Opportunity Cost Essay Sample

Opportunity cost refers to the value of the next lucrative foregone alternative (Cherunilam, 2008). Therefore, the cost is incurred for having not taken a second best alternative available. For the banks, an opportunity cost would be the profit that they would gain in case they lend a loan to a borrower but would not due to the loan lending limits. In the business lending, the information that is granted tends to reduce the uncertainty and any risk that can emerge (Baker, & Powell, 2009). The banks’ level of willingness to offer loans will depend on the information that they have from the borrower. The lending risks will tend to be lower in situations where the loans are little as compared to the business turnovers, asses and the earnings. The lending risks will also tend to be lower in a situation whereby the existing or rather the projected levels in gearing are low. The credit risks will tend to arise from an inability of counterparties from a bank to meet obligations as well as the collateral failing to secure receivables from the banks. Due to the credit risks, the banks are forced to abide by the lending limits. The credit risk management will tend to work towards restricting losses that may occur due to the credit risks that may arise from the clients as well as other related exposures towards an acceptable level while seeking towards optimizing risk/return ration (Abbott, 2011).

Capital rationing is one of the techniques used towards imposing limits on capital for the banks. In this case, the entire process of lending limits works towards reducing the concentration of the credit risks hence the volatility of returns in a bank and the probability of its insolvency. Capital rationing will therefore work towards hard rationing the loans that banks can make hence forcing the banks to reject particular lending chances. The main objective of capital rationing is protecting the company and in this case, the bank, from having to over-invest its assets (Baker, & Powell, 2009). In case the bank over-invests on its assets, then it would experience low returns on investments and face compromised financial position. Considering the standard finance theory, a loan that increases the concentration of the credit risks into the bank’s portfolio should not face rejection. It should be reflected in higher rates of returns that are demanded by a bank’s investors that offer the funds in which all loans are funded. This means that the cost of capital for the bank will tend to increase. The main device that works towards capital rationing has to increase cost of capital for the banks. Cost of capital refers to cost of debt as well as equity. The main advantage that comes with capital rationing for the banks is the effective budgeting for the bank’s resources (Abbott, 2011).

On the contrary, to the above efforts, concentrations remain as the most important cause of majority of the credit problems. The credit concentrations are mostly perceived as the exposures whereby potential losses are relative to bank’s capital, the total assets or whereby the adequate measures are available, a bank’s general risk level. In this case, the large losses reflect not only the large exposures but to mention, also a potential for the unusual high levels of losses give default. The credit concentrations can be categorized into tow levels that include the conventional and the ones based on the common or the correlated risk factors. The conventional concentrations on credit involve the concentrations of credits towards individual borrowers or rather to counterparties, as well as groups of counterparties and the industries (Milling, 2003). The credit concentrations based on the correlated risks factors tend to reflect on specific situations and can be uncovered by analysis. In this case, a recurrent nature found in credit concentrations difficulties raises an issue of a reason as to why the banks tend to allow the concentrations to develop.

Moreover, the external regulations set by authorities also tend to offer lending limits to banks. In the case of Basel II, a bank was forced to reject the lending opportunity by imposing a lending limit. It is clear that the banking supervisors require setting the specific regulations in order to limit the concentrations towards an individual borrower or rather set related borrowers (Hibbeln, 2010). They should also work towards ensuring that banks are at a position to set lower limits towards a single-obligor borrower. Many managers of the credit risks tend to monitor the industry concentrations. The Base II guidelines on capital are more likely to the bank is required to hold on to more capital in economic downturns. Base II works towards ensuring a control of how much capital that banks require putting aside in order to guard themselves against the various financial and operational dangers or risks that they are likely to face. It does so through setting up the risk and capital management necessities that are designed towards ensuring the banks own adequate capital towards any lending risk that it exposes itself in its lending as well as its investing activities (Abbott, 2011). The entity tends to apply three major pillars that include the minimum capital requirements for the banks to be involved in lending and investing actions. It also involves the supervisory review and the market discipline. Minimum capital requirements by the banks tends to enhance maintenance of a regulatory capital that is calculated through considering some factors such as credit risks, market and operational risks for the banks. Supervisory review involves offering the regulators strong tools that are over the previously applied. In this case, all the banks are capable of reviewing all their systems of risk management. Lastly, the market pillar works towards complementing the minimum requirements of capital as well as the supervisory review activities through development of disclosures required that would allow for participants in the market to be able to measure the capital base or adequacy of a bank. In this case, a sufficient understands ding of a bank capital adequacy offers a [roper base of control on them. Base II is therefore capable of determining the banks to reward as well as those to penalize in their lending activities (Hibbeln, 2010).

