Gap analysis is a method employed in asset and liability management that can be used to evaluate the interest rate of the risks or the liquidity risk. These two terms have a minor distinction and therefore people distinguish between the interest rate and liquidity gap. Gap analysis was initially widely used in the late 80s in management of interest rate risk. The method corresponded with the duration analysis.
Maturity gap of the bank is considered to be the rate of risk-sensitive assets and liabilities. The market values at each point at maturity for both assets and liabilities are evaluated. After which they are multiplied by the change by the change in the rate and added to give the net interest expense or income.In the example provided, maturity gap is twenty years as it is the time the portfolio takes to mature. However, the maturity date is subdivided into phases of three, six months, and one year and consecutively.
Portfolio matures within a given set of time, say, three years. The years are subdivided into equal terms of which can be three months. In finance, these subdivisions are known as bucket. In this case, it means the portfolio will mature after five buckets. These months are subjected to different interest rate which means the portfolio can earn low or high values. The portfolio can, therefore, be said to value that figure as the rate may change. In some cases, the value of the portfolio is considered by basing on the next bucket. The interest rate gap between two buckets is known as re-pricing gap.
The current ratio will shift and have a higher value than the previous one. The current liabilities will increase as a result and hence affect the equity values.
Historically, equities have been known to offer long-term returns when equated with other assets. The situation is called premium. The investors face one problem currently in that the equity returns are volatile. The objective of every investor is to secure that equity risk premium with less volatility. There are various approaches that can be used to reduce the volatility of the equity.
Asset allocation: It is a conventional method that seeks to reduce the equity volatility by shifting the equity allocation at the right time basing on the relative rewards anticipated for the different assets. One challenge though is that timing the markets is technically hard. Being out of the market during the wrong time can cost the investor.
Using derivatives: derivatives can help reduce the volatility of the equity by purchasing the total equity insurance to hedge against the losses. The strategies aim at holding on another type of portfolio that will rise and fall in alternatively to cancel out the risks. There are some challenges to this however; it is legally and structurally complex has leverage and operational risks and limited trustee comfort when carrying out these strategies.
Geographically diversification: through diversifying across developed and emerging markets, the overall equity-efficiency improves, and the risk is reduced. Moreover, at the same time, one attains exposure to equity risk premiums. The basic principle to this theory is that the global markets are not correlated when it comes to stock trading. Nevertheless, during the financial crisis, diversification offers little protection.
Capital buffers: Basel III requires the banks to build up capital beyond times of financial stress that can be used when business make losses. The set committee outlined a capital conservation buffer that the financial institutions should maintain. The value was set to be 2.5 % of the bank risk’s weighted assets. Building the buffers included such measures such as reducing the dividends, bonus and salary payments. The bottom-line of this regulation is to prevent banks from distributing capital to show their financial strength when they have depleted their financial buffer. The capital to build the buffer has remained a challenge as the shareholder and investors would claim better dividends. The attractiveness of the business is the dividends it pays to its shareholders.
Basel guidelines are the responses mad from the committee of Basel Committee on banking Supervision following the 2008 crisis. The aim of Basel III was to strengthen the individual financial systems and institutions by eliminating the weakness that was found in Basel II that was revealed during the crisis. Basel III contains a multi-dimensional impact on financial institutions and requires the require changes in the IT system which was not there in Basel II.
The business of Subprime of lending was based on the premise that the housing would continue going up. These assumptions were proven completely wrong during the financial crisis during 2008. Following the crisis, the system that was there previously Basel II was to be overhauled completely and Basel III was put in place to counter the weakness already found in the Basel II. Basel II requires higher risky assets which bring in a greater exposure to the umbrella of risk-weighted assets calculations. The system requires a higher capital requirement. It is also different from Basel II in that it introduced the requirements to manage the liquidity better. Lastly, Basel III introduced an additional requirement of absolute ratio to consider the model error that might be present in risk-weighted assets calculations.
When introduced, Basel III rules strengthened the capital reserves and introduced strict reporting requirements that cover risk, liquidity and leverage parameters. The system also strengthened the weak links in the financial systems by introducing the Central Clearing Houses. Additionally, the systems reduced dependency on the rating agencies.
The introduction of the new system requires a higher technology system within the systems. This has been a challenge as the market has to change to corresponds to the new technology demands. Most of the institutions cannot afford the technology hence become difficult for them to implement. Another issue that has presented a challenge to the implementation of Basel III is lack of skilled personnel. Initially, the system didn’t require more technical staff. In the current, financial institutions will require hiring an IT specialist to roll out the programs. The employee will also require to be trained adding on the company costs. All these factors have been a hindrance towards implementation of the Basel III.
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