The Case of Norwegian Sturt Company’s Asset Liability Management Theory

1. Background

At the beginning of 1997, Norwegian Sturt Company was celebrating the first breakthrough in net profit in the company’s history. A historic achievement of US$1 billion. The company's net profit in 1996 was US$1.154 billion, and its total production increase at the end of the year was US$80 billion (see Figures 1 and 2). The company is the 12th largest bank-owned company in the United States, with more than 53,000 employees and a stock market value of more than $16 billion. The company boasts 30,449 locations (employees call them "stores") in all 50 states. The company consists of three subsidiaries: Norse Bank, which has branches in 16 states; Norse Mortgage Company, which claims to have issued one in 15 mortgages in the United States; Norse Finance Company, a consumer credit company with 3.6 million customers.

Funding Structure

The three companies under Norsted provide the company with a variety of profitable assets, including US$38 billion in net loans and leases (Figure 1) . A significant portion of the company's assets are consumer credit, including installment payments, sales financing contracts and credit card loans. Norstor also owns substantial mortgage servicing rights. In addition, the company also offers a variety of commercial credit. Small branches located outside the city are actively engaged in small business loans and Small Business Administration loans (government guaranteed). Larger branches usually provide financing for medium-sized enterprises. Additional affiliates specializing in asset-backed commercial credit and equipment leasing help diversify the company's loan portfolio. In addition, the company also holds nearly $19 billion in securities investments, so that the company can freely use some securities to adjust its asset and liability positions.

Norstor benefits from a stable funding base. Because the company has a sales network consisting of retail trusts and numerous small operating locations, 58% of the company's total funds are composed of core deposits, including demand deposits, ordinary savings and NOW account deposits, money market checking and consumer savings certificates . The company has a very high percentage of core deposits based on industry averages. Core deposits are a highly stable, low-cost source of funds. As market interest rates rise, the increase in core deposit interest rates lags behind. Even if interest rates are raised, they are raised slowly. Short-term borrowings, consisting of federal funds borrowings, repurchase agreements, private treaty financing and commercial paper issued by Norsk Mortgage and Finance Corporation, accounted for 11.6% of total funding. Other sources of funding include approximately 4% purchasing deposits—certificates of deposit and foreign deposits in amounts greater than $100,000—18.5% long-term debt and modest equity funds (mostly retained earnings).

Interest rate sensitivity

The direction of interest rate fluctuations was very unclear in 1997, and the interest rate level did not change much throughout 1996, although market experts began to pay attention to savings intentions at the end of the year. Some people believe that the Federal Reserve will soon raise interest rates to combat the coming inflationary pressures. At the beginning of 1997, it was clear in the first quarter that there were calls to raise interest rates. Norse's financial executive explains how the company's incremental liability management system manages interest rate sensitivity risk. [17]

Management of assets and liabilities

The goal of asset and liability management is to manage the structure of the balance sheet in order to obtain the most satisfactory interest rate sensitivity risk and liquidity combination. The central point of the management process is the Asset Liability Management Committee (ALCO), which negotiates decisions to control investments, financing, off-balance sheet commitments, total interest rate sensitivity risks and liquidity, and oversees their implementation. These policies form the basic framework for corporate and branch asset liability management processes. The company's risks are well controlled and all indicators are within the limits stipulated in the policy.

Definition of interest rate sensitivity risk

Interest rate sensitivity risk refers to the risk that changes in future interest rates will lead to a decrease in net interest income or the net market value of the company's balance sheet. The two basic ways of defining interest rate risk in the financial services industry generally refer to an accounting perspective and an economic perspective, and often a definition that combines these two approaches may provide a more comprehensive description of interest rate risk than a definition from one perspective alone.

The accounting perspective focuses on the risk of changes in net income over a specific time frame, differences in the timing of interest rate resets (repricing risk or gap risk) and differences in changes in market interest rates (basis risk) Determines the net income risk corresponding to changes in interest rates.

The economic perspective focuses on the risk to the market value of a company's balance sheet, with net market value referring to the market value of owners' equity. The sensitivity of the market value of owners' equity to changes in interest rates reflects the interest rate risk inherent in the institution's short-term positions and long-term earnings trends. Assessing interest rate risk from an economic perspective focuses on net worth risk arising from mismatches between various maturities.