In addition, the external regulations on lending limit by Base II come with advantages and disadvantages. In this case, the banks should work towards formulating their own credit risk management procedures. In this case, they should work towards ensuring that all the capital allocations are more risk sensitive. Enhancing the disclosure requirements will also ensure that all the market participants have a better understanding of the institutions of lending. The banks will experience an advantage of protecting its investments and capital and any risks will be minimized of having to lose their capital to loans. The banks will also be able to budget for their corporate resources with such regulations (Milling, 2003). The capital that remains in the banks can be used to acquire new investments instead of lending the same to the borrowers that means exposing the banks to more risks. On the contrary, there is a disadvantage to the banks undergoing such regulations. The banks will have to lose any benefits that would accrue out of lending the loan to the borrower. The amount of return on loans is the opportunity cost in this case. The bank is supposed to make earnings on the loan it lends as interest. Due to the regulations that lead to its lending limits, then the banks will not be able to offer loans beyond certain limits meaning that they would have to lose any benefits that could accrue from the loans (Milling, 2003). For instance, if the lending proportion is set at 10% of capital owned by a bank, then it means that the bank can only lend 10% to the customers who come claiming for the loans. In this case, the risk management in the bank will not offer a chance for a client or an industry to make borrowings over limited amount. This is because borrowing the entire amount would be risky for the bank. Therefore, the risk management group in a bank will only offer a range of only 1% to each client. In case a client requests to make lending of more than 1% to a customer, then the risk management team will tend to object the request. This will be done irrespective of the profitability or the returns on the loan. It is done in order to reduce the entire risk of credit concentration. The opportunity cost arises in that the bank will have to abide by the provisions made by risk management regardless of any profits that would have been accrued. In this case, the cost of not accruing the profits is the opportunity cost. The opportunity cost can be estimated. Say a certain bank has a lending limit that ranges at $20 million towards certain borrower. The limit has been determined as a 10% of the total capital base for the bank, which is $200 million. This limit is being used through lending money to the certain borrower. Nevertheless, the borrower appears in the bank trying to acquire more loans of $10 million. In this case, the bank engages in calculations and finds out that the loan would have generated an additional $1 million. However, the bank would have to reject the entire offer hence suffering an opportunity cost of $1 million.

From the above, the bank may engage in various internal restrictions that would see it towards solving the problem of opportunity cost. However, the task might prove difficult. The bank may decide to offer the new loan to the borrower while transferring the credit risk to other institutions. This may appear difficult since the loans are not easily traded since the process is more complex. It may also be subject to strong approval by the borrower and this may prove difficult (Abbott, 2011). Another problem is that the loan may not bear the same value to another institution like that which it had with the bank. The bank may also work towards increasing its equity but it will also be difficult since the loans are not lent from the bank’s equity. For instance, for a bank to make an extra loan of $10 million, it would have to raise the $100 million over its equity. This will make its total exposure to a borrower hit $30 million. This will therefore not exceed the required 10% of the total capital that is now $300 million. The bank will therefore be able to lend the loan and cover up the opportunity cost of $1 million. This will only be possible if the transactions are constrained by the internal limits.

