Lecture Retail and merchant banking – Lecture 17

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 1/7

‘Basic Lending

Principles

Basic Lending Principles

- According to section 6 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

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

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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 asa major concern

Lecture 18

' ÄAsset management

banking

Basic Lending Principles

Asset management banking

- One of the main challenges to a bank Is ensuring its own liquidity under all

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Basic Lending Principles

Asset management banking

- Excess funds are typically invested In

assets that will provide it with liquidity

- The holding of assets that can readily be turned into cash when needed Is Known as asset management banking

: Liability managemenrt

banking

Basic Lending Principles

Liability management banking

- In contrast, large banks generally lack Sufficient deposits to fund their main

business dealing with large companies, governments, other financial institutions and wealthy individuals

Basic Lending Principles

Liability management banking

- Most of these banks borrow the funds they need from other major lenders in the form

of short-term liabilities which must be

continually rolled over

- This is known as liability management,

A much riskier method than asset

management.

Basic Lending Principles

Liability management banking

- Asmall bank will lose potential income If It gets its asset management wrong

* Alarge bank may fail if it gets its liability

management wrong

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

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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

- Alarge 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 Arumour a bank, even though

unfounded, can trigger a run causes a

solvent bank to fall

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 ts 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

Basic Lending Principles

: Profitability Managemenrt

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