lending payment and risk taking

8/9/2019 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.

lending payment and risk taking

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