ECON248: Money and Banking Ch.6 Dr.

Mohammed Alwosabi

• The Bank Balance Sheet

Chapter 6 • Basic Banking
(Ch 9 in the Text) • General Principles of Bank Management
• Managing Credit Risk
• g g Interest Rate Risk
Managing
Banking and Management • Off-Balance-Sheet Activities
of Financial Institutions

1 2

• Because banking system plays a major The Bank Balance Sheet

role in channeling funds from the • To understand how banking works we start
savers/lenders to investors/borrowers, it is by looking at the bank balance sheet.
important to study • The bank balance sheet is a list of the bank
1. how the banking system runs its business assets (what bank owns) and liabilities
to maximize its profit, (what it owes) where
total assets = total liabilities + bank’s equity
2 how and why banks make loans
2. loans, and capital (net worth)
3. how they acquire funds and manage their • Banks make profits by receiving interest
assets and liabilities. rates on their asset holdings of securities
and loans that is higher than the expenses
of their liabilities.

3 4

Liabilities a. non-interest bearing checking account

• Liabilities are source of funds a bank uses (demand deposits),
to purchase assets. b. interest-bearing accounts (NOW accounts:
negotiable order of withdrawal), and
• Banks obtain funds by borrowing and by
c. money market deposit accounts (MMDAs).
issuing (selling) other liabilities such as
deposits. • MMDAs are not subject to reserve
requirements as checkable deposits are,
• Liabilities
Li biliti include:
i l d and are not included in the M1 definition of
1. Checkable Deposits. money.
• They are bank accounts that allow the
owner of the account to write checks to
third parties.
• Checkable deposits include: 5 6

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

• Checkable deposits and money market 2. Non-transaction deposits.

deposit accounts are payable on demand, • They are the main source of bank funds.
which means if a depositor shows up at the • Owners cannot write checks on non-
bank and requests payment by making a transaction deposits, but the interest rates
withdrawal the bank must pay him paid on these deposits are usually higher
immediately. than those on checkable deposits.
• Similarly, if a person who receives a check • There are two basic types of non-
written on an account from a bank and transaction deposits:
presents that checks at the bank, it must
pay the funds out immediately. a. saving accounts and
b. time deposits (also called CDs).

7 8

• Saving accounts, which funds can be added 3. Borrowings.

to or withdrawn from at any time. • Banks also obtain funds by borrowing
• Time deposits have a fixed maturity length from the central bank, other commercial
and charge high penalties for early banks, and corporations.
withdrawal. They are less liquid than saving 4. Bank Capital.
accounts but earn higher interest rate. • Bank capital or net worth is the difference
• Deposits are the largest liability of banks b t
between total
t t l assets
t and
d total
t t l liabilities.
li biliti
• Bank capital is raised by selling new equity
(stock) or retained earnings.

9 10

Assets 1. Reserves.
• Assets are the uses to which funds are put. • Reserves include
• The funds obtained from issuing liabilities a. what banks keep with central bank, plus
are used to acquire income-earning assets
such as securities and loans. b. currency (papers and coins) kept in the
• Banks assets are referred to as uses of bank vaults.
funds, and the interest payments earned on • Reserves are held for two reasons:
them are what enable banks to make profit. a. it is required by regulations.
• Asset side of the balance sheet includes: • Banks must keep a fraction (required
reserve ratio) of the money in their
checkable deposits as reserve. This is
called required reserves.
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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

b. banks hold additional reserves, called 3. Cash items in process of collection.

excess reserves, to meet obligations when • When a check written on an account at
funds are withdrawn, directly by a another bank is deposited in your bank
depositors or indirectly when a check is and the funds for this check has not been
written on an account. collected from the other bank, it is an asset
2. Loans. for your bank because it is a claim on
• Banks make their profits primarily by another bank for funds that will be paid
issuing loans. within a few days.
• Because of the lack of liquidity and higher 4. Securities.
default risk, the bank earns its highest • A bank’s holdings of securities are an
return on loans. important income-earning asset.

