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Qualitative Asset Transformation
April 10, 2012

Qualitative Asset Transformation

It is a way of managing risks and transforming the nature claims. It is the method that is known to provide better alternatives in finding the counterpart for every transaction.

Interest Rate Risk

This is a kind of a risk. It is a risk that involves the reduction of the value of the security on a bond especially when the interest rate rises.

Nash Equilibrium

A Nash Equilibrium is a set of strategies. It is a set where no player benefits by any of the other player partner changing his strategy as the other players remain unchanged. With this kind of a concept, the corresponding payoff is said to be in a Nash Equilibrium.

Term Structure of interest rates

This is a yield curve structure that displays the relationship between the spot rates of zero coupon securities and their term to maturity. This curve enhances the determination of interest rate pattern.

Perfect Competition in Banking

This is a market structure which involves many sellers who are price takers in a pure monopoly. Thus, if a bank is the only one manipulating the rates it brings up a competitive market structure.

Monopoly

This is a situation where a single company owns nearly all the markets of a given product at a given time. A monopoly situation occurs where there is a barrier to an entry in the industry because of various factors mainly being governmental policies.

Liquidity

This is a state of an asset or the money paper like check being readily convertible into cash. It can also apply to as the availability of the cash in times of demand.

Mathematical Model on Liquidity Insurance

Liquidity insurance is one of the core banking businesses where a bank is able to withdraw money on a short notice demand.

Interest Rates Risk in Banking

This is the largest market risk in the banking book. It is the risk that reflects the extent to which the banks financial condition is affected by the changes in the market interest rate.

Risk-based capital Adequacy

It is the shift of determination from the liability side in the balance sheet to the credit side. This is done using the formula that assigns specific risk weights to different assets.

International Interbank market

This is a global wide money market. It is a market that bank lend money to each other. This can either be across the border or locally in foreign currency.

Why are Banks Subject to runs?

This is because of the mismatch of liquidity. This implies that the bank liabilities are more liquid than the assets. This is a problem in a bank especially when too many depositors demand withdrawing. Bank authority can control bank runs by being committed to equilibriums on both the assets and liabilities.

Risk Preferences

Risk Averse Preference

This is a situation where people have clear defined preferences. Their risks are higher than the corresponding utility

Risk Neutral preference

This is a category of people whose risk is anonymous or genuine. This implies that their risk is equal to the corresponding utility.

Risk Lover preference

These are a category of people who have undefined risks. Their risks are minimal; that is they are lower than the corresponding utility.

Question 1

Explain the Klein-Monti model of monopoly and its relationship to banking.

This is the most popular industrial organization model of the banking industry since it it can be arguably be attributed to its simplicity and also to its relative power in the modeling of the effects of the frequent issues about the performance and the conduct of the bank. When the Klein-Monti model is applied to banking, we make the assumption that there is only one bank in the economy. The single bank faces a downward sloping demand function for its loans (L) represented by rL and a deposit function that is upward sloping (D) represented by D. L and D are inversely related. Under the framework, the bank chooses the amount of deposits and loans which determines its corresponding level of interest rates. The bank`s profit function can be represented by the following equation:

π = π(L,D)=( rL(L)-r)l+(r(1-α)- rD(D))D-C(D,L)

The first order conditions for profit maximization

δ π/ Δl=r`L(L)L+ rL-r-C`L(D,L)=0

The only problem with this model is that the bank has the whole control over the rates. Thus it can decide to charge high interest rates for the sake of its profitability. This is a disadvantage to the customers since they incur high costs. In a monopolistic situation, bank sets volume of loans and deposits to equate Lerner index to inverse elasticity. Bank can separate its decision process, as optimal deposit rate is independent of the loan market and vice versa. Implies intermediation margins reduced as substitutes for banking products appear.

Question 2

What are the means by which banks can manage credit risk

Risks are reductions in firm value because of changes in the business environment. Credit risk is the potential that a bank borrower may fail to meet the obligations in accordance with the agreed terms. The aim of every credit risk management team is to maximize the bank’s risk adjustment rate of return by maintaining the credit risk exposure in the satisfactory limitations. The bank manages the credit risks through a critical component of a comprehensive approach to the risk management which is essential to the long term success of any banking system. The five C’s of credit risk include the capital, capacity, conditions, collateral, and character.

