FIN20013 Banking and Financial Institution Management

This assignment solution covers key concepts in banking and financial institution management, including repricing gaps, net interest income (NII) sensitivity, and duration gaps. It analyzes the impact of interest rate changes on a bank's financial health, considering both rate-sensitive assets and liabilities. The solution also evaluates a bank's capital adequacy against Basel III requirements and discusses the implications of fluctuating demand deposits. Formulas and calculations are provided to illustrate the effects of interest rate shocks on net worth and to determine the expected net interest income. The document provides insights into managing interest rate risk and ensuring sufficient liquidity in banking operations, offering a comprehensive overview of the financial stability of a bank.

Banking and Financial Institution Management 1
BANKING AND FINANCIAL INSTITUTION MANAGEMENT
Student’s Name
University
Course
Date

Banking and Financial Institution Management 2
Banking and Financial Institution Management
1. The repricing gap measures the difference between the value of an asset dollar which has
repricing chances and the liabilities’ dollar value that is likely to reprice in a given
duration of time (Morina, 2015.). Repricing in this context implies that there is a potential
for a receiving a new interest rate on a dollar.
The formula for calculating the Repricing gap is
RSA – RSL
From the balance sheet the repricing gap if the planning period is
a. 6 months is
Repricing gap = RSA – RSL
=$50 – $205 = $–155 Million
b. 2 years
Repricing gap = RSA – RSL
($50 + $100) – $205 = $–55 million
2. What will happen to the net interest income of the bank if interest on the bank's rate
sensitive assets is forecasted to decrease by 60 basis points and rate-sensitive liabilities to
increase 25 basis points in 6 months' time;
The formula used is
∆NII = CGAP (∆R)
∆NII= ($50)3.65 $205(2.25)
RSA by the end of 6 months with the decrease of $1.82 Million the RSL with will
increase by

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$ 10.11 million. The increase in the RSL is because the liabilities will be much higher
because of the increasing interest rate and the RSA which is the bank's size will reduce by
$1.82 million.
The change in the net interest income, which is a decrease, in this case, is as a result of
increased financing cost without earnings rate increasing in a corresponding manner (van
den End, 2012). Thus the change in NII will be as a result of financing risk. It should be
noted that the answer to this question does not include an assumption about reinvesting
the initial interest rate at a rate that is much higher. Due to the uncertainty in the
economy, based on the bank's estimate there is a potential for the decrease in the demand
deposits. Some of the impacts may that have on the bank's overall asset-liability include
drawing of checks as means of payment by the account holders. This is from the fact that
checks drawn on demand are usually a primary portion of all the available payment
means in banks which the opposite in the households. Demand deposits allow the owners
to deposit and withdraw funds with no notices given in advance. Both the deposits and
the withdrawals are in the form of checks which gets out as well as into the demand
deposit account of the holder (Van Deventer, 2013). Although it is expected that the
movement of the funds both from the banks and outside to have no effect on the demand
deposits in a bank set up, there can still be an impact in the economy since such funds
movement targets specific banks as individual entities.
For every check that is withdrawn on a demand deposit account available in a bank, there
is a reduction in the left in that particular account. The transfer results to an increase in
the amount available for another holder either in the same bank or a different bank
account because there is a deposit of the check in a different account in a different

