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Banking and Finance Assessment

Task

Word Limit

There is a word limit for each question. Footnotes/references are not included in the word count. The most important thing is to answer the question in a succinct manner. This means that your answer can consist of a word count less than the imposed word limit. A ten percent (10%) leeway on word counts is permitted.

Footnotes/references must be used for citation purposes only and not for the development of your arguments. A bibliography is not required for this assessment task.

You are a manager at OakReach Bank in charge of interest rate risk. Your team has computed the 1-year repricing GAP to be -600 million AUD (negative GAP). For the purpose of this situation we are not taking into account other GAP timeframes.

  1. Describe in one sentence what OakReach Bank’s GAP tells you about your bank’s rate-sensitive assets relative to its rate-sensitive liabilities (2 mark)
  2. Your chief economist anticipates continuing inflation pressure into 2022, which they predict will force the RBA’s hand to increase benchmark interest rates. Assume your chief economist is correct in their prediction. Design an interest rate swap such that changes in interest rates have no impact on your bank’s change in net income. (6 marks)

Rosy Bank is a well-diversified bank that lends to both consumers, and small and large corporations. In the past week its credit department received a number of loan applications from different companies. The loan officer is ready to approve 25 applications with a total volume of $125 million. Each loan is $5 million. All loans have equal risk and an interest rate of 4%. All loans have a 5 year maturity.

Before sending the final approval to each company, you are asked to find an appropriate funding method. Your team in the liability management department has computed the marginal and total profit for each option. Note that the amount listed is the exact amount to be raised using this funding option.

Funding option

 

Amount ($ million)

 

Interest rate

 

Marg. Profit

Total Profit

5-year CD

75

2.60%

1.4%

$1.05 million

3-year bond

125

2.80%

0.9%

$1.50 million

1. Discuss your preferred funding option and motivate your choice. Note: you need to choose 1 option at this point. (5 marks)

After years of steady growth and maintaining a rather conservative risk profile the bank has recently been sold to a large institutional investor. The institutional investor, BigCapital LLC, aims to achieve an 18% ROE at Rosy Bank. We obtain the following additional information:

Operating costs

$100 million

Earning assets

$2,500 million

Tax rate

35%

Equity

$300 million

 

2. Using your selected funding option under a., which interest rate does Rosy Bank charge on the new loans, keeping in mind the 18% ROE target? You don’t need to take into account the yield on existing assets. (5 marks)

 

3. Assume now that the cost of liabilities, the yield on assets, profit margin, and asset yield is fixed. Which other actions might Rosy Bank take to achieve the 18% target ROE? List two actions and motivate briefly. (4 marks)

Titanium Bank, a bank headquartered in Australia has issued a large volume of loans to corporations in Indonesia. Currently, 35% of loans on Titanium’s balance sheet are issued in AUD to Indonesian corporations.

1. Use Titanium Bank’s situation to describe the relation between foreign exchange risk and credit risk. (3 marks)

 

2. What can Titanium Bank do to mitigate the risk(s)? List 2 options. (3 marks)

Wonder Bank is an established player in the Australian market with the following liability side.

Liabilities

Amount ($ billion)

Withdrawable deposits

400

Long-term debt

120

Coco bonds (Tier 2)

10

Share premium reserve

10

Common shares

40

In addition, the bank holds the following off-balance sheet items. Risk weights for all off-balance sheet items are 100%.

Item

Amount ($ billion)

Current exposure

Credit conversion factor

Letters of credit

50

-

30%

3-year Interest Rate Swap

100

$5 billion out of the money

5%

 

1. Compute Wonder Bank’s off-balance sheet risk-weighted assets. (3 marks)

 

2. Assume that the minimum Tier 1 capital ratio is 8%, and the minimum Total capital ratio is 10.5%. Wonder Bank has $406 billion in on-balance sheet risk-weighted assets. Compute the bank’s Tier 1 capital ratio and total capital ratio (2 decimals), and interpret. (7 marks)

Discuss the potential impact of Decentralized Finance (DeFi) applications on commercial banks. Relate your answer to the reason why banks exist.

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