Financial Markets and Risk - Coursework Example

Financial Intermediation/Business of Banking/ Banking Risks Introduction Financial intermediation is a bank’s core performance matrix. Banking originates from intermediation, and intermediation provides banks with the opportunity to engage in business transactions and expand the economic cycle of the economy. However, there are various key areas within any commercial bank, and a basic understanding of these areas is crucial for any banking professional. The factor which carries the utmost importance is realizing the risks involved in transactions, and being able to mitigate them to acceptable levels.

Following are a few key points which encompass the very essence of such an exercise. Question 1 When talking about depository institutions, we imply that these institutions are willing to take funds from the general public and then extend these funds to those who require them. The process of obtaining excess liquidity from the market and extending this credit to the illiquid market is the process of Financial Intermediation, and the body who acts in such a capacity is a financial intermediary.

This is an indirect form of financing and most financial firms including commercial banks and saving & loan institutions engage in it. On the whole of things, the general public is mostly the lender of credit units, whereas the Government and other corporations are the borrowers. The benefits to customers is two way. Firstly, those customers who have surplus funds will be able to hold their money in the form of bank deposits and earn interest income, which is also called the time value of money.

Flipping the coin, the individuals who borrow will be able to get loan facilities readily available from a bank that has excess liquidity. We must keep in mind that if a bank’s liquidity is abundant, it would be willing to loan out funds at cheaper rates. Question 2 The balance sheet of a bank is very simple to understand. If the bank has loaned out any funds, they will appear on its Asset section. Any form of funds which the bank has taken will appear on the liability side of the balance sheet.

The difference between the two is the equity of its shareholders, which is usually retained earnings and issued capital. Liquidity management is a complex situation, as large commercial banks have billions of dollars worth of inflow and outflow on a daily basis. In case there is a large outflow, the bank may need to borrow funds in the over night repo market to make sure it has adequate liquidity to meet its requirements. In the case of a large inflow, the bank will need to adjust its CRR so there isn’t any violation of regulations laid down by the Central Bank.

In a nutshell, its deposits are used to meet liquidity shortages, while its assets are used for excessive liquidity management. Now let us understand the participation of a commercial bank in the various financial markets. Interbank: In this market, the bank engages in trading transactions of foreign currency, which includes buying and selling in spot value, forward value etc. There are other various tools such as sell/buys and buy/sells. Equity Market: Banks also hold a decent amount of their liquidity in the form of liquid stocks.

The idea is to realize profits in the form of capital gains, dividends etc while at the same time having the option to immediately dispose of the investment to generate short-term liquidity management. Financial Derivatives: In this market, the bank hedges its outstanding exposure of interest rate risk, exchange rate risk etc. Financial instruments include options, forwards, futures, swaps. More complex products include Credit Default Swaps, Mortgage-Backed Securities etc. Bond Markets: Banks hold a reasonable amount of its funds invested in government and corporate issued securities known as bonds and t-bills.

The idea is to generate income, which is dependent on the risk profile of the investment. Government securities are risk free, and hence derive the lowest yield. Money Market: Banks can borrow and lend funds to and from other banks in this market through various deployment and loaning facilities such as repos, reverse repos, call lending/borrowing, collateralized borrowing/lending etc. As mentioned earlier, the nature of the transaction determines where the item will end up on the balance sheet.

Financial derivatives usually are not reported on the balance sheet. Bonds held are shown in assets. Foreign currency reserves are shown in assets, same as equity held for trading and till maturity. All borrowing facilities are listed under the liabilities section. Question 3 An increase in the general interest rate climate can affect a bank’s interest rate exposure as well as its profitability. There are two possible scenarios. In the first alternative, we assume that the bank has borrowed funds at a fixed rate, while lent out funds at a floater.

When the interest rates rise, its paying the same interest on its deposits, while its placements are now yielding higher returns, and vice versa. This relates to the profitability of the bank. The first factor which determines the interest rate exposure is the tenure of the transaction. If interest rates are expected to go up, banks would want to borrow long and lend short to make the most of the rising yield curve. The risk is that if a bank fails to secure long term borrowing, then when it funding reaches maturity, it will have to borrow again but this time the rates will be higher.

The second risk which exists is the implication of yield changes on prices. When interest rates rise, yields of bonds and t-bills go up, thus bringing down the price. If an institution were to sell of its securities during this time period, it would have to realize a capital loss. These are some of the scenarios which affect the bank’s profitability and interest rate risk which it runs. References Analyzing a Bank’s Financial Statements. www.investopedia.com. N.D., Web. May 04, 2011. Bank Balance Sheet: Liquidity and Solvency. www.calculatedriskblog.com. April 26’ 09. Web. May 04 2011.

Interest Rate Risk Management. http://www.boj.org.jm. 2005. Web. May 04 2011. Interbank Market Liquidity and Central Bank Intervention. http://finance.wharton.upenn.edu. June 29 2008. Web. May 04 2011.