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CMA Final · Risk Management in Banking and Insurance · Introduction to Risk Management

Mahalakshmi Bank has funded a 10-year fixed-rate housing loan book mainly through 1-year deposits that reprice every year. Market interest rates rise sharply, so the bank's cost of funds increases while the yield on the existing loans stays unchanged. Which risk does this situation primarily illustrate?

This is repricing or gap risk, a form of interest rate risk in the banking book. Long-term fixed-rate loans are funded by short-term deposits that reprice sooner, so when rates rise the cost of funds climbs while loan yields stay fixed, squeezing net interest income without any borrower default.

  1. ACredit risk arising from borrower default
  2. BRepricing (gap) risk within interest rate risk in the banking bookCorrect
  3. CForeign exchange risk from open currency positions
  4. DSettlement risk from failure of a counterparty to deliver

Explanation

Assets (long-term fixed-rate loans) reprice more slowly than liabilities (1-year deposits). When rates rise, funding costs rise faster than asset yields, squeezing net interest income. This is repricing or gap risk, a component of interest rate risk in the banking book. Credit risk is wrong because no borrower default is involved.

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