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 have assets and liabilities - loans, deposits, CASA accounts etc. Each of these type of assets and liabilities have different maturities and rates.

The main type of risks facing banks and funds are - (i) credit risk - this risk arises if customers are not able to meet their payment obligations. (ii) market risks are caused by change in interest rates, spread and currency risks. (iii) liquidity risk - this is the risk that the financial institution will not be able to meet its obligations when it becomes due.

Yield curves shows the term structure of interest rates. An upward sloping yield curve means that the yield rises with increase in maturity. Thus banks and funds have to ensure that the maturity of their liabilities is less than its assets as it can compress the net interest margin. But there has to be a certain threshhold otherwise liquidity problems will arise. The threshhold is calculated by using mathematical models.

Downward sloping yield curve will mean long term yields will fall below short term yields. The maturities of assets and liabilities will have to be adjusted in a manner so that maturity of liabilities is more than assets. This will help the bank increase its profitability as well as manage maturity of assets and liabilities.

Flat yield curve means that all maturities have similar yields. Banks and funds, in such cases, should try and match the duration and maturity of its assets and liabilities.

Proper asset liability management will have to be done by proper control, mitigation and hedging process.

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