In the banking sector, credit risks represent the largest source of risk. For this reason, banks often hold a significant amount of capital aimed at cushioning them against potential extreme losses. Banks employ a number of measures in managing their credit risks that include: establishment of an environment that is appropriate for credit risk management. This is done by the bank`s board of directors who are responsible for periodical approvals and review of the existing credit risk management strategy. The strategy adopted often reflect the bank`s level of tolerance for risk and the expected level of profitability the bank expects for a given level of credit risks. In addition the credit risk strategy approved by the bank is implemented by the top management in addition to identifying and developing the necessary procedures and policies necessary for effective, measuring monitoring and controlling the credit risks. Similarly, the banks should identify and manage inherent credit risks in their products and services. This can be achieved by ensuring that products and services new to the bank are subjected to thorough risk management procedures and controls before they are ultimately introduced into the bank`s mainstream activities.

An addition method for managing credit risks lies in the design of sound process for credit issuance. The banks need to operate within a well-defined framework of credit issuance. This includes a clear definition of the bank`s target population (market) and a deep understanding of the borrower as well the structure and purpose for which the loan is taken and the source of income for repayment. Similarly, banks need to establish the credit ceilings depending on the in individual borrower`s capacity. This can be supported by having in place developed system for loan approval in addition to developing amendments, refinancing and renewal of existing credit to their customers. I addition they should set up a system that continuously monitors the administration of the various portfolios that bear credit risk. In the recent past, the use of credit reference bureaus has gained momentum. Through this facility, banks can effectively monitor an individual’s credit history and ascertain whether he/she is a known defaulter. The bank is in a position to avoid lending to individuals with bad credit history. At the bank level, they need to establish a system that monitors the performance of individual credits including the determination of the level of adequacy for both reserves and provisions.

Question 3

Critically discuss the roles and the features of deposit insurance and the lender of last resort and outline the relationship between bank runs.

A number of people especially in the United States lack confidence of the financial industry because they do not have proper understanding of the monetary system in the country. Thus the deposit insurance takes the role of monitoring and overseeing the banking industry to prevent the misuse of the public money they also guarantee the depositors when the institution makes irreparable mistakes. The other purpose of deposit insurance is to promote financial stability as it protects the small savers. This is done through the removal of the incentives for a bank to run and develop. Thus the insurance deposit has a feature of transparency and certainty regarding the resolution process for the failed banks.

Lenders of last resort are the institutions, mostly the central bank, that offer money to the banks that are experiencing financial difficulty or are nearly collapsing. Both the deposit insurance and the lenders of the last resort maintain the stability of the bank. The presence of the central bank affects the solvency of the commercial banks. There is a possibility of a bank run if the depositors fear that the bank may not be in a position to discharge its obligations. This poses a danger to even the healthier banks leading to serious disruption in economic activity. This calls for the involvement of the central bank as a regulator. Given that the individual banks keep a certain fraction of their reserves with the central bank, the role of the central bank ass the lender of last resort naturally follows.

Question 4

Economic theories that justify the existence of banks

The theories that try to explain the existence of the bank starts with the concepts of monitoring, commissioning, liquidity, information processes, and linearization. The well-known theory refers to the role of banks as an entity that verifies the debtors. The ability to monitor the financial condition of the bank explains the existence of the bank. It involves the macro-prudential indicators both aggregated and micro-prudential conditions of a health individual financial institution.

Systematic risk occurs when many banks fail at ago. There are a number of systematic risks that include asset price mismatching and liquidity provision, exposure to asset price bubbles, sovereign default, and mismatch of currency in the banking system, occurrence several waves of panic and equilibrium among others. Macro-prudential policies are important to counteract these risks.

Question 5

Why are the contingent claim grown strongly in the recent years

A contingent claim is context of bankruptcy law. It is a claim owned by the debtor under certain circumstances. For instance one can be a guarantor of another person’s loan and then the person fails to pay. This is a contingent debt and it has some triggering event or conditions if not cleared. These claims have gained popularity in the modern business world. This is because of the intensified trading insecurities in the stock market and the use of call and put options. Through the contingent claims the banks are in a position to avoid holding capital and it is costly for the bank. the bank can reduce the effects of the moral hazard problem by charging lower interest rates to the borrower and recovering the loss through the various fees levied. Similarly, the borrower is protected against future possible rationing of credit that could possibly arise from poor credit rating, variations in the bank`s capacity to lend and the general credit rationing within the economy.

Question 6.

The Traditional approaches to the understanding the nature of intermediation and the key economic theories of banking which underlie them.

The traditional theories created a way for the current theories the four main traditional theories included the great man theory, the situational theory, the path goal theories, and the situational theories. Traditional theories include economies of scale which argues that the major source of transaction costs arise from the fixed costs used to evaluate a firm`s assets. Because of this, banks are in a better position to pool the risks together and diversify their investment portfolios better than individuals. Similarly, banks can offer payments systems at a more affordable rate. Currently the traditional theories are not being used but they have been renovated to the new theories. The banks play a role of agency by accepting to take deposits and give out the loans. This is a theory of commitment which aims at satisfying the customers. Nevertheless there must be some asymmetric information where the lender verifies whether the borrowers information is right thus allocating the market efficiently.

