Bank Management.docx.docx

CHAPTER 3 1 What are the major categories of depository institution assets and their approximate percentage contribution to total resources? What are the major categories of depository institution lia[.]

CHAPTER 3

1 What are the major categories of depository institution assets and their approximate percentage contribution to total resources? What are the major categories of depository institution liabilities? What are the fundamental differences between them?

For a large bank, assets consist approximately of marketablesecurities (20%), loans (70%), and other assets (10%) Liabilitiesconsist of core deposits (40%-60%), noncore, purchased liabilities(20%-40%), and other liabilities (5 %-10%) as a fraction of assets.Small banks typically obtain more funds in the form of core depositsand less in the form of noncore, purchased liabilities Small banksoften invest more in securities as well Of course, the actualpercentages for any bank depend on that bank’s business strategy,market competition, and ownership

2 Depository institutions typically differentiate between interest and noninterest income and expense What are the primary components of each? Define net interest income (NIM) and burden What does a bank’s efficiency ratio measure?

A bank's interest income consists of interest earned on loans andsecurities while noninterest income includes revenues from depositservice charges, trust department fees, fees from nonbanksubsidiaries, etc

- Interest expense consists of interest paid on interest-bearing coredeposits and noncore liabilities while noninterest expense iscomprised of overhead costs, personnel costs, and other costs Abank’s net interest income equals its interest income minus interestexpense Note that interest income may be calculated on atax-equivalent basis in which tax-exempt interest is converted to itspre-tax equivalent

- A bank’s burden is defined as its noninterest expense minusnoninterest income This is often quoted as a fraction of total assets

- A bank’s efficiency ratio is calculated as noninterest expensedivided by the sum of net interest income and noninterest income.The denominator effectively measures net operating revenue aftersubtracting interest expense The efficiency ratio measure thenoninterest cost per $1of operating revenue generated Analysts

often interpret the efficiency ratio as a measure of a bank’s ability tocontrol overhead relative to its ability to generate noninterestincome (and overall revenue)

3 Using PNC (in Exhibit 3.2) as a typical large depository institution, which balance sheet accounts would be affected

by the following transactions? Indicate at least two accounts with each transaction

a Arturo Rojas opens a money market deposit account with

$5,000 The funds are lent in the overnight market for one week

b Just as a real estate developer pays off a strip shopping mall loan, a new resident optometrist takes out a mortgage

on a home

c The bank hires an investment banker to sell shares of stock to the public It plans to use the proceeds to finance additional commercial loans.

a) Aturo Rojas opens a money market deposit account with

$5000 The funds are lent in the overnight market for one week Liabilities: money market deposit accounts +5,000

Assets: LN & LS in domestic off +5,000

b) Just as a real estate developer pays off a strip shopping mallloan, a new resident optometrist takes out a mortgage on a home

No transaction because both of these are related to real estateloans

c) The bank hires an investment banker to sell shares of stock tothe public It plans to use the proceeds to finance additionalcommercial loans

No transaction is made

4 Arrange the following items into an income statement Label each item, place it in the appropriate category, and determine the bank’s bottom-line net income a Interest paid on time deposits under $100,000: $78,002

b Interest paid on jumbo CDs: $101,000

c Interest received on U.S Treasury and agency securities:

$44,500

d Fees received on mortgage originations: $23,000

e Dividends paid to stockholders of $0.50 per share for 5,000 shares

f Provisions for loan losses: $18,000 g Interest and fees on loans: $189,700

h Interest paid on interest checking accounts: $33,500

i Interest received on municipal bonds: $60,000

j Employee salaries and benefits: $145,000

k Purchase of a new computer system: $50,000

l Service charge receipts from customer accounts: $41,000

m Occupancy expense for bank building: $22,000

n Taxes of 34 percent of taxable income are paid

o Trust department income equals: $15,000

Income statement

Interest on U.S Treasury & agency securities

$44,500

Interest on municipal bonds 60,000

Interest paid on interest-checking accounts $33,500

Interest paid on time deposits 78,002

Provisions for loan losses = $ 18,000

Net interest income after provisions = $63,698

Fees received on mortgage originations $23,000

to measure each type of risk and explain how to interpret high versus low values.

