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Commercial and Investment Banking Essay Sample

Commercial and Investment Banking Pages
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Q 1. GENERAL PRINCIPLES OF BANK MANAGEMENT

The general principles of bank management include;

Liquidity management- involves maintaining asset that can be easily converted into cash. The cash serves the purpose of depositor withdrawal either from checking or savings account or checks written by the depositor to other banks. Liquidity management make sure cash is available upon depositors demand to withdraw or payment.

To keep enough cash on hand, the bank must engage in liquidity management practices. A bank needs to hold enough excess reserves that can be able to meet all depositors need. This shield the bank from additional cost in meeting the depositors need. Such additional costs include the cost of borrowing from other banks, sale of securities, calling in loans and resulting in borrowing from federal bank.

Asset management; a bank need to manage its asset is effectively so as to maximize its profits. This can mainly done through, acquiring liquid assets that have acceptable low level of risk such government securities, diversifying its asset holding portfolio as risk asset management strategy, issuing loans yielding higher interest to borrowers who are deemed safe, last the bank s meet to maintain enough reserve to meet its depositors need without resulting to borrowing in order to save on cost of borrowing.

Liability management with the increased innovation and changes in operation of banks operation a banks need to ensure the cost of funds is minimized. This ensures a bank will be able to meet its obligation as the fall due.

Capital adequacy management-the manager must decide the amount of capital the bank should maintain and then acquire the needed capital in consideration of the regulation existing in the market. Capital is essential in bank as is prevents failures and also influence returns on common stock holders.

Q . 2 Discuss the techniques of managing credit risk and interest rates risk

There are various techniques used by banks to manage credit risk they include,

Prescreening and loan monitoring

Banks usually collects information pertaining to their prospective clients. The information collects helps to evaluate the borrowers classify the borrower either as safe borrower or risky borrower in this event the bank is able to manage the credit risk

Another way is continuously monitor the borrower after the lender have issued loan, this help to solve the problem of moral hazard where the borrower under take more risky venture than the one the money was borrowed for.

The second manage credit risk establishment of the long customer relationship this helps the banks to collect information about the borrower asses the overall credit worthiness of the borrower.

Third the bank can manage the credit risk by placing stringent condition on the use of the borrowed funds. In this case the bank issues restrictive covenants that restrict the borrower from engaging in risky activities.

Fourth a bank need to ask for collateral, in which it would recover the money in the event the borrower fail to repay the amount borrowed.

Fifth another credit management tool is credit rationing. In this case the bank refuses to lend the borrower funds even if they are willing and able to pay high level of interest rates.

Now let us turn our interest to measure to manage the interest rate risk, interest rates are very volatile therefore the bank needs to appropriately hedge against loss emanating from the changes interest rates. Therefore, the bank needs to undertake a gap and duration analysis, in this case sensitivity of profits to interests, where the liabilities which are sensitive to changes in the rate interest are subtracted to from assets that are responsive to changes in the rate of interest in gap analysis.

Q 3. Discuss the off-balance sheet activities on banks

Off- balance sheet activities are becoming increasingly popular to bank. These activities have been observed a source of higher returns to the bank. Off-balance-sheet activities include;

Loan sales

One of the main off-balance-sheet activities that yield high return to banks is sale of loans. In this case the bank sells its loan in contract thus removing the loan from the bank balance sheet. In this case the loan is sold at premium as compared to initial value of the loan. Institutions will be willing to purchase the loan due to the higher interest on the loans.

Generation of free income

This is amount of cash that a bank obtains through provision of specialized services to their clients. Banks offer specialized packages to their client like assessing the implication of a loan on company, processing standing orders, con ducting foreign exchange trades on behalf of the companies and modeling of financial instruments and later selling the off to interested investors.

These activities have significantly increased bank earnings, however, their increase vulnerability of bank to insolvency. Bank in effort to diversify their sources of revenue engage in off-balance-sheet, off-balance-sheet involves a lot of speculation. Speculation is dangerous and very risky since it can lead to bank insolvency.

In addition off-balance- activities act as deviation of the core objective of the bank which is to offer banking services to its client, this leads to emergence of principal-agent problem

Q.4. Discuss the principles for managing credit risk

Financial institution in a bid to resolve the problem of adverse selection and moral hazards developed the principle of managing credit risk. They include, developing long-term customer relationship, borrowers of screening and monitoring, credit rationing, loan commitments, compensating balances and collateral requirements.

