Assume an immediate and sustained one percent across-the-board rise in interest rates. Based on a review of Exhibit 3, discuss how one would use interest rate sensitivity gap information to estimate the impact of rising interest rates on the earnings of Norwest Corporation.
If the interest rates are anticipated to increase by 1 percent then to reduce the impact on earnings the corporation must keep a Positive Gap. This means that the rate sensitive assets should be more than the rate sensitive liabilities. If this is positive then the increase in interest rates increases the net interest income. The Gap of the corporation is mostly positive for all the time periods except for the investments that are of less than six month maturity. On all the classes with a positive gap the corporation will benefit due to the anticipated increase of 1%. It will only lose on the negative gap because the net interest income will reduce for the assets and liabilities of six months maturity. The interest expense will be more on account of increase in the rate and the gap being negative i.e. the amount of liabilities exceeding the amount of assets, there will be a fall in the net income. The cumulative gap of the corporation is positive at $1194 million.
Describe in your own words Norwest’s methodology for determining ‘accounting risk’ and economic risk and differentiate between them.
Interest rate risk is the risk where changes in market interest rates affect a bank’s financial position. Changes in interest rates impact a bank’s earnings (i.e. reported profits) through changes in its Net Interest Income (NII). Changes in interest rates also impact a bank’s Market Value of Equity (MVE) or Net Worth through changes in the economic value of its rate sensitive assets, liabilities and off-balance sheet positions. The interest rate risk, when viewed from these two perspectives, is known as