Quick Quiz: Market Risk
Insights Liquidity Position: Summary Ratios
Gap Analysis
Gap Analysis for Insights Bank and Trust
EAR report for Insights Bank and Trust

Quick Quiz: Market Risk

Directors are responsible for setting limits on their bank’s interest rate risk and monitoring their bank to ensure it stays within board-prescribed limits.
True
False	Policy guidance by the federal banking agencies make it the directors’ responsibility to set limits on a bank’s interest rate risk and to monitor the bank’s risk taking to ensure that it stays within established limits.

The federal banking agencies recommend that banks monitor their income and capital exposure to interest rate changes.
True
False	Because interest rate movements can affect a bank’s income and capital, the banking agencies recommend monitoring both.

The federal banking agencies recommend that an analysis of a bank’s interest rate risk exposure incorporate both a gradual rise in rates and a one-time jump in rates.
True
False	Policy guidance from the federal banking agencies recommends using a gradual rise and a 200 basis-point (2 percent) jump in interest rates when estimating a bank’s market risk exposure.

Gap is a useful tool for assessing the effects of interest rate changes on a bank’s capital position.
True
False	Gap is a useful tool for monitoring a bank’s income exposure to interest rate risk, but it doesn’t measure possible risks to the bank’s capital position. Moreover, gap analyses have weaknesses relative to the EAR and EVE methodologies in that gap is unable to measure optionality, basis and yield curve risk.

Assumptions used in modeling a bank’s interest rate exposure are an important determinant of the estimated exposure the bank faces.
True
False	The accuracy of a model in estimating a bank’s exposure to interest rate changes is highly dependent upon the accuracy of the assumptions underlying the model analysis.

Fill in the table below with the likely change in a bank’s net income (rise or fall) from an interest rate change if the bank is negatively or positively gapped.

Back to top

Insights Liquidity Position: Summary Ratios

Provided below are the liquidity summary ratios for Insights Bank and Trust.

What is your evaluation of liquidity trends at the bank? Is the liquidity increasing, decreasing or remaining stable?
	Increasing	The correct answer is Decreasing. Insight Bank’s liquidity position is tightening. The ratios in the table are rising, indicating falling liquidity. To fund the "Vision for Success" program, the bank has been selling securities, reducing its liquidity. Also, there is growing dependence on noncore funds. These funds could be difficult and costly to replace if the bank’s creditworthiness comes into question.
	Decreasing
	Remaining stable

In light of your evaluation of liquidity trends, how would you vote on the ALCO ’s recommendation to sell the bank’s low-yielding Treasury notes and buy the higher yield notes being offered by the Federal Home Loan Bank? Would you vote for or against the motion to buy the notes?
	Vote yes, to buy the notes	The correct answer would be to Vote no, do not buy the notes. Tying up the bank’s funds in a five-year, illiquid note issued by the Federal Home Loan Bank may not be a wise move given the liquidity strains at the bank. Consequently, the ALCO’s recommendation to the board is not a good one. It may be better to keep the bank’s funds in more liquid investments that can be sold quickly to fund additional loan growth. Madison isn’t trying to harm the bank, but, by totally focusing on the bank’s bottom line, she is ignoring the bank’s liquidity needs and exposing it to greater liquidity risk. The lesson here is always to consider the total needs of the bank in your decision-making.
	Vote no, do not buy the notes

Back to top

Gap Analysis

Below is a Gap analysis worksheet for Bank A. Use the worksheet to answer the following:

Is this bank positively or negatively gapped in the short run?
	Positively gapped
	Negatively gapped	The correct response is Negatively gapped. The bank is negatively gapped over the short run. Within the next three months, $25.8 million of its liabilities will mature or reprice, while only $16.9 million in assets will. This results in a gap of -$8.9 million (9.8 percent of earning assets) and a ratio of risk-sensitive assets to risk-sensitive liabilities of 0.66 during the zero to three month time frame. Notice that the negative gap reverses itself within six months.   Rise in rates expected Fall in rates expected Negatively gapped Net income will fall Net income will rise Positively gapped Net income will rise Net income will fall The negatively and positively gapped designations can be taken as indications of the relationship between interest rate changes and corresponding changes in net interest income. For instance, a negatively gapped bank’s net interest income will move in the opposite direction of the change in interest rates. A positively gapped bank’s net interest income will move in the same direction as the change in interest rates.

