Within a bank, as an intermediary between those with excess money (the depositors) and those who need money (the borrowers), there are two important questions that need to be answered:
- How risky is a borrower?
- What is the funding cost of money?
These are the two important questions that need to be considered before we look at the profit required for sustaining the business operations in order to cover its running costs.
When these decisions are not made properly, it threatens the viability of a bank. There could be two possible outcomes in such instances:
- If the bank does not make enough profit to cover the cost of risk and operations when a risky event occurs, the bank could collapse.
- If the bank fails to meet the depositor's requirements or fails to honor its borrower's agreements to lend, it hurts the credibility of the bank, thus driving potential...