Bank Management

Bank Management

Part A

1. Investment income= Interest income – Interest expense

= [(400 x 5%) + (450 x 7%)] – [(600 x 1%) + (200 x 2%)]

= (20 + 31.5) – (6 + 10)

= 51.5 – 16

= £35.5 mm

Net Interest Margin (NIM) = (Investment income – Interest expenses)

Average Earning Assets

= £35.5/ £850

= 4.2%

GAP = Rate sensitive assets – Rate sensitive liabilities

= £400 – £600

= – £200

1. Bank A will most likely experience a rise in interest income owing to an increase in interest rates. Based on the GAP model, -£200 more in assets compared to liabilities will reprice at escalated rates.

Change in net interest income owing to 2% upward change in yield curve

= change in rates x GAP = (200 x 0.02)

= +4

NIM would rise to 39.5/ 850 = 4.6%

• Change in net interest income owing to 2% upward change in yield curve

= change in rates x GAP = (200 x 0.01)

= +2

NIM would rise to 37.5/ 850 = 4.4%

Part B

1. Weighted average duration of assets= (750/ 1000) x 3years + (150/1000) x 6 years

= 2.25 + 0.9

= 3.15 years

Weighted average duration of liabilities= (500/ 1000) x 1 year + (400/1000) x 3 years

= 0.5 + 0.4

= 0.9 years

Net Interest Income = (750 x 10%) + (150 x 6%)

= 75 + 90

= 165

Investment income = Interest income – Interest expense

= [(750 x 10%) + (150 x 6%)] – [(500 x 4%) + (400 x 8%)]

= (75 + 90) – (20 + 32)

= 165 – 52

= £113 mm

Net Interest Margin (NIM) = (Investment income – Interest expenses)

Average Earning Assets

= £113/ £900

= 12.56%

DGAP

Duration of Assets = 2.83

Duration of Liabilities = 1.79

Liabilities/ Assets ratio= 1000 / 900 = 0.9

DGAP = (Duration of Assets – Duration of Liabilities) x Liabilities/ Assets ratio

= 2.83 – 1.79

0.9

= 1.22

DGAP* = Duration of Assets – DGAP

= 2.83 – 1.22

= 1.61

1. Bank B will most likely not experience any changes in interest income owing to an increase in interest rates. Based on the GAP model, £0 more in assets compared to liabilities will reprice at escalated rates.

• Change in net interest income owing to a 1% upward change in the yield curve

= change in rates x DGAP = (0 x 1.22)

= 0

NIM would remain constant at 113/ 900 = 12.56%

Part C

1. Immunization is critical in assisting large companies and institutions to safeguard their portfolios from interest rate exposure oscillations. Immunization is deemed to be a “quasi-active” risk mitigation method since it possesses the features of both passive and active approaches (Oberoi 2018, p.82). The immunization plan has an opportunity cost of relinquishing the upside potential of an action plan for the guarantee that the portfolio will attain the anticipated yield. The instruments best placed to attain the buy-and-hold strategy are high-rated bonds with limited likelihoods of default (Frame & White 2005, p.178). Actually, the best form of immunization is investing in a zero-coupon bond and ties the bond’s maturity to the anticipated maturity date of the cash flow. This action eradicates any positive or negative inconsistency of return related to the cash flow reinvestments. Immunization can either take the form of duration matching, convexity matching, cash flow matching, as well as trading futures, forwards and options on bonds. Investors and portfolio managers often employ hedging methods to decrease specific risks (Timothy, 2004, p.59). Despite hedging techniques being imperfect, it is technically an immunization plan if properly executed.

For immunization to occur, Bank B needs to maintain leverage adjusted duration gap (ADG) of 0 (Chaudron 2018, p.98). In this regard, the bank should diminish its assets’ duration to 1.611(1.79 x 900/1000) years through the increased adoption of treasury bills as well as floating-rate loans. Alternatively, Bank B could opt to raise the duration of its deposits, probably by employing fixed-rate CDs with a three-to-four years maturity period (Gerlach, Mora, & Uysal 2018, p.173). Eventually, Bank B could hire a blend of diminishing asset duration and raising liability length such that DGAP equals 0. The bank’s duration gap of 1.22 years is too huge, and it is highly unlikely that Bank B will manage to diminish it to zero by employing balance sheet adjustments alone. For instance, assuming that Bank B shifted all its loans into T-bills, the asset durations would still surpass the liabilities duration after modifying for leverage. The implication of this modification in the asset mix would be sacrificing a substantial income gain from the loan portfolio comparative to the T-bill revenues in most economical settings.

References

Chaudron, R., 2018. Bank’s interest rate risk and profitability in a prolonged environment of low-interest rates. Journal of Banking and Finance. 89, 94-104.

Frame, S. and White, L. 2005. Fussing and fuming over Fannie and Freddie; how much smoke, how much fire? Journal of Economic Perspective. 19, 159-184.

Gerlach, J., Mora, N., and Uysal, P. 2018. Bank funding costs in a rising interest rate environment. Journal of Banking and Finance. 87, 164-186.

Oberoi, J., 2018. Interest rate risk management and the mix of fixed and floating-rate debt. Journal of Banking and Finance. 86, 70-86.

Timothy, G., 2004. Managing interest rate risk in a rising rate environment. RMA Journal, Risk Management Association (RMA), November 2004.