Question

Your bank has 50 percent of its loans priced off of the current prime rate at prime + 1 percent, on average. The majority of the bank's liabilities are interest-bearing core deposits (NOWs, MMDAs, and small time deposits).

Required:
a. Assume that the prime rate immediately rises from 6 percent to 6.5 percent. Will management likely increase deposit rates by 0.50 percent immediately? Explain why or why not. What will be the impact on the bank's spread?
b. Assume that the prime rate immediately falls from 6 percent to 5.5 percent. Will management likely decrease deposit rates by 0.50 percent immediately? Explain why or why not. What will be the impact on the bank's spread?

Answer 1

a. Assume that the prime rate immediately rises from 6 percent to 6.5 percent. Will management likely increase deposit rates by 0.50 percent immediately? Explain why or why not. What will be the impact on the bank's spread?

First of all we must analyze what type of deposits represent most of the bank's liabilities. NOW accounts, money market deposits (aren't very flexible) and small time deposits. These deposits tend to have short maturities, so an increase in the deposit rates will not affect them a lot. That means that the bank will probably not increase the deposit rate immediately, simply to earn a higher spread (resulting in higher income). The bank's spread will increase by 0.5%.

b. Assume that the prime rate immediately falls from 6 percent to 5.5 percent. Will management likely decrease deposit rates by 0.50 percent immediately? Explain why or why not. What will be the impact on the bank's spread?

The bank will immediately decrease the deposit rate. Banks will never lose 1¢ on purpose. Again, since most deposits have short term maturity, the decrease will not affect the account owners that much. The spread might increase, but it will never decrease. In the best case scenario, it will remain the same.