10.3 Objectives of a Commercial Bank Flashcards
1. What is the main objective of a commercial bank?
The main objective of a commercial bank is profitability. Shareholders, who are the owners of the bank, seek dividends as a return on their investment. Commercial bankers prioritize profitability to satisfy shareholders and advance in their careers within the bank. The most effective way to achieve profitability is by borrowing funds at low short-term interest rates and lending them out at higher long-term interest rates, where the profit margin is greater. Short-term borrowing can be obtained from money markets, while long-term lending can include mortgages and business loans that involve higher risks and can be charged with higher interest rates over an extended period. It is not financially beneficial for commercial banks to hold short-term liquid assets with low returns when more significant profits can be earned through long-term investments and loans.
evaluation: Why is excessive pursuit of profit considered dangerous for commercial banks?
The excessive pursuit of profit can be considered dangerous for commercial banks due to the increased likelihood of insolvency and liquidity crises, leading to bank failure. While profitability is a crucial objective, taking excessive risks to maximize profit can jeopardize the stability and long-term success of the bank. Balancing profitability with other objectives, such as liquidity, security, and risk management, is crucial for the long-term health and sustainability of the bank, benefiting both bank managers and shareholders.
- What is the objective of liquidity for a commercial bank?
The objective of liquidity for a commercial bank is to avoid a liquidity crisis and prevent a run on the bank. To accomplish this, commercial banks must, to some extent, sacrifice profitability by holding more short-term liquid assets, such as cash, reserves at the Bank of England, money market lending, or short-term investments. While these assets may not offer the same level of profitability as long-term investments and loans, they ensure that the bank can meet its short-term liabilities and prevent a panic among depositors leading to a bank run. By maintaining adequate liquidity, the bank can uphold its stability and continue operating smoothly even during challenging times.
- Why is security an objective for a commercial bank?
Security is an objective for a commercial bank to avoid insolvency and manage risk effectively. To prevent potential losses and maintain financial stability, commercial banks must offer loans that are less likely to default. This can involve issuing loans to safer borrowers and providing loans backed by collateral. By managing risk more favorably and focusing on security, the bank reduces the chances of incurring significant losses that could lead to insolvency. However, it is important to note that prioritizing security may require the bank to sacrifice some profit, as loans with lower default risk typically do not command the highest interest rates. Striking a balance between profitability and security is crucial for the long-term health and sustainability of the bank, ensuring the interests of bank managers and shareholders.
