Bank's Asset Liability Duration question, interest, deposits, decrease, commercial

jbaldyga

A question from Q-bank:

A commercial bank takes in short-term deposits and uses those funds to make longer term loans. As such, the duration of the bank's assets tends to be longer than the duration of the bank's liabilities. What will happen when interest rates?

a) assets will decrease in value by more than the bank's liabilities causing the bank's equity (surplus) to decrease

b) liabilities will decrease in value by more than the bank's assets causing the bank's equity (surplus) to increase

c) assets will increase in value by more than the bank's liabilities causing the bank's equity (surplus) to decrease.

The correct answer is A.

Can anyone provide an explanation and how to go about thinking through this problem?

Chuckrox

If correct answer is A, then I/R shall falls.

wake2000

When interest rate rises, value of bonds and other interest rate instruments fall.

Now the extent to how much it falls depends on the duration of those instruments. Since assets are long term, its duration will be more than liabilities and thus will be impacted more. Surplus will decrease.

Zestt

The answer is A.

Step 1: When a bank has short term liabilities, the duration of the these liabilities is small and also negative. Note that. Once you get that concept you are on your way.

Step 2: When the assets are long term, the duration is higher and also positive.

Step 3: Add the durations of the long term assets and the short term liabilities to get the real position of the equity/surplus. You will get a net positive duration.

Step 4: Determine the effect of interest rate on this net duration.