Measurement of interest rate risk

From an accounting perspective, the traditional method of measuring interest rate risk is in the form of a gap report. The gap report describes the return of assets and liabilities within a given period. Pricing is different. Although it provides a rough measure of interest rate risk, it only provides a static (i.e., at one point in time) measure, and it does not account for basis risk or those that do not change symmetrically or proportionally with changes in interest rates. risk.

Companies often use a simulation model as the primary method of measuring return risk. Simulation models, due to their dynamic nature, can capture future balance sheet movement trends, different patterns of interest rate changes and the relationship between interest rate changes (basis risk), which affect net income. It also reflects the impact of embedded option risk because it takes into account interest rate caps and floors, as well as prepayment rates as a function of interest rates. Simulation models are often used to calculate the size of the one- and three-year gaps that correspond to changes in earnings set by the company, usually caused by changes in interest rates.

Measuring interest rate risk from an economic perspective is accordingly accompanied by a market valuation model, in which the market value of each asset and liability is calculated by summing the cash flows generated by that asset or liability. value to calculate. When calculating present value, the market rate used to discount the cash flows should reflect, as closely as possible, the characteristics of the given asset or liability.

Management of Interest Rate Risk

Most current simulation models predict net income based on different interest rate scenarios. One of the most common scenarios is that short-term rates remain unchanged but long-term rates increase slightly, and this scenario is used as the base case against which other interest rate changes are compared. If short-term rates rise by 200bps over the next 12 months relative to the base case short-term rate, while long-term rates increase only slightly, the result is that net income will be approximately $40 million lower relative to the base case. If short-term rates fall by 200bps over the 12-month period compared to the base case short-term rates, the result is an increase in net income of approximately $63 million. The analysis also takes into account the impact of derivatives used to hedge balance sheet items and the impact of interest rates on the rate at which mortgages and mortgage-backed bonds prepay. However, in this case of interest rates. Net income also excludes the impact of changes in the capitalized value of mortgage servicing rights.

The market valuation model is used to measure the sensitivity of the market value of owners' equity to wide fluctuations in interest rates. Modeling market value risk is widely used in the financial services industry, including establishing modeling procedures, setting policy limits and interpreting mathematical results.

Changes in interest rate sensitivity

Exhibit 3 shows the company's interest rate sensitivity gap in December 1996. The cumulative gap within one year is (3317) million US dollars, or of total assets (4.2%). In comparison, the one-year shortfall in December 1995 was $2,762 million, or (3.8%) of total assets. The cumulative shortfall over the three years in December 1996 was $990 million, or 1.2% of total assets, compared with $1603 million and 2.2% in December 1995. ). The relatively small change in the gap value expressed as a percentage is due to the many offsetting changes in the balance sheet over a year, including increases in the investment portfolio and demand deposits. The current interest rate sensitivity position makes the company's earnings more susceptible to rising interest rates but more neutral to falling interest rates.

In addition to adjusting the price and structure of assets and liabilities, the company also uses off-balance sheet derivative financial instruments to manage interest rate risks. The Company primarily uses interest rate swaps, interest rate cap and floor futures contracts and options as part of its overall risk management activities. Certain derivative financial instruments can artificially change the pricing or other characteristics of the underlying assets and liabilities that are insured. The company mainly uses interest rate swaps to hedge certain fixed-rate debt and certain deposit-type liabilities and convert these sources of funds into sources of floating-rate funds. Interest rate floor options, futures contracts and futures contract options are mainly used to hedge the company's mortgage loan servicing rights. Interest rate floor options can ensure that when interest rates are lower than a predetermined level, the company can receive repayment calculated based on the interest rate floor. Unrealized gains (losses) in interest rate floor options and futures contracts can approximately determine the fair value of mortgage servicing rights, so that banks lose a portion of future servicing revenue due to increased prepayment levels due to low interest rates, but this loss will offset by unrealized gains.

