Commercial and Investment Banking - Essay Example

Commercial and Investment Banking Answer 1 There are various advantages as well as disadvantages of relationship lending. It should also be noted that with alterations in the competitive circumstances surrounding an organization, the lending relationships alter as well. During instances, when an organization has limited number of financing alternatives, relationship lending proves to be very beneficial for the organization. The chief attributes of relationship lending are the thorough inspection of the organization by the bank as well as the contractual agility. Lending relationships, particularly those that are long term associations make it simpler for small sized organizations to have access to outside funds. Owing to the risky nature of the small firms, it becomes very difficult for them to borrow funds if they lack lending relationships with banks. However, such kind of organizations predictably attempt to get access to further diversified sources of funds, after they have formed long term lending associations with banks. Thus, it can be stated that the organization’s preceding lending association with a bank enables it to gain admission to the public securities market. Furthermore, the association of the organization with a bank persists to play a crucial role even when the organization is capable of issuing public securities. Nonetheless, when an organization diversifies its sources of funds, it has to face certain consequential drawbacks. The funding diversification restricts the bank’s readiness to assist the organization when it faces financial distress. This restriction in the bank’s flexibility is true even when the organization had taken up only diminutive values of public debt. In spite of everything, it can be conclusively stated that a good lending relationship with a bank augments the probability of fruitful negotiation when an organizations encounters financial difficulties (Berlin, 1996). Answer 2 a) Kwan (2004) defines a large bank merger as the amalgamation of the operations of two banks, which are huge in size and the merger provides a large geographic scope to the subsequently merged institute. In the recent years, the large bank mergers have been an indication of the process for creating an extensive nationwide banking franchise. b) The regulatory modifications in the 1990’s have created immense opportunities for the banks to pursue the overseas economies. The banks have benefitted in terms of economies of scale as well as scope. Mergers have enabled the banks to provide more number of products and services and as a result the unit price of production has reduces. Additionally the expansion had created a circumstance where the shared expenses of providing two corresponding services are not more than the joint expenses of providing the two services separately. c) It is believed that mergers can increase the bank’s capability to diversify risk. Prior studies have implied that geographic spreading out would offer diversification advantages to a banking organization. This can be accomplished in the form decreased portfolio risk on the asset side, in addition to decline in the funding risk on the liability side. Banks are likely to attain these benefits as it spreads funding actions over a wider geographic region. Furthermore, studies have also indicated that product extension could result in diversification benefits. The benefits would be more distinguished amid the banking as well as the securities activities, while it would be less prominent in the activities between banking and insurance (Kwan & Laderman, 1999).Consequently, a larger bank is anticipated to be less susceptible to economic instabilities. Hence large bank mergers could lessen the cost of capital for the banks, further augmenting the advantages related to economies of scope and scales that can be accomplished only from the production procedure. d) The large bank mergers can change the market structure of the banking industry and hence also have a solid influence on the banking competition. This is the reason why the bank merger applications are monitored by the banking regulators. Studies have indicated that the markets for a large number banking products as well as services continue to be local in nature. This is in-spite of the developments in information technology in addition to electronic commerce. Actually, the current large bank mergers for market extension are evidence to the significance these large banks give to retaining a local market existence. To put it in other words, bank mergers can result in concentration in the local as well as national banking markets and hence consequently lessen the level of competition in the markets. e) Internet banks provide a cost efficient system as they can do away with the expenses related to bank branches and other implicit costs. However they lack human touch and a large percentage of customers do not prefer to carry out their monetary transactions in an artificial setting. On the other hand, the brick and mortar banks provide hand holding facility to its customers through its frontline employees. Though brick and mortar banks have to make a considerable investment in setting up the bank branches, staff them as well as maintain them; it is still economical for them. This is not owing to the economies of scale in terms of reduced expenses, but instead due to the enhanced revenue earnings from the bank branches (Campbell, 2005, p. 13). f) Bank branches generate high revenues which more than make up for the expenses involved in building and maintaining them. The efficiency of a bank is determined by its efficiency ratio. In this context, the efficiency ratio is computed by dividing the bank’s non-interest costs by