Question

Explain the general risk measurement and risk management functions of banks. Discuss how these functions are applied by banks when they use Asset and Liability Management and gap analysis to manage liquidity risk and interest rate risk.

Answer 1

Solution:

Liquidity Planning is one of the most important function of risk management in banks. A bank will be considered having adequate liquidity when it can raise funds either by increasing its liability or liquidating its assets at a reasonable costs. Liquidity risk arises when a bank fund its long terms assets with short term liabilities, this should be avoided as this would lead to refinance risk.

Rate sensitive assets:

In a Bank’s balance sheet, rate sensitive assets are those assets value of which is sensitive to change in the interest rate such as bonds, loans, financial leases etc. These assets can either repriced considering the interest rate change.

Rate sensitive liabilities:

In a Bank’s balance sheet, rate sensitive liabilities are those liabilities value of which is sensitive to change in the interest rate. These liabilities can either repriced considering the interest rate change.

Rate sensitive Gap:

Rate sensitive gap strategy requires bank to perform an analysis of maturities and repricing opportunities with regards to bank bank’s rate sensitive assets and liabilities. Rate sensitive gap management requires to get optimum gap between rate sensitive assets and liabilities and in turn ensure that for each period, net amount of rate sensitive assets is equivalent to net amount of rate sensitive liabilities. By doing this, bank can hedge itself against any fluctuation in interest rate regardless of the direction of change of interest rate.

Negative rate gap:

A negative gap arises when a bank’s of financial institute’s rate sensitive liabilities exceed its rate sensitive assets. This mean that its liabilities would be reprices at lower interest rate and it would increase the income. However, if interest rates increase, liabilities would be repriced at higher interest rates, and income would decrease.

Positive rate gap:

When interest sensitive assets exceed its interest sensitive liabilities, positive gap arises.

Zero duration gap:

Both, negative and positive interest/rate gaps are also called duration gap. Zero duration gap means that there is no positive gap or negative gap and the bank has protected itself against any interest rate movements in either direction.