Final answer:
Local banks can manage their capital more efficiently by selling loans and creating securities. Still, this reduces liquidity and raises the risk of cash flow shortages.
Step-by-step explanation:
When a local bank issues a loan, it often does not require significant extra funds since it may be planning to sell that loan in the short term, converting it into a financial security. This approach enables banks to be more efficient with their capital. However, this strategy also reduces liquidity and heightens the risk of short-term cash flow shortages due to several factors.
One considerable risk for banks is the potential for a high level of loan defaults, which is difficult to manage due to the nature of a bank’s assets and liabilities. The asset-liability time mismatch, where bank liabilities such as customer deposits can be withdrawn in the short term while its assets, primarily loans, and bonds, are repaid over a longer term, can lead to substantial liquidity challenges.
If interest rates rise unexpectedly, banks that have issued loans at lower fixed interest rates may struggle. They may either lose deposits if they don't offer competitive rates to depositors or face financial difficulties if they increase deposit rates but continue earning less interest from their earlier loans.
This is a classic example of the dangers banks face when there is a misalignment between the interest they earn on assets and the interest they pay on liabilities.
Furthermore, when a firm is deciding how to access financial capital, it might choose to borrow from a bank, issue bonds, or issue stock. While borrowing allows a firm to maintain control, it commits it to scheduled interest payments, which can be burdensome if the income is not sufficient. Alternatively, issuing stock dilutes ownership but does not commit the firm to regular interest payments.