How depository institutions make money ?
Depository institutions seek to generate income by the return on assets they earn and the cost of their funds. They by money and sell money. How do they buy and sell money ?Life insurance companies and property and casualty insurance companies are also in the spread business. Explain liability and types of liability available ?
By liabilities of a financial institution we mean the amount and timing of cash outlays that must be made to satisfy the contractual terms of obligation issued. The liabilities of any financial institution can be categorized into four types.
â€¢Type 1 liabilities :
Here both the timing and the amount of cash outlay is known with certainty. Depository institutions know the amount they are committed to pay (principle + interest), on the maturity of a fixed rate deposit. A Type 1 liability requiring financial institutions to pay $50,000 six months from now is an example. GIC- Guaranteed investment contract, is the obligation of the life insurance company to guarantee an interest rate for a sum of money(premium), up to a specified maturity date.
â€¢Type 2 Liability :
The amount of cash outlay is known, but the timing of cash outlay is uncertain. For an annual premium, life insurance companies agree to make specified dollar payments to policy beneficiaries upon the death of the insured.â€¢Type 3 liabilities :
The timing of cash outlay is known but the amount is uncertain. An obligation issued whose interest rate adjusts periodically according to some benchmark. CD(??) have a stated maturity. CD can be fixed and can be floated. If a depository institution issues a three year floating rate CD that adjusts every three months, than the interest rate paid is three months T-bill point + 1% point. Here the maturity is three years but the amount depository institutions need to pay is uncertain.â€¢Type 4 liability :
Both the timing and amount of cash outlay is uncertain. General insurance products and pension obligation. Why are these type 4 liabilities for issuer to policyholder, in light of automobile and home insurance policy How to manage liquidity in cases of uncertainty ?
â€¢Converting or renegotiating debt instruments , changing the nature of obligation. Depositors and institutions withdraw funs prior to maturity dates incurring early withdrawal penalty.
â€¢Life insurance products have cash-surrender value. At specified dates, policyholders can exchange policy for a lump-sum payment. These lump-sum payments penalize policyholders for turning in policy. Some life insurance companies have loan value that means policyholders have the right to borrow against cash value of the policy.
â€¢Such practice creates drag on liquidity, draining the cash out from institutions.
Source : http://www.lawyersnjurists.com/resource/course-materials/finance/depository-institutions-make-money-2/