Banking and the Economy- How do banks work and how do they make profit? What is a financial crisis and are they common?

University Degree Business and Administrative studies

BANKING SECTOR

How do banks work and how do they make profit?

Banks transform customer’s savings into lending which know as financial intermediation. We save money in bank then the bank will turns around and lend it to someone else in order to make money for itself.

Banks sell money which is in the form of loans, and other financial products. They make profit based on the interest they charge on loans. Banks also charge fees for services like checking, access and overdraft protection.

For a retail bank what is the difference between its assets and its liabilities?

Assets are anything that can be sold for value to earn revenue and profit for the bank which are advances that have a much longer term. Assets are uses of funds which consist of loans and mortgages, investments, bonds and bills.

Liabilities are obligation that must eventually be paid and short-term deposits; hence, it is a claim on assets. Liabilities are sources of funds which consist of deposits, other borrowings such as money that bank borrow from other sources.

What is a bank’s liquidity ratio and why it is typically very low?

Liquidity Ratio: Total Cash / Total Assets = £25 / £275 = 9.1%

It is a percentage of assets kept as ready cash relative to total assets. There is no legal minimum for this ratio, but generally banks agree to keep about 2-3% of their assets in ready cash. The higher this ratio, the banks hold more cash and they do lesser spending. Thus, many banks have a profit incentive to see this ratio is kept as low as is possible. When the ratio is lower then the more often banks will need to enter into REPO agreements.

What can a bank do if it does not have enough cash to meet withdrawal demands of its customers?

A bank can borrow from central bank. Central bank acts as lender of last resort and banks are allowed to ask for money from central bank if they really short on cash flow in short period time. Besides, they can borrow from other commercial banks. They use the interbank rate to be applied on the money they owe.

Why the central bank is always referred to as the lender of last resort?

A acts as the lender of last resort and government banker. It is an institution pleased to prolong when banks are unable to get necessary funds from elsewhere and intended to avoid bankruptcy of banks. They provide ready cash enable banks to meet their obligations to their depositors. They are ready to offer short-term liquidity to maintain the public’s faith in the banking system. They also have supervisory powers to assure that banks do not behave recklessly or fraudulently.

In banking what does Equity Capital mean and why is it so important?

Equity capital is money that is raised when stocks are sold in a corporation. A bank is a corporation, and its owners are the stockholders. From the bank's profits, the stockholders are paid annual dividends. Only a small proportion of a bank's income comes from equity capital invested in the bank.

Equity capital is important because it can affect the capital ratio of a bank. If the ratio is low it will not have sufficient ...

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In banking what does Equity Capital mean and why is it so important?

Equity capital is important because it can affect the capital ratio of a bank. If the ratio is low it will not have sufficient capital to resist many losses, will lead to financial crisis. Anyway, equity capital can be increased by investments from investors and thus can boost the economic growth.

For a bank what is the leverage ratio?

Leverage ratio: Total Equity / Total Assets = £10 / £275 = 3.6%

The leverage ratio is a measure of capital adequacy which shows how much of a bank’s equity is on hand to cover any loss in value of the assets. For example, the leverage ratio is 3.6%. It means for every £100 of assets, there is £3.6 of the owner’s money on hand to cover any lending loss. The required minimum usually is 3%.

What does risk adjusted assets mean and how are they calculated?

Risk adjusted assets mean the assets have been re - calculated to take in consideration the risk that the full value of the loan that cannot be recouped. The bank is trying to measure how much money they would lose if all their assets were written down.

Calculating risk adjusted assets is done similar to a weighted average which is calculated by assigning a risk weight to each asset, multiplying each asset value by its risk weight, and summing up the results, shown in the balance sheet above.

For a bank what is the Capital Ratio and what can it do if it is too low?

Capital Ratio: Total Equity ÷ risk-adjusted assets = £10 / £120.5 = 8.3%

The capital ratio is the ratio of a bank’s equity to a risk-weighted sum of the bank's assets. A minimum capital ratio of 8% is required. Example from the balance sheet means banks should have £1.00 of their own money to cover £8.3 of all potential lending losses.

The bank can increase its total equity if the ratio is too low. Equity capital can be increased by find new investors to invest.

Besides, it can increase retained profits by postpone the payment of dividends. Next, improve profitability, either by increasing its loan rates and bank charges, or by cut down employees and closing underperforming branches, or merge with another bank.

Another way is by decreasing risk adjusted assets by change the composition of assets to those which have a lower risk weighting. Therefore over time, lending to private individuals and small businesses (weighted at 100%) reduced. As existing loans are paid back, this returned money will be lent out by banks, however if they keep these monies which means reduce their lending, the value for risk- adjusted assets will fall. (Brahim, 2011)

FINANCIAL CRISIS

What is a financial crisis and are they common?

Financial crisis is a situation where some financial institutions or assets suddenly lose a large part of their value. Financial crises directly result in a loss of paper wealth; they do not directly result in changes in the real economy unless a recession or depression follows. The financial crises are not common. Different types of financial crisis included banking crisis, speculative bubbles and crashes, currency crises and wider economic crises.

