Exam 2, Chapters 5, 7, 10, and 11

In making decisions about the appropriate amount of interest rate risk, bank management should consider the following.

(1) The profitability of a bank that does not take some interest rate risk might be inadequate. (2) A policy of eliminating all interest rate risk on the balance sheet may be incompatible with the desires of the bank's loan customers. (3) The expertise and risk preference of management are also significant.

What 3 factors affect NII?

(1) the interest rates earned on assets and paid for funds (2) the dollar amount of the various earning assets and liabilities (3) the earnings mix of those funds (rate x dollar amount)

Net interest income (NII)

= Interest income - Interest expense

Net interest margin (NIM)

= NII / Earning assets

What kind of aggressive gap management would be appropriate if interest rates are expected to fall?

A bank that uses dollar gap to manage its interest rate risk would want to shift to a negative gap position in order to benefit from the falling rates. It could do this by lengthening the maturity of its asset portfolio (making longer-term, fixed-rate loans, for example, or buying longer-term securities), and/or shortening the maturity structure of liabilities (through, for example, borrowing more federal funds or selling more short-term certificates of deposit). From a duration gap perspective, bank management would want to increase the maturity of assets and shorten the maturity of liabilities. If interest rate did fall, the market value of assets would increase more than the market value of liabilities, and the market value of equity would increase.

Federal Home Loan Bank

A government-sponsored enterprise (GSE) whose primary function is to enhance the availability of residential mortgage credit by making low-cost funds available to member institutions.

Corporate bond

A long-term debt security by a private corporation.

Why do lenders charge points on mortgage loans?

A point is one percent of the principal amount of the loan. Points are charged to increase the lender's yield on the mortgage loan.

Investment grade bonds are assigned letter ratings by Moody's/S&P's as follows:

Aaa/AAA - Highest-grade bonds that have almost no probability of default Aa/AA - High-grade bonds having slightly lower credit quality than triple-A bonds A/A - Upper-medium-grade bonds that are partially exposed to possible adverse economic conditions Baa/BBB - Medium-grade bonds that are borderline between definitely sound and subject to speculative elements, depending on economic conditions

Portfolio risk

According to portfolio theory, the riskiness of any security should not be evaluated in isolation but in the broader context of all assets held by an investor. The effect of a security on the risk per unit of return of the bank's total portfolio of assets can be considered. It is possible for a securities portfolio to decrease the portfolio risk of the bank's assets, especially if the returns on securities over time are not perfectly correlated (or synchronized) with the returns on loans over time.

Prepayment risk

All mortgage-derivative securities are exposed to this risk. For example, when interest rates decline, refinancing of mortgages by homeowners to take advantages of the lower interest payments can cause prepayments of outstanding mortgages.

What are the advantages and disadvantages of an ARM from the lender's point of view?

An ARM allows lenders to maintain a positive spread between their cost of funds and returns on loans, if the repricing of the loans are done in a timely fashion. For example, if the repricing of loans is only done once a year, and interest rates (and cost of funds) change dramatically during the year, the lender's may not be able too maintain their positive spread. Rate caps are another factor to consider. They to limit lenders ability to maintain a positive spread.

Interest rate futures contract

An agreement between two parties to exchange a commodity for a fixed price at a specified time in the future.

Interest rate swap contract

An agreement in which a bank and another party (referred to as a counterparty) trade payment streams but not principal amounts. e.g., a bank with a long-term fixed-rate mortgage portfolio could agree to receive a floating-rate payment stream and to pay the counterparty an equivalent fixed-rate payment stream

Market value accounting

Approved in the 1990s by the Financial Accounting Standards Board (FASB). Rules that require banks to classify securities for valuation purposes on their accounting statements. Three classes: (1) assets held to maturity, (2) trading securities, and (3) assets available for sale. Most bonds are held to maturity and therefore are carried on the books at historical cost.