The Company's net cash flows from off-balance sheet derivative financial instruments used to manage interest rate risk increased net interest income by approximately $56.9 million in 1996, compared with an increase of $7.1 million in 1995. In 1994 there was an increase of $12.3 million. This resulted in an increase in the net interest margin of 9 bps in 1996, compared with an increase of only 1 bps in 1995 and an increase of only 2 bps in 1994. Based on interest rate levels as of December 31, 1996, the Company is expected to service mortgage loan entitlements Derivative financial instruments used to maintain capital value - including interest rate swaps and floor options. The related net cash flows generated in the future were approximately US$74 million in 1997, approximately US$55 million in 1998, and approximately US$52 million in 1999. US dollars, approximately US$32 million in 2000, approximately US$23 million in 2001, and a total of approximately US$59 million thereafter.

2. Questions for thought

1. Discuss the limitations of relying on the interest rate sensitivity gap to analyze interest rate risk. As this case suggests, the method of classifying assets and liabilities The approach is to classify based on certain repricing events (maturity, adjustment for changes in market interest rates, amortization of a portion of principal, anticipated prepayment of certain assets and redemption of liabilities prior to maturity). What factors would you cite to illustrate the limitations of the interest rate sensitivity gap report in terms of its accuracy in measuring interest rate risk and the limitations associated with the methodology used to create the gap report?

2. Assume that the overall level of interest rates immediately rises by 1% and can be maintained at this level. Based on the analysis of Figure 3, discuss how to use the information on the interest rate sensitivity gap to estimate the impact of rising interest rates on Norway. impact on company earnings.

3. In your own words, describe Norster's method of determining accounting risk and economic risk and the differences between them.

4. What do you think are the practical difficulties in revenue simulation models? Why is it the preferred method when measuring interest rate risk?

5. What difficulties do you think Norster will face in creating a reliable market value model?

6. Assume that Norwegian Sturt believes that interest rates will rise sharply in 1997 and estimates that earnings will decline. Discuss the actionable steps that Norwegian Ste can take to reduce the scale of its earnings decline. Describe on-balance sheet and off-balance sheet actions that the company could take.

Illustration 1 Consolidated balance sheet of Norway Sturt Company and branches

Except for the number of shares, all other data are in millions of US dollars

12 As of March 31, 1996, 1995

Assets

Cash and deposits with banks 4856.6 4320.3

Interest-bearing deposits with banks 1237.9 29.4

Total cash and cash equivalents 7,371.3 4,946.5

Securities in trading accounts 186.5 150. 6

Securities used for investment

(Fair price in 1996 was $745.2, fair price in 1995 was $795.8) 712.2 760.5

Investment and mortgage-backed securities for sale 16247.1 15243.0

Total securities investment 16959.3 16003.5

Loans for sale 2827.6 3343.9

Mortgage loans for sale 6339.0 6514.5

Loans and leases, Deducting the amount of unrealized discounts 39381.0 3 6153.1

Loan loss provision (1040.8) (917.2)

Net loans and leases 38340.2 35235.9

Business premises and Net value of equipment 1200.9 1034.1

Net value of mortgage loan servicing rights 2648.5 1226.7

Interest receivable and other assets 4302.1 3678.7

Total assets 80175.4 72134.4

Liabilities and shareholders' equity

Deposits

Non-interest deposits 14296.3 11623.9

Interest-bearing deposits 35833.

9 30404.9

Total deposits 50130.2 42028.8

Short-term borrowings 7572.6 8527.2

Accrued expenses and other liabilities 3326.2 2589.5

Long-term liabilities 13082.2 13676.8

Total liabilities 74111.2 66822.3

Preferred shares 249.8 341.2

Amount of unredeemed shares under the employee stock ownership system (61.0) (38.9)

The total number of preferred shares is 188.8 302.3

Ordinary shares, par value $1, the outstanding share capital in 1996 and 1995 were 3755333 625 and 358332153 625.9 597.2 respectively

Provide fund 948.6 734.2< /p>

Undistributed profits 4248.2 3496.3

Unrealized net gains on securities held for sale 303.5 327.1

Notes receivable from the employee stock ownership plan (11.1) ( 13.3)

Treasury stocks - 6,830,919 and 5,571,696 (233.3) (125.9) in 1996 and 1995 respectively

Foreign exchange translation difference (6.4) (5.8)

Total shareholders' equity 6064.2 5312.1

Total liabilities and owners' equity 80175.4 72134.4

Illustration 2 Norwegian Sturt Company and consolidated income statements of branches

Except for the number of shares, the units of all other data are in millions of U.S. dollars

