1. Integrating Asset and Liability Management. What is accomplished when a bank integrates its
liability management with its asset management?
ANSWER: Integrating asset and liability decisions can improve performance. For example, the
decision to focus on short-term CDs as a source of funds may result in a decision to concentrate on
rate-sensitive assets, such as floating-rate loans. This strategy reduces interest rate risk.
2. Liquidity. Given the liquidity advantage of holding Treasury bills, why do banks hold only a
relatively small portion of their assets as T-bills?
ANSWER: Treasury bill yields are sometimes lower than a bank’s cost of obtaining funds. Thus,
banks should not concentrate their investment in Treasury bills.
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3. Illiquidity. How do banks resolve illiquidity problems?
ANSWER: Banks can resolve illiquidity by selling some assets to obtain funds, or borrowing funds in
the federal funds market or from the discount window.
4. Managing Interest Rate Risk. If a bank expects interest rates to decrease over time, how might it
alter the rate sensitivity of its assets and liabilities?
ANSWER: It may increase its concentration of rate-sensitive liabilities and reduce its concentration
of rate-sensitive assets.
5. Rate Sensitivity. List some rate-sensitive assets and some rate-insensitive assets of banks.
ANSWER: Rate-sensitive assets include floating-rate loans and short-term securities. Rate-insensitive
assets include long-term fixed-rate loans and long-term securities.
6. Managing Interest Rate Risk. If a bank is very uncertain about future interest rates, how might it
insulate its future performance from future interest rate movements?
ANSWER: It can attempt to match the degree of rate sensitivity of assets and liabilities, through
maturity matching, interest rate futures contracts, or interest rate swaps.
7. Net Interest Margin. What is the formula for the net interest margin? Explain why it is closely
monitored by banks.
ANSWER: The net interest margin is closely monitored by banks because it usually is the primary
contributor to the bank’s return on assets.
Interest revenue – Interest expenses
Net interest margin =
8. Managing Interest Rate Risk. Assume that a bank expects to attract most of its funds through short-
term CDs and would prefer to use most of its funds to provide long-term loans. How could it follow
this strategy and still reduce interest rate risk?
ANSWER: It could use floating-rate loans, so that its assets are rate-sensitive even with long-term
9. Bank Exposure to Interest Rate Movements. According to this chapter, have banks been able to
insulate themselves against interest rate movements? Explain.
ANSWER: Banks can attempt to minimize their exposure to interest rate risk because they have the
flexibility to use assets whose rate sensitivity is similar to the liabilities. Yet, banks are unable to
perfectly match the rate sensitivity of assets and liabilities. Research has found that bank values are
typically inversely related to interest rates.
10. Gap Management. What is a bank’s gap, and what does it attempt to determine? Interpret a negative
gap. What are some limitations of measuring a bank's gap?
Chapter 19/Bank Management y 203
ANSWER: A bank gap is measured to determine its exposure to interest rate risk. A negative gap
implies that a bank would be adversely affected by rising interest rates, since the value of rate-
sensitive liabilities exceeds the value of rate-sensitive assets.
Value of Value of
Gap = rate-sensitive – rate-sensitive
It is difficult to classify some assets or liabilities as rate sensitive or rate insensitive, since the degree
of rate sensitivity may vary within a given classification.
11. Duration. How do banks use duration analysis?
ANSWER: Banks measure duration of assets and liabilities so that they can determine whether their
assets are more or less rate-sensitive than their liabilities.
12. Measuring Interest Rate Risk. Why do loans that can be prepaid on a moment’s notice complicate
the bank’s assessment of interest rate risk?
ANSWER: A fixed-rate loan may be perceived as rate insensitive. Yet, if it is prepaid, the funds are
loaned out to someone else at the prevailing rate. Therefore, this type of loan can be sensitive to
13. Bank Management Dilemma. Can a bank simultaneously maximize return and minimize default
risk? If not, what can it do instead?
ANSWER: Banks cannot maximize return unless they incur some default risk, so they must balance
the risk and return objectives, based on their degree of risk aversion.
14. Bank Exposure to Economic Conditions. As economic conditions change, how do banks adjust
their asset portfolio?
ANSWER: Expectations of a stronger economy may encourage banks to provide more risky loans,
since the probability of default may decrease, and the potential return is higher. Expectations of a
weaker economy may encourage banks to use a more conservative approach. Expectations of higher
(lower) interest rates encourage banks to have more rate sensitive assets (liabilities).
15. Bank Loan Diversification. In what two ways should a bank diversify its loans? Why? Is
international diversification of loans a viable solution to credit risk? Defend your answer.
ANSWER: Banks should diversify across geographic regions and industries, to reduce exposure to
Not necessarily. If the countries receiving loans tend to experience similar business cycles,
international diversification of loans has only limited effectiveness. International diversification of
loans to creditworthy borrowers has some merit, but the creditworthiness criterion should not be
ignored just to achieve international diversification.
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16. Commercial Borrowing. Do all commercial borrowers receive the same interest rate on loans?
ANSWER: Interest rates on loans at a given point in time are dependent on the degree of risk of the
17. Bank Dividend Policy. Why might a bank retain some excess earnings rather than distribute them as
ANSWER: Banks retain earnings as a source of capital.
18. Managing Interest Rate Risk. If a bank has more rate-sensitive liabilities than rate-sensitive assets,
what will happen to its net interest margin during a period of rising interest rates? During a period of
declining interest rates?
