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Changes in the level of interest rate. A negative GAP indicate that the bank have more
RSL than RSA. When interest rate rise during the time interval, the bank pays higher rates on
all repriceable liabilities and earns higher yields on all repriceable asset.
Changes in the relationship between the yields on earning assets and rates paid on interest
bearing liabilities.
A derivative is any instrument or contract that derives its value from another underlying
asset, instrument, or contract. Derivative instruments are future, forwards, option and swaps.
7. Explain macrohedge
If GAP is positive, the bank is asset sensitive and its net interest income rises when
interest rate fall. If the GAP is positive, bank should use a long hedge. If rates rises, bank’s
higher net interest income will be offset by losses.
Interest Rate Cap is an agreement between two counterparties that limits the buyer’s
interest rate exposure to a maximum limit. Buying an interest rate cap is the same as purchase
a call (put) option.
9. What are the objectives for which banks hold cash for?
To meet customers regular transaction needs
To meet legal reserve requirements
To assist in the check payment system
To purchase correspondent banking services
10.Why do banks prefer to hold more liquid assets as compared to
holding more cash?
Bank must have sufficient cash assets on hand to meet clearing needs. Liquidity
requirements arise because of a mismatch in cash inflows and outflows. Thus, cash holdings
are determined by anticipated and unanticipated cash outflows versus cash inflows.
11.Explain how a bank’s credit risk and interest risk can affect its
liquidity risk?
Banks that assume large amounts of credit or interest rate risk accept greater volatility in
profits. If losses arise, depositors may move their funds creating a liquidity crisis, especially
when there is a chance of bank failure.
The purpose of required reserve is to enable the Federal Reserve to control the nation’s
money supply. The Fed have three monetary policy tools which are open market operation,
discount rate and required reserve ratio.
High financial leverage magnifies the profitability or loss of a bank. The owner’s portion
of financing is relatively small, yet the owner reaps the profits. Although debt is a cheaper
source of funds than equity, it carries high fixed costs that must be paid to remain solvent.
Bankers that focus on profits often prefer low equity than regulators want. Regulators
generally focus on bank risk and safety, so they prefer greater equity.
Bank capital reduced risk by providing a cushion for firms to absorb losses and remain
solvent. Next, provide ready access to financial markets, which provides the bank with
liquidity. Lastly, constraining growth and limits risk taking.
Banks are operationally solvent as long as cash inflows exceed mandatory cash outflows.
The existence of common equity capital reduces mandatory cash outflows because
management can defer dividend payments. Losses on assets can be charged against capital so
that the market value of assets still exceeds the market value of liabilities.
Existing risk based capital requirements focus on credit risk. The risk classes used, for
example, are determined by a relative ranking of default risk on the underlying assets. The
percentage requirements, which indicate how much capital a bank must hold in support of
risk assets, increase as default risk increase.
Regulators can impose higher capital requirements when they determine that banks
have assumed excessive liquidity or interest rate risk, but there is no formal procedure for
such assessments at most banks. Large banks that are subject to substantive market risk, do
have formal capital requirements tied to their risk exposure as measured by VAR in their
trading, interest rate risk.
The leverage capital ratio compares a bank’s equity capital to its adjusted total assets and
thus indicate how much equity versus debt a bank must have at a minimum. Regulators
impose this requirement so banks will be forced to operate with some capital even if they
were to hold only zero risks.
18.Define Basel II Capital Accord. Discuss and explain the THREE (3)
pillars of regulation of Basel II Capital Accord.
Base II attempts to integrate Basel capital standards with national regulations, by setting
the minimum capital requirements of financial institution with the goal of ensuring institution
liquidity. The Basel Accord’s approach to capital requirements was primarily based on credit
risk, it did not address operational or other types of risk. There are three pillars of regulation
which are minimum capital requirements, supervisory review and market discipline.