Question

1. How does the proportion of capital for a typical bank compare with that of a typical industrial firm? Do you believe banks have adequate capital? Why?
2. What are the main factors a bank must consider when setting the interest rate to offer on deposits?
3. Define ‘bank capital’. What is the economic importance of capital to a firm?
4. What are the major uses of funds for a bank? What are the differences between large and small banks? Explain the difference.
5. Why do banks hold Treasury securities and state government bonds investment portfolios?
6. Why do you think small banks have a higher proportion of assets in investments than do large banks?
7. What customer characteristics do banks typically consider in evaluating consumer loan applications? How does each of these factors influence the decision of the bank to grant credit?
8. What do we mean by ‘off-balance-sheet’ activities? If these things are not on the balance sheet, are they important? What are some off-balance-sheet activities?
9. What are the major benefits of getting assets ‘off the balance sheet’ through either loan sales orsecuritisation?
10. What is a contingent asset? What is a contingent liability? Provide an example of each.
11. Explain the profitability versus solvency and liquidity dilemma facing bank management.
12. Explain why the credit risk associated with a loan portfolio is less than the sum of the credit risk associated with each of the loans in the portfolio.
13. Liquidity management can be practised on either side of the balance sheet. How are asset and liability management similar and how do they differ? Why do smaller banks have limited access to liabilitymanagement?

Answer 1

How does the proportion of capital for a typical bank compare with that of a typical industrial firm? Do you believe banks have adequate capital? Why? In general banks seem thinly capitalized (highly leveraged)compared to industrial firms. A typical bank is financed with less than 10% capital and even less for large banks. Most industrial firms are financed with 40% to 60% capital. Because most banks are prudently managed and all banks are highly regulated, their capital is probably adequate. Industrial firms do not have their primary operating debts insured by the government, nor is their liquidity guaranteed by the central bank.

What are the main factors a bank must consider when setting the interest rate to offer on deposits? There are 2 major factors. (1), the bank must offer a high enough interest rate to attract and retain deposits. If deposit rates are too high, however, they squeeze the spread between the average return on assets and the average cost of liabilities. (2), to meet competition, banks not only have to lower rates charged on loans, but also have to increase rates on deposits. Bank managers should recognize that market forces ultimately determine deposit rates.

Define ‘bank capital’. What is the economic importance of capital to a firm? Bank capital comprises capital stock, undivided profits, and special reserve accounts (not to be confused with reserve balances at the Fed). Capital is the “cushion”against which losses—particularly loan losses--are written off. Capital is also the residual claim of owners against the firm. For regulatory purposes, capital notes (debt) may count as part of a bank's capital if they are subordinated.

What are the major uses of funds for a bank? What are the differences between large and small banks? Explain the difference.

A bank’s major uses of funds are lending and investing. Investment securities are more importantto the portfolios of smaller banks than to those of larger banks. Larger banks have access to many more sources of liquid funds than do smaller banks, and therefore they do not need to rely as heavily on investment securities for liquidity. Smaller rural banks are more likely to carry significant portfolios of agricultural loans. Smaller banks are less likely to supplement their lending activities with leasing.

Why do banks hold Treasury securities and state government bonds investment portfolios?

Such securities are held as they are highly liquid and hence can be quickly turned into cash tomeet obligations. This is part of what is called the profitability-versus-safety dilemma facingbank management where the conflicting goals of solvency and liquidity on the one hand andprofitability on the other need to be balanced. Unfortunately, it is a set of conflicts not easilyresolved. For example, liquidity could be achieved by holding only Treasury securities. In thisstrategy, bank management would sleep well but eat poorly because profits would be low.

Treasury securities and state government bonds investment portfolios are heldby banks as they are highly liquid and therefore can efficiently be convertedinto cash. However, liquidity demands could be met by Treasury securitiesalone but profits would be low (low risk, low return). High risk loans (highreturn) could result as an expense to the bank if its asset portfolio is shiftedand could result in bank failure in extreme cases. This is known as theprofitability-versus-safetydilemma as faced by bank management. It is a conflict of solvency and liquidity goals ( long term vs short term.)

