Banking Operations and Governance

This report covers topics related to Banking Operations and Governance. It includes a discussion on the cumulative re-pricing gap, net income of the bank, impact of decrease in demand deposits, and sufficiency of liquid capital to cushion unexpected losses. The report also includes a duration gap analysis of VRY-SMPL Bank.

Banking Operations and Governance
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Contents
Part 1- Dragon Slayer Bank.......................................................................................................3
Part B- VRY-SMPL Bank..........................................................................................................9
References................................................................................................................................15
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Part 1- Dragon Slayer Bank
1. Cumulative re-pricing gap
Formula for cumulative re-pricing gap-
Value of asset to be re-priced- Value of liability to be re-priced
(a) Planning period is 6 month
Assets to be re-priced in 6 months-
S.no Name Amount ($ million)
1. 6 month T-bills (4.25%) 50
2. 10 year commercial loan
(12.25%
Re-priced @ 6 months)
730
3. 15-year commercial loan at
10%
interest (re-priced monthly)
220
Total 1000
Liabilities to be re-priced in 6 months
S.no Name Amount ($ million)
1. Demand deposits 300
2. Savings accounts (2.0%) 205
3. 3 month CD (2.50%) 150
Total 655
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Cumulative re-pricing gap= 1000- 655= $345 million (Karisma and Widyantoro, 2016)
(b) Planning period is 2 years
Assets to be re-priced in 2 years-
S.no Name Amount ($ million)
1. 6 month T-bills (4.25%) 50
2. 10 year commercial loan
(12.25%
Re-priced @ 6 months)
730
3. 15-year commercial loan at
10%
interest (re-priced monthly)
220
4. 2 year personal fixed rate
loan at
6.50%
100
Total 1100
Liabilities to be re-priced in 2 years
S.no Name Amount ($ million)
1. Demand deposits 300
2. Savings accounts (2.0%) 205
3. 3 month CD (2.50%) 150
4. 9 months CDs (3.85%) 150
5. 1 year term deposit (4.0%) 520
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6. 2 year term deposits (4.30%) 200
Total 1525
Cumulative re-pricing gap= 1100- 1525= $425 million
2. Net income of the bank if interest on the banks rate sensitive assets is forecasted to
decrease by 60 basis points and rate-sensitive liabilities to increase 25 basis points in 6
months’ time?
Total assets to be matured in next 6 month= $1000 million
Decrease in interest on banks rate sensitive asset by 60 basis point will result in loss of
interest income by $6 million (1000*.006).
Increase in rate sensitive liabilities by 25 basis point ill result in loss on income by $1.6375
million (655*.0025).
Net Income of the bank will decrease by $7.6375 million.
3. Due to the uncertainty in the economy, based on the bank’s estimate there is a
potential of decrease in the demand deposits. What are some of the impact may that
have on the bank’s overall asset-liability?
Demand deposit is an amount invested by a customer of bank which can be withdrawn by the
customer at any time during a financial year. These deposits can be withdrawn on demand of
the customer. The decrease in amount of demand deposits with the bank would have various
impacts on financial position of the company that are as follows-
1. Impact on overall cost
Majorly demand deposits are used by banks and financial institutions for covering the cost of
their daily operations. The interest paid on these demand deposits is very low and hence it
becomes a good source for banks to operate daily business. In case of decline in demand
deposits with the bank, they have to opt for other sources of finance to cover cost of daily
operations. The interest cost of such sources will definitely be higher as compared to interest
rate paid on demand deposits. This would increase the overall cost of the bank and would
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also decrease profitability margins for the bank. The payments made by bank to shareholders
in form of dividend and bonus shares would also reduce.
2. Availability of liquid funds
Availability of liquid funds with the bank at any point of time would also be reduced. This
will have direct impact on liquidity position of the company as company has to borrow short
term borrowing to replace demand deposits. This would increase the current liability
component with the bank. This would also affect current ratio and quick ratio of the company
which are indicators of financial stability of a bank (Lang and Schmidt, 2016).
3. Current liability of the company would also increase as demand deposits would be
replaced with current liabilities.
