Managing Interest Rate

Risk: GAP and

Earnings Sensitivity

1
Managing Interest Rate Risk
◼ Interest Rate Risk
◼ Thepotential loss from unexpected
changes in interest rates which can
significantly alter a bank’s profitability
and market value of equity

2
Managing Interest Rate Risk
◼ Interest Rate Risk
◼ When a bank’s assets and liabilities do
not reprice at the same time, the result
is a change in net interest income
◼ The change in the value of assets and
the change in the value of liabilities will
also differ, causing a change in the
value of stockholder’s equity

3
Managing Interest Rate Risk
◼ Interest Rate Risk
◼ Banks typically focus on either:
◼ Net interest income or
◼ The market value of stockholders' equity
◼ GAP Analysis
◼ A static measure of risk that is commonly
associated with net interest income (margin)
targeting
◼ Earnings Sensitivity Analysis
◼ Earnings sensitivity analysis extends GAP
analysis by focusing on changes in bank
earnings due to changes in interest rates and
balance sheet composition

4
Managing Interest Rate Risk
◼ Interest Rate Risk
◼ Asset
and Liability Management
Committee (ALCO)
◼ The bank’s ALCO primary
responsibility is interest rate risk
management.
◼ The ALCO coordinates the bank’s

strategies to achieve the optimal

risk/reward trade-off

5
Measuring Interest Rate Risk with
GAP
◼ Three general factors potentially cause a
bank’s net interest income to change.
◼ Rate Effects
◼ Unexpected changes in interest rates
◼ Composition (Mix) Effects
◼ Changes in the mix, or composition, of
assets and/or liabilities
◼ Volume Effects
◼ Changes in the volume of earning assets
and interest-bearing liabilities
6
Measuring Interest Rate Risk with
GAP
◼ Consider a bank that makes a $25,000
five-year car loan to a customer at
fixed rate of 8.5%. The bank initially
funds the car loan with a one-year
$25,000 CD at a cost of 4.5%. The
bank’s initial spread is 4%.
◼ What is the bank’s risk?

7
Measuring Interest Rate Risk with
GAP
◼ Traditional Static Gap Analysis
◼ Static GAP Analysis
GAPt = RSAt - RSLt
◼ RSAt

▪ Rate Sensitive Assets

▪ Those assets that will mature or reprice
in a given time period (t)
◼ RSLt
▪ Rate Sensitive Liabilities
▪ Those liabilities that will mature or
reprice in a given time period (t)
8
Measuring Interest Rate Risk with
GAP
◼ Traditional Static Gap Analysis
◼ Steps in GAP Analysis
1. Develop an interest rate forecast
2. Select a series of “time buckets” or time
intervals for determining when assets
and liabilities will reprice
3. Group assets and liabilities into these
“buckets”
4. Calculate the GAP for each “bucket ”
5. Forecast the change in net interest
income given an assumed change in
interest rates

9
Measuring Interest Rate Risk with
GAP
◼ What Determines Rate Sensitivity
◼ The initial issue is to determine what

features make an asset or liability rate

sensitive

10
Measuring Interest Rate Risk with
GAP
◼ Expected Repricing versus Actual
Repricing
◼ In general, an asset or liability is normally
classified as rate sensitive within a time
interval if:
▪ It matures
▪ It represents an interim or partial principal
payment
▪ The interest rate applied to the outstanding
principal balance changes contractually during
the interval
▪ The interest rate applied to the outstanding
principal balance changes when some base
rate or index changes and management
expects the base rate/index to change during
the time interval 11
Measuring Interest Rate Risk with
GAP
◼ What Determines Rate Sensitivity
◼ Maturity
◼ If any asset or liability matures within a
time interval, the principal amount will be
repriced
▪ The question is what principal amount is
expected to reprice
◼ Interim or Partial Principal Payment
◼ Any principal payment on a loan is rate
sensitive if management expects to
receive it within the time interval
▪ Any interest received or paid is not included in
the GAP calculation