What customer characteristics do banks typically consider in evaluating consumer loan applications?

1. Character – This is a highly subjective evaluation of the business owner’s personal history. Lenders have to believe that a business owner is a reliable individual who can be depended on to repay the loan. Background characteristics such as personal credit history, education, and work experience are all factors inn this business credit analysis. Character is the single most important factor considered by a reputable bank. Banks want to do business with people who are honest, ethical and fair. (The difference between the ability to repay a loan and the willingness to repay a loan is an example of a person’s character.) The knowledge, skills, and abilities of the owner and management team are vital components of this credit factor.

2. Capacity – This is an evaluation of the company’s ability to repay the loan. The bank needs to know how you will repay the funds before it will approve your loan. Capacity is evaluated by several components, including the following:

• Cash Flow refers to the income a business generates versus the expenses it takes to run the business analyzed over a specific time period-usually two or three years. If the business is a start up, prepare a monthly cash flow statement for Year 1.
• Payment history refers to the timeliness of the payments that have been made on previous loans. Today there are companies that evaluate commercial credit ratings (such as Dun & Bradstreet) that are able to provide this kind of history to lenders.
• Contingent sources for repayment are additional sources of income that can be used to repay a loan. These could include personal assets, savings or checking accounts, and other resources that might be used. For small businesses, the income of a spouse employed outside the business is commonly considered.

3. Capital – A company’s owner must have his own funds invested in the company before a financial institution will be willing to risk their investment. Capital is the owner’s personal investment in his/her business which could be lost if the business fails. The single most common reason that new businesses fail is undercapitalization. There is no fixed amount or percentage that the owner must be vested in his/her own company before he is eligible for a business loan. However, most lenders want to see at least 25% of a company’s funding coming from the owner. Contrary to what is advertised in the media, a bank will not fund 100% of the business venture. In almost every case, any principal that will own more than 10% of the company is required to sign a personal guanantee for the business debt.

4. Collateral – Machinery, accounts receivable, inventory, and other business assets that can be sold if a borrower fails to repay the loan are considered collateral. Since small items such as computers and office equipment are not typically considered collateral, in the case of most small business loans, the owner’s personal assets (such as his/her home or automobile) are required in order for the loan to be approved. When an owner of a small business uses his/her personal assets as a guarantee on a business loan, that means the lender can sell those personal items to satisfy any outstanding amount that is not repaid. Collateral is considered a “secondary” source of repayments-banks want cash to repay the loan, not sale of business assets.

Financial institutions will generally advance up to 80% of valid accounts receivable.

5. Conditions – This is an overall evaluation of the general economic climate and the purpose of the loan. Economic conditions specific to the industry of the business applying for the loan as well as the overall state of the country’s economy factor heavily into a decision to approve a loan. Clearly, if a company is a thriving industry during a time of economic growth, there is more of a chance that the loan will be granted than if the industry is declining and the economy is uncertain. The purpose of the loan is an important factor. If a company plans to invest the loan into business by acquiring assets or expanding its market, there is more of a chance of approval than if it plans to use the fund for more expenses. Typical factors included in this evaluation step include: the strength and number of competitors, size and attractiveness of the market, dependence on changes in consumer tastes and preferences, customer or supplier concentration, length of time in business, and any relevant social, economic, or political forces that could impact the business.

6. Confidence – A successful borrower instills confidence in the lender by addressing all of the lender’s concerns on the other Five C’s. Their loan application sends the message that the company is professional, with an honest reputation, a good credit history, reasonable financial statements, good capitalization and adequate collateral.

• When applying for a small business loan, don’t forget the importance of personal relationships. Apply for a loan at a bank where you already have a positive business relationship. Also, make an attempt to meet with the person who will be evaluating your application, such as the bank’s lending officer, rather than the teller who handles your day-to-day banking transactions.

