Banking and Interest Rates - Chapter 5

Chapter 5: Banking and Interest Rates

• Chapter objectives include describing financial institutions, banking services, selecting financial institutions, identifying interest rate components, and explaining interest rate fluctuations.

Types of Financial Institutions

• Depository institutions accept deposits and provide loans
  • Commercial banks accept deposits and use funds for commercial and personal loans
  • The UAE central bank guarantees deposit amounts.
• Savings institutions (or thrift institutions) accept deposits and give mortgage and personal loans to individuals.
• Credit unions are non-profit depository institutions for members with a shared affiliation.
• Nondepository institutions do not offer federally insured deposits but provide other financial services.
  • Finance companies specialize in personal loans to individuals.
  • Securities firms facilitate security purchases/sales through investment banking and brokerage services.
  • Insurance companies protect individuals/firms from adverse events.
  • Investment companies sell shares to individuals and use proceeds to create mutual funds.
  • Financial conglomerates offer diverse financial services to individuals/firms (e.g., Bank of America, Citigroup).
• Exhibit 5.1 illustrates how a financial conglomerate serves individuals through its subsidiaries.

Banking Services Offered by Financial Institutions

• Checking services allow fund access through checks.
  • Fees may apply if bills or loan payments are late.
  • Banks often issue debit cards and provide online banking, including bill pay and account transfers.
• Monitoring accounts includes recording checks and reconciling statements with registers.
  • UAE Penal Code (Article 401) outlines penalties for bounced checks.
• Exhibit 5.2 provides a worksheet example to reconcile a bank statement.
• Check float is the time between writing a check and account reduction. UAE banks now often clear checks same day.
• Electronic checking deters fraud as the payee verifies sufficient funds.
• Credit cards (Visa/Mastercard), debit cards, and interchange fees are discussed.
  • Debit cards facilitate easy money transfers but may potentially encourage overspending in some cases.
• Additional services include saftey deposit boxes, ATMs, cashier's checks, money orders, and traveler's checks.

Selecting a Financial Institution

• Criteria used often relate to convenience, online banking, deposit rates, insurance, and fees.

Interest Rates on Deposits and Loans

• Interest rates on deposits and loans directly affect cash inflows and outflows.
• Certificates of deposit have minimum investment, interest rate, and maturity specified. UAE central bank issues CDs to banks.
• Risk-free rates are guaranteed returns even when the bank defaults. These returns are about 2.5% in the UAE.
• Risk premium is an additional return beyond the risk-free rate. This is earned from deposits guaranteed by the government.
• Loan rates are typically higher than deposit rates.
• Loan rates are adjusted based on economic conditions and a borrower's credit, with potentially higher rates for borrowers with poor credit history.
• A "twisted perception" of risk premium suggests that investors may pursue risky investments to compensate for low incomes, even though this is often not financially sound for those with lower incomes.
• Comparing loan rates to maturity time frames and risk tolerances may help inform financial choices.
• Term structure of interest rates describes the relationship between debt security maturity, and associated yields. These are often based on U.S. Treasury-issued securities with differing maturities.
• Shifts in yield curve graphs can be found in publications like The Wall Street Journal.
• Financial institutions obtain funds through deposits and provide loans, enabling profit from this spread in rates. The loan rates generally exceed the offered deposit rates.
• Exhibit 5.3 and 5.4 display annualized deposit rates and interest rate comparisons among various maturities, respectively. Exhibit 5.5 traces trends in one-year CD rates and loan rates through time.

Why Interest Rates Change

• Monetary policy is undertaken by the Central Bank to control the money supply, including demand deposits and public currency. Open market operations include the purchase/sale of Treasury securities to adjust the amount of funds at commercial banks. Changes in the supply of money directly alter interest rates.
• Government demand for funds can affect interest rates via changes in government borrowing; a decrease causes a surplus, leading to lower rates.
• Business demand for funds also affects interest rates.