Question

AA Rate Commercial Bank has RM 200 million of floating-rate loans yielding the T-bill rate plus 2 percent. These loans are financed with RM 200 million of fixed-rate deposits costing 9 percent. A savings bank has RM 200 million of mortgages with a fixed rate of 13 percent. They are financed with RM 200 million of Certificate of Deposits with a variable rate of the T-bill rate plus 3 percent.

(a) Analyze the type of interest rate risk each financial institution faces.

(b) Propose a mutually beneficial swap that would result in each financial institution having the same type of asset and liability cash flow. Illustrate the proposed swap in the diagram.

(c) What are some of the practical difficulties in arranging this swap?

Answer 1

Part (a)

The commercial bank has assets yielding variable interest rate while its liabilitites are on fixed interest rate. Hence, if the interest rate decreases, interest income will reduce however interest expenses will remain the same. Hence, net income is subjected to the adverse risk of any decline in interest rate.

The savings bank has assets on fixed rate of interest but its liabilities have variable rate of interest. The savings bank is therefore subjected to an adverse risk of anyh increase in interest rate. An increase in rate will not impact the interest income but interest expenses will increase, thus adversely impacting the net income.

Part (b)

Difference in the fixed rate = 13% - 9% = 4%

Let T = T bill rate

Difference in the variable rate = (T+3%) - (T + 2%) = 1%

Hence, the gap = Difference in the fixed rate - Difference in the variable rate = 4% - 1% = 3%

Hence, the potential net benefit of swap = 3%

One possible swap could be this:

The blue lines are existing transactions. The green lines are proposed swap transaction involving an intermediary bank.

Commercial bank enters into a swap wherein:

• It pays T + 2% floating to intermediary bank
• It receives 10% fixed from the intermediary bank
• Net benefit of swap = Inflows - outflows = (10% + T + 2%) - (T + 2% + 9%) = 1%

Savings Bank

• It pays 12% fixed to the intermediary bank
• It receives T + 3% floating from intermediary bank
• Net benefit of swap = Inflows - outflows = (13% + T + 3%) - (T + 3% + 12%) = 1%

Intemediary bank

• Net benefit of swap = Inflows - outflows = (12% + T + 2%) - (T + 3% + 10%) = 1%

Thus each of the three banks get a net benefit of 1% due to swap adding to the total potential benefit of swap = 3%

Part (c)

Practical problems:

• Getting an intermediary bank to get this swap done
• Pricing formula may not be agreeable to the intermediary bank
• The floating rate assets may not be tied to the same rate as the floating rate liabilities. This would result in basis risk.
• Also, if the mortgages are amortizing, the interest payments would not match those on the notional amount of the swap.