The primary risks faced by banks are credit risk, liquidity risk,market risk (as interest rate risk and foreign exchange risk),operational risk, reputational risk, and legal risk In general,promised, or expected, returns should be higher for banks thatassume increased risk There should also be greater volatility inreturns over time

a Credit risk: Net loan charge-offs/Loans

High risk - high ratio; Low risk - low ratio

High risk manifests itself in occasional high charge-offs, whichrequires above average provisions for loan losses to replenish theloan loss reserve Thus, net income is volatile over time.

b Liquidity risk: Core deposits/Assets

High risk - low ratio; Low risk - high ratio

High risk manifests itself in less stable funding as a bank relies more

on noncore, purchased liabilities that fluctuate over time Thesenoncore liabilities are also higher cost, which raises interestexpense

c Market risk in the form of interest rate risk: (|Repriceableassets-repriceable liabilities|)/Assets

High risk - high ratio; Low risk - low ratio

High risk banks do not closely match the amount of repriceableassets and repriceable liabilities Large differences suggest that netinterest income may vary sharply over time as the level of interestrates changes

d Market risk in the form of foreign exchange risk: Assetsdenominated in a foreign currency minus liabilities denominated inthe same foreign currency

High risk – a large difference; Low risk – a small difference

High risk manifests itself when exchange rates change adverselyand the value of the bank’s net position of assets versus liabilitiesdenominated in a currency changes sharply

6 Bank L operates with an equity-to-asset ratio of 6 percent, while Bank S operates with a similar ratio of 10 percent Calculate the equity multiplier for each bank and the corresponding return on equity if each bank earns 1.5 percent on assets Suppose, instead, that both banks report

an ROA of 1.2 percent What does this suggest about financial leverage?

a) EM of Bank L = Assets/Equity = 1/6% = 16,67 EM of Bank S =1/10% = 10

b) ROE Bank L = ROA*EM = 1,5% * 16,67= 25% ROE Bank S =ROA*EM = 1,5%*10 = 15%

c) ROE Bank L = 1,2%*16,67 = 20% ROE Bank S = 1,2%*10 = 12%JUNIOR FINANCE TBS 2013-2014

d) We notice that the EM of Bank L > EM of Bank S, Bank L has alower capital to assets as cushion for any loss risk, hence itrepresents a higher risk of insolvency than Bank S

Bank L offers a better a return on investment to its stockholders25% than Bank S does (15%) Although the same return on assets,the 2 banks offer different ROE because of EM The bank with higher

EM so with higher financial leverage offers a better ROE but presents

a higher risk of insolvency

We notice that the decline of ROA of 0,3% had a larger impact onthe difference between the 2 banks ROE about 8% (20%-12%)because of the EM magnified this ROA decline

In sum, with high financial leverage, a bank offers a better return oninvestment for its stockholders but do not preserve them frominsolvency risk Moreover, with a high financial leverage, any change

in ROA will be amplified in the ROE

7 Define each of the following components of the return on equity model and discuss their interrelationships:

a) ROE – return on any dollar invested in the company

b) ROA – return on any dollar of assets

c) EM – the assets financed by one dollar of equity

d) ER – the expenses generated per one dollar of assets

e) AU – income revenue generated per one dollar of total assets

8 Explain how and why profitability ratios at small banks typically differ from those at the largest money center banks.

Profitability ratios differ across banks of different size as measured

by assets The primary reasons are that different size banks have

different asset and liability compositions and engage in differentamounts of off-balance sheet activities Typically, small banks reporthigher net interest margins because their average asset yields arerelatively high while their average cost of funds is relatively low.This reflects loans to higher risk borrowers, on average, andproportionately more funding from lower cost core deposits ROEs,

in turn, are often lower because small banks operate with morecapital relative to assets, that is with lower equity multipliers, sothat even with comparable ROAs the ROEs are lower Large banksROAs are increasing faster over time because large banks operatewith lower efficiency ratios as they have been more successful ingenerating fee income

9 Regulators use the CAMELS system to analyze bank risk What does CAMELS stand for and what financial ratios might best capture each factor?

