change in EVE for any change in rates
295
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
296
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Implications of DGAP
 The value of DGAP at 1.42 years indicates
that the bank has a substantial mismatch
in average durations of assets and
liabilities
 Since the DGAP is positive, the market
value of assets will change more than the
market value of liabilities if all rates
change by comparable amounts
 In this example, an increase in rates will cause
a decrease in EVE, while a decrease in rates
will cause an increase in EVE
297
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Implications of DGAP > 0

A positive DGAP indicates that assets are more price
sensitive than liabilities
 When interest rates rise (fall), assets will fall
proportionately more (less) in value than
liabilities and EVE will fall (rise) accordingly.

Implications of DGAP < 0

A negative DGAP indicates that liabilities
are more price sensitive than assets
 When interest rates rise (fall), assets will fall
proportionately less (more) in value that
liabilities and the EVE will rise (fall)
298
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
299
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Duration
GAP Summary
300
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 DGAP

As a Measure of Risk
DGAP measures can be used to
approximate the expected change in
economic value of equity for a given
change in interest rates
ΔEVE  - DGAP[
y
]MVA
(1  y)
301
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 DGAP

As a Measure of Risk
In this case:
.01
ΔEVE  - 1.42[
]$1,000  $12.91
1.10

The actual decrease, as shown in
Exhibit 8.3, was $12
302
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 An Immunized Portfolio
 To immunize the EVE from rate changes in
the example, the bank would need to:
 decrease the asset duration by 1.42 years
or
 increase the duration of liabilities by 1.54 years
DA/( MVA/MVL)
= 1.42/($920/$1,000)
= 1.54 years
or
 a combination of both
303
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
304
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 An

Immunized Portfolio
With a 1% increase in rates, the EVE
did not change with the immunized
portfolio versus $12.0 when the
portfolio was not immunized
305
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 An Immunized Portfolio
 If DGAP > 0, reduce interest rate risk by:
 shortening asset durations
 Buy short-term securities and sell longterm securities
 Make floating-rate loans and sell fixed-rate
loans
 lengthening liability durations
 Issue longer-term CDs
 Borrow via longer-term FHLB advances
 Obtain more core transactions accounts
from stable sources
306
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks

An Immunized Portfolio

If DGAP < 0, reduce interest rate risk by:
 lengthening asset durations
 Sell short-term securities and buy long-term
securities
 Sell floating-rate loans and make fixed-rate
loans
 Buy securities without call options
 shortening liability durations
 Issue shorter-term CDs
 Borrow via shorter-term FHLB advances
 Use short-term purchased liability funding from
federal funds and repurchase agreements
307
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Banks
may choose to target variables
other than the market value of equity in
managing interest rate risk
 Many banks are interested in
stabilizing the book value of net
interest income

This can be done for a one-year time
horizon, with the appropriate duration
gap measure
308
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 DGAP* = MVRSA(1 − DRSA) − MVRSL(1 −
DRSL)
 where
 MVRSA = cumulative market value of ratesensitive assets (RSAs)
 MVRSL = cumulative market value of ratesensitive liabilities (RSLs)
 DRSA = composite duration of RSAs for
the given time horizon
 DRSL = composite duration of RSLs for
the given time horizon
309
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks

DGAP* > 0


DGAP* < 0


Net interest income will decrease (increase)
when interest rates decrease (increase)
Net interest income will decrease (increase)
when interest rates increase (decrease)
DGAP* = 0

Interest rate risk eliminated
 A major point is that duration analysis can be used
to stabilize a number of different variables
reflecting bank performance
310
Economic Value of Equity
Sensitivity Analysis
 Involves the comparison of changes in
the Economic Value of Equity (EVE)
across different interest rate
environments
 An
important component of EVE
sensitivity analysis is allowing
different rates to change by different
amounts and incorporating projections
of when embedded customer options
will be exercised and what their values
will be
311
Economic Value of Equity
Sensitivity Analysis
 Estimating the timing of cash flows
and subsequent durations of assets
and liabilities is complicated by:
 Prepayments
that exceed (fall short of)
those expected
 A bond being
 A deposit that is withdrawn early or a
deposit that is not withdrawn as
expected
312
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example
 First
Savings Bank
Average duration of assets equals 2.6
years
 Market value of assets equals
$1,001,963,000
 Average duration of liabilities equals 2
years
 Market value of liabilities equals
$919,400,000

