schwser 2020 practice exam vol 1 exam 1, question 4 C
solution: “the move from demand deposits, which have instant access, to term deposits, which require a notice period before withdrawal, will increase the duration of the liabilities of the bank. this will lower the duration mismatch between assets and liabilities and increase the correlation of assets and liabilities, thereby lowering the expected volatility of shareholder capital.”
i don’t really get this, is it because a systemic shock usually leads to borrowers delaying/defaulting payments?
My understanding is that correl between assets and liabs increase as their duration will need to be more closely matched with more conservative assets. As we know with demand deposits, customers can come and demand their funds whenever, the banks need to take care and accordingly invest their assets more conservatively to accommodate any withdrawals. Because your investing more conservatively, equity volatility goes down as the banks are more likely to accommodate those withdrawals via safe investing rather than risky investing which could lower the banks a ability to do the same.
Not quite. You need to understand this from the Bank’s ALM perspective. Banks or any depository institution for that matter need to maintain a healthy duration gap between its Assets and Liabilities such that the margin to bank’s bottom line is stable. Long duration assets (Loans and Advances) need to be funded by Long duration liabilities ( Term deposit) .
Economic shocks for obvious reason tend to destabilise the duration gap and thereby causing volatility to the bottom line which further destabilises the banks shareholders capital.
Hence the idea is to to return to basics whenever such an incident(s) happen
They’re overbidding their hand here.
One assumption that they’re making is that by decreasing demand deposits and increasing time deposits, the only component of the formula for the duration of the equity that will be changed is the duration of the liabilities; i.e., the leverage multiplier (A/E) will not change, nor will the magnitude of the liabilities’ returns compared to the assets’ returns. They’re also assuming that the proper measure of the equity volatility is the effective (though they call it modified) duration of equity.
The systematic shock – whatever that is – doesn’t really play into it (apart from giving the bank an excuse to panic, and giving the senior executive a chance to shine). The question is simply: How do we lower the effective duration of equity?