Question

Assume the following balance sheet for the first national bank:

Assets -

- Rate sensitive assets 40 Million

- Fixed rate assets 60 Million

Liabilities -

- Rate sensitive liabilities 80 million

- fixed rate liabilities 20 million

What is the effect of a 4% increase in interest rate on profits?

Answer 1

The banking sector's profitability increases with interest rate hikes. Institutions in the banking sector, such as retail banks, commercial banks, investment banks, insurance companies, and brokerages have massive cash holdings due to customer balances and business activities.

Increases in the interest rate directly increase the yield on this cash, and the proceeds go directly to earnings.

But in this case of the national bank, they have a large amount of rate-sensitive liabilities then rate-sensitive assets. So, the bank has to transfer this rate increase to the customers which it can use as a profit in another case if it has low rate-sensitive liabilities.

So, the national bank is going to face a decrease in its profit, if the interest rate increase by 4%

Explanation -

• Rate sensitive assets are 40 Million and Rate sensitive liabilities are 80 million. so, the benefits of an increase of 4% interest in 40 million are direct gets transferred to the customers because we have more rate sensitive liabilities and we remained with another 40 million with rate-sensitive liabilities
• Fixed-rate assets 60 Million and fixed-rate liabilities 20 million. the national bank has lent out with 60 million fixed-rate assets which include 40 million from that balance rate-sensitive liabilities and the remaining 20 from fixed-rate liabilities 20 million. So, the benefits of an increase of 4% interest can be earned only in 20 million but we have to pay that 4% to that 40 million balance rate-sensitive liabilities. Hence, we remained with an extra payout of 4% interest on 20 million which is 800000

The national bank has a negative effect of 800000 on profit after a 4% increase in the interest rate.