Organizations including banks exist with an underlining goal of making profit. Banks engage in various income generating activities including taking deposits, advancing of loans, and financing of foreign trade. They also put chargers on the services they offer and levy interest on loans. Capital, asset and liability management is central in initiating major decisions in a bank. The process enables the financial institution to effectively manage the balance sheet in attempts to maintain bank’s liquidity. The approach drives at controlling the asset quality, liquidity, sensitivity and volume together with maturity. This paper will enumerate how banks make money and examine the asset, liability and capital management. Besides, it will delve into the analysis efficient market as well as explain the concept of lemon/free-rider problem. Lastly, the theory of bureaucratic behavior will be described and explain how Fed operates according to the public interest.
How Banks Make Money
Interest
Interest from loans advanced to customers forms the largest source of income for banks. Deposits which refers to the money that account holders entrust their banks for safekeeping are loaned at an interest rate. Banks loan the customers’ money to other people in the form of car and student loan, mortgages, credit cards among many others. The money that is lent is supposed to be paid back at a stipulated interest rate. An example is show in the simple income statement below:
Income Statement for the Year Ended 31st December 2017
Notes
2013
2012
USD
USD
Revenue
16
120,000
100,000
Cost of Sales
17
(65,000)
(55,000)
Gross Profit
55,000
45,000
Other Income
18
17,000
12,000
Distribution Cost
19
(10,000)
(8,000)
Administrative Expenses
20
(18,000)
(16,000)
Other Expenses
21
(3,000)
(2,000)
Finance Charges
22
(1,000)
(1,000)
(15,000)
(15,000)
Profit before tax
40,000
30,000
Income tax
23
(12,000)
(9,000)
Net Profit
28,000
21,000
Inducing charges on vaults also enables banks to make money and thus increase their profit base. Some individuals fear keeping their valuable and precious items like documents and jewelry in the house. This is due to risks such as theft, destruction or fire. An individual would thus approach a bank to keep the items safely in exchange of a fee. In the same vein, banks have also come up with means of capitalizing on the income through incorporating different kinds of vaults basing on dimensions and size to suit the needs of the customer. The customer in return pays an annual fee for safety and maintenance services.
Fees are also vital factor through which banks make money. The fees include ATM card transaction, account research fees, and dormant account activation fees. Every time a customer swipes a card at a store, the merchant pays an interchangeable fee. A large portion of the fee goes to the bank and a smaller part is taken by the store merchant. Also, standing orders charge and withdrawal of deposits before maturity date are other types of the fees that aggregate to form a source of revenue and income for banks.
In order for banks to maximize their profit, they need to be on top of their banking affairs. Bank managers use three management tools including asset, liability and capital to increase their income. Banks forms an extensive framework that monitors, measures and manages the different risks of a bank relating to credit, liability and equity, and interest rate risks. Banks are thus required to effectively plan their strategies to minimize risks. Management of the liabilities and assets is fundamental in making vital decisions in a structured framework and drawing focus on the risks that are bestowed to a bank. The process does encompass the management of assets along with the cash flows. Appropriate management is fundamental in acquiring, maintaining and directing cash flows to increase the profitability levels. The structure of asset liquidity management comprises of liquidity, credit and interest rates risk management. Capital management is a function which assists organizations in formulating funding procedures and outlining the capital requirements. Projection of growth and profit is thus made possible. Liquidity Risk
Liquidity risk is where a bank is unable to meet its short tern financial demands. It arises when an organization finances long term assets using the short-term liabilities. The risk is also associated to call, time and funding risks. For example, funding risk may occur when retailers withdraw their deposits without anticipation. On the other hand, when assets of banks are converted into non-performing assets, it forms time risk as the expected cash flow is not attained by the organization. Call risk happens due to precipitation of contingent liabilities and that a bank could not be able to capture the available profitable business opportunities. Hence, asset liquidity management is critical in managing liquidity risk.