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5. Deposits at other banks (corresponding Basic Banking

banking). • In general terms, banks make profits by
• Many small banks hold deposits in larger selling liabilities with one set of
banks in exchange for a variety of characteristics (a particular combination of
services, including check collection, maturity, liquidity, risk, size, and return) and
foreign exchange transactions, and help using the proceeds to buy assets with a
with securities purchase. different set of characteristics.
6. Other Assets. • This process is often referred to as asset
• The physical capital (bank buildings, transformation.
computer, and other equipment) owned by
the banks is included in this category.

15 16

• For example, a saving deposit held by one • The process of transforming assets and
person can provide the funds that enable providing a set of services (check clearing,
the bank to make a mortgage loan to record keeping, credit analysis, and so
another person. forth) is like any other production process in
• The bank has, in effect, transformed the a firm.
saving deposits (an asset held by the • If the bank produces desirable services at
depositor) to a mortgage loan (an asset held low cost and earns reasonable income on
by the bank). its assets, it earns profits; if not, the bank
suffers losses.

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

• To make the analysis of the operation of a • For example, if you have just opened a
bank more concrete, let us use a tool called checking account with a $100 bill.
T-account. • You have a $100 checkable deposit at a
• A T-account is a simplified balance sheet, bank (the First Bank), which shows up as a
with lines in the form of a T, that lists only $100 liability on the bank balance sheet.
the changes that occur in balance sheet • The bank now put your $100 bill into its
items starting from some initial balance vault so that the bank’s
bank s assets rise by the
sheet position. $100 increase in vault cash.

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• The T-account for the First Bank looks like • Note that opening a new checking account
this leads to an increase in the bank's reserves
Assets Liabilities equals to the increase in checkable
Vault cash +$100 Checkable deposits +100 deposits.
• Alternatively, suppose you had opened the
• Because vault cash is part of reserves, we account with a $100 check written on an
can rewrite the T
T-account
account as follows account at another bank (the Second Bank),
Assets Liabilities we would get the same result.
Reserves +$100 Checkable deposits +100 • The initial effect on the T-account of your
bank (the First Bank) is as follows:

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First Bank
Assets Liabilities Assets Liabilities
Cash items Checkable deposits +100 Reserves $100 checkable deposits $100
In process of +100
collection Second Bank
Assets Liabilities
• To collect the fund of its customer (you)
Reserves - $100 checkable deposits - $100
from the Second Bank, the First bank will
deposit the check in its account with the
central bank, and the central bank will • When a bank receives additional deposits, it
gains an equal amount of reserves; when it
collect the funds from the Second Bank. loses deposits, it loses an equal amount of
• If the central bank transfers the $100 of reserves.
reserves from the Second Bank to the First • To make a profit, bank rearranges its
Bank and the final balance sheet position of balance sheet when it experiences a change
the two banks are as follows in its deposits.
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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

• As we know, the bank obliged to keep a • To make a profit, the bank must put to
certain fraction of its checkable deposits as productive use all or part of the $90 of
required reserves. excess reserves it has available.
• This fraction is called required reserves • If the bank decides not to hold any excess
ratio (RRR). reserves but to make loans instead. The T-
• If the required reserves ratio is 10%, the account then looks like this
First Bank required reserves have increased
First Bank
by $10.
Assets Liabilities
First Bank
Required Reserves + $10 checkable deposits $100
Assets Liabilities
Loans + $90
Required Reserves + $10 checkable deposits $100
Excess Reserves + $90
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• The bank now is making profit because it GENERAL PRINCIPLES OF BANK

holds short term liabilities such as MANAGEMENT
checkable deposits and uses the proceeds • The bank manager has five primary
concerns:
to buy longer-term assets such as loans 1.To make sure that the bank has enough
with higher interest rates. ready cash to pay its depositors when there
• The above discussion has shown you how a are deposit-outflows (because depositors
bank operates. Now let us see how a bank make withdrawals and demand payment).
T keep
To k enoughh cashh on hand,
h d theth bank
b k
manages its assets and liabilities to earn the must engage in liquidity management,
highest profit. which is the acquisition of sufficiently liquid
assets to meet the bank obligations to
depositors.

