credit management handbook

7/29/2019 Credit management Handbook

1/56

1

Muhammad Hamad

Fa09-BBA-057

Department of management sciences

COMSATS institute of information technology Islamabad


2/56

2

CHAPTER 1

FINANCIAL SYSTEM AND STRUCTURE


3/56

3

1.1 IntroductionA stereotype view of bankers and other financers is that they are evil genius, brilliant or both.

There is no doubt that there are always black sheeps present in every department, and sector of

the economy which due to greed or their vested interested did mistakes and took advantage of the

system while hurting other stakeholders but normally financers and bankers like other people in

society did a great job for the betterment of human race. To understand the financial system with

all its glory and complexity one must be sharp enough to judge things happening in the economy

on the basis of truth and ground realities. It must be kept in mind that financers and bankers are

like other professional, politicians, scientists, professors, and government officials did mistakes

in past and there is no guarantee that mistakes wont happen in future because no one on this

planet is perfect; perfection lies with nature only. Adam Smith in his book An Inquiry into the

Nature and Causes of the Wealth of Nations, published in 1776 said;

But man has almost constant occasion for the help of his brethren, and it is in vain for him to

expect it from their benevolence only. He will be more likely to prevail if he can interest their

self-love in his favor, and show them that it is for their advantage to do for him what he requires

of them.

Economic development of a country depends on number of factors among all those factors

financial system has a vital role to play for the economic development. As financial system

connects the savers with investors and channelize funds from surplus units of the economy to

deficit units. Creating a link between borrower and lenders is the function of financial system.

Borrowers include inventors, entrepreneurs, government agencies, households and established

businesses which have identified profitable projects but they dont have funds to capitalize on

their idea (revenues < expenses). Lenders are those households, businesses, government and non

government agencies which have excess funds meaning their revenues are greater than their

current expenses. The financial system performs the important function of creating a bridge

between these two units of economy, or savers to borrowers. If there is no existence of financial


4/56

4

system the money will not flow from the surplus units to

deficit units, as a result economic activity as well as

circulation of money will be limited. And many

productive activities wont be carried out due to lack of

funds available.

Financial system can be defined as it is a network of

interconnected banks, intermediaries, markets and

facilitators which perform three major functions-

allocation of resources, sharing risk, and intertemporal

trade as shown in fig 1.1.

Sharing risks means that financial system shares risks attached with the initiation of new

projects, new product development, going global, competition, and all those external and internal

risks of business to which business is exposed. Allocation of capitalis a process through which

financial system provides funds to those sectors of

economy which are in an urgent need to have funds to

carry out profitable activities. Different sectors of economy compete with each other to get funds

from financial system and it is the responsibility of financial system to allocate capital to most

efficient units of economy to reap the benefits of their profitable activities, thus enhancing

economic development. Third function of financial system is helping in intertemporal trade.

Some time individual, small companies, and those dealing in growing markets have enough

wealth to convert their ideas in to profitable activities that is internal financing but it is rare

phenomena that any unit of economy has sufficient amount of funds available to meet their

requirements. Most of the individual and companies has to seek the help of financial system to

generate enough amount funds to finance their projects that is external financing. Now matter

external financing is equity based or debt based one has to seek the help of financial system tofull fill their current needs. Fig 1.2 shows the dual status of an individual in financial system.

And this dual function is carried out by almost all the actors in the financial system at one time

they are providers of funds and at times they seek funds from financial systems.

Sharing risks

Intertemporaltrade

Allocatingcapital

Figure1.1 Source: Lecture material


5/56

5

Why we need a financial system is

basic question? And why

individuals and business cant raise

funds without the help of financial

system? Are some basic questions

regarding the financial system and

its importance? Answer to these

questions is simple and discussed

below.

Argument for financial system there

are number of reasons due to which

financial system is required. Firstly

it is difficult for lenders to find suitable borrowers which will use the funds of lender in right

direction and will pay back the principle amount as well as cost of funds. Secondly the process of

lending requires some fixed cost and

these cost are greater than rewards

stemming from lending for individual lenders or small group of lenders. Its not to say that small

financial institutions and individual lenders cant do a great job but for a business it is necessary

to achieve minimum efficient scale. Minimum efficient scale is that level of business that is

necessary for a business to continue its operation.

Financial system achieve efficiencies due to two reasons first one is specialization and second it

economies of scale fig. Financial system is made up of banks and other financial institutions for

which lending is prime function so they become specialized in advancing loans to deficit units

and they achieve economies of scale by providing their services to a large number clients.

Asymmetric information is a problem faced by financial system which limits its efficientworking. Simply stating asymmetric information means that one party in the contract has

superior information than other party; and the one with superior information exploits other party.

Particularly for financial system it means when borrower has more information than lender. Two

other issues which originate from asymmetric information are adverse selection and moral

hazard consequences of asymmetric information are shown in fig 1.3. Adverse selection is pre

Figure 1.2 Source: Lecture material
http://images.flatworldknowledge.com/wright_2.0/wright_2.0-fig02_001.jpg


6/56

6

contractual behavioral issue that

those borrowers which have high

level of risk offer higher interest

rates to get the loans and most of

the time they successfully raise

funds. It is said that if lenders are

aware of this selection bias they will

never give their money out and take lending risk ever.Moral hazardis post contractual problem

which states that there is change in intentions and behavior of borrower after receiving money

from lender. For example a borrower raised funds to open a restaurant but after having money in

hand he starts thinking of short cuts

use money in gambling, and makes

other speculative investment completely forgetting the interests of lender. Another example is

that if someone has fire insurance they may be more likely to commit arson to reap of insurance.

