Download - Lending Payment and Risk Taking
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FI- Lending, Payments & Risk Taking
FI - IV
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Finanancial Systems
Financial system changing rapidly, specially since
mid nineties.
Change is driven by innovations.
Two kinds of innovations taking place in FIs:
-first, serves existing needs in new ways
-second, uses technology to serve new needs
To participate in this process of innovation andchange one has to understand the needs the FIs
serve and the technology it uses.
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What are the needs that FIs serve?
If we define the needs too narrowly innovation
will leave us behind
We must be careful not to define the needs
too narrowly.
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The financial systemmakes it easier to
trade
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Need for Trade
People trade because they differ in what
they need and what they have.
The basis of trade is diversity. It allows specialization.
Self sufficiency may sound appealing but
makes little economic sense. Trade benefits everybody.
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Saving, Investment & Lending
Lending is a form of trade.
In lending we give up purchasing power
now in exchange for purchasing power infuture.
Some persons want purchasing power in
future, while others want it now.
Life cycle of Savings.
Turning wealth into income.
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Savings & Wealth
Life-cycle pattern of savings over a lifetime
- borrowing & repayment
- savings & dis-saving
Savings not the only way to acquire wealth However, wealth is acquired, it represents a
command over purchasing power
Typically, the owners of wealth do not wish to
exercise their purchasing power immediately,rather they covert it into a flow over time.
Precautionary reserve: assets held as protectionagainst fluctuations in income & savings
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Investment
Savers and holders of wealth are potentiallenders.
Business Investment : Business incurs expenses
before it makes profit.- fixed capital
- working capital
Household investment : productive/ un-
productive- House/ car,
- education of children
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Gains to trade in borrowing &
Lending
Gains to borrowers.
G
ains to lenders. Both groups stand to gain from trade.
Savers do better by lending money to
those with productive use for it thanby making investments themselves.
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Trade in Risk
Business & households face avariety of risks
Trade can reduce the risks indifferent ways.
Two principal forms of trade in
risk are :- insurance
- forward trx
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Insurance
Insurance is useful in dealing with such eventsas accidents, illness and natural disasters.
Reciprocal Insurance: Whereby those facing riskagree to share the losses. RI is a form of trade.mutual aid, gift exchange
External Insurance: those who do not face a riskagree to share the losses of those who do.
Gains from trade in risk: All parties benefit.
Those not inherently exposed, yet willing to takean exposure, in exchange for payment of fee,gain and so do the insuree.
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Forward Transactions
Forward Transactions are yet another form of tradein risk.
FT is a trx in which two parties agree in advance onthe terms of a trade to be carried out at a specified
future time. Price risk: can be mitigated by a forward trx.
In forward trx. Price is set today, for delivery andpayment at specific time in the future.
Hedger: who takes a position in one asset to offsetthe risk of a position in another asset.
Speculator: who takes a position in an asset solelyto profit from a change in price.
Gains from trade in Forward. Trx.
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Difficulties of trade
Trade is beneficial, however, there
are difficulties
The role of FIs is to overcome the
risks
Trade & trust- credit trading vs cash trading
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Problems involved in Lending Lending involves promises which at times may not
be kept.
The risk of default need not deter banks from lending
Full assessment of risks is the key to lendingdecisions and for that the bank needs information-industry study, project study , balance sheet, trackrecord of Co., other liabilities etc.
Terms of lending,
Contract: equity, debt contract ; Incentive effect
Security : primary, secondary
Follow up & monitoring
Liquidity: conflicts of interest
trade off short/long term
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Problems in Trade in Risks
Problems in trade in risks similar to lendingbecause these involve promises too.
Moral hazards: tendency of insured to take more
risks because they have insurance. Adverse selection:Tendency of worse risks to
buy insurance and better risks not to.
These risks increase the cost of claims to the
insurer. Financial systems try to address many of such
risks and reduce its costs.
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Problems of Forward transactions
A forward trx. is an exchange of one promise
for another: one part promises to buy the
other promise to sell.
The risk associated with default on a fwd trx
is replacementrisk. These are mutual.
Precautions required similar to lending: info
gathering, contracting & monitoring.