Screening and Monitoring

In order to eliminate the problem of adverse selection, banks in prescreening of potential borrowers. The bank has to screen all the borrowers in order to distinguish between safe borrowers and risky borrowers in doing this the bank collect information that would help the bank evaluate the credit worthiness of the bank.

After issuing the required fund the banks need to monitor the borrower such that the borrower does not engage activities than the one indicate in the loan agreement.

Credit ratio

A bank may reject a borrower plea for fund even the borrower have the ability to repay the borrowed funds or even pay higher interest .credit ratio can also .be partial where the bank limit the amount of credit to extended to a customer.

Loan commitments

Loan commitment is a pledge by the bank to provide fund to an enterprise where the interest rate pegged on the market rate of interest, this help the bank to obtain information on the customer.

Compensating balances and collateral backing

All loans to be backed up by a collateral such collateral may be a asset of an enterprise or a requirement deposit some amount of cash(compensating balance).

Q.5 Discuss the rapid development s that have resulted in many new financial products and the services due to the recent rapid developments in information technology.

Technological advancement has fostered financial innovation leading to creation of new financial products. In addition to this, improvement in information technology has reduced the cost of transaction in the financial institution as well as reducing the problem of information asymmetry among the market players. Rapid developments in technology have led resulted to development of the following financial products.

Bank credits and debit cards-

In 1960’s technological advancements led to the successful invention of credit cards that had previously failed. After this success, bank credit occasioned innovation of debit cards. A debit card was different from the bank credit since the funds used through this card were immediately deducted from card holder’s bank account.

Electronic banking

The most popular electronic banking facility facilitated by the development in technology was the automated teller machine (ATMs where a customer can perform) almost all service offered in banks. In addition, the reducing cost of telecommunication has also led the emergence of internet banking or rather home banking. Where customers us a virtual bank in the cyber space to perform all service as if the customer had visited the bank premises.

Electronic payment

This is a service where a bank creates a website where customers can login and pays electronically instead of the tradition methods. This has been occasioned by the development of cheap computers and the rapid development in information technology infrastructures such as internet.

E money

This is innovation of money that only in electronic form for example the presence of stored value card, smart card and also e-cash

Other products that have been occasioned by the development of technology is the junk bond, commercial paper as well as securitization. Securitization refers to a situation where lenders pool various loans and convert them into sellable assets.

Q.6 Discuss the regulations that have been the major forces behind such innovation such as mutual fund, sweep accounts and strips.

Financial innovation of various financial products has been occasioned by the presence of regulation that has restricted banks in conforming to standards that limits their profitability. The regulations include;

Reserve requirement,

Reserve requirement are the reserve that a bank is need to deposit with the federal bank. In this case the bank lending capacity is constrained as the monetary authority mops the excess liquidity of the bank. The federal bank does not pay interest on the fund held as reserve requirements, the interest that the bank could have earned by lending the funds act as tax to the bank. This regulation has led to financial innovation such as the mutual fund which is not subjected to the minimum reserve requirements and sweep account. Where fund over some certain amount in a checking account are swept out and invested in overnight securities. This convert such deposit into non checkable deposit thus they are not restricted to the reserve requirements

Restrictions on interest paid on deposits

In an effort to acquire more funds to loan and earn higher returns banks had to develop financial products that were attractive to the depositors, but to the presence of regulation q banks are not supposed to interest on checkable deposit therefore, they had to develop products such as the treasury strips, sweep accounts and mutual fund that don‘t fall under the checkable deposits

Q7.Discuss financial innovation and the decline of traditional banking

Financial innovation have led the banks to be more competitive thus abandoning the traditional banking to adopt the new era of banking. This can be illustrated by the decline in the role of commercial bank as a source of fund for the non financial borrowers, intermediation role of banking can be observed as irrelevant. Intermediation is a situation where a bank advance loan s to borrowers which are funded by deposits.

In overall the profitability of the bank has not significantly improved but there has been increase in income resulting from off-balance-sheet activities. This implies that profitability arising from traditional banking have declines. The decline in profitability offers a good explanation why the banks are reducing their tradition business.