Financial system cant eliminate the problem of asymmetric information but it tries to minimize

its effects. By the means of carefully screening the applicants for credit and insurance, and after

the transaction by monitoring their activities. With asymmetric information business can raise

funds on relatively cheap interest rates that allow them to be more efficient, and creative. By

providing liquidity and capital to business through financial markets and intermediaries financial

system overcome the problem of asymmetric information. Financial instruments also called

financial securities are used to raise funds. Financial security is contract between lender and

borrower which specifies the obligation of the borrower, the rewards of the lender, time of the

contract. Simply saying a financial security describes who owes what to whom, under what

condition payment become due and the mode of payment as well. There are three major

classifications of financial instruments- debt, equity, and hybrid. Debt instruments are those

instruments which show a lender borrower relationship and stats that after how much time the

principle amount and interest payments become due.Equity instruments present ownership stake

of an individual in a specific organization like shares. Hybrid financial instruments are those

securities which have characteristics of both debt and equity instruments examples are preferred

stock and convertible bonds.

AdverseSelection

Transaction withAsymmetricInformation

Moral Hazard

Figure 1.3



7/56

7

Financial markets can be grouped on the

basis of issuance, and maturity of

instruments. On issuance base there are

two types of financial markets- primary

market and secondary market. Primary

marketis that market in which a company

offers its securities for first time that is

also called IPO initial public offering.

Secondary market is that market in which

already issued securities are traded, secondary market is important in the sense that it provides

investors the opportunity to sell their securities when they need cash or due to any other reason.

Over the counter market is also becoming popular that is basically a network of brokers and

deals worldwide, which helps in sale and purchase of securities. On the basis of maturity

financial markets can be classified as money market, capital market, and derivative market fig

1.4.Money marketis a market in which short term financial securities having maturity of one or

less than one year like certificates of deposits, T- bills, commercial papers, and banker

acceptance are traded. In capital marketlong term debt and equity instruments are traded which

has maturity of more than one year. Example of capital market instruments are stocks, and

bonds. Derivatives contracts trade in a third type of financial market which allows investors to

spread and share a wide variety of risks the instruments involved are options, future, and swap. A

financial intermediary is a financial institution that connects surplus and deficit agents. The

classic example of a financial intermediary is a bankthat consolidates bank deposits and uses the

funds to transform them into bankloans (Wikipedia); other examples include insurance agencies,

dealers, and brokers. The definition of financial intermediaries given by Van Horne in his book

financial management is;

Financial intermediaries are financial institutions that accept money from savers and use thosefunds to make loans and other financial investments in their own name. They include

commercial banks, saving institutions, insurance companies, pension funds, finance companies

and mutual funds

MoneyMarkets

Less than 1 year

maturity

T-bills

Commercial paper

L/Cs

Bankers acceptances

CapitalMarkets

More than 1 year

maturity

Equities (stocks)

Corporate bonds

Government bonds

Mortgages

DerivativesMarkets

Options

Futures

Swaps

http://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Bank_depositshttp://en.wikipedia.org/wiki/Loanshttp://en.wikipedia.org/wiki/Loanshttp://en.wikipedia.org/wiki/Bank_depositshttp://en.wikipedia.org/wiki/Bankhttp://en.wikipedia.org/wiki/Financial_institution


8/56

8

Commercial banks are the most important source of funds for companies and individual, banks

accept deposits from household, firms, and government, which are liabilities of bank and

advance short, medium, and long term loans to deficit units of the economy. Insurance

companies are in the business of collecting periodic payments called premium from those they

insure in exchange for providing payouts if any adverse event occur. There are two types of

insurance companies- property and casualty insurance; there other one is life insurance

companies. Property and casualty insurance companies insure against thefts, accidents, fires, and

other unpleasant events of similar nature. These institutions invest mostly in those securities

which are tax exempt. They also invest partly in corporate stocks, and bonds. Life insurance

companies insure against loss of life, these companies are tax exempted so they heavily invest in

stocks, bonds, and make other long term investment which yield more than investing in tax

exempted securities like municipal bonds. Other financial intermediaries include pension funds,

mutual investment funds, and finance companies. The critical decision for borrowers is that

whether to use financial markets to raise funds or they should go to financial intermediaries. This

decision depends on the costs involved in obtaining funds. Which alternative offers low level of

cost the will be selected. For example for a reputed organization it will be easy to raise funds by

financial market through issuance of bonds at relatively low cost but a newly established firm

found that it will beneficial to get a loan from bank. On the other side of picture lenders or

investors face tradeoff between, risk, return, and liquidity. Investors want low risk but higher

level of return and liquidity which in most of the cases is not possible. If an instrument offers

high return the level of risk involved will also be high. Investors invest their savings in market or

intermediaries depending upon how much risk they can take, what are their liquidity

requirements, and the most important element is promised returns. Financial systems are

complex mechanisms to channelize funds so there is need to have a watch dog over the

participants so that the system delivers its best. Usually this regulatory authority is the central

bank of the state which through its policies tries to maximize the effectiveness of the financial

system. Regulatory authority plays four major functions. Firstly by ensuring transparency in

system try to minimize the problem of asymmetric information. Secondly acts as lender of last

resort when any participant get into trouble and no one lends money then regulatory authority

lends money for the smooth functioning of system. Thirdly by ensuring the easiness of entry and


9/56

9

exit regulatory authority tries to enhance the efficiency. Fourthly through its policies protect the

interests of lenders and borrowers.

1.2 ConclusionA sound and established financial system is the prerequisite for economic growth. If financial

system does not exist the savings of investors will not be sufficient enough to fulfill their future

needs at the same time entrepreneurs wont be able to convert their ideas into physical goods

restricting the improvements in standard of living. Financial system offers a lot of option to

lenders and borrower to invest and to raise funds respectively depending upon their

requirements. Asymmetric information is the biggest problem face by financial system its a

constraint on smooth and efficient working of financial system. Central bank which is the

regulatory authority for financial system tries to ensure transparency which reduces asymmetric

information but government can only act as a helping hand for financial system.


