Bank XYZ wishes to raise its liabilities by $30m to cover its long-term lending for the...

Bank XYZ wishes to raise its liabilities by $30m to cover its long-term lending for the next quarter. It can raise the funds via the issuance of either 90-day certificates of deposit or 5-year bonds. Discuss how the bank’s choice of liability can: (a) directly affect its liquidity risk; (b) indirectly affect its credit risk

Expert Solution

The bank wants funds of dollar 30 million which is a long term asset of the bank which it may Finance either by issuing 90 days certificate of deposits or or certificate of deposits or or a 5 year Bond Bond year Bond Bond where the first one is is one is is a short term source of of finance and the later one is a long term term is a long term one is a long term term source of finance

Under choice one the bank finances such fund by short term source of finance finance which is 90 days certificate of deposit it effects the liquidity of bank directly because the redemption redemption of such certificate of deposit comes earlier then the payback of such asset and it is is to be paid either my liquidating the current assets or taking more short term finances finances which also effects the profitability of the bank short term finances charges charges finances charges charges more interest then long term term finances But under second choice Bank finances there long term asset buy asset buy term asset buy asset buy buy a long term source of Finance in which the Redemption of such such that comes when the Asset liquidates generally so there is a little risk of liquidity under choice 2
Under choice one The credit risk of bank is also affected by such decision as profitability is decreased and there is a liquidator crisis means shortfall of liquid money so the people landed to the bank wants their money as soon as possible and it may affect to the liquidation when people lose faith in bank - Under choice 2 there is a presence of little credit risk because when the long term liquidates its proceeds are used to pay off off the long term Bond and there is no situation of no situation of liquidity crisis so the people who lended to bank bank doesn't feel so risky and doesn't lose faith in bank

The basic principle to finance all the above financial needs is the concept of matching. It means that short term assets should be financed through short term sources of finance, medium term assets should be finance through medium term sources of finance and long term assets should be finance through long term sources of finance.

*Long term Sources Should be used to finance Long term assets

*Medium term Sources Should be used to finance Medium term assets

*Short term Sources Should be used to finance Short term assets

So under choice 1 Bank faces liquidity risk as well as as credit risk but under choice 2 Bank face only a little risk

so the second choice is Preffered

jeff jeffy answered 2 years ago

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