One of the main reasons why financial institutions exist is that they facilitate the circulation and flow of funds in the economy. They act as intermediaries in the economy, between investors and institutions that are in need of funds to invest ad expand their operations. Individuals and companies who have funds to save deposit them with the financial institutions and earn interest out of it. The financial institutions then use these savings to create credit and offer loans to institutions and individuals in need of finances (Madura 2009). They also provide capital for investors who want to start up businesses. This way, funds flow in the economy throughout.
The other reason why the financial institutions exist is pooling of resources from small savers offering a variety of benefits for the savers. The financial institutions offer different rates of returns for the savers depending on the type of saving plan the saver chooses. These savings plans include time deposits, savings accounts, fixed deposits accounts, or investments in mutual or stock funds. The savers can consequently get credit facilities against the savings made to fund a particular project.
Existence of financial instruments in the economy triggers economic growth and development. In areas where management of savings is efficient to reach the investors in need of funds, the result is the investments transfer some positive effects to the whole economy. High investment levels results to increased earning and returns to investors, who in return have more funds to invest (Madura 2009). The increased investments results to increased economic growth. Likewise, in economically challenged areas with underdeveloped financial institutions, there are low levels of investments resulting to low or no economic development at all.
Financial institutions also engage in a very crucial duty in the management of inflation and money levels in the economy. The Central banks of different counties use financial institutions in determining the amount of money in circulation. When the economy has heavy flow of money and inflation is on the increase, the central banks increased rates at which it lends money to financial institutions. The financial institutions in return increase the rates at which they lend money to the customers. Increase in rates of interest discourages people from taking loans from the financial institutions. This reduces the amount of money in circulations and inflation is, thus managed. When there is a shortage of money in circulation, the banks offer loans at lower interest rates, which encourage customers to take up more loans. This increases the amount of money in the economy (Madura 2009).
Financial institutions also exist to help diversify risks for investors and individuals. When clients deposit their money with the banks, they diversify their risks. Moreover, customers view banks as one of the safest mode of investments. (455 words)
Question 2: interest risk and credit risks.
Interest rates risk is the risks resulting from the movement of interest rates. Interest rates risks can form the basis of a banks’ profitability and increase in shareholders values. On the other hand, this risks serious threat to the banks’ capital base and profits. Changes in the rates of interest have great effects on the earning of a financial institution by changing the net interest income. It affects the underlying value of the financial institutions’ balance sheet items and off-balance sheet items because the present values of the future cash flow change as the rates of interest change.
Banks measure Interest rate risks using full valuation method, through revaluing bonds or other portfolios for a particular interest rate change. For instance, the bank revalues the values of its bonds or portfolio on the basis of 50, 100, and 200 basis points increase in rates of interest. The bank then calculates the total values of bonds under the different situations. It can also be measured through the duration approach where the bank keeps watch of the move of interest rates through price volatility. Through the price changes, the bank is able to determine the interest rates risks.
Interests rates risks can be controlled using four basic elements of managing the balance sheet and the balance sheet items. First, the board and management should have adequate controls and oversight of balance sheet items and off-balance sheet items. Secondly, the bank should have sufficient risk management policies that will help keep interest rates at desirable levels. Thirdly, the banks should put in place control and monitoring functions. These procedures should be consistent with the nature of the activities that the bank carries out. Lastly, the banks should have effective internal controls and frequently carry out independent audits to keep interest rates in check.
Credit risk refers to the risk that a borrower fails to meet their contractual obligations as per the terms agreed by both parties. Whenever the banks perceive high credit risks, then they charge higher interest rates on the borrower. Therefore, credit risk is very important for the bank as it is a great determinant of the amount of income the bank earns.
Banks measure Credit risk through considering three different elements; the probability that the borrower will default, the credit exposure at the time and the amount of money that can be recovered after the client defaults. The bank obtains the clients’ FICO score, which determines the level of creditworthiness of the customer, then the bank calculates the debt-income ratio for the customer given by total recurring monthly repayments divided by the gross income. Then the bank factors in the clients’ potential debt (Choudhry, et-al 2003). This way, the bank is able to determine the credit risk posed by the potential customer.
Control of Credit risks is through putting in place adequate credit risk environment, making it certain that the sufficient controls over risk, having an effective credit-offering processes and ensuring an effective monitoring process.