Why fund managers can't ignore sensitivity training
posted on Friday, June 9, 2017 in Strategies
In personal relationships, a lack of sensitivity by one of the partners can lead to friction, or ultimately a breakdown of the relationship. Read more about how the importance of sensitivity can also be found in interest rate risk management where (similar to marriage) if ignored, can lead to several undesirable outcomes.
The sensitivity of a financial institution's balance sheet stems directly from the inherent mismatch between the repricing intervals and magnitudes of asset and liability cash flows. In particular, we can break this imbalance down into two balance sheet conditions: asset-sensitive or liability-sensitive.
If a financial institution's balance sheet cash flow position is asset sensitive, the institution's asset cash flows reprice or are reinvested at a faster rate or in a larger magnitude than liability cash flows. This situation causes interest income to be more sensitive than interest expense as interest rates move. If rates increase, the appreciation in asset yields may lead to an increase in interest income and an expansion in net interest margin. The antithesis occurs if rates decrease as asset cash flows are reinvested at lower rates and net interest margin may compress. Asset-sensitive cash flow positions are typical of financial institutions with large volumes of adjustable-rate assets with short repricing intervals. Generally, to prevent financial underperformance in declining rate environments, the institution can extend asset duration by purchasing or originating non-optionable bullet loans or investments or shorten liability duration by offering short-term deposit accounts or borrowing in shorter maturities.
A liability-sensitive balance sheet position implies that a financial institution's liability cash flows reprice or are refinanced at a faster rate or larger magnitude than asset cash flows. This balance sheet profile creates a situation where interest expense is more sensitive than interest income to movements in interest rates. If market rates move upward, a larger increase in interest expense creates net interest spread compression. If market rates decline, interest expense declines as time certificate and non-maturity deposit rates decline and net interest margin slowly expands. It is natural for a financial institution to support a liability-sensitive interest rate risk profile due to the short-term nature of the funding base. Typically, a liability-sensitive institution can either extend its liability base duration or shorten its asset base to prevent financial underperformance in rising rate environments.
Proper funds management policies and procedures are and should always be an integral part of any financial institution's business strategy. The FHLB of Des Moines (FHLBDM) has a plethora of products and services that can assist members in the funds management process. For instance, if your institution displays an asset- sensitive interest rate risk profile, the member could utilize short-term repo advances (1-month or 3-month) to shorten the liability base repricing interval and limit spread compression in declining rate environments. Historically, these short-term repo products have been highly correlated to Prime and are priced at a significant spread below Prime.
All of these products can be used to mitigate basis risk and prevent spread compression on Prime-based assets should rates decline. Additionally, members can utilize LIBOR or Prime-based advances to combat an asset sensitive profile in declining rate environments. The FHLBDM also has many long-term, non-amortizing advances that could be used to compensate for a liability- sensitive profile if rates increase. If the member cannot extend liability duration through retail deposits, FHLBDM advances are a cost-effective and efficient alternative that provide significant marginal cost benefits.
Don't leave your fund management to chance. We have powerful analytical tools that can assist your institution in evaluating strategic funding decisions and mitigating unwanted interest rate risk. To discuss funding options and strategies, call your VP/Relationship Manager or email Member Strategies
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