Financial Markets and Risks - Coursework Example

Financial Markets and Risks Introduction It is hard to believe that the whole financial system can collapse almost instantaneously, a system that hasbeen in operation since even before man could read or write, has collapsed yet once more in 2007. Why so, all the experts and leaders of the world are unwilling to change it? This is because only a little bit of the problem is caused by the system, the rest […] is caused by the people running this system; people, who can be shaken by greed and fierce competition. Thus this report tries to shed a light on a bank’s operations and illustrates how even diminutive factors can lead a bank to failure if neglected. I. Financial Intermediation In its most basic form, the transfer of financial capital from one source to another is called financial intermediation; and the agent that acts as a broker for the transfer is known as a financial intermediary (Mayer & Vives, 1995). For example, a bank lends money to borrowers from the pool of funds lying in its savings accounts; here the bank acts as an intermediary to the account holders and borrowers. Thus, it has been established that the prime function of a bank is to act as a financial intermediary, and it is through this same manner that a bank makes profit, by lending capital at a slightly higher rate that it pays to its savings/deposit account holders. Benefits to the customers of commercial banks 1. Undoubtedly, the primary benefit to the customer is the safety of his money. Any loss that a arising out of bad debt that a bank incurs is not reflected in the customer’s savings. 2. Secondly, the time for which the customer wants to earn interest depends solely on him (except in the case of term deposit accounts). 3. The money of a customer that would have otherwise been just a useless surplus would actually be used for the overall good of the economy whilst earning the customer interest. (Thakor & Boot, 2008) Financial Intermediation services provided by commercial banks 1. Lending the money deposited by its customers in saving accounts. One major issue with this is that withdrawal from savings accounts is more frequent, so the bank needs to refill the gap by promoting deposits in its other saving accounts. 2. Guaranteeing safety to attract deposits and then lending that money for higher interest rates (after checking the credibility of course) to potential borrowers. 3. Providing bulky corporate loans (venture capital, loans for expansion, acting as underwriters) against a number of smaller deposit accounts. II. Balance Sheet Structure of a Commercial Bank In order to offer a much more practical and convenient explanation, data from an actual balance sheet of Standard Chartered Bank has been used, following are two images of the segments of a bank’s balance sheet: Figure 1: Assets (Standard Chartered Bank, 2011) Figure 2: Liabilities and Equity (Standard Chartered Bank, 2011) A bank’s balance sheet substantially defers from a company’s balance sheet, as figures such as accounts payable/receivable or even inventories is absent from a bank’s balance sheet. Moreover, cash-in-hand is more often than not quite lower in percentile as compared to a general company’s balance sheet; this is because Banks need to keep their cash in circulation constantly in order to earn a decent interest. The picture is even more lucid within figures 3 & 4 on the next page […] Figure 3: Assets of Standard Chartered Bank 2010 Figure 4: Liabilities of same 2010 Amongst all assets and liabilities, the largest are loans to customers (liabilities) and deposits by customers (assets). This is the financial intermediation provided by this bank as discussed within the previous topic. Now in this case the bank accepted $306,992 from customers and lent about $240,000 to its other customers; and then the bank has invested some of the money as holdings within other companies (investment securities). It is absolutely imperative for a bank to keep a close check on these figures, especially the deposits, as it is the most important instance for managing and tracking liquidity. Then there are derivative financial instruments, which are essentially safety instruments that are used to hedge a bank’s other security/asset holdings. These derivative contracts may be interest rate swaps (which are more common amongst commercial banks) or currency instruments. In case of banks such as this, stock options and equity derivatives typically compromise a very diminutive amount of the total figure. Furthermore, ‘financial assets/liabilities held at a fair value through profit or loss’ is a placeholder signifying those assets and loans that have a very short expiry; some of the derivative swaps in this case would be to hedge the interest rate risks against some of these financial assets held at a fair value. Yet another important liquid figure is ‘loans to other banks’, it is a common practice for commercial banks to grant or even take loans from other banks, these loans are usually quite substantial and carry a low interest rate, preferably near a bank’s breakeven point. This is typically used when the bank either needs more funds to lend out, or it needs to place a huge load of funds on interest to avoid surplus cash which doesn’t earn any interest. This is yet another parameter to manage liquidity. All deposits by banks, some financial liabilities, capital reserves and retained earnings form the capital of a commercial bank. Effect of higher interest rates on a commercial bank’s profits and risk exposure Roots of the most obvious effect lies within a bank’s basic operations; more specifically, a bank’s policy to borrow money at short term and lend it for a much longer term. This would prove to be disastrous (especially if the bank has lent the money at a fixed rate), since the bank would be paying more interest on the increased rates. (Madura, 2008, p. 43) Secondly, it is a generally accepted belief that higher interest rates promote savings and that the populace would then withdraw some funds from risky-semi risky investments such as derivatives, stocks and bullion, and keep the money in savings accounts; which would then result in two outcomes: First, the banks would now have surplus savings as compared to loans, as less number of people would want to get a loan at higher rates and more people would want to hold liquidity with banks; so the bank would be paying a significantly higher interest (on a ratio basis) Furthermore, the stock markets and other investments would be devalued as the populace has now withdrawn their money from it. Goodwill of the bank would be affected significantly as higher interest rates also attract bad-mouthing. Since the banks would have a surplus, and the markets would be crashing, liquidity will slowly start to diminish in value as it is not being used for anything and is just lying with the bank; i.e., the cash flow account of many firms (especially smaller firms) will start to dry up. Works Cited Madura, J. (2008). Financial markets and institutions. Cengage Learning. Mayer, C., & Vives, X. (1995). Capital markets and financial intermediation. Cambridge University Press. Standard Chartered Bank. (2011, March 11). Annual Report of Accounts. Retrieved May 5, 2011, from http://files.shareholder.com/downloads/stanchar/1254112424x0x452557/3E6A18CC-2253-424A-876E-B8442701C64A/AR2010.pdf Thakor, A. V., & Boot, A. W. (2008). Handbook of financial intermediation and banking. London: Elsevier. Read More