Banks and other depository institutions make loans, invest in government securit

Question

Banks and other depository institutions make loans, invest in government securities, buy and sell federal funds, and accept deposits with a wide spectrum of maturities and with many payable on demand. Furthermore, depository institutions are the principal repositories of the public's liquid assets and many of these institutions' liabilities are considered a means of payment (money).

(a) Briefly discuss the risks facing these institutions within the context of how these institutions can have such a wide variety of assets and liabilities and still maintain their ability to make illiquid loans, meet deposit withdrawals on demand, and make profits for their shareholders. Within this context, discuss the effect of different yield curve structures (upward sloping, downward sloping, or flat) on the profitability and riskiness of banks choices of loans, investments, and liabilities (deposits).

Explanation / Answer

Banks and other depository institutions are always open to various risks. Risks here simply means "loss" of the money by the bank but whats important for us to know is which are the risk bank can face during their working. On the broad basis, we have :

1) Credit Risk : where the debtor is unable to pay the loan amount back and bank suffer the loss.

2) Operational Risk : where the functioning of the mangement is not good resulting in the loss of money. Here you can say that mangment didnt work the details of the debtor properly which causes loss to the bank or mangment didn't work out the proposal of loan and the debtor moves to the other bank again causing loss.

3) Market Risk: where we are talking to market slow down i.e inflation or deflation thus harming the money supply in the market which may hamper the working of the financial institutions.

4) Political Risk: where because of political instability in the country or beacuse of governmental policies, bank may suffer loss.

5) Exchange Rate Risk: where the financial institutions are engaged in foreign currencies, there they are always at the risk of exchange rate fluctuations.

These are the major risks faced by the financial institutions all over the world.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.

The shape of the yield curve depends on the maturity time i.e longer the maturity, the higher the yield. Thus for example Flat yield is there when all maturities have similar yields.

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