Banks Balance sheet consists of Assets & Liabilities – on the Asset side we have loans , mortgages, credit cards , investments and on the liabilities side we have demand and time deposits, CDs etc..
Banks take deposits at a certain rate and lend them at a higher rate to earn income which is called as NII. If the short term asset is funded by long term liability or long term asset is funded by long term liability, this kind of situation then bank faces the risk of re pricing the asset or liability if the asset or liability is rolled over as interest rate may not be the same for two periods.
Banks use below two models or tools to safeguard itself from such scenarios.
- Repricing risk model – Funding gap model , this analyses the impact of change in IR on NII through Gap analysis
- Duration Gap model – This analysis the change in IR on market value of assets and liabilities.
Let’s first look at Repricing risk model – this arises due to mismatch of maturities of the assets and liabilities and can give rise to refinancing or repricing risk.
Let’s say if bank has funded 10 year fixed rate loan @ 10% by 2 year term deposit @ 9%, ideally 10 year loan should be funded by 10 year deposit however in this case two year deposit will be rolled over but the rate will be may not the same and if the rate of the deposit increases by 12% then bank will have an impact in its NII.
In Repricing gap analysis – Assets and Liabilities are put under different time buckets.
Fixed asset or liab is put under time bucket as per their maturity & Floating rate time bucket is defined as per its reset or fixing date.