Question of the Week

Which of the following statements is (are) true with respect to the factors that a manager must take into account when managing the portfolios of commercial banks?

I. If interest rates are expected to rise, banks will generally lower the ratio of interest sensitive assets to interest sensitive liabilities.
II. Inflation protection is not generally needed when choosing assets for the investment portfolio.
III. The investment horizon for a bank's investment portfolio tends to be very long.
IV. With regards to the investment portfolio, liquidity is a far more important objective than asset value appreciation.

a) IV only.
b) I and III only.
c) I, III, and IV only.
d) II and IV only.

Answer:

The correct answer is: d)

(I) is incorrect because if interest rates are expected to rise, banks will generally "increase" the ratio of interest sensitive assets to interest sensitive liabilities. In other words, long-term bonds are issued to lock in their interest costs and at the same time, short term loans are made out so that they may be renewed at higher rates as they mature.
(II) is correct because the bank's liabilities are stated in nominal terms (ie. These liabilities will not change in accordance with inflation).
(III) is incorrect due to the fact that the investment portfolio is used to fund increases in loan demands, which can happen at any time.