∆Net Worth / TA ≅ -DGAP (∆i / 1+ I)

Approximation for the expected change in the market value of the equity relative to total assets for a given change in interest rates. Equation 5.11a (139)

What is asset/liability management?

Asset/liability management is the coordinated management of the entire portfolio of a financial institution. It considers both the acquisition of funds from various sources and the allocation of funds to profitable investments. The traditional focus of ALM has been on net interest income. However, it also considers market values, via duration. Finally, simulations allow other aspects of risk management to be brought into the ALM process.

Nonrate-sensitive asset/liabilities

Assets and liabilities whose interest return or cost do not vary with interest rate movements over the same horizon.

Rate-sensitive asset/liabilities

Assets and liabilities whose interest return or costs vary with interest rate changes over some given time horizon.

Junk bonds are rated as follows:

Ba/BB - Lower-medium-grade bonds that bear significant default risk should difficult economic conditions prevail B/B, Caa/CCC, Ca/CC, C/C - Speculative investment of varying degree that have questionable credit quality DDD, DD, D - Bonds in default, differing only in terms of their probable salvage value

Why has asset management been less emphasized over the last 20 years?

Banks are finding alternative approaches to meeting liquidity needs. One approach is to borrow the funds, which is known as liability management. An advantage of liability management over asset management is that funds can be invested in longer-term securities earning higher rates of return than money market instruments. Since the yield curve is normally upward sloping, this yield advantage is generally present. Furthermore, it frees up funds to meet loan demands. Loans have greater risk but offer the greatest potential for earning higher rates of return.

Why is it advantageous for banks to accept some amount of interest-rate risk? How much interest-rate risk should a bank take?

Banks are in the business of managing risk. In their intermediation functions, banks necessarily accept some degree of interest rate risk. If they took no interest rate risk, they would not be meeting the needs of their deposit and loan customers. Moreover, in the increasingly competitive market for financial services, it is difficult if not impossible for a bank to make an acceptable rate of return on assets or equity unless it takes some degree of interest rate risk. While taking some degree of interest rate risk would seem to be necessary for all banks, the exact amount of interest rate risk will vary substantially from bank to bank with the risk preferences of management and also with the degree of expertise of management in forecasting interest rate change and in making adjustments in the bank's portfolio.

Discuss optimality in bank liquidity management. How does uncertainty affect optimal bank liquidity?

Banks must find an optimal balance between not having sufficient liquidity to readily meet loan demands and deposit withdrawals and having too much liquidity which would incur an opportunity cost in terms of investing in higher earning assets (see Figure 11.3). Uncertainty tends to increase the potential costs of maintaining either too much or too little liquidity. In terms of Figure 11.4 in the text, the dispersions of liquidity needs and liquidity sources increases causing their overlapping area to increase. To make sure that liquidity needs are met, the optimum amount of liquidity would have to be increased.

What are collateralized commercial paper programs and medium-term notes? How do they help banks meet liquidity needs?

Collateralized commercial paper is issued through a separate entity known as a special purpose corporation (SPC). The funds raised from the commercial paper are used to make credit card loans, commercial loans, consumer loans, leases, and other loans by banks. In effect, this securitization of bank loans provides collateral for investors in the commercial paper. Medium-term notes are debt securities continuously offered for sale by the bank in maturities ranging from 9 months to 30 years. No underwriter is required. Terms of the notes can be tailored to the demands of investors. Both of these sources of liquidity enable banks to access nondeposit funds that were previously unavailable to them

Value-at-risk (VAR)

Considers the maximum amount that could be lost in investment activities in a specified period of time. Given a certain probability and holding period, VAR measures the maximum amount by which the investment portfolio will decline in value.

Explain the meaning of the term "consumer installment credit."

Consumer installment credit refers to loans to individuals for personal use (not for business, or real estate), and that are scheduled to be repaid in two or more installments.

Core deposits

Deposits that form a stable source of funds for lending banks. They are not sensitive to interest rates.

