Asset Liability Management – Rate Sensitive Gaps, Earnings at Risk, Cost to Close and MVE Analysis
A quick review of a number of Asset Liability Management (ALM) tools used by the banking and financial services industry in the world. The tools covered in this note include
Rate Sensitive Gap,
Earnings at Risk,
Cost to Close and
Market Value of Equity (MVE) Analysis
We look at Rate Sensitive Gap in a more detailed, process and calculation oriented fashion while the other three approaches are covered only at a higher level.
Rate Sensitive Gap
Rate sensitivity measures the responsiveness of the asset and liability portfolio to changes in interest rates. Rate sensitive assets and liabilities thus are instruments whose values are impacted by changes in market interest rates. These may include both on balance sheet as well as off balance sheet items. Rate sensitive gap is the difference between the book values of rate sensitive assets and liabilities and is calculated for various maturity buckets as well as cumulatively across buckets.
Fixed rate instruments may be adversely affected by changes in interest rates throughout their tenor, whereas floating rate instruments may be adversely affected by changes in market interest rates between re-pricing dates. Therefore in the calculation of rate sensitive gap, fixed rate instruments are slotted into the various maturity buckets based on the days remaining to maturity (note that each coupon and maturity payment of the fixed income instrument is stripped and slotted separately in to the relevant bucket) whereas floating rate instruments should ideally be slotted into the relevant maturity buckets based on the days remaining to the next reset/ re-pricing date. However, if re-pricing data is not readily available then days to maturity may also be used in determining what bucket should be used for floating rate instruments. In general rate sensitive liabilities, assets and off-balance sheet positions should be group into time buckets according to residual maturity or next re-pricing period, whichever is earlier.
Step 1: Define the time buckets
The time buckets used for the rate sensitive gap analysis need to be determined such as buckets of up to 1 month, 1 to 3 months, 3 to 6 months, up to 1 year, 1 to 2 years, 2 to 3 years, 3 to 5 years, 5 to 10 years, above 10 years and non-rate sensitive bucket.
Step 2: Classification of on- and off- balance sheet items
Classify all on- and off- balance sheet items as rate sensitive and non-rate sensitive items.
Step 3: Slot items into relevant time buckets
Slot items into the relevant time bucket residual time to maturity or time to next re-pricing date. Sum the book values across all assets and all liabilities in each bucket to get the total assets and liabilities across each bucket.
Step 4: Calculate rate sensitive gap
Calculate GAP across each bucket. The Gap is the difference between rate sensitive assets and rate sensitive liabilities.
GAP = Total Rate Sensitive Assets – Total Rate Sensitive Liabilities
Step 5: Calculate off-balance sheet gap
Off-Balance sheet GAP is calculated across each bucket for only interest bearing instruments.
Step 6: Calculated interval gap
The Interval Gap is computed as:
Interval GAP = On-Balance sheet GAP + Off-Balance sheet GAP
Step 7: Calculate cumulative gap
Cumulative gap is computed as the sum of the interval gaps across buckets.
Other ALM Risk Measurement Tools
Fall in Market Value of Equity
Fall in market value of equity depicts a change in the market value of equity due to changes in market values of assets and liabilities. The respective change in assets and liabilities is computed from the interest rate shock derived, based on the value at risk (VaR) approach.
For a detailed step-by-step calculation example of the fall in market value of equity you may like to see the following post:
Earnings at Risk
Earnings-at-Risk (EAR) is computed in order to evaluate the impact of interest rate change on earnings. The approach used is a VaR based approach that takes into account non-parallel shifts in the term structure and its impact on the earnings portfolio of the bank. The balance sheets items to be included in the calculation are those which are interest rate sensitive and generate income or expense cash flows. For the purpose of calculation, the book value of cash flows will be taken into account.
For a detailed step-by-step calculation example of Earnings at Risk you may like to see the following post:
Cost to Close
The cost to close concept originates from the rate gaps that exist between assets and liabilities. The concept illustrates that the gaps that exist in interest rate sensitive assets and liabilities needs to be closed out as they create liquidity risk for the current portfolio. If the gap is negative in a particular bucket, it means that rate sensitive assets in the bucket are less than rate sensitive liabilities. The liabilities in that bucket need to be settled but adequate assets to match those liabilities are not present. Hence the institution needs to go out in the market and borrow money to settle the excess liability and close the gap.
The gap is to be closed by borrowing on the going interest rate in the market. For example, a negative gap in the 1 month bucket will be closed by borrowing short term for one month at interbank rate. The amount will essentially be borrowed at a spread over a benchmark market rate.
ALM Concepts & Reporting Template – Background materials
- Asset Liability Management – Assumptions, Convention, Tweaks & Hacks
- ALM Banking Models – Introductory Case Study
- Why does bank regulation fail? The Kill a bank in one day simulation
Also see the new Cost to Close example under ALM courses and what’s new section.
If you would like to buy the “Asset Liability Management Crash Course and Survival Guide package” please see the Asset Liability Management section or click on the banner above. The ALM package guide includes easy-to-read-and-work-with downloadable pdf files, excel templates and ready-to-work with models that are shared to illustrate usage and speed up learning for advanced financial modeling, forecasting and simulation topics including interest rate forecasting and simulation, value at risk analysis, Internal Capital Adequacy Assessment Process (ICAAP), and asset liability management.