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Risk2 - Essay Example

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FINANCIAL MARKETS AND RISKS QUESTION 1 The need for maintaining safety and solvency in commercial banks: emphasis on adequate liquidity and capital adequacy. A bank is a place for the “safe-keeping” of funds (Caprio et al, 2006). This means that people and entities send monies to the bank and that means that aside the primary need to continue existing and operating as a going concern, a bank needs to have enough money to satisfy its primary safe-keeping responsibility it owes its customers…
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Risk2
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Download file to see previous pages These regulations cut across the need for adequate liquidity and capital. “Liquidity is the ability to make payments as the fall due” (Moir, 1999). This implies that liquidity refers to access to money or liquid resources that can be easily transformed into cash in a short time. This is what enables a business to pay for its cost of operations and trading activities. The lack of liquidity will cause a business to fold up. Liquidity is mainly borne out of cash inflows and short term convertibles to cash. These resources are used to fund working capital. A bank, like any other business needs to hold enough liquid resources to fund its operations and existence. It needs to pay its workers, pay for the premises they use for operations as well as working tools like computers, cars and other day-to-day expenses. Without this, a bank will obviously fold up. Due to the nature of banking, there is the need for banks to look beyond working capital for the maintenance of operations. They need to hold enough liquid resources to meet the cash demands of their clients within short notices. This therefore means that a bank needs to have enough cash in its vaults or within reach so that when entities banking with them call for their monies, they will be able to honour their legal obligation to pay customers as and when they come to make demands. This puts the need to hold sufficient cash or cash resources for the payment of clients an inherent part of the working capital structure of commercial banks. However, banks also have the duty of increasing the wealth of people saving with them. A rational person who holds money will want it to increase in value by earning some interest or profits through savings or investments. In the capitalist setting where people have the right to choose when and how to invest their money, banks have an obligation to come up with competitive interests for people who decide to save with them. Higher interest rates offered by commercial banks enables them to get more customers. This means that the commercial banks have the duty to invest the money of people who save with them in ventures that bring sufficient returns that enables them to pay high interests to their customers. Commercial banks therefore need to hold assets that can be used to re-generate revenue and sold for profits to attain the aim of providing high interest for their customers (Matz & Neu, 2007). As these assets generate revenues for the bank, the bank increases the wealth of the clients and earn more money through the sale of the assets. Thus, capitalisation is an important part of retail banking. Though the need to capitalise money deposited by clients is vital, clients also come in from time to time and demand their money. Due to the legal obligation of banks to make funds of their customers available to them when they need it, there is a strong need for banks to draw a balance between liquidity and capitalisation. A bank therefore needs to be careful to ensure that it has a fair balance between the two extremes. Investing too much money will mean shortage of money to pay customers who demand money. Also, failure to invest an adequate amount of money will mean that the bank will rake in lower ...Download file to see next pages Read More
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