Duration gap

Duration is defined as the weighted average time (measured in years) to receive all cash flows from a financial instrument. The duration gap is the difference between the durations of a bank's assets and liabilities. It is a measure of interest rate sensitivity that helps to explain how changes in interest rates affect the market value of a bank's assets and liabilities, and, in turn, its net worth. The net worth is the difference between assets and liabilities (eq. 5.7). It follows that changes in the market value of assets and liabilities will change the value of the net worth (5.8). By using duration, we can calculate the theoretical effects of interest rate changes on net worth. eq. 5.7NW = A - L eq. 5.8∆NW = ∆A - ∆L Duration net worth (duration equity value) is the theoretical value of the bank's equity taking into account the market value of its assets and liabilities.

DGAP = Da - W(DL)

Equation 5.9 DGAP = Duration gap Da = Average duration of assets DL = Average duration of liabilities W = Ratio of total liabilities to total assets

ΔNII = RSA$ (Δi) - RSLA$ (Δi) = Gap$ (Δi)

Equation for showing the effects of changing interest rates on net income for banks with different gap positions. ΔNII is the expected change in the dollar amount of net interest income Δi is the expected change in interest rates in percentage points

How does the gap matrix work? e.g., table 5-4 (129)

First, since each asset and liability item must be allocated entirely among the incremental gap positions, reading across each row must produce a sum in each asset or liability category that is the same as the amount shown in the balance sheet. Second, a considerable amount of judgment is required in the allocation of many balance sheet items among the different maturity positions. This is especially the case for the liability side of the balance sheet.

If bank management focuses on utilizing the dollar gap to control interest rate risk, what are the two steps of the strategy?

First, the direction of future interest rates must be predicted. Second, adjustments must be made in the interest sensitivity of the assets and liabilities in order to take advantage of the projected interest rate changes.

What are the two basic types of 1-4 family residential mortgage loans. Which is the most widely used? Why?

Fixed-rate adjustable rate. Fixed rate mortgages were more widely used in 1990s, but not in 1988. When interest rates are relatively low, borrowers then do favor locking-in fixed rates. ARMs have the advantage of benefiting from lower interest rates if and when they decline. Holders of fixed rate mortgages can always refinance their loans if it is cost efficient to do so. Conversely, ARMs have the disadvantage of increasing payments when rates increase

$ ∆Net Worth ≅ -DGAP (∆i / 1+ I) x TA

For the dollar amount of the change in net worth. Equation 5.11b (139)

What is funding-liquidity risk and market-liquidity risk? How might banks use management information systems to control these risks?

Funding-liquidity risk is related to maintaining sufficient cash to meet investment objectives. Cash needs in securities activities such as maintaining margin accounts on financial futures positions used to hedge balance sheet risks is an example. Market-liquidity risk is associated with cash flow demands that arise from large fluctuations in securities market prices. Management information systems are valuable in terms of collecting liquidity information and simulating possible scenarios that could cause operational or crisis liquidity problems.

Briefly distinguish between the following types of loans: graduated payment mortgages, shared appreciation mortgages, and reverse annuity mortgages, home equity loan.

Graduated payment mortgages - payments are lower in the early years of the loan and then increase. This type of mortgage is designed for home buyers whose income is expected to increase, who want a larger loan than they can afford on their current income. Shared appreciation mortgage - the borrower agrees to share part of the appreciated value of the property with the lender when the property is sold. Reverse annuity mortgage - the borrower borrows against equity in a home, which may be repaid from the estate of the borrower upon death. It is designed for elderly customers. Home equity loan - a second mortgage that provides funds that may be used to purchase consumer goods and services, or for other purposes.

In what respects are the Home Mortgage Disclosure Act and the Community Reinvestment Act similar?

HMDA prohibits lenders from denying real estate credit based on a borrower's race, color, or national origin. CRA has similar requirements. Both laws require public disclosure of compliance.

Inflation risk

Here the investor is concerned that the general price level will increase more than expected in the future. Unanticipated increases in inflation lower the purchasing power of earnings on securities. An unexpected surge can cause interest rates on bonds to suddenly increase with potentially large price declines.

