Western Independent Banker - May/June 2013 - (Page 17)
By Greg Webb
Managing Interest Rate Risk to Achieve
DURING MOST STRATEGIC planning
retreats, facilitators make sure that community bank boards of directors and
executive management consider expanding through mergers and acquisitions,
raising capital through stock issuances,
improving bank stock liquidity, etc.
These may be good ideas, but facilitators often overlook discussing legitimate threats to long-term profitability
simply because they do not sell those
services. One such threat is interest rate
risk, which is rising despite the Federal
Reserve’s actions that stabilized interest
rates since the financial crisis began. To
address this, community bank boards
and executive management should
develop and implement plans that proactively mitigate interest rate risk.
Interest rate risk is the risk that a
community bank’s earnings will decline
because of unanticipated and untimely
changes in interest rates. This risk
• Re-pricing risk, which is caused by timing differences between contractual rate
changes and cash flows among assets and
liabilities. For example, interest rates on
long-term fixed-rate loans will change
more slowly than short-term deposits
that are used as funding.
• Basis risk, which is caused by the weak
correlation among various types of interest rates used to price assets and liabilities. An example would be interest rates
on prime-rated loans changing by 25
basis points while the rate on LIBORbased deposit changes by 50 basis points.
• Yield curve risk, which is caused by the
changing rate relationships among different maturities of the same interest rate
index. A common example would involve
interest rates among various maturities of
Treasury securities changing by different
amounts of basis points.
• Option risk, which is caused by the
amount and timing of a bond’s cash flow
changing as market interest rates change.
The most common example would be
an issuer calling a bond before maturity
because market interest rates have significantly declined below its contractual
• Price risk, which is caused by changes
in the value of mark-to-market bonds
as market interest rates change.
Interest rate risk measurement tools
are, at best, imprecise tools that generally
indicate the level and direction of a community bank’s interest rate risk. These
tools are estimates based on (1) projected
earnings using various interest rate scenarios, or (2) projected net present value
of the cash flows of assets and liabilities
using various interest rate scenarios
and assuming that all financial instruments are held to maturity (also known
as the economic value of equity or EVE
approach) or (3) a blend of both.
These measurement tools include:
• Gap Analysis, which identifies maturity and re-pricing mismatches between
assets and liabilities and separates them
into rate-sensitive assets (RSA) and
rate-sensitive liabilities (RSL) according to their re-pricing time horizons.
The most common gap ratio formula
is (RSA – RSL)/Average Earning Assets.
Normally, the examiners do not like to
see that a community bank’s one-year
cumulative gap ratio exceed + or – 10
• Simulation Analysis, which determines
the effect changes in interest rates have
on a community bank’s short-term net
interest income, net income, and EVE.
Most banks that use simulation use
more than one model and apply several
interest rate scenarios, because these
models are dependent on the accuracy
of the assumptions and data used.
• Duration Analysis, which calculates the
weighted average term to maturity of
the cash flows of the community bank’s
assets and liabilities.
Community bank boards and
executive management should do the
continued on page 20
Interest rate risk measurement tools are, at best, imprecise tools that generally indicate the level and direction of a community
bank’s interest rate risk.
Western Independent Banker
Table of Contents for the Digital Edition of Western Independent Banker - May/June 2013
A Message from the Chair
Data Mining for Profits in 2013
Banks Must Face Their Own Fiscal Cliff
Boost Your Bottom Line with Lending Process Enhancements
Managing Interest Rate Risk to Achieve Strategic Profitability
Moving Mobile Banking Toward Acceptance – and Profitability
Alternative Revenue Strategies to Improve Bank Profitability
Analyzing Customer Performance to Increase Bank Profitability
WIB Service Corporation Report: Secrets to Success in 2013
Professional Development Resources
Welcome New Members
Index of Advertisers/ Advertiser.com
Western Independent Banker - May/June 2013