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.
- 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
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).
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.
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
on deposits will rise faster than
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
(CGAP) over a certain period, e.g. 1 YR:
BUS 468 / MGT 568: FINANCIAL MARKETS – CH 22
Professor Mark J. Perry