313
314
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example

First Savings Bank

Duration Gap
 2.6 – ($919,400,000/$1,001,963,000) × 2.0 = 0.765
years

Example:
 A 1% increase in rates would reduce EVE by $7.2
million
 ΔMVE = -DGAP[Δy/(1+y)]MVA
 ΔMVE = -0.765 (0.01/1.0693) × $1,001,963,000
= -$7,168,257
 Recall that the average rate on assets is
6.93%
 The estimate of -$7,168,257 ignores the impact of
interest rates on embedded options and the
effective duration of assets and liabilities
315
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example
316
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example

First Savings Bank

The previous slide shows that FSB’s EVE
will fall by $8.2 million if rates are rise by
1%
 This differs from the estimate of -$7,168,257
because this sensitivity analysis takes into
account the embedded options on loans and
deposits
 For example, with an increase in interest rates,
depositors may withdraw a CD before maturity
to reinvest the funds at a higher interest rate
317
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example
 First

Savings Bank
Effective “Duration” of Equity
 Recall, duration measures the percentage
change in market value for a given change
in interest rates
 A bank’s duration of equity measures
the percentage change in EVE that will
occur with a 1 percent change in rates:
 Effective duration of equity = $8,200 /
$82,563 = 9.9 years
318
Earnings Sensitivity Analysis
versus EVE Sensitivity Analysis
 Strengths and Weaknesses: DGAP and
EVE-Sensitivity Analysis

Strengths
Duration analysis provides a
comprehensive measure of interest rate
risk
 Duration measures are additive

 This allows for the matching of total assets
with total liabilities rather than the matching of
individual accounts

Duration analysis takes a longer term view
than static gap analysis
319
Earnings Sensitivity Analysis
versus EVE Sensitivity Analysis
 Strengths and Weaknesses: DGAP and EVE-
Sensitivity Analysis
 Weaknesses





It is difficult to compute duration accurately
“Correct” duration analysis requires that each
future cash flow be discounted by a distinct
discount rate
A bank must continuously monitor and adjust
the duration of its portfolio
It is difficult to estimate the duration on assets
and liabilities that do not earn or pay interest
Duration measures are highly subjective
320
A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 GAP and DGAP Management
Strategies
 It
is difficult to actively vary GAP or
DGAP and consistently win
 Interest rates forecasts are frequently
wrong
 Even if rates change as predicted,
banks have limited flexibility in
changing GAP and DGAP
321
A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example
 Consider
the case where a bank has
two alternatives for funding $1,000 for
two years
A 2-year security yielding 6 percent
 Two consecutive 1-year securities, with
the current 1-year yield equal to 5.5
percent

 It is not known today what a 1-year
security will yield in one year
322
A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example
 Consider
the case where a bank has
two alternative for funding $1,000 for
two years
0
1
2
Two-Year Security
$60
0
$60
1
2
One-Year Security & then
another One-Year Security
$55
?
323
A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example

Consider the case where a bank has two
alternative for funding $1,000 for two
years

For the two consecutive 1-year securities
to generate the same $120 in interest,
ignoring compounding, the 1-year security
must yield 6.5% one year from the present
 This break-even rate is a 1-year forward rate of
:
 6% + 6% = 5.5% + x so x must = 6.5%
324
A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example
 Consider the case where a bank has two
alternative for investing $1,000 for two
years
 By investing in the 1-year security, a
depositor is betting that the 1-year interest
rate in one year will be greater than 6.5%
 By issuing the 2-year security, the bank is
betting that the 1-year interest rate in one
year will be greater than 6.5%
 By choosing one or the other, the depositor
and the bank “place a bet” that the actual rate
in one year will differ from the forward rate of
6.5 percent
325
Yield Curve Strategies
 When the U.S. economy hits its peak, the
yield curve typically inverts, with shortterm rates exceeding long-term rates.

Only twice since WWII has a recession
not followed an inverted yield curve
 As the economy contracts, the Federal
Reserve typically increases the money
supply, which causes rates to fall and the
yield curve to return to its “normal”
shape.
326
Yield Curve Strategies
 To take advantage of this trend, when the
yield curve inverts, banks could:

Buy long-term non-callable securities


Prices will rise as rates fall
Make fixed-rate non-callable loans

Borrowers are locked into higher rates
Price deposits on a floating-rate basis
 Follow strategies to become more liability
sensitive and/or lengthen the duration of
assets versus the duration of liabilities

327
328