12
Measuring Interest Rate Risk with
GAP
◼ What Determines Rate Sensitivity
◼ Contractual Change in Rate
◼ Some assets and deposit liabilities earn
or pay rates that vary contractually with
some index
◼ These instruments are repriced

whenever the index changes

▪ If management knows that the index will
contractually change within 90 days, the
underlying asset or liability is rate
sensitive within 0–90 days.
13
Measuring Interest Rate Risk with
GAP
◼ What Determines Rate Sensitivity
◼ Change in Base Rate or Index
◼ Some loans and deposits carry interest
rates tied to indexes where the bank has
no control or definite knowledge of when
the index will change.
◼ For example, prime rate loans typically
state that the bank can contractually
change prime daily
▪ The loan is rate sensitive in the sense that its
yield can change at any time
▪ However, the loan’s effective rate sensitivity
depends on how frequently the prime rate
actually changes
14
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Rate,Composition (Mix) and Volume
Effects
◼ All affect net interest income

15
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ The sign of GAP (positive or negative)
indicates the nature of the bank’s
interest rate risk
▪ A negative (positive) GAP, indicates that
the bank has more (less) RSLs than RSAs.
When interest rates rise (fall) during the
time interval, the bank pays higher (lower)
rates on all repriceable liabilities and earns
higher (lower) yields on all repriceable
assets 16
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ The sign of GAP (positive or negative)
indicates the nature of the bank’s interest
rate risk
▪ If all rates rise (fall) by equal amounts at the
same time, both interest income and interest
expense rise (fall), but interest expense rises
(falls) more because more liabilities are
repriced
▪ Net interest income thus declines (increases),
as does the bank’s net interest margin
17
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ If a bank has a zero GAP, RSAs equal
RSLs and equal interest rate changes
do not alter net interest income
because changes in interest income
equal changes in interest expense
◼ It is virtually impossible for a bank to

have a zero GAP given the complexity

and size of bank balance sheets
18
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income

19
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ GAP analysis assumes a parallel shift
in the yield curve

20
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ If there is a parallel shift in the yield curve
then changes in Net Interest Income are
directly proportional to the size of the
GAP:
∆NIIEXP = GAP x ∆iEXP
▪ It is rare, however, when the yield curve shifts
parallel. If rates do not change by the same
amount and at the same time, then net interest
income may change by more or less
21
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ Example 1
▪ Recall the bank that makes a $25,000 five-
year car loan to a customer at fixed rate of
8.5%. The bank initially funds the car loan
with a one-year $25,000 CD at a cost of
4.5%. What is the bank’s 1-year GAP?

22
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ Example 1

▪ RSA1 YR = $0
▪ RSL1 YR = $10,000
▪ GAP1 YR = $0 - $25,000 = -$25,000
▪ The bank’s one year funding GAP is -
$25,000
▪ If interest rates rise (fall) by 1% in 1 year,
the bank’s net interest margin and net
interest income will fall (rise)
▪ ∆NIIEXP = GAP x ∆iEXP = -$10,000 x 1% = -
$100
23
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ Example 2
▪ Assume a bank accepts an 18-month
$30,000 CD deposit at a cost of 3.75% and
invests the funds in a $30,000 6-month T-
Bill at rate of 4.80%. The bank’s initial
spread is 1.05%. What is the bank’s 6-
month GAP?