4. Does the bank have sufficient liquid capital to cushion any unexpected losses as per
the Basle III requirement? Please ignore the cyclical buffer requirement
According to the framework of Basil iii, the total Tier 1 capital of a bank should be equal to
4.5% of the total risk weighted assets. In this report risk ratio between tier 1 capital and total
weighted asset would be calculated for evaluating whether bank have sufficient funds to
cover any unexpected losses as per Basle III requirement (Dermine, 2015).
Calculation of risk weighted assets are as follows-
Name of asset Amount Risk weight Risk weighted asset
Cash 55 0% 0
2 year personal fixed rate loan at
6.50%
100 125% 125
3 year T bills 100 2.5% 2.5
3 year 5.5% semi-annual coupon
T-notes
90 2.5% 2.25
(5 year 6.2% semi-annual coupon
T-notes
100 2.5% 2.5
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5 year personal loan 350 125% 437.5
5 year bond 8.0% annual coupon
issued by Spanish government with
rating credit rating B
150 2.5% 3.75
10 year commercial loan (12.25%
Re-priced @ 6 months)
730 100% 730
15-year commercial loan at 10%
Interest
220 100% 220
20-year sovereign bonds 12.0%
annual-coupon issued by
Cambodian government with BB
Rating
150 2.5% 3.75
20-year mortgages at 8.5% interest 390 100% 390
Total 1917.25
Tier 1 capital= Ordinary equity+ Preference shares+ retained earnings
= 20+20+40= $80 million
Ratio= 80/1917.25*100
= 4.17%
It is essential that bank should maintain a ratio between tier 1 capital and risk weighted asset
of 4.5%. In case of Dragon Slayer bank this ratio is not adequately maintained by the
management. Therefore Bank does not have enough liquid capital as per Basle III
requirement.
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8

Part B- VRY-SMPL Bank
5. Duration gap of the bank
First of all duration would be calculated for individual bonds in the balance sheet of the
company. Duration is calculated by following formula-
= Present value of cash inflows form the bond / present value of bond (Kaufman, G.G. and
Hopewell, 2017)
1. Duration for 5 year semi-annual 6.45%pa coupon bond-
Present value of cash inflows form the bond
Period
Cash inflow
(CI) T CI*T
DF
@3.25
% PV
1 16.125 0.5 8.0625 0.969
7.81256
3
2 16.125 1 16.125 0.938
15.1252
5
3 16.125 1.5
24.187
5 0.909
21.9864
4
4 16.125 2 32.25 0.88 28.38
5 16.125 2.5
40.312
5 0.852
34.3462
5
6 16.125 3 48.375 0.825
39.9093
8
7 16.125 3.5
56.437
5 0.799
45.0935
6
8 16.125 4 64.5 0.774 49.923
9 16.125 4.5 72.562 0.75 54.4218
9

5 8
10 16.125 5 80.625 0.726
58.5337
5
10 250 5 1250 0.726 907.5
Total
1263.03
2
Present value of bond
PV of interest receivable = 4.16* 32.5= 135.2
PV of redeemable value= .726* 250= 181.5
= 316.7
Duration = 1263.032/ 316.7= 3.98 years
2. 10 year 3.5% annual coupon bond
Period
Cash inflow
(CI) T CI*T
DF
@6.5% PV
1 3.5 1 3.5 0.939 3.2865
2 3.5 2 7 0.882 6.174
3 3.5 3 10.5 0.828 8.694
4 3.5 4 14 0.777 10.878
5 3.5 5 17.5 0.729 12.7575
6 3.5 6 21 0.685 14.385
7 3.5 7 24.5 0.643 15.7535
8 3.5 8 28 0.604 16.912
9 3.5 9 31.5 0.567 17.8605
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10 3.5 10 35 0.533 18.655
10 100 10 1000 0.533 533
Total 658.356
Value of bond
Present value of bond
PV of interest receivable = 7.18* 3.5= 25.13
PV of redeemable value= .533* 100= 53.3
= 78.43
Duration = 658.356/ 78.43= 8.4 years
3. 10 year treasury bond 7.5 % semi-annual coupon
Perio
d
Cash
inflow
(CI) T CI*T
DF
@3.25
% PV
1 13.125 0.5 6.5625 0.969
6.35906
3
2 13.125 1 13.125 0.938
12.3112
5
3 13.125 1.5 19.6875 0.909
17.8959
4
