Discuss limitations in the reliability of interest rate sensitivity gap. What factors would you site to show the weaknesses in the precision of and methodology for creating interest rate sensitivity gap report?
Interest rate sensitivity "gap" analysis ,is used to provide a general overview of interest rate risk profile. The effect, of interest rate changes ,on the assets and liabilities of a financial institution may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring an institution's interest rate sensitivity gap.
The interest rate sensitivity gap is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets.
Significant factors in managing the risk include the frequency, volatility and direction of rate changes, the slope of the interest rate yield curve, the size of the interest-sensitive position and the basis for repricing at rollover dates.
The actual ability to reprice certain interest-bearing liabilities depends on other factors in addition to the movement of interest rates. These factors include competitor's pricing, the current rate paid on interest-bearing liabilities, and alternative products offered in the financial market place
Limitations:
Interest rate risk arises when an institution's principal and interest cash flows (including final maturities), both on- and off-balance sheet, have mismatched repricing dates.
The primary weakness is that it ignores the time value of money. Moreover, simple gap analysis (based on contractual term to maturity) assumes that the timing and amount of assets and liabilities maturing within a specific gap period are fixed and determined, therefore ignoring the effects of principal and interest cash flows arising from honoring customer draw downs on credit commitments, deposit redemptions, and prepayments, either on mortgages or term loans, as well as the timing of maturities within the gap period
GAP further ignores the impact of embedded options. For this reason, most banks conduct earnings sensitivity analysis, or pro forma analysis, to project earnings and the variation in earnings under different interest rate environments.
Gap analysis does not capture basis risk or investment risk, is generally based on parallel shifts in the yield curve, does not incorporate future growth or changes in the mix of business, and does not account for the time value of money.
Accordingly, the use of gap reports should be complemented with present-value sensitivity systems, such as duration analysis or simulation models.
How one would use interest rate sensitivity gap information to estimate the impact of rising interest rates on earnings of Norwest Corporation.
Factors affecting NII :
Changes in the level of i-rates.
(This assumes a parallel shift in the yield curve which rarely occurs)
Changes in the slope of the yield curve or the relationship between asset yields and liability cost of funds
Changes in the volume of assets and liabilities
Change in the composition of assets and liabilities
According to exhibit 3, interest sensitivity gap for December 2006 was $(3317) million. The relatively small changes in gaps in percentage terms are due to number of offsetting changes in balance sheet during the year, including increase in investment portfolio and demand deposits. This made the corporation a bit vulnerable to rising rates and neutral to falling rates.
Also, the corporation's net cash flows from off balance sheet activities used to manage interest rate risk added $56.9 million to net interest income in 1996
Describe in your own words Norwest's methodology for determining 'accounting risk' and economic risk and differentiate between them.
Interest rate risk is the risk where changes in market interest rates affect a bank's financial position. Changes in interest rates impact a bank's earnings (i.e. reported profits) through changes in its Net Interest Income (NII). Changes in interest rates also impact a bank's Market Value of Equity (MVE) or Net Worth through changes in the economic value of its rate sensitive assets, liabilities and off-balance sheet positions. The interest rate risk, when viewed from these two perspectives, is known as 'earnings perspective' and 'economic value perspective', respectively. Generally, the former is measured using the TGA (Traditional gap analysis) and the latter is measured using more sophisticated DGA. Banks should carry out both the analyses.
Spread Risk (reinvestment rate risk)
Changes in interest rates will change the bank's cost of funds as well as the return on their invested assets. They may change by different amounts.
If interest rates change, the bank will have to reinvest the cash flows from assets or refinance rolled-over liabilities at a different interest rate in the future.
An increase in rates, ceteris paribus, increases a bank's interest income but also increases the bank's interest expense.
Static GAP Analysis considers the impact of changing rates on the bank's net interest income.
Price Risk
Changes in interest rates may change the market values of the bank's assets and liabilities by different amounts.
If interest rates change, the market values of assets and liabilities also change.
The longer is duration, the larger is the change in value for a given change in interest rates.
Duration GAP considers the impact of changing rates on the market value of equity.
Norwest uses a simulation model to determine earnings risk whereas measurement of economic perspective is done through a market valuation model. The cash flows are discounted by a market interest arte chosen to reflect as closely as possible the characteristics of a asset or liability
What would you suppose to be some practical difficulties in art of earnings simulation modeling? Why is it preferred method for measuring interest rate risk?
Practical Difficulties:
A simulation can misrepresent the bank's current risk position because it relies on management's assumptions about the bank's future business. The myriad of assumptions that underlie most simulation models can make it difficult to determine how much a variable contributes to changes in the value of the target account.