Aggressive investment strategies

In general, these strategies can be classified into two groups: yield-curve strategies and bond-swapping strategies.

Segmented markets

In the financial system because there are different participants and needs in the money and capital markets. Occurs due to the desire by firms to maintain maturity structures of assets and liabilities that are matched for the most part.

Expectations theory

Investors earn the same rate of return regardless of their holding period. Meaning, an investor would earn the same amount by either purchasing a two-year bond and holding it for two years or purchasing a one-year bond now and another one-year bond next year.

Municipal bonds

Issued by state and local governments to finance various public works, such as roads, bridges, schools, fire departments, parks, and so on. They normally offer higher yields that do the U.S. government and agency securities because they are exposed to default risk.

What is funds management? What does it seek to do?

It combines both asset management and liability management. It seeks to compare total liquidity needs with total liquidity sources. As such, it is a more comprehensive approach to managing liquidity than focusing on one liquidity approach or another.

Is real estate good or bad collateral?

It depends: Residential real estate is durable, and easy to identify. However, values of both residential and commercial real estate can decline, and the property in question may not be highly marketable. In late 1980s and early 1990s, there were large scale defaults on commercial real estate and construction and development loans.

What is the "money market approach" to liquidity management?

It entails holding liquid securities that are timed to mature when it is estimated that a liquidity need will arise

What is a balloon loan?

It is a partially amortized, fixed rate loan (mortgage or other type of loan), where only a portion of the debt is paid off in periodic payments, and the unamortized amount is paid off in lump sum, or balloon payment at maturity

Discuss the risks and returns associated with using liability management to handle liquidity needs. Why can a carry trade strategy be risky?

Liability management will tend to increase asset returns because funds are shifted from lower-earning money market instruments to higher-earning capital market instruments and loans. However, bank risk increases due to increased credit risk and greater interest rate risk of longer-term assets. Also, if for any reason the bank encountered a problem with public confidence, the lower level of liquid assets held due to liability management would compound its liquidity problems at that time. A carry trade strategy is implemented by borrowing short-term funds and investing these funds in longer-term securities. As long as interest rates do not increase, the carry trade can earn a positive yield spread. However, rising interest rates would collapse the positive yield spread and result in capital losses on the Treasury debt securities. As an example of this interest rate risk, in 1994 Orange Country, California experienced large losses on its carry trade strategy as interest rates rose at that time.

Adjustable rate mortgage loans (ARMs)

Loan which the interest rate changes over the life of the loan. The basic idea behind this type of loan is to help mortgage lenders keep the returns on their assets higher than the costs of their funds. The adjustment period may be monthly, annually, or any other time period, and changes are made according to the terms of the contract.

Agency securities

Mortgage-backed securities (MBSs) include participation certificates (PCs), guaranteed mortgage certificates (GMCs), and collateralized mortgage obligation (CMOs). PCs are ownership claims on conventional mortgages held by Freddie Mac with monthly payments of interest and principal. GMCs are also claims on a pool of mortgages held by Freddie Max, but the interest payments are made semi-annually like a corporate bond and principal is paid once a year. CMOs repackages the cash flows from both pooled mortgages and MBSs (with standardized terms of payment and maturity) into different payment combinations.

Treasury notes/bonds

Most of these purchased by banks have maturities ranging from one to five years. They are coupon-bearing instruments, consistent with their income function. Since the market is deep and broad, these provide an extra measure of bank liquidity. They can serve to secure both deposits of public money (e.g., tax and loan accounts of the U.S. Treasury) and loans from FRBs, and they are widely accepted for use in repurchase agreements.

What is the difference between a debt card, a credit card, and prepayment card?

No credit is extended on a debt card or prepayment; credit is extended on a credit card.

Explain what is meant by nonprice competition in credit cards.

Nonprice competition includes the variety of services and benefits offered by credit card issuers. These include travel insurance, frequent flying miles, discounts on automobiles, and so on.

