Interest rate increase

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lawrence90sg

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Hi Guys,
I don understand the particular 2 statements well. Can you help to provide some clarity on here.
Statement 1: I/R increase
  • Changes in net interest margins: The bank financial intermediation business model entails maturity transformation (i.e., borrowing short term and lending long term); thus, interest rate assets have a longer maturity than liabilities. In other words, bank balance sheets are typically characterized by a maturity mismatch. If there is a steepening of the yield curve, the net interest margin would be expected to increase due to the maturity mismatch. Meanwhile, long-term assets have higher incremental returns than the incremental costs of short-term liabilities.
Second Statement:
When the duration of assets is larger than the duration of liabilities, the duration gap is positive. In this situation, if interest rates rise, assets will lose more value than liabilities, thus reducing the value of the firm’s equity.
How come the net effect is different? When asset maturities is longer than liabilties.
Thanks
 
For a bank, their assets is their loan portfolio and their liabilities are deposited (cash). If interest rates rise and they have more loans locked in at lower rates, its value goes down as a portfolio of loans vs one with new higher rates, that they make money on.
Firm equity = Assets - Liability. Assets goes down, the company’s “net worth” goes down if liability is unchanged or goes up if they now have to payout higher interest rates to customers on current deposits.
 
Hi,
i understand this part on what you saying.
But what about the difference in this 2 statement.
Since they are talking about the same thing (Duration), why is the net effect different.
First thing, is duration mainly fixed on floating instruments?
2nd thing, when i/r go up, i though those with a higher duration should suffer?
Thanks
 
I extract statement 2 from Wiki. but I also saw a particular similar statement from the part on Managing instituional investor (managing bank)
Statement 1 was from CFA webpage.
Thanks
 
Lawrence90sg,
I think both statements are correct and not in conflict with each other. I recall the second statement too. Anyways, last night I emailed Marc from the LevelUp BootCamps, he wrote back:
“Changes in net interest margin or “net interest spread” as the CFA candidate curriculum refers to the difference between what a bank pays on its deposits (liabilities) and its loan portfolio (assets). More importantly the bank manages its’ exposure to interest rate movement through duration management.
When interest rates are falling the bank wants longer duration liabilities (loans) and shorter duration assets (deposits) to maximize the net interest margin and insulate the loans/assets from falling rates. Alternatively, if rates are rising the bank want to shorten its loan portfolio (assets) so they reset at higher rates when rates rise and have long duration liabilities (deposits) that will stay at low rates as long as possible, again maximizing net interest margin.
While maturity is important since it is a determining factor in duration (longer maturity - longer duration) it is not the only factor in managing interest rate sensitivity.” - Marc LeFebvre
Bank duration is comprised of both fixed and floating instruments, they take a point estimate to calculate the average exposure. If interest rates goes up, you “suffer” if your duration is longer and you have more bank assets than liabilities to offset the losses.
Hope that helps.
 
HI Godism17,
Thanks alot.
Btw, i thought net interest margin difference between Asset and liabilities instead of the otherway round.
Secondly, what do you understand about the last sentence on statement 1” Meanwhile, long-term assets have higher incremental returns than the incremental costs of short-term liabilities.”
Cause i am not very sure on it.
Thanks
 
It might jsut be me but im reading maturity mistmatch and duration as two seperate things. Duration is the sensitivity to interest rates on bond prices whereas maturity mismatch is a different issue.
If you have a longer maturity and the yeild curve steepens, you’re reinvesting coupons longer and at a new higher rate than if you had a shorter duration.
If you duration is mismatched that means the face value of your liabilities and assets have changed and you may no longer be able to satify your liabilities with a sale of your assets at market value.
 
It sounds like they are saying their long-term loans they own (an asset) have higher returns than their short term deposits which makes sense. Think a higher rate they recieve from 30yrs mortages (4.5%) vs short 6-mths CD deposits (1.5%) they have to pay out as liabilities.
 
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