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2.To pursue an acceptable low level of risk by Liquidity Management and the Role of
acquiring assets which have a low rate of Reserves
default (credit risk) and by diversifying
asset holdings (asset management). • To show how banks deal with deposit
3.To acquire funds at low cost (liability outflows that occur when depositors
management). withdraw cash or write checks that are
4.To decide the amount of capital the bank deposited in other banks let us assume that
should maintain and then acquire the the bank has the following initial balance
needed
d d capital
it l (capital
( it l adequacy
d
management). sheet with RRR=10%
5.To manage risks associated with financial
institution practices such as interest-rate
risk (the risk of earnings and returns on
bank assets that results from interest-rate
changes).
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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

First Bank Assets Liabilities

(numbers are in millions) Reserves $10 Deposits $90
Assets Liabilities Loans $80 Bank Capital $10
Reserves $20 Deposits $100 Securities $10
Loans $80 Bank Capital $ 10
Securities $10 • The bank loses $10 millions of deposits and
$10 million of reserves.
reserves However,
However its RR now
• From the above information we can see that is $9 millions and ER = $1 millions.
the bank has ER=$10 • The conclusion is that if the bank has ER, a
• If a $10 million deposit outflow occurs, the deposit outflow does not necessitate
bank’s balance sheet becomes changes in other parts of its balance sheet.
• The situation is quite different when a bank
31 does not hold ER 32

Assets Liabilities • After $10 million has been withdrawn from

Reserves $10 Deposits $100 deposits and hence reserves, the bank has a
Loans $90 Bank Capital $10 problem. The RR is $9 million, but the bank
Securities $10 has no reserves.
• When the bank suffers the $10 million • To eliminate this shortfall , the bank has
deposit outflows, its balance sheet becomes four options
Assets Liabilities
Reserves $0 Deposits $90
Loans $90 Bank Capital $10
Securities $10

33 34

1. To borrow the $9 million from other banks 2. To sell some of its securities to help cover
or corporations. The BS becomes the deposit outflow. For example, it might
Assets Liabilities sell $9 million of its securities and deposit
Reserves $ 9 Deposits $90 the proceeds with the central bank,
Loans $90 Borrowing from other resulting in the following BS
Securities $10 banks and corporations $9 Assets Liabilities
Bank Capital $10 Reserves
ese es $9 Deposits
epos ts $90
Loans $90 Bank Capital $10

• The cost of this activity is the interest rate Securities $1

on these borrowings. • The bank incurs some brokerage and other
transaction costs when it sells these
securities. In addition, it may not be the
35 right time to sell 36

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

3. To borrow $9 million in discount loans from 4. To reduce the bank’s loans by $9 million
the central bank. Its BS now would be and deposit the amount with the central
Assets Liabilities
bank. This transaction changes the BS as
follows
Reserves $9 Deposits $90
Assets Liabilities
Loans $90 Borrowing from the
Reserves $9 Deposits $90
Securities $10 central bank $9 Loans $81 Bank Capital $10
Bank Capital $10 Securities $10
• This process is the costliest way of
• The cost associated with discount loans is acquiring reserves because if the bank
the interest rate that must be paid to the refuses to renew the loans to some of its
central bank (called the discount rate). customers this will upset them and may
take their businesses away from he bank.
37 38

• And if the bank sells some of the loans off • ERs are insurance against the costs
to other banks, these loans will be sold associated with deposit outflows.
lower than their full value
• A bank is willing to pay the cost of holding
ER (the opportunity cost, the earnings
• The above discussion explains why banks forgone by not holding income-earning
hold ER even though loans or securities assets such as loans or securities) to insure
earn a higher return.
against loses due to deposit outflows.
• When a deposit outflow occurs, holding ER
allows the bank to escape the costs of (1) • Because ERs have a cost, banks also take
borrowing from other banks or other steps to protect themselves; for
corporations, (2) selling securities, (3) example, they might shift their holdings of
borrowing from the central bank, or (4) assets to more liquid securities (secondary
calling in or selling off loans. reserves).
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Asset Management (1)Banks try to find borrowers who will pay

• To maximize its profits, a bank must high interest rates and are unlikely to
default.
simultaneously seek
• Loans officers engage in screening of the
(1) the highest returns possible on loans and potential borrowers to reduce the adverse
securities, selection process.
(2) reduce risk, and (2) Banks try to purchase securities with high
(3) have efficient liquidity management. returns
t andd low
l risk.
i k
• In order for banks to accomplish these three (3) Banks must attempt to lower risk by
goals, they follow a strategy of asset diversifying their assets, and making
different types of loans to different types of
management that can be summarized in the customers.
following four basic ways.
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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