Banks have faced declining cost advantages in Acquiring funds (liabilities), this was occasioned by the abolishment of the Q regulation thus making the banks to be more competitive in efforts of acquiring fund and also reduce earlier enjoyed cost advantage over other financial institution.

Decline in income advantage on uses of funds (assets), banks also face reduced income advantages from financial product such as securitization and commercial paper. This occasioned by the fact that firms now were allowed to issue securities to the members of the public directly. Technological advancement allowed other players to be able efficiently conduct services that were earlier offered by the banks. Therefore, could only increase their income in engaging in off-balance-sheet activities, or expand their tradition role by venturing new and risk segments of lending so as to remain in business.

Q8 discuss the types of services securities brokers offer and provide an example of using the limit order book

Security brokers acts as agents of an investor while trading in the secondary markets. They offer several type of service which include

Securities orders, there are three types of orders, market orders, limit order and short sells

A market order is instruction to the broker to sell or buy security at the prevailing market prices. In this case the order is vulnerable to price volatility

The limit order is instruction to the broke by an investor where an investor specifies the maximum price at which the broker can buy the security and in event of a sale the investor specifies the minimum acceptable price. In addition an investor can issue a stop loss order where in an event that security, price such a point the broker should the security to avoid enormous losses and the take profit order where the security price hit the take profit point. An example of limit order is as illustrated below as used by a broker.

Unfillied limit odres

Buy security sell security

Prices no of securities

Pricesno. of securities

Short sale is situation where an investor borrows security from a brokerage house with an intention of selling them today and returning the borrowed security at later date in future. The investor anticipates that the price of the security in question will decline thus offering the b investor profits.

Other service include provision of margin credit, margin credit is an instance where the investor deposit funds with the brokerage, then the brokerage company extend more fund to investor than the ones deposited to buy securities.

In addition to services listed above brokers also both technical and fundamental analysis to the client as well as investment advice

Q10. Discuss the factors that determine the supply for bonds

There are various factors that affect the supply of bonds; in this section we will discuss some of these factors.

Prices of bonds

According to economic theory, there is positive relationship between the prices of bond the supply of bond this represented by the movement along the supply curve, that is the amount of bond supplied increases with increase in prices of bonds.

Expected profitability of investment opportunities

If the economy is experiencing a boom there are numerous expected profitable of investment opportunities, this increases the supply of bond making the bonds supply curve to shift to the right. Similarly, if the economy is experience a recession there will be less expected profitable investment opportunities thus resulting in a decline in the supply of bonds.

Expected Inflation

The real cost is assumed to be difference between the nominal rate of interest and the inflation rates. Therefore, an increase in the level of inflation leads to a decline in the real cost associated with borrowing thus increasing the supply of bonds thus shifting the bond supply curve to the right. The reverse is true.

Government budget

A government budget may have deficits or surplus. If the government budget has deficits, the treasury issues more bond so that the government can raise fund for the deficit, but if the government budget has a surplus the government will not issue bonds. Therefore, presence of governments deficits increase the supply of bonds and make the bond supply curve to shift to the right.

Q11. Discuss the factors that determine the demand for bonds

A number of factors influences the demand for bonds, some of these factors include

Prices of bond

When the prices of bond increases the quantity of bonds demand declines this because they bond are now expensive thus not affordable, the vice versa occurs when the price of bond changes to due changes in market conditions.

Wealth

If the economy is expanding and there is an increase in accumulation of wealth this will lead to increase in bond and also make the bon demand curve to shift outwards or to the right. The demand for bonds will decline wit decline will decline when the economy is in a stack wealth decline thus the demand for bonds.

Expected rate of interest

When the expected rate of interest on bonds increases, this leads to decline in expected long-term capital gains, thus lowering the demand for bonds. This makes the demand curve of bond to shift in ward. The vice versa is true.

Expected inflation

If there is an increase in expected inflation we expect that the returns from the bonds will decline, this causes the demand for bonds to decline and the demand for bonds will shift in inwards. The vice versa is true.

The level of risk associated with the bonds

If the risk associated with bond increases relative to risk of holding other assets, this result to a decline in the quantity of bonds demanded. This makes the demand curve for bonds to shift to left or inwards. A decline in the risk associated with the bond leads to increased, in amount of bonds demanded thus a shift in the demand curve for bond to the right.

