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How do banks work and how do they make profit? Essay

Banks transform customer’s savings into lending which know as financial intermediation. We save money in bank then the bank will turns around and lend it to someone else in order to make money for itself. Banks sell money which is in the form of loans, certificates of deposit and other financial products. They make profit based on the interest they charge on loans. Banks also charge fees for services like checking, ATM access and overdraft protection. For a retail bank what is the difference between its assets and its liabilities?

Assets are anything that can be sold for value to earn revenue and profit for the bank which are advances that have a much longer term. Assets are uses of funds which consist of loans and mortgages, investments, bonds and bills. Liabilities are obligation that must eventually be paid and short-term deposits; hence, it is a claim on assets. Liabilities are sources of funds which consist of deposits, other borrowings such as money that bank borrow from other sources. 3. What is a bank’s liquidity ratio and why it is typically very low?

Liquidity Ratio: Total Cash / Total Assets =  25 /  275 = 9. 1% It is a percentage of

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assets kept as ready cash relative to total assets. There is no legal minimum for this ratio, but generally banks agree to keep about 2-3% of their assets in ready cash. The higher this ratio, the banks hold more cash and they do lesser spending. Thus, many banks have a profit incentive to see this ratio is kept as low as is possible. When the ratio is lower then the more often banks will need to enter into REPO agreements.

What can a bank do if it does not have enough cash to meet withdrawal demands of its customers? A bank can borrow from central bank. Central bank acts as lender of last resort and banks are allowed to ask for money from central bank if they really short on cash flow in short period time. Besides, they can borrow from other commercial banks. They use the interbank rate to be applied on the money they owe. 5. Why the central bank is always referred to as the lender of last resort? A Central Bank acts as the lender of last resort and government banker.

It is an institution pleased to prolong credit when banks are unable to get necessary funds from elsewhere and intended to avoid bankruptcy of banks. They provide ready cash enable banks to meet their obligations to their depositors. They are ready to offer short-term liquidity to maintain the public’s faith in the banking system. They also have supervisory powers to assure that banks do not behave recklessly or fraudulently. 6. In banking what does Equity Capital mean and why is it so important? Equity capital is money that is raised when stocks are sold in a corporation.

A bank is a corporation, and its owners are the stockholders. From the bank’s profits, the stockholders are paid annual dividends. Only a small proportion of a bank’s income comes from equity capital invested in the bank. Equity capital is important because it can affect the capital ratio of a bank. If the ratio is low it will not have sufficient capital to resist many losses, will lead to financial crisis. Anyway, equity capital can be increased by investments from investors and thus can boost the economic growth.

For a bank what is the leverage ratio? Leverage ratio: Total Equity / Total Assets  10 / 275 = 3. 6% The leverage ratio is a measure of capital adequacy which shows how much of a bank’s equity is on hand to cover any loss in value of the assets. For example, the leverage ratio is 3. 6%. It means for every  100 of assets, there is  3. 6 of the owner’s money on hand to cover any lending loss. The required minimum usually is 3%. 8. What does risk adjusted assets mean and how are they calculated?

Risk adjusted assets mean the assets have been re – calculated to take in consideration the risk that the full value of the loan that cannot be recouped. The bank is trying to measure how much money they would lose if all their assets were written down. Calculating risk adjusted assets is done similar to a weighted average which is calculated by assigning a risk weight to each asset, multiplying each asset value by its risk weight, and summing up the results, shown in the balance sheet above. 9. For a bank what is the Capital Ratio and what can it do if it is too low?

Capital Ratio: Total Equity risk-adjusted assets =  10 /  120. 5 = 8. 3% The capital ratio is the ratio of a bank’s equity to a risk-weighted sum of the bank’s assets. A minimum capital ratio of 8% is required. Example from the balance sheet means banks should have 1. 00 of their own money to cover 8. 3 of all potential lending losses. The bank can increase its total equity if the ratio is too low. Equity capital can be increased by find new investors to invest. Besides, it can increase retained profits by postpone the payment of dividends.

Next, improve profitability, either by increasing its loan rates and bank charges, or by cut down employees and closing underperforming branches, or merge with another bank. Another way is by decreasing risk adjusted assets by change the composition of assets to those which have a lower risk weighting. Therefore over time, lending to private individuals and small businesses (weighted at 100%) reduced. As existing loans are paid back, this returned money will be lent out by banks, however if they keep these monies which means reduce their lending, the value for risk- adjusted assets will fall. (Brahim, 2011)

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