Commercial Banks - Coursework Example

(BME, 2007). The third category of products offered by financial institutions is investment funds. These accumulate assets from investors and invest the assets in a diversified pool of assets. According to the BME consulting report of 2007, investment funds can be classified as equity fund, bond funds, balanced funds, money market funds, real estate funds and other funds such as hedge funds. (BME, 2007). The other product is life insurance. This product is among the largest net asset pools of consumers in the European market.

The UK is the largest market in Europe in relation to total life insurance provisions. (BME, 2007). Derivatives are the other category of investments issued by financial institutions. “Derivatives are special non-standardized instruments tailored to meet the different investment strategies and needs of consumers.” (BME, 2007) There are mainly two types of derivatives. They are warrants and certificates. Lastly, there is private equity. Consumers consider this class of assets better than public equity since the liquidity and transparency level is lower, and is a more established class of assets.

(BME, 2007). From a report by the Bank of England, with an increase in interest rate, consumers will shift their investments to suit their risk attitudes. If the rise in interest rate reduces their level of earnings, investors will opt to sell their assets and invest in a different category that will maximize their earnings. For example, a rise in the interest rate of bonds will lead to a fall in its price. With this, investors will tend to sell their bonds before maturity and reinvest in securities with a lower prevailing interest rate.

In the same report, savings have a direct relationship with changes in interest, whereas investments have an indirect or negative relationship. The increase in interest will make savings more attractive and reduce greatly on borrowings. This is because the rate of borrowing will increase and the income from savings will rise. At higher interest rates, savers will tend to forge their current consumption and increase their savings to take advantage of the high rates. 

The interest earned thereon will be considered as a reward for the postponed consumption.

Consumer’s cash flow will also be affected by the increase in interest rate. In reference to savers,  an increase in interest, money received from their savings accounts and building society deposits will increase. As for those who have borrowed loans, their interest obligation will increase reducing their cash inflow (Howells & Bain, 2009).

The asset prices are also affected. With an increase in interest rate, return on savings in banks and building societies increases. This will in turn lead to investors opting to change their asset portfolio. For example, they may reduce their investment in equity stocks as well as real estate and opt to invest in securities whose asset value is high. The other implication is that investors from outside the U.K will be attracted to investing in the country. With high interest rates relative to other countries, investors will prefer to channel their funds into the U.K. As a result of this, there will be a tendency of the currency to appreciate against other currencies (Santomero, 2007).

Q.3 The main risks to commercial banks of a significant rise in the general level of interest rates

According to Anthony, Commercial banks operate in a risky environment. One major risk faced by commercial banks when interest rates increase is the changes in cash flows and earnings. This is referred to as the economic risk or exposure. It occurs mainly because of the timing differences when repricing bank assets, its liabilities as well as off-balance sheet securities (Flannery, 2011).

The other risk is commonly known as the basis risk. This arises due to the imperfect correlation in the adjustment of rates earned and paid on different securities with similar repricing characteristics. An increase in interest rate will reduce the bank’s earnings and lower its net worth. The increase in interest rate creates a mismatch in the maturity structure of the bank and the repricing terms of the bank’s assets and liabilities (Flannery, 2011).

Translation risk also poses a threat to commercial banks when interest rates rise. This will affect banks that have subsidiaries in other countries. There is a foreign exchange risk involved when reporting the financial position of the bank’s subsidiaries to the parent company. There will be an exchange difference when the subsidiary is reporting its financial performance. As a result, the financial statement may give a negative view of the operations of the subsidiary to those who read the financial statements (Santomero, 2007).

Interest sensitivity of banks to their non-interest income may also affect it negatively. A good example is with lowering of mortgage loans, repayments will tend to increase, and this will reduce the number of mortgage loans serviced by the bank. This will reduce the bank’s income free from mortgages. (Howells & Bain, 2009).