CAMELS

C = Capital adequacy: equity/assets

A = Asset quality: nonperforming loans/loans; loan charge-offs/loans

M = Management: no single ratio is good, although all ratios indicateoverall strategy

E = Earnings: aggregate profit ratios; ROE, ROA, net interest

margin, burden, efficiency

L = Liquidity: core deposits/assets; noncore, purchasedliabilities/assets; marketable securities/assets

S = Sensitivity to market risk; |repriceable assets-repriceableliabilities|/assets; difference in assets and liabilities denominated inthe same currency; size of trading positions in commodities, equitiesand other tradeable assets

10 Rank the following assets from lowest to highest liquidity risk:

a Three-month Treasury bills with one-year construction loan

b Four-year car loan with monthly payments

c Five-year Treasury bond with five-year municipal bond

d One-year individual loan to speculate in stocks

e Three-month Treasury bill pledged as collateral

a Three-month Treasury bills

e Three-month Treasury bill pledged as collateral

b Four-year car loan with monthly payments

d One-year individual loan to speculate in stocks

f one-year construction loan

g five-year municipal bond

c Five-year Treasury bond

11 In each pair below, indicate which asset exhibits the greatest credit risk Describe why

a Commercial loan to a Fortune 500 company or a loan to a corner grocery store

b Commercial loans to two businesses in the same industry; one is collateralized by accounts receivable from sales, while the other is collateralized by inventory as work-in-process

c Five-year Baa-rated municipal bond or a five-year agency bond from the Federal Home Loan Bank system

d One-year student loan (college) or a one-year car loan

a) Commercial loans to a Fortune 500 company or a loan to acorner grocery store

The grocery store poses a greater credit risk because the Fortune

500 company has proved its ability to make capital while thegrocery store may have a harder time due to big name retailers.b) Commercial loans to two businesses in the same industry; one

is collateralized by accounts receivable from sales, while the other iscollateralized by inventory as work-in-process

The business collateralized by inventory poses a higher risk becausethere is the chance that the inventory it possesses won’t be turnedinto capital

c) Five-year Ba-rated municipal bond or a five-year agency bondfrom the Federal Home Loan Mortgage Corporation

The five-year agency bond poses a greater credit risk becauseanything relating to a home loan mortgage corporation can be riskyd) One-year student loan or a one-year car loan

The student loan is riskier because the loan can be given to anindividual with no previous credit while a car loan is generally givenprior to a credit check to ensure repayment

12 What ratios on common-sized financial statements would indicate a small bank versus a large, multibank holding company? Cite at least five.

The largest banks generally employ fewer people per dollar of assetsthan smaller banks

The largest banks are generally offering very standardized loans anddeposit products, hence competition is steep and margins smallSmaller banks generally operate with proportionately more coredeposits and fewer volatile liabilities as compared with the largestbanks

Largest banks report much higher net charge-offs than smallerbanks

Larger banks operate with less equity and more debt

13 In some instances, when a depository institution borrower cannot make the promised principal and interest payment on loan, the bank will extend another loan for the customer to make the payment.

a Is the first loan classified as a nonperforming loan?

b What is the rationale for this type of lending?

c What are the risks on this type of lending?

a The new loan is typically not classified as nonperforming because

no payments are past due

b Often a bank recognizes that the loan is in the problem stage andthe borrower renegotiates the terms in its favor; rationale is that theborrower may default if the loan is not restructured Note that thisrestructuring gives the appearance that asset quality is higher

c The primary risk is that the bank is throwing more money down asink hole and will never recover any of its loan

14 Suppose that your bank had reported a substantial loss during the past year You are meeting with the bank’s board

of directors to discuss whether the bank should make its traditional (25 years straight) dividend payment to common stockholders Provide several arguments for why the bank should authorize and make the dividend payment The, provide several arguments for why it should not make the payment What should decide the issue?