ANSWER: During a period of rising interest rates, the bank’s net interest margin will decline. During
a period of declining interest rates, the bank’s net interest margin will increase.
19. Floating-Rate Loans. Does the use of floating-rate loans eliminate interest rate risk? Explain.
ANSWER: The use of floating-rate loans may reduce interest rate risk, but not eliminate it, because
the rate sensitivity on assets will still not match up perfectly with the rate sensitivity on liabilities.
20. Asian Crisis. Explain why bank decision making is sometimes blamed for the Asian crisis.
ANSWER: Bank credit was literally provided to some firms that did not deserve credit. Once
economic conditions deteriorated, those firms experienced financial problems.
21. Managing Exchange Rate Risk. Explain how banks become exposed to exchange rate risk.
ANSWER: When banks accept deposits in one currency and provide loans in a different currency,
they are exposed to exchange rate risk. Banks whose currency composition of assets differ from the
currency composition of liabilities are exposed to exchange rate risk. Banks may also become
exposed if they offer forward contracts that are not offset by opposite commitments.
1. Net Interest Margin. Suppose a bank earns $201 million in interest revenue but pays $156 million in
interest expense. It also has $800 million in earning assets. What is its net interest margin?
Interest revenues – Interest expenses
Net interest margin =
$201 million – $156 million
Chapter 19/Bank Management y 205
2. Calculating Return on Assets. If a bank earns $169 million net profit after tax and has $17 billion
invested in assets, what is its return on assets?
net profit after taxes
= . 99 %
3. Calculating Return on Equity. If a bank earns $75 million net profits after tax and has $7.5 billion
invested in assets and $600 million equity investment, what is its return on equity?
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net profit after tax
4. Managing Risk. Use the balance sheet for San Diego Bank in Exhibit A (next page) and the industry
norms in Exhibit B (page following Exhibit A) to answer the following questions:
a. Estimate the gap and determine how San Diego Bank would be affected by an increase in interest
rates over time.
Gap = Rate-sensitive assets – Rate-sensitive liabilities
= $0 – $18 billion
= –$18 billion
The bank would be adversely affected by rising interest rates.
b. Assess San Diego Bank's credit risk. Does it appear high or low relative to the industry? Would
San Diego Bank perform better or worse than other banks during a recession?
ANSWER: The bank has a greater proportion of commercial and consumer loans than the industry
average, and therefore appears to have greater default risk.
c. For any type of bank risk that appears to be higher than the industry, explain how the balance
sheet could be restructured to reduce the risk.
ANSWER: The bank could reduce its interest rate risk by using floating-rate loans and by trying to
attract some funds through medium-term (one- to five-year) CDs. It could reduce the default risk by
restructuring its asset portfolio to contain more Treasury and municipal securities, less consumer
loans, and less commercial loans.
Chapter 19/Bank Management y 207
Exhibit A: Balance Sheet for San Diego Bank
(in Millions of Dollars)
Assets Liabilities and Capital
Required $800 Demand Deposits $800
Commercial NOW Accounts $2,500
Fixed-rate $7,000 MMDAs $6,000
Consumer loans $5,000 Short-term $9,000
From 1 to 5 years None
Mortgages Total $9,000
Fixed-rate $2,000 Federal funds $500
Long-term bonds $400
Short-term None Capital $800
Fixed Assets $500
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TOTAL AND CAPITAL
ASSETS $20,000 $20,000
Exhibit B: Industry Norms in Percentage Terms
Assets Liabilities and Capital
Required reserves 4% Demand Deposits 17%
Commercial loans NOW Accounts 10%
Fixed-rate 11% MMDAs 20%
Consumer loans 20% Short-term 35%
From 1 to 5 years 10%
Mortgages Total 45%
Fixed-rate 3% Long-term bonds 2%
Total 10% Capital 6%
Fixed Assets 5% __________
TOTAL ASSETS 100% AND CAPITAL 100%
Chapter 19/Bank Management y 209
5. Measuring Risk. Montana Bank wants to determine the sensitivity of its stock returns to interest rate
movements, based on the following information:
Quarter Return on Montana Stock Return on Market Interest Rate
1 2% 3% 6.0%
2 2 2 7.5
3 –1 –2 9.0
4 0 –1 8.2
5 2 1 7.3
6 –3 –4 8.1
7 1 5 7.4
8 0 1 9.1
9 –2 0 8.2
10 1 –1 7.1
11 3 3 6.4
12 6 4 5.5
Use a regression model in which Montana’s stock return is dependent on the stock market return and
the interest rate. Determine the relationship between the interest rate and Montana’s stock return by
assessing the regression coefficient applied to the interest rate. Is the sign of the coefficient positive
or negative? What does it suggest about the bank’s exposure to interest rate risk. Should Montana
Bank be concerned about rising or declining interest rate movements in the future?
ANSWER: The coefficient for the market variable is 0.38, while the coefficient for the interest rate
variable is –1.15. The t-statistics for the coefficients suggest significance at the 0.10 level for the
market variable, and at the 0.05 level for the interest rate variable. The R-Squared statistic is about
0.75, which suggests that 75 percent of the variation in Montana’s stock returns can be explained by
the market and interest rate variables.
The sign of the interest rate coefficient is negative, which implies a negative relationship between the
interest rate movements and the stock returns of Montana Bank. Therefore, Montana Bank would be
concerned about a potential increase in interest rates.
Some models use the change in the interest rate level rather than the interest rate level itself, but this
example simply illustrates how the bank could assess exposure to economic variables.