Yield curve

Normally, the yield curve has an upward slope, with longer-term securities offering higher yields than shorter-term securities. In a recession, interest rate levels are low due to the weak demand for funds by business firms, and the shape is steeply upward sloping than at other times. During a business expansion, the level of the yield curve will rise in response to increased demand for funds by business firms and will gradually flatten in shape but remain generally upward sloping. Finally, at the end of an economic expansion, the yield curve will be at its highest level and take on a variety of shapes. At some point, high interest rates will precipitate a business slowdown, and the yield curve could collapse in a matter of months.

Distinguish between open- and closed-end consumer loans. Give an example of each.

Open-end loans have no definite maturity. Credit card loans are one example of open-end credit. Closed-end loans, such as loans for automobiles, have a definite maturity.

How does operational liquidity management differ from crisis liquidity management?

Operational liquidity refers to the ability of the bank to meet its liquidity in times of normalcy. Crisis liquidity is the ability of the bank to sustain itself when under financial distress due to abnormal losses on loans (for example). If the bank were using relatively expensive purchased sources of funds, there is a greater likelihood that a severe drain of funds from the bank could occur due to high loan losses (or some other factor that could cause a loss of public confidence) than if the bank were using large proportions of insured deposits from the local community.

Annual percentage rate (APR)

Percentage cost of credit on an annual basis. The APR is the internal rate of return (IRR) on the loan.

Describe the secondary mortgage market

Pools of mortgage loans are bought and sold. Some of the mortgage pools are enhanced by guarantees from government agencies, such as GNMA, or by private firms. The Major participants include FNMA, GNMA, and FHLMC.

Reverse convexity

Prices decline as interest rates decline, the opposite of the normal experience in which prices rise in response to falling interest rates

Price risk

Refers to the inverse relationship between changes in the level of interest rates and the price of securities. Important because securities purchased when there is slack loan demand and interest rates are relatively low may need to be sold later at a capital loss (to meet loan demand) in a higher interest rate environment. They should be timed to mature during anticipated periods of increased loan demand

How do regulators evaluate bank liquidity? How much liquidity is adequate?

Regulators are interested in making sure that banks carry an adequate quantity of liquidity, as opposed to the least cost amount. Adequacy is judged by evaluating a number of factors, including the amount of liquid assets held, lending and investment commitments of the bank, sources and stability of deposits, interest sensitivity of assets and liabilities, and ability to cope with changes in business conditions.

What are lagged reserves requirements? How is vault cash counted in maintaining reserves using LRR?

Required reserves using LRR under Regulation D are computed on the basis of daily average balances of transactions deposits during a 14-day period ending every second Monday (the computation period). Figure 11.1 in the text gives an example for illustrative purposes. Reserve requirements are computed by applying the ratios shown in Table 11.3 of the text. It should be noted that average daily vault cash held in a subsequent 14-day computation period are counted as reserves, which means they are deducted from the amount required based on transactions accounts to get the required reserve balance. The reserve balance that is required must be maintained with the Federal Reserve during a 14-day period (the maintenance period) that begins on the third Thursday following the end of the transactions computation period. Thus, there is a 17-day lag between the end of the transactions computation period and the beginning of the maintenance period.

Liquidity Premium

Risk-adverse lenders prefer to lend funds for short periods of time, unless a premium is paid for foregoing greater liquidity and lending funds for longer periods. This added return or premium is known as a liquidity premium.

Explain the following terms: a) settlement charges and RESPA, buydown, due-on-sale clause.

Settlement is the process by which ownership, evidenced by the title, is transferred from the seller to the buyer; RESPA is the Real Estate Settlement Procedures Act that governs settlement; buydown occurs when the seller pays the lender some amount to permit the buyer to obtain a lower interest rate/payments for the first few years of the mortgage loan. Due-on-sale clause means that the mortgage is not transferable to a buyer, and the loan balance must be paid when the house is sold.