10/56

10

CHAPTER 2

FINANCIAL CRISIS


11/56

11

2.1 Introduction

Financial crisis is not a new phenomenon for the world economy, over past five hundred years

many crisis have shacked the financial systems. Sometimes financial crisis even lead to major

social and political developments like after the financial crisis of 17641768 and 1773 American

Revolution started. And after her independence America faced many financial crisis in 1792,

18181819, 18371839, 1857, 1873,

1884, 18931895, 1907, 19291933,

and 2008. The prime reason for the

occurrence of financial crisis is the

asymmetric information that leads to

create a trust deficit among lenders

and borrowers. Lenders no more

show confidence in working of

financial system and they start

pulling out their monies. Financial

crisis doesnt change the real

economy unless a recession or

depression occurs. Interest rates raises, increases in level of uncertainty increases, government

fiscal problems all have bad consequences on economy and this is termed as shocks. Five shocks

alone or after certain time period may lead to financial crisis. Creation of asset bubbles may alsolead to financial crisis. This chapter will focus on financial crisis, its types and reason, asset

bubbles and how and why they are created, financial panics, the reasons behind current financial

crisis, and the role of government to minimize the chances of occurrence of financial crisis in

detail fig 2.1 shows a snap shot of Figure 2.1 Source: Google images


12/56

12

financial crisis.

Financial crisis is defined as financial crisis

is a situation in which one or more financial

markets or intermediaries cease functioning

or function inefficiently. There are two

major types of financial crisis- systematic

and non systematic financial crisis.

Systematic financial crisis affects the

economy as a whole great depression is

example of systematic financial crisis while

non systematic financial crisis effects only

to specific sectors of the economy i.e.

saving crisis, credit crunch and etc. If non-systematic financial crisis are not properly controlled

they become systematic financial crisis which hurts whole financial system fig 2.2 shows this

phenomena. Either it is systematic financial crisis or non systematic financial crisis it hurt the

flow of funds from savers to investors, and it also become more difficult to spread risk. The

reasons for financial crisis are- increased uncertainty increase in interest rates, government fiscal

problems, balance sheet deterioration, banking problems and panics.Increased uncertainty when

investors have doubt about their future earnings by investing due to inflation and other reasons

than to be on safe side they hold their money instead of investing in productive activities which

lead to decrease in economic activity.

Increase in interest rate when interest rate in economy increases it become expensive for

borrowers to get loans. Increased interest rate also lead to adverse selection as most risky

borrowers offer high interest rate to get loan, when these borrowers are unable to pat back

default rate increase. For those businesses which hold government bonds increase in interest rate

cause balance sheet deterioration decreasing the net worth of the business. Government fiscal

problems those governments which spend more than they receive as tax have to borrow from

financial markets and intermediaries. When the level of debt increase it become difficult for

government to service debt, which lead to decrease in value of government securities and

devaluation of currency. When currency devalues it become difficult for firms which have raised



13/56

13

finances from international market to meet their obligation and the result is default. Balance

sheet deterioration when the net worth of companies fall due to decrease in value of assets or

increased value of liabilities than most of the businesses tend to involve in riskier activities

because they have less on stake. Due to balance sheet deterioration adverse selection and moral

hazards occur agency problem also plays its role. Banking problems and panic banks are most

important participants of financial system. When due to any reason balance sheet of bank got

hurt, bank will reduce lending to avoid bankruptcy, or to meet the requirements of regulatory

authority. Decreased lending hinders the flow of funds from investors to entrepreneurs reducing

the economic activity. When a bank fails other banks in the system also suffer due to two major

reasons, firstly banks often owe each other considerable sums and secondly when a bank fails

customers of banking system lose confidence in banking system; they rush to their respective

funds to with draw their money. The above discussed five points increases asymmetric

information, and decrease economic activity. Exchange rate crisis occur and like an ice ball starts

getting bigger and bigger, that is the point where recession turns to depression.

Asset bubble means a rapid increase in value of an asset; assets might be a financial asset like

bond, or any other form of security or any physical asset like real estate etc. causes of increase in

value of asset are low interest rates, new technology, increase in demand, and leverage. Low

interest rate there is inverse relation between interest rate and present value of asset. The fall in

interest rate leads to increase in present value of any asset. According to present value formula

that is PV = FV/(1 + i)n when i in formula gets smaller present value gets higher. Low interest

rates can cause bubbles by lowering the total cost of asset ownership. Expectation for the

invention of new technology increase g in Gordon growth model which ultimately leads to

increased present value. Increase in demand of an asset may also cause asset bubble, demand

increases when investors have expectations that future value will rise. When news about increase

in price of asset affects economy rather than economy affecting demand this is the situation

when asset bubbles are created. When investors use leverage that is borrow more than their ownsaving to maximize their return this can lead to creation of asset bubble, most leverage investors

are not too much smart because higher the risk higher the return.

Financial panic occurs when leveraged financial intermediaries must sell assets to meet lenders

call. Lender ask their money back either due to increase in interest rates or decrease in value of


14/56

14

collateral. Calls are normal every day

part of business operations but due to

burst of an asset bubble calls they come

in such a way that borrower cant

mange. During panic situation

everybody sells and with a very few

number of buyers, highly leveraged

firm find it difficult to sell quickly or at

fair price to meet the call and repay the

money as result bank start suffering.

Interest rates go up and lending reduced

when due to panic situation

deleveraging of system took place causing negative asset bubble. High interest rate and low

value expectations drove prices low. During financial panic volume of lending is reduced hurting

the real economy which cause unemployment to handle the situation lender of last resortplays

its role by adding liquidity in the system, increasing money supply, lending to worthy investors

and making up beat statement about economy fig 2.3. Most common form of lender of last resort

is government central bank through which government implements its policies; though some

other institutions like IMF tried to act as lender of last resort with a mixed level of success.