(4) Banks must manage the liquidity of their Liability Management

assets so that they can satisfy reserves • Banks aggressively set target goals for their
requirements without bearing huge costs.
asset growth and tried to acquire funds by
• This means that banks will hold some issuing liabilities as they were needed.
securities that are more liquid even if they
earn somewhat lower return than other • For example, when a bank finds an
assets. attractive loan opportunity it can acquire
• The
Th bank
b k mustt balance
b l its
it desire
d i for
f funds by selling negotiable CDs or through
liquidity against the increased earnings borrowing from the central bank fund
that can be obtained from less liquid market.
assets such as loans.

43 44

• Because of the increased flexibility and Capital Adequacy Management

importance of liability management, most • Banks have to make decisions about the
banks now manage both sides of the
balance sheet together in an asset-liability amount of capital they need to hold for three
management (ALM) committee. reasons.
(1)Bank capital helps prevents bank failure, a
situation in which the bank cannot satisfy
its obligations to pay its depositors and
other
th creditors.
dit
(2)The amount of capital affects returns for
the owners (equity-holders) of the bank.
(3)A minimum amount of bank capital (bank
capital requirements) is required by
regulatory authorities.
45 46

How Bank Capital Helps Prevent Bank Failure • Suppose a $5 million of bad loans to both
• Let us consider two banks with identical banks are written off (valued at zero), the
balance sheet except that the High Capital total value of assets declines by $5 million.
Bank has a ratio of capital to assets of 10% • As a consequence, bank capital, which
while the Low Capital Bank has a ratio of equals total assets minus liabilities, also
4%. declines by $5 million. The balance sheets
High Capital Bank of the two banks look like this.
Assets Liabilities High Capital Bank
Reserves $10 Deposits $90 Assets
A t Li biliti
Liabilities
Loans $90 Bank Capital $10 Reserves $10 Deposits $90
Loans $85 Bank Capital $5
Low Capital Bank
Assets Liabilities Low Capital Bank
Reserves $10 Deposits $96 Assets Liabilities
Loans $90 Bank Capital $4 Reserves $10 Deposits $96
47 Loans $85 Bank Capital - $1 48

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

• The High Capital Bank still has a positive How the Amount of Bank Capital Affects
net worth (bank capital) of $5 million after Returns to Equity Holders.
the loss. The value of Low Capital Bank’s • Because owners of a bank must know
assets has fallen below its liabilities and its whether their bank is being managed well,
net worth is now -$1 million. they need good measures of bank
profitability.
• The bank does not have sufficient assets to • A basic measure of profitability is the return
pay off all holders of its liabilities on assets (ROA), the net profit after taxes
(creditors) So,
(creditors). So it is insolvent and per dollar
d ll off assets.
t
government regulators will close the bank. net profit after taxes
• A bank maintains capital to lessen the ROA =
assets
chance that it will become insolvent. • The return on assets provides information
on how efficiently a bank is being run,
because it indicates how much profits are
generated on average by each dollar of
49 assets. 50

—However, what the bank’s owners (equity • There is a direct relationship between the
holders) care about most is how much the return on assets (which measure how
efficiently the bank is run) and the return on
bank is earning on their equity investment. equity (which measure how well the owners
—This information is provided by the other are doing on their investment).
basic measure of bank profitability, the • This relationship is determined by the so-
return on equity (ROE), the net profit after called equity multiplier (EM), which is the
amount of assets per dollar of equity capital
taxes per dollar of equity (bank) capital.
assets
net profit after taxes EM =
ROE = equity capital
equity capital

51 52

• Bank capital is costly because the higher it • In more uncertain times, when the
is the lower will be the return on equity for a possibility of large losses on loans
given return on assets. increases, bank managers might want to
• In determining the amount of bank capital, hold more capital to protect the equity
managers must decide how much of the holders.
increased safety that comes with higher • Conversely, if they have confidence that
capital they are willing to trade off against loan losses won’t occur, they might want to
the lower return on equity that comes with reduce the amount of capital, have a high
higher capital.
capital equity multiplier,
multiplier and thereby increase the
return on equity.

