ALM Basics: Measuring Interest Rate Risk
Note: This post is part of a series on the basics of asset liability management.
So, how do banks measure interest rate risk? At one time, banks relied almost exclusively on GAP measurements to quantify interest rate risk. GAP, in its simplest form, measures the amount of assets repricing in any given time bucket and compares it to the number of liabilities repricing in the same time bucket. A bank that has more assets repricing than liabilities for a given time frame is said to be asset sensitive, or positively gapped. A bank that has more liabilities than assets repricing in a given time frame is said to be liability sensitive, or negatively gapped. While GAP is still a useful tool in evaluating risk, it has several inherent flaws that greatly limit its effectiveness. The two most prominent flaws are:
- GAP fails to capture the magnitude of rate changes, or the beta of each balance sheet category. For example, a bank may have a similar amount of loans and deposits repricing at the same time, but if the loans receive 100% of a rate change and the deposits only receive 50% of a rate change, then there is exposure to declining rates.
- GAP does not properly capture the frequency of repricing. For example, loans that reprice each quarter are generally only measured in the first repricing date, and not in subsequent time buckets.
Because of these limitations, banks have developed more sophisticated ways of capturing the true interest rate exposure on their balance sheets. Most community banks rely on two methods, one that captures short term interest rate risk, and another that captures long term interest rate risk.
For short term interest rate risk, banks perform an income simulation. In this simulation, banks make assumptions about how loans and deposits will reprice in a given interest rate environment, and how optionality in the balance sheet (like prepayments and calls) will be exercised. With these assumptions, banks then model what each part of the balance sheet will do in a series of interest rate environments and what the impact will be on net interest income, thereby determining what rate environments represent an exposure to earnings (click here for more on income simulation).
For long term interest rate risk, banks calculate a market value of equity, also known as net portfolio value or economic value of equity. Market value of equity is calculated by "marking to market" each category of the balance sheet, and netting the liability market value from the asset market value. This calculation is performed under a range of rate environments, showing where the bank has more or less value to shareholders. Since marking to market is essentially a net present value calculation, it captures the entire expected life of the balance sheet, and a change in value will reflect a change in the long term interest rate risk (click here for more on market value of equity).
There are several other methods for modeling and measuring interest rate risk, including stochastic modeling and monte carlo simulations. However, income simulations and market value of equity are the two most common in community banks, as they will generally properly capture the risk in a less complex balance sheet.