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Before the invention of different financial derivatives, banks were using asset liability management as a natural hedging tool. The asset liability management involves matching the mix of variable and fixed rate loans and deposits to formulate a balance sheet mix that will have the minimum exposure to the interest rate risk. The financial literature suggests that as banks became involved in many non-traditional services the risks increases and the asset liability management is no longer sufficient for banks to be safe; and as a result, banks are forced to enter derivatives position in order to hedge against the interest rate risk. However, have banks lost their ability for natural hedging completely? There was a time in the history when banks were providing only traditional services, mostly loans and deposits, and those banks were able to succeed in hedging without using any financial instruments. We want to test whether traditional banks operating in the current interest rate environment would be able to succeed in natural hedging and avoid the financial distress by properly managing the assets and liabilities.

Hypothesis 1: In a bank engaged exclusively in traditional banking, natural hedging is sufficient to prevent the financial distress.

We define financial distress as a significant decrease in the net income. As a benchmark for the significant decrease we will use 5% decrease in one year. If the bank net income

decreases by 5% in a particular year, the effect on the earnings per share is even more dramatic and investors are very likely to consider the bank to be in a financial distress.

Although, banks report the composition of the balance sheet in the audited annual reports, they do not report the percentages of the fixed versus variable rate assets and liabilities. Due to unavailability of this data, it is hard to empirically observe whether the asset-liability

management actually helps banks to avoid the financial distress. Therefore, we will use a Monte Carlo simulation that closely reproduces the real operations of banks and therefore, allows formulating an inference to the real world situation.We will test the first hypothesis by running the Monte Carlo simulation of bank earnings under different interest rate scenarios. From the data generated through the simulation we will analyze how income changes with the change in the balance sheet mix and the term structure of interest rates.

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We believe that if the bank properly matches the fixed and variable rate assets and liabilities in the balance sheet and also correctly prices the loan portfolio, it could easily avoid the financial distress without using any derivative instruments. However, if this is not the case, just a moderate position in the financial derivatives will be sufficient for a bank to avoid the financial distress. According to our observations, Canadian banks hold a great amount of

derivatives. They claim that one portion of these derivatives is used for the hedging purposes and another portion is used for speculation. Still, banks do not officially report how much derivatives they use solely for hedging purposes. During the 2007 financial crisis we evidenced that some banks used financial services for speculation and due to the wrong prediction of the economy have incurred large losses. If the bank manages properly the asset-liability portfolio, and prices the loans with enough premiums, it should be relatively safe and can easily avoid the financial distress. However, under extreme conditions the natural hedging might not work and the bank will need to use financial derivatives. We will run the Monte Carlo simulations of net interest income of a bank under extreme economic conditions and will test how big should be position in the derivatives to offset income volatility.

Hypothesis 2: If the natural hedging is not sufficient to prevent financial distress in a bank engaged exclusively in traditional banking, just a moderate position in derivatives is sufficient for financial safety.

Modern banks do not only generate net interest income but also collect a large portion of revenues from fee-based services and activities. The rapid growth of fee-based income in the recent years has brought many discussions. The financial literature has not yet reached consensus on whether fee-based income provides diversification opportunity and makes earnings less volatile. We aim to analyze the effect of fee-based income on the bank earnings in Canadian context. According to the literature, some sources of the fee-based income are risky and lead to higher volatility in the net income. However we believe that although some fee-based activities generate the highly volatile income, some services generate stable income. We will empirically analyze the fee-based activities of six largest Canadian banks to identify which activities lead to a more volatile income and which activities contribute a constant income stream. Then we will test our hypotheses by a Monte Carlo simulation of different types of banks that provide different levels of the fee-based activities.

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Hypothesis3: In a bank engaged in traditional and non-traditional banking, natural hedging is sufficient to prevent financial distress.

Hypothesis 4: Some sources of the fee-based income could be a substitute for hedging against the interest rate risk.

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