In this series of posts we are concentrating on interest rate risk, arguably second only to credit risk in importance to most banks. The value of banks’ assets and liabilities are highly sensitive to changes in the level of interest rates. Forecasting shifts in yield curves accurately and with a high degree of confidence is difficult. These shifts may be parallel, but rarely are, where yields change by an equal amount at all maturities or non-parallel. If bank asset liability management were a simple matter then people working in Treasury would get paid a lot less. There are three methods available and used for the assessment of interest rate risk:
Duration matching. Duration matching involves analyzing the price sensitivity of assets and liabilities to changing interest rates. We will focus on the techniques associated with duration matching. Gap analysis. Gap analysis is essentially a method based on placing assets and liabilities into one of a number of different “time buckets” determined by when they are due to be repriced. Sensitivity analysis. This method involves subjecting a portfolio to a wide range of possible changes in interest rates and assessing the potential impact of each scenario. Management has to assign a probability to each scenario.
None of these methods is without its problems. One of the fundamental issues faced is that of balancing a perceived need to maintain stable reported earnings with maximizing economic value. In practice management at most commercial banks prioritize earnings stability.
