Question

a) What are the reasons that make banks wanting to keep capital? What are the reasons for banks to avoid keeping too much capital?

b) What are off-balance-sheet activities? Why do banks engage in them? Explain how off-balance-sheet activities can contribute to the risk of the bank

Answer 1

a) Banks wants to keep capital when there is an economic choas and there are risk associated with the overall economy on the way down side because there are higher probability of default due to risk of an impending recession, and people are always looking for restructuring of their loan.when there is such a scenario that recovery of various loans are looking bleak so a bank should always try to keep adequate amount of capital in order to absorb all losses and it do not face the liquidity crunch.

Bank do not want to keep much capital and loan the most of it when it is expecting an economic recovery and economic upside so that there would be less probability of default and more money supply in to the market and there are better creditworthiness of the borrower.

b)off balance sheet activities are those activities which are basically assets and liabilities for the bank but they generally do not appear on the balance sheet of the bank.

Bank engage into them for making higher income and having an additional stream of income through fees income.

These activities can have the potential to become the hidden liabilities and it can be those toxic liabilities which can lead to the insolvency of the bank as we can see in the case of collateralized debt obligations in 2008.