Question

A) Judy runs a bank and believes interest rates will increase in the future. Explain what size interest rate gap the bank should have and why.

B) Explain how the Volcker Rule was designated to limit market risk banks face.

Answer 1

A) A bank borrows money at a particular interest rate and it lends money at a particular interest rate and the spread between these 2 rates is the profit that it earns.Thus interest rate risk is very critical to the banking business. This risk exposure is measured by interest rate gap. In the given case, Judy believes the interest rate to increase in future, this might have consequences such as more investment by the general public in the bank with a desire to earn more interest and another consequence would be that the cost of borrowing of the bank shall go up. Thus increased interest rates are not very favourable for banks and therefore it would be advisable if they maintain a small interest rate gap to avoid losses.

B) Volcker Rule puts certain restrictions on the banks by not allowing the banks to make certain kind of investments that are assumed to not benefit its clients and banks are prohibited from maintaining relationships with certain types of institutions such as private equity funds, etc. The sole reason behind this is to protect the interests of clients of the banks and of the banks themselves from transactions of speculative nature.Banks as the backbone of an economy and these restictions and rules limit the market risk as transactions of very high risk are prohibited. It simply reduces the market risk by separating commercial banking from investment banking.