Dividend payment: For: the loss is temporary and stockholdersexpect the dividend payment Failure to make the payment willsharply lower the stock price because stockholders will be alienated.Against: the bank has not generated sufficient cash to make thepayment from normal operations By paying the cash dividend, thebank is self-liquidating The cash dividend will lower the bank’scapital What normally decides the issue is whether the loss is trulytemporary or more permanent Management typically errs byassuming that losses are temporary, and thus continues to makedividend payments when it should be reducing or eliminating them

15 Explain how each of the following potentially affects a bank’s liquidity risk: a Most (95 percent) of the bank’s securities holdings are classified as held-tomaturity

b The bank’s core deposit base is a low (35 percent) fraction

of total assets

c The bank’s securities all mature after eight years

d The bank has no pledged securities out of the $10 million

in securities it owns.

a Securities that are classified as held-to-maturity typically cannot

be sold for liquidity purposes unless a release is issued Therefore it

is more difficult for this bank to meet financing needs should aliquidity crunch occur, and liquidity risk is higher

b A low core deposit base means that the bank is relying more onnoncore, volatile liabilities that are more likely to leave the bank ifrates change The bank’s funding resources are then less reliable,subjecting the bank to higher liquidity risk

c Even if the securities are capable of being sold quickly (as theyare classified as available-for-sale), these securities are subject to

more interest rate risk and may decrease in value should interestrates increase This means that the bank is subject to higherliquidity risk.

d No pledged securities means that the bank has more securitiesthat it can sell should a liquidity crisis occur, indicating that thisbank has lower liquidity risk

CHAPTER 4

1 When confronted with runaway noninterest expense, management’s first impulse is to cut costs What are the advantages and disadvantages of this approach? What other approaches are possible?

If a bank doesn’t have a set up plan to control expenses, thencutting costs is the correct approach However, cutting costs oftenmeans releasing employees which can have a negative impact onservice Improving technology around the firm is one good way ofimproving efficiency while cutting costs

2 What are the primary sources of noninterest income for both a small community bank and a large bank with many subsidiaries and global operations?

The primary sources of noninterest income for a community bankare generally deposit fees, trust fees, mortgage fees, fees andcommissions and fees from insurance produces, credit card fees andinvestment product fees The primary sources of noninterest incomefor large Global, Nationwide, and Super Regional Banks are depositfees, investment banking fees, asset management fees, mortgageservicing fees, and trading profits

3 What are the components of noninterest expense?

Personnel expenses, occupancy expenses, goodwill, intangibleamortization, and other operating expenses

4 Describe why the efficiency ratio is a meaningful measure

of cost control Describe why it may not accurately measure cost control What are the three primary parts of the efficiency ratio? Are there any trade-offs among these three components? Explain.

The efficiency ratio is stated as non interest expenditure divided bythe total sum non-interest income and net interest income

The costs in overhead are measured for generating $1 of revenue

A figure that is less shows that a bank is more proficient as it takesless overhead for producing $1 revenue

The efficiency ratio of a bank is a quick and easy way to measurethe ability of bank to turn resources into revenue

Actually the lower the lower the better

When the efficiency ratio increases, is an indication that the costsare increasing or the revenues are decreasing.

Efficiency ratio may not accurately measure cost control

This is because cost control is the practice of identifying andreducing expenses of the business so as to increase profit

This starts in the budgeting process

Efficiency ratio only measure accurately the costs incurred as thebank turns resources into revenue

Efficiency ratios have proven inaccurate in measuring cost controls.The three parts of the efficiency ratio

Calculation of turn over of receivables

Repayment of liabilities the quantity and usage of equity

The general use of inventory and machinery

A trade off is expressed as an opportunity cost

It involves the sacrifice that must be made to gain a certain product

or experience

Among the three components there are trade offs

For instance in the general use of inventory, sacrifice must be made

so as to gain fully from the product in terms of generating revenue

5 Which of the following banks evidences better productivity? Both banks have $700 million in assets and conduct the same volume and type of business offbalance sheet

Tri-Cities Bank Pacific Rail Bank

The assets per employee ratio suggests that Pacific Rail Bank (PRB)

is more productive because it can manage more assets peremployee Of course, this ratio ignores the volume of a bank’s off-balance sheet activity The average personnel expense ratioindicates that Pacific Rail Bank pays its employees more, onaverage, that Tri-Cities Bank This may indicate high cost – andhence lower productivity – but it may also reflect the fact that PRBsimply pays its people more because they are more productive

Many high performance banks have the profile that PRB has withthese ratios.

