Bank Analysis School - Case Study & Resources

APPENDIX D: Key considerations for evaluating the term structure of the balance sheet

Short-term assets are highly rate sensitive Short-term assets such as Federal Funds sold and interest-bearing bank balances allow banks to benefit quickly from rising interest rates. However, in a declining rate environment, yields on short-term assets drop rapidly, which can compress margins if liabilities reprice more slowly. Loans are typically shorter duration and reprice faster than securities Loan portfolios often consist of shorter-duration assets, such as lines of credit, variable-rate loans, or amortizing real estate loans. In contrast, securities — especially longer-term bullet maturity Municipal bonds and U.S. Treasury bonds which do not provide any cash flow until maturity — tend to have longer durations. As a result, banks with large investment portfolios generally have longer-term overall asset structures. Watch for optionality Some assets contain embedded options that can significantly affect their duration and interest rate risk profile. For example: • Residential mortgage loans include prepayment options, which borrowers may exercise when interest rates fall to refinance at lower rates. • Callable bonds give the issuer the right to redeem the bond early, which they are more likely to do when rates decline and refinancing becomes favorable. In both cases, the bank is forced to reinvest proceeds in a lower-rate environment. This reinvestment risk can reduce future asset yields and compress net interest margin. Core deposits strengthen liability stability A strong, stable base of core deposits (e.g., checking, savings, and no) provides lower-cost, sticky funding that typically reprice slowly. Wholesale funding offers precision, but less control over price While banks have less pricing power over wholesale funding sources—such as brokered CDs, listing service deposits, or FHLB advances—these sources offer flexibility in choosing specific maturities. For example, long term borrowings can be used to match the duration of long-term fixed-rate assets and help manage interest rate risk.