Final answer:
The bank's market value of equity is at risk if interest rates rise due to the longer duration of its assets compared to its liabilities, which can result in the bank paying more interest to depositors than it receives from borrowers.
Step-by-step explanation:
The bank's market value of equity is at risk if interest rates rise. This situation is due to a discrepancy in the average duration of the bank's assets and liabilities - the assets have a longer duration (3.5 years) than the liabilities (2 years). When interest rates go up, the value of existing bonds and loans (fixed income assets) decreases, causing a greater drop in the value of the bank's longer-term assets compared to its shorter-term liabilities. This mismatch can result in the bank paying out more in interest to depositors than it receives from its loans, eroding the equity's value.
An understand of the asset-liability mismatch is essential here. Assets such as loans or mortgages are paid back over a long period, but liabilities, like customer deposits, can be withdrawn quickly. Therefore, a rise in interest rates can lead to increased costs for the bank if it raises rates for depositors to prevent outflow, potentially outstripping the interest collected from previously lower-rate loans and bonds. This situation exemplifies the importance of managing the interest rate risk and asset-liability match within banking institutions.