The degree of liquidity of bond relative to the liquidity of other asset

If the bond has higher level of liquidity when compared to other asset this will result in increase in demand for, but if other assets have higher liquidity then this results in decline in quantity of bonds demand thus a shift of the bond demand curve inward.

Q12 How moral hazard affects the choice between debt and equity contracts

An equity contract is created when an individual acquires a common stock of an enterprise. Equity contracts holder participate in profit sharing. The equity contracts holders do not manage affairs of the business, but they seek the services of managers who act as agents. In this case the equity contracts holders are the principal. They main objective of agents is to maximize the equity contracts holders’ value. This gives rise to principal-agent problem which is a form of moral hazard problem. In order to control the problem of moral hazard equity contract holders engage in monitoring activities such as auditing. If equity contract holders do not engage in monitoring activities then the moral hazard problem makes common stock unattractive, thus it will be hard for the firm to raise fund trough the issue of common stock.

Moral hazard in the case debt contract arises when the borrower invested fund in highly risky activities. In this case lenders engage borrowers into signing loan agreement with conditions that the borrowers should conform to (also known as covenants). These covenants help to reduce the problem of moral hazard. Many debs contract are issued with condition thus making them more attractive than the equity contracts.

Q13. how moral hazard influences financial structure in debts market

Moral hazard in the debt markets emerges where the borrower engages in activities that are more risky than the initial purpose of the funds. If the borrower engages in activities that are more risky then are likely to get higher returns. The lender will only received a fixed portion of the funds earned but take home large portion of the profits at the expense of the lender and this give rise to the moral hazard problem.

This has made the financial players to change the structure of the debts contracts in order to incorporate measure that would curb the moral hazard problem. Therefore the markets have been modified as follows,

Collateral and net worth
Lenders in the debt market ask for collateral from a buyer when issuing loan. The lender would recover his money from the collateral issued in the event the borrower invested the borrowed funds in a risky venture and looses everything. In this case the borrower has a lot to lose thus curbing the moral hazard problem.

Monitoring and Imposing of restrictive covenants
Another way in which moral hazard have influenced the financial structure in debts market is increased monitoring of the borrowers by the lenders so as to ensure that the borrower conform to restrictive covenants attached to the loan issues.

Financial intermediation

Financial intermediation is one of role of banks in traditional baking; this role eliminates the problem of free-riding also it help solve the problem of moral hazard in making private loan enhancing monitoring and imposing of restrictive covenants.

Q14. Discuss factors that causes financial crises

Financial crisis refers to a situation where the financial market is unstable due to disruptions occasioned by the problem of information asymmetry that gives rise to adverse and moral selection problems. There are several factors that contribute to occurrence of financial crisis.

Asset market effects on balance sheets,

A Decline in stock market results in deterioration of balance sheet of the borrowing firm. A decline in the stock market implies loss of the enterprise net value and this scares lenders away. This also results in increase in moral hazard problem since firms will borrow in order to invest in risky ventures so that they can earn higher returns, the same result are obtained when there is decline in the anticipated price level

Unanticipated decline in the value of the domestic currency can lead to a financial crisis where the debts that a country has are all in foreign currency, this leads to a currency crisis which increases the moral hazard and adverse selection problem thus resulting to instability in the financial markets.

Deterioration in financial institutions’ balance sheets, If financial institution balance sheet are deteriorating then are faced with contraction in their capital base thus reducing significantly the amount of fund they advance to investor. This reduces the amount investment in an economy thus forcing the economy into a recession. Banking crisis,

If the financial balance sheet deterioration is worse this can lead to failure of a bank. If banks start to fail fear engulf the public thus resulting to panic withdrawal. This result decline in amount of credit advanced for investment purposes, thus higher interest rates. Panic and contagion increase adverse selection and moral hazard problem in financial market as observed in the Asian financial crisis.

Increases in uncertainty,

If there is increased uncertainty in the financial sector mainly occasioned by a recession or collapse of a financial institution lenders are not able effectively distinguish between safe and risky borrowers. Therefore there result top reducing the amount of lending; this inflates the adverse selection and moral hazard problem.