6 Southwestern Bank reports that just 20 percent of its customers were profitable Assuming that this applies to individuals’ account relationships, make three recommendations to increase the profitability of these accounts.

Recommendations:

1) identify which accounts are unprofitable and which products orservices are most commonly used by these individuals; repricethese accounts to encourage individuals to bundle their productsand services to avoid charges;

2) increase minimum deposit balances for customers to avoidservice charges, while maintaining access to the most basic bankingservices at reasonably low cost;

3) offer accounts with minimum fees and balances as long as thecustomer agrees not to enter the bank or branch and thus conductsall business electronically

7 Suppose that your bank imposes the following fees and/or service charges Explain the bank’s rationale and describe how you would respond as a customer

a $1.50 per item for use of an ATM run by an entity other than your own bank

b $4 per transaction for using a live teller rather than making an ATM or telephone transaction

c Increase in the charge for insufficient funds (where a customer writes a check for an amount greater than the balance available in the account) from $25 per item to $30 per item

d A 1 percent origination fee for refinancing a mortgage

a) $1.50 per item for use of an ATM run by an entity other thanyour own bank

This is the equivalent of the bank paying a teller to process yourwithdrawal, although this is much cheaper It is merely aconvenience fee, which is understandable

b) $4 per transaction for using a live teller rather than making anATM or telephone transaction.

It is costlier for the bank to provide a teller rather than an ATM, andalthough this fee is poor practice, it may be an incentive to use theless costly ATM they provide

c) Increase in the charge for insufficient funds from $25 per item

to $30 per item

The bank is simply trying to reduce the chance of a customer writing

a false check and reducing their credit As a customer it would beunderstood as a rational decision by the bank

d) A 1% origination fee for refinancing a mortgage

This is a way for the bank to increase their noninterest income in aslight way Although it’s only 1% it adds up As a customer thisshouldn’t pose an issue unless it is a repeated occasion

8 List the three primary sources of revenue from a commercial customer’s account In today’s economic environment, indicate whether each is growing or declining

in use and explain why.

Expense reduction: strength is the immediate impact as costsdecline; weaknesses include the loss of employee and customermorale and making cuts that lower service quality

Revenue enhancement: strength is that revenues grow withoutcutting the range of products and services offered; weakness is that

it is difficult to implement in the near term and their may not be animmediate improvement in burden or the efficiency ratio

Contribution growth: strength is that this is the best long-termstrategy as service quality improves and employee/customer morale

is unchanged; weakness is that it is a long-term strategy with noimmediate payoff

9 For each of the following accounts, evaluate the profitability of the customer’s account relationship with the bank Did profits meet expectations? The expense figure includes the cost of debt but not the cost of equity Figures are in millions of dollars.

Expenses Revenue Target Profit Class Action

Corp

11 Describe the strengths and weaknesses of expense reduction, revenue enhancement, and contribution growth strategies.

Expense reduction can have a tremendous impact on a business As

a positive, it can emphasize the profit margin due the expensereduction, but it can also harm a business by the possibility of thosereductions coming from the release of employees, thus reducingefficiency and profit Revenue enhancement can provide an easystream of income for a business by adding subtle fees to commontransactions or services, but it may come at the cost of reducedcustomer satisfaction Contribution growth strategies are anexcellent way for a business to set a planned path for success andgrowth; however, if the strategy planned is determined to beunsuccessful a new one must be formulated quickly

