INTRODUCTION
One of the main business areas of a bank is the on-lending of funds borrowed from depositors. This on-lending targets different sectors in the economy.
Loans are made for various maturities and are not always funded by liabilities of the same maturity. The result of this is that if there is a mismatch of maturities between assets and liabilities.
When the maturiries on assets and liabilities are mismatched. interest rate movements can, depending on the extent of the mismatch, can significantly affect a bank's earnings.
INTEREST RATE RISK
Interest rate risk is the potential for variations in earnings resulting from unexpected changes in interest rates. Along with credit and liquidity risk, interest rate risk make up the three main portfolio risks to a bank.
The interest rate risk exposure (in monetary terms) is the extent of the future gain or loss resulting from the unexpected movement in interest rates.
Jamaican banks, especially up to recent times, were particularly vulnerable to interest rate risk because of the frequent steep unexpected variations in interest rates.
ASSET & LIABILITY MANAGEMENT COMMITTEES
In general, modern banks have utilised Asset and Liability Management committees (made up of CEO and other senior mangers) and Risk Management units working along with Treasury to identify, measure and control overall risks.
In order to control interest rate risk, bank managers have two main tools at their disposal. These are interest sensitivity gapping and duration analysis.
The interest sensitivity gap is essentially an accounting model while the duration model has its roots in economics.
GAP MANAGEMENT
The interest sensitivity gap or gap management focuses on interest sensitive assets and liabilities. The Interest sensitive being those items that move in the same direction as short term movements in interest rates.
The concept is fairly simple. When interest sensitive assets exceed interest sensitive liabilities, there is a positive gap with assets re-pricing before liabilities (ARBL), while if it is lower, there is a negative gap with liabilities re-pricing before assets (LRBA).
The positive gap is also known as long funded or long book position, while the negative gap is known as short funded or short book position.
If both (interest sensitive assets and interest sensitive liabilities) are equal, there is no gapping or we have what is called a match-funded situation.
GAPPING RULES
There are simple gapping rules. With rising interest rates, widen interest sensitivity gap. While, with declining rates the simple rule is to close gap positions.
Gap management typically looks at maturities taking place within ninety days and is essentially short term and tactical in focus with the specific emphasis being on how the unexpected change in interest rate affects the bank's net interest margin (NIM).
This can be determined by using the formula: change in interest rate multiplied by the extent of the gap - rate sensitive assets – rate sensitive liabilities (RSA – RSL). This serves as a good indicator for management as to the potential gains or losses that could result from interest rate swings.
UTILITY OF INTEREST SENSITIVITY MANAGEMENT
Interest sensitivity management is popular among certain users, as it is easy to use and understand. In addition, the information required for calculations are from financial statements and therefore, is easily accessible.
Its utility also extends to providing other useful information such as the portion of rate sensitive assets maturing in a particular period and as such, the extent to which new funding will be required.
In other words, it can also be used as tool in estimating/calculating the portion of a bank's assets/liabilities that will mature in particular period and, therefore, the extent of funding required.