Interest Rate Risk
The risk affects the market value of equity and thus influences the profitability of the bank. It arises when there are changes in the interest rates and thus affecting the price value of the assets. The risk poses a compelling threat to the bank’s capital base and earnings. Credit screening is used to determine the financial status of a person as one is able to see how many accounts one has, the credits that are active and the loans that a person has.
ALLL model based on value at risk is used to determine economic capital in banks. The graph is distributed into two segments as shown below.
The first segment forms the likely expected loss while the second is the unlikely unexpected loss and the difference between the two forms the estimated economic capital.
The unexpected loss is calculated using the formulae:
EL = PD (%) * LGD (%) * EAD ($)
Where PD= Profitability Default which is the partial or total loos on a credit obligation by a client
LGD= Loss Given Default which is conditional expectation of loss when default happens.
EAD = Exposure at Default which “measures the exposure of a counterparty at the time of default”.
EAD is given as; EAD= a * (RC + PFE).
Where
a= 1.4
RC=replacement cost
PFE= Potential Future Exposure
In a bank, Gap analysis is an asset-liability management technique that is used to determine the liquidity risk or what is also called the interest rate risk (IRR). The technique provides the differences between the rate-sensitive assets and rate-sensitive liabilities within a specified time. The method is this appropriate in asset- liquidity management.
The bank’s standard framework in measuring the funding liquidity risk (FLR) denotes the comparison of the “expected cumulative cash shortfalls” in a given time against the “stock of available funding sources.” However, a problem arises on the way to assign the cash flows to future periods and particularly the financial products that depict to be uncertain in their cash flows. The weighted average life is used to determine the indeterminate maturity. The technique is use to determine the financial products that have cash-flow pattern which differ significantly from the given cash flow product of a contract within a specified time.
Yield curve, re-pricing, and options risks are related to occurrence of interest rate risks. .A bank thus adopts a framework that would shield it from the harm. Lending capital to customer exposes a bank to the risk. For example, changes in the rate of correlation between the yield curves which affect the activities of the bank cause basis risk. Again, any alteration in the interest rates that is related to options creates option risk. The liabilities and the assets of a bank will be affected due to the noticeable changes in the present and future value of cash flow. The mismatch between the loans and deposits in a bank is destructive and thus there is a need to systematically measure the risk in order to have control over the adverse effects.
Credit risk
The risk arises when a client defaults in paying borrowed money. For example, when a person fails to make payment due on the credit card or the mortgage loan, a bank could run into credit risk. Mitigating of credit risks calls for the adoption of risk based pricing, credit derivatives a covenant among others.
Conclusion
Banks are just like other business enterprises which are driven with an objective of making money. Interest, vault charges, fees and penalties are examples of ways in which a bank makes money. Asset, liquidity and capital management is a process designed to reduce the risk which could detrimentally affect the operations of the bank. Undoubtedly, asset liquidity management helps in attaining a better balance in the long-term viability. Every bank thus needs to take suitable approaches that would eliminate occurrences of risks.
Efficient Market and the Lemon/Free-Rider Problem
Introduction
The concept of market efficiency is significant in finance and comprises of three critical concepts. These are operational, allocative and informational efficiency. The concept of efficient market is vital as it forms a blueprint for investment options. An investor is able to make an informed decision when faced with a set of investment portfolio. The efficient market is fundamental in predicting the return for systematic risks in a diversified portfolio. Additionally, the lemon or the free-rider problem has been a major concern for many investors. The problem affects the firm’s security prices and makes the investors risk losing his or her gains. People that take advantage of the lemon or free-rider problem lower security prices in the market. This affects the good and performing firms.
Lemon or Free-rider problem
A buyer will only pay a low value if he or she cannot be able to determine whether a product that is sold is lemon. Therefore, the market becomes inefficient and small in terms of movement of goods from the sellers to the buyers. In the same vein, if lenders are unable to differentiate between the good and bad firms, they will end up paying only low prices for their securities, and this means that they will charge high-interest rates. The good organizations will not be able to bother selling the securities at low prices. Therefore, the market becomes inefficient and small. The common problem explains the reasons why bonds and stock cannot be used as the primary sources of financing in organizations. Sale of information as well as government regulation of the financial system could be used to address the lemon problem. Financial mediation is also important and collateral help to reduce the consequences of defaulting.
