After studying this chapter you will be able to understand: Basic lending principles, liquidity, asset management banking, liability management banking, profitability, profitability management.
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- According to section 6 of the Banking Regulation Act, 1949, banking means
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* Another major reason of the lending function is to add value to the bank - By lending the funds mobilized by it, a
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- Profitability through lending will be
obtained if the bank Is In a position to take and manage credit risk that arises on
account of the quality of the borrower and liquidity risk that may arise by borrowing Short and lending long In order to attain
greater spreads
- Further, the spreads earned in this activity will also be exposed to risk arising from
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Liquidity:
* Liquidity for a bank means the ability to meet its financial obligations
* A bank lending finances invests In
relatively illiquid assets, but it funds Its loans with mostly short-term liabilities - A shortage of liquidity has often been a
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- Liquidity:
- Holding assets In a highly liquid form
tends to reduce the income from that asset (cash, for example, is the most liquid asset of all, but pays no Interest)
- So banks try to reduce liquid assets as far as possible
- However, a bank without sufficient liquidity to meet the demands of its depositors
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- Liquidity:
- The result is that most banks now try to forecast their liquidity requirements and
maintain emergency standby credit lines at other banks
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Asset management banking
- One of the main challenges to a bank Is ensuring its own liquidity under all
reasonable conditions
- Commercial banks differ widely in how they manage liquidity
* Asmall bank derives Its funds primarily from customer deposits Its assets are
mostly loans to small firms and
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Asset management banking
- Excess funds are typically invested In assets that will provide it with liquidity
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Liability management banking
- In contrast, large banks generally lack Sufficient deposits to fund their main
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Liability management banking
- Most of these banks borrow the funds they need from other major lenders in the form of short-term liabilities which must be
continually rolled over
- This is known as liability management,
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Liability management banking
- Asmall bank will lose potential income If It gets its asset management wrong
* Alarge bank may fail if it gets its liability
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Liability management banking
- The key to liability management is the ability to borrow always
‘ Therefore, a bank’s most vital asset Is Its creditworthiness If there is any doubt
about Its credit, lenders can easily switch to another bank
‘ The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of
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Liability management banking
- In recent years, large banks have been making increasing use of asset
management in order to enhance liquidity, holding a larger part of their assets as
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Liability management banking
* A‘bank run’ is an overwhelming demand for cash by a bank’s depositors
- Alarge depositor assumes a risk and
needs to know something about the bank’s own balance sheet
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Liability management banking
- Even if the depositor Knows the bank has adequate liquidity
‘ Large depositors must, therefore, be
concerned about what others are likely to believe Arumour a bank, even though
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Profitability
- A bank generates profit from the
differential between the level of interest it pays for deposits and other sources of
funds and the level of interest it changes In its lending activities
- This difference ts referred to as the
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Profitability
* Historically Profitability from lending
activities has been cyclic and dependent on the needs and strengths of loan
customers
- In recent history, investors have
demanded a more stable revenue stream and banks have therefore, placed more emphasis on transaction fees, primarily
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Profitability
- However, lending activities still provide the
bulk of a commercial or retail bank’s income
- In the past few decades, banks have taken many measures to ensure that they
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Profitability
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Profitability Management
- Profitability management Is a total
management process, rather than just an accounting or analysis procedure
- In contrast to asset and liability
management, it places primary emphasis on the profit and loss account and
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Profitability Management
* With profitability management, profitability is not merely reported; it is planned,
measured and interpreted
- Planning ensures that efforts are directed toward the achievement of corporate
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Profitability Management
- Measurement checks and adjusts progress against plan by matching
revenue received with related expense - Interpretation develops a valid picture of
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Profitability Management
* Profitability management involves the monitoring of three distinct types of
profitability statistics The profits of bank can be measured in three ways;
- By organization - By product
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Profitability Management
* Organizational profitability is the most familiar type since all banks have some system for reporting the performance of their major organizational units
‘ However, an effective profitability