Question

How can a depository intermediary afford to purchase long-term risky direct claims from funds demanders and finance these purchases with safe, liquid, short-term, low-denomination deposits? What can go wrong in this process?

Answer 1

Depository intermediaries can afford to do so because the rate that they must pay for attracting the funds is less than that they can charge for riskier assets. However a lot can go wrong on this.

• The depository intermediaries cant repay its depositors on demand (credit & liquidity risk) if the money lent is not repaid. Diversification of credit risk can be a key way to limit the credit risk of depository intermediaries.
• Difference between rate earned on assets & rate paid on liabilities is referred to as net interest margin. This can become negative if the interest rates rise or if the rates on long term securities fall below the interest rates risk on short term securities after adjusting for the risk.
• As the assets & liabilities are of different claims, there are chances that assets would drop resulting in an insolvent institution. Because the assets are primarily financial, their value can be volatile. As a result of this risk management is considered to be crucial for today’s financial institution.
• Depository intermediaries can attract many savers with minimum amount of funds. Then they invest these bulk savings in investments that can’t be liquidated immediately. The savers would withdraw the money if they lose confidence on these depository intermediaries which can result in liquidity crisis & can ultimately cause insolvency.