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Chapter 2
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 1
1. Financial System
Financial System is composed of the products and services
provided by financial institutions, which includes banks, insurance
companies, pension funds, organized exchanges, and the many
other companies that serve to facilitate economic transactions.
Virtually all economic transactions are effected by one or more of
these financial institutions. They create financial instruments, such
as stocks and bonds, pay interest on deposits, lend money to
creditworthy borrowers, and create and maintain the payment
systems of modern economies.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 2
1. Financial System
These financial products and services are based on the following fundamental
objectives of any modern financial system:
-To offer products and services to reduce financial risk or to compensate risk-
taking for desirable objectives,
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 3
1. Financial System
- To collect and disperse information that allows the most efficient allocation of
economic resources,
- To create and maintain financial markets that provide prices, which indicates
how well investments are performing, which also determines the
subsequent allocation of resources, and to maintain economic stability.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 4
1. Financial System
Most people use the word Bank to describe a Depository Institution.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 5
1. Financial System
- These Non-depository institutions are sometimes referred to as the
Shadow Banking System, because they resemble banks as financial
intermediaries, but they cannot legally accept deposits.
Consequently, their regulation is less stringent, which allows some
Non-depository institutions, such as hedge funds, to take greater
risks for a chance to earn higher returns.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 6
1. Financial System
- Depository Institutions—banks that accept deposits—
contribute to the economy by lending much of the money
saved by depositors. However, deposits do not provide
all of an economy's funding, since only the wealthy save
a significant amount of money and most of it is not in
low-interest paying deposits which are taxable as
ordinary income.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 7
2. Banking System
Banks play a central role in the money creation process and the
payment system. Bank credit is an important factor in financing of
investment and growth. Therefore, regulators have a special interest
in keeping banking system stable and efficient.
Banks are corporations usually listed on the stock exchange and are
owned by shareholders. Banks fund themselves from both retail as
well as wholesale sources. Generally, banks rely on deposits as well
as funding from private markets.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 8
2. Banking System (Cont..)
Banks are engaged in a wide range of activities to increase their capital and
profits.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 9
2. Banking System (Cont..)
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 10
2. Banking System (Cont..)
Central Banks: to monitor financial Institutions and stabilize the economy.
- Central bank is the monitory authority and bank supervision aims to make the
financial system stable.
- Central banks control the availability of money and credit to ensure low
inflation, high growth and stability of financial system.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 11
2. Banking System (Cont..)
Assets Liabilities
Cash 5 Deposits 90
Marketable Securities 10 Debt 5
Loans 80 Equity Capital 5
Fixed Assets 5
Total 100 Total 100
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 12
2. Banking System
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3. Bank Capital and Profitability
Remember that net worth equals assets minus
liabilities.
Net worth is referred to as Bank Capital, or
Equity Capital.
We can think of capital as the owners’ stake in
the bank.
Capital is the cushion banks have against a
sudden drop in the value of their assets or an
unexpected withdrawal of liabilities.
It provides some insurance against insolvency.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 14
3. Bank Capital and Profitability
An important component of bank capital is Loan
Loss Reserves:
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 15
3. Bank Capital and Profitability
- There are several measures of Bank Profitability.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 16
3. Bank Capital and Profitability
2 .The bank’s return to its owners is measured by
the Return on Equity (ROE).
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 17
3. Bank Capital and Profitability
3. The final measure of bank profitability is Net
Interest Income.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 18
3. Bank Capital and Profitability
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 19
3. Bank Capital and Profitability
To generate fees, banks engage in numerous off-
balance-sheet activities.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 20
3. Bank Capital and Profitability
2. Letters of Credit
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 21
3. Bank Capital and Profitability
3. Standby Letter of Credit
- Is a guarantee of payment issued by a bank on
behalf of a client that is used as "payment of last
resort" should the client fail to fulfill a contractual
commitment with a third party. Standby letters of credit
are created as a sign of good faith in business
transactions, and are proof of a buyer's credit quality
and repayment abilities.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 22
4. Preventing Bank Failure
There are many types of risks affect banks such as
Credit Risk and Liquidity Risk which may lead to
Systemic Risk [Discussed in Ch 1].
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 23
4. Preventing Bank Failure (Cont..)
In 1988, Basel I contains three main elements. Firstly, the BCBS
published the minimum capital ratios for banks. Banks were required
to have effective regulatory Capital Adequacy Ratio (CAR) of at
least 8% of the total assets on a risk adjusted basis.
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 25