MONEY & BANKINGAlMoatassem Mostafa

Lecture Six: Saturday, 29 October 2016

3. The Operation of Commercial

Banks

Credit Risks

The Balance Sheet of

Commercial Banks

Lecture Outline• How Commercial Banks Operate• Credit Risks

• Asymmetric Information• Adverse Selection• Moral Hazard

The Operation of Commercial Banksالتجارية البنوك عمل آلية

• Commercial banks, which are basically privately-owned financial institutions, aim to achieve profit.

• This is why loans are granted by commercial banks at a higher interest rate than the one offered on deposits.

• Checkable accounts, for instance, are offered lower or zero interest.

• Commercial banks operate by borrowing short and lending long.

• Borrowing short indicates that commercial banks accept deposits and repay them on demand by the deposit holder. In contrast, they grant loans for a longer period of time and with a higher interest rate.

Borrowing Short & Lending Long

Credit Risksاإلئتمان مخاطر

• Lending is not a completely safe practice as it might involve the risk of not repaying some of the debts.

• Commercial banks try to diversify the borrowers who are granted loans in order to diversify or pool the risks of debt non-repayment.

• In order to reduce such risks, commercial banks also try to gather as much information about its potential borrowers; they study the financial conditions and the operation of businesses before they are granted a loan.

• Based on this information, a commercial bank can determine the ability of a firm or business to repay a loan.

Credit Risks

Asymmetric Informationالمتماثلة المعلوماتغير

• During the process of gathering information, commercial banks might, however, face tricky behaviors from their potential borrowers.

• Since borrowers know more about their situation than commercial banks, they try to be selective in the information they provide banks.

• The information provided by borrowers might be misleading and could convince banks that the borrowers are in a better financial condition than they really are.

• This would, consequently, influence banks to grant loans to these borrowers based on such information. This problem is called asymmetric information.

• Asymmetric information is a situation in which one party in a transaction knows more information than the other party; this party then tries to manipulate this information to influence the other party to enter into this contract or transaction.

• The problem of asymmetric information results in two additional problems: adverse selection and moral hazard.

Adverse Selectionاإلختيار سوء

• Adverse selection generally happens before a loan contract is agreed upon.

• It is a situation in which borrowers with worse financial conditions are more likely to seek loans than borrowers with better financial conditions.

• Good borrowers are those who use the loans granted to them more efficiently and who are more likely to pay the loan back, while bad borrowers are less likely to pay the debt back.

• Since banks grant loans at a higher interest rate, good borrowers will always be reluctant to apply for these loans, while bad borrowers are most likely to apply for loans with high interest.

• Commercial banks, therefore, have to be selective when they grant loans in order to identify good borrowers from bad ones.

Adverse Selection

Moral Hazardاألخالقي الخطر

• Moral hazard arises after the loan contract is agreed upon.

• It is a situation in which the borrower behaves differently after being granted the loan in a way that could cause harm to the bank.

• In this situation, the borrower behaves differently once he/she was granted the loan than if he/she did not have the loan

Example• imagine that Belinda approaches a commercial bank to

get a loan to open another branch for her restaurant in order to maximize her profits. She convinces the bank, based on asymmetric information, that her business is doing well and the bank grants her the loan. Belinda then uses the loan in renovating her office in the restaurant and in buying a larger LED TV instead of opening a new branch.

Facing Credit Risks• Commercial banks resort to a number of methods in order

to reduce the risks of asymmetric information as much as possible.

• The first method is that commercial banks try to gather sufficient information about the borrowers’ financial conditions, and thus, their ability to repay loans.

• Commercial banks also resort to other methods beside gathering information on the borrowers. These methods aim to impose some restrictions on the borrowers’ to guarantee that they use their loans in their planned purposes.

Facing Credit Risks

Gathering Information

on BorrowersCollateral Covenant

Collateralالضمانات

• Commercial banks might require collateral or indicate covenants in the loan contract.

• A collateral is an asset pledged by the borrower as a security for the loan. In case the borrower is unable to repay the loan, the bank has the right to confiscate on this asset.

• Some borrowers present their houses or cars as a collateral for the loans they get from banks.

Collateral

Covenantتعهد

• a covenant is a clause in the loan contract under which a borrower is obliged to use the loan in a certain purpose.

• A commercial bank could ensure the fulfillment of a covenant through requiring that a borrower open up his/her checking account in this bank.

• In that case, this commercial bank could monitor all the transactions that take place on this account and ensure that the loan is used as agreed upon in the loan contract.

Loan Agreement Template