December 31, 1996, 1995, 1994

Interest income

Loan and lease interest

4301.5 3955.8 3071.2

Interest on securities investments 36.2 83.8 71.5

Interest on investments held for sale and mortgage-backed securities 1170.1 1065.3 835.9

Interest on loans held for sale 254.3 195.7 111.4

Interest on mortgages for sale 468.5 366.2 257.2

Interest on money market investments 63.0 35.7 21.9

Interest on securities held in trading accounts 24.7 14.8 24.6< /p>

Total interest income 6318.3 5717.3 4393.7

Interest expenses

Deposit interest expenses 1324.9 1156.3 863.4

Interest expenses on short-term borrowings 454.1 515.8 290.3

Interest expense on long-term debt 838.0 775.9 436.4

Total interest expense 2617.0 2448.0 1590.1

Net interest income 3701.3 3269.3 2803.6

Currently accrued losses Reserves 394.7 312.4 164.9

Net interest income after deducting provisions 3306.6 2956.9 2638.7

Non-interest income

Trust income 296.3 240.7 210.3

Service fees charged to deposit accounts 329.5 268.8 234.4

Mortgage service business income 821.5 535.5 581.0

Data processing service income 72.5 72.4 61.6

Credit card income 122.2 132.8 116.5

Insurance income 279.6 224.7 207.4

Other fees and service fee income 294.4 230.3 182.3

Net profit (loss) from securities investment — 0.6

(0.2)

Net loss on held-for-sale investments and mortgage-backed securities (46.8) (45.1) (79.0)

Net income on venture capital investments 256.4 102.1 77.1

Trading income 35.3 39.9 (18.1)

Other income 103.7 45.5 65.0

Total non-interest income 2564.6 1848.2 1638.3

Non-interest expenses

Wages and benefits 2097.1 1745.1 1573.7

Site occupation fee 316.3 254.4 227.3

Equipment rental, depreciation and maintenance fees 327.7 272.7 235.4

Business development fee 227.9 172.7 190.5

Information fee 285.2 225.0 184.8

Data processing fee 163.0 136.2 113.4

Amortization of intangible assets 161.5 124.7 77.0

Other expenses 511.0 452.0 494.3

Total non-interest expenses 4089.7 3382.3 3096.4

Pre-tax income 1781.5 1422.8 1180.6

Income tax 627.6 466.8 380.2

Net profit 1153.9 956.0 800.4

Average balance of common shares and common share equivalents 369.7 331.7 315.1

Earnings per share

Net profit

Weighted profit per share Share income 3.07 2.76 2.45

Diluted income 3.07 2.73 2.41

Dividend 1.050 0.900 0.765

Illustration 3 Interest rate sensitivity analysis of Norwegian Sturt companies and branches

Except for ratios, the units for the rest of the data are

Amounts repriced or matured in millions of dollars

Balance sheet prepared at December 1996 average

Within 6 months 6 months to 1 year 1 year~3 Years 3 years ~ 5 years 5 years or more

Loans and leases 16813 3103 5966 2863 10437

Securities investment 2218 2088 2700 1935 8166

Price for sale 1659 — — — —

Mortgage loans for sale 5881 — — — —

Other profitable assets 4251 — — — —

Other assets — 650 — — 10102< /p>

Total assets 31822 5841 8666 4798 28705

Interest-free deposits 4134 63 268 178 8832

Interest-bearing deposits 16508 3733 4770 981 9633

Short-term borrowings 8230 — — — —

Long-term debt 3938 709 2266 2321 4154

Other liabilities and equity 1 — 188 — 8925

Total liabilities and equity 32811 4505 7492 3480 31544

Swaps and options (3860) 196 1153 866 1645

Sensitivity gapa (4849) 1532 2327 2184 (1194)

Cumulative Sensitive gap (4849) (3317) (990) 1194 —

The proportion of gap in total assets (6.1%) (4.2) (1.2) 1.5 —

a. Equal to [Assets - (Liabilities + Owners’ Equity) + Swaps and Options], the sensitivity gap should include the factors that affect the company’s interest rate sensitivity from off-balance sheet instruments. ]

Notes

[1] One might think that it should be the "effective duration structural theory of interest rates" and precisely define the duration of a security as the effective duration of the cash flow, or If the security only makes one payment, that is the only time the cash flow is paid.

