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Answer: The bank models its retail non-maturity deposits as floating-rate, putable bonds.
The correct answer is B. The bank models its retail non-maturity deposits as floating-rate, putable bonds. This is because non-maturity deposits have two embedded options: the bank's option to change the interest rate and the depositors' option to withdraw their deposits. These characteristics make non-maturity deposits similar to floating-rate, putable bonds. Option A is incorrect because banks typically adjust deposit rates with a lag and by less than the full change in market rates. Option C is incorrect as mortgages have negative convexity due to the prepayment option, meaning their value increases less than an option-free bond when interest rates fall. Option D is incorrect because interest rate risk and credit risk can interact, especially during stress situations, and should be modeled with a rule linking credit spreads to changes in macroeconomic variables and interest rates.
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The Chief Risk Officer (CRO) of a local financial institution wants to ensure the assumptions used in the bank's economic capital models are dependable. The CRO has asked a member of the verification team to thoroughly review the bank's approach to assessing interest rate risk in its banking book and verify the assumptions used in its interest rate models. Among the following, which assumption would be the most appropriate for the bank to implement?
A
The bank changes the interest rate it offers to depositors by the full amount of any change in market interest rates.
B
The bank models its retail non-maturity deposits as floating-rate, putable bonds.
C
The bank assumes that its residential mortgages exhibit positive convexity as interest rates decrease.
D
The bank models its interest rate risk in the banking book independently from its credit risk.