Transcript Lecture 18.pptx

Revise Lecture 17
•Basic Lending Principles
Basic Lending Principles
• According to section 6 of the Banking
Regulation Act, 1949, banking means
‘accepting for the purpose of lending or
investment of deposits of money from the
public, repayable on demand or otherwise
and withdrawable by cheque, draft, order or
otherwise’.
Basic Lending Principles
• Another major reason of the lending function
is to add value to the bank.
• By lending the funds mobilized by it, a bank
will be in a position to earn spreads to sustain
profitability.
Basic Lending Principles
• Profitability through lending will be obtained if
the bank is in a position to take and manage
credit risk that arises on account of the quality
of the borrower and liquidity risk that may
arise by borrowing short and lending long in
order to attain greater spreads.
• Further, the spreads earned in this activity will
also be exposed to risk arising from both
interest and exchange rates.
Basic Lending Principles
• Thus, while lending, the bank should try to
balance its spreads and the risk levels.
•
Liquidity
Basic Lending Principles
Liquidity:
• Liquidity for a bank means the ability to meet
its financial obligations.
• A bank lending finances invests in relatively
illiquid assets, but it funds its loans with
mostly short-term liabilities.
• A shortage of liquidity has often been a trigger
for bank failures.
Basic Lending Principles
• Liquidity:
• Holding assets in a highly liquid form tends to
reduce the income from that asset (cash, for
example, is the most liquid asset of all, but pays
no interest).
• So banks try to reduce liquid assets as far as
possible.
• However, a bank without sufficient liquidity to
meet the demands of its depositors risks
experiencing a bank run.
Basic Lending Principles
• Liquidity:
• The result is that most banks now try to
forecast their liquidity requirements and
maintain emergency standby credit lines at
other banks.
• Banking regulators also view liquidity as a
major concern.
Lecture 18
• Asset management banking
Basic Lending Principles
Asset management banking
• One of the main challenges to a bank is ensuring
its own liquidity under all reasonable conditions.
• Commercial banks differ widely in how they
manage liquidity.
• A small bank derives its funds primarily from
customer deposits. Its assets are mostly loans to
small firms and households and it usually has
more deposits than it can find creditworthy
borrowers for.
Basic Lending Principles
Asset management banking
• Excess funds are typically invested in assets
that will provide it with liquidity.
• The holding of assets that can readily be
turned into cash when needed is known as
asset management banking.
• Liability management banking
Basic Lending Principles
Liability management banking
• In contrast, large banks generally lack
sufficient deposits to fund their main business
dealing with large companies, governments,
other financial institutions and wealthy
individuals.
Basic Lending Principles
Liability management banking
• Most of these banks borrow the funds they
need from other major lenders in the form of
short-term liabilities which must be
continually rolled over.
• This is known as liability management,
A much riskier method than asset management.
Basic Lending Principles
Liability management banking
• A small bank will lose potential income if it
gets its asset management wrong.
• A large bank may fail if it gets its liability
management wrong.
Basic Lending Principles
Liability management banking
• The key to liability management is the ability
to borrow always.
• Therefore, a bank’s most vital asset is its
creditworthiness. If there is any doubt about
its credit, lenders can easily switch to another
bank.
• The rate a bank must pay to borrow will go up
rapidly with the slightest suspicion of trouble.
Basic Lending Principles
Liability management banking
• In recent years, large banks have been making
increasing use of asset management in order
to enhance liquidity, holding a larger part of
their assets as securities as well as securitizing
their loans to recycle borrowed funds.
Basic Lending Principles
Liability management banking
• A ‘bank run’ is an overwhelming demand for
cash by a bank’s depositors.
• A large depositor assumes a risk and needs to
know something about the bank’s own
balance sheet.
• However, a healthy balance sheet does not
eliminate all risks.
Basic Lending Principles
Liability management banking
• Even if the depositor knows the bank has
adequate liquidity.
• Large depositors must, therefore, be
concerned about what others are likely to
believe. A rumour a bank, even though
unfounded, can trigger a run causes a solvent
bank to fail.
Basic Lending Principles
•
Profitability
Basic Lending Principles
Profitability
• A bank generates profit from the differential
between the level of interest it pays for
deposits and other sources of funds and the
level of interest it changes in its lending
activities.
• This difference is referred to as the SPREAD
between the cost of funds and the loan
interest rate.
Basic Lending Principles
Profitability
• Historically. Profitability from lending activities
has been cyclic and dependent on the needs and
strengths of loan customers.
• In recent history, investors have demanded a
more stable revenue stream and banks have
therefore, placed more emphasis on transaction
fees, primarily loan fees, but also including
services charges on an array deposit activities.
Basic Lending Principles
Profitability
• However, lending activities still provide the
bulk of a commercial or retail bank’s income.
• In the past few decades, banks have taken
many measures to ensure that they remain
profitable while responding to ever-changing
market conditions.
Basic Lending Principles
Profitability
• The banking industry’s main obstacles to
increasing profits are existing regulatory
burdens, new government regulations and
increasing competition from non-traditional
financial institutions.
• Profitability Management
Basic Lending Principles
Profitability Management
• Profitability management is a total
management process, rather than just an
accounting or analysis procedure.
• In contrast to asset and liability management,
it places primary emphasis on the profit and
loss account and secondary emphasis on the
balance sheet.
Basic Lending Principles
Profitability Management
• With profitability management, profitability is
not merely reported; it is planned, measured
and interpreted.
• Planning ensures that efforts are directed
toward the achievement of corporate
objectives.
Basic Lending Principles
Profitability Management
• Measurement checks and adjusts progress
against plan by matching revenue received
with related expense
• Interpretation develops a valid picture of
people and businesses, thereby serving as a
basis for the next planning cycle.
Basic Lending Principles
Profitability Management
• Profitability management involves the
monitoring of three distinct types of
profitability statistics. The profits of bank can
be measured in three ways;
• By organization
• By product
• By account
Basic Lending Principles
Profitability Management
• Organizational profitability is the most familiar
type since all banks have some system for
reporting the performance of their major
organizational units.
• However, an effective profitability management
system will also measure the performance of
services and accounts.