How does each of these factors influence the decision of the bank to grant credit?

The Size

It represents the total assets of the institution, where many studies have confirmed. There is a close relationship between the size of the enterprise and the granting of the loan and an important factor in the approval of the loan granting. While there are a range of studies have suggested that a small – sized enterprises are more likely to reject loan applications submitted, as well as the rejection of loan applications submitted linked inversely with the size of the founder . This confirms the fact that large enterprises enjoy the ease in obtaining loans.

Demographic Characteristics of the Client

Larousse defines the profile as ‘a set of traits that characterize someone from its ability to function, a job’.

We can say that the demographic characteristics of the client are sex, age, education level; years of experience… etc. can be relied upon in the type’s classification of private manager’s age and educational levels. Moreover, their impact on personal competence. As the charismatic fair and good reputation in the financial community, and committed to all its obligations in order to persuade the bank required credit granting.

Financial Situation Enterprise

It can be considered as the health status of the institution, as the bank based in his study of the loan file. The reliability of the financial information provided is a prerequisite to making the right decision, but it is linked to overall transparency of the latter, only . The dependence on the financial situation of the institution is mainly directed at the institutions that a transparent, as it is linked positively with the size of the enterprise. Thus owning the customer good financial position to cover the loan granted to him as collateral in the event of not being able to repay what it has.

The Bank - Enterprise Relationship

This variable includes number of factors that indicate the bank’s relationships with the organization are:

Multiple Banks “Multi-Banking”

This represents a variable number of banks, such as those dealing with the institution in the request for the loan, as it represents an important factor in determining the relationship between the parties. Nevertheless, there are studies to say that the multiplicity of banks reduces the likelihood of reject the loan rejected. However, there is the opposite of the first studies say that because of the variety of banking institution becomes unable to give a positive picture of its financial position. From Point of decision – making can be a variety of banks that make it harder to negotiate the terms of the loan. In this case, banks impose on institutions guarantees used as a pressure tool that is what makes the bank in a strong position. It is also to avoid banks granting loans have multiple sources of funding. Because it limits the use of information in addition to the enterprise deal with one bank generates an atmosphere of trust and cooperation between with the passage of time.

Duration of the Relationship (Strength of the Relationship)

There are several parameters to measure the strength of the relationship, but the most commonly used factor is duration. Where the strength relationship between the bank and the borrowers affect the loan rate and extent of availability. There are other factors to measure the strength of the relationship, including term. In addition, the number of banks that deal with the institution. Only a set of studies that can force the relationship to replace the collateral in order to obtain the loan, and many studies have confirmed this idea.

“They can replace beings.”

The Nature of the Relationship

The basis for the continuation of the relationship between the bank and the institution is trust. Where you play a big role in creating a favourable environment for communication between them through the exchange of information, as is one of the most effective ways to limit the problem of information. Where it expresses the nature of this relationship through a number of banks that deal with the organization, duration of the relationship, the loan amount, Interest rate and banking services. It is the results of the study carried out by the. In the framework of relational financing, the bank can minimize the risk of asymmetric information, and then be able to distinguish between the entrepreneurs and the quality (minimization of the risk of adverse selection). The exchange of information for the duration of the relationship would reduce the likelihood of dispelling the assets value granted in the form of guarantees.

The model of Stiglitz et al. is based on the existence of ex-ante information asymmetry.

The model of Williamson is based on the existence of asymmetric information ex-post.

The Characteristics of The Loan

Used loan characteristics are usually guarantees and interest rates, which are considered as substitutes (can one compensate the other) .

Amount Required

The study among the first to integrate the loan size in the granting of the loan. There are two theories opposing, on the part of the loan leads to a rejection of the size, and the other helps the size of credit to cover Loan costs and increases the chances of getting it.

Interest Rates

An interest rate of profit or surplus loan can be produced, and is at the same time represents the interest that the organization paid for the loan rate. In previous experimental studies, most contributions consider that the loans granted size is linked largely with interest followed the price policy of the party banks, banks prefer rejected loan applications to raise interest rates.

