Get borrowers with low default risk. Paying high interest rates.
Buy securities with high return and low risk.
Manage liquidity. In particular, manage credit risk and interest rate risk.
(1) Manage credit risk
(2) Manage interest rate risk.
(1) Managing credit risk (it is about solving asymmetric information problems)
Asymmetric information in loan markets results from the fact that lenders (bank) do not know as much about
the risks that investors (borrowers) are willing to take as the latter do.
To deal with this problem, the banks devote a great deal of their activities to the production of information.
(a) Screening (deals with adverse selection)
(b) Monitoring and enforcement of restrictive covenants (deals with moral hazard)
(c) Specialization in lending (controversial)
(d) Establishing long-term customer relationships
(e) Loan commitment arrangements (I.e. line of credit) promotes (iv)
(f) Collateral and compensating balances (maintaining a portion of the loan in a bank account with
the lending institution)
(g) Credit rationing (refusing a loan or limiting the amount.
(2) Managing interest rate risk
Bank earnings are very sensitive to changes in interest rates. Thus, banks need