Investment policy

Should be formally established so managers can make decisions that are consistent with the overall goals of the organization.It seeks to maximize the return per unit risk on the investment portfolio of securities, although regulatory requirements, lending needs, tax laws, liquidity sources, and other factors can limit return/risk performance.It should have sufficient flexibility to enable it to shift investment goals in response to changes in financial and economic conditions and competition from rival institutions.

How do small and large banks differ in the management of their money positions?

Small banks tend to run a surplus of reserves at the beginning of the reserve maintenance period. Subsequently, they sell off their excess reserves in the fed funds market. Large banks have the opposite reserve patterns over time. They experience increasing shortages of reserves as the maintenance period proceeds and must borrow reserves in the fed funds market.

Yield spread

The difference in yields between low and high-quality bonds. It tends to vary with economic conditions.

Convexity

The extent to which bond prices change asymmetrically relative to yield changes

What is the difference between a finance charge on a loan and the APR?

The finance charge is the difference between the amount borrowed and the amount repaid. It includes interest, service charges, fees, and most other items charged to obtain the loan. The APR is the percentage cost of credit on an annual basis. It is the internal rate of return on the loan.

What is the first step in any bank liquidity analysis? Discuss two methods of accomplishing this first step.

The first step is to estimate liquidity needs. One way to do this is to use the sources and uses of funds method. This involves estimating the supply of deposits and other sources of funds and the demand for loans in the coming weeks or months. Forecasting these quantities requires that the manager take into account economic trends and competitive market conditions. The second way to do this is to use the structure-of-deposits method. The different kinds of deposits are arrayed and probabilities of withdrawal are assigned for each. This method focuses on the most likely source of liquidity needs, but it ignores loan demands.

Aggressive/defensive asset liability management

The goal of defensive ALM is to insulate the net interest income from changes in interest rates; that is, to prevent interest rate changes from decreasing or increasing the net interest income. In contrast, aggressive ALM focuses on increasing the net interest income through altering the portfolio of the institution. The success of aggressive ALM depends on the ability to forecast future interest rate changes. An aggressive strategy seeks to raise the level of net interest income, whereas a defensive strategy attempts to reduce the volatility of net interest income.

Briefly explain the influence of rate, dollar amount, and mix on net interest income.

The higher the interest rate on assets, the higher the net interest income. All else is the same, the larger the volume of funds raised and invested, the larger the net interest income. Finally, as the mix of sources of funds is shifted to lower cost instruments, or as the mix of assets is shifted toward higher yielding loans and securities, the net interest income increases.

Distinguish between the incremental gap and the cumulative gap. Why is this distinction important?

The incremental gap measures the difference rate sensitive assets and rate sensitive liabilities over increments of the planning horizon. The cumulative gap measure this difference over a more extended period, i.e., it is the sum of the incremental gaps.

Explain the intent of the Truth in Lending Act.

The intent is to provide consumers with sufficient information about the financial aspects of a loan (i.e., APR, finance charges) so that they can make an informed choice.

Immunization

The isolation of the market value of equity to interest rate changes. This is a problem with duration gap management because it will only be effective if interest rates for all maturity securities shift up or down by exactly the same amount (i.e., only if the yield curve moves upward or downward by a constant percentage amount). Yield curves seldom move in this way.

Cumulative gap

The measure of the difference between rate-sensitive assets and liabilities over a more extended period. It is the sum of the incremental gaps. Incremental gaps are measures of the difference between rate-sensitive assets and rate-sensitive liabilities over increments of the planning horizon (maturity buckets).

What is the difference between defensive and aggressive asset/liability management?

The principal difference between these two strategies relates to their goals: defensive asset/liability management attempts to insulate the financial performance of the bank (measured either in terms of income or the market value of assets and liabilities) from the effects of changing interest rates. Aggressive asset/liability management seeks to increase income or the market value of equity by forecasting interest rates and adjusting the portfolio to take advantage of the expected changes in rates.