12 Your bank has just calculated the profitability of two small business customers In both instances, the bank earned a monthly profit of $375 from both Detail Labs and The Right Stuff Detail Labs had a large loan with the bank

and small account balances Its principals bought no other services from the bank The Right Stuff had only a small loan, but used the bank for payroll processing and the firm’s checking account transactions The principals also had checking and CD accounts with the bank

a What additional services or products would you suggest that the bank market to each of these customers?

b Discuss how the source of profitability will influence the choice of services and products that you recommend.

a The bank should sell credit-related services to Detail Labs and itsprincipals Perhaps credit and debit cards might serve as therelationship medium The principals might also want cashmanagement services for the business to help the firm best use itscash The bank should sell noncredit services to The Right Stuff,including cash management services, trust services, etc becausethe principals are likely not in the borrowing stage of their business

or personal lives

b If profits come from loans, the bank must ensure that the loansare priced at a reasonable spread over the matched maturity(duration) cost of funds Additional products and services might betied to those required by borrowers If profits come from the depositprocessing side or investment services side, loans might be used as

a way to maintain the account relationship with profits coming fromfees

b Select a series of sequential time intervals for determining howmany assets and liabilities are rate sensitive within each interval;the objective is to identify the timing of expected repricings.

c Classify assets and liabilities as either rate sensitive orfixed-rate within each time interval; from this information, calculatestatic GAP by comparing RSAs with RSLs If a bank has off-balancesheet commitments, impute the balance sheet impact on cash flowrate sensitivities

d Forecast net interest income and net income given theassumed repricing characteristics of the underlying assets andliabilities; the objective is to assess the amount and variation inearnings

2 Are the following assets rate sensitive within a six-month time frame? Explain

a Three-month T-bill

b Federal funds sold (daily repricing)

c Two-year Treasury bond with semiannual coupon payments

d Four-year fully amortized car loan with $350 monthly payments including both principal and interest (for the first six months, principal payments total $448)

e Commercial loan priced at the bank’s prime rate plus 2 percent

a) Three-month T-bill

yes – matures

b) Federal funds sold (daily repricing)

yes - matures daily

c) Two-year Treasury bond with semiannual coupon payments

no - principal is received in 2 years.

d) Four-year fully amortized car loan with $350 monthlypayments including both principal and interest (for the first sixmonths, principal payments total $448)

yes, a portion is rate sensitive each month - the partial principalpayments during the first

6 months are rate sensitive

e) Commercial loan priced at the bank’s prime rate plus 2 percentyes/no – depending on whether the prime rate changes within 6months If the prime rate

changes within 6 months, the full amount of loan principal is ratesensitive If the prime

rate does not change, nothing is rate sensitive Looking forward, theanalyst must

forecast whether prime will change to assign the principal amount to

a specific time

interval

3 Consider the following bank balance sheet and associated average interest rates The time frame for rate sensitivity is one year Figures are in thousands.

sensitiv e

a Calculate the bank’s GAP, expected NII, and NIM if interest rates and portfolio composition remain constant during the year This bank is positioned to profit if interest rates move in which direction?

b Calculate the change in expected NII and NIM if the entire yield curve shifts 2 percent higher during the year Is this outcome consistent with the bank’s static GAP?

c Suppose that, instead of the parallel shift in the yield curve in Part b, interest rates increase unevenly Specifically, suppose that asset yields rise by 0.50 percent while liability rates rise by 0.75 percent Calculate the change in NII and NIM Is this uneven shift in rates more or less likely than a parallel shift?

d Suppose the bank converts $20,000 of RSLs to fixed-rate liabilities during the year and interest rates remain constant What would the bank’s NII equal compared with the amount initially expected? Explain why there is a difference.

a Calculate the bank’s GAP, expected NII, and NIM if interestrates and portfolio composition remain constant during the year.This bank is positioned to profit if interest rates move in whichdirection?

GAP= $400

Expected net interest income = [3,300(.073) + 1,400(.087)] 2,900(.038)+1,650(.061)]

-=362.70 - 210.85 =151.85Expected NIM = 151.85/4,700 = 0323

 This bank will likely see its net interest income increase ifinterest rates increase

 According the GAP model, $400 more in assets than liabilitieswill reprice at higher rates

b Calculate the change in expected NII and NIM if the entire yieldcurve shifts 2 percent higher during the year Is this outcomeconsistent with the bank’s static GAP?