If interest rates rise significantly within the next three months, what is likely to happen to earnings?
	Earnings will rise
	Earnings will fall	The correct answer is Earnings will fall. If rates rise, earnings at this bank will fall over the next quarter. This is because many of its liabilities—its NOW accounts, MMDAs, savings deposits, etc.—will start paying the new, higher rates right away, while most of its earning assets will continue to generate revenue at the old, lower rates. Only after six months, when the value of repriced assets exceeds the value of repriced liabilities, will earnings return to normal.
	Earnings will remain the same

Back to top

Gap Analysis for Insights Bank and Trust

Assets	0-1 Months	1-3 Months	3-6 Months	6-12 Months
Federal funds sold	0	0	0	0
Due from banks	0	0	0	0
U.S. Gov't securities	1,581	0	1,500	3,000
Municipals	92	0	0	0
Other Securities	0	0	0	0
Loans - fixed	200	200	1,845	2,697
Loans - floating	3,445	550	1,155	2,419
Total rate-sensitive assets	5,318	550	1,155	2,419
Liabilities
NOW accounts	200	300	500	1,000
Money market deposits	3,928	0	0	0
Savings accounts	100	100	100	200
CDs < $100M	783	704	1,508	1,056
CDs >100M	1,163	1,046	3,488	1,860
Federal funds purchased	2,500	0	0	0
Other borrowed money	0	0	100	0
Total rate-sensitive lia.	8,674	2,150	5,696	4,116
RSA-RSL (interval gap)	(3,355)	(1,400)	(1,196)	4,000
RSA-RSL (cumulative gap)	(3,355)	(4,756)	(5,952)	(1,952)
RSA/RSL	0.61	0.56	0.64	0.91
Gap/earning assets%	(7.99)	(11.32)	(14.17)	(4.65)

Caption: Gap Analysis for Insights Bank

How is the bank gapped (use the six- to 12-month cumulative gap)?
	Positively gapped
	Negatively gapped	The correct answer is Negatively gapped. The bank is negatively gapped ($1,952). A bank’s gap over a given time period is the difference between the value of its assets that mature or reprice during that period and the value of its liabilities that mature or reprice during that period. If this difference is large (in either a positive or negative direction), then interest rate changes will have large effects on net interest income. The positive and negative direction of the gap for a bank is also useful information. For instance, if your bank is positively gapped (Rate-Sensitive Assets [RSA] are greater than Rate-Sensitive Liabilities [RSL]), its net interest income will move in the same direction as the change in interest rates. If interest rates increase, net interest income will increase; if interest rates fall, so will net interest income. On the other hand, if your bank is negatively gapped (RSLs exceed RSAs), then its net interest income will move in the opposite direction of interest rate changes. If rates increase, net interest income will fall; if rates fall, net interest income will rise. Because most banks use short-maturity deposits to fund long-maturity loans, most banks have negative short-run gaps.

What is the Asset and Liability Committee’s (ALCO) expectation with respect to interest rate changes in the near future? Does the committee expect rates to rise or fall? Review the transcript.
	Interest rates will rise
	Interest rates will fall	The ALCO ’s expectation is that interest rates will rise.
	Interest rates will remain the same

Given the bank’s gap position, what will happen to the bank’s net interest income if rates move as expected? Will it rise or fall?
	Net interest income will rise
	Net interest income will fall	The correct answer is that the bank’s net interest income will likely fall as interest rates rise. The bank is negatively gapped, which indicates a negative relationship between interest rate changes and net interest income. As rates rise, income will fall.
	Net interest income will remain the same

Back to top

EAR report for Insights Bank and Trust

Below is the EAR report for Insights Bank and Trust. Use the report to answer the following:

• What does the model forecast is likely to happen to earnings over the next year? Looking at the interest-rate projections, what do you think is causing this change?

• What seems suspicious about the projections here? As applies in other types of reports, look for changes in trends or time periods, discrepancies among the numbers or anything that might look unusual.

• What is happening to the confidence interval on ROA over time? What does this tell you about the precision of the forecast?

What does the model forecast is likely to happen to earnings over the next year? Looking at the interest-rate projections, what do you think is causing this change?

Remember, Earnings At Risk models provide forecasts based on assumptions about what will happen to interest rates and how the bank will respond. The best way to assess the output from such a model is to ask a lot of questions about the underlying assumptions and the level of confidence associated with the forecast. Though you will not be responsible for selecting or defending the assumptions surrounding an EAR model, you need to verify that the creators of these models have thoughtfully considered all of the underlying issues.