the summation of its net interest income and its noninterest income. Since the efficiency of a bank is said to have improved when its efficiency ratio falls, branches promote efficiency of the banks as the income generated by them is much higher than the costs involved (Campbell, 2005, p. 13). Answer 3 In order to control the effect of inflation on the latest monetary base growth, it has been widely recommended that the Fed starts issuing debt in the form of Fed bills. Akin to the Fed sale of government or other securities, the issuance of Fed bills would also diminish the monetary base in a similar manner. Nonetheless, there are certain differences between the Fed sales of government securities and the issuance of Fed bills. In general, the sale of government securities by the Fed would impel it to form covenants for its lending programs. On the other hand, the issuance of Fed bill would not require any such contracts. This facility would allow Fed to decrease the monetary base, without having to lessen the credit it had given out during the latest financial crisis. The lack of covenants would also enable the Fed to give out loans to certain markets or institutes without resulting in a raise in the monetary base. If Fed is permitted to sell or issue its individual debt bills, then it would be in a position to restructure and reorganise market credit for whatsoever reason it considers essential or desirable. This reallocation of credit in the market would not influence the rate of funds or the expansion of monetary aggregates and also not result in enlarged monetary base. In fact, the sale of Fed bills is a form of credit relocation, since it requires Fed to borrow from the Fed bill buyers and relending those funds to another market segment (Thorton, 2009, p. 2). Answer 4 The Phillips curve model acts as a beneficial structure for assessing the trend of inflation as well as the perils of deflation. William (2010) had differentiated between two types of Philips curve models, the unanchored and the well-anchored. Both the models have very dissimilar inference for the probability, severity and extent of deflation. The author states that in the unanchored model, the expected inflation rates are believed to rely principally on historic rates of inflation. As a result, in this case the expected inflation rate oscillates around the actual inflation. On the other hand, in the well-anchored model, the expected inflations depend on the objectives and strategies of the central bank. Severe recession can result in deflationary spiral if the expected inflations are reliant on the past inflation rates. The appearance of slack as a result of recession leads to a decline in the inflation rate, which further prompts individuals to decrease their expected upcoming inflation rates. With the increase in the severity and the duration of recession, the expected inflation rates continuously decline resulting in a deflationary spiral. While, in context of the well-anchored Philips curve model, during recession the individuals anticipate that the central bank would take up activities and measures to improve the inflation rate. As a result of this anticipation, the prices of goods rise up. Hence, in this model, the development of deflationary spiral is very rare and takes place only when monetary policies fail to improve the economic condition (William, 2010, p. 1). Answer 5 In order to examine the influence of the financial sector on real economic results, it is imperative to measure the output of the financial institutes comprising the financial sector. However, in general, banks or other financial organizations do not acquire explicit fees for their service offerings. As an alternative, these organizations balance their service charges by means of the spread involving interest rates on loans as well as deposits. The absence of explicit service charges in lending services makes it complicated to evaluate and quantify the output of the financial institutes. Especially, in the case of banks, they obtain their service fees by charging the borrowers comparatively elevated interest rates, at the same time as paying lenders comparatively low interest rates. Additionally, there are other difficulties involved in the quantification of financial services output, such as estimating real lending services in addition to computing real and nominal services to depositors (Alon et al., 2011). With the intension of overcoming the complexity of measuring the financial output, an approach is executed to assign the implicit worth of the financial services with the help of the difference between the deposit and the lending rate of interest. This assigned implicit value is classified in the income statements of banks and other financial institutes as the net interest margin. However, most of the times different financial institution employ different measurement approaches to compute the value of their outputs. As a result, the conflicting measurement approaches across the financial institutes makes it more complicated to evaluate the overall influence of financial sector on economic results (Alon et al., 2011). Answer 6 The implementation of monetary policy as well as the evaluation of its credibility makes the computation of expected inflation rates very crucial. One can compute the inflation expectations by observing the difference between the real and the nominal Treasury yields. In this context, the yield of the conventional treasury securities can be referred to as the nominal Treasury yield and the yield of Treasury inflation-protected securities (TIPS) is considered to be the real yield. The rate of inflation at which investments in both the securities would be similarly beneficial for a specified maturity is termed as the breakeven