What is an ‘Asset Bubble’ and what have these got to do with the banking sector?

An asset bubble is formed when people or financial institutions buy an asset or a commodity in the hopes of selling it later at a higher price which means they are speculating on future rises in the asset’s value. If there is a bubble, people will all flock to a particular asset, prices of assets will over-inflated. However if enough people believing now is the time and decide to sell their ‘holding’, the asset’s price will fall, the bubble will burst. Thus, it will cause economic recession and unemployment rate increase with high level of debts. As a result, banks will face bankruptcy.

Why does a problem in the banking sector affect the economy as a whole?

Firstly, bank controls the orderly flow of funds between economic agents. Thus, a problem in the banking sector can affect the cash flow in the economy. Second, it mobilizes resources in the form of savings by offering attractive investment opportunities. Thirdly, it pools savings and allocates them in the form of loans to investment projects. The banking sector acts as an intermediary between savers and investors in an economy. By affecting the money supply, that monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth. Savings and investment cannot occur in an unstable financial environment, thus disallowing for the growth of the economy as a whole. (Varner, 2010)

What has triggered the most recent financial crisis?

The trigger of the crisis was the bursting of the United States housing bubble and the sub-prime mortgage crisis. The reasons are relate to the creation of a new financial instrument - collateralized debt obligations (CDO). CDO was a type of Bond linked to the USA housing market and was created and sold by Investment Banks on the Money Markets. Many UK and European banks creating and selling CDO’s also in 2000. However the USA housing market started to crash in 2007, thus these US Bonds became worthless and as the sub-prime mortgage market in the US collapsed, faith in European CDOs also started to fall in value. (Begg & Ward 2009, p. 284) By 2007, bank balance sheets around the world saw huge write downs and large reduction in the value of this asset. Some notable banks approached insolvency and most were experiencing large falls in their capital ratios –credit crisis occurred.

Thus, if a bank has make ill-considered loans or investments, which then go into default, the bank’s capital ratios will fall. If all banks made the same poor investment and lending decisions then financial crisis develop. (Brahim, 2011)

How did the UK Government initially support banks in the recent financial crisis?

The UK Government is bail outs and nationalisation under the Banking (Special Provisions) Act 2008 to initially support banks in the recent financial crisis. The long term support of UK banks came in the form of equity injections; the UK Government became shareholders in banks that had trouble. Besides, Government take an ownership (equity or stock) interest to the extent taxpayer assistance is provided, so that taxpayers can benefit later. Next, the UK government also support and allowed many institutions to merge if it meant they would survive. (Brahim, 2011)

What do they mean by ‘Quantitative Easing’ and has it worked?

Quantitative Easing (QE) is a government monetary policy used by some central banks to increase the money supply by buying securities from the market to stimulate their economy. It increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

QE has not worked so far in this recession because it is not a good time to lend. Firstly, given the banks have cash; they might just hold the cash in their accounts instead of lending it out to consumers as intended. The problem here is that this whole recession is due to high levels of debt, so by trying to solve the problem by creating more debt is not really a solution. (Ray, 2009)

Besides that, if as a bank still had some CDO’s of indeterminate value on books, the bank will not want to lock up this cash in further loans; they will have it on hand to cover any final write down in CDO assets.

Likewise, given that many banks have government Bonds from other countries and these governments are themselves struggling with high levels of debt, banks will not want to lock up this cash in further loans, they will prefer to have it on hand to cover any future defaults by these governments. Thus, all of this shows QE will fail.

Is the financial crisis that started in 2007 over?

The financial crisis that started in 2007 is not over yet because USA unemployment rate is still high and above 9%, European still in trouble. Besides that, economic hardship still remains in many countries. In addition, the amounts of problem banks are still rising. Furthermore, states continue to slide toward bankruptcy. According to the , 48 states are facing budget shortfalls in 2010. (Varner, 2010)

However, some economists said that financial crisis in 2007 is ended because stock markets are back for previous level for emerging markets.

What books could I read to find out more about the recent financial

crisis?

Robert, W.K 2010, Lessons from the financial crisis, causes, consequences and our economic future, John Wiley & Sons, Hoboken.

This book is about lessons from the financial crisis and it explains all the causes,

consequences and the future of our economic.

Lawrence, R.K & Shabbir, T 2006, Recent financial crises; analysis, challenges and implications, Edward Elgar Publishing Limited, UK.

The second book explains the history of recent financial crises and it analyse the

Challenges and implications of recent financial crisis.

Shiller, R.J 2008, The subprime solution, Princeton University Press, UK.

This book explains about how’s today global financial crisis happened and how to

do about it.

TOTAL: 2070 words

References

Begg, D & Ward, D 2009, Economics for business, 3rd edition, McGraw-Hill Education (UK) Limited, New York.

Brahim, F 2011, ‘Financial crisis and the national economy’, lecture notes distributed in UMECXW-20-1Econonomics for Business and Accounting, Taylor’s University, Subang Jaya, on 15 February 2011.