Collaterals

collaterals are considered as an organizer of the supply and demand for loans, can be used as a mechanism to separate or distinguish between different clients; as the acceptance of the borrowers to provide important safeguards gives a positive signal about their financial situation, and the largest annexation n m to recover the loan amount granted in the case of failure.

In fact, credit guarantees contracts that are used as a means to choose between projects and as a stimulus enabling them to eliminate the problem of adverse selection, and balancing. While others are opposed to the wealth effect on the decision – making. Because it cannot reduce the problem of adverse selection in the case of whether the original wealth changed (Preliminary) (i.e. time to get the loan and the time to maturity).

What do we mean by ‘off-balance-sheet’ activities? If these things are not on the balance sheet, are they important? What are some off-balance-sheet activities?

What Is Off-Balance Sheet (OBS)?

Off-balance sheet (OBS) items is a term for assets or liabilities that do not appear on a company's balance sheet. Although not recorded on the balance sheet, they are still assets and liabilities of the company. Off-balance sheet items are typically those not owned by or are a direct obligation of the company. For example, when loans are securitized and sold off as investments, the secured debt is often kept off the bank's books. An operating lease is one of the most common off-balance items.

Understanding Off-Balance Sheet

Off-balance sheet items are an important concern for investors when assessing a company's financial health. Off-balance sheet items are often difficult to identify and track within a company's financial statements because they often only appear in the accompanying notes. Also, of concern is some off-balance sheet items have the potential to become hidden liabilities. For example, collateralized debt obligations (CDO) can become toxic assets, assets that can suddenly become almost completely illiquid, before investors are aware of the company's financial exposure.

Off-balance sheet items are not inherently intended to be deceptive or misleading, although they can be mis-used by bad actors to be deceptive. Certain businesses routinely keep substantial off-balance sheet items. For example, investment management firms are required to keep clients' investments and assets off-balance sheet. For most companies, off-balance sheet items exist in relation to financing, enabling the company to maintain compliance with existing financial covenants. Off-balance sheet items are also used to share the risks and benefits of assets and liabilities with other companies, as in the case of joint venture (JV) projects.

The Enron scandal was one of the first developments to bring the use of off-balance-sheet entities to the public's attention. In Enron's case, the company would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it. If the revenuefrom the power plant was less than the projected amount, instead of taking the loss, the company would then transfer these assets to an off-the-books corporation, where the loss would go unreported.

• Off-balance sheet (OBS) items are an accounting practice whereby a company does not include a liability on its balance sheet.
• While not recorded on the balance sheet itself, these items are nevertheless assets and liabilities of the company.
• Off-balance sheet items can be used to keep debt-to-equity (D/E) and leverage ratios low, facilitating cheaper borrowing and preventing bond covenants from being breached.
• The practice of off-balance sheet financing has come under increasing scrutiny after a number of accounting scandals revealed the mis-use of the practice.

Most commonly known examples of off-balance-sheet items include research and development partnerships, joint ventures, and operating leases.

Among the above examples, operating leases are the most common examples of off-balance-sheet financing. In the case of operating leases, the asset itself is presented on the balance sheet of the lessor, and the lessee reports in its financial statements only the required rental expense paid against usage of the asset. International Financial Reporting Standards (IFRSs) have set numerous rules for the entities to follow in determining whether a lease should be classified as finance lease or operating lease.

What are the major benefits of getting assets ‘off the balance sheet’ through either loan sales orsecuritisation?

These benefits arise from the fact that off-balance-sheet financing creates liquidity for a business while avoiding leverage, thus improving the overall financial picture of the company. This can help companies keep their debt-to-equity ratio low: If a company is already leveraged, additional debt might trip a covenant to an existing loan. The trade-off is that off-balance-sheet financing is usually more expensive thantraditional on-balance-sheet loans. Business owners should work closely with their CPAs to determine whether the benefits of off-balance-sheet financing outweigh the costs in their specific situaton.

