Depository Institution are financial intermediaries that accept deposit. They include commercial banks (or simply bank) saving and loan association and credit union. It is common to refer to the depository institutions other than banks as depository institutions are highly related and supervised because of the important role that they play in the financial system.
Checking accounts are still the principal means that people and business entities use for making payments.
Government monetary policy is implemented through various activities with banks. Because of their important role, depositor institution are afforded special privileges such as access to federal deposits insurance and access to a government entity in order to acquire funds for liquidity or emergency needs.
Deposits represent the liabilities(debt) of the deposit accepting institution with the funds raised through deposits and other funding sources, depository institution make direct loans to various entities and invest in securities.
Their income is demand the interest income from their portfolio of loans, income from their portfolio of securities and fee income.
The asset liability problem of depository institutions
The asset liability problem that depositor institution face is quite simple to explain although not necessarily easy to solve. A depository institution seeks to earn a positive spread between the assets it invest in (loans securities) and the costs of its funds ( deposits and other sources). This difference between income and cost is referred to as spread income, or margin income. The spread income should allow the institution to meet operating expenses and earn a fair profit on its capital.
In generating spread income a depository institution faces several risks. These include credit risk.regulatory risks and interest rate (or funding risk)
Interest rate risk
Interest rate risk is the risk that a depository institution’s spread income will suffer because of changes in interest rate. This kind of risk can be explained by illustration. Suppose that a depository institution raises $100 million by issuing a deposit account that has maturity of 1 year and by agreeing to pay an interest rate 7%. Ignoring for the time being the fact that the depository institution can not invest the entire 100 million because of reserve requirements suppose that $100 million is invested in a U.S.treasury security that matures in 15 years paying an interest rate of 9% Because the funds are invested in U.S. Treasury security there is no credit of risk.
All depository institution face this interest rate risk, or funding problem. Manager of a depository institution who have particular expectation about the future directions of interest rates will seek to benefit from these expectation. Those who expect interest rates to rise may pursue a policy to borrow funds for the bay term and lend funds for the share term. If interest rates are expected to drop, managers may elect to borrow short and lend funds for the short term. If interest rate are expected to drop, managers may elect to borrow short and lend long.
The problem of pursuing a strategy of positioning a depository institution based on interest rate expectation is that considerable adverse financial consequences will result if those expectation are not realized. The evidence on interest rate forecasting suggest that it is a risky business.
Some interest rate risk, however, is interest in any balance sheet of a depository institution. Managers must be willing to accept some risk but they can take various measures to address the interest rate sensitivity of the institution’s liabilities and its assets.
A depository institution should have an asset liability committee that is responsible for monitoring the exposure to interest rate risk.