Question

TCO C) A bank has $125 million in three (3) year loans earning a fixed rate equal to 6.5%. The assets are funded by $125 million in liabilities that have a cost of 4.5% and a maturity of 1 year. If interest rates are projected to fall 100 basis points by next year, by how much will the bank's profits and NIM change in year 2? Does this bank face refinancing risk or reinvestment risk? Explain.

Answer 1

The earning rate on loan is fixed at 6.5% so change in rates will not change this, but yes it will affect the liabilities

As rate of interest is expected to fall, banks cost will go down by 1%,

profits in year 1 = (125 x 6.5%) - (125 x 4.5%) = 2.5 million

profits in year 2 = (125 x 6.5%) - (125 x 3.5%) = 3.75 million

so bank's profit will go up by 3.75 -2.5 = 1.25 million

NIM in year 1= 6.5% - 4.5% = 2%

NIM in year 2 = 6.5% - 3.5% = 3%

so bank's NIM will go up by 1%

ANSWER : PROFITS WILL GO UP BY $1.25 MILLION

ANSWER : NIM WILL GO UP BY 1%

ANSWER : AS RATE HAS DECREASED, BANK DOES NOT FACE REFINANCING RISK

AND THE EARNINGS ARE FIXED FOR 3 YEARS, SO DOES NOT FACE REINVESTMENT RISK

NIM