24
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Level of Interest Rates
◼ Example 2

▪ RSA6 MO = $30,000
▪ RSL6 MO = $0
▪ GAP6 MO = $30,000 – $0 = $30,000
▪ The bank’s 6-month funding GAP is $30,000
▪ If interest rates rise (fall) by 1% in 6
months, the bank’s net interest margin and
net interest income will rise (fall)
▪ ∆NIIEXP = GAP x ∆iEXP = $30,000 x 1% =
$300

25
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in the Relationship Between
Asset Yields and Liability Costs
◼ Net interest income may differ from that
expected if the spread between earning
asset yields and the interest cost of
interest-bearing liabilities changes
◼ The spread may change because of a

nonparallel shift in the yield curve or

because of a change in the difference
between different interest rates (basis risk)
26
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in Volume
◼ Net interest income varies directly with
changes in the volume of earning assets
and interest-bearing liabilities, regardless
of the level of interest rates
◼ For example, if a bank doubles in size but
the portfolio composition and interest
rates remain unchanged, net interest
income will double because the bank
earns the same interest spread on twice
the volume of earning assets such that
NIM is unchanged
27
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Changes in Portfolio Composition
◼ Any variation in portfolio mix
potentially alters net interest income
◼ There is no fixed relationship between

changes in portfolio mix and net

interest income
▪ The impact varies with the relationships
between interest rates on rate-sensitive
and fixed-rate instruments and with the
magnitude of funds shifts
28
29
 Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.0
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.0% $ 600 4.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

30
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.0
◼ Interest Income
▪ ($500 x 8%) + ($350 x 11%) = $78.50
◼ Interest Expense
▪ ($600 x 4%) + ($220 x 6%) = $37.20
◼ Net Interest Income
▪ $78.50 - $37.20 = $41.30

31
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.0
◼ Earning Assets
▪ $500 + $350 = $850
◼ Net Interest Margin
▪ $41.3/$850 = 4.86%
◼ Funding GAP
▪ $500 - $600 = -$100

32
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.1
◼ What if all rates increase by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 500 9.0% $ 600 5.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

33
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.1
◼ What if all rates increase by 1%?

Interest Income $ 83.50

Interest Expense $ 43.20
Net Interest Income $ 40.30
Net Interest Margin 4.74%
Funding GAP $ (100)
∆NIIEXP $ (1.00)

◼ With a negative GAP, interest income

increases by less than the increase in
interest expense. Thus, both NII and NIM
fall.
34
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.2
◼ What if all rates fall by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 500 7.0% $ 600 3.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

35
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.2
◼ What if all rates fall by 1%?

Interest Income $ 73.50

Interest Expense $ 31.20
Net Interest Income $ 42.30
Net Interest Margin 4.98%
Funding GAP $ (100)
∆NIIEXP $ 1.00

◼ With a negative GAP, interest income

decreases by less than the decrease in
interest expense. Thus, both NII and NIM
increase.
36
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.3
◼ What if rates rise but the spread falls by
1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.5% $ 600 5.5%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

37
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.3
◼ What if rates rise but the spread falls by
1%?
Interest Income $ 81.00
Interest Expense $ 46.20
Net Interest Income $ 34.80
Net Interest Margin 4.09%
Funding GAP $ (100)

◼ Both NII and NIM fall with a decrease in the

spread. Why the larger change?
▪ Note: ∆NIIEXP ≠ GAP x ∆iEXP Why?
38
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.4
◼ What if rates fall but the spread falls by
1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 500 6.5% $ 600 3.5%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

39
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.4
◼ What if rates fall and the spread falls by
1%?
Interest Income $ 71.00
Interest Expense $ 34.20
Net Interest Income $ 36.80
Net Interest Margin 4.33%
Funding GAP $ (100)

◼ Both NII and NIM fall with a decrease in the

spread.
▪ Note: ∆NIIEXP ≠ GAP x ∆iEXP
40
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.5
◼ What if rates rise and the spread rises
by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 500 10.0% $ 600 5.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

41
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.5
◼ What if rates rise and the spread rises by
1%?
Interest Income $ 88.50
Interest Expense $ 43.20
Net Interest Income $ 45.30
Net Interest Margin 5.33%
Funding GAP $ (100)