As earlier mentioned, opportunity cost refers to the cost of the best-foregone alternative. In this case, it will be discussed based on a bank having to undergo through the cost of losing the profits that would be gained from lending a loan that it actually fails to lend due to lending limits. It is the difference between the original value of the loan and the value of the loan prior to completion of payment with interests. In this, lending the loan would be the best option for the bank although the lending limits deter it from lending beyond certain values (Baker, & Powell, 2009). Starting with the first example, an analysis can be done on the opportunity cost. In the above situation, the bank is only limited towards offering 10% of its capital that is $20 million. In this case, if a customer wishes to acquire more loans above the $10 million, then the bank is more unlikely to grant the same. This is because it would be more risky to offer the loan above its lending limits. This means that the bank will have to forgo the profit of $1 million that would be gained through interest. Therefore, the $1 million profit will be the opportunity cost that must be the best-foregone alternative.

In the second instance, the bank is trying to increase its equity in an attempt of increasing its lending abilities. However, it is quite clear that the loan cannot be initiated form the entire equity of the bank. The bank may decide to do this through its internal restrictions and raise its equity. From the above example, if the bank wishes to make an extra loan of $10 million, then it would have to raise its equity to $100 million. This will increase its exposure to the customer to $30 million from the original $ 20 million. The new capital base will then be $300 million hence the lending will not exceed the 10% lending limit set by the risk management. Therefore, the bank will be capable of making loans to the client and earn profits that would have otherwise been forgone if an extra loan were not offered. This is in attempt to cover up the opportunity cost through internal restrictions. The foregone investments that could have been made by the loaned asset are known as opportunity cost.

From all the arguments, people may have different opinions concerning opportunity cost. Some will argue that there should not be opportunity cost while others argue that there should be opportunity cost. For the supporters of opportunity cost, they would argue that having to undergo the best alternative will help the banks remain secure in their lending and investing activities. It would help them be capable of managing their resources in a better way since they are not prone to losses that may occur due to lending beyond their lending limits. However, the opponents of opportunity cost will tend to look at the losses that the banks undergo of failing to offer extra loans to borrowers due to lending limits. It is clear that the banks lose more profits that could have otherwise been earned from the loans. Therefore, the two sides appear to balance hence the need of the banks to formulate better procedures in offering loans to customers to ensure safety as well as full satisfaction of its customers (Hibbeln, 2010).

A participation loan refers to loans made through many lenders towards a single borrower. In this case, several banks join together in order to offer a huge loan to a borrower. One of the banks will have to play the duty of a lead bank while recruiting the other banks in order to participate alongside sharing the risks and the profits accrued. Banks can utilize participation loans in order to reduce risks. This will be done by pooling all the risks and spreading them to the other banks. Therefore, the lead bank can offer huge amounts of loans beyond its lending limits (Baker, & Powell, 2009). In this case, it can be able to cover up the opportunity cost. The profit required to be earned will be earned as well. In further attempts to offer good customer relationships with the banks, extra services such as consultancy and advices can be offered freely customers. Banks should develop strategies to offer consultancy services to client who come seeking for loan advices. Through advices, the customers will be aware of the benefits of participation loans and the various ways they can acquire huge loans from a bank. This will further solve the problem of opportunity cost. The banks should work towards offsetting opportunity cost while at the same instance ensuring proper customer relations (Milling, 2003).

In conclusion, opportunity cost is a huge area of discussion especially in the lending institutions, banks that tend to rely on the external regulations although they are also at a point of setting up internal restrictions. The external regulations depict the lending limits. There is an example of Base II that contains the regulations of banks to observe certain lending requirements. Opportunity cost refers to the value of the best-foregone alternative (Baker, & Powell, 2009). The alternative is more likely to bring the best benefits to the bank, but is foregone due to certain limits. Credit concentrations should be reduced as much as possible by the banks to avoid losses. Moreover, the banks can utilize the process of capital rationing as a way of reducing the credit risks that might be emerge.

At Writing-Expert.com you can find a professional essay writer online to have your college essay written starting at $10/page. We write quality custom essays with a plagiarism free guarantee!

You can rely on our experts any type of work Order Now