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

Managing Credit Risk • Adverse selection in loan markets occurs

• Banks and other financial institutions make because bad credit risks (the most likely to
default on their loans) are the ones who
loans that must be paid back in full. usually line up for loans.
• The possibility of default subjects the • In other words, those who are most likely to
financial institutions to credit risk. produce an adverse outcome are the most
• The economic concepts of adverse likely to be selected.
selection and moral hazard provide a • Borrowers with very risky investment
framework for understanding the principles projects
j t have
h muchh to
t gaini if their
th i projects
j t
that financial institutions have to follow to are successful. However, they are the least
reduce credit risk and make successful desirable borrowers because of the greater
possibility that they will be unable to pay
loans. back their loans.

55 56

• Moral hazard exists in loan markets because • The attempts of financial institutions to
borrowers may have incentives to engage in solve these problems help explain a number
activities that are undesirable from the
lenders point of view. In such situations, it of principles for managing credit risk such
is more likely that the lender will be as
subjected to the hazard of default. (1)screening and monitoring,
• To be profitable, financial institutions must
overcome the adverse selection and moral (2) establishment of long-term customer
hazard problems that make loan defaults relationships,
relationships
more likely. (3) loan commitments,
(4) collateral and compensating balance
requirements, and
(5) credit rationing.
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• Screening. • The lender uses the information collected

• Adverse selection in loan markets requires from the various forms the borrowers filled
that lenders screen out the bad credit risks in to evaluate how good a credit risk you are
from the good ones so that loans are by calculating your credit score, a statistical
profitable to them. measure derived from your answers that
• To accomplish effective screening, lenders predicts whether you are likely to have
must collect reliable information from trouble making g your
y loan payments.
p y
prospective borrowers. • Deciding on how good a risk you are cannot
• Effective screening together with be entirely scientific. Personal judgment of
information collection form an important the loan officer that is based on the
principle of credit risk management. experience and other factors is also
important.
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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

Monitoring and Enforcement of Restrictive • By monitoring borrowers activities to see

Covenants whether they are complying with the
• Once a loan has been made, the borrower restrictive covenants and by enforcing the
has an incentive to engage in risky activities covenants if they are not, lenders can make
that make it less likely that the loan will be sure the borrowers are not taking on risks at
paid off. their expense.
• To reduce this moral hazard,
hazard financial • The need for banks and other financial
institutions (the lenders) should write institutions to engage in screening and
provisions (restrictive covenants) into loan monitoring explains why they spend so
contracts that restrict borrowers from much money on auditing and information-
engaging in risky activities. collecting activities.

61 62

Specializing in Lending. • Similarly, by concentrating its lending on

• Banks often specialize in lending to local firms at specific industries, the bank
firms or to firms in particular industries. becomes more knowledgeable about these
• It looks like the bank is not diversifying its industries and is therefore better able to
portfolio of loans and thus exposing itself to predict which firms will be able to make
more risk. timely payments on their debts.
• However,
H th
the adverse
d selection
l ti problem
bl
requires the bank to screen out bad credit
risk.
• It is easier for the bank to collect
information about local firms and determine
their creditworthiness than doing the same
thing for firms far away. 63 64

Long-Term Customer Relationship • The long-term customer relationships

• Another principle of credit risk management reduce the costs of information collection
is to establish a long-term relationship with and make it easier to screen out bad credit
customers. risks. LT customer relationships enable
• This allows banks and other financial banks to deal with even unanticipated moral
institutions to obtain information about their hazard contingencies.
borrowers.
borrowers • The borrower has the incentive to avoid
• If a prospective borrower has had an risky activities that would upset the bank in
account with or loans from a bank over a order to preserve a long-term relationship
long period of time, a loan officer can look with the bank, which will make it easier to
at past activity on the accounts and learn get future loans at low interest rates. This
quite a bit about the borrower. behavior benefits both the bank and the
65
customer. 66

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

Loan Commitments • The advantage for the firm is that it has a

• Banks also create long-term relationships source of credit when it needs it.
and gather information by issuing loan • The advantage for the bank is that the loan
commitments to commercial customers. commitment promotes a long-term
• A loan commitment is a bank’s commitment relationship, which in turn facilitates
for a specified future period of time to information collection.
provide a firm with loans up to a given
amountt att an interest
i t t rate
t that
th t is
i tied
ti d to
t • A loan commitment agreement is a powerful
some market interest rate. method for reducing the bank’s costs for
• The majority of commercial and industrial screening and information collection.
loans are made under the loan commitment
arrangement.

