How do the supply of and demand for loan able funds, together, determines the interest rate?

Explain
with the help of diagram.
The loanable funds theory of interest rate determination views the level of interest rates in financial markets as
resulting from factors that affect the supply and demand for loanable funds. This is similar to the way that the
prices for goods and services in general are viewed as being the result of the forces of supply and demand for
those goods and services.
Figure 82(a) shows the effects of an increase in the supply curve for loanable funds, from SS to SS " (and
the resulting decrease in the equilibrium interest rate , from i * to i *" ), while F igure 82(b) shows the
effects of an increase in the demand curve for loanable funds, from DD to DD " (and the resulting increase
in the equilibrium interest rate , from( i * to i *" ).
(diagram)

How has the increased level of financial markets integration affected interest rates?
Increased financial market integration, or globalization, increases the speed with which interest rate changes and
volatility are transmitted among countries. The result of this quickening of global economic adjustment is to
increase the difficulty and uncertainty faced by the Federal Reserve as it attempts to manage economic activity
within the U.S. Further, because FIs have become increasingly more global in their activities, any change in
interest rate levels or volatility caused by Federal Reserve actions more quickly creates additional interest rate
risk issues for these companies.

What is the repricing gap? In using this model to evaluate interest rate risk, what is meant by rate
sensitivity? On what financial performance variable does the repricing model focus? Explain.
The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the
dollar value of liabilities that will reprice within a specific time period, where reprice means the potential to
receive a new interest rate. Rate sensitivity represents the time interval where repricing can occur. The model
focuses on the potential changes in the net interest income variable. In effect, if interest rates change, interest
income and interest expense will change as the various assets and liabilities are repriced, that is, receive new
interest rates.

Consider the following balance sheet positions for a financial institution:

i)
ii)
iii)

Rate-Sensitive Assets = $200 million;

Rate-Sensitive Assets = $100 million;
Rate-Sensitive Assets = $150 million;

Rate Sensitive Liabilities = $100 million

Rate Sensitive Liabilities = $150 million
Rate Sensitive Liabilities = $140 million

A. Calculate the repricing gap and the impact on net interest income of a 1 percent increase in interest
rates for each position.
B. Calculate the repricing gap and the impact on net interest income of a 1 percent decrease in interest
rates for each position.
C. What conclusion can you draw about the Repricing model from these results
Solution

R]=ate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million.

Repricing gap = RSA - RSL = $200 - $100 million = +$100 million.
NII = ($100 million)(.01) = +$1.0 million, or $1,000,000.

Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million.

Repricing gap = RSA - RSL = $100 - $150 million = -$50 million.
NII = (-$50 million)(.01) = -$0.5 million, or -$500,000.

Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million.

Repricing gap = RSA - RSL = $150 - $140 million = +$10 million.
NII = ($10 million)(.01) = +$0.1 million, or $100,000.

a. Calculate the impact on net interest income on each of the above situations assuming a 1 percent
decrease in interest rates.

b.

NII = ($100 million)(-.01) = -$1.0 million, or -$1,000,000.

NII = (-$50 million)(-.01) = +$0.5 million, or $500,000.

NII = ($10 million)(-.01) = -$0.1 million, or -$100,000.

What conclusion can you draw about the repricing model from these results?

The FIs in parts (1) and (3) are exposed to interest rate declines (positive repricing gap) while the FI in
part (2) is exposed to interest rate increases. The FI in part (3) has the lowest interest rate risk exposure
since the absolute value of the repricing gap is the lowest, while the opposite is true for part (1).

What is meant by Market Risk?

Market risk is the uncertainty of the effects of changes in economy-wide systematic factors that affect earnings
and stock prices of different firms in a similar manner. Some of these market-wide risk factors include
volatility, liquidity, interest-rate and inflationary expectation changes

Why is the measurement of Market risk Important to the managers of a financial institutions?
Measurement of market risk can help an FI manager in the following ways:
a. Provide information on the risk positions taken by individual traders.
b. Establish limit positions on each trader based on the market risk of their portfolios.
c. Help allocate resources to departments with lower market risks and appropriate returns.
d. Evaluate performance based on risks undertaken by traders in determining optimal bonuses.
e. Help develop more efficient internal models so as to avoid using standardized regulatory models.

What is meant by daily earnings at risk (DEAR) ? What are the three measurable components? What is
the price volatility component?
DEAR or Daily Earnings at Risk is defined as the estimated potential loss of a portfolio's value over a one-day
unwind period as a result of adverse moves in market conditions, such as changes in interest rates, foreign
exchange rates, and market volatility. DEAR is comprised of (a) the dollar value of the position, (b) the price
sensitivity of the assets to changes in the risk factor, and (c) the adverse move in the yield. The product of the
price sensitivity of the asset and the adverse move in the yield provides the price volatility component.

What are the five common risks to Financial Institutions? Explain each of them.

Default or credit risk of assets, interest rate risk caused by maturity mismatches between assets and liabilities,
liability withdrawal or liquidity risk, underwriting risk, and operating cost risks.

Identify and explain three economic disincentives that probably would dampen the flow of funds between
household savers of funds and corporate users of funds in an economic world without financial
intermediaries.
Investors generally are averse to purchasing securities directly because of (a) monitoring costs, (b) liquidity
costs, and (c) price risk.

Monitoring the activities of borrowers requires extensive time, expense, and

expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting
lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The longterm nature of corporate equity and debt would likely eliminate at least a portion of those households willing to
lend money, as the preference of many for near-cash liquidity would dominate the extra returns which may be
available. Third, the price risk of transactions on the secondary markets would increase without the information
flows and services generated by high volume.

