Question 1
Banks use repricing gap as a risk management technique that is used to evaluate the uncertainty of income accrued from the net interest income primarily attributable to interest from payments of loans and advance s less interest paid on customer deposits subject to change in interest rates. It is also the difference in value of assets and liabilities in consideration of interest rate changes within a certain range of maturity also known as time buckets. In order to calculate the repricing gap one needs to list the assets and liabilities of a bank in relations to their time buckets, say; matured, maturity up to one month, maturity up to 3 months, maturity up to 9 months and so on, then get the net of assets and liabilities by getting the difference between the assets and liabilities within the respective maturity time buckets. The sum of the repricing gaps will form the cumulative gap. The time breaks or maturity buckets within which changes of interest rates can occur is known rate sensitivity. The cumulative gap would assist an analyst in depicting the cumulative sensitivity of net interest income of a financial institution.
The life insurance and commercial banks are financial institutions whose statement of financial position are indifferent contrast to them being in a similar industry. The life insurance company as a ‘financial institution that offers protection to individuals and their respective families from death through a deposit termed as a premium whereas a commercial bank is a financial institution that accepts deposits in terms of cash and issues loans.’ The difference in assets and liabilities is majorly depicted on maturity of instruments. For life insurance companies the liabilities are usually maturity payments that are usually long term whereas the premiums received are placed in long term investments as corporate and government bonds and sometimes mortgage assets. As for corporate banks, the assets are between short, medium and long term maturities. On the liabilities we have mainly deposits whose terms are short term and middle term. Another difference between the two institutions is the pay-outs. As for banks, term deposits are definite and known at the time of maturity unlike insurance which depends on a stochastic formulae to determine the maturity amount.
Financial institutions also enjoy diversification by acquiring a pool of loans and advances hence developing a portfolio. The banks enjoy the risk mitigation as loans are subjected to interest rate risks amongst other financial risks. For instance, a bank that has a mixture of long term and short term loans is a plus where the economy has volatilities in interest rates than a bank that has a single or individual loan. Concentration risk is also a menace when it comes to loans and advances. Loan concentration risk is having a large portion of a loan portfolio in one defined group, be it a sector, and industry, clientele, etc.
The difference between revolving loans and non-revolving loans is dependent on replenishment of payments. The revolving credit keeps on toping up once paid whereas the non-revolving ends on maturity.
Question 2
The growth of a financial institution off balance sheet item depends on its contingent assets and liabilities. Off Balance sheet items are usually contingent contracts that involve borrowings and payments. For instance, a borrower who’s granted a loan limit to operate becomes part of off balance sheet. If then the borrower uses the limit then it becomes an on balance sheet loan. Similarly, the off balance sheet can grow in terms of liabilities. For instance, through the custodian, the bank can offer a letter of credit to facilitate trade payments in the event of default then it results to an off balance sheet liability. The increase of off balance sheet items may occur due to unforeseen granted loan limits and letters of credits and guarantees.
When issued trading takes place in treasury securities where parties exchange monies in payment of securities not issued. A financial institution then can by exposed to interest rate risks when trading in forward purchases of treasury instruments. Most often the treasurer of a financial institution would buy the instrument based on the prevailing yields of the market factoring inflation and other market oriented parameters. It is in this calculation that might expose the financial institution to interest rate risk due to under-pricing. Suppose a bank purchased a forward treasury bill at $100 dollars for a tenure of 3 months and the prevailing yield is 8% and the treasurer anticipates that the treasury department will issue the bill at 10% and then sells the bill at 11% but instead the treasury department offers the bill at 6%, this will mean that the bank will make less profit as opposed to what it should have made at the prevailing yield.
Financial Institutions are usually exposed to drawdown risk related to uncertainty of funding required to fund the drawdown as the clients are not usually subjected to optimal draw downs. The uncertainties resultant to the financial operations comes with a price in cases where low levels of liquidity are maintained and cannot accommodate the drawdowns. Aggregate funding risk on the other hand happens when all clients demand for loans from the drawdown facility which ultimately result to credit risk. The common factor between takedowns and aggregate risk is the rise of interest rates as the economy tends to increase demand and the facility becomes depleted.
