Meaning of Bank Goals and Constraints
All types of banks are for-profit institutions. They perform payment services, intermediation services, and other financial services to earn profit. But, like any other business, the goal of a bank is stated in terms of shareholders’ wealth maximization. It means every bank should strive to maximize the wealth of shareholders of the bank. The wealth of shareholders of the bank is measured in terms of the market value of the shares.
Banks make a variety of decisions. Lending and borrowing decisions are the routine function of bank management. Banks have to make decisions on the pricing of their products, investments of funds, adding new services and dropping out the existing services, and many other activities. Banks take all these decisions on the basis of their goals of maximization of the wealth of the shareholders.
Bank management undertakes any activities if such activities add to the wealth of the shareholders and does not undertake the activities that do not contribute to the wealth of the shareholders. In other words, banks undertake only those activities that increase the market value of the shares. The market value of a bank’s shares depends on the cash flows that accrue to shareholders of the bank.
Shareholders receive two types of cash flows —cash dividend and market value of the share. The market value of the share depends on (1) the number of cash flows that accrue to bank shareholders, (2) the timing of cash flows, and (3) the risk involved in those cash flows. Cash flows accrued to banks’ shareholders, as we discussed just now, are cash dividends and the market value of the share.
Timing and risk factors affect the value of the share of a bank. As we know that cash flows received earlier are more valuable than those received later. Similarly, the risk involved in the cash flows is incorporated in the discount rate. The involvement of different types of risks poses the probability of variation in the expected cash flows of the shareholders.
Banks are exposed to various types of risks. The most important of them are— credit risk, interest rate risk, liquidity risk, operational risk, price risk, compliance risk, foreign exchange risk, strategic risk, and reputation risk. Banks should manage properly all these risks to minimize the risks involved in the cash flows of the banks and maximize the market value of the shares. The cash flows with high risk are discounted at a higher rate and discounting cash flows at higher rates results in the low market value of the shares.
Banks have to operate their business within certain constraints that may adversely affect their earnings. Market constraints, social constraints, and legal and regulatory constraints are major constraints within which banks operate their business. Market constraints include the economic health of the country and the competition. The growth and profitability of banks depend on the economic growth of the country. In a growing economy, banks also grow and the banking industry may be profitable and prosperous. In a downturn economy, banks also suffer.
Similarly, another market constraint is competition. Other financial institutions provide similar types of services. All these market constraints affect the profitability and cash flows of the banks. Social constraints include the economic health of the communities the banks served for. It also affects the performance of the banks. Banks may mobilize more savings from well-to-do communities and channel more funds for domestic and productive purposes.
Banks have to comply with the regulation of the concerned supervision and monitoring authority. The legal and regulatory constraints such as constraints on the balance sheet compositions, customer relationship, the distribution of cash dividend, and off-balance sheet activities also affect the profitability and cash flows that incur to the shareholders and affect the banks to achieve their goal of maximization of wealth of the shareholders. Thus, banks should operate their business managing different types of risks within the market, social, and legal, and regulatory constraints to maximize the wealth of their shareholders.