Integrating the Different Economies of the World - Coursework Example

For a progressive and thriving economy, banks must equip themselves with awareness regarding the various risks and benefits that prevail in the market. This report elaborates on the characteristics of a financial intermediary and how the consumers derive benefits from it. In addition, the report also identifies the major components of a bank’s balance sheet and how its operations are reflected in it. The impact of an inclining trend in the interest rate is also discussed in this report

(a) A financial intermediary can be defined as an institution that acts as the middleman between investors and firms raising funds [1]. Several types of financial intermediaries such as Banks, Insurance companies, building societies, pension funds, credit unions, etc function in an economy. The function of a financial intermediary is of prime importance in economic growth as it brings in contact with two parties i.e. one having a surplus of funds and looking for a venture to invest in to earn a return on the money and the second type who is looking to borrow funds. In the real world, the demand of lender and borrower rarely reconcile, and thus a financial intermediary comes into play. A financial intermediary, such as a bank, acquires funds from the lenders and subsequently lends them to the borrowers according to their desired rates. In this particular exercise, the financial intermediary takes into consideration various needs of the lender and borrower such as maturity (which means the duration or term for which the lender wants to lend and the borrower wants to acquire) and rate of return/cost of debt (the lender wants to maximize the return, whereas the borrower wants to minimize the cost).
The financial intermediary also aligns the information available, between lenders and borrowers, without which the parties would not be able to achieve their desired outcome. [2] Since a financial intermediary enjoys economies of scale and has greater expertise in managing the risk and rewards, it offers considerable cost savings to the lender and borrowers over direct lending and borrowing. In addition, the financial intermediary also offers risk aversion which assists the parties involved in spreading out and reducing the risk.
(b) The assets side of the balance sheet of commercial banks primarily comprises Cash and Bank balances, Loans and advances to banks and customers, financial assets, and derivative financial instruments. Whereas the liability side of commercial banks presents items such as Customer deposits, subordinated loans, retirement benefit liabilities, trade portfolio liabilities, and other financial liabilities. The banks usually finance their operations from the money that has been borrowed from the lenders in the form of customer deposits. Most commercial banks tend to invest in government securities which are readily convertible into cash at the time of need. [3] The investment portfolio of the banks, although represents a smaller portion of the bank’s assets as compared to the loans and advances exposure, is the primary source to discharge its liabilities (deposit withdrawals) and also to finance the banking operations (sanctioning of advances). In addition to maintaining a liquid investment portfolio, there are other options through which a bank can generate liquidity such as borrowing from the central bank of the country in which it operates, borrowing from other banks at the interbank borrowing rate (such as LIBOR) and raising capital through the fresh capital issue. [3] A commercial bank’s capital comprises the aggregate of issued, subscribed, and paid-up capital, and retained earnings.

The interbank transactions pertain to the foreign exchange transactions between various banks. In the balance sheet of a bank, these items are reflected as derivative financial instruments. These include forward foreign exchange, over-the-counter (OTC) options, and swap transactions. Money market transactions involve lending and borrowing over a short-term period and involve trading treasury bills, investment bonds, and mortgages. The equity market (capital market) involves the trading of shares listed on the stock exchange. Both money market and equity market transactions are represented in the balance sheet as the trading portfolio. Bond markets involve the selling of debt securities, majorly government securities, and the transactions are usually reflected in the balance sheet under trading portfolio or are classified as available-for-sale assets.
(c) A hike in the interest rate is likely to cause the depositors to ask for a higher return on their investments. Interest rate plays an important role in shaping the consumption patterns of the consumer. A higher interest rate would require them to forgo their current consumption and invest in commercial banks so that they can yield good returns on their investments. On the other hand, it would increase the cost of debt for the borrowers as now they have to pay an additional amount of interest to the commercial bank. The increase in the interest rate is likely to deter companies and individuals to acquire loans and advances from the banks and thus it is likely to create a mismatch between the assets and liabilities of the commercial banks. Due to the increase in the interest rate risk, a gap is created between the interest earned and the interest expensed, thus the profitability of the bank takes a downward plunge. Read More