FALL 2012 MONEY AND BANKING (MGT411)

ASSIGNMENT # 2 DUE DATE: 8TH JANUARY, 2013 MARKS: 30

Learning Objectives: The first question will enable the students to understand liquidity risk and various ways to mitigate this risk. The second question will enable the students to understand interest rate risk and the effect of this risk on the profitability of the banks.

Question No. 1: a) You are a bank manager and given the responsibility to manage the liquidity risk being faced by the bank. The Balance Sheet of the bank is given below: Table: Balance sheet of a bank holding no excess reserves Assets (in Million) Liabilities (in Million) Reserves Rs.15 Deposits million million funds Loans Rs.95 Borrowed million million Securities Rs.35 Bank capital n million million

Rs.90 Rs.35 Rs.100millio Rs.20

A customer demands Rs.5 million cash withdrawals from the bank; what changes in the above Balance Sheet will occur if you decide to manage the liquidity risk through: 1. Adjusting assets by: a. Selling the securities b. Reducing the loans 2. Adjusting liabilities by: a. Borrowings b. Attracting deposits Note: You are required to prepare four different Balance Sheets for each of the above mentioned strategies. (10 marks)

b) Discuss why bankers prefer liability management over asset management in order to mitigate liquidity risk? (5 marks)

Question No. 2: a) You, as a bank manager, are managing the banks assets and liabilities in such a way that interest rate the bank has to pay on its liabilities is 4% while interest rate the bank charges on its various assets is 6%. Suppose 30% of the banks assets fall into the category of interest-sensitive while others are not sensitive to the changes in interest rate. Similarly, half of the banks liabilities are interest-sensitive while rests of the half are not. What will be the impact on the profitability of the bank if the interest rate rises by 1% on all assets and liabilities of the bank? (10 marks)

b) What will be the impact of increase in interest rate on the profitability of the bank if the bank has more interest-sensitive liabilities than interest-sensitive assets? (5 marks)

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