Asset-Liability Management: Determining and Measuring
Interest Rates and Controlling Interest-Sensitive and Duration
Gaps
Bank Management & Financial Services (6th Edition) by Rose &
Hudgins
G. M. Wali Ullah
Lecturer
Independent University, Bangladesh (IUB)
ASSET-LIABILITY MANAGEMENT
 The Purpose of Asset-Liability Management is to Control a Bank’s Sensitivity to Changes in Market Interest Rates and
 Limit its Losses in its Net Income or Equity
ASSET-LIABILITY MANAGEMENT
• INT
REVENUE
• INT COSTS
Response to
changing IR
• MKT VALUE
OF ASSETS
• MKT VALUE
OF
LIABILITIES
NET
INTEREST
MARGIN
INVESTMENT
VALUE,
PROFITABILIT
Y AND RISK
NET
WORTH
Market Interest Rates
Function of:
 Risk-Free Real Rate of Interest
 Various Risk Premiums
 Default Risk
 Inflation Risk
 Liquidity Risk
 Call Risk
 Maturity Risk
Yield Curves
 Graphical Picture of Relationship Between Yields and Maturities on Securities
 Generally Created With Treasury Securities to Keep Default Risk Constant
 Shape of the Yield Curve
 Upward – Long-Term Rates Higher than Short-Term Rates
 Downward – Short-Term Rates Higher than Long-Term Rates
 Horizontal – Short-Term and Long-Term Rates the Same
Yield Curves
Interest Rate Hedging
 To protect profits against adverse changes in interest rates, management tries to
hold fixed the Net Interest Margin (NIM)
NIM 
Interest Income - Interest Expenses
Total Earnings
Assets
 Management aims to Insulate the Bank from the Damaging Effects of Fluctuating
Interest Rates on Profits
Interest-Sensitive Gap Management

Interest-Sensitive Gap Management
Interest-Sensitive Assets: Interest-Sensitive Liabilities:
 Short-Term Securities Issued by the
 Borrowings from Money Markets
Government and Private Borrowers
 Short-Term Loans Made by the Bank
to Borrowing Customers
 Variable-Rate Loans Made by the
Bank to Borrowing Customers
 Short-Term Savings Accounts
 Money-Market Deposits
 Variable-Rate Deposits
Interest-Sensitive Gap Management
Asset-Sensitive Bank
Liability-Sensitive Bank
 Interest Rates Rise
 Interest Rates Rise
 NIM Rises
 Interest Rates Fall
 NIM Falls
 NIM Falls
 Interest Rates Fall
 NIM Rises
Important Decision Regarding IS Gap
 Management Must Choose the Time Period Over Which NIM is to be Managed
 Management Must Choose a Target NIM
 To Increase NIM Management Must Either:
 Develop Correct Interest Rate Forecast
 Reallocate Assets and Liabilities to Increase Spread
 Management Must Choose Volume of Interest-Sensitive Assets and Liabilities
Aggressive Interest-Sensitive Gap Management
Expected Change
in Interest Rates
Best InterestSensitive Gap
Position
Aggressive
Management’s
Likely Action
Rising Market
Interest Rates
Positive IS Gap
Increase in IS
Assets
Decrease in IS
Liabilities
Falling Market
Interest Rates
Negative IS Gap
Decrease in IS
Assets
Increase in IS
Liabilities
Eliminating Interest-Sensitive Gap
IS GAP
Asset sensitive
Liability sensitive
THE RISK
POSSIBLE MANAGEMENT RESPONSE
Losses if interest rates fall (NIM will be 1. Do nothing
reduced)
2. Extend asset maturities or shorten liability
maturities
3. Increase ISL or reduce ISA
Losses if interest rise (NIM will be
reduced)
1. Do nothing
2. Shorted asset maturities or lengthen liability
maturities
3. Decrease ISL or increase ISA
Problems with Interest-Sensitive Gap Management
 Interest 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
 Interest-Sensitive Gap Does Not Consider the Impact of Changing Interest Rates
on Equity Position