Callable securities, interest rate risk, and the gap report
Originally published 1/11/2007 © 2021 Olson Research Associates, Inc.
I was reviewing with a bank client (and his examiner) yesterday one of the short-comings of the gap report as an interest rate risk measurement tool. This particular bank has a large volume of callable securities that are likely to be called in the current rate environment. To illustrate the problem with the gap report, I’m going to simply the numbers for Simple State Bank:
Assets:
$60,000 3–Month Treasury Bonds
$40,000 5–Year Callable Agency Bonds (callable quarterly)
Liabilities & Equity:
$30,000 3–month CDs
$40,000 6–Month CDs
$20,000 3–year CDs
$10,000 Equity
So here’s the question: Is this bank asset sensitive or liability sensitive? In other words, which rate environment causes net interest income to decline? If the bonds are placed in the 3–month bucket because they are likely to call, the bank’s cumulative gap ratio is 143% which traditionally means asset sensitive. Generally speaking net interest income at asset sensitive banks will benefit from rising rates.
Is that what will happen at Simple State Bank?
Probably not. Why? Because if rates rise and these bonds don’t call, the bonds are placed in the “> 3 year” bucket. In this case the bank’s cumulative gap ratio is 86%. Now the bank is liability sensitive because fewer assets can reprice to new rates.
For this bank, the one cumulative gap ratio of 143% is essentially useless in measuring the bank’s interest rate risk. The best tool to measure this exposure is an income simulation which recalculates the level of net interest income in three (or more) different scenarios: Base-case, Rates-down, and Rates-up. The simulation should model whether these bonds call or not and adjust the level of income accordingly.
The callable behavior of bonds is a type of “optionality” embedded in the bank’s investment portfolio. Optionality can be found in the loan portfolio (principal pre-payments), deposits (early-withdrawal of CD’s), and borrowings (convertible, or callable advances). The more optionality on a bank’s balance sheet, the less valuable gap is as an interest rate risk measurement tool.