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If a bank has a negative gap and a positive duration gap, an increase in market interest rate will _____ bank profits and _____ bank capital respectively.

1) decrease, decrease
2) increase, decrease
3) increase, increase
4) decrease, increase

1 Answer

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Final answer:

A bank with a negative gap and a positive duration gap faces decreased profits and bank capital when market interest rates rise. Increases in loan supply can raise loan quantities and lower interest rates.

Step-by-step explanation:

If a bank has a negative gap and a positive duration gap, an increase in market interest rate will decrease bank profits and decrease bank capital respectively. The correct answer is 1) decrease, decrease. A negative gap indicates that the bank has more rate-sensitive liabilities than assets, therefore when interest rates rise, the cost of liabilities will increase more than the income from assets, reducing profits. A positive duration gap means that the assets are more sensitive to changes in interest rates than liabilities. In a rising interest rate environment, the value of these assets will decline more than the value of liabilities, leading to a decrease in bank capital due to potential capital losses on securities held. When considering changes in the financial market, a rise in the supply of loans can lead to an increase in the quantity of loans made and received because more funds are available for borrowing. Conversely, a fall in the supply of loans would likely decrease the quantity of loans. For interest rates, a rise in the supply of loanable funds typically leads to a decline in interest rates since more funds are chasing the same level of demand, which leads to lenders having to offer more competitive rates.

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