Bailouts,by contrast, restore the losses suffered by one or more economic agents, usually with

taxpayer money. The restoration can come in the form of outright grants or the purchase of equity but

often takes the form of subsidized or government-guaranteed loans .Nevertheless, if the lender of last

resort cannot stop the formation of a negative bubble or massive de-leveraging, bailouts can be

an effective way of mitigating further declines in economic activity. The most recent crisis occur

because of nonsystematic subprime mortgage crisis of 2006, when loans were advanced to even

the individual who dont have job or any other source of income at a low interest rate. In 2008,

the failure of several major financial services companies turned it into the most severe systemic

crisis in the United States since the Great Depression . The troubles began with a major housing

asset bubble and Mortgages which became much easier to obtain. Regulators allowed such

practices in the name of affordable housing, even though six earlier U.S. mortgage securitization

schemes had ended badly. In June 2006, housing prices peaked, and by the end of that year it

Shock

Interest rates rise

Asset values fallSell off/defaults

Credit tightens

Interest rates rise

Lending volume falls

More selloff/defaults

Asset values fall



15/56

15

was clear that the bubble had gone bye-bye. By summer 2007, prices were falling quickly. Defaults

mounted as the sale/refinance option disappeared, and borrowers wondered why they should continue

paying a high mortgage on a house worth low than that. The government responded with huge bailouts of

subprime mortgage holders and major financial institutions.

2.2 Conclusion

Many theories have been offered on the topics of how financial crisis occur and how to prevent

them but there is a little consensus, and financial crisis is still a regular phenomena for the

economies worldwide. Interest rate increase, balance sheet deterioration, government fiscal

problems, banking problems and panics, and creation of asset bubbles all may lead to financial

crisis. It is the responsibility of regulatory authorities to make policies in order to keep a check

on smooth operations of financial system by decreasing level of uncertainty, and asymmetric

information.


16/56

16

CHAPTER 3

BANK MANAGEMENT


17/56

17

3.1 Introduction

Balance sheet of an organization shows financial strength of firm at a particular date. Due to

nature of business in which banks are involved i.e financial intermediation their financial

statements are quite different from any other business. Financial statements of banks merely

show the risk that banks take in performing their function. Table 1 shows simplified balance

sheet of a typical bank.

Liabilities Assets

Deposits Cash 3

Short term/ Demand 65 Loans and advances

Medium term 20 Short term 30

Borrowings 5 Medium term/ long term 25

Capital and Surplus 10 Investments 40Fixed assets 20

Total 100 Total 100

Table 1

The above balance sheet shows following characteristics

Sources of funds are primarily short term in nature with short term maturities. Financial leverage is very high, this is risky and can lead to earning volatility. Due to nature of business fixed assets are low. Interest rate change may hurt banks income because banks heavily invest in loans and

advances which are subject to interest rate volatility.

Operating leverage is relatively low due to comparatively lower fixed costs.


18/56

18

Bank liabilities- bank liabilities are

classified on the basis of maturity

and interest rates. Major bank

liabilities are demand deposits as

shown in table 1. Banks assets on

the other hand are made up of cash,

loans and advances, investments and

fixed assts. Loans and advances are

most important component of

banks assets. Banks must ensure to manage assets and liabilities to develop right mix of

liquidity and profitability. There is tradeoff between liquidity and profitability as shown in fig

3.1. A bank must make sure that it has enough reserves to meet customers demand for cash in a

way that it doesnt hurt profitability. This is called liquidity management. Like goal of any

organization banks are doing business to earn money, for this purpose banks have to create

portfolio of its investment to earn maximum by using its assets this is known as asset

management. Liability management refers to get funds at a minimum price. Capital adequacy

management refers to the concept that bank must have net worth or equity capital to create a

cushion against bankruptcy and any loss. To protect themselves from changes in interest rates

banks involved in activities which are not shown on balance sheet that is fee based banking.

Banks almost charge fee on any transaction now a days. Contingent liabilities are example of off

balance sheet items that arises when a customer default on letter of credit etc. Income statement

shows items that are sources of income and expense. The major source of earning for bank is

interest on loans and expense is interest paid to depositors and other investors. To maximize

earning bank must increase the spread that is difference between that rate of interest bank pays to

investors and interest rate it receives from borrowers: this only possible when you get cheap

funds and lend at high rate. Burden is difference between noninterest expense and non interest

income typically noninterest income is not sufficient enough to cover noninterest expense

creating burden for bank. Banks net income depends upon following factors

Net interest income Burden Provisions for loan

Have enoughreserved to

satisfy depositoutflows

Use efficientlyenough to earn

profit



19/56

19

Profit or loss from sale of assets Tax

Comparison of banks is a difficult job. Which bank is working better and which is not? The

answer of this question depends on the way we analyze banks. On method of analysis is DuPont

approach. DuPont approach is four step decomposition process of return on equity by this

approach analysts try find where a bank is lacking behind and what needs to be changed. Below

DuPont approach given by David Cole in 1972 has been discussed.

Step 1

Return on equity = Net income/ Average total equity

Return on equity can be written as

Return on equity = (Net income / Average total assets) X (Average total assets/ Average total

equity)

Return on equity = Return on assets X Equity multiplier

Equity multiplier is a double edge sword. It states that using low level of equity is profitable,

equity multiplier signifies the effect of return on asset it increase the earnings when bank is

making profit but also signifies the loss when return on asset is negative.

Step 2

Net income = Total revenueTotal expenseTaxes

Total revenue is interest income plus noninterest income plus profit on sale of investments.