◼ Both NII and NIM increase with an increase

in the spread.
▪ Note: ∆NIIEXP ≠ GAP x ∆iEXP
42
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.6
◼ What if rates fall and the spread rises
by 1%? Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 500 7.0% $ 600 2.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000
43
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.6
◼ What if rates fall and the spread rises by
1%?
Interest Income $ 73.50
Interest Expense $ 25.20
Net Interest Income $ 48.30
Net Interest Margin 5.68%
Funding GAP $ (100)

◼ Both NII and NIM increase with an increase

in the spread.
▪ Note: ∆NIIEXP ≠ GAP x ∆iEXP
44
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.7
◼ What if the bank proportionately
doubles in size?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 1,000 8.0% $ 1,200 4.0%
Fixed rate $ 700 11.0% $ 440 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000
45
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 3.7
◼ What if the bank proportionately doubles
in size?
Interest Income $ 157.00
Interest Expense $ 74.40
Net Interest Income $ 82.60
Net Interest Margin 4.86%
Funding GAP $ (200)

◼ Both NII doubles but NIM stays the same.

Why? What has happened to the bank’s
risk?
46
 Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.0
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 8.0% $ 450 4.0%
Fixed rate $ 250 11.0% $ 370 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

47
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.0

Interest Income $ 75.50

Interest Expense $ 40.20
Net Interest Income $ 35.30
Net Interest Margin 4.15%
Funding GAP $ 150

◼ Bank has a positive GAP

48
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.1
◼ What if rates increase by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 9.0% $ 450 5.0%
Fixed rate $ 250 11.0% $ 370 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

49
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.1
◼ What if rates increase by 1%?

Interest Income $ 81.50

Interest Expense $ 44.70
Net Interest Income $ 36.80
Net Interest Margin 4.33%
Funding GAP $ 150
∆NIIEXP $ 1.50

◼ With a positive GAP, interest income

increases by more than the increase in
interest expense. Thus, both NII and NIM
rise.
50
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.2
◼ What if rates decrease by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 7.0% $ 450 3.0%
Fixed rate $ 250 11.0% $ 370 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

51
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.2
◼ What if rates decrease by 1%?

Interest Income $ 69.50

Interest Expense $ 35.70
Net Interest Income $ 33.80
Net Interest Margin 3.98%
Funding GAP $ 150
∆NIIEXP $ (1.50)
◼ With a positive GAP, interest income
decreases by more than the decrease in
interest expense. Thus, both NII and NIM
fall.
52
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.3
◼ What if rates rise but the spread falls by
1%? Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 8.5% $ 450 5.5%
Fixed rate $ 250 11.0% $ 370 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

53
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.3
◼ What if rates rise but the spread falls by
1%?
Interest Income $ 78.50
Interest Expense $ 46.95
Net Interest Income $ 31.55
Net Interest Margin 3.71%
Funding GAP $ 150

◼ Both NII and NIM fall with a decrease in

the spread. Why the larger change?
▪ Note: ∆NIIEXP ≠ GAP x ∆iEXP Why?
54
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.4
◼ What if rates fall and the spread falls by
1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 6.5% $ 450 3.5%
Fixed rate $ 250 11.0% $ 370 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

55
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.4
◼ What if rates fall and the spread falls by
1%?
Interest Income $ 66.50
Interest Expense $ 37.95
Net Interest Income $ 28.55
Net Interest Margin 3.36%
Funding GAP $ 150

◼ Both NII and NIM fall with a decrease in the

spread.
◼ Note: ∆NIIEXP ≠ GAP x ∆iEXP

56
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.5
◼ What if rates rise and the spread rises
by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 10.0% $ 450 5.0%
Fixed rate $ 250 11.0% $ 370 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000
57
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.5
◼ What if rates rise and the spread rises
by 1%?
Interest Income $ 87.50
Interest Expense $ 44.70
Net Interest Income $ 42.80
Net Interest Margin 5.04%
Funding GAP $ 150