67 68

Collateral and Compensating Balances • One particular form of collateral required

• Collateral requirements for loans are when a bank makes commercial loans is
important credit risk management tools. called compensating balances.
• Collateral is property promised to the lender • Compensating balances means that when a
as compensation if borrower defaults. firm receives a loan it must keep a required
• It lessens the consequences of adverse minimum amount of funds in a checking
selection
l ti because
b it reduces
d the
th lender’s
l d ’ account at the bank.
losses in the case of loan default. If a • By requiring the borrower to use a checking
borrower defaults on a loan, the lender can account at the bank, the bank can observe
sell the collateral and use the proceeds to the firm’s check payment practices, which
make up for it losses on the loan. may yield a great deal of information about
the borrower’s financial condition.
69 70

Managing Interest Rate Risk • Rate-sensitive: when interest rates change

• Interest-rate risk refers the risk of earnings frequently (at least once a year)
and returns that is associated with changes • Fixed-rate: when interest rates remain
in interest rates. unchanged for a long period (over a year)
• To see what interest-rate risk, let’s look at • Suppose the interest rates rise by 5%. The
the balance sheet of the First Bank income on assets increase by $1 million (=
Assets Liabilities 5% X $20 million of rate-sensitive assets),
Rate-sensitive
R t iti assetst $20 R
Rate-sensitive
t iti liabilities
li biliti $50 while
hil payments t on liabilities
li biliti increase
i by
b 2.5
25
Variable-rate and Variable-rate CDs million (= 5% x $50 million of rate-sensitive
short-term loans Money market deposit liabilities). Thus, the profits of the First Bank
Short-term securities Accounts
now decline by $1.5 million ($1m – $2.5m).
Fixed-rate assets $80 Fixed-rate liabilities $50
Reserves Checkable deposits
Long-term loans Saving deposits
Long-term securities Long-term CDs
71 72
Equity capital

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

• Conversely, if interest rates fall by 5%, the Gap and Duration Analysis
bank’s profits will increase by $1.5m. • The sensitivity of bank profits to changes in
• The conclusion is that if a bank has more interest rates can be measured more
rate-sensitive liabilities than assets, a rise in directly using gap analysis and /or duration
analysis.
interest rates will reduce bank profits and a
decline in interest rates will increase bank • Gap analysis refers to the difference
between the rate-sensitive assets and rate-
profits. sensitive
iti liabilities.
li biliti
• In our example, the gap is $20m – $50m = -
$30m.

73 74

• By multiplying the gap times the change in • Duration Analysis examines the sensitivity
the interest rate we can immediately obtain of the market value of bank’s total assets
the effect on bank profits. and liabilities to changes in interest rates.
• For example, when interest rates rise by 5% • Duration analysis involves using the
the change in profits is 5% x -$30m, which average (weighted) duration of a financial
equals -$1.5m. institution’s assets and liabilities to see how
the net worth responds to a change in
interest rates.
rates
• Suppose the average duration of the First
Bank’s assets is 3 years (the average
lifetime of stream of payments in 3 years),
and the average duration of its liabilities is 2
years.
75 76

• In addition, the bank has a $100m of assets • Similarly, a 5% decrease in interest rates
and $90m of liabilities. increase the net worth of the bank by 5% of
• Thus the bank capital is $10m (10% of the the total asset value.
assets). • Both gap analysis and duration analysis
• With a 5% increase in interest rate, the indicate that the First Bank will suffer if
market value of the bank’s assets falls by interest rates rise but it will gain if they fall.
15% (= -5% x 3). However, the market value
off the
th liabilities
li biliti ffalls
ll by
b 10% ((= -5%
5% x 2).
2)
Hence, the net worth has declined by 5% of
the total original asset value.

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ECON248: Money and Banking Ch.6 Dr. Mohammed Alwosabi

79 80

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