9.5 Interest-Rate Risk #Notebook

 9.5 Interest-Rate Risk #Notebook

A Bank's profits highly rely on the difference between what it pays for its liabilities and earns on its assets. 

If interest rates increase +, the difference will decline -

*Because the value of its rate-sensitive liabilities exceeds that of its rate-sensitive assets.

For example, suppose a bank b pays 3% for your deposits and then receives 7% on the mortgages it lent. The difference is 4%, the amounts can be huge if they have billions of assets and liabilities on hand. The bank will be paying $100 billion * .03 = $3 billion to earn $7 billion.

If interest rates increase +1% on each side of the balance sheet, The bank will be paying $4 billion to earn $8 billion. 

Formally, this type of calculation, called basic gap analysis, is

 

Cρ = (Ar−Lr) × △i

Cρ = changes in profitability

Ar = risk-sensitive assets

Lr = risk-sensitive liabilities

i = change in interest rates

Duration, also known as Macaulay’s Duration, measures the average length of a security’s stream of payments. 

△%P = −△%i × d = △%MktV = −△%i × Dyr

Δ%P = % change in market value

Δi = change in interest (not decimalized, i.e., represent 5% as 5, not .05. Also note the negative sign)

d = duration (years)

So, let's get some practice...

Exp I. 

If interest rates increase 2% and the average duration of a bank’s $100 million of assets is 3 years, the value of those assets will fall approximately.....

△%MktV = −△%i × Dyr = −2 × 3 = −6%, or $6 million.

Then, at the same time..

If the value of that bank’s liabilities is $95 million, and the duration is also 3 years, the value of the liabilities will also fall, 95 × .06 = $5.7 million, effectively reducing the bank’s equity (6 − 5.7= ) $.3 million. 

If the duration of the bank’s liabilities is only 1 year, then its liabilities will fall −2 × 1 = −2% or 95 × .02 = $1.9 million, and the bank will suffer an even larger loss (6 − 1.9 =) of $4.1 million. If, on the other hand, the duration of the bank’s liabilities is 10 years, its liabilities will decrease −2 × 10 = −20% or $19 million and the bank will profit from the interest rate rise.

Apparently, we get the key point....

A basic interest rate risk reduction strategy when interest rates are expected to fall is to keep the duration of liabilities short and the duration of assets long. 

That way, the bank continues to earn the old, higher rate on its assets but benefits from the new lower rates on its deposits, CDs, and other liabilities. 

Quite the opposite, when interest rates increase +, banks would like to keep the duration of assets short and the duration of liabilities long.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

10.5 Banking Industry Profitability and Structure #Notebook

Banking Industry Profitability and Structure

When interest rates rose enough to cause disintermediation, to cause funds to flow out of banks to higher-yielding investments, banks are likely to compete with each other for funds and deposits. 

Securitization has hurt banks by giving rise to numerous small lenders that basically sell every loan they originate.

In 1933, at the nadir of the Great Depression, commercial and investment banking activities, strictly separated by legislation, Glass-Steagall. 

The banking crisis of the 1980s has caused some reforms, including greatly easing restrictions on branch banking and investment activities.

Due to the deregulation, banks began to merge in large numbers (consolidation), and participating in nonbanking financial activities, like insurance (conglomeration).

Due to the demise of Glass-Steagall, conglomerate banks can now more easily tap economies of scope, consolidation and conglomeration have left the nation with fewer but larger and more profitable banks to supply numerous products or services. 

Consolidation has allowed banks to diversify their risks geographically and to tap economies of scale, due to the high initial costs of employing the latest and greatest computer and telecommunications technologies.

Complex banking organizations or large, complex financial institutions point to the costs of the new regime. These institutions are too big, complex, and politically potent to regulate effectively.

However, they are also taking on higher levels of risk. A combination of consolidation, conglomeration, and concentration helped to trigger a systemic financial crisis acute enough to negatively affect the national and world economies.

Those big banks control the vast bulk of the industry’s assets and rapidly gaining market share. Nevertheless, U.S. banking is still far less concentrated than the banking sectors of most other countries. 

In Canada, the commercial bank Herfindahl index hovers around 1,600, and in Colombia and Chile, the biggest five banks make more than 60% of all loans. The Herfindahl index is calculated by summing the squares of the market shares of each bank.

However, bank entry is fairly easy, so new banks will form to compete with them, the Herfindahl index may be ultimately back in line. Consultants like Dan Hudson of NuBank.com help new banks to form and begin operations.

The U.S. banking industry is increasingly international in scope. Foreign banks can enter the U.S. market relatively easily. Foreign banks can buy U.S. banks or simply establish branches in the United States. 

The internationalization of banking means that U.S. banks can operate in other countries, and also a way to diversify assets. 

In continental Europe, like Germany and Switzerland, so-called universal banks that offer commercial and investment banking services and insurance prevail. 

Great Britain and its commonwealth members, full-blown financial conglomerates are less common for now, but most banks engage in both commercial and investment banking activities. 

Increasingly, the world’s financial system is becoming one, make it more efficient, but also raises fears of financial catastrophe.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.