Question

Esabelle Mensah is a Treasurer of E5 Bank Limited. During ALCO last month members expressed concern about the continuous decline in interest rates over the next 1 year and its impact on the bank’s net interest income. The Treasurer was therefore tasked to make a presentation to ALCO at the next monthly meeting on the interest rate risk the bank currently has and what should be done to hedge this risk. She has gathered the following extracts from the bank’s balance sheet as at 31st March 2020.

Assets 1. Consumer loans – GHS 450m, 5-year maturity with rates fixing every 6 months

2. Corporate Loans - GHS 350m, 2-year tenor with 3 months rate fixing. The remaining term to maturity is 2 months

3. Fixed rate loans - GHS 180m, 5-year personal loans.

4. Government Securities-GHS 150m 91 day, 160m 182 day and 2-year 140m bond.

5. Fixed assets-GHS 120m

Liabilities

1. Current Accounts - GHS 300m

2. Savings Accounts - GHS 350m

3. Time Deposits - GHS 200m with 12 months maturity

4. Negotiable Certificate-GHS 150m 6months maturity

5. Interbank borrowings – GHS 50m with 7 days to mature

6. Subordinated debt-GHS 100m with rates fixing every 6mths

5. Equity - GHS 400m You are required to:

i. Calculate the 12 months Rate Sensitive Assets (RSA), Rate Sensitive Liabilities and Re-pricing gap.

ii. Calculate the impact of a 150 basis point decline in interest rate on the bank’s net interest income over the next 12 months

iii. Calculate the impact on the bank’s net interest income if as a results of decline in market interest rates, asset rates fall by 300bps whilst liability rate fall by 150bps.

iv. Briefly highlights the challenges associated with using the Re-pricing model to estimate the level of interest rate risk in the banking book.

Answer 1

Solution:

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.

i. In current example, rate sensitive assets/liabilities are as follows:

Rate sensitive assets	Value in million GHS	Maturity	Rate change frequency
Consumer loans	450	5 years	6 months
Corporate loans	350	2 years	3 months
Government securities	150	91 days
Government securities	160	182 days
Government securities	140	2 years
Total (Assets)	1,250
Rate sensitive Liabilities	Value in million GHS	Maturity	Rate change frequency
Savings account	350
Time deposits	200	12 months
Negotiable certificate	150	6 months
Interbank borrowing	50	7 days
Subordinated debt	100	6 months
Total (Liabilities)	850
Repricing gap (Assets – Liabilities)	400
Sensitive ratio (Assets/Liabilities)	1.47

Maturity bucket	Rate sensitive assets	Rate sensitive liabilities	Gap	Cumulative gap
0-7 days		400	-400	-400
7 days to 3 months	150		150	-250
3 - 6 months	160	250	-90	-340
6 months to 1 year		200	-200	-540
1 - 2 years	490		490	-50
2-5 years	450		450	400

Bank has cumulative negative gap of GHS 50 million for next 2 years. Hence, Bank’s earnings will decrease if there is a rise in the interest rate in next 2 years. However, the cumulative gap for 2-5 years bucket is positive, meaning if there is a rise in the market interests’ rates, interest income will increase by more than interest expenses.

ii.

Net interest income: The net interest income is derived as follows:

Net Interest Income = Total Interest Income − Total Interest Cost

= [Average Interest Yield on rate sensitive assets × Volume of rare sensitive assets +

Average Interest Yield on Fixed (non-rate Sensitive assets) × Volume of Fixed Assets]

−

[Average interest cost on rate sensitive liabilities × Volume of interest sensitive liabilities +

Average interest cost on fixed (non-rate sensitive) liabilities × Volume of fixed(non-rate sensitive) liabilities]

Since, during next 12 months, banks has cumulative negative gap of (-ve) GHS 540 million, any decline in interest rate would benefit the bank.