Instructions: Read the following scenario below and offer a comprehensive soluti
ID: 2742857 • Letter: I
Question
Instructions: Read the following scenario below and offer a comprehensive solution to each problem. Also write a solution and which you do the following for each case:
Analyze the key economic issues in the case.
Recommend three different business solutions to the case using managerial economic models and methods.
Justify the role of managerial economics by identifying the metrics you would use to assess the success of your decisions.
Scenario:
Banks are often functionally organize, with a deposit division responsible for gathering deposits, an a loan division responsible for making loans. Banks make money by borrowing short (from depositors) lending long (to home homeowners). If the short-term rates they pay to epositors are lower than long-term rates they earn from mortgage loans, the banks make money.
In fact, banks often fin that they can increase profit by reducing the maturity of deposits (short-term deposits pay lower rates) an by increasing the maturity of loans (longer-term loans earn higher rates).
However, increasing the maturity on loans an reducing the maturity on deposits also increase interest-rate risk: when interest rates rise (as they did in the early 1980s) bank borrowing costs increase dramatically as depositors demand higher rates. Unfortunately, revenue from loan payments does not increase at the same rate because the rates are locked in loans of longer maturities. In fact, interest-rate risk is closely related to the difference in maturities between deposits and loans. A regional bank recently discovered that it was exposed to a particularly high level of interest-rate risk.
Explanation / Answer
Supervisors should evaluate whether internal measurement systems for banking book interest rate risk are adequate for managing risk in a safe and sound manner and adequate for use in supervisory evaluations of capital adequacy. Depending on the nature and scale of a bank’s business, a wide variety of methodologies could be employed in internal measurement systems. Such evaluations could be performed through a review of internal and external audit findings or through on-site supervisory reviews.
A bank’s internal systems must meet the following criteria-
(a) They must assess all material interest rate risk associated with a bank’s assets, liabilities and off-balance-sheet positions in the banking book. To do this, they must accurately incorporate all a bank’s interest rate sensitive on and off-balance sheet holdings.
(b) They must utilise generally accepted financial concepts and risk measurement techniques. In particular, they must be capable of measuring risk on both an earnings and economic value approach. The monitoring of interest rate risk in the banking book for supervisory purposes would be based on risk as measured by the economic value approach.
(c) Their data inputs are adequately specified (commensurate with the nature and complexity of a bank’s holdings) with regard to rates, maturities, re-pricing, embedded options and other details to provide a reasonably accurate portrayal of changes in economic value or earnings.
(d) The system’s assumptions (used to transform positions into cash flows) are reasonable, properly documented and stable over time. This is especially important for assets and liabilities whose behaviour differs markedly from contractual maturity or repricing, and for new products. Material changes to assumptions should be documented, justified and approved by management. In particular, supervisors would not normally expect core deposits - those deposits which can be withdrawn without notice but which in practice tend to remain with the bank - to be given an assumed maturity or repricing frequency of longer than three to five years without additional empirical analysis.
(e) Interest rate risk measurement systems must be integrated into the bank’s daily risk management practices. The output of the systems should be used in characterising the level of interest rate risk to senior management and boards of directors.
If supervisors determine that a bank’s internal measurement system does not adequately capture interest rate risk in the banking book, the first, most immediate course of action is to require the bank to bring its system to the required standard. In the interim, the bank must supply its supervisor with information on the interest rate risk in its banking book in a form specified by the supervisor.