ASSET/LIABILITYMANAGEMENT

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Equity Valuation Focus• Basic fixed rate asset valuation rule:

– Rates rise value falls– Rates fall value rises

• Management’s task: Maximize market value of equity– MVEQ is the market value of assets (MVA) minus the

market value of liabilities (MVL)– Rate changes result in changes in MVA and MVL– Changes in MVEQ caused by interest rate changes

reflect interest rate risk

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Duration GAP• Duration GAP Analysis

– Price sensitivity of bank’s assets and liabilities– Impact of rate changes on stockholders’ equity value

• Duration measures effective maturity of an asset or liability– Time-weighted average of present value of expected

cash flows relative to its price– Measures price sensitivity to rate changes

• The larger the duration, the larger the price sensitivity

• The smaller the duration, the smaller the price sensitivity

Duration Example

CF yr time weighted100 100 / (1+ 0.12 ) = 89.2857 x 1 = 89.2857

100 100 / (1+ 0.12 ) 2 = 79.7194 x 2 = 159.4388

100 100 / (1+ 0.12 ) 3 = 71.1780 x 3 = 213.5341

1100 1100 / (1+ 0.12 ) 4 = 699.0699 x 4 = 2796.2795

YTM Price = 939.25 3258.5412%

Present Value

Duration = 3258.54 / 939.25 = 3.47 years

• What is the duration of a bond with a $1,000 face value, 10% annual coupon payments, 4 years to maturity and a 12% YTM?

Duration GAP

• Duration GAP Model– Focus on managing market value of equity– Compares duration of assets with duration of

liabilities– The larger the duration GAP, the larger the change

in the economic value of stockholders’ equity when interest rates change

– A duration GAP of zero implies that changes in rates would not affect the value of equity

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Positive and Negative Duration GAPs• Positive DGAP – assets are more price

sensitive than liabilities• Rates rise: assets fall proportionately more in value

than liabilities, so EVE falls • Rates fall: assets rise proportionately more in value

than liabilities, so EVE rises

• Negative DGAP - liabilities are more price sensitive than assets

• Rates rise: assets fall proportionately less in value than liabilities, so EVE rises

• Rates fall: assets rise proportionately less in value than liabilities, so EVE falls

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EVE Sensitivity Analysis• Similar steps as earnings sensitivity analysis

• However, in EVE analysis the focus is on:

– The relative durations of assets and liabilities

– How much the durations change in different interest rate environments

– What happens to the economic value of equity across different rate environments

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EVE Sensitivity Analysis

Rate Shocks DOWN200 STATIC UP200UP300 UP400

FFS and Other 10,984 10,852 10,720 10,655 10,589

Net Loans 151,608 147,286 142,412 139,863 137,458

Securities 135,789 124,577 114,611 109,628 104,645

Non-earning Assets 23,186 23,186 23,186 23,186 23,186

Assets (Market Value) 321,567 305,901 291,029 283,332 278,878

MMDA/NOW/Savings 104,523  96,409 92,206 90,104 88,003

CD’s 93,015  91,544 90,073 89,338 88,603

Checking 51,526 47,526 44,635 43,189 41,744

FFP & Other Borrowings 32,324 30,728 29,077 28,252 27,427

Other 3,279 3,279 3,279 3,279 3,279

Liabilities (Market Value) 284,667 269,486 259,270 254,162 249,055

Economic Value of Equity 36,900 36,415 31,759 29,170 26,823

Percentage Change 1.3%  0 -12.8% -19.9% -26.3%

Equity Ratio 11.48%  11.90% 10.91% 10.30% 9.72% 8

Assumptions

• Prepayments on loans• Does the model account for loan floors and

caps?• Call options on investment securities• Non-Maturity Deposits

– Betas– Decay Rates

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Assumptions-Deposit Betas

• Core Deposit accounts typically have administered rates, meaning the rates change when management at the bank say they change. We do know however that there is often some response to market rate changes. To model this sensitivity we use a Beta factor. This is the percentage of rate change each account will move with a 100 basis point movement in Fed Funds.

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Assumptions-Deposit Betas

• Betas vary from bank to bank.• Betas can vary from time to time depending

on the liquidity needs of the bank and changes in competition.

• While it is useful to look at how the bank has historical changes interest rates, the assumptions used in the model are a prediction (guess) of how much the bank will change the rates in the future.

Assumptions-Deposit Betas• Per 100 basis point change in fed funds, betas

for the following types of accounts typically range as:

• Savings: 5 to 30 basis points• MMDA: 10 to 50 basis points• NOW: 10 to 50 basis points• Some banks may be outside of these ranges.• Most models allow the bank to have different

betas for upward or downward rate shocks.

Assumptions-Decay Rates• Decay rates essentially are an assumption about

the average life of your non-maturity deposits. They will have the most impact on your bank's EVE measurement. The longer you model these deposits to be, the more base EVE for the bank. Calculating the value of all assets and liabilities is a reasonably straightforward exercise except when it comes to core deposits. They have a beginning balance and a rate, but they are missing the term structure (i.e. they're "non-maturity" deposits). The decay assumptions you provide give them an assumed term structure.

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Assumptions-Decay Rates• Decay Rates are the most powerful

assumptions in the measurement of EVE.• They are also the most difficult to determine.• FDICIA Decay Rates• Industry Studies• Bank Deposit Study• Stress Testing

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Assumptions-Decay Rates

• FDICIA Decay Rates – Developed in 1980’s. Many models use these as default assumptions. May not be an accurate picture of your bank’s decay rates.

• Industry Studies – Several models have recently adopted these as they indicate significantly longer decay rates than FDICIA rates. May not relate to what is going to happen when rates rise.

Assumptions-Decay Rates

• Bank Deposit Study – Very expensive and likely will not show how your deposits will react when rates start to rise from these low levels.

• Stress Testing – Whatever assumption is being used for decay rates, they should be stress tested to see what speed will cause excess risk to the bank.

Assumptions-Decay Rates

• The following slide is an example from a real bank of what can happen to the projected EVE from quarter to quarter with a change to the decay rate assumptions.

• The model’s vendor lengthened the decay rate assumptions when they purchased an industry deposit study from a third party.

Assumptions-Decay RatesChecking NOW MMDA/Savings

Quarter 1 72 Months 60 Months 48 Months

Quarter 2 100 Months 100 Months 100 Months

Change in EVE +200 Basis Points +300 Basis Points +400 Basis Points

Quarter 1 -12.8% -19.9% -26.3%

Quarter 2 +4.6% +4.1% +6.0%

Assumptions-Decay Rates

• Why did EVE increase on the previous slide?• By lengthening the decay rates, the bank

shifted from a positive duration GAP to a negative duration gap.

Surge Deposits• Bank on previous slide had experienced

growth in NMD’s from 56% to 63% of total deposits over past two years. ( Approximately $15 million)

• Most banks have experienced sharp growth in NMD’s over the past two to five years.

• Customers are parking money until rates start up.

• How should this effect decay rates?

Regulatory Requirements

• Must be measured for changes in interest rates up to 400 basis points.

• Realistic Policy Guidelines

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Policy ExampleChange in EVE

+/- 100 Basis Points -10%

+/- 200 Basis Points -15%

+/- 300 Basis Points -20%

+/- 400 Basis Points -30%

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Conclusion/Takeaways

• Duration GAP analysis is the basis for modeling risks to EVE from interest rate changes.

• In most banks decay rate assumptions have the biggest effect on the models projections.