Banks as the Important System - Term Paper Example

INTERNATIONAL BANKING Introduction A bank can be described as a financial system or intermediary, which takes deposits and directs them into different lending activities. This is often through direct means like offering of loans or indirectly through the capital markets. One of the most important functions of a bank is to link its customers, which have capital surpluses and those that have deficits. In this case, those that have capital surpluses will often keep their money with the bank, so that those that do not have can borrow. Banks are to be important systems that determine the growth and developing of the economy of countries. For this reason, they are often regulated through creation of policies and regulations. Most nations have developed fractional banking systems, which are essential in the regulation of the banking industry (Somashekar 2009, 34). Through this system, banks have various liquid assess, which are equal to part of their current liabilities. In addition to different regulations aimed at ensuring liquidity, banks are often subject to the most minimal capital requirements depending on the internationally set standards that are known as Basel Accords. Banks and Liquidity Risk It has often been said that liquidity is something that be recognized easily that being defined; additionally, it is a highly elusive concept. As far as its barest essentials are concerned, is all about having cash at the moment one needs it. In relation to banks, liquidity can be defined as the ability of a bank to provide funding to the increases in assets in order to achieve various obligations as soon as they arise (Hall 2008, 16). This often has to take place without the banks having to incur any unacceptable losses. Management of liquidity risks aims at ensuring that banks can continue performing their most fundamental roles. It is important to note that while outflows are often identified with certainties, risks are often due to need to achieve indecisive obligations about cash flow. In most cases, they depend on the external events as well as the behavior and actions of various agents. The liquidity aspects of a certain bank are ultimately a function of its confidence. This confidence arises from the counterparties and depositors in the banking institution and its presumed capital adequacy or solvency. A liquidity shortfall in a certain individual institution can often have various repercussions in its broad systems. In this case, the withdrawal of one institution has a multiplier effect, having the ability to spread to other systems, which can bring about various unexpected loses and other challenges. This distinction is often made between the market liquidity risk as well as funding liquidity risk. Funding liquidity risk refers to the risk that firms may not be efficient in meeting expected and the unexpected future cash flows and the collateral needs without having to impair the daily operations or the particular funding conditions in the firm. On the other hand, market liquidity risk is defined as the risk, which firms cannot offset easily do away with without having to affect the prevailing market prices significantly. Liquidity Indicator in a monetary Market (Shams, 2013) Measuring liquidity risk Liquidity risks are often very complex, requiring that that rely on information they have in the process of determining their liquidity risks (Ruozi & Ferrari 2012, 24). In most case, the information relating to their functions and those from their trading activities are often important in helping the bank calculate and measure its liquidity risk. Under the Basel II standards, the minimum laid standards for liquidity risks depend on two main complementary ratios. First is the LCR, better known as Liquidity Coverage ratio, with the second one being the net Stable Funding Ratio (NSFR). The liquidity coverage ratio has its minimum requirements aimed at strengthening the ability of the banks to endure various short-term liquidity uncertainties. On the other hand, the NSFR seeks to encourage resilience, which has to be for a very long time. The LCR is calculated as shown The LCR is supposed to be at least 100% The stock of a bank’s liquid assets is divided into two main categories; first is level one, which comprises of assets that are liquid. Some of its attributes include, being entitled for use as an important form of collateral when taking loans. Secondly, they are easily convertible into cash. The second group of assets are those in level two; these kind of assets are often described as being quite less liquid. In order to account for their reduced liquidness a discount of about 15% is usually applied in the process of calculating the LCR ratio. Three key parameters often exist in the realistic application of the particular LCR requirements. The first parameter involves the discount offered to the liquid assets, which makes up the numerator when calculating the LCR. The second one is the run-off rates that are applied to liability classes as well as assets. Lastly, the final parameter is that of the division of parameter deposits, which are divided into volatile and core portions. On the other hand, the NSFR is calculated as follows In this formula, the available amount of stable finding involves the equity, preferred demand deposits as well as the preferred stock by the bank. In this regard, demand deposits are grouped into two main categories. The first group comprises of stable demand deposits and the second one has those that are unstable. Stable deposits, are those that are expected to last for more than a year in the bank, this is according to the standards laid down in Basel III. The available amount of stable funding is often calculated as the total amount of value of each of the funding source that is held by the bank, multiples by a certain prescribed factors in each of the funding sources (Drehmann & Nikolaou 2010, 62). It is important to note that available stable funds for the bank often relate to liabilities while the total value of the stable funding pays attention to assets. Bank liquidity risk and bank stock returns. From the foregone discussion, it is evident that bank liquidity risk refers to the ability for the bank to settle its current obligations with utmost urgency using the resources it has within its reach (Narusis 2008, 12). In this regard, a bank is said to be illiquid when it is found to be unable to settle its obligations with the set time, which has to be immediate. When this happens, the banks and depositors and all other shareholders often end up incurring huge losses. According to the definition above, it is