Bank Spread Management

What is Bank Spread Management ?

Meaning of Spread

Spread is the difference between the interest rate charged to borrower & the interest rate paid to depositors. It reflects efficiency in financial inter-mediation. Clearly, a high positive spread is desirable, but policy should aim to maintain and stabilize the spread over time. Interest spread is an important indicator of efficiency of banking operations. The growth of spread in recent years clearly establishes that banks have not fully passed on the benefit of falling interest rates to their customers. Despite the initiatives taken by the RBI, lending rates of banks have exhibited considerable downward rigidity.
In particular, spread management must pay attention to interest rate cycles, to risk and return on the bank's portfolio of assets, and to the impact of assets and liabilities acquired on overhead costs.

Meaning of Spread Management

Spread management focuses on the spread between the average yield from assets and the average cost of funds. Before deregulation most bank liabilities consisted of non-interest-bearing demand deposits and fixed-rate time and savings deposits, consequently spread management responded mostly to rates that banks could charge for loan and security investments. As those rates in creased, banks were able improve their spreads between returns on assets and cost of funds. With the advent of deregulation, however, customers converted low rate savings and time-deposits to higher-rate CD liabilities. Also, banks began to bid aggressively for borrowed funds. These developments reduced the rate spread between the banks' assets. and liabilities, and encouraged banks to pursue flexible loan pricing and asset-funding policies consistent with cyclical trends in the economy. 
Figure shows a spread-management strategy that can be used over the course of a business cycle as short-term interest rates rise and fall.

For example, during the recovery phase of the business cycle, when short-term rates are increasing, banks should focus on-variable-rate assets while relying on fixed-rate sources of funds. During the prosperity phase, they should shift to fixed-rate loans and investments to lock in high returns and rely upon rate-sensitive sources of funds in anticipation of lower costs when interest rates decline.

An even simpler strategy of this type is called yield spread management, or simply spread management. Suppose commercial bank issued a 6-month CD or an insurance company wrote a 6-month Guaranteed Investment Contract (GIC). The profitability of these instruments (ignoring the optionality of the GIC) would depend on the difference between the yield on the asset invested against these products (such as 6-month commercial paper or 6-month fixed-rate notes) and the yield paid on the products by the institution. Spread management is managing the profitability of a book of such products based on the assets invested in to fund these products. In the short-term, profitability will be higher if low quality assets are used; but over the longer run, there may be defaults which reduce the profitability.

Classes of Products for Spread Management 

The characteristic of the main product classes that make up the portfolio to be managed by the asset liability manager. Retail transactions, such as deposits and mortgages, have many implicit or explicit options, such as the option for customers to prepay the principal before it is finally due or the option for deposit customers to withdraw their money at any time. This introduces customer behavior into the modeling of the risks. The behavior depends on the structure and purpose of the product. The main class of products for spread management is shown in below :

class of products for spread management

Assets Side of Commercial Bank

Assets of commercial bank are as follows:

1) Retail Personal Loans : 
Retail personal loans may be either fixed or floating rate. If they are floating, they are priced off the prime rate. Fixed-rate loans are generally paid-off in equal installments. The installments include both interest payments and a partial repayment of the outstanding principal.
For example, if the annual rate is 8%, a 2100, 6-year loan would have annual installments of Rs.21.63. Retail loan agreements generally allow the customer to pay the loan amount back to the bank earlier than originally required. Customers might do this if they had an unexpected windfall or if rates had fallen and they were able to get a replacement loan elsewhere at a lower rate. This prepayment risk is not significant for loans of one or two years, but is significant for mortgages.

2) Retail Mortgages : 
Most mortgages in the United States are fixed rate and have a maturity of many decades. In the emerging markets, mortgages tend to be for a shorter term and only fixed for the initial years. This reduces the interest-rate risk for the bank, but increases the probability of the customer being unable to pay if interest rates rise. From an ALM perspective, long-term, fixed-rate mortgages could be considered to be simple bonds if it was not for the prepayment option. 

To understand the importance of the prepayment option, consider Rs.100, 10-year bond paying 10% annually.If the current 10-year rate was 10%, the bond would be worth Rs.100. If the rates dropped to 5% the bond would be worth Rs.159 and the holder would have gained Rs.59.