Expense includes Interest expense plus noninterest expense plus provisions. The effect of

dividing both sides by average total assets is to decompose return on asset

(Net income / average total asset) = (Revenue/ average total assets) - (Expense/ average total

assets) - (Taxes/ average total assets)

Return on asset = Asset utilizationexpense ratiotax ratio


20/56

20

This shows that to maximize return on asset bank has to maximize asset utilization and minimize

expense and tax ratio.

Step 3

We can decompose revenues as

Revenues = Interest income + Noninterest income + Net profit or loss on sale of securities

Dividing both sides of equation by average total asset

(Revenues / average total asset) = (Interest income / average total asset) + (Noninterest income /

average total asset) + (Net profit or loss on sale of securities / average total asset)

Asset utilization= Yield on assets + non-interest income rate + profit rate on sale of securities

Step 4

Expense = Interest expense + overhead expense + provisions

Dividing both sides by average total assets

(Expense / average total assets) = (Interest expense / average total asset) + (overhead expense /

average total asset) + provision / average total asset)

(Interest expense / averagetotal asset) shows cost of funds, these ratios are expense related so

lower the ratio is better. Provision rate signifies the asset quality of the bank.

To keep expense low a bank can use following strategies

Identify surplus expenses and eliminate them. Change product and service strategies to increase revenue.

Increase non-interest income to reduce burden.

In this way every aspect of banks business can be analyzed and findings use for decision making

purpose.

Return on equity = Profit margin x asset utilization x equity multiplier


21/56

21

Profit margin reflects expense control, tax management, pricing strategies, and effectiveness of

marketing.

3.2 Conclusion

Banks are most important component of financial system and helps in development of economy.

Banks made flow of funds easy then ever think transferring huge sum of amount from one place

to other there are threats involved in transferring cash banks provide the services and transfer

fund from one place to another in just few minutes. But there are complexities involved behind

the scene bank have to earn profit, mange tax, and decrease burden. For analyzing banks

operation DuPont approach provide a simple understanding of banking operations by

decomposing return on asset.


22/56

22

CHAPTER 4

CREDIT RISK MANAGEMENT


23/56

23

4.1 Introduction

The primary function of the banks in traditional banking is to channelize funds from surplus to

deficit units of the economy. Banks get funds from households, firms and sometimes from

government institutions at a low interest rate and lend it to deficit units (households, firms); the

difference between these two rates is the profit

of the bank fig 4.1. Despite of increasing

growth in modern banking that is fee based

banking interest income remains the major

contributor to the banks profit. So in

performing its primary function of financial

intermediary and extending loans to deficit

units of the economy all the banks bear a specific type of risk that is termed as credit risk. There

are two reasons for credit risk either borrower wants to pay but he is unable to pay or borrower is

not an honest person, both of the conditions are risky as they can lead to serious losses to bank.

Loss to the bank may be in the form of reduction in its portfolio or otherwise the actual loss to

the bank may happen. If borrower is expecting to pay its obligation to the bank by future cash

flows this will lead to the credit risk. Investors are compensated to take credit risk by interest

payment, the rate of return is directly related to credit risk i.e. higher the risk higher the returnthe bonds issued by risky firm offer more

interest rates on its debt instruments then

issued by stable organizations. Credit risk is calculated by borrowers overall ability to pay this

calculation involves character, collateral, and capacity. Just like the systematic risk attached with

a non banking institution credit risk is attached with the bank for its entire life. A banks



24/56

24

performance is judged by its investment quality and if any borrower defaults the bank losses its

reputation. Credit risk is attached with every single transaction being held by the bank and there

is not even a single situation in which bank can say that there is no credit risk in this transaction.

There is difference in credit risk involved in dealing with individuals and firms. There is greater

probability that an individual will default on loan due to higher interest rates attached to

consumer loans then an institution so that individuals are scrutinized more than firm but it must

be kept in mind it is not to say there is no risk is advancing loans to firms. Credit risk can be

defined as it is a risk that financial obligations to your bank will not be paid on schedule or in full

as agreed by your customer, resulting in a possible loss to your bank. Or simply credit risk is the

risk of loss of principle or loss of reward (interest amount) generating from a borrowers inability

to repay loan or meet the contractual obligations. There are five types of credit risk which will be

discussed briefly here.

Lending risk- itis the risk that occurs by the extension of the credit or credit sensitive products

such as loans and overdraft which are being given by the bank. Lending risk can be minimized

by taking collateral which is the most secure mean to handle lending risk. Lending risk has

further two types- direct lending risk and contingent lending risk. Direct lending risk occurs

when bank directly deals with a customer in a straight forward transaction which is aimed at

some kind of purchase i.e. car financing etc bank bears the full risk for the entire life of the

transaction in car financing example bank bears the risk until all the installments (principle +

interest) have been made by the borrower and car ownership is transferred to his name that is the

life of transaction. On the other hand contingent lending riskoccurs when a bank on behalf of his

customer assures another party that his customer will meet the terms and conditions of the

agreement and if he fails the banks will be responsible to make payments. So contingent lending

risk arises when potential customer obligations become actual obligations to the bank. This risk

is associated with transactions like letter of credit and guarantees. Issuer risk this risk occurs

when bank is involved in underwriting activities: underwriting means that bank promises to aninvestor about the sale or purchase of securities at a specific price and within a specified period

of time and if bank fails on agreement bank has to bear the loss. If the issuer of the securities

defaults it will also result in loss to the bank. Mostly investment banks are exposed to this kind

of risk as they are more frequently involved in underwriting activities. Issuer risk is interrelated

with price risk.Counter party riskcounter party is a customer with whom we have an agreement


25/56

25

to pay each other agreed values at a specific future date. Counter party risk occurs when an

organization will not be able to meet its obligations on bonds, derivative credit or on trade credit.

