one but four kinds of interest rate risks - core, yield curve twist, options, and basis. In order to develop a strategy for selective risk taking, bankers must, at least implicitly, develop a perspective on the productivity of each of these risks. That is, they should attempt to quantify the risk/return tradeoffs by determining the expected return on the risk capital that must be allocated to each risk category. We noted further that the typical bank's rate of return on the interest rate-risk business as a whole usually sums to a single-digit number. In large measure, this subnormal return reflects undue emphasis on forms of risk that are relatively unproductive - i.e., they consume outsize amounts of capital because of highly volatile earnings histories, or they provide low expected returns because they are based on using poor information to outguess the marketplace. What prescriptions are in order to improve interest rate-risk results? First, reduce day-to-day gap positioning. Success in assuming this core risk requires information on interest rates consistently better than that available to other market participants. (Our article last August detailed a more productive way to take core risk when information and/or skill limitations prescribe a more passive course of action.) Second, since so few banks have the superior information and skills needed to take core risk productively, consider committing more capital than the average of peer banks to secondary forms of interest rate risk that exhibit greater productivity. In this article, we discuss an approach to analyzing the productivity of one of these risk types - prime basis exposure. We single out this risk because most banks actually have much more basis than core risk; yet they have surprisingly little understanding of the level of this risk or its power to generate earnings. Basis risk arises from the possibility of differential responses of asset and liability prices (yields) to given movements in general rates. The major source of basis risk in banking is the spread between prime and short-term wholesale cost of funds. The latter, at least for large banks, is highly correlated with movements in the London interbank offered rate or rates that are closely linked to it. Many more bank assets than liabilities are indexed to prime, while many more liabilities than assets are indexed to Libor. As a result, if the prime-Libor spread narrows, net interest income decreases. If, for example, the prime-Libor spread drops 50 basis points from its current level, the after-tax net income of many banks we have studied would decline by 10% to 15%. Managements have a choice: Take this risk or hedge it by doing a basis swap - i.e., entering into a contract to pay prime less a contracted rate and receive Libor for a specific period of time. Whether to hedge or not, and in what amounts, can be quantitatively analyzed: measure the return on risks taken by dividing the extra income from not hedging by the risk capital assigned to cushion against an unfavorable change in the prime- Libor spread. For prime risk, the extra income equals the current prime-Libor spread minus hedging costs. The capital needed to protect against basis exposure should be an amount that covers a so-called worst-case mark-to-market loss - i.e., an amount sufficient to neutralize 99.5% of loss outcomes, based on historical analysis. Otherwise put, the chance that the chosen level of capital will not cover the dollar losses in the bank's prime-Libor position should come to less than one in 200. As a simplified example, consider the returns from prime basis risk taken this year. The prime-Libor spot spread has approximated 300 basis points. To hedge its position for two years, a period that corresponds to the average tenor of prime portfolios, a bank must pay about prime minus 270 basis points. Hence, extra income comes to 30 basis points, or about 18 basis points after tax. Based on the worst-case basis change that occurred between February 1986 and December 1993, the amount of capital needed to neutralize 99.5% of loss outcomes comes to about 60 basis points. This means that our 18 basis points of after-tax income yields a current return in the range of 30% to 35%. As this return is considerably higher than the returns garnered by the typical bank from its interest rate-risk position as a whole, it would appear that in 1995 prime-Libor basis exposure constituted an eminently productive use of bank capital. Interestingly, banks generally neither pursue nor minimize this form of risk. Most banks take the prime-Libor exposure that arises naturally from their book of business. Many of these banks do not actively track their exposure to this risk in either the aggregate or versus peers. They often argue in their defense that actively managing this risk is out of the question. The only way to do this, they say, is to use prime-Libor swaps. And the swaps tend to be priced in a one-sided manner, since most banks are naturally long prime. Although the prime-Libor swap market may be one sided - a circumstance reflected in an overgenerous bid-ask spread - this condition need not continue to hold true. For example, if bankers without enough natural exposure to prime to satisfy their risk appetites wanted to redress this circumstance, how better than to take the other side of a one-sided market - i.e., become willing swap counter parties to those anxious to hedge by paying Libor to receive prime? In addition, hedgers can consider reducing basis risk by using caps on Libor, floors on prime, and tying deposit rates for some accounts to prime. Whether or not prime basis risk will remain highly profitable in the future depends on the capacity of banks to continue exerting the kind of market power that has helped raise the prime-Libor spread from 145 basis points in the '80s to its current level of about 300 basis points. It should be noted, however, that the power of banks to improve spreads is by no means unfettered. In fact, the rise in the prime spread is somewhat deceptive. Although it has undoubtedly increased secularly, another spread - that of actual loan prices over the posted prime - has fallen. A loan that might have fetched 100 to 150 basis points over prime of few years ago now commands a premium of only about 25 to 30 basis points. . For its part, the general marketplace seems to feel that the prime-Libor spread will be eroding somewhat in the future. This is evidenced by the fact that the cost of hedging prime seven years out is about 20 basis points higher than the cost of a two-year hedge. The implication is that a prime-denominated yield will be lower relative to open-market rates than it is now. Bankers who feel the marketplace may in fact be underestimating the decline in the prime-Libor spread could profit by accelerating their swap program - i.e., taking bets against what they view as an incorrect implied forward estimate of the prime-Libor spread. Our point, however, is not to argue for increased or decreased basis risk exposure. Rather, our aim is merely to reemphasize that the various forms of rate risk have quite different and changing levels of productivity, and that banks must continually assess historical and prospective returns in order to optimize exposures. Subsequent columns will continue the analysis of the relative productivity of the four risk types.

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