Initial Value = ---------------------- = Rs.100

                                  (1+10 %)10


New Value = ---------------------- = Rs.159


3) Credit-Card Receivables : 
Many banks have a large portion of their assets in the form of credit card receivables, either from credit cards that they have originated or from Asset-Backed Securities (ABS) that are backed by credit-card receivables. Interest payments are usually a fixed percentage above the prime rate, often with caps on the maximum that can be charged.
The value of credit card receivables depends on two main factors, the default rate and the difference between market rates and the rate charged on the cards. The most important factor is the default rate, which can be on the order of 10% to 20%. The default rate is generally measured as a credit risk, but it is also possible to model it as an ALM risk in a similar way to the modeling of prepayments for mortgages. 

4) Commercial Loans : 
Large commercial loans are priced relative to the prevailing market rates and can therefore be considered to have the characteristics of bonds, possibly with prepayment options that will be exercised as efficiently as if they were traded instruments.

5) Long-Term Investments : 
The ALM book often also includes such balance-sheet items as "strategic investments", which were bought by the senior management as a way of investing the bank's excess funds. The ALM book may also included real estate that is used by the bank or owned by the bank as an investment. Long-term investments such as these have values that are sensitive to interest-rate movements and therefore should be included in the analysis of the bank's structural interest-rate position. It is difficult to model the interest-rate sensitivity of illiquid equities or real estate, but a reasonable proxy is to use the interest-rate sensitivity of market indices or to build cash-flow models for company income and real-estate rental rates. 

6) Traded Bonds and Derivatives : 
The ALM book can also include liquidly traded instruments, such as bonds, swaps and options. Identical instruments could also be held in the trading book, but the instruments in the ALM book are held either to modify the interest-rate position of the book or as temporary place to invest the bank's funds before they are used for customer transactions.

Liabilities Side of Commercial Bank

Liabilities of commercial bank are as follows :

1) Retail Checking and Savings Accounts : 
Checking and savings accounts are also known as Demand Deposit Accounts (DDA). Demand deposits such as checking and savings accounts have a contractual maturity of zero because they must be repaid to the customers as soon as they are demanded. Checking and savings accounts receive interest payments that are equal to or close to zero. Customers have DDAs for convenience and cash management. From a bank's point t of view; the profitability of a checking account is the income the bank can make from investing the funds, plus any fees charged to the customer, minus all the administrative costs. Although checking accounts are demand deposits and can be withdrawn at any time, in practice the total balance for the sum of all checking accounts in a bank is typically relatively stable. The net effect is that the banks can rely on having most of this money for many months or years. However, when interest rates rise, the total balance of checking accounts tends to fall as customers become more careful in sweeping their checking accounts into high-yielding savings accounts.
In general, the value of a liability is the NPV of the cash flow the liability. In the case of a non-interest bearing checking account, the cash flows arise from changes in the net balance.

2) Retail Fixed Deposits : 
Fixed Deposits (FDs) are offered in increments of months or years. Fixed deposits are also known as Certificates of Deposit (CDs). In FDs, customers guarantee not to withdraw the funds for a given period and they are rewarded by receiving a relatively high fixed-interest payment. If the customers withdraw their funds early, they forfeit the interest income. If at the end of the deposit period, customers choose to redeposit (or "roll over") the funds, the new rate is based on the prevailing market rates. Fixed deposits therefore have interest-rate characteristics that are similar to short-term bonds or floating-rate bonds. The main difference between f fixed deposits and bonds is that the interest rate is not tied directly to the market rate, but is more commonly tied to the prime rate minus a few per cent. The prime rate is the rate posted by the bank to its retail customers. It is only changed when there is a significant change in market rates and typically changes every one to six months. It is often modeled as a lagged response to changes in the three-month rate. The prime rate is changed by banks as a response to both the market rates and the competitive situation; the value of fixed deposits is therefore a complex function of the market behavior, customer behavior and bank behavior.

3) Deposits from Commercial Customers : 
Large deposits from commercial customers are generally priced very close to the prevailing inter-bank rate and are therefore well approximated as bonds.

4) Bonds Issued by the Bank : 
The ALM book also contains bonds issued by the bank. These bonds are occasionally issued by banks to adjust their interest-rate position, raise funds or modify the capital structure. They are a useful benchmark in determining the bank's true cost of debt.