In the traditional theories, the bank was viewed as an intermediary that accepts a deposit with a set of characteristics and makes loans with a different set of characteristics. The innovation and technology have eliminated some of the comparative advantages of the banks in the banking business as they exploit the new comparative advantages.

Question 7

Distinguishing the main theoretical models of banking competition

There are various natures of competition in a business. These competitions have theoretical models that explain them. The theory of pure competition explains of its low barriers to entry, a variety of choices, and the fact that there is no business with a specific dominance. The theory of Oligopoly competition explains on its advantages to big businesses like banks, automotive industries, gasoline retail, or insurance companies. The theory of monopoly competition explains the advantage of a business being single with no close competition or an alternative substitute. The monopolistic competition theory explains its structure of one dominating company and few medium or smaller sized companies surrounding it.

To measure the degree of competition the company does an empirical investigation to get the results on reduction in profits as a result of cost inefficiency. The simulated data analyses the markets where the banks have differed in their marginal costs. To empirically ascertain the degree of competition use is made of the systematic bank distress which is defined as the duration over which the bank is not in a position to meet its function of intermediation which is lending, payment services and deposit taking. The distress for individual banks is measured in terms of the degree of closeness (proximity) to bankruptcy or entry into a situation of bankruptcy. The z-score is often applied to measure the level of competition and it represents the total asset to capital ratio and the specific returns gained from the assets.

Question 8

Credit Risk versus Liquidity Risk

Credit Risk

Credit risk is that a bank incurs due to the inadequacy of funds to lend out to the borrowers, who happen to be its clients. This risk occurs during crises periods that banks experience bank runs that arise due to existing uncertainty about the future of the bank.

Liquidity risk

This is the risk that the bank experiences whenever it has inadequate funds to runs its daily activities and operations. Liquidity risks arise to lack of funds or the inability of the bank to convert its assets quickly in the market into cash. Because of these difficulties, the bank may be unable to continue its operations.

The two risks are related. Credit risk occurs when there is inadequate credit in the form of cash as cash act as a form of liquidity that enables the bank to execute its daily duties like lending and withdrawing. The bank manages these two types of risk by being committed to balancing the liquid and the illiquid assets. Their negligence can lead to a serious crisis for example in 1991-1992 the poor commitment to balancing the two lead to an economic crisis in commercial banks.

Question 9

What are the benefits of securitization that account for the rapid growth in recent year

Securitization refers to a process of taking the illiquid assets and then through financial engineering transferring them to security. The group created makes it easier for the investor as he is able to buy the interest as a group. Securitization has a number of benefits which differs with the one using it. For instance, the originator benefits by using securitization to finance sources related to third party claims earlier than the time of maturity. Bank as the originator also benefits by having opportunities for new loan and credit placing because of capital relief.

The role of Securitization in the financial crisis observed in the US and other developed countries during mid 2007

The 2007 crisis required an immediate action and cash was more required than the assets or the illiquid money. Thus, through securitization, the nations were able to change the illiquid assets to liquid for the emergency purposes. During those times, the banks were obsessed with securitization and thus they borrowed a lot of money so as to lend out through the creation of securitization. Since the banks were not willing to stop on securitization process, the global crisis came in.

Question 10

Define and discuss credit risk in relation to banks QAT functions. How do banks manage such risks?

QAT is the qualitative asset transformation which is one way of managing risk by transforming assets to cash. This alternative is important as its functions expresses. It provides better alternatives in finding a counterpart for any transaction. It also performs transformations which include duration, divisibility, liquidity, credit risks, and currency. It manages risk by mismatching loss to the intermediaries; it helps in the diversification of funds or rather shifting of funds to others.

QAT helps in handling some risks like Credit Risk. These are risks that a party to contract fails to fully discharge the terms of contract. Credit risk is the possibility that a bank client does not meet the responsibilities on agreed terms and conditions. The main aim of credit control is to reduce the bank`s risks adjusted rate of return by making assumption and sustaining credit exposure within the acceptable restrictions. Credit risks is comprised of two elements; the quantity of risk, which is the exceptional loan balance as on the date of failure to pay and the quality of risk, which is the severity of loss defined by both probability of failure to pay as reduced by the recoveries that could be created in the process of default. In general, credit risk is a combination of the results of risks of non-payment an exposure risk. Banks can manage credit risks by analyzing the portfolio in order to identify the concentration of credit risks, migration statistics, and recovery information among others. This is because at the transaction point, the ratings of credit are vital measures of assessing credit risk that is rampant across the whole company where bank account and credit roles are treated. In addition, credit risk can be managed by the bank through the concept of netting, which takes different forms depending upon the organization involved.