For this reason, many banks supplement their earnings simulation measures by isolating the risk inherent in the existing balance sheet using gap reports or measurements of risk to the economic value of equity.
In measuring their earnings at risk, many bankers limit the evaluation of their risk exposures to the following two years because interest rate and business assumptions that project further are considered unreliable. As a result, banks that use simulation models with horizons of only one or two years do not fully capture their long-term exposure.
A bank that uses a simulation model to measure the risk solely to near-term earnings should supplement its model with gap reports or economic value of equity models that measure the amount of long-term repricing exposures.
Preference over Gap Methods:
It Allows management to incorporate the impact of different spreads between asset yields and liability interest costs when rates change by different amounts.
Simulation models allow some of the assumptions underlying gap reports to be amended. For instance, gap reports assume a one-time shift in interest rates. Simulation models can handle varying interest rate paths, including variations in the shape of the yield curve. Gap reports usually assume the improbable C that all current assets and liabilities run off and are reinvested overnight. Simulation models can be more realistic.
A simulation model can accommodate various business forecasts and allow flexibility in running sensitivity analyses. For instance, basis risk can be evaluated by varying the spreads between the indices the bank uses to price its products. Perhaps the strongest advantage of simulation models is that they can present risk in terms that are meaningful and clear to senior management and boards of directors.
The results of simulation models present risk and reward under alternative rate scenarios in terms of net interest income, net income, and present value (economic value of equity).These terms are basic financial fundamentals that are readily understood by bank management.
Simulation models can handle the intermediate principal amortizations of products such as installment loan, handle caps and floors on adjustable rate loans and prepayments of mortgages or mortgage-backed securities under various interest rate scenarios (embedded options), handle nonstandard swaps and futures contracts, change spread relationships to capture basis risk, model a variety of interest rate movements and yield curve shapes, test for internal consistency among assumptions, analyze market or economic risk as well as risk to interest income
What difficulties do you suppose Norwest faces in creating a reliable market value model?
Banks typically focus on either:
net interest income or
the market value of stockholders' equity
As a target measure of performance.GAP models are commonly associated with net interest income (margin) targeting. Earnings sensitivity analysis or net interest income simulation, or "what if" forecasting provides information regarding how much NII changes when rates are assumed to increase or fall by various amounts.
Equity has a higher expected return relative to other asset classes; leading to a tendency for maximization of the equity exposure under a certain risk tolerance. From a corporate finance perspective it is very doubtful that this is the optimal solution since the risk of holding equities simply results in a higher corporate cost of capital, which offsets the risk premium you would hope to earn. Further, the risk/return framework does not give any weight to the severity of the ruin or the downside risk
Market Valuation Model: The market valuation model measures sensitivity of market value of equity to interest rate changes. MVE sensitivity analysis effectively involves the same steps as earnings sensitivity analysis. In MVA analysis, however, the bank focuses on:
The relative durations of assets and liabilities,
How much the durations change in different interest rate environments, and
What happens to the market value of equity across different rate environments?
Embedded options sharply influence the estimated volatility in MVE
Whenever management chooses to change asset and liability maturities and/or durations in anticipation of rate changes, it is placing a bet against forward rates from the yield curve.
However, measuring the effects of this exposure for a given portfolio of loans
With embedded options is tricky, because the values and properties (i.e., the deltas, gammas, Vegas, thetas, and rhos) of these options are subject to considerable volatility and lack of consensus. Moreover, even if there were uniformity of opinion, all of the relevant considerations are subject to change with time passing and/or changing market conditions.
Hence, problems for Norwest in creating such a model. The corporation also uses off balance sheet items to manage interest rate risk.
Discuss the practical steps it can take to reduce the size of the earnings reduction. Describe both on-balance sheet measures and off- balance sheet measures the corporation might take.
The cost of debt is based on the prevailing market rates plus a company-specific credit spread. First, with regard to interest rate risk, one of the objectives of corporate risk management is to lower the absolute interest cost. The cost of debt and especially the company-specific credit spread are determined, among other factors, by cash flow and accounting ratios. Lower volatility in ratios and cash flows are perceived as positive by lenders. This means that lenders will subsequently lower the credit spreads and increase borrowing possibilities for the company.
The value of a company increases when the tax shield related to debt exceeds the cost of financial distress that is associated with debt. A combination of annual volatility in stock returns and leverage of the company determines the expected value of the tax shield. High financial leverage and earnings volatility will lead to lower expected values of the tax shield.
The combination of lower required return on equity and a lower effective cost of debt can help to provide the option for a company to increase its leverage.
Fund long-term assets with matching noninterest-bearing liabilities.
Use off-balance sheet transactions to hedge.
Reduce asset sensitivity: by Buy longer-term securities, Lengthen the maturities of loans.
Move from floating-rate loans to term loans.
