Questions and Answers

Questions and Answers

Select one factor that affects cash flows for a bank valuation. Why is this factor significant for banking operations?

Interest is a factor that affects bank cash flow. Commercial banks are involved in selling loans products to their customers. Thus, if interest rates are high, the customers reduce their borrowing due to a high rate of return and vice versa which goes to affect the bank’s profitability (Pasiouras & Kosmidou, 2007).

Select one factor that affects the required rate of return for investors in commercial banks. Why is this factor significant for investors?

Investors in the commercial bank will be affected by the risk of investments. Risky investments will make the investor seek a higher rate of return on investment while for those with lower risks investors will demand a low rate of return (Pasiouras, & Kosmidou, 2007).

Differentiate interest income from non-interest income. Which, if any, is more significant for the long-term health of banks (in your opinion)? Why?

Interest income is the money earned by the bank as a result of interest charged on lending money which is the core function of the bank while non-interest income is money earned by banks from other functions other than lending money such as loan processing fee (Chi, & Li, 2017). For the long-term health of the bank, the non-interest income is more significant since it cushions the bank operations from low-interest rates that result in loss.

Refer to Exhibit 20.5 in Chapter 20. Briefly explain one-way bank managers may minimize the risk of loan losses given economic conditions.

Problem 1 – assessing bank performance (chapter 20, page 576).

Banks can minimize the risk of loan losses due to economic conditions by setting aside a certain amount to cushion the expected loss on the loan portfolio (Chi, & Li, 2017). Thus, the loan loss provision or provision for bad debts as a bank credit risk management approach will mitigate the anticipated loss.

Briefly explain why a bank’s capital – or net worth – is important when it comes to possible losses, such as during the 2008-09 financial crises.

Banks’ capital or net worth helps the bank to increase its loan portfolio making them lend more quickly after a financial crisis. Therefore, a well-capitalized bank will revitalize the economy during difficult and good times.

Briefly explain one of the risks banks face. Why is this risk significant for banks?

Banks face credit risks defined as the ability of borrowers to pay the principal amount and interest charged on loan facilities in total or delay in making payment (Pasiouras, & Kosmidou, 2007). This occurs due to the insolvency of the borrower and the core function of the bank in selling loans.

Select and briefly explain one way banks may manage interest rate risk. Why might it be impossible to eliminate the risk completely?

Interest rate risks are managed by the bank by a soothing approach. The soothing approach makes the bank divide the loans or deposits to ensure that they have a component of a fixed and variable rate (Chi, & Li, 2017). Thus, if the interest rate rises, only the variable loan rate will be expensive leading to less impact on borrowings. The risks cannot be eliminated due to the fixed component of interest rate on loans.

Select one notable bank failure during the 2008-2009 credit crises. What was the primary reason for this failure?

The biggest failure of the 2008 -2009 credit crisis was the denial of the bailout by the government to the Lehman brothers making it insolvent. This failure occurred due to the overvaluation of the mortgage market.

Briefly explain how a credit union differs from a traditional commercial bank.

The credit union is a not-for-profit institution that is owned by members while a traditional commercial bank is incorporated for the profit motive that can be owned by a private individual or members of the public (Pasiouras, & Kosmidou, 2007). Thus, in a traditional commercial bank, no membership is required but in a credit union, one has to be a member.

References

Chi, Q., & Li, W. (2017). Economic policy uncertainty, credit risks, and banks’ lending decisions: Evidence from Chinese commercial banks. China journal of accounting research, 10(1), 33-50.

Pasiouras, F., & Kosmidou, K. (2007). Factors influencing the profitability of domestic and foreign commercial banks in the European Union. Research in International Business and Finance, 21(2), 222-237.