evident that bank liquidity risk is often motivated by the probability that for a certain duration of time the bank can fail to manage its obligations immediately. With respect to banks, liquidity risks come in two main components (Choudhry 2011, 35). First is the future in (random) as well as the outflows of money. Second, it is grouped according to the future prices (random), which is essential in the process of getting additional funding liquidity funding from various funding. It is important that a clear distinction be made between the banks concept of liquidity and liquidity risk. In this regard, liquidity is often seen as a mere binary idea, meaning that a bank has the option of settling its obligations or failing to do so. The decision depends on the decision of its managers bearing in mind the effect that such an action will have on its customers and other stakeholders. The difference between liquidity risk and liquidity is very straight-forward and often same as many other kinds of risks (Castagna & Fede 2013, 9). For instance, the same distinction can be established between default and credit risk. Like liquidity, default can also be described as a binary concept, unlike Credit, which does not behave in the same way. The credit risk that is linked to a loan is often determined by the possibility that the borrower may find it hard to manage to settle the payment (Gundlach 2004, 37), hence default at a certain point. In this case, just like liquidity risk, credit risk can also be classified as forward-looking concept that relies on various infinite values, according to the particular credit worthiness of the banks borrower. Bank stock returns A bank’s capital is often divided into certain amount of shares of certain amounts. The groups of these shares in are often referred to as stocks. In this case, bank stock returns often refer to the profits that banks make from the kinds of shares and stock operate. In the recent past, banks have been successful from the kinds of shares and stock that it has floated in the market. However, the economic crisis that was witnessed a few years reduced the returns that most banks were getting from their stocks. This follows the fact that, banks are affected directly by changes in the economic dimensions. While liquidity risk relates to the ability of the bank to settle its obligations immediately out of the assets that it has in its environment, stock returns depends on various economic factors and trends in order for the bank to field significant returns. In this case, the bank has to make a proper forecasting of the market dynamics before devising on the means to raise money from this method. Banks as equity investments The figure below shows the performance of various bank stocks in relation to the overall market index in various advanced economies. From the graphical analysis, it is evident that a common pattern exists in all the markets. The performance of bank stocks was strong between 1990 and 2007, although they faced a slight reversal, which happened at the turn of the century. An underperformance was witnessed in the past four years following the financial crisis that occurred during this time. In the United Kingdom and United States, the pattern and behavior is very profound, however, it is not the same in the continental Europe. The indicated period that had the strains in the financial system in the Japanese economy in the 1990s led to various incidents during the initial half of the indicated period. Bank equity performance relative to broad indices (Shams, 2013) Banks often represent a good share of the wide market portfolio in most of the developed equity markets. For instance, in the United Kingdom and the United States, this share is said to have grown significantly in the recent two decades. This happened according to the increase in the financial activities. It is estimated that during this time, many people had opted to invested in the bank stocks and in the entire financial marts out of the expectation that they would make financial gains from their investments. Examining bank stock returns In the process of examining bank stock returns, banks often rely on the asset-pricing framework in order to identify the particular drivers of the stock returns. In this approach, the workhorse in the analysis becomes the model of factor pricing, which is essential in describing the cross section of the equity returns. This model is of the very common in the empirical literature in finance. This model is often very useful in the description of the individual returns of stock with regard to its sensitivity to various pricing factors, which are often expressed in terms of returns on the specific stock portfolios. One of the factors often corresponds to the market portfolios as provided for in the CAPM (Capital Asset Pricing Model) model. The other two factors have been described as being value and size, such that size factors relates to the differences in terms of returns of portfolios of the small capitalization stocks as well as an additional portfolio comprising of large capitalization stocks (Plunkett & Research 2009, 49; Banks 2005, 45). On the other hand, the value factor is described as the difference arising from the stock returns of those firms with low and high ratios of the book-to-markets values. Bibliography Banks, E. 2005. Liquidity risk: Managing asset and funding risks. Palgrave Macmillan, Houndmills, Basingstoke, Hampshire. Castagna, A., & Fede, F. (2013). Measuring and managing liquidity risk. Wiley, Chichester, West Sussex, U.K. Choudhry, M. (2011). An introduction to banking liquidity risk and asset-liability management. John Wiley & Sons, Chichester, U.K. Drehmann, M., & Nikolaou, K. (2010). Funding liquidity risk: Definition and measurement. Bank for International Settlements, Monetary and Economic Dept, Basel, Switzerland. Gundlach, M. (2004). Credit-risk in the banking industry. Springer-Verlag Berlin Heidelberg, Berlin. Hall, M. (2008). Banks. Heinemann Library, Chicago, Ill. Narusis, R. (2008). Liquidity risk. Syddansk Universitet, Odense. Plunkett, J., & Research, L. (2009). Plunketts banking, mortgages & credit industry almanac 2010 the only comprehensive guide to the banking industry ([6th ed.). Plunkett Research, Houston, Tex. Ruozi, R., & Ferrari, P. (2012). Liquidity risk management in banks economic and regulatory issues. Springer, Berlin. Shams, M., et al. 2013. Assessment and Explanation of Bank’s Liquidity Risk Forecasting Model Using of Liquidity at Risk Case Study: Agricultural Bank. International Business Research. Vol 9, No. 3: 12-25 Somashekar, N. (2009). Banking. New Age International (P), New Delhi. Read More