But we are accustomed to calling it term structure because this description is more consistent with the terminology of financial markets.

[2] The U.S. Department of the Treasury refers to securities with an initial maturity of more than 10 years as Treasury bonds (bonds), and securities with an initial maturity of one to 10 years as Treasury bills (notes). Those that are one year or less are Treasury bills (bills). Treasury bonds and Treasury bills are coupon securities, and Treasury bills are sold at a discount below their face value.

[3] The U.S. Treasury Department has not issued repurchase securities since 1986.

[4] This result is not absolutely accurate because we did not discount future net interest income, but this present value analysis does not significantly change the conclusion of this case.

[5] Alvin Fisher: "Appreciation and Interest", published in "Publications of the American Economic Association", 1896 (8).

[6] Calculated forward rates certainly don’t tell us much about actual future spot rates. The actual interest rate on a future day is not necessarily the same as the current interest rate we expect to have on that same day in the future.

[7] Investors who also invest in one-year-at-a-time bonds will also compare this plan with buying 3-year bonds and selling them after 2 years This does not complicate the statement above. Investors will require (1+r1)(1+fn,t) ≧[(1+r3)2((1+R1,2-P3)/P3)]2/3, where R1,2 represents 3 years The expected price (such as the forward price) of the bond at the end of the second year (i.e., the one-year bond 2 years later), P3 represents the current price of the bond.

[8] Eugene. Fama: "Forward Interest Rate Indicators as Predictions of Future Spot Interest Rates", Journal of Financial Economics, pp. 361-377, General Issue No. 4 (1976), 1976 (3).

[9] Stanley. Diller: "Liquidity Premium on Treasury Securities", "Economic Research", Goldman Sachs (1976); Oden. Taufus and David. Mudd, "Liquidity Premiums and Term Strategies," Morgan Stanley (1987).

[10] Franco. Modigliani and Richard. Sage: "Changes in Interest Rate Policy", "American Economic Review", pp. 178-197, 1966 (56).

[11] More advanced models include J. McCulloch: "Measuring the Term Structure of Interest Rates", Journal of Business, pp. 19-31, 1971 (44), and John. C. Kukos, Jonarone E. Ingosolo and Stephen A. Ross: "Reexamination of the Traditional Term Structure Hypothesis of Interest Rates", "Journal of Finance"; pp. 769-799, 1981 ( 36).

[12] This example is based on Ira G. Kawaller and John F. Marshall: <>, Financial Analysts Journal (may\June 1996 ); pages 51-55.

[13] m can be calculated using a financial calculator or the formula m=(ln 100-ln P0)/ln(1+r1/2).

[14 ] On March 11, 1996, the FHLB bonds with an interest rate of 6.87% due on March 26, 2001 were bonds to be issued, and investors committed to purchase these bonds to be issued on the future issuance date (that is, the settlement date). Bonds, the issuance date in this case is March 26, 1996. However, the value of the bond was calculated based on the condition of the yield curve on March 11, 1996, the date the commitment was made. Commitments on bonds to be issued may be traded prior to issuance.

[15] This case quotes indicators from each page of the bank’s unified operating report (Figure 1). As an exercise to familiarize yourself with UBPR, the reader can try to find the stated data from the table.

[16] Employees in the investment department use the bank's computer simulation system to calculate the matrix in Figure 7 every month. The matrix gives data on interest rate risk for the current period and the following year.

In addition to providing the sensitivity data of the current period's net interest income, it also reveals the sensitivity of the bank's future net interest income from a static perspective. A static view can tell us about interest rate risk at future dates if the items on the balance sheet today are the same as at future dates.

To calculate the interest rate risk matrix, the bank estimates the net interest income in future dates assuming that interest rates do not change. Then, given the range of interest rate changes, calculates the risks brought by the stock of assets and liabilities. Amount of change in income. The bank assumes that changes in interest rates are instantaneous (such as changes in interest rates +1%, +2%, +3%, +4% and -1%, -2%). This is actually unrealistic, because changes in interest rates are a A gradual process. Banks prefer gradual changes in interest rates. In addition, banks also examine changes in basis, that is, the risk arising from different interest rates on various financial instruments with the same maturity.

[17] The source of the following narrative content is the 1996 annual report of Norskstar printed by Norskett.