Financial Intermediation and Risk - Coursework Example

Financial Intermediation and Risk Introduction Financial intermediation is a core function of commercial banking in today’s era. However, this function entails a plethora of risks and issues which need to be understood and furthermore mitigated so that the institution can operate at optimum efficiency. The need to be knowledgeable about these issues is primarily to make more educated decisions about core banking operations. This will lead to a reduction in operational deficiencies and at the same time enhance the profitability of the bank. Question 1 Financial intermediation is the process of facilitating customers and corporations in such a way that the intermediary institution absorbs the surplus liquidity in the market and passes it on to the entities which require these funds to meet their requirements. If we take look at most financial institutions, we’ll see that they act in the capacity of financial intermediaries. The idea behind this service is to take advantage of the imbalance present in the economy and strive to achieve equilibrium, albeit with the added benefit of service revenue. Since it would be difficult for an individual debtor or creditor to obtain/place their funds, banks provide them with comprehensive asset/liability management solutions. Financial intermediaries include, but are not limited to, commercial banks and saving & loan institutions. Talking more specifically on the benefits to the customers of commercial banks, there are two ways in which the customer can gain. The first case involves the customer having surplus funds which earn him nothing. If the customer starts searching for a high-yield investment, it can take them a long time and during this period, their funds earn them nothing. The convenience which a depository institution provides is that the customer can place funds at a fixed rate. Although this rate probably doesn’t earn the highest IRR, its still better than nothing. On the other hand, we have those entities which require funds to manage their financial situation. These institutions and retail clients can obtain convenient loans from commercial banks and loaning institutions. Since the depository has a huge portfolio of funding opportunities, this also mitigate the risk factor as there is no concentrated exposure on a single entity. Question 2 Unlike the balance sheet of conventional corporations, a bank’s balance sheet is fairly simple. Any and all funds which have been placed with the bank come under the liability section of the balance sheet of the bank, whereas any and all fund placements by the bank come under the asset section of the balance sheet of the bank. If we delve into more detail, the assets of a bank include placements with other banks, placements in the form of regulatory requirements with the central bank, advances made to corporate entities, consumer loans made out to retail clients, investments made in various securities etc. On the liability side, we have its entire deposit base and any other borrowing from institutions in the form of repos, call borrowing etc. The reminder is the equity of the shareholders. Liquidity Management is a complex mechanism handled by the Treasury of a bank. Huge volumes of funds are flowing in and out of the bank, and it has to ensure that it maintains a check on this so no regulatory/compliance objection is raised, both internal and external. Deposits are used to meet liquidity shortages, which assets are created to tackle excessive liquidity. Following are the various forms of participation by a bank in financial markets: Interbank Market: This is the market where banks trade FX, both in spot and forward. Various tools in this market include buy/sells and sell/buys. Equity Market: Banks hold an adequate and sizable equity security portfolio. They can benefit from additional income in the form of capital gains and dividends, while at the same time are able to manage short term liquidity requirements. Also, this helps in maintaining SLR requirements. Financial Derivatives: This market allows banks to hedge various risk exposures such as interest rate risk, liquidity risk etc. the tools include swaps, options, forward contracts and futures trading. More complex products include Credit Default Swaps, Mortgage-Backed Securities etc. Bond Markets: This market gives the banks opportunity to diversify its investment portfolio and earn higher yields on corporate risk and government securities. The tools include corporate bonds, t-bills and treasuries. Money Market: The money market is perhaps the most useful in terms of securing funding and deploying liquidity. The tools include overnight swaps, repos and reverse repos, collateralized lending/borrowing and the most common being call lending/borrowing. The previously stated, the nature of the transaction determines where is it placed on the balance sheet. Question 3 Banks are always exposed to a high degree of interest rate risk. This exposure can lead to an impact on the risk management and profitability of the bank if the interest rates begin rising. If there is a forecast that rates will rise, banks will want to borrow long-term and lend short-term so that they can take advantage of the rate hike. Imagine a bank securing a fund at a low fixed rate. When rates rise, it can deploy this liquidity in the money market for a higher return and vice versa. This relates to the profitability of the institution. The tenure of the transaction is the first major factor which needs to be considered when discussing interest rate climate. For longer tenures, the risk is higher owing to the opportunity cost of entering into a less liquid transaction. If the rate start rising and the bank has failed to secure funds, it will borrow at higher yield in the future, which will hurt the bottom line of the institution. The second risk which needs to be accounted for is the inverse relationship between yields and prices of securities. In an economy where the interest rate climate is on the rise, increased yields will drive the price of the security down. Organizations holding such securities will incur capital losses on the instrument unless its held to maturity. At the same time, they will be stuck with a lower yielding asset when they could have invested in the higher rate securities. References Analyzing a Bank’s Financial Statements. www.investopedia.com. N.D., Web. May 04, 2011. Read More