Banking and Financial Institution Management 4
account or in the same bank on of account. When the accounts involved in a transaction
are in the same bank account, there is usually no effect on the total demand deposit of the
bank as well as in the assets and liabilities. When the transaction involves different banks
in that the checks are deposited in a different bank, definitely the two banks are affected
in terms of the total demand deposits as well as their liabilities.
3. No, from the balance sheet the bank does not have sufficient liquid capital cushion any
unexpected losses as per the Basel III Requirement. The subordinated debt amount that
can be counted towards liquid capital cannot be sufficient to stand in for Tire I liquid
capital. It should be noted that part of Tier I capital should be used as Tier II liquid
capital (Yan, 2012). This implies that the qualifying capital of equity added to the
subordinated debt should not be enough amount of liquid capital to run and sustain the
bank for a reasonable period of time.
It should be understood that in this scenario the loan loss reserve amount is not clearly
indicated. This is from the fact that the percentage risk adjustment assets that could not
qualify for Tier II capital are not sufficient (Landier, 2013). An additional capital amount
may be left to be used by the bank. This implies that there is a deficit in the amount of
capital as shown in the balance sheet above and as determined in the illustration above.
4. A duration gap is an accounting and financial term used by banks among other financial
institutions with the aim of measuring the risks associated with an exchange rate.
Duration is one of the mismatches that can occur which are termed as mismatches of
asset liability. In other words, duration gap is the difference which occurs in the interest-

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yielding assets price sensitivity of a bank which is compared to the change in interest
rates of the market (Bagus, 2012).
The formula used to calculate Duration gap is
Duration Gap = Duration of earning assets – Duration of paying Liabilities x
Paying Liabilities
earningassets
DA = (5 yrs.)($250) + (10 yrs.)($450) = 8.2yrs.
$700
DL = (0.5 yrs.)($250) + (6.0 yrs.)($450) = 6.3 yrs.
$450
DGAP = 8.2-(450/700)(6.3) = 4.15 yrs.
When the assets duration is greater than the liabilities duration, the resultant duration gap
is usually positive. In such a situation, when the interest rates rise, the assets directly
affected will lose more value compared to liabilities which leads to the reduction in value
of the bank's equity.
5. The change in net worth when there is a change in interest rates is usually given by
  A
L
kwhere
R
R
AkDDE LA 


 1
**
From the illustration above, there are three that are important when determining the value
of E.
One of the factors is the adjusted duration gap which is leveraged denoted by
[DA - D L k]

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It should be noted that the larger the adjusted duration gap, the more exposed is the Bank
to the interest changes. This implies for a bank or a financial institution to be on the safer
side of the operation, the leveraged adjusted duration gap should remain as low as
possible (van den End, 2012).
The second factor that is crucial in the net worth determination is the value of Assets (A)
a financial institution (a bank) owns. The value of Assets in this case represents the size
of the financial institution. The larger the size of a financial institution or a bank, the
greater it is exposed to interest changes (Horvátová, 2013). This implies that small
financial institutions are rarely affected by interest rate changes and if it happens the
difference is not much.
The third factor that is important when determining the value of E is the interest rate
shocks denoted by R/1 + R. An interest rate shock takes place when there is a sudden
change in the interest rate (Robertson, 2014). In the start, it might behave as if it is a
normal interest change which moves upwards of downwards but as time moves by, it
becomes more complicated.
With the above illustration, the change in net worth when there is a change in interest
rates by 1.5% will be
  A
L
kwhere
R
R
AkDDE LA 


 1
**
E=4.15 yrs * $700 * 1.5
1+ 6.5
E=4.5 * $700 * 0.2
E= 630

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So there is a reduction in the bank’s net worth from 700 to 630 million of Assets due to
the change in the interest rate.
6. Maturity Gap of the bank
Maturity gap is the interest rate risk measurement for risk-sensitive assets (RSA) and
Liabilities (LSA). Through the use of maturity gap model, the possible variation in the
net interest income variable is measured. In the practical application, if there are changes
in the interest rates, the interest income and the interest expense changes which can be
attributed to the repricing of the various assets and liabilities.
Given the figures in the balance sheet above, the expected net interest income of the bank
at the end of the first year is calculated as follows
Interest income realized from Assets – Interest expense realized from Liabilities
= ($2.50 x 6.45%) + ($1.00 x 3.5%) + ($3.50 x 5.5%) – ($3.00 x 6.3%)
= 16.13 + $3.5 + $19.25 – ($19.97)
= $18.91

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Bibliography
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