 Change in net interest income = change in rates x GAP = 02(400) = 8

 NIM would increase to 159.85/4,700 = 0340

c Suppose that, instead of the parallel shift in the yield curve inPart b, interest rates increase unevenly Specifically, suppose thatasset yields rise by 0.50 percent while liability rates rise by 0.75percent Calculate the change in NII and NIM Is this uneven shift inrates more or less likely than a parallel shift?

 Change in interest income = 01 (3,300) = 33

 Change in interest expense = 0175 (2,900) = 50.75

 Change in net interest income = -17.75

 New NIM = 134.10/4,700 = 0285

d Suppose the bank converts $20,000 of RSLs to fixed-rateliabilities during the year and interest rates remain constant Whatwould the bank’s NII equal compared with the amount initiallyexpected? Explain why there is a difference

Change in interest expense = 300 x 023 = 6.90

Net interest income would fall to 144.95; the decrease reflectsgreater borrowing at higher current interest rates (6.1 % versus3.8%)

4 Suppose that your bank buys a T-bill yielding 4 percent that matures in six months and finances the purchase with a three-month time deposit paying 3 percent The purchase price of the T-bill is $3 million financed with a $3 million deposit

a Calculate the six-month GAP associated with this transaction What does this GAP measure indicate about interest rate risk in this transaction?

b Calculate the three-month GAP associated with this transaction Is this a better GAP measure of the bank’s risk? Why or why not?

a 6-month GAP = $3 - $3 = 0; this seems to indicate no risk

b 3-month GAP = 0 - $3 = -$1 million; this indicates a negative GAP,which is consistent with the bank's actual mismatch of rate sensitiveassets and liabilities The issue is to select a time interval that isshort enough to capture a difference in the repricing frequency ofassets versus liabilities

5 What is the fundamental weakness of the GAP ratio as compared with GAP as a measure of interest rate risk?

 The GAP ratio = RSAs/RSLs ignores the size of a bank's GAPrelative to the size of the bank, and thus provides no informationregarding the potential magnitude of a change in net interestincome when interest rates change Also, which bank is riskier?

 Consider a 1-year time frame where Bank A has RSAs of $5and RSLs of $4 for a GAP ratio of 1.25 Bank B has RSAs of $500 andRSLs of $400 for a GAP ratio of 1.25

 Both banks are the same size Bank A has a small GAP andvirtually no risk according to this measure Bank B has a GAP that ismuch farther from zero and is thus riskier

6 Discuss the problems that loans tied to a bank’s base rate present in measuring interest rate risk where the base rate

is not tied directly to a specific market interest rate that changes on a systematic basis.

When the base rate used to price loans is not tied to a specificindex, there is no certainty as to when or how much the base ratewill change over time Changes are at the discretion of anotherinstitution In GAP analysis, this makes it difficult to determine orestimate how rate sensitive the loan really is It cannot beaccurately classified within the rate sensitivity report

7 Consider the following asset and liability structures:

County Bank Asset: $10 million in a one-year, fixed-rate commercial loan

Liability: $10 million in a three-month CD

City Bank Asset: $10 million in a three-year, fixed-rate commercial loan

Liability: $10 million in a six-month CD

a Calculate each bank’s three-month, six-month, and year cumulative GAP

one-b Which bank has the greatest interest rate risk exposure

as suggested by each GAP measure? Consider the risk position over the different intervals.

a Calculate each bank’s three-month, six-month, and one-yearcumulative GAP

County Bank City Bank

3-month: County Bank;

6-month: same;

1-year: City Bank

To best assess risk, one must select time intervals that differentiatethe true effective repricing frequency of assets versus liabilities

