IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system
A bank holds ₹1,000 crore of deposits that depositors can withdraw on demand, and uses ₹800 crore to make five-year loans. It also keeps ₹200 crore in liquid assets. Which statement correctly describes the bank's function and the risk it creates?
The bank performs maturity transformation, borrowing short-term on demand and lending for five years. With only ₹200 crore liquid against ₹1,000 crore of deposits, it faces liquidity risk if withdrawals exceed about 20%. Holding some liquid assets reduces, but does not remove, that exposure.
- AIt performs maturity transformation, and so is exposed to liquidity risk if many depositors withdraw at onceCorrect
- BIt performs currency transformation, and so is exposed only to exchange rate risk
- CIt performs no transformation, since deposits equal total assets
- DIt eliminates liquidity risk because 20% of deposits are held in liquid assets, enough to meet any possible withdrawals
- It performs risk transformation only, and has no liquidity exposure because loans are secured
Explanation
Short-term demand liabilities fund long-term loans, which is maturity transformation. Only ₹200 crore of the ₹1,000 crore is liquid, so a run of more than 20% of deposits could not be met without selling or recalling loans. Liquid assets reduce but do not eliminate the risk, and security on loans does not make them immediately cashable.
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