Question

1. Why would an increase in interest rates lead to problems in S&Ls? Use gap and duration analysis to explain your answer briefly.

2. Regulators allowed S&Ls that were already insolvent to stay open and in addition deregulated the industry so these S&Ls could take on more risks. How would these policies affect moral hazard? Briefly explain your answer.

Answer 1

S&L stands for savings and loans organisations. Increase in interest rates would compel S&Ls to pay a higher interest rate on savings, at the same time because of higher interest rates, less number of individuals and companies borrow money as credit turns expensive.

Now gap analysis is essentially the banks sensitivity to interest rate movements. The bank will have to time the increase in interest rates on savings accounts so that simple maturities can be used to generate simple indicators of the interest rate sensitivity. To determine how the consumers are borrowing at specific interest rates. If at higher interest rates no consumers are borrowing that it increases the risk exposure.

Duration analysis determines the difference between duration of assets and liabilities which are held by financial entities. If the duration of assets is higher than liabilities, it could pose risks as interest rates rise, the assets will lose value.

Moral hazard arises when banks go on taking risks, that is increasing their risk exposure by not increasing the asset size or reducing the liability side, essentially when one is protected by the consequences of it. For example banks are certain that if they are insolvent and even if they risk it, they would be rescued by the regulators or the government. This leads to moral hazard.