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). Continue reading Opportunity Cost Essay Sample

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