Free-rider problem denotes to be detrimental in the financial sector. Ordinarily, the problem occurs when there is a public good that people enjoy and benefit from and yet they do not pay for it. It becomes hard for the government to exclude some people from enjoying the good and thus the two major features of public goods are that they are non-exclusive and non-viral. The problem of free-rider in financing arises when certain individuals purchase information that concern a certain firms and thus take advantage of the details to make investment decisions and yet they did not involve in generating the information. Hence, those who purchase the company data will later invest in securities that are of high quality and have a high return. The ideology creates a free-riding investor. Notably, when many investors are free riders, they end up pushing the prices of securities of the good performing firms high and thus make them less profitable for purchasing.
Efficient Market
Operational, Allocative and Informational Efficiency
Allocation efficacy refers to a security market where capital is allocated in a way that is beneficial to all the participants. Efficiency occurs when businesses in both the private and public sectors are able to acquire funds to finance profitable projects. Allocation efficiency promotes economic growth. Operational efficiency explains a condition where an organization is able to carry out operations in fairly and equitable manner. Here, the costs associated with operations of the organization should be at the lowest point. On the other hand, informational efficiency refers to a situation where the actual market price of the shares reflects the intrinsic values. Therefore, the idea implies that the observed market value of the securities needs to reflect the entire information that is relevant and related to the securities. In this regard, an investor is able to make an informed decision and takes risks that would culminate to a higher return.
Forms of Efficient Market
Weak-Form Market Efficacy
This form of efficiency means that the share prices reflect all the past information of the asset and it is not appropriate for decision making. Weak efficiency limits the investor in deciding the best security to invest in as it does not incorporate current market prices. Some of the information that considered under weak market efficiency include the past rate of return, the historical sequence of the asset prices and past stock movement. There is no technical analysis that is employed, and thus the stock prices are likely to be undervalued or even overvalued. Evolution of past share prices is used to predict the future share price and gains associated with the asset.
Semi-Strong Form Efficiency
It is a form of market efficiency; the price of securities fully mirrors the past information on prices and also incorporates the public information. It is also not appropriate for decision making because only the historical trends of the shares are analyzed to predict the future trends. Additionally, public details involving the capital market along with non-market information like dividends, economic performance, price earnings and political views are analyzed. New public information is integrated into the analysis of share prices and later adjusted in order to reflect the securities true value. Hence, public information alone is not viable in making investment choices that would generate higher stock gains.
Strong Form Efficiency
This is appropriate in making investment decisions. Both the past, the current public information of the shares and the private information are used to generate the market value of securities and their possible return. The fact that it incorporates private information in the analysis makes it to be reliable for an investor. Professionals such as fund managers and security analysts have private information that is available to the public. Strong market efficiency helps to lower cases of undervaluation or overvaluation of shares. An investor who uses this form of market efficiency in making financial decisions is likely to realize lucrative returns.
Conclusion
Market efficiency has essential implication to both the organization and the investors. The concept helps the one to make wise investments and generate higher returns. An investor chooses from a diversified portfolio and lower the risks associated securities. It is also used to predict price changes and is significant in achieving superior gains. Again, the lemon and free-rider problem denote to be detrimental and affects firms and individuals who would want to venture into security investment. The problem decreases the prices of assets from good firms and thus makes them be less profitable.
Fed and the Theory of Bureaucratic Behavior
Introduction
The theory of bureaucratic behavior explains that the goal of bureaucracy is the maximization of welfare relating to power and prestige. The underlining premise of the theory attacks Fed’s autonomy. According to the argument embedded in the framework, Fed does not act in the interest of the public. However, it contends that Fed initiates policies that are only beneficial to itself. The theory goes ahead to stipulate that Fed only works to gain control over the other banks but not necessarily to satisfy the welfare of people. Nevertheless, the arguments are highly refutable, and it is important to note that the function of the Fed is to provide a safe and a flexible financial system for the nation. It also promotes stability, and the roles call for the autonomy of the institution.
Theory of Bureaucratic Behavior
The theory elucidates that the Federal bank will never operate according to the public interest. Therefore, it concludes that central bank is fundamentally driven with the objective of maximizing its welfare. However, the argument is false. Undoubtedly, Fed always initiates viable decisions and operates in attempts to satisfy the public interests. Therefore, maximization of a person’s welfare is a priority objective of Fed. The bureaucratic theory alludes that Fed’s goal is inclined on enhancing its power and this affects the decision making processes. Notably, one would refute the bureaucratic reasoning alleging that Fed seeks its autonomy to benefit itself. Preferably, the autonomy is significant in enacting policies that would denote to promote the health of the economy both in the short and long run.
Fed Structure
The structure of Fed is organized in form of Board of Governors, Fed Reserve Banks, Member Banks, Depository institutions, Federal open market committee and lastly the advisory councils. The structure helps Fed to keep its undertakings hidden in order to avoid any conflicts that would arise with the Congress together with other politicians. The formulate policies such as open market operation and set the level of interest rate to mitigate the negative impacts that would arise from the bureaucratic behavior. The structure enables Fed to regulate other banks and thus eliminate any adverse effects that would affect the economy.
Organizational Chart
Fed’s Charter
In 1913, the Federal Reserve Act (FRA) was established and termed to be the US central bank. Its charter stated that it was to provide the country with a more flexible, and safe financial and monetary system. The charter set the purpose, functions and structure of the organization and also stipulated its operations and accountability. The congress and the president have the power to amend the FRA.
The FRB is a regulatory authority which manages the money supply of the nation. The open market operation is the primary tool. The authority is responsible in influencing the overall credit and liquidity conditions of the economy. The regulatory committees involved in the formulation of monetary policy, operation of a nationwide payment system and as well as the distribution of currency to the public via the depository institutions. Comparing The FRB with The Federal Deposit Insurance Corporation (FDIC) regulatory authority, it is clear that the two are concerned with the well-functioning of the Fed’s operations. FDIC charter mandates it to provide stability “to the economy and the failing banking system.” On the other hand, FRB charter stipulates that it to “provide the nation with a safer, flexible, and stable monetary and financial system.” The FDIC was created in the wake of the great depression to provide deposit insurance that would guarantee the safety of the depositors. The regulatory authority is also responsible for supervising and analyzing the stability and safety of the financial institutions. On the other hand, FRB is concerned with monetary policy and controls the money supply.
The office of controller of currency (OCC) charter has a provision to supervise and regulate the national banks as well as the federal savings in the federal branches. OCC mission is to ensure that savings both from the banks and federal are safe as well as offer an access to financial services. OCC is required to comply with applicable laws and regulations stipulated in its charter.
Fed oversees banks operations in attempts to mitigate risks. It does this through the monetary policies including open market operations, lowering ad increasing of interest rates and bank reserves. Fed uses expansionary and contractionary monetary policies to manage the economy. Arguably, the expansionary monetary policy maintained by the FRB lowers the unemployment and interest rates in the economy. The policy is again essential in facilitating investment. In contractionary monetary policy, Fed’s regulatory authority seeks to contract the money supply, increase the rate of interest to promote a savings culture and curb inflationary effect. Evidently, people and especially politicians cannot make correct choices for the good of the economy. Therefore, the bureaucratic theory does not hold and that independence of Fed enables it to pursue policies that are politically unrelated. Autonomy is fundamental because many of the political decisions seem to be favorable in the short run but adversely affect the economy in the long run.
To sum up, premise for the theory of bureaucratic behavior is false. It is not true that Fed initiates policies in order to satisfy itself. On the contrary, Fed is concerned with maximizing the welfare of the public. Thus, the undertakings will always be geared towards benefiting the entire economy. The fundamental role that is centered on the welfare of the people explains why fed needs to be independent and practice autonomy. Notably, any interference from the outside forces would result in unfavorable impacts, especially in the long run. FDIC and FRB are vital regulatory authorities that influence Fed’s operations. Their policies significantly aid in promoting the welfare of the nation.