The firms which have credit insurance may also face this risk either due to insurer liquidity

problems or due to long term strategic issues of the insurance firm.Pre-settlement riskis the risk

that a counter party will fail to meet its contractual obligations to the bank before settlement date

of the contract. Pre-settlement risk is measured in terms of the current economic cost to replacethe defaulted contract with another customer plus the possible increase in the economic

replacement cost due to future market volatility. (Source: Lectures material) Settlement riskis the

risk that a counter party will fail to meet its contractual obligations to the bank on settlement date

of the contract. It occurs on maturity date when bank exchange funds with other party and may

cause serious problems due to timing difference if price fluctuates it may cause more than 100%

loss.

Principals involved in credit risk management- There are some principles involved in credit risk

management that guides credit officers. Firstly before extending any type of credit a sound

evaluation of the customer and facility must done to better understand customers funds

requirements and his ability and willingness to pay principle as well as interest amount when

they become due. Secondly there must be an effective credit management unit that ensures the

safety of funds and recovery. Thirdly senior management must define the criteria for lending to

help credit officers and set limits about the extension of credit to specific industries according to

prevailing economic conditions. Finally internal risk rating must be performed to keep macro

risk levels within acceptable limits.

Traditional model of Credit risk analysis- Traditional model of credit risk analysis is also known

as five Cs approach to check the credit worthiness of the customer. Traditional model of Credit

risk analysis is a method for judging a customer on the basis of character, capacity, capital,

collateral, and conditions. First C character shows the credit history of the borrower and his

willingness to pay it might be measured by looking at trend in credit card bills payment and

much other such kind of ways. Second C suggests the ability of the borrower to generate cash

flows to meet its future obligations. Third C capital is about the wealth saved by the borrower the

more the wealth the more will be the confidence of credit officer in lending money. Fourth C

tells about the collateral which the borrower will offer to the bank as the security to pay back


26/56

26

principle as well as interest payment. The liquidity of the collateral is an important aspect for

credit officer. Fifth C is about condition of the market especially downside. Safety of fundssafety

of the funds being advanced is very much important for the credit officer. While lending and

advancing loans bank must be sure that money is going in right hands that is the borrower will

use this money in a legal productive activity and will generate enough cash flows to pay back

principle amounts and cost of capital. If borrower is not trust worthy and he misuse the borrowed

amount by investing in bad portfolio it may lead to the liquidity problems for the bank.

New model of credit risk analysis -The new model of credit risk analysis along with considering

individual characteristics of borrower also consider the surrounding environment to make

decision whether the conditions are feasible to advance loan or not. There are four factor

involved in new model of credit risk analysis. First one is External environment not only

includes the firm or individual which is applying for funds but also all the other actors playing

their role in the environment. Credit officer have to know how this environment affects the

borrower and his cash flow generating ability. Second factor is Industry risk- bank has to

evaluate the specific risks of the industry in which business is operating. Whether the industry is

exposed to high level of risk or not is the basic question for bank. Internal riskinternal risks are

firm specific risks, internal risk may arises due to management structure of the organization, its

policies and etc. Financial riskis most important among four factors of new model of credit risk

analysis as it is the risk that increase the credit risk of the firm. By paying attention to all these

factors and evaluating the borrower on these parameters it would be easier for the bank to make

any decision regarding credit risk involved in the transaction. The new model for credit risk

analysis adopt the approach of analysis of broad to narrow that is it analyze the external risk first

and then industry risk, internal risk, and financial risk respectively.

Business cycle-Business cycle shows economic fluctuation over a period of time. It has for

components recession, trough, recovery, and peak as shown in fig 4.2. Recession shows a

tendency of economic problems, it is said that if the economic growth is negative in two

consecutive quarters the economy is facing recession. At this stage Bankruptcies occur and weak

business find it difficult to remain in business. Governments try to avoid recessionary trends by

proper use of fiscal and monetary policies. At trough things are worst; trough is characterized by

high level of unemployment along with lowest level of production, bankruptcies of banks and


27/56

27

other financial intermediaries happen due to

heavy bad loans. At the recovery stage

economy start showing improvements,

employment level increase, stock prices goes

up, and business confidence returned,

economy looks much better than trough

because the prices which have achieved their

lowest stop falling further.

At peak economy shows its best with

minimum unemployment, level of production

increases firms achieve economies of scale and economies of scope, demand level also increase.

These fluctuations have special importance for analyst to access the level of risk present in the

economy. These fluctuations are measured by changes in national income. National income and

its measures are best parameters to analyze the economic condition of a country. Gross national

product (GDP) and gross national product

(GNP) are the frequently used measures of

national income. GDP is defined as the total market values of goods and services produced

within the geographical limits of a country; GNP is a better approach to measure national income

as it includes GDP plus remittances. GNP is measured by formulae given below.

Y =C+I+G+(XM), where

Y =National income, C = Consumption, I = Investment, G = Government spending,

X =Exports, andM = Imports.

After calculation of GNP per capita income is calculated by dividing gross national product by

total population. The rate of change in national income has important implications for thebusiness as it shows which sectors are growing in the economy and the yearly variations in the

components of national income exhibits trends which may cause threats or create opportunities

for business to make more profits. If there is an increase in per capita income this shows that

people will demand more as their purchasing power is increasing so this will business confidence

in economy. Change in price level is measured by Consumer price index and wholesale price



28/56

28

index and it is an external risk for both lender and borrower. Inflation is rise in general price

level 4% to 5% of inflation is considered healthy for the economy as it promises the suppliers in

economy a gradual increase in their revenues thus enhancing economic activity on the other hand

deflation has negative impacts on economy. Balance of payment is the difference between

receipts and payments of a country due to import and export activities. Study of balance of

payment shows the condition of industries that are directly or indirectly attached to imports and

exports. If exports are high the demand for the currency of that particular country will also be

high that will lead to appreciation of currency if imports are high it will lead to depreciation of

currency. A stable political environment, peace and rule of law enhance business activities and

growth of business as well, terrorism, civil war, injustice, and riots hurt business badly and this

shows external risk for the business. An analyst must pay attention to fiscal policy of the

government as fiscal policy describes how and from where government will gerenerate its

revenue and where it will spend, which industries are being promoted by the government shows

both threats and opportunities for business. Monetary policy shows the interest rates and how

government will control the money supply in economy this is given by the central bank to

achieve certain goals like stability of price level and exchange rates. Changing patterns in

demographics may also pose threats to an existing business the composition of population is

changing now young generation demands more than earlier generation. Change in demographics

shows demand for particular industries and their earning potential. Culture, social customs,

norms and values must be kept in mind while analyzing the riskiness of a specific industry.