Identify and explain the two functions in which financial Institutions may specialize that would enable
the smooth flow of funds from household savers to corporate users.
FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in
the asset transformation function. The brokerage function can benefit both savers and users of funds and can
vary according to the firm. FIs may provide only transaction services, such as discount brokerages, or they also
may offer advisory services which help reduce information costs, such as full-line firms like Merrill Lynch. The
asset transformation function is accomplished by issuing their own securities, such as deposits and insurance
policies that are more attractive to household savers, and using the proceeds to purchase the primary securities
of corporations. Thus, FIs take on the costs associated with the purchase of securities.

What are the four major types of loans made by U.S. commercial banks? What are the basic
distinguishing characteristics of each type of loan?

TYPES OF LOANS
1. Commercial and Industrial Loans
Syndicated loan: A loan provided by a group of FIs as opposed to a single lender.
Secured loan: A loan that is backed by a first claim on certain assets (collateral) of the borrower if default
occurs.
Unsecured loan: A loan that has only a general claim to the assets of the borrower if default occurs.
Spot loan: The loan amount is withdrawn by the borrower immediately.
Loan commitment: A credit facility with a maximum size and a maximum period of time over which the
borrower can withdraw funds; a line of credit.
Commercial paper: Unsecured short-term debt instrument issued by corporations.
2. Individual (Consumer) Loans
Revolving loan: A credit line on which a borrower can both draw and repay many times over the life of
the loan contract.
3. Other Loans

What is refinancing risk? Explain with the help of example.

The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset
investments
Refinancing risk is the uncertainty of the cost of a new source of funds that are being used to finance a longterm fixed-rate asset. This risk occurs when an FI is holding assets with maturities greater than the maturities of
its liabilities. For example, if a bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank
faces a risk of borrowing new deposits, or refinancing, at a higher rate in two years. Thus, interest rate increases
would reduce net interest income. The bank would benefit if the rates fall as the cost of renewing the deposits
would decrease, while the earning rate on the assets would not change. In this case, net interest income would
increase.
What is Market or Trading risk? And what modern conditions have led to an increase in this particular
type of risk for Financial Institutions?

Market risk: The risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange
rates, and other asset prices.
Market risk arises when FIs actively trade assets and liabilities (and derivatives) rather than hold them for
longer-term investment, funding, or hedging purposes.
Market risk is closely related to interest rate, equity return, and foreign exchange risk in that as these risks
increase or decrease, the overall risk of the FI is affected. However, market risk adds another dimension
resulting from its trading activity.

Why DOES Credit risk exist for Financial Institutions? And how does diversification affect an Financial
credit exposure?
Credit risk: The risk that the promised cash flows from loans and securities held by FIs may not be paid in
full.
Firm-specific credit risk: The risk of default of the borrowing firm associated with the specific types of
project risk taken by that firm.
Systematic credit risk: The risk of default associated with general economy wide or macro conditions
affecting all borrowers.

Liquidity risk arises when financial Institutions liability holders such as depositors or insurance policy
holders, demand immediate cash for the financial claims they hold with a Financial Institutions. Explain.
Liquidity risk: arises when an FIs liability holders, such as depositors or insurance policyholders, demand
immediate cash for the financial claims they hold with an FI or when holders of off-balance-sheet loan
commitments (or credit lines) suddenly exercise their right to borrow (draw down their loan commitments). In
recent years, the Federal Reserve has expressed concerns about both liability-side and asset-side (loan
commitment) liquidity risks.

Benefits of Market Risk Measurement (MRM)

1. Management information. MRM provides senior management with information on the risk exposure taken
by FI traders. Management can then compare this risk exposure to the FIs capital resources.
2. Setting limits. MRM considers the market risk of traders portfolios, which will lead to the establishment of
economically logical position limits per trader in each area of trading.
3. Resource allocation. MRM involves the comparison of returns to market risks in different areas of trading,
which may allow for the identification of areas with the greatest potential return per unit of risk into which more
capital and resources can be directed.
4. Performance evaluation. MRM, relatedly, considers the return-risk ratio of traders, which may allow a more
rational bonus (compensation) system to be put in place. That is, those traders with the highest returns may
simply be the ones who have taken the largest risks. It is not clear that they should receive higher compensation
than traders with lower returns and lower risk exposures.
5. Regulation. With the Bank for International Settlements (BIS) and Federal Reserve currently regulating
market risk through capital requirements (discussed later in this chapter), private sector benchmarks are
important, since it is possible that regulators will overprice some risks. MRM conducted by the FI can be used
to point to potential misallocations of resources as a result of prudential regulation. As a result, in certain cases
regulators are allowing banks to use their own (internal) models to calculate their capital requirements.

Q.1 What is meant by the Financial Sector Stability. Evaluate the overall Financial Sector stability in
year 2015 as compared to Year 2014.
Q.2. What is meant by Banking Sector Stability Map? Evaluate the Pakistan Banking sector stability
across various dimensions on growth and soundness highlighted in the Banking Stability Map in the
Financial Stability Review (FSR) 2015.
Q.3. what are the main issues and challenges that may pose risks to the stability of financial sector in
Pakistan in the forthcoming period. ?
Q.1 Describe briefly the key important points discussed in the FSR 2015 Section under the Process of
Financial Intermediation.
Q.2 What is Advances to Deposit ratio (ADR)? Significance? And what are the main factors behind the
its declining trend as shown in Figure 1.3.
Q.3 what are the factors attributed to sluggish and slowdown in Consumer financing trend during the
period of 2008-12? and how it performing now days? Explain briefly.