Asset/liability management (ALM)

The process of making such decisions about the composition of assets and liabilities and the risk assessment. Bankers make these decisions every day about buying and selling securities, about whether to make particular loans and how to fund their investment and lending activities. These decisions are based upon, (1) their outlook for interest rates, (2) the composition of their assets and liabilities, and (3) the degree of risk that they are willing to take. The principal purpose has been to control the size of the net interest income.

Call risk

The risk that a bond issuer will redeem a callable bond prior to maturity. When banks attempt to purchase bonds during high interest rates periods and later plan to sell them for sizeable capital gains as rates fall, the call risk is worth especially evaluating.

Marketability risk

The risk that an individual or firm will have difficulty selling an asset without incurring a loss. To guard against this, investment managers should evaluate the likelihood of liquidity demands exceeding secondary (or liquid) reserves and then purchase investment securities to take into account this potential added liquidity.

What factors affect monthly payments on a residential mortgage loan? Explain the effect of each factor.

The size of the loan, interest rate, and maturity are the principal factors. The first two factors are positively related to the size of the payments, while maturity is negatively. That is, large loans and high rates result in large monthly payment for a given maturity, while payments can be reduced by extending the maturity

Passive investment strategies

The space-maturity investment strategy (ladder approach) involves spreading available investment funds equally across a specified number of periods within the bank's investment horizon. The split-maturity approach (barbell approach) offers a balance of higher income on the long-term securities (assuming the yield curve is upward-sloping) and good liquidity through substantial purchases of short-term securities.

Maturity buckets

The time period classifications over which to measure the interest sensitivity of an asset or liability. Is also sometimes called planning horizons.

Dollar gap

The total effect of interest rate changes on profitability can be summarized by this method. This method is also referred to as the funding gap or the maturity gap. It is the difference between the dollar amount of interest-rate-sensitive assets (RSA) and the dollar amount of interest-rate-sensitive liabilities (RSL). = RSA ($) - RSL ($)

Simulated asset liability models

These make it possible to evaluate various balance sheet strategies under differing assumptions. Most simulation models require assumptions about the expected changes and levels of interest rates and the shape of the yield curve, pricing strategies for assets and liabilities, and the growth, dollar amounts, and mix of assets and liabilities. Alternative assumptions allow for the creations of various "what if" projections. Simulation models allow bank management to determine the risk/return trade-offs for different balance sheet strategies. Because of their flexibility in testing difference scenarios, they are a superior tool for ALM.

How are reserve requirements calculated for MMDAs?

They are counted as nonpersonal time deposits and, as such, there is no reserve requirement.

What is the relationship between bond prices and interest rates?

They move inversely. e.g., interest rates fall, bond price rises or conversely, interest rates rise, bond price falls

Why are legal reserves considered a tax on banks? What did the Federal Reserve to recognize this issues?

They would be a tax to the extent that reserves were held in excess of the quantity the bank would hold if there were no reserve requirements. If no interest was earned on reserve balances, there would be an opportunity cost of funds for the bank. The Federal Reserve invests reserves it holds for banks in U.S. Treasury securities and thereby earns interest on reserves. These earnings are used to meet its operating expenses; however, the majority of these funds are paid into the U.S. Treasury for meeting the fiscal budget of the U.S. government. Since October 2008, the Federal Reserve has paid interest on legal reserves to banks, which is generally set at the federal funds target rate used in monetary policy.

Duration drift

This is an issue with duration gap management. For example, a financial institution finances a long-term (seven-year duration) portfolio with a mixture of five and ten-year duration deposits. After three years the duration of the assets has declined very little, but the duration of the deposits has declined substantially. After four years the duration mismatch is even larger. This happens because maturities were not matched initially even though durations were. This raises the issue of how often you should rebalance the portfolio (annually, quarterly, monthly, etc.) Such rebalancing is costly and would not be undertaken unless there are clearly defined benefits.