Increases in interest rates,

Investors who invest in risky ventures are usually ready pay high interest rates. Therefore, when interest increases due to contractionary monetary policy or increased in demand of credits the problem of adverse selection and moral hazard become persistent thus the financial markets are bound to fail

Government fiscal imbalances

Where the government are faced by a budget deficit they usually result in domestic borrowing this weakness the banking system as it impedes credit extension capacity of the bank. In this case fiscal imbalances results to aggravation of moral hazard and adverse selection problems

Q 15. Discuss the dynamic of financial crisis in emerging markets

Emerging markets like the developed economies have not spared by the financial crisis phenomenon, although the dynamics of financial crisis in developing economies have some different elements as delineated below. Financial crisis in developing economies can be outlined in three stages discussed below.

Stage one is instigation of financial crisis, in emerging economies financial crisis emanate two basic circumstances, mismanagement of financial liberation. With world experiencing increased globalization emerging market have not been left behind, they have opened up their economies to rest of the world. Liberalization involves removal of restriction that existed in a country’s financial markets. When a country liberalizes its financial markets banks can be able to borrow from abroad, this increases a bank lending capacity. A lending boom just as in the case of the US often result into lending crash characterized by high degree of credit default. This leads to deterioration of banks liquidity leading to a collapse of the bank.

In addition, these economies usually have weak regulatory systems to control the financial markets. These regulatory authorities are also vulnerable tom power individual with interest in the country’s financial market.

Another factors is the presence of budget deficit in the emerging economies, where the government of emerging economies are faced by a budget deficit they usually result in domestic borrowing this weakness the banking system as it impedes credit extension capacity of the bank. In this case fiscal imbalances results to aggravation of moral hazard and adverse selection problems.

Other factors that lead to occurrence of financial crisis in developing countries include increase in interest rate that leads aggravation of moral hazard and adverse selection problems, the increase in interest also leads to decline asset prices and increase in uncertainty disable political systems the uncertainty only heightens the problem adverse selection.

When either of this factors occurs, they lead to a currency crisis which our second stage. With country know facing high interest rates payment abroad, increased level of uncertainty, fall in asset prices thus worsening the bank financial health, and the presence of budget deficits. The domestic currency depreciates thus destabilizing the fixed exchange rate, thus this results to a currency. Usually in an effort to defend the domestic currency the government results in raising the level of interest rates, thus increasing cost for banks leading to bank insolvency. This followed by withdrawal of investors from the country as soon they realize the government won’t be able to repay its debts and this result into speculative attacks of domestic currency.

The last stage is usually referred as full-fledged financial crisis; usually loans obtained were in terms foreign currency thus depreciation of domestic increase the level of indebtedness. In addition, the collapse of the domestic currency leads to higher level of inflation thus the collapse of the economy

Q16 Discuss government safety net and the potential adverse selection and moral hazard problems it may create.

Government safety net is measure implemented by the government in an effort to minimize chances of panic withdrawal. Usually this involves deposit insurance by federal institution created for this purposes only, when bank fail the government will compensate the depositors and seek the funds from this body and the liquidation process.

Although government safety net was developed to minimizes cases of panic withdrawal it leads to element of moral hazard problem where, depositors even if they have observed the worsening of the bank financial situation will not withdraw they deposits a financial institution with this safe net venture in risky investments since they know that, if they fail they will be bailed out by federal government. This disadvantage the tax payers since the government source of revenue is taxes.

Government safety net also results to the problem of adverse selection where, bank that are most likely to fail are the ones that take up the insurers. This based on the reasoning that creditors and depositors who clearly knows that their deposits are insured will not care to monitor the banks operations, thus resulting to the problem of adverse selection. Also this makes risk loving entrepreneurs to attracted, because they know that they can easily engage in risky activities.

Q 17. Discuss “capital requirements” “financial supervision” “assessment of risk management and mark to market accounting” as method of reducing adverse selection and moral hazard

The federal bank always limits the amount of minimum reserve requirements that a bank needs to maintain. Usually the leverage ratio is considered to be 5% this estimated through dividing the amount of bank capital with the total asset of the bank.

With an increase in the minimum reserve requirements this reduces the amount of resource available to the bank to purse risky activities, this thus reduces the problem of adverse selection and moral hazard. In addition the stakeholders’ effort to institute minimum capital requirements lead to the establishment of Basel accord which impedes the off-balance sheet activities of banks thus reducing the adverse and moral hazard problem.

