468-22 - Chapter 22 - INTEREST RATE and INSOLVENCY RISK...

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Chapter 22 - INTEREST RATE and INSOLVENCY RISK Interest Rate Risk - In the process of FIs performing their asset-transformation function, FIs are exposed to Interest Rate Risk, from Mismatched Maturity/Duration: Borrowing Short, Lending Long. For example, the S&L crisis in the 1980s/1990s was caused by rising interest rates and the devastating effect on duration mismatch. The recent wave (2003-2005) of fixed-rate mortgage refinancing at thrifts (S&Ls) exposes them to interest rate risk, especially if interest rates __________. Problem is especially an issue in the NE, because of the heavy concentration of thrifts (81% in Mass, 64% in Conn.), and their reliance on fixed-rate mortgages for loans/assets. See In The News on p. 604. Insolvency Risk - Result of excessive liquidity, credit or interest rate risk that causes the FI to become financially insolvent (Liabilities ≥ Assets, Net Worth ≤ 0). Interest Rate Risk Measurement and Management . Interest rate changes, especially interest rate increases, impact both the: a) income statement of the FI, and b) the balance sheet, and market value, of the FI. REPRICING MODEL is a CF analysis of interest income (+CFs) from loans; and interest expense (-CF) on deposits, looking at Rate-Sensitive Assets (RSAs) vs. Rate-Sensitive Liabilities (RSLs). Rate sensitivity results from either: a) variable rate loans or deposits that adjust to market rates, or b) maturing loans or deposits that will adjust, and roll over to current market rates. Until recently, Fed required quarterly reporting of repricing gaps. Refunding or Funding Gap = RSAs - RSLs, over some period from 1 day to 5+ years. Maturity mismatch exposes an FI to a possible Refunding/Funding Gap. See example in Table 22-1 on p. 606. Point: In the LR, Funding Gap = 0 for the FI, but in the SR the FI is exposed to Interest Rate Risk, especially in the SR (< 6 months) if interest rates __________. If RSA < RSL and interest rates increase, the FI's net income will decrease, because the interest expense on deposits will rise faster than interest income on loans. Formula : Δ NII = GAP * (ΔR), where: Δ NII = Change in Net Interest Income ($) GAP = (RSA - RSL) ΔR = Change in Interest Rates For the first time period (1 day), for every 1% increase in R: Δ NII = (-$10m) x .01 = -$100,000 For the third time period (3-6 months), for every 1% increase in R: Δ NII = (-$15m) x .01 = -$150,000 We can also calculate cumulative gaps (CGAP) over a certain period, e.g. 1 YR: BUS 468 / MGT 568: FINANCIAL MARKETS – CH 22 Professor Mark J. Perry 1
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CGAP (one-year): -$10m + -$10m + -$15m + $20m = -$15m Δ NII (one-year) = (-$15m) x .01 = -$150,000 Note: Changes in interest rates also affect the market value (PV) of the loans and deposits, and these balance sheet changes are not accounted for in the Funding Gap Model, which assumes historic or book values of assets and liabilities (loans and deposits). Example: 30-year, $100,000 fixed-rate
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This note was uploaded on 01/24/2012 for the course MGT 568 taught by Professor Staff during the Spring '11 term at University of Michigan.

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468-22 - Chapter 22 - INTEREST RATE and INSOLVENCY RISK...

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