Can a financial institution keep borrowers from engaging in risky activities if there are no restrictive covenants written into the loan agreement?

Ans. by applying the restrictive covenants in the provision of loans, the financial institution minimizes the credit risk. These covenants provide security to the financial institution and enforce the borrowers that as per term of loan providers use the lending money. But in the loan agreement no restrictive covenant not given, then risky investments are present for borrowing amount of such borrowers. The credit risk also increases related to the financial institution who gives the loan. In risky investments, the borrower has to invest according to the restriction issue by banks.

 The financial institution also minimizes the credit score as compared to less capability of the borrower to take the loan in the future. it also enforces the borrower to invest in risky investments or activities so the borrowers can obtain the expense of the lender according to its performance. The financial institution never wants to lose its money and for this purpose, it tries all the remedies to save its money in the case where the restrictive covenant not present in the loan provider.

1.      Why are secure loans an important method of lending for a financial institution?

Ans. by some mortgage, the secured loan is considering a secure method. By keeping some asset as a mortgage for the loan amount, the lenders provide the loans according to usage. As compare to loan amount, the value of mortgage is higher in general point of view. The asset utilize in the mortgage is consider as collateral for the lenders usage. In the credit management tools, collateral is used as very important for the mortgage term. For reducing their credit risk belong to amount of lending the banks are normally used the collaterals. For minimizing the credit risk, banks normally use the collaterals in their transactions.

It is normally happen that when the borrower never obtain is expected return or lower that its set limit then the chance of schedule payment to the banks on due date also minimize. For safe guard his investment, the banks take preventive measurements in case of these types of situations. Bank can perform many actions like it offset the loss from the proceeds received and sell the collateral at the market price. Bank less considers the use of underlying asset in adversity and adverse selection of loan in case of secured loan.

2.      Diego applied for $450000 loan for his local brewing company. However, the bank approved his loan for only $250000. Which type of credit risk management strategy was applied by this bank which type of asymmetric problem is the bank trying to solve?

Ans. lenders adopted the credit rationing methods which is very effective  for moral hazard asymmetric information problem and for the curb adverse selection. Even if the borrower has the capability of paying off the loan at the stated interest rate, the credit rationing means denying the issuance of loan to the borrower. In two different types the credit rationing can be occur for denying the amount of loan that are by restricting the size of the loan or the borrower is agreeable to state rate of interest.

The lender want to insured that moral hazard problem is curbed  while its restricting the size of loan. There is bigger probability of getting into moral hazard when the loans are bigger involved in the transactions. borrower use with the intention that they tend to pay for all those loans that are smaller in size and creating a form of easy for the users.   Some interest related with the accomplishment of investment needs are being used to cater real investment needs of borrower and it also consider its needs. Bank approc less amount of loan . for their risk management practices, banks use this approach to display applications of credit rationing concepts. By restricting the size of loan the banks has put efforts to curb the chances of moral hazard .

3.      Why is being nosy a desirable trait for a banker?

Ans. for the banks, the being nosy is most desirable trait. In screening processes, it is very useful characteristics. The adverse selection of loan can be minimize through this process. This process also include all the data information about the investment and borrowers with details. Not at the cost of their investment banks, never want to enhance the level of their profits. Banks perform all the precautionary measurements related to its borrower and collect all the relevant information which includes investment patterns, his credit report, and aloe the financial health of the borrower with other additional information to get complete satisfaction. \

Banks want to get maximum information about the borrowers to minimize the adverse selection and to find out all the risky loans that bank is going to issue. As per the term and conditions mention in the covenant of loans, the banks collect complete information about the borrowers, its credentials, access their capabilities to pay the complete amount of loan. So being nosy is most desirable characteristic for the banks and keep itself safe and secure.

4.      The following is an excerpt from the federal reserve web site, released September 21,2016,,,, the committee decide to maintain the target range or the federal funds rate at ¼ to ½ percent. The committee judges that the case for an increase in the federal funds rate has strengthened but decided for the time being , to wait for further evidence of continued progress toward its objectives.” Explain what would be the immediate effect on a bank income if its income gap analysis yield a GAP=-$500 million, what would happen to bank income if the increase in the federal funds rate finally materializes?

Ans. with the regard to the interest rates on the loans and savings kept by the banks, the interest rates volatility is explain as the differences observed. How the banks demarcate its investment rates and lending rates and it also affected at large scale that interest rate volatility and basis this volatility according to its requirements. Interest rate volatility effected with the economic conditions and prevalent monetary policy. The income gap of banks is -$500 million in the current time. Federal fund rate also increase by the fed. Such action minimizes the income gap of banks and the profitability of banks going to increase. When the fed rate is going to high then its return also going to high and also its yield on cash and its immediate proceeds going to reach at upper level.

The interest income on the current distributed loans would be increase in the result of such activities and hikes. So it can easily explain that when the federal fund rate is going to increase then the profitability of banks also increase and its income gap minimize in effective way and all these factors must consider with proper attention and verify their impact on banks and its income.

5.      Because diversification is a desirable strategy for avoiding risk, it never makes sense for a financial institution to specialize in making specific types of loans, is this statement true, false or uncertain? Explain your risk.

Ans. the given statement is not true because banks play major role in the development of economy and when they show their specialization in the loans and provide with proper process then they operate the loans most effectively and establish the economies of scale. Banks has determined their creditworthiness easier and collect information about all the local firm through its specialization. It minimizes the likelihood of defaults and also minimize the problem of adverse selection in which banks do not entirely known the credit position of firms and other credit related data.

Banks collect the interest on a periodic basis and such payments are present for collateral and contracts with the extends loans of banks in addition. Payment of loans was not so much unstable as per banks. All those investors who belong to equity investments, for them the diversification is important because of unstable payments of these investors. In case of default the banks are able to collect the information and money so the diversification is not required at every time or for every investor. Banks have ability to manage its issues according to investor’s information and they follow the market information and economic condition according to current time.