Banking Practice Exam

When a bank anticipates that interest rates will decrease, it makes strategic sense for it to become more liability sensitive. This means that the bank would prioritize managing its funding sources, particularly its liabilities, in a way that benefits from lower interest payouts.

In a declining interest rate environment, the bank’s cost of funds could decrease. If the bank is liability sensitive, it can take advantage of reduced rates by having a greater proportion of its liabilities re-price sooner. This means that as existing liabilities, such as loans or deposits, mature, the bank can refinance or reissue new debts at the lower interest rates, which ultimately helps maintain better margins.

By shifting towards a strategy that favors short-term liabilities, the bank protects itself against the risk of falling rates negatively impacting interest income while allowing it to benefit from lower interest expenses. This positioning can help improve financial performance as rates move down, as the bank would retain a greater spread between the interest it earns on assets and the interest it pays on liabilities.

The other options involve strategies that are less effective in a declining rate environment. For instance, increasing GAP specifically targets extending asset durations to earn more from interest income, which could be detrimental if rates fall. Issuing long-term subordinated debt or increasing rates on long