Question

• Summarize the most significant uses of the funds banks obtain; include a description of each and the risks involved. Next, discuss why a bank might invest in securities, even though loans typically generate a higher return; discuss risk as a factor. Finally, discuss how a bank might allocate funds to each type of asset and how this helps a bank to manage risk for the bank and its customers.

Answer 1

Solution:

This question is answered in three parts as follows:

a) Uses of funds Bank obtains

Funds mobilized by bank are deployed to asset generation.

Various Assets generated are :

Loan Assets

Advances in the form of Overdraft

Investments in Securities & Equity

and Cash

Risks involved in Loan Assets is risk of default

Government Securities carry zero risk of default

However , private debt securities are also subjected to default .

Investment in Shares are subjected to market risk.

b) Why Bank invest in securities even though loans typically generate a higher return

Banks are supposed to maintain certain portion of Deposits in the form of Cash and Securities as per Central Bank guidelines. These, are safe and highly liquid form of Assets to meet requirement of refund of deposits.

Bank invests in Loans which gives higher returns, however, it carries higher risk in the form of default.

c) Bank Fund Allocation

As mentioned in various types of Assets like Loans, Advanced, Securities Shares and Cash.

This way of funds allocation is done to minimise risk and maximize returns for the bank and its customers .