Understanding Bank Balance Sheet, Interest Rates, And Portfolio Composition Is Crucial For Financial Essay.

Consider the four banks balance sheet in Appendix A and associated average interest rates. The period for rate sensitivity is one year.
For each four banks in Appendix A, calculate their GAP, expected NII, and NIM if interest rates and portfolio composition remain constant during the year. Explain how each bank is positioned to profit if interest rates move in which direction.
PART 2
Calculate the change in expected NII and NIM if interest rates shift 2 percent higher during the year. Is this outcome consistent with each bank’s static GAP?
PART 3
Suppose that, instead of the parallel shift in interest rates in PART 2, interest rates increase unevenly. Specifically, suppose that asset yields rise by 0.50 percent while liability rates rise by 0.75
percent. Calculate the change in NII and NIM. Is this uneven shift in rates more of less likely than a parallel shift?
PART 4
Suppose each bank converts £150 of RSLs to fixed-rate liabilities during the year and interest rates remain constant. What wold the bank’s NII equal compared with the amount initially expected? Explain why there is a difference.
PART 5
Discuss the strength and weaknesses of static GAP analysis.

Bank A:

GAP Analysis:

1. GAP = 500 -600 = (£100)
2. Expected Net Interest Income =  [(500*7%) + (350*9%)] – [(600*3%) + (220*4%)] = £(66.5 – 26.8) = £ 39.7
3. Expected Net Interest Margin = 39.7/850 = 0.0467
4. The bank is likely to see an increase in the net interest income if there is an increase in the interest rates. According to the GAP model, the bank currently has £100 less in assets than in liabilities.

Bank B:

GAP Analysis:

1. GAP = 550 - 550 = £0
2. Expected Net Interest Income =  [(550*7%) + (400*9%)] – [(550*3%) + (370*4%)] = £(74.5 – 31.3) = £ 43.2
3. Expected Net Interest Margin = 43.2/950 = 0.0455
4. There will be decrease in the net interest income if there is an increase in the interest rates as the assets and liabilities are equal and there is going to be no change in the fixed rate interest. According to the GAP model, the bank currently has equal amount in assets as well as in liabilities, therefore, there is no GAP as of such (Alexander, 2016).

Bank C:

GAP Analysis:

1. GAP = 600 - 500 = £100
2. Expected Net Interest Income =  [(600*3%) + (300*4%)] – [(500*7%) + (350*9%)] = £(30 – 66.5) = (£ 36.5)
3. Expected Net Interest Margin = -36.5/900 = -0.0405
4. There will be decrease in the net interest income if there is an increase in the interest rates as effective interest rate on the liabilities is much more than the yield on the assets. According to the GAP model, the bank currently has £100 more in assets than in liabilities.

Bank D:

GAP Analysis:

1. GAP = 500 - 600 = (£100)
2. Expected Net Interest Income =  [(500*3%) + (350*4%)] – [(600*7%) + (220*9%)] = £(29 – 61.8) = (£ 32.8)
3. Expected Net Interest Margin = -32.8/850 = -0.0386
4. There will be decrease in the net interest income if there is an increase in the interest rates as the assets are lower than liabilities and also the interest rate on the liabilities is much more than the yield on the assets (Boccia & Leonardi, 2016). According to the GAP model, the bank currently has £100 less in assets than in liabilities.

Change in the expected NII and the NIM has been shown below in case the interest rate shifts 2% higher during the year (Davis, 2017).

Change in NII = Change in Rates * GAP

Bank A = -.02*-100 = +£2

Bank B = -.02*0 = £0

Bank C = -.02*100 = -£2

Bank D = -.02*-100 = +£2

Changes in the NIM would be as follows:

Bank A = 41.7/850 = 0.0490

Bank B = 43.2/950 = 0.0455

Bank C = -38.5/900 = -0.0428

Bank D = -30.8/850 = -0.0362

Explanation: In case the interest rate rises by 2% during the year, its outcome is no consistent with each bank’s static GAP as can be seen from the above analysis, for few of them , the net interst income has increased whereas for the others it has decreased. This is mainly because some of them were in loss initially and others were in profit (Belton, 2017).

Bank A

Change in the interest income = 0.005*500 = 2.5

Change in the interest expense = 0.0075*600 = 4.5

Change in the net interest income = 2.5 – 4.5 = -2

New Net interest income = 39.7 – 2 = 37.7

New NIM = 37.7 / 850 = 0.0443

Bank B

Change in the interest income = 0.005*550 = 2.75

Change in the interest expense = 0.0075*550 = 2.75

Change in the net interest income = 2.75 – 2.75 = 0

New Net interest income = 43.2 – 0 = 43.2

New NIM = 43.2/950 = 0.0455

Bank C

Change in the interest income = 0.005*600 = 3

Change in the interest expense = 0.0075*500 = 3.75

Change in the net interest income = 3 – 3.75 = -0.75

New Net interest income = -36.5 – 0.75 = -37.25

New NIM = -37.25 / 900 = -0.0414

Bank D

Change in the interest income = 0.005*500 = 2.5

Change in the interest expense = 0.0075*600 = 4.5

Change in the net interest income = 2.5 – 4.5 = -2

New Net interest income = -32.8 – 2 = -34.8

New NIM = -34.8 / 850 = -0.0409

Explanation: The uneven shift in the rates is more likely than the parallel shift in the rates in any economy. This is mainly driven by the policies of the individual banks as well as of the government (Werner, 2017).

