Question

Problem #3 Consider a commercial bank with the balance sheet that includes variable interest deposits worth $200 and variable interest loans worth $100. Assume that initially the interest paid on deposits is 2% and the interest rate earned on loans is equal to 4% i)What is the value of the GAP in this bank? What is the contribution to profit generated by variable interest assets and liabilities in this bank? ii Explain what happens to the contribution to bank profit if all interest rates increase by 1 percentage point. What is the impact on the bank's profits of fall in all interest rate by 1 percentage point? i Would the variability of profits be higher if the interest rate paid on deposits was constant and always to 2%? equal iv) Would the variability of profits be higher if the interest rate earned on loans was constant and always equal to 4%?

Answer 1

Given Extracts from Bank's Balancesheet 4%Deposits 2% Loans $200 $100 Primary source of income for any Bank or Financial Institutions are Interest earned on Loans Primary Expense would be Interest paid on Deposits to Customers. -> Interest earned on Loans@4% = $100 X 4 % $4 i) ->Interest paid on Deposists @2% = $200 X 2% = $4 Basically GAP in banking terminology meant by Asset and Liability Mismacthes. Value of GAP Assets - Liabilities $100 $200 -$100. In our current example interst earned on Loan issed is higher compared to Interest paid on Deposists, But because of Low Asset component i.e Loans issued ($100) compared to Liabilities i.e deposits accepted ($200), No profit is earned which is Interest earned Interest paid $4- $4 0 If all Interest rates increases by 1 % then Interest earned increases from 4% to 5 % and ii) Interest paid increased from 2% to 3% . Interest earned@5% $100 X 5% = $5 Interet paid @ 3% = $200 x 3 % = $6 Profit or Loss = Interest earned - Interest paid $5-$6-$1 (Loss) If all Interest rates falls by 1% then Interest earned decreases from 4% to 3 % and Interest paid decreases from 2% to 1 % . Interest earned@3 % = $100 X 3% = $3 Interet paid @ 2% = $200 X 2% = $4 Profit or Loss Interest earned - Interest paid $3-$4 -$1 (Loss) III) If the Expense rate (Rate of Interest on Deposist) is Fixed and Income rate (Rate of Interest on Loans) varies then Banks might end up paying interest even when markets are adverse where Interest earned is very low. It causes huge variation in Profit some times. iV) If the Income source (Rate of Interest on Loans) is constant and Expense part (Rate of Interest on Deposist) is variable then it would create higher variability in Profits. It is because Expense may either increase or decrease based on Market volatility but Income remains same. In cases where Expense rate is being decreased then Banks might see higher profits. But if Expense rate is being Increased then banks might see huge decrease In profits.