Regulatory framework also is threat for business operation if the cost of non compliance is high

then the risk level of that particular industry is also high. In Pakistan government policies

encourage trade but create hurdles for manufacturing concerns. An effective legal system

minimizes the risk of the business by ensuring the businessman the right of property both

physical and intellectual; this increases the level of confidence of businessman and increase

economic activity. Technological industries are the most risky than all other industries because

today technology changes over night creating pressures to change every moment for the

businesses operating in technological industries. Strong labor union can also cause problems for

business enterprise by exercising their hold on labor market which leads to decrease in efficiency

of business.


29/56

29

4.2 Conclusion

There is always some risks attached to any business activity, risk is defined as the actual

outcome will differ from expected outcomes. In case of banks it is the responsibility of credit

officer to collect the maximum information about the borrower and then use both qualitative and

quantitative methods to make decision whether to extend credit or not. While making this

decision external threats and risk attached to the working of economy must also be considered

because if borrower will default due to economic downside and other external threats it will lead

to his in capability to pay back principle and interest amount to bank which lead to serious loss to

bank and can even be a threat to very existence of the banks. So it is the responsibility of credit

officer to keep in mind all circumstances which can hurt the borrower and then bank

respectively.


30/56

30

CHAPTER 5

INDUSTRY RISK


31/56

31

5.1 Introduction

In todays rapidly changing environment where every day there are opportunities for business

enterprise to make money there are also threats for existing businesses. A number of products

have vanished and new products have taken their place. Think of type writers at times they were

one of the important assets of organization but after that computers have took over, now

computer technology is used in many creative ways which also require change for companies to

survive. Like human industries also have life cycle and face critical events in their life cycle.

Stages of life cycle of an industry are start, growth, maturity, stability and decline. Every stage

has its own challenges but start and decline stages are most important for a credit risk analyst.

Because business get funds from banks so it is important for credit officer to fully understand the

nature of industry in which

business is operating, and the

specific risks attached to that

industry. If industry is not doing

well bank will face loss which

might threaten its very existence.

To have a better understanding of

industry risk it is important to

differentiate between types of

industry risks. There are two

types of industry risk one is risk

from external environment- risk from external environment effect all the businesses in economyfor example political instability, tax, and legislation. Other type is industry specific risk- these

are the risks and pressures faced by a specific industry only for example tobacco products

manufacturing companies are

facing a great pressure from

society and government. Fig 5.1 shows industry life cycle.



32/56

32

Permanence of industry is a phenomenon related to the product and technology of the industry.

Most of the industries have the permanence which could not be removed but the participants

though changes. Sometimes an industry is eliminated from the market scene because of another

replacement industry that diminishes or eliminates the need for the original industry. The factor

of permanence assumes considerable importance in assessing the prospects of hi-tech industries.

Attitude of the governmentfor a specific industry may increase or decrease level of risk attached

to a specific industry if government is trying to promote an industry it will extend subsidies

provide protection, give tax benefits, and extend loans at low level of cost all will contribute to

decrease the level of risk involved on the other hand if government dont want an industry to

flourish it just by increasing legal issues involved can limit the operation creating risk for the

bank extending loan to such industry and for sure for the industry as well. Factors of production

and industry has a strong relationship the four factors of production land, labor, capital and

entrepreneurship, there availability and quality create risk as well as opportunities. Land include

the free gifts of nature to every one for example water but today the availability of these free

gifts are not easy think of beverage companies making drinks how much for them is water. Labor

is human basically performing a mental or physical job for monetary reward finding quality labor

is also a big issue. Capital is finances available for a credit risk analyst it important to check all

the available sources of funds to business. Last factor of production entrepreneur or management

is most important if quality factor of productions are available but management dont have

necessary skills to produce well by using these resources it will increase risk.

Business cycle and industry- Some industries are cyclical while others are not. By cyclical

industries we mean those industries which operate only for a specific period of time in a year for

example construction firms. On the other hand food industry is not effected by business cycle so

it not a cyclical industry. Cyclical industry has more risk than non cyclical industries.

Profitability of industry differs from on industry to other depending on demand for products and

some other factors discussed next. Competition among the existing firms in the industry- ifcompetition within industry is high then the level of profits will be low, participants may involve

in price war like telecom industry in Pakistan. Competition among the existing firms in the

industry can be further divide in growth rate, number of rivals, differentiation, switch costs, level

of fixed cost, and exit barriers. High growth means low competition as demand is high as every

participant is getting its fair share. Higher the number of rivals higher the competition. But if


33/56

33

products are differentiated by means of branding and other marketing tools than competition will

be low. Switch costs are also important is clients has to bear high level of costs to switch from

one product to other than competition will be low. High level of fixed cost require producer to

produce more for the purpose of decreasing per unit fixed cost, increased production means

excess supply and as result high level of competition. Exit barrierwhich states that the Market

rivalry tends to be more vigorous when it costs more to get out of a business than to stay in and

compete. Threat of new entrants- states that if it is difficult for new firms to enter the industry it

will work for the advantage to existing enterprises. Threat of new entrants depends on economies

of scale, first mover advantage, Channels of distribution and relationships, and legal barriers.