inflation rate. The breakeven inflation rates offer helpful measures of expected inflation rates owing to the fact that they are obtainable at an elevated frequency for an extensive array of time periods. Nevertheless, there are certain difficulties in utilising breakeven inflation rates as a measure of anticipated inflation. The breakeven inflation rate depends on the premium that the purchasers of bond are prepared to give for security against the peril that inflation will exceed its anticipated path and the elevated yields they need for holding comparatively less liquid TIPS. The inflation risk aspect drags down the observed yields of TIPS in comparison to that of the nominal bonds. As a result, the breakeven inflation rises to a considerable extent. On the other hand, the liquidity aspect drives the observed TIPS yields in the upward direction, resulting in a low breakeven inflation rate. The yield premiums related with both the liquidity and the inflation risk aspects fluctuate over the period and frequently in the opposite direction. Thus, it is difficult to compute the residual expectations part of the breakeven inflation rate (Christensen & Gillan, 2011). Answer 7 Caballero et al, (2009) recommended that the overseas associations that banks had formed with other banks during the last thirty years were helpful in granting access to liquidity during the financial crisis. On the basis of evaluation of data at a comprehensive national level, the authors found that, for developed economies, the degree to which a certain nation’s banks acted as mediators in indirect bank dealings and associations was a significant indicator of crisis severity. The more significant a nation’s banks were as mediators in the international banking system, the less harsh was the downturn in that nation’s stock market during the financial crisis of 2008. This might indicate an inclination of counterparties to allocate elevated precedence to maintaining associations with these banks and consequently persisting to supply them liquidity in addition to meeting other responsibilities. In case of the developing economies, the less associated a nation’s banks were in general, the harsher was the decline in its stock market. The banks which did not possess a large number of direct associations and dealings and had instead depended on many mediators to acquire credit were severely impacted. This is because for such banks, the liquidity dearth may possibly have been particularly severe, augmenting the consequences of the financial crisis. Consequently, it can be stated that bank relationships play a very vital role in determining a nation’s access to credit during periods of recession. One of the chief indicators of the intensity of the financial crisis in a nation was determined by the variations in that nation’s stock market index in 2008. Caballero et al, (2009) found that measures of nation’s bank relationships were correlated with the variations in its stock market index. Answer 8 James (2009) assessed the association amid credit market circumstances and resources of corporate liquidity used for public and private organizations for the period 1997 to 2007. The researcher evaluated the credit market circumstances by means of the net percentage of loan officers slimming down the credit standards. Tight credit circumstances are characterized as phases when the net percentage of loan officers contracting credit standards is more than the median for the sample time duration. The author scrutinized three basis of corporate liquidity, namely, cash, trade credit and credit lines. The privately held organizations depend greatly on trade credit as soon as credit markets constrict. If line size reduced due to lessening of credit demand, then these private organizations would not be able to augment their utilization of comparatively high-priced trade credit. On the other hand, liquidity resources meant for public organizations do not fluctuate considerably with alterations in bank loan standards. One of the reasons for this is that small sized private organizations are put under more restricted agreements or are more liable to have their credit reduced during periods of economic depression. This justification is constant with the judgment that credit-line accessibility in favour of public organizations is considerably less susceptible to operating performance in comparison to that of private organizations. On the whole, James (2009) recommended that credit lines are a more reliant foundation of liquidity for the private organizations in comparison to that of the public organizations. Furthermore, impaired entree to public debt as well as commercial paper markets may direct public organizations to depend highly on credit lines in support of liquidity. References Alon, T., et al., 2011. What is the value of bank output? FRBSF Economic Letter. Berlin, M., 1996. For Better and For Worse: Three Lending Relationships. Business Review. Federal Reserve Bank of Philadelphia. Campbell, D. 2005. Branch Bonanza. Region Focus. Christensen, J. & Gillan, J., 2011. TIPS Liquidity, Breakeven Inflation, and Inflation Expectations. FRBSF Economic Letter. Caballero, J. et al, 2009. Bank Relationships and the Depth of the Current Economic Crisis. FRBSF Economic Letter. James, C. M., 2009. Credit Market Conditions and the Use of Bank Lines of Credit. FRBSF Economic Letter. Kwan, S.H., & E. Laderman. 1999. On the Portfolio Effects of Financial Convergence: A Review of the Literature. FRBSF Economic Review2, pp. 18–31. Kwan, S., 2004. Banking Consolidation. FRBSF Economic Letter. Thorton, D. L., 2009. Negating the Inflation Potential of the Fed's Lending Programs. Economic Synopses. William, J. C., 2010. The Risk of Deflation. FRBSF Economic Letter. Read More