PART 2

In case each of the given 4 banks converts its £150 of the rate sensitive liabilities into the fixed rate liabilities during the year and the interest rate remains to be constant, following would be changes in the NII as compared to the initially expected amount (Goldmann, 2016).

Bank A

Change in the interest expense = 150*0.01 = 1.5

Net interest income would be falling to 38.2 (39.7  - 1.5)

The decrease in the net interest income is reflecting greater borrowing being made at higher interest costs (  4% versus 3%)

Bank B

Change in the interest expense = 150*0.01 = 1.5

Net interest income would be falling to 41.7 (43.2  - 1.5)

The decrease in the net interest income is reflecting greater borrowing being made at higher interest costs (  4% versus 3%)

Bank C

Change in the interest expense = 150*0.02 = 3

Net interest loss would be falling to -33.5 (-36.5 + 3)

The decrease in the net interest loss is reflecting greater borrowing being made at lower interest costs (  7% versus 9%) (Choy, 2018)

Bank D

Change in the interest expense = 150*0.02 = 3

Net interest loss would be falling to -29.8 (-32.8 + 3)

The decrease in the net interest loss is reflecting greater borrowing being made at lower interest costs (  7% versus 9%)

A static gap is calculated as sensitivity to interest rates and its exposure. It can be calculated for both short term and long-term periods. It helps in analyzing the situation of the prevailing market rates conditions and then taking necessary decisions based on the same. In cases where there is a negative sign in the gap figures it reflects that there are larger number of liabilities in comparison to the assets and there are chances of getting exposed to rising interest rates in the market. It can be calculated for multiple periods and it is mostly calculated for less than one-year period. They are not as precise as other measurements because they do not take into consideration factors like cash flow, average maturity and loan repayments etc (Chaudron, 2018).

The main strengths of this kind of calculations is –

• It is easy to understand since it does not include many complex calculations, it is easy to analyze and helps the bankers in taking decisions with respect to investment of funds.
• It functions best in cases that involves smaller changes in case of interest rates and that makes it easy for the bankers to take important decisions with respect to the same. Large changes in interest rates reflects poor conditions where the exposure of risk is very high (Frame & White, 2005).
• It helps in analyzing the current market conditions by taking into consideration the changing bank rates and helps the bank in maintaining a level of liquidity that is needed to keep the securities in a marketable position and lends the banker an informative value on the securities in which they deal (Gerlach, et al., 2018).

The main weakness of this kind of calculations are –

• Measurement Errors – There are chances that post calculations many post calculations errors may crop up, due to the high liquid nature of the involved and the possibility of market fluctuations is also very high in the same. These measurement errors make the decisions based on these calculations redundant and invalid.
• It does not consider the time value of money, so this makes the calculation redundant and invalid in times to come. It also does not provide the most accurate picture of the current market scenario based on the prevailing conditions (Oberoi, 2018).
• It considers that most of the demand deposits in the market are not sensitive to interest rates, but as we know that this is not a condition and demand deposits are sensitive to rate changes as similar as other deposits.
• It often ignores the embedded options that is present in case of banks assets and liabilities.
• It also does not consider the cumulative impact of the changes in the interest rate that might occur in times to come and how the same will impact the overall deposit and lending that is done by these banks (Timothy, 2004).
• They do not take into consideration many factors like cash flow calculation, average rates, loan repayments etc. which makes it difficult for the people to analyze whether they should invest in a security or not based on this static gap calculations.

References

Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.

Belton, P., 2017. Competitive Strategy: Creating and Sustaining Superior Performance. London: Macat International ltd.

Boccia, F. & Leonardi, R., 2016. The Challenge of the Digital Economy: Markets, Taxation and Appropriate Economic Models. s.l.:Springer.

Chaudron, R., 2018. Bank's interest rate risk and profitability in a prolonged environment of low interest rates. Journal of Banking and Finance, Volume 89, pp. 94-104.

Choy, Y. K., 2018. Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, p. 145.

Davis, P., 2017. Value Investing: Do Quant Strategies Measure Up?. Financial Analysts Journal, pp. 1-172.

Frame, S. & White, L., 2005. Fussing and fuming over Fannie and Freddie; How much smoke, how much fire?. Journal of Economic Perspective, Volume 19, pp. 159-184.

Gerlach, J., Mora, N. & Uysal, P., 2018. Bank funding costs in a rising interest rate environment. Journal of Banking and Finance, Volume 87, pp. 164-186.

Goldmann, K., 2016. Financial Liquidity and Profitability Management in Practice of Polish Business. Financial Environment and Business Development, Volume 4, pp. 103-112.

Oberoi, J., 2018. Interest rate risk management and the mix of fixed and floating rate debt. Journal of Banking and Finance, Volume 86, pp. 70-86.

Timothy, G., 2004. Managing interest rate risk in a rising rate environment. RMA Journal, Risk Management Association (RMA), November.

Werner, M., 2017. Financial process mining - Accounting data structure dependent control flow inference. International Journal of Accounting Information Systems, Volume 25, pp. 57-80.