Managing interest rate risk for a bank

CFA Level III Portfolio Management
#1

Hey all,

Kind of having trouble understanding this concept.

So Schweser says this on page 190 of Book 2 regarding managing bank interest rate risk.

It is generally easier and timelier to adjust the characteristics of the investment portfolio than it is to adjust the characteristics of the liabilities or of the other assets (the loans). Generally the investment portfolio manager adjusts the bank’s investment portfolio duration such that overall asset duration is kept in the desired relationship to liability duration.

In theory if a manager forecasts increasing interest rates, she can decrease the duration of the portfolio to set the overall asset duration below the liability duration. If the interest rate prediction is correct, the assets will decline less than the liabilities for an economic gain. The reality is this is very risky and is not done or done in very limited fashion for banks. Bank leverage is very high with very low equity capital to assets. Thus the primary goal is to adjust the duration of the portfolio such that overall duration of assets matches liability duration.

How exactly can the manager of the bank’s investment portfolio ‘decrease the duration of the portfolio to set the overall asset duration below the liability duration’ when the majority of the bank’s assets are in loans of which he has no control of. I’d assume the portfolio size is a fraction of a bank’s outstanding loans receivables so how will a little asset allocation have any affect on the duration of bank’s overall assets? I guess I’m irked by the word “overall”.

Any help trying to understand this topic is appreciated!

#2

They can match A/L durations by swaps or can decrease an asset (a pool of loan) duration by securitization process. There are also more tools avail for A/L management.

#3

If you want to decrease the duration of your assets you can:

  • Enter into a pay fixed, receive floating swap
  • Sell bond futures
  • Sell long-term bonds and buy short-term bonds

These are probably the most straightforward transactions.

#4

Thanks for the responses but still not entirely clear. When we talk ALM and matching asset and liability duration from a bank’s perspective, are we talking about managing its interest rate risk (reduced interest rate spread and/or devaluation of B/S) or liquidity risk (being unable to provide a loan or honoring a deposit withdrawal)?

#5

Interest rate risk.