8 Consider the rate sensitivity report shown in Exhibit 7.7

a Is FSB positioned to profit or lose if interest rates rise over the next 90 days? Include in your discussion an analysis

of the most likely rate environment

b Suppose that management has misstated the rate sensitivity of the bank’s money market deposit accounts because the bank has not changed the rate it pays on these liabilities for six months and doesn’t plan to change them in the near future Will the bank profit if rates rise over the next 90 days?

a If the data accurately reflect sensitivity, that is if base rateschange as assumed, MMDAs reprice as assumed, and the datacorrectly capture when cash flows will actually reprice, then FirstSavings Bank will lose if rates increase because the cumulative GAP

is -$15.448 million As such, more liabilities will reprice than assetswhen rates rise

b If MMDAs are not repriced within 30 and 90 days while the bank'sbase rate does increase, then the $17.3 million in MMDAs is not

expected to reprice and First Savings Bank’s effective cumulativeGAP is +$2.3 million through 90 days Thus, net interest income willtypically rise when rates rise.

9 Assume that you manage the interest rate risk position for your bank Your bank currently has a positive cumulative GAP for all time intervals through one year You expect that interest rates will fall sharply during the year and want to reduce your bank’s risk position The current yield curve is inverted with long-term rates below short-term rates

a To reduce risk, would you recommend issuing a month time deposit and investing the proceeds in one-year T-bills? Will you profit if rates fall during the year?

b To reduce risk, would you recommend issuing a month time deposit and making a two-year commercial loan priced at prime plus 1 percent? Why?

three-a To reduce risk, would you recommend issuing a three-monthtime deposit and investing the proceeds in one-year T-bills? Will youprofit if rates fall during the year?

Financing a 1-year T-bill with a 3-month will not reduce the positivegap as both instruments are rate-sensitive for the one-year interval

b To reduce risk, would you recommend issuing a three-monthtime deposit and making a two-year commercial loan priced atprime plus 1 percent? Why?

According to GAP, both the deposit and loan are rate sensitive within

3 months assuming the prime rate changes Whether thistransaction reduces risk depends on the effective rate sensitivity of

a prime-based commercial loan, and whether the bank will continue

to fund the loan with short-term deposits If the base rate does notchange during the first year, the bank has reduced its positive GAPwith this transaction If the prime rate changes more frequently, theGAP may not be reduced

10 Your bank has 50 percent of its loans priced off the current prime rate at prime plus 1 percent, on average The majority of the bank’s liabilities are interest-bearing core deposits (NOWs, MMDAs, and small time deposits)

a Assume that the prime rate immediately rises from 6 percent to 6.5 percent Will management likely increase

deposit rates by 0.50 percent immediately? Explain why or why not What will be the impact on the bank’s spread?

b Assume that the prime rate immediately falls from 6 percent to 5.5 percent Will management likely decrease deposit rates by 0.50 percent immediately? Explain why or why not What will be the impact on the bank’s spread?

a) Bank would not immediately raise deposits rates in thisscenario because majority of bank’sliabilities have short termmaturity Short- term deposits holders are not very pricesensitivebecause they are more interested in quick liquidity.Short term deposits convey that the bank isliability sensitive inshort term and therefore any increase in interest rate wouldreduce the netinterest income from the bank.On the other handbank would immediately raise the interest rates on its loans asthey are pricedat prime plus one percent This will help bank inwidening its interest rates spread

b) If the prime rate immediately falls from 6% to 5.5%, bankwould immediately raise depositsrates because more liabilitiesthan assets are repriced at the lower rate such that interestrateexpenses falls more than interest income falls.On other handbank would not raise the interest rates on its loan as they arepriced at prime plusone percent This will help bank in decreasingthe impact of spread

11 An embedded option associated with each of the following instruments potentially alters the rate sensitivity

of the underlying instrument Indicate when the option is typically exercised and how it affects rate sensitivity The current prime rate is 3.25 percent

a Fixed-rate mortgage loan with a yield of 5.5 percent and 30-year final maturity

b Time deposit with five years remaining to maturity; carries a fixed rate of 4 percent

c Commercial loan with a two-year maturity and a floating rate set at prime plus 2.5 percent There is a cap of 6 percent representing the maximum rate that the bank can charge on the loan