Page 537 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 511

In order to maximize profit, institutions can either increase revenues or mini-
mize costs. In this respect, interest revenues and interest costs are typically much
larger than noninterest revenues like service fees and noninterest costs like labor,
equipment, and real estate expenses. The net interest margin is the difference net interest margin A profit measure
between interest revenues and interest costs divided by total assets. Because inter- for financial institutions that equals the
difference between interest revenues
est revenues and interest costs are so large, as interest rates go up or down, the net
and interest costs divided by total
interest margin can change. If interest rates go up and cause interest costs and assets
interest revenues to rise, but interest costs rise more than interest revenues, then
net profit margin will decrease. Alternatively, as interest rates rise, if interest rev-
enues increase more than interest costs, the net profit margin will increase. The
sensitivity of institutions’ profitability to interest changes is known as gap risk. gap risk The sensitivity of a financial
Since changes in interest rates can immediately affect their profitability, financial institution’s profitability due to changes
in interest changes
institutions seek to reduce gap risk.
Another key source of revenues and costs is credit risk. Credit risk is the chance credit risk The chance that promised
that promised interest and principal on debt will not be paid. Institutions seek to interest and principal on debt will not
be paid
make loans to customers or invest in debt securities that offer revenues adequate to
offset the costs of losses from default or nonpayment. To do this, they charge higher
interest rates on loans and debt securities that have higher credit risk than other
investments. If a riskless debt security paid an interest rate of 5 percent and a
loan was made with sufficient credit risk to require a risk premium of 4 percent, the risk premium The added interest rate
total interest rate charged on the loan would be 9 percent. Institutions can also that must be paid on risky debt and
equity securities in addition to the
offset losses from credit risk by securing loans with collateral, such as inventory
riskless rate of interest, such as the U.S.
purchased with funds from the loan. If debt is secured and default on promised government debt interest rate
payments occurs, the institution can seize the collateral as payment. Finally, to
manage credit risk, institutions normally set aside some amount of funds to cover
anticipated losses in any quarter. It is common sense that, if an institution makes
thousands of investments in risky debt instruments, some debt contracts will
default. As mentioned earlier, institutions set aside a reserve for losses that can be reserve for losses Funds set aside by
used to absorb anticipated losses without affecting profitability. If losses due to financial institutions to absorb
anticipated losses without affecting
credit risk exceed loan loss reserves, however, these unanticipated losses will need
profitability
to be absorbed by equity, thereby lowering the equity value of the institution. Of
course, if equity is wiped out by large, unanticipated debt losses, the institution is
bankrupt.
Capital risk is the chance that unanticipated losses will exceed the institution’s capital risk The chance that
level of equity capital on its balance sheet. A bankrupt institution is closed by unanticipated losses will exceed the
institution’s level of equity capital on
regulatory officials and subsequently merged with a healthy institution in most
its balance sheet and cause
cases. The merger of a failed institution can occur literally overnight. Indeed, only bankruptcy
the most observant customers might notice the change in the name of the institu-
tion the next morning. Most institutional failures come about due to excessive
credit risk. Regulations require that institutions maintain reasonable levels of
equity capital to absorb unanticipated losses. Consequently, as institutions
increase their credit risk, regulators will require institutions to increase their equity
capital.
Financial institutions earn profits by managing risks. Those institutions that can
earn the highest return per unit risk will have the highest stock prices. Like other
private firms, the ultimate goal of financial institutions is to maximize stock prices.
Failure to do so will result in shareholder losses, not to mention potential replace-
ment of managers and loss of customers.

reality Do your parents have a defined benefit or defined contribution pension
CH ECK plan? Which one would you prefer to have?

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