Study Questions

Some companies make tires. Some sell hamburgers. Banks are in the business of money. Making tires requires management to make decisions on how much to invest in manufacturing - how much in distribution - how many people to hire - where to get the money. Selling hamburgers requires management to make decisions on how much to invest is restaurants - how much in advertising - how many people to hire - where to get the money. Banking managers must decide how much to invest in buildings and branches - how much in advertising - how many people to hire - but much more importantly - how to make their customer's money work best for the bank.

Banks are in the business of money. Every day, a bank's investable balances can fluctuate by millions of dollars - depending on maturing investments - number and amounts of checks written - and even the payday of major employers in the local area. In order to maximize a banks overall profitability, much attention MUST be given to the prudent investment of the banks funds. In making choices about investing these funds - remember that ALL bank deposits belong to someone else, the customer - the bank must consider its fiduciary responsibility to make safe and sound investments. This is compounded by the fact that they must also make profitable investments.

So then, the function of the bank management is to make safe and profitability investments while considering the liquidity needs of the bank. Liquidity, is the ability to have funds available to meet the withdrawal needs of the customers.

All banks have similar alternatives for investing. From a safety standpoint - investing in government securities is probably the safest. However, it doesn't provide for as much of a return and it doesn't help the customer's borrowing needs. Investing in the stock market - may have a great return (at least sometimes) - but it is not very safe - and it doesn't help with the customer's borrowing needs either. Making loans to the customer - helps them (and the community) - and has a pretty good return - but it is not very liquid, since most customers borrow for a term and can't repay just whenever the bank might need some funds.

So the challenge then, is to find the right mix of loans (usually the most profitable alternative that is also safe) and other investments that can provide for both short term and long term liquidity. Other intermediaries long ago realized that all bankers might have liquidity needs and markets were created that allowed long term investments, like bonds and treasury issues to be bought and sold - regardless of original maturity. Additionally, it was recognized that if one bank might have to much money on one day, another - maybe across country - might need funds for that day.

In deciding what kind of investments to make - and this applies to loans as well as bonds or government issues - each institution must consider the risk of the investment versus the reward (return) of the investment. In Finance textbooks this is known as the "Risk/Reward Ratio". In that the higher the risk - the higher the reward or rate of interest required.

Risk comes in two forms. First is "Market" risk. This is the probability that interest rates will either rise or fall and the investment made will either be below or above market. In this case the Loan interest will be worth less than the amount invested based on changes in the market. The second is Credit Risk - or the borrower's ability to repay. "Credit Risk" was be covered in the preceding chapter on loans. Both of the risk types must be considered on each investment type.

ASSIGNMENT:

There is NO specific assignment for this session.

Discuss the four factors that must be considered when a bank sets an interest rate for a loan.