◼ Both NII and NIM increase with an

increase in the spread.
◼ Note: ∆NIIEXP ≠ GAP x ∆iEXP
58
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.6
◼ What if rates fall and the spread rises
by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 7.0% $ 450 2.0%
Fixed rate $ 250 11.0% $ 370 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000
59
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.6
◼ What if rates fall and the spread rises
by 1%?
Interest Income $ 69.50
Interest Expense $ 31.20
Net Interest Income $ 38.30
Net Interest Margin 4.51%
Funding GAP $ 150

◼ Both NII and NIM increase with an

increase in the spread.
◼ Note: ∆NIIEXP ≠ GAP x ∆iEXP
60
 Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.7
◼ What if the bank proportionately
doubles in size?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 1,200 8.0% $ 900 4.0%
Fixed rate $ 500 11.0% $ 740 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000
61
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 4.7
◼ What if the bank proportionately doubles
in size?
Interest Income $ 151.00
Interest Expense $ 80.40
Net Interest Income $ 70.60
Net Interest Margin 4.15%
Funding GAP $ 300

◼ Both NII doubles but NIM stays the same.

Why? What has happened to the bank’s
risk?
62
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.0

Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 8.0% $ 600 4.0%
Fixed rate $ 250 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

63
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.0

Interest Income $ 75.50

Interest Expense $ 37.20
Net Interest Income $ 38.30
Net Interest Margin 4.51%
Funding GAP $ -

◼ Bank has zero GAP

64
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.1
◼ What if rates increase by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 9.0% $ 600 5.0%
Fixed rate $ 250 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

65
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.1
◼ What if rates increase by 1%?

Interest Income $ 81.50

Interest Expense $ 43.20
Net Interest Income $ 38.30
Net Interest Margin 4.51%
Funding GAP $ -

◼ With a zero GAP, interest income

increases by the amount as the increase in
interest expense. Thus, there is no
change in NII or NIM!
66
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.2
◼ What if rates fall and the spread falls by
1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 6.5% $ 600 3.5%
Fixed rate $ 250 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

67
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.2
▪ What if rates fall and the spread falls by 1%?

Interest Income $ 66.50

Interest Expense $ 34.20
Net Interest Income $ 32.30
Net Interest Margin 3.80%
Funding GAP $ -
◼ Even with a zero GAP, interest income
falls by more than the decrease in interest
expense. Thus, both NII and NIM fall with
a decrease in the spread. Note: ∆NIIEXP ≠
GAP x ∆iEXP
68
 Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.3
◼ What if rates rise and the spread rises
by 1%?
Balance Sheet
Assets Yield Liabilities Cost
Rate sensitive $ 600 10.0% $ 600 5.0%
Fixed rate $ 250 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000
69
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Example 5.3
◼ What if rates rise and the spread rises by 1%?
Interest Income $ 87.50
Interest Expense $ 43.20
Net Interest Income $ 44.30
Net Interest Margin 5.21%
Funding GAP $ -
◼ Even with a zero GAP, interest income rises
by more than the increase in interest expense.
Thus, both NII and NIM increase with an
increase in the spread. Note: ∆NIIEXP ≠ GAP x
∆iEXP
70
Measuring Interest Rate Risk with
GAP
◼ Factors Affecting Net Interest Income
◼ Summary of Base Cases
GAP
Positive Zero Negative
NII $35.30 $38.20 $41.30
NIM 4.15% 4.51% 4.86%

◼ If a Negative GAP gives the largest NII

and NIM, why not plan for a Negative
GAP?