What is a contingent asset? What is a contingent liability? Provide an example of each.

A contingent asset is something that offers potential gains such as loan commitments and unrealized gains on derivative securities contracts. A contingent liability is something that has potential losses an example would be letters of credit and unrealized losses on derivative securities contracts.

Explain the profitability versus solvency and liquidity dilemma facing bank management.

Because of banks’ large proportion of short-term liabilities and low equity capitalization, banks are more subject to failure than other businesses. Too many liquid assets means high safety but low profitability. Too many risky loans or investments may mean higher profit because of higher expected yield; but higher than expected losses can cause bank failure because of low equity capitalization.

Explain why the credit risk associated with a loan portfolio is less than the sum of the credit risk associated with each of the loans in the portfolio.

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Liquidity management can be practised on either side of the balance sheet. How are asset and liability management similar and how do they differ? Why do smaller banks have limited access to liabilitymanagement?

The way that asset and liability management are similar is the management of cash flow requirements over a given period of time should be done in conjunction so that the asset side of the balance sheet agrees with the liability side. Cash flow projections should be completed over a 30, 90, or 180 day period to determine which assets will be switching from investments into liquid assets and which liquid assets will be converting into to longer-term illiquid assets. On the same idea, the liability side should be evaluated to determine which debt payments or short-term liabilities will be due and how those should be managed to ensure liquidity. A company may need to raise cash or capital to make these payments if needed.

B) Smaller banks usually have limited access to liability management due to the lack of management capabilities at small banks. Small banks usually only have a few senior members of management that are tasked with running the entire bank and are not able to focus on any specific needs of the bank. They end up focusing on more immediate issues such as loan management.

What Is Asset/Liability Management?

Asset/liability management is the process of managing the use of assets and cash flows to reduce the firm’s risk of loss from not paying a liability on time. Well-managed assets and liabilities increase business profits. The asset/liability management process is typically applied to bank loan portfolios and pension plans. It also involves the economic value of equity.

Understanding Asset/Liability Management

The concept of asset/liability management focuses on the timing of cash flows because company managers must plan for the payment of liabilities. The process must ensure that assets are available to pay debts as they come due and that assets or earnings can be converted into cash. The asset/liability management process applies to different categories of assets on the balance sheet.

[Important: A company can face a mismatch between assets and liabilities because of illiquidity or changes in interest rates; asset/liability management reduces the likelihood of a mismatch.]

Factoring in Defined Benefit Pension Plans

A defined benefit pension plan provides a fixed, pre-established pension benefit for employees upon retirement, and the employer carries the risk that assets invested in the pension plan may not be sufficient to pay all benefits. Companies must forecast the dollar amount of assets available to pay benefits required by a defined benefit plan.

Assume, for example, that a group of employees must receive a total of $1.5 million in pension payments starting in 10 years. The company must estimate a rate of return on the dollars invested in the pension plan and determine how much the firm must contribute each year before the first payments begin in 10 years.

Examples of Interest Rate Risk

Asset/liability management is also used in banking. A bank must pay interest on deposits and also charge a rate of interest on loans. To manage these two variables, bankers track the net interest margin or the difference between the interest paid on deposits and interest earned on loans.

Assume, for example, that a bank earns an average rate of 6% on three-year loans and pays a 4% rate on three-year certificates of deposit. The interest rate margin the bank generates is 6% - 4% = 2%. Since banks are subject to interest rate risk, or the risk that interest rates increase, clients demand higher interest rates on their deposits to keep assets at the bank.

The Asset Coverage Ratio

An important ratio used in managing assets and liabilities is the asset coverage ratio which computes the value of assets available to pay a firm’s debts.

Smaller banks usually have limited access to liability management due to the lack of management capabilities at small banks. Small banks usually only have a few senior members of management that are tasked with running the entire bank and are not able to focus on any specific needs of the bank.