Strategies of Spread Management

Successful bank management rests strongly on the management of the spread between assets and liabilities. Since, development banks have enjoyed a preferential treatment, the cost of funds has been low; thus allowing them to hold assets (loans) of relatively low profitability. Yet, as the cost of funds becomes increasingly high. there seems to be no other alternative, but to inject more professionalism in the management of bank funds This may allow the bank to continue providing development services at the lowest possible cost.
For simplification purposes the analysis in this section abstracts from the other two important aspects of bank management liquidity and risk, to concentrate on return, i.e. the spread between assets and liabilities. We analyze the cost and the revenue components of net earnings.

Management of Liabilities 

The strategies for management of liabilities are as follows :
  1. The share of current and savings deposit to the total deposits be improved in case the cost of deposits at the branch is rising. The average cost of raising total deposits be watched at periodic intervals and should not be allowed to go up abnormally. The average cost of raising deposit for the industry as a whole should be taken as a benchmark and it should be ensured that average cost of mobilizing deposits should not cross this benchmark. The share of high cost certificate of deposits in total deposits at the branch be kept at the lowest possible level.
  2. In respect of NRI deposits, thrust be placed on saving bank NRO and NRE accounts as these deposits cost the lowest. The scope for increasing NRI deposit is very vast and some of the banks have already opened fully computerized branches at important centers to cater to their needs.
  3. Similarly, customers in personal and corporate sector need special attention. It has dawned on most of the banks that retail banking can provide a good clientele base in personal segment. Some of the hanks are now moving from wholesale deposit which proves to be costlier than retail deposits. 
  4. Handling remittance and cash management on behalf of corporate is also developing into profitable business segment. Drafts, TTS, MTs and prompt movement of funds from one center to another not only provide access to float funds or transit funds, but also add to profitability by way of earning fees.
  5. As the major component under 'other liabilities' is inter-branch adjustment, branches may strive for early reconciliation of entries. This area has till now remained neglected, but with the decision of RBI to impose 100% provisioning requirements for debit entries which are more than 3 years old and are lying un-reconciled, there is now tremendous pressure to clean the back-log otherwise profitability will be affected.

Management of Assets 

The strategies for management of assets are as follows :
  1. The biggest task in the area of assets management is to save advances from becoming non-performing assets. A non-performing asset hits profitability hard in the sense that besides losing interest income bank is deprived of the use of capital as well. On top of this NPA needs provisioning to full extent which is a further drain on profitability. NPAs also affect liquidity situation they create maturity mismatches. Recovery of dues in respect of existing bad and doubtful advances and monitoring of performing assets to check erosion of their quality are of paramount importance in today's context.
  2. In building assets, it is important to develop asset mix so as to optimize return as also create assets with lowest possible risk weight-age. Advances carrying guarantee of Central and State Government carry lowest risk weight-age provided account is standard in nature. Similarly off-balance sheet items also carry varying degree of risk weight-age. As this risk weight-age of assets have a bearing on capital and w.e.f. 31" March 2000 onwards capital to be provided against these risk weighted assets will go up from 8 per cent to 9 per cent, there is now a need to watch the growth of risk weight-age as assets grow at the branch level.
  3. There are certain assets which have a refinance line available, e.g. export finance and bill finance Depending upon the policy decision of ALCO of the bank, it will be worthwhile to pursue creation of these assets in those banks where resources are coming in the way of growth of balance sheet. 
  4. Lending to the priority sectors, agriculture and weaker sections be maintained at around the stipulated levels with a view to utilizing the funds available with the bank to earn income in other areas more profitably.
  5. Computerized credit information system in some banks has brought about-marked improvement in the information system in regard to credit. Branches may fully utilize CIS of their bank as a credit management tool.
  6. Lending to industries be made based on their outlook, prospects, etc. Efforts be made to diversify risks by fixing exposure norms for various sectors and sub-sectors and staying away from those industries which are in the grip of recession. 
  7. Banks are moving to housing finance as it is perceived that chances of recovery in this sector are very high leading to low NPA. Others have switched over to consumer loans and auto-loans in a big way. Strategy is based on the premise that risk gets diversified in retail lending compared to wholesale lending.
  8. Recovery of existing NPAs should be taken-up on war footing. At centers where incidence of NPA is high, special recovery management branches be created. Other places may have recovery cells or officers exclusively attending to recovery of loans be posted. Recovery through compromises in respect of genuine cases through court or out of court settlements be effected. All cases where suits are yet to be filed may be immediately taken-up either through court or debt recovery tribunal depending upon the amount involved. Execution of decrees be expedited. DICGC claims be preferred.