What is the Liquidity Coverage Ratio (LCR) under new regulations adopted by the Basle Committee? How is it related to financial crisis?

This new liquidity ratio was established due to the 2008-2009 financial crisis. It seeks to measure the potential ability of large, internationally-active banks to withstand liquidity stresses in a period of economic stress as in the recent crisis. The ratio is computed as follows: LCR = High-quality liquid assets (HGLA) / Total net cash outflows over the next 30 days

Interest-sensitivity ratio

This ratio expresses the dollar amount of RSAs as a fraction of the dollar amount of RSLs. = RSA$ / RSL$

Relative gap ratio

This ratio expresses the dollar amount of the gap (dollar RSAs - dollar RSLs) as a percentage of total assets. = Gap$ / Total assets

Stress testing

This reveals the effects on income and capital of larger changes in interest rates. This can be thought of as testing the implications of a worst-case scenario and is uses simulation.

Preferred habitat

This theory takes into account all three of these yield curve factors. It hypothesizes that investors will switch from their normal maturity preference (or habitat) to a different maturity range of securities if yield differentials are sufficiently high to compensate for the potential price risks associated with mismatched asset and liability maturities.

What are the three problems with dollar gap management?

Time horizon ignores the time at which the interest-rate-sensitive assets and liabilities reprice within the time period, implicitly assuming that all rate-sensitive assets and liabilities reprice on the same day. This is solved with the maturity bucket approach which divides the portfolio of assets and liabilities into subcategories, referred to as maturity buckets. The implicit assumption that the correlation coefficient between the movement in general market interest rates and in the interest revenue and cost for the portfolio of the financial institution is one; that is, when interest rates in the market rise (or fall) by 10%, the interest revenue on rate-sensitive assets and the interest cost for rate-sensitive liabilities will rise (fall) by precisely 10%. One method of dealing with this is the use of the standardized gap. This measure of the gap adjusts for the different interest rate volatility of various asset and liability items. It uses historical relationships between market interest rates and the interest rates of the bank's asset and liability items in order to alter the maturity and therefore interest sensitivity of the portfolio items. The final and most significant problem is the focus on net interest income rather than shareholder wealth.

Gap analysis

Under this approach, all assets and liabilities are classified into groups - interest-rate sensitive or non-interest-rate sensitive - according to whether their interest return (assets) or interest cost (liabilities) varies with the general level of interest rates. Thus, the focus of this approach is on net interest income. This approach classifies assets or liabilities according to their interest sensitivity (how often the assets/liabilities are repriced).

When would asset liquidity be preferred to liability management?

Whenever it is the least cost approach to meeting liquidity needs. An example is during periods in which interest rates are relatively high and are expected to rise further in the near future. Issuing deposits may be quite expensive at such times and would have to be rolled over at ever higher rates as interest rates increased. Moreover, at such times money may be so tight that too high a price must be paid by the bank to obtain funds compared to simply selling off some of its liquid assets.

How would an increase (decrease) in interest rates affect a bank with a positive dollar gap? Negative dollar gap?

With a positive dollar gap the bank would have more rate sensitive assets than rate sensitive liabilities. As interest rates increase (decrease), the bank's earnings on assets (cost of liabilities) would rise faster than its costs of liabilities (earnings on assets) causing an increase (decrease) in profits. The opposite relationships hold in the event of a negative dollar gap. As rates rise, the bank's profit would decline (rise).

Distinguish between open- and closed-end leases for automobiles.

With open-end automobiles leases, the bank is responsible for selling the car at the end of the lease, and the customer may be responsible for the residual value, if it is less than agreed upon. With closed-end leases, the bank assumes the risk of the residual value. Thus, the lease payments are higher under the later method.

If the ratio of liquid assets and liabilities in period t divided by estimated liquidity needs in period t is between zero and one, might there be a problem with bank liquidity?

Yes. In this case the bank's total sources of liquidity could fall below liquidity demands at the bank.

Asset-backed securities

pools of financial securities backed by income-generating assets