Question

1. Describe how bankers manage credit risk and interest rate risk.
2. Explain why regulators mandate minimum reserve and capital ratios.
3. Discuss the opportunity cost to holding reserves, which pay no interest, and capital, which must share the profits of the business.

Answer 1

Answer :

There are two ways in which a bank can manage its interest rate risks:

(a) by matching the maturity and re- pricing terms of its assets and liabilities and

(b) by engaging in derivatives transactions.

A basic interest rate risk reduction strategy when interest rates are expected to fall is to keep the duration of liabilities short and the duration of assets long. That way, the bank continues to earn the old, higher rate on its assets but benefits from the new lower rates on its deposits, CDs, and other liabilities

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk.

When a lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides for greater cash flows.

Banks manage credit risks by monitoring a number of factors including loan concentrations, credit risk by counterparties, country exposures, and economic and market conditions. Provisions and net charge-offs are indicators of banks' asset quality.

Part 2.

• Capital requirements are regulatory standards for banks that determine how much liquid capital (easily sold assets) they must keep on hand, concerning their overall holdings.
• Express as a ratio the capital requirements are based on the weighted risk of the banks' different assets.
• In the U.S. adequately capitalized banks have a tier 1 capital-to-risk-weighted assets ratio of at least 4%.
• Capital requirements are often tightened after an economic recession, stock market crash, or another type of financial crisis.

Capital requirements are set to ensure that banks and depository institutions' holdings are not dominated by investments that increase the risk of default. They also ensure that banks and depository institutions have enough capital to sustain operating losses (OL) while still honoring withdrawals.

The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum amount of reserves that must be held by a commercial bank. The minimum reserve is generally determined by the central bank to be no less than a specified percentage of the amount of deposit liabilities the commercial bank owes to its customers. The commercial bank's reserves normally consist of cash owned by the bank and stored physically in the bank vault (vault cash), plus the amount of the commercial bank's balance in that bank's account with the central bank.

The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's borrowing and interest rates by changing the amount of funds available for banks to make loans with. Western central banks rarely increase the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they generally prefer to use open market operations (buying and selling government-issued bonds) to implement their monetary policy.

Part 3.

Factors to be considered :

a. the interest rate, which represented the opportunity cost of holding money

b. the price level, which would affect how much money was needed for transactions

c. income, because as income rises you buy more, and as it falls you buy less

• Bankers must manage their bank’s liquidity (reserves, for regulatory reasons and to conduct business effectively), capital (for regulatory reasons and to buffer against negative shocks), assets, and liabilities.
• There is an opportunity cost to holding reserves, which pay no interest, and capital, which must share the profits of the business.
• Left to their own judgment, bankers would hold reserves > 0 and capital > 0, but they might not hold enough to prevent bank failures at what the government or a country’s citizens deem an acceptably low rate.
• That induces government regulators to create and monitor minimum requirements.