im13 - Chapter 13 The Business of Banking Overview This...

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Chapter 13 The Business of Banking Overview This chapter is a key one for courses that emphasize financial institutions. It focuses on the role banks play as intermediaries in the saving-investment process and on how banks manage the risks involved in their deposit and lending activities. The chapter begins with a discussion of the balance sheet of a typical commercial bank. Most students will be familiar with the basics of balance sheets either from their principles of economics course or from an introductory accounting course. Nevertheless, time spent reviewing the basics of the definitions of assets and liabilities and the basics of entries on a balance sheet or T-account is not wasted, even in policy-oriented courses, because understanding the money creation process relies on it. The discussion moves on to an analysis of how banks earn profits by providing transactions and intermediation services. Surprisingly, the notion that banks are privately owned, profit- making companies comes as news to some students. The risk-sharing, liquidity, and information framework is used to analyze the relationship between savers and banks. Banks provide risk-sharing benefits to savers by allowing them to hold claims against a diversified portfolio of loans; bank deposits meet savers’ demands for liquidity; and banks gather information on and monitor borrowers. Banks are subject to liquidity risk because their assets tend to be relatively illiquid loans, whereas their assets tend to be relatively liquid deposits. A succinct discussion is provided of how banks use asset and liability management to reduce liquidity risk. In their relationships with borrowers, banks are concerned about credit risk and interest rate risk. Credit risk—the risk that borrowers may default on their loans—is handled by diversification, credit-risk analysis, collateral, credit rationing, monitoring and restrictive covenants, and long-term relationships. Interest rate risk is handled through direct asset and liability management—in the discussion of which the concepts of duration and duration gap are introduced—and through the use of floating-rate debt and swaps. Finally, financial innovations by banks in the period between the 1960s and the beginning of the new century are discussed. The risk-sharing, liquidity, information framework can be used to predict the financial innovations that banks carried out. Banks have a comparative advantage in lower transactions and information costs and the growth of off-balance-sheet lending—standby letters of credit, loan commitments, and loan sales—has allowed them to exploit these cost advantages without making traditional loans. Similarly, their comparative advantage in credit-risk analysis has allowed them to expand into credit-card lending. Outline
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im13 - Chapter 13 The Business of Banking Overview This...

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