Question

The ABC Bank takes funds from depositors and gives out commercial, housing and car loans. Now, instead of keeping the housing and car loans on its books, it sells them to a hedge fund. However, the borrowers still make payments to ABC Bank which then remits the payments to the hedge fund. The bank receives a fee from the hedge fund for servicing the loans. Discuss two (2) advantages to ABC Bank from switching its housing and car loans business to the fee-based income model of banking instead of earning an interest spread (difference in interest between what the bank charges its customers and pays its depositors).

Answer 1

Two advantages to ABC Bank from switching its housing and car loans business to the fee-based income model of banking instead of earning an interest spread are:

· ABC Bank has shifted the risk associated with the loans to the hedge fund. This enables the bank to avoid being exposed to financial risks associated with the loans. In case of any default the risk will have to be borne by the hedge fund and not ABC Bank.

· The second advantage is that ABC Bank will not require to have a significant quantum of funds to make new loans because of the fact that the bank is planning to hold the loan for a short time only after which it will sell the loan to the hedge fund.