Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

 Bank prevents adverse selection by requiring collateral. Borrowers pledge assets to the

bank. If a borrower defaults on the loan, then the bank will seize the asset. For example,

the house becomes the collateral for a mortgage. If the homeowner defaults on the

mortgage, then the bank takes possession of the house.

 Bank minimizes adverse selection by credit rationing. Banks establish a maximum amount

of loan for a borrower. For example, banks grant a maximum credit of $1,000 to college

students. If a bank granted a credit limit of $10,000, then some students would borrow the

full amount and cannot repay the credit-card balance.

 Banks use restrictive covenants to minimize adverse selection. Banks specify conditions or

restrictive covenants in the loan agreement that prevent the borrowers engaging in certain

activities. For example, a person applies for a home-improvement loan and plans to use the

loan to speculate in the derivatives market. Bank place a restrictive covenant in the loan

agreement. Borrower can only use the loan for home improvement.

 Banks may ask the borrower to have another relative having a good credit history co-sign

the loan. If the borrower defaults, then the bank can demand payment from the borrower or

co-signer.

 Banks minimize adverse selection by fostering a long-term relationship with the borrowers.

When the banks know their customers well, they can accurately assess the customers’ risk

of default.

The Interest Rate Risk

Interest rates became volatile during the 1980s, forcing banks to become more concerned
with interest-rate risk. Banks experience an interest-rate risk, when changes in the interest rates
cause the banks’ profit to fluctuate. We show an example of a bank’s balance sheet below:

Your Bank
Assets Liabilities
Interest-rate sensitive assets: $20 million
 Variable-rate loans

 Short-term securities

Fixed-rate assets: $80 million
 Long-term bonds

 Long-term securities

Interest-rate sensitive liabilities: $50 million

 Certificates of deposit

 Money market deposit accounts

Fixed-rate liabilities: $50 million

 Checkable deposits

 Savings accounts