Question 11

Explain why bank runs may raise and the role of deposit insurance and the lender of last resort in relation to bank runs

A bank run is a situation where customers fear that the bank may be insolvent and thus a large number of customers withdraw their deposits. A number of people especially in the United States lack confidence of the financial industry because they do not have proper understanding of the monetary system in the country. Thus the deposit insurance takes the role of monitoring and overseeing the banking industry to prevent the misuse of the public money they also guarantee the depositors when the institution makes irreparable mistakes. The other purpose of deposit insurance is to promote financial stability as it protects the small savers. This is done through the removal of the incentives for a bank to run and develop. Thus the insurance deposit has a feature of transparency and certainty regarding the resolution process for the failed banks.

Lenders of last resort are the institutions, mostly the central bank, that offer money to the banks that are experiencing financial difficulty or are nearly collapsing. Both the deposit insurance and the lenders of the last resort maintain the stability of the bank. The presence of the central bank affects the solvency of the commercial banks. There is a possibility of a bank run if the depositors fear that the bank may not be in a position to discharge its obligations. This poses a danger to even the healthier banks leading to serious disruption in economic activity. This calls for the involvement of the central bank as a regulator. Given that the individual banks keep a certain fraction of their reserves with the central bank, the role of the central bank ass the lender of last resort naturally follows.

Question 12

Why some transactions are done in the bank and others undertaken by the market.

Marketing transactions focus on getting the customers to buy a certain product. This is in the perspective of luring the customer for an off purchase. This focuses strongly on price and short term benefits and the performance of the product this is with limited services. The bank transaction mainly focuses on the services and bringing value to the customer. This transaction assures long term performance and services making all aspects of quality becoming a major concern.

Discussing the Economic theories, which justify the existence of bank?

Economic theory contributes to policy analysis and since economics is a policy science it explains many aspects of economic theory that are mysterious. One of them is the theory explaining the existence of the bank existence of a bank. The theories that try to explain the existence of the bank starts with the concepts of monitoring, commissioning, liquidity, information processes, and linearization. The well-known theory refers to the role of banks as an entity that verifies the debtors. The ability to monitor the financial condition of the bank explains the existence of the bank. It involves the macro-prudential indicators both aggregated and micro-prudential conditions of a health individual financial institution.

Question 13

What are the functions of the financial systems?

A financial system is a system which enhances the transfer of money between different savers or investors. This system can operate either globally, locally or in a specific firm. Some of the functions of the financial systems include saving function. This is where public saving finds their way into the hands of the manufacturing through the financial system. Financial systems also perform the liquidity function where the financial markets enhance an investor an opportunity to liquidate investment like stocks bonds debentures. The system also performs policy function. This is where the government intervenes in the financial system to affect the macroeconomic variables.

Describe the forms of Market efficiency

An efficient market is where prices are predictable and not random. Thus, one can easily discern an investment pattern. Market efficiency mainly implies to informational efficiency. This means that market prices can adjust instantaneously to the new information that explains the future prices. Market efficiency can either be strong, semi-strong or weak. The weak market efficiency explains that the past price behavior is incorporated in the current price. Thus, to this model, it is useless to improve the estimates of the future. The semi-strong form states that all the information is included in the price. The strong market efficiency indicates all the prices from both the private and the public are reflected in the price. Thus to the strong form the trading for a profitable insider is impossible.

Describe the models of banking competition

There are various methods that describe the banking competition. These models explain the various types of competition, for instance, the theory of pure competition explains of its low barriers to entry, a variety of choices, and the fact that there is no business with a specific dominance. The theory of Oligopoly competition explains on its advantages to big businesses like banks, automotive industries, gasoline retail, or insurance companies. The theory of monopoly competition explains the advantage of a business being single with no close competition or an alternative substitute. The monopolistic competition theory explains its structure of one dominating company and few medium or smaller sized companies surrounding it.

Derive the equilibrium in the model of monopoly for loans and deposits (the Klein-Monti model).

A pure monopolistic model is where there is a sole supplier in the market. As a result, the monopolistic takes the market demand curve and controls it by controlling the price. The monopolist faces a downward slope AR curve with an MR curve with twice the gradient of AR. the firm remains to be a price maker and has power over the setting of price and the output. Nevertheless, it cannot change the price to the one that the consumers in the market cannot bear. The elasticity of demand acts as a constraint on the pricing behavior of the monopolist. When the bank wishes to maximize profits it establishes short run equilibrium