CORPORATE ISSUES IN GLOBAL FINANCE 5
CorporateIssues in Global Finance
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Q1.Docapital and liquidity requirements impose costs on banks? In whatsense? From a societal viewpoint, does it make sense to have highcapital and liquidity requirements? Explain your reasoning
Accordingto Ross (2011), an increase in liquidity and capital requirements onbanks increases the banks funding costs. Liquidity requirementsimposed on banks, by the government regulator, such as the centralbank increase their ability to fund customer withdrawals as they falldue. They are applied when the government wants to increase ordecrease the supply of funds in the economy. This implies that thebank holds more cash and has limited cash to lend. As a result, whenthe bank is faced with cash demands, it is forced to borrow from thecentral bank or from other banks at a higher cost in terms ofinterest. Similarly, capital requirements imply that the bank holdsmore cash with the central bank. It reduces the amount of cash thatthe bank holds to meet the cash demands from new customers. It isforced to borrow from other banks at higher rates to serve its newcustomers. The high costs may be absorbed by the bank or transferredto the customer. To maintain the customers, banks will absorb thehigher costs and their profits are reduced. The impact can be viewedas the cost of loosing new business due to lack of available cash tolend.
Q2.Inthe US, bank regulators are beginning to rely more heavily on the useof Stress Testing to assess whether large banks are operating withenough of a safety margin. Briefly explain the Pros and Cons ofregulators relying more heavily on stress testing.
Amongstthe benefits of stress testing involves enhancing the management ofbanks in identifying areas that are vulnerable to expected changes inshort term interest rates or declining real estate market conditions.The pre identification reduces the exposure of banks to stress,enabling them to take prior changes before the actual incidencehappens. For example, the bank may change loan pricing on severalproducts to attract or discourage interest on the products. Thestress tests enable the manager to understand where the portfolio isover exposed geographically and concentration wise. It also assistsin the identification of the specific types of loans within eachconcentration having potential troubles. In addition, it exposes thepotential factors with most adverse effects on given portfolios.Finally, tests develop a roadmap to manage banks risks when theunexpected happens. The major disadvantage of the tests is that bankswill hoard cash to appear healthy in the short run. Hoarding cashwill result to an increase in interest rates, as there is limitedsupply of money in the economy. In the end, the stress tests willonly increase the cost of doing business for the banks by requiringthem to hold more capital (Ross, 2011).
Q3.Whydo some observers say that Depository Institutions (DIs) are“special”? What important functions do DIs perform that otherfinancial institutions do not? Which types of functions should beperformed exclusively by DIs, and which could be performed equallywell by organizations different from DIs? Explain.
Depositoryinstitutions are regarded as special due to the nature of theirbusiness activities that links savers and borrowers. In the process,they improve the efficiency of managing the savers funds through avariety of ways such as reducing information costs, maturityintermediation, and transmission of monetary supply, creditallocation, denominational intermediation, payment services andtransaction cost services (Ross, 2011).
Amongstthe special functions performed by depository institutions, includethe reduction of information costs. It is enhanced by the aggregationof funds causing economies of scale. It enables the depositoryinstitution to collect information at a relatively lower cost than asingle investor or any other financial intermediary. Second, maturityintermediation involves matching the maturities of the depositoryinstitutions assets that are composed of loans, and liabilities thatare made up of cash requirements by depositors. It is best done as aresult of experience and identifying situations where the depositorscannot lack cash upon demand (Ross, 2011).
Depositoryand financial institutions can perform certain functions equally. Thetransmission of monetary supply involves the use of the financialinstitutions by the government, through regulation, to control theamount of money circulating in the economy. Similar to paymentservices, denomination intermediation and credit allocation (Ross,2011).
Ross,S., & Westerfield, R. (2011). Corporatefinance (7thed.). Boston: McGraw-Hill/Irwin.