Introduction to Finance Chapter 8: Banking Services

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Questions and Answers

What best describes the primary role of commercial banks in a two-tier banking system?

  • They function solely as government agencies managing public funds.
  • They act primarily as investment banks facilitating mergers and acquisitions.
  • They maintain direct relationships with business and households, managing accounts and providing loans. (correct)
  • They issue currency and manage monetary policy.

Which of the following is NOT considered an asset on a bank’s balance sheet?

  • Checkable Deposits (correct)
  • Municipal Bonds
  • Loans to customers
  • Cash and Cash Equivalents

What is the primary difference between a loan and a credit?

  • Credit involves a fixed amount up front, while loans provide payment flexibility.
  • Loans require repayment with interest while credit allows no repayment obligations.
  • Loans are renewable while credit is a one-time arrangement.
  • Loans provide funds for a specified purpose while credit allows for spending up to a limit. (correct)

Which of the following services is considered a core service provided by commercial banks?

<p>Payment services (D)</p> Signup and view all the answers

In the context of bank liabilities and equity, what does the term 'total liabilities' refer to?

<p>The total amount of money the bank owes to creditors. (C)</p> Signup and view all the answers

Which type of loan is specifically classified as a consumer loan?

<p>Credit card loan (B)</p> Signup and view all the answers

What is a primary focus of the additional non-bank services provided by commercial banks?

<p>Providing services like leasing and factoring. (B)</p> Signup and view all the answers

Which of the following accurately describes 'Bank Capital' in the context of a bank's balance sheet?

<p>The funds that belong to the equity holders of the bank. (D)</p> Signup and view all the answers

What is the primary purpose of bank guarantees and letters of credit?

<p>To facilitate trust between market participants (D)</p> Signup and view all the answers

Which step comes after the loan application in the lending process?

<p>Credit Proposal (D)</p> Signup and view all the answers

Which of the following is NOT one of the 5Cs of creditworthiness analysis?

<p>Cash Flow (C)</p> Signup and view all the answers

What distinguishes a capital lease from an operating lease?

<p>A capital lease results in ownership transfer to the lessee at the end (D)</p> Signup and view all the answers

In a leasing agreement, who is responsible for the purchase of the asset?

<p>The financial institution (D)</p> Signup and view all the answers

What is a key feature of an operating lease?

<p>It involves short-term rent without an ownership transfer (B)</p> Signup and view all the answers

Which of the following best defines a leaseback arrangement?

<p>The lessee sells an asset and leases it back (D)</p> Signup and view all the answers

What is usually required by a bank as collateral for a letter of credit?

<p>Securities or assets specified by the bank (B)</p> Signup and view all the answers

What is the primary reason a lessee might choose an operating lease?

<p>To temporarily use the asset without long-term commitment (B)</p> Signup and view all the answers

In a capital lease, who retains ownership of the asset?

<p>The financial institution (B)</p> Signup and view all the answers

What is one of the main advantages of a lease compared to a loan?

<p>Leasing usually involves lower required collateral (B)</p> Signup and view all the answers

What is the primary purpose of a leaseback arrangement for a firm?

<p>To maintain ownership of the asset while improving liquidity (A)</p> Signup and view all the answers

How does a Certificate of Deposit (CD) differ from a savings account?

<p>CDs require a commitment to keep money until maturity (B)</p> Signup and view all the answers

What is a common characteristic of checkable deposits?

<p>They can be withdrawn at any time (A)</p> Signup and view all the answers

Which feature distinguishes a capital lease from an operating lease?

<p>Ownership transfers to the lessee at the end of the lease (A)</p> Signup and view all the answers

What might motivate a financial institution to prefer leasing over lending?

<p>Leases provide higher protection against default (D)</p> Signup and view all the answers

What is one main characteristic of an overdraft?

<p>The bank charges a fee for the limit regardless of usage. (B)</p> Signup and view all the answers

What distinguishes a secured loan from an unsecured loan?

<p>Secured loans involve collaterals such as property or assets. (A)</p> Signup and view all the answers

Which type of loan requires regular payments over a set period?

<p>Closed-end loan (D)</p> Signup and view all the answers

When might someone choose to take out a short-term loan?

<p>To cover immediate cash flow needs. (B)</p> Signup and view all the answers

Which of the following describes a characteristic of fixed interest rates?