Question 3
Futures are types of derivatives also known as hedge instruments that are made on future exchanges whose contract is binding to either buy or sell at a stated future date and specified price. The future contract require margins and cash flows on a daily basis to hedge the risk. The margin refers to the amount of money a future trader must put up to open an account to start trading. The cash flows obtained from the profits must be kept within the margin limits.
A letter of credit acts as an insurance product as it ‘offers commitment or guarantee to a seller of a good that on default of the purchaser to make payment, then the financial institution the fronts the payment. Insurance contracts covers insured from underlying but unforeseen risks.
Considering an insurance company that plans to sell a bill of 6months maturity in 3 Months can sell the bill in forward contract to mitigate and hedge against the interest rate risk. In a case where a bank has an asset maturing at 13 years and a liability maturing at 7 years, then the bank can buy a forward contract to hedge the interest rate risk for the remaining 6 years.
Question 4
Commercial Banks are involved in the implementation of monetary policy by defining a bottom line reserve requirement along with a discount rate. The purchase of treasury bills through open markets also ensure that banks participate in the implementation of monetary policy. Technology, though a positive change it is still a disrupter in the financial services market.
Banks are using technology as a competitive edge through innovations of best and efficient services. Cash withdrawals, deposits and even customer complaints have been channelled to online and application facilities. This has then resulted to competition risk as companies strive to franchise and embrace this technology at the expense on increasing operational costs.
The regulators use financial institutions to control the supply and demand of money in the economy. The higher the requirement the less the financial institutions lending margins. This means that the whenever there is excess circulation of money then the regulator increases the reserve requirement. It is also through the reserve requirement that the regulator is able to control inflation.
Question 5
Exchange settlement accounts are defined as ‘the means that financial payments are settled in clearing process.’ (Reserve Bank of Australia, 2017). The settlements have distinguished characteristics ranging from the manner of payment, interest payment and nature of transaction. The settlement mandates that all interbank payments should be done through the exchange which earns a payment of 25% below the regulator. The exchange is required not to overdraw the account and should be in credit in all times.
Financial institutions are able to offset the asset side liquidity risk attributable to loans commitment by having cash and cash requirements easily convertible to cash at minimal costs. The institutions can also mobilize customer deposits that have penalties in call offs, a good example is fixed deposits.
The holding of large amounts of cash benefits the institution by mitigating the risk of liquidity. Holding treasury instruments are considered as good instruments as they are easily convertible to cash.
Question 6
The value at risk is described as the potential and estimated losses that may be accruable to an investment on a daily basis attributable to changes in the market i.e. interest rates, foreign exchange or market yields. The value at risk differs from the maturity gap and repricing assessment in determining the effects of interest rate on the bank assets and liabilities in that, the value at risk considers the results of the historical events of the bank, how much losses the bank has made in relations to the interest risk, whereas the maturity gap is on an actual basis. Apart from interest rates, the models can be used to determine how much losses one can undertake due to volatilities in trading in foreign currency i.e. proprietary trading. Another use of the model is monitoring the losses attributable sue to trading government also known as available for sale due to volatilities in bond yields.
Discuss some of the shortcomings in the estimation of this approach.
The back simulation is a common practice embraced in calculating the value at risk of investment portfolios. This technique uses the confidence intervals which are subjected to the number of days used in observation for analytical purposes. The days used are weighted on a single digit hence limiting the analysis on accuracy as the model does not depict the actual changes in the market. As a point of remedy Monte Carlo approach is recommended.
The Bank for International settlement (BIS), introduced internal models approach for measuring market risk. This models with approval of bank regulators are then implemented. The models are based on a value at risk methodology that considers confidence intervals of 99% and a minimum ten day holding period. The model also restrains the charge to a historical approach where the charge should be higher than the previous losses over 60 days. In addition the BIS mandates that the banks should hold diverse types of capital, i.e. Tier 1 capital, tier 2 and tier 3 capital. However, FIs are allowed to hold three types of capital to meet this more conservative requirement. The first type of capital includes shareholders’ funds and retained earnings, whereas tier two includes capital includes subordinated debt. The last type of capital includes subordinated debt whose maturity is less than 2 years.
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