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'Banks may fail by over-extending their loan book' - Leaving Cert Economics - Question 4 (a) - 2009
Question 4 (a)
'Banks may fail by over-extending their loan book'. Explain this statement within the context of a bank's twin requirements of liquidity and profitability.
Worked Solution & Example Answer:'Banks may fail by over-extending their loan book' - Leaving Cert Economics - Question 4 (a) - 2009
Step 1
Explain the statement in terms of liquidity
Answer
Liquidity refers to a bank's ability to meet short-term obligations by having enough liquid assets available. If a bank over-extends its loan book, it may lend too much money and not retain sufficient liquid assets. This can lead to a situation where the bank cannot respond to withdrawal requests from customers or meet other immediate cash demands. For instance, if a significant number of clients demand their deposits, and the bank has primarily invested in long-term loans, it might face a liquidity crisis.
Step 2
Explain the statement in terms of profitability
Answer
Profitability involves generating the highest possible return on assets to satisfy shareholders. While extending loans can increase potential profits, it also carries risks, especially if the loans are not repaid. High-risk loans can lead to defaults, increasing bad debts and resulting in losses. A bank focused solely on profitability might ignore the necessary liquidity, exposing itself to financial instability. The balance is crucial: over-lending without adequate liquidity can ultimately threaten profitability and the bank's overall survival.
Step 3
Balance between liquidity and profitability
Answer
Banks must maintain a balance between their earning assets (loans) and liquid assets. The ideal asset structure typically sees a mix such as 50% in term loans and overdrafts and 30% in liquid assets. By over-extending their loan book, banks risk undermining this balance, which can lead to either insufficient liquidity or excessive exposure to bad debts, ultimately resulting in bank failure.