Threat of substitute also effects the profitability if substitute products are available, then the

industry profitability is affected by the factors influencing the substitutes. Take the example of

tea and coffee tea producers cant charge too much because people will switch to coffee. Relative

price, satisfying ability, and willingness of customer to pay for substitute are those factors which

direct threat of substitute and these factors differ from industry to industry.Bargaining power of

buyers affect the competitive environment of any industry if buyers have more bargaining power

than they will put pressures on participants of the industry for low price, high quality and more

value added services, all these add to costs of seller decreasing its profitability. Bargaining

power of suppliers also affect the profitability of industry if suppliers are strong they by raising

prices, lower quality, and hindering availability of raw material can affect the profits of industry

to a larger extent. In this case industry is client and suppliers are sellers.

Competitor analysis in the framework of industry analysis is very helpful in giving insight about

what other players are doing in industry. Competitor analysis highlights blue oceans the areas

and opportunities which have not been discovered yet. Company analysis studies internal risks

which generate from firms weaknesses. Decision-making skills, policies and competencies

define certain crucial risks that can make or break a business enterprise. For survival of an

enterprise strategy, methods, technology, and motivation are key factors. In company analysisfirm ask itself different questions and try to answer them to improve its competitive strengths.

Understanding of business activity plays important role in study of internal risk. Understating

business activity includes the study of products, processes, and operations, raw materials and

technology and the ways to increase the efficiency of business. A companys ability to manage

risk is shown by past data put previous data alone cant guarantee efficient risk management in


34/56

34

future. Inpeer analysis firm compares it performance with those having same nature of business.

And with the help ofSWOTAnalysis Company finds what its strengths are and how it can earn

money by using these strengths and overcome weaknesses so that these weaknesses doesnt

become threats in future. Management analysis shows performance of company with respect to

its management practices. Despite having excellent technology and quality raw material if

management is not good than firm will fail. Management risk include One-man rule, Joint

Chairman/CEO/MGD position, imbalance in top management team, weak finance function, lack

of skilled managers, disharmony in management, change in ownership, cultural rigidity, lack of

internal controls, low staff morale, fraudulent management, myopic vision (nearsightedness),and

inadequate response to change.

5.2 Conclusion

Different industries have different level of risk attached for a credit risk analyst it is very

important to understand those risks. Understanding of industry life cycle gives credit risk analyst

information about risk because the start and decline stage of industry life cycle are critical with

high level of risks. Poter Diamonds five forces explain level of competition in industry high

level of competition shows high level of risks. Internal risk along with industry risk must also be

kept in mind while advancing loans, because this ensures the safety of funds.


35/56

35

CHAPTER 6

FINANCIAL RISK


36/56

36

6.1 Introduction

Financial risk is the possibility that owners

stockholders will lose money by investing in

the firm which is using more debt. By using

debt a firm maximizes its return on equity with

equity multiplier effect. If a firm is using debt

then there is possibility that firm may not be

able to repay its fixed interest expense if future

cash flows are disturbed. If liquidation occurs

than the claims of creditors are settled first

than stock holder so more financially leveraged firm are more risky the cost of equity also goes

up as investors demand more compensation for taking risk. Financial analysis helps to find out

the risk attached to an organization which is using debt financing and these findings help to take

decision whether to extend loan or not fig 6.1

shows types of financial risks.

Importance of financial statements financial statements shows health of any organization at a

specific period of time. Financial statements include balance sheet, income statement, statement

of cash flow, and statement ofowners equity. By using financial statements analyst can analyse

the credit risk of the firm and then take lending decisions and monitor the lending portfolio.

Audited financial statements are the major source of information to conduct financial analysis

because they contain data related to land, building, machinery, vehicles, stock, receivables, cash,

bank deposits and borrowings, capital, external creditors, tax liabilities, sales, cost of sales,

selling expenses, other overheads, interest costs and cash flows/funds flows, among others. By

using previous data of at least five years a credit analyst can check the credit worthiness of an

organization and make future prediction. Balance sheetshows the financial position of the firm

on a particular date say yearly, semi annually, quarterly or monthly. Balance sheet explains lot of

Figure 6.1 Source: Google images


37/56

37

queries regarding the borrowers creditworthiness. Balance sheet helps in knowing the capital

structure,short-term and long-term liabilities of the business, credit provided by trade suppliers,

taxation and other statutory liabilities outstanding, amount of fixed assets and are they put to

their best use. Besides looking at the balance sheet and other financial analysis credit executive

looks at the borrower from a different angle. Following are the credit executive assessment

criteria to look from another angle.Intangibles like good will often contribute to a large extent to

firms total assets so it is important for analyst to deduct good will from total assets to exactly

know the net worth of firm. Another important component is unsubordinated shareholders loan

if unsubordinated shareholders loans are included as part of the equity or shareholders funds

this item should be excluded, especially in the case of limited liability companies. Dividends

payable must be treated as a current liability rather part of shareholders equity. For more

understanding qualitative analysis is done to find out the financial health of the firm through

financial appraisal which is the use of financial evaluation techniques to determine which of a

range of possible alternatives are preferred.Financial ratio analysis- Financial ratio analysis is

the calculation and comparison of ratios which are derived from the information in a company's

financial statements. The level and historical trends of these ratios can be used to make

inferences about a company's financial condition, its operations and attractiveness as an

investment.Standard Ratios, The relationship between items, or group of items, appearing on the

financial statements can be expressed mathematically in the form of Proportions, ratios, rates or

percentages. The need of the financial statement analysis arises from the fact that only numeric

values dont give the accurate information to the stakeholders of the firm, thus ratios are

needed.