4 13.125 2 26.25 0.88 23.1
5 13.125 2.5 32.8125 0.852
27.9562
5
6 13.125 3 39.375 0.825 32.4843
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8
7 13.125 3.5 45.9375 0.799
36.7040
6
8 13.125 4 52.5 0.774 40.635
9 13.125 4.5 59.0625 0.75
44.2968
8
10 13.125 5 65.625 0.726
47.6437
5
11 13.125 5.5 72.1875 0.703
50.7478
1
12 13.125 6 78.75 0.681
53.6287
5
13 13.125 6.5 85.3125 0.659
56.2209
4
14 13.125 7 91.875 0.639
58.7081
3
15 13.125 7.5 98.4375 0.618
60.8343
8
16 13.125 8 105 0.599 62.895
17 13.125 8.5
111.562
5 0.581
64.8178
1
18 13.125 9 118.125 0.562
66.3862
5
19 13.125 9.5
124.687
5 0.545
67.9546
9
20 13.125 10 131.25 0.527 69.1687
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5
20 350 10 3500 0.527 1844.5
Total
2745.24
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Value of bond
Present value of bond
PV of interest receivable = 16.25* 7.18= 116.675
PV of redeemable value= .527* 350= 184.45
= 301.125
Duration = 2745.249/ 301.125= 9.1 years
4. 6 year annual coupon (6.30%pa) bond
Period
Cash
inflow
(CI) T CI*T
DF
@6.5
% PV
1 18.9 1 18.9 0.939 17.7471
2 18.9 2 37.8 0.882 33.3396
3 18.9 3 56.7 0.828 46.9476
4 18.9 4 75.6 0.777 58.7412
5 18.9 5 94.5 0.729 68.8905
6 18.9 6 113.4 0.685 77.679
6 300 6 1800 0.685 1233
Total
1536.34
5
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Value of bond
Present value of bond
PV of interest receivable = 18.9 * 4.84= 91.45
PV of redeemable value= .685* 300= 205.5
= 296.95
Duration = 1536.345/ 296.95= 5.17 years
Duration of assets and liabilities
Name Nature Duration Weight Duration*
weight
5 year semi-
annual 6.45%pa
coupon
Bond
Asset 3.98 =250/700
=0.36
1.43
10 year 3.5%
annual coupon
bond
Asset 8.4 =100/700
=0.14
1.176
10 year treasury
bond 7.5 %
semi
annual coupon
Asset 9.1 =350/700
=0.50
4.55
6 year annual
coupon
(6.30%pa) bond
Liability 5.17 =300/700
.43
2.22
Duration of assets= 1.43+1.176+4.55= 7.156
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Duration of liabilities= 2.22
Duration of bank= 7.156-2.22= 4.93 years
6. Calculation of net worth if the market yield goes up by 1.5%p.a.
Current net worth of the bank is $400 million
Duration of net worth = Duration of bank* Total assets / net worth (Kaufman, G.G. and
Hopewell, 2017)
= 4.93* (700/400)
= 8.63 years
% change in net worth= - Duration of net worth* change in rates
= 8.63* .015= - 12.94%
Ne net worth would be= 400- (400*12.94%)
=348.24
7. Maturity gap of the bank
Maturity gap= Maturity of assets- maturity of liabilities
Maturity of assets in case of VRY-SMPL Bank= (250*5+ 100*10+ 350*10)/ 700
= 8.21 years
Maturity of liabilities= (250*0+ 300*6)/ 550
= 3.27 years
Maturity gap = 8.21-3.27= 4.94 years
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References
Dermine, J., 2015. Basel III leverage ratio requirement and the probability of bank
runs. Journal of Banking & Finance, 53, pp.266-277.
Karisma, H. and Widyantoro, D.H., 2016, October. Comparison study of neural network and
deep neural network on repricing GAP prediction in Indonesian conventional public bank.
In System Engineering and Technology (ICSET), 2016 6th International Conference on (pp.
116-122). IEEE.
Kaufman, G.G. and Hopewell, M.H., 2017. Bond price volatility and term to maturity: A
generalized respecification. In Bond Duration and Immunization (pp. 64-68). Routledge.
Lang, M. and Schmidt, P.G., 2016. The early warnings of banking crises: Interaction of broad
liquidity and demand deposits. Journal of International Money and Finance, 61, pp.1-29.
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