71
Measuring Interest Rate Risk with
GAP
◼ Rate, Volume, and Mix Analysis
◼ Many financial institutions publish a
summary in their annual report of how
net interest income has changed over
time
◼ They separate changes attributable to
shifts in asset and liability composition
and volume from changes associated
with movements in interest rates
72
73
Measuring Interest Rate Risk with
GAP
◼ Rate Sensitivity Reports
◼ Many managers monitor their bank’s
risk position and potential changes in
net interest income using rate
sensitivity reports
◼ These report classify a bank’s assets
and liabilities as rate sensitive in
selected time buckets through one year

74
Measuring Interest Rate Risk with
GAP
◼ Rate Sensitivity Reports
◼ Periodic GAP
◼ The Gap for each time bucket and
measures the timing of potential
income effects from interest rate
changes

75
Measuring Interest Rate Risk with
GAP
◼ Rate Sensitivity Reports
◼ Cumulative GAP
◼ The sum of periodic GAP's and
measures aggregate interest rate risk
over the entire period
◼ Cumulative GAP is important since it

directly measures a bank’s net interest

sensitivity throughout the time interval

76
77
Measuring Interest Rate Risk with
GAP
◼ Strengths and Weaknesses of Static
GAP Analysis
◼ Strengths
◼ Easy to understand
◼ Works well with small changes in

interest rates

78
Measuring Interest Rate Risk with
GAP
◼ Strengths and Weaknesses of Static GAP
Analysis
◼ Weaknesses
◼ Ex-post measurement errors
◼ Ignores the time value of money

◼ Ignores the cumulative impact of interest

rate changes
◼ Typically considers demand deposits to
be non-rate sensitive
◼ Ignores embedded options in the bank’s
assets and liabilities
79
Measuring Interest Rate Risk with
GAP
◼ GAP Ratio
◼ GAP Ratio = RSAs/RSLs
◼ A GAP ratio greater than 1 indicates a
positive GAP
◼ A GAP ratio less than 1 indicates a

negative GAP

80
Measuring Interest Rate Risk with
GAP
◼ GAP Divided by Earning Assets as a Measure
of Risk
◼ An alternative risk measure that relates the
absolute value of a bank’s GAP to earning
assets
◼ The greater this ratio, the greater the interest
rate risk
◼ Banks may specify a target GAP-to-earning-
asset ratio in their ALCO policy statements
◼ A target allows management to position the
bank to be either asset sensitive or liability
sensitive, depending on the outlook for
interest rates
81
Earnings Sensitivity Analysis
◼ Allows management to incorporate the
impact of different spreads between
asset yields and liability interest costs
when rates change by different
amounts

82
Earnings Sensitivity Analysis
◼ Steps to Earnings Sensitivity Analysis
1. Forecast interest rates.
2. Forecast balance sheet size and
composition given the assumed interest
rate environment
3. Forecast when embedded options in
assets and liabilities will be exercised
such that prepayments change,
securities are called or put, deposits are
withdrawn early, or rate caps and rate
floors are exceeded under the assumed
interest rate environment
83
Earnings Sensitivity Analysis
◼ Steps to Earnings Sensitivity Analysis
4. Identify when specific assets and liabilities
will reprice given the rate environment
5. Estimate net interest income and net
income under the assumed rate
environment
6. Repeat the process to compare forecasts of
net interest income and net income across
different interest rate environments versus
the base case
◼ The choice of base case is important because
all estimated changes in earnings are
compared with the base case estimate

84
Earnings Sensitivity Analysis
◼ The key benefits of conducting earnings sensitivity
analysis are that managers can estimate the impact
of rate changes on earnings while allowing for the
following:
◼ Interest rates to follow any future path
◼ Different rates to change by different amounts at
different times
◼ Expected changes in balance sheet mix and volume
◼ Embedded options to be exercised at different times
and in different interest rate environments
◼ Effective GAPs to change when interest rates change
◼ Thus, a bank does not have a single static GAP, but
instead will experience amounts of RSAs and RSLs
that change when interest rates change

85
Earnings Sensitivity Analysis
◼ Exercise of Embedded Options in Assets and
Liabilities
◼ The most common embedded options at
banks include the following:
◼ Refinancing of loans
◼ Prepayment (even partial) of principal on
loans
◼ Bonds being called
◼ Early withdrawal of deposits
◼ Caps on loan or deposit rates
◼ Floors on loan or deposit rates
◼ Call or put options on FHLB advances
◼ Exercise of loan commitments by borrowers
86
Earnings Sensitivity Analysis
◼ Exercise of Embedded Options in Assets and
Liabilities
◼ The implications of embedded options
◼ Does the bank or the customer determine
when the option is exercised?
◼ How and by what amount is the bank being
compensated for selling the option, or how
much must it pay to buy the option?
◼ When will the option be exercised?
▪ This is often determined by the economic and
interest rate environment
◼ Static GAP analysis ignores these embedded
options
87
Earnings Sensitivity Analysis
◼ Different Interest Rates Change by
Different Amounts at Different Times
◼ Itis well recognized that banks are
quick to increase base loan rates but
are slow to lower base loan rates when
rates fall

88
Earnings Sensitivity Analysis
◼ Earnings Sensitivity: An Example
◼ Consider the rate sensitivity report for
First Savings Bank (FSB) as of year-end
2008 that is presented on the next slide
◼ The report is based on the most likely
interest rate scenario
◼ FSB is a $1 billion bank that bases its
analysis on forecasts of the federal funds
rate and ties other rates to this overnight
rate
◼ As such, the federal funds rate serves as
the bank’s benchmark interest rate

89
90
91
92
Earnings Sensitivity Analysis
◼ Explanation of Sensitivity Results
◼ This example demonstrates the
importance of understanding the impact
of exercising embedded options and the
lags between the pricing of assets and
liabilities.
◼ The framework uses the federal funds
rate as the benchmark rate such that rate
shocks indicate how much the funds rate
changes
◼ Summary results are known as Earnings-
at-Risk Simulation or Net Interest Income
Simulation
93
Earnings Sensitivity Analysis
◼ Explanation of Sensitivity Results
◼ Earnings-at-Risk
◼ The potential variation in net interest
income across different interest rate
environments, given different
assumptions about balance sheet
composition, when embedded options
will be exercised, and the timing of
repricings.

94
Earnings Sensitivity Analysis
◼ Explanation of Sensitivity Results
◼ FSB’s earnings sensitivity results reflect
the impacts of rate changes on a bank
with this profile
◼ There are two basic causes or drivers
behind the estimated earnings changes
◼ First, other market rates change by
different amounts and at different times
relative to the federal funds rate
◼ Second, embedded options potentially
alter cash flows when the options go in
the money

95
Income Statement GAP
◼ Income Statement GAP
◼ Aninterest rate risk model which
modifies the standard GAP model to
incorporate the different speeds and
amounts of repricing of specific assets
and liabilities given an interest rate
change

96
Income Statement GAP
◼ Beta GAP
◼ The adjusted GAP figure in a basic
earnings sensitivity analysis derived
from multiplying the amount of rate-
sensitive assets by the associated beta
factors and summing across all rate-
sensitive assets, and subtracting the
amount of rate-sensitive liabilities
multiplied by the associated beta
factors summed across all rate-
sensitive liabilities
97
Income Statement GAP
◼ Balance Sheet GAP
◼ The effective amount of assets that
reprice by the full assumed rate change
minus the effective amount of liabilities
that reprice by the full assumed rate
change.
◼ Earnings Change Ratio (ECR)
◼ A ratio calculated for each asset or
liability that estimates how the yield on
assets or rate paid on liabilities is
assumed to change relative to a 1 percent
change in the base rate
98
99
Managing the GAP and Earnings
Sensitivity Risk
◼ Steps to reduce risk
◼ Calculate periodic GAPs over short
time intervals
◼ Match fund repriceable assets with
similar repriceable liabilities so that
periodic GAPs approach zero
◼ Match fund long-term assets with non-
interest-bearing liabilities
◼ Use off-balance sheet transactions to
hedge 100
Managing the GAP and Earnings
Sensitivity Risk
◼ How to Adjust the Effective GAP or
Earnings Sensitivity Profile

101
Managing Interest Rate
Risk: GAP and
Earnings Sensitivity

102