Supervision

This refers to overseeing the operation of financial institution; in this case the regulatory authority aims at weeding out undesirable financial institutions that are likely to be controlled by overambitious parties that are likely to engage in speculative activities. One of the main ways which the regulatory institution weeds lout undesirable institutions is chartering financial institution. In addition, institutions are monitored to ascertain whether there are complying to the capital requirements and other set procedures, this function limit the problem of moral hazard by limiting the amount of risk a bank can take. These actions limit both the adverse and moral hazard problems.

Asset management

The bank asset management has shifted from the traditional capital requirements to risk management techniques. The bank examiners are now focused on ascertaining quality of the oversight that the management and board of directors provide to the company, asses the adequacy of the policies in presenting significant risks facing the company, how effective the internal controls are in prevention of fraudulent activities and assessment of quality of the risk evaluation and monitoring systems. These assessments help in minimizing the risk of adverse and moral hazard problem.

Mark-to-market accounting

According to this concept financial institution are required to mark down the value of their asset as per the market prices this either leads to increase in the, value of the firm asset or a drop in value thus affecting the capital of the business respectively. Therefore, adoption mar-market accounting helps in ascertaining the true value of the firm thus reducing the adverse and moral hazard problem.

Q18. Discuss where you think financial regulation might be heading as a result of the current financial

I believe the market should prepare for the following,

Speculation of financial regulation as a result of financial crisis

Precursors like Alt-A mortgages, structured credit products like collaterized debt obligations among others triggered the financial crisis. The financial innovations have the potential of increasing the access of credit to poor members of the society though agency problems of the originate-to-distribute business model limited it.

Improved Regulation of mortgage Brokers

There will be more regulatory scrutiny to mortgage brokers previously unregulated and without appropriate incentives to ensure repayment. More strict licensing requirement for mortgages originators have also emerged, requiring them to disclose the terms more clearly and also restricting borrowers from taking more than they can afford to service.

Regulation Compensation

This refers to Controlled compensation schemes by government for all parties in the mortgage chain.

Higher Capital requirements

This involves ensuring that financial institutions have enough capital relative to their assets and risks by regulating and supervising the institutions. Capital requirements will be increased and tightened especially for the institutions off-balance sheet activities.

Extra Regulation of Privately Owned Government-Sponsored Enterprises
Fresh regulations to rein in privately owned government-sponsored enterprises are considered necessary. This can be achieved by fully privatizing them, nationalizing them completely, strengthening regulations or forcing them to shrink dramatically in size so they no longer expose the taxpayer to huge losses.

Heightened Regulation to Limit Financial Institutions’ Risk Faking

Stricter regulation of investment banks to limit risk taking.

Increased Regulation of Credit-Rating Agencies

This is to restrict conflicts of interest at credit-rating agencies and give them greater incentives to provide reliable ratings through regulation.

Additional Regulation of Derivatives

Extra regulations both on disclosure and how derivatives are traded are expected to be put in place, predominantly on derivatives such as credit-default swaps.

Q.19 Discuss the three choices bank have for credit under Basel II

The standardized approach

This method is used by a bank which is usually considered not be sufficiently complicated, thus this method uses internal ratings to measure credit risk. According to this method bank are rated according to the weight assigned to the country of incorporation. If the country of incorporation is rated between AAA and AA- the bank is assigned a risk weight of 20 %, but if it is rated between A+ and A- a risk weight of 50% is assigned to the bank, if it rate between BBB+ and B- the risk weight assigned to the bank is 100% and lastly if it has a rating below B- the risk weight assigned to the bank is 150%.

The IRB approach

According to this method capital requirement of bank is used to assign risk to the banks. The IRB approach uses the following formula arguing there is 99.9% probability the loss on a will be less than

Ʃ [EAD x LGD x (WCDR – PD) x M A]
Where
PD: The probability that a party will default within one year
EAD: The amount exposure at that likely to be defaults
LGD: amount lost if default occurs
WCDR is the probability there will be a default
Advanced IRB approach

This method only differ from the normal IRB approach in that the bank usually provide will provide their own estimate on all the parameters that is PD, EAD, LGD and M

References

Lansky, M. (2010). The global crisis. Oxford: Blackwell Publishing Ltd.

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