<p>They are set at the time the loan is initiated and do not change. (A)</p> Signup and view all the answers

What is the purpose of a loan primarily used for long-term investments?

<p>To fund activities that cannot be financed with personal capital. (D)</p> Signup and view all the answers

What is one potential disadvantage of taking an unsecured loan?

<p>They are riskier for lenders and often carry higher interest rates. (C)</p> Signup and view all the answers

Which of the following is an example of revolving credit?

<p>An overdraft facility (B)</p> Signup and view all the answers

Flashcards

Commercial Bank

A bank that interacts directly with businesses and individuals, managing accounts, deposits, loans, and other financial services.

Bank Balance Sheet (Assets)

The resources owned by a bank, such as cash, securities, and loans.

Bank Balance Sheet (Liabilities & Equity)

The bank's obligations and the owners' stake, encompassing deposits, borrowings, and retained profits.

Loan

A specific agreement where money is given to a borrower (often with interest) for a fixed period and the borrower pays it back.

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Credit

A line of credit, available funds up to a limit, without the direct disbursement of money until needed by the borrower.

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Cash Equivalents

Short-term, highly liquid investments that are readily convertible to cash with little risk of loss of principal.

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C&I Loans

Business loans, a type of commercial loan from a bank.

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Core Bank Services

The fundamental tasks of a bank, including payment services, deposit taking, and lending.

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Unsecured Loan

A loan not backed by collateral. Lenders take on greater risk compared to secured loans, often charging higher interest rates.

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Secured Loan

A loan backed by an asset (collateral) as security. Lenders have a recourse if repayment fails.

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Fixed Interest

A loan with a predetermined interest rate that remains consistent throughout the loan term.

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Floating Interest

A loan with an interest rate that changes based on a benchmark rate (e.g., inflation) during the loan's lifetime.

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Open-End Loan

A revolving credit with a spending limit that renews as debt is paid. Flexible use and repayment.

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Closed-End Loan

A loan for a fixed amount, used for a specific purpose with a specific repayment schedule.

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Bank Guarantee

A promise from a financial institution to make payment for a third party if the client of the bank is unable to make the payment. It strengthens trust between market participants and is common in international trade.

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Letter of Credit

Similar to a bank guarantee, it assures the seller that they will be paid even if the buyer defaults. The bank requires collateral and a fee.

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Creditworthiness Analysis

The process of assessing a borrower's ability and willingness to repay a loan. It involves evaluating their character, capacity, capital, collateral, and conditions.

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Character (5C)

Refers to the borrower's history, reputation, and management team. It assesses their trustworthiness and ethical track record.

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Capacity (5C)

Evaluates the borrower's ability to repay the loan based on their income and existing debt obligations. It looks at the debt-to-income ratio.

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Capital (5C)

Represents the borrower's own funds invested in the business. It shows the amount of their skin in the game.

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Collateral (5C)

An asset that can be used to compensate the bank if the borrower defaults on the loan. It provides security for the lender.

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Conditions (5C)

Focuses on the purpose and intended use of the loan. It assesses the risk and potential impact of the borrower's plans.

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Capital Lease

A lease where the lessee eventually owns the asset. The financial institution registers the asset and handles amortization.

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Operating Lease

A lease where the lessee only uses the asset temporarily and does not own it. The financial institution owns the asset.

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Leaseback

A firm sells its asset to a financial institution and immediately leases it back. This helps firms with liquidity problems.

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Lease vs Loan

A lease gives the financial institution ownership, while a loan makes the borrower the owner. In case of default, the financial institution can easily claim the asset in a lease.

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Checkable Deposits

Deposits that can be withdrawn at any time, used for payment and electronic banking services.

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Savings Accounts

Deposits not used for payments, but accrue interest, typically with higher returns than checkable deposits.

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Certificate of Deposit (CD)

Time deposit with a fixed term, offering higher interest rates than regular savings accounts.

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Non-Transaction Deposits

Deposits not used for payment transactions, mainly focusing on savings and investment.

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Study Notes

Introduction to Finance - Chapter 8: Banking (Core) Services

  • Commercial banks are the second tier in a two-tier banking system.
  • They interact directly with businesses and households.
  • They manage accounts, deposits, credits/loans and provide other financial services.

Balance Sheet of Banks

  • Assets: Cash and cash equivalents, US Treasuries, Municipal Bonds, Asset-backed securities, Loans (commercial and industrial loans, real estate loans, residential mortgages, home equity loans, commercial mortgages, consumer loans, credit cards, auto loans, interbank loans).
  • Liabilities and Equity: Checkable deposits, Non-transaction deposits, Borrowings from other banks, Bank capital.

Balance Sheet - Assets and L&E

  • Assets: Represent resources owned by the firm. Bought or created to increase firm value.
  • Liabilities and Equity (L&E): Total liabilities represent overall amount of money owed by firm to creditors. Equity is the capital provided by owners, also from profitable operations (reinvested profits). Both asset and L&E categories constitute funds used and sources of capital for the firm.

Services of Commercial Banks

  • Core bank services: Payment service, gathering deposits, giving loans.
  • Additional non-bank services: Leasing, factoring, intermediation (insurance, security trade), foreign exchange trade, financial services (credit cards), asset management (investment funds), and others.

Loans

  • Loan vs Credit:
    • Credit: Creditor provides a line of credit, borrower withdraws up to limit; no actual money disbursement; opportunity for future withdrawal.
    • Loan: Lender provides a specific amount of money; borrower pays back with interest. Loan has actual money disbursement.
  • Loan vs Credit (examples):
    • Credit (e.g., overdraft): Bank sets a limit and allows customer to withdraw as needed. Bank charges a fee to use the limit.
    • Loan (e.g., mortgage): Bank provides a specific amount of money for a specified purpose; borrower pays back with interest. Money disbursed automatically.
  • Why we need credit/loan:
    • Long-term: To fund activities beyond available capital, often for long-term investments.
    • Short-term: To secure liquidity, bridge short-term cash flow gaps (e.g., overdraft).
  • Categorization of Loans: Unsecured (no collateral, higher risk, higher interest), Secured (collateral, lower risk, lower interest); Maturity (short-, medium-, long-term).
  • Interest payment: Fixed (set interest rate), Floating (interest rate changes during loan).
  • Technical form: Open-end loan (revolving credit, pre-set spending limit, flexible use, eg., credit card), Closed-end loan (specific purpose, specific time, eg., mortgage).

Bank Guarantees and Letter of Credit

  • Not actual loans, promise of payment if client defaults.
  • Strengthen trust between market participants, often in international trade.

How Letter of Credit Works

    1. The bank provides a guarantee & requires collateral.
    1. Buyer & Seller complete transaction,
    1. Seller provides documents to prove delivery to the bank.
    1. The bank pays seller, then buyer pays the bank.

Process of Lending

  • Loan application
  • Analysis of creditworthiness
  • Credit proposal
  • Contract
  • Disbursement
  • Monitoring
  • Repayment
  • Collecting/handling payment problems

Analysis of Creditworthiness – 5C

  • Character: Firm/individual history, management.
  • Capacity: Ability to repay loan, debt-to-income ratio.
  • Capital: Financial resources of the borrower.
  • Collateral: Asset to compensate lender if borrower defaults.
  • Conditions: How borrower intends to use loan funds.

Leasing

  • Definition: A contract where a lessor (financial institution) buys an asset and the lessee (borrower) receives possession and use of the asset. Periodic lease payments are made, with an option for ownership at the end of the agreement.
  • Meaning: The financial institution owns the asset, and the lessee uses and pays for it.
  • Process:
    1. Lessee chooses an asset.
    2. Lessor purchases asset and obtains ownership.
    3. Lessor grants possession and use; collects periodic payments.

Types of Lease

  • Capital lease
  • Operating lease
  • Leaseback

Capital vs Operating Lease

  • Capital Lease: Long-term funding, ownership is transferred or an option to buy, used for investments and long-term assets.
  • Operating Lease: Short-term rental use, no transfer of ownership.
  • Key Differences (Chart): Ownership, Registration of Asset, Amortization, Maturity, Collateral, Termination

Leaseback

  • Firms with liquidity problems sell assets to financial institutions & lease it back. Firm keeps asset but receives funds.

Lease vs Loan

  • Lease: Financial insitution owns asset,
  • Loan: Borrower owns asset,
  • Lease grants greater protection to financial insitutions,
  • Lease funding is less sensitive to borrower's financial position.

Deposits

  • Checkable Deposits: Deposits where depositors can withdraw at will. Includes checking accounts. (often low or no interest).
  • Non-transaction Deposits (Savings Accounts): Not used for payment, pay higher interest rates.

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Introduction to Finance - Lecture 8: Commercial Banks PDF

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