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After studying this chapter you will be able to understand: Basic lending principles, liquidity, asset management banking, liability management banking, profitability, profitability management.
Revise Lecture 17 • Basic Lending Principles Basic Lending Principles • According to section of the Banking Regulation Act, 1949, banking means ‘accepting for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise’ Basic Lending Principles • • Another major reason of the lending function is to add value to the bank By lending the funds mobilized by it, a bank will be in a position to earn spreads to sustain profitability Basic Lending Principles • • Profitability through lending will be obtained if the bank is in a position to take and manage credit risk that arises on account of the quality of the borrower and liquidity risk that may arise by borrowing short and lending long in order to attain greater spreads Further, the spreads earned in this activity will also be exposed to risk arising from both interest and exchange rates Basic Lending Principles • Thus, while lending, the bank should try to balance its spreads and the risk levels • Liquidity Basic Lending Principles Liquidity: • • • Liquidity for a bank means the ability to meet its financial obligations A bank lending finances invests in relatively illiquid assets, but it funds its loans with mostly short-term liabilities A shortage of liquidity has often been a trigger for bank failures Basic Lending Principles • • • • Liquidity: Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is the most liquid asset of all, but pays no interest) So banks try to reduce liquid assets as far as possible However, a bank without sufficient liquidity to meet the demands of its depositors Basic Lending Principles • • • Liquidity: The result is that most banks now try to forecast their liquidity requirements and maintain emergency standby credit lines at other banks Banking regulators also view liquidity as a major concern Basic Lending Principles Liability management banking • • • The key to liability management is the ability to borrow always Therefore, a bank’s most vital asset is its creditworthiness If there is any doubt about its credit, lenders can easily switch to another bank The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of Basic Lending Principles Liability management banking • In recent years, large banks have been making increasing use of asset management in order to enhance liquidity, holding a larger part of their assets as securities as well as securitizing their loans to recycle borrowed funds Basic Lending Principles Liability management banking • • • A ‘bank run’ is an overwhelming demand for cash by a bank’s depositors A large depositor assumes a risk and needs to know something about the bank’s own balance sheet However, a healthy balance sheet does not eliminate all risks Basic Lending Principles Liability management banking • • Even if the depositor knows the bank has adequate liquidity Large depositors must, therefore, be concerned about what others are likely to believe A rumour a bank, even though unfounded, can trigger a run causes a solvent bank to fail Basic Lending Principles • Profitability Basic Lending Principles Profitability • • A bank generates profit from the differential between the level of interest it pays for deposits and other sources of funds and the level of interest it changes in its lending activities This difference is referred to as the SPREAD between the cost of funds and the loan interest rate Basic Lending Principles Profitability • • Historically Profitability from lending activities has been cyclic and dependent on the needs and strengths of loan customers In recent history, investors have demanded a more stable revenue stream and banks have therefore, placed more emphasis on transaction fees, primarily loan fees, but also including services Basic Lending Principles Profitability • • However, lending activities still provide the bulk of a commercial or retail bank’s income In the past few decades, banks have taken many measures to ensure that they remain profitable while responding to everchanging market conditions Basic Lending Principles Profitability • The banking industry’s main obstacles to increasing profits are existing regulatory burdens, new government regulations and increasing competition from non-traditional financial institutions • Profitability Management Basic Lending Principles Profitability Management • • Profitability management is a total management process, rather than just an accounting or analysis procedure In contrast to asset and liability management, it places primary emphasis on the profit and loss account and secondary emphasis on the balance sheet Basic Lending Principles Profitability Management • • With profitability management, profitability is not merely reported; it is planned, measured and interpreted Planning ensures that efforts are directed toward the achievement of corporate objectives Basic Lending Principles Profitability Management • • Measurement checks and adjusts progress against plan by matching revenue received with related expense Interpretation develops a valid picture of people and businesses, thereby serving as a basis for the next planning cycle Basic Lending Principles Profitability Management • Profitability management involves the monitoring of three distinct types of profitability statistics The profits of bank can be measured in three ways; • By organization • By product • By account Basic Lending Principles Profitability Management • • Organizational profitability is the most familiar type since all banks have some system for reporting the performance of their major organizational units However, an effective profitability management system will also measure the ... section of the Banking Regulation Act, 1949, banking means ‘accepting for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdrawable... credit lines at other banks Banking regulators also view liquidity as a major concern Lecture 18 • Asset management banking Basic Lending Principles Asset management banking • • • One of the main... lending activities has been cyclic and dependent on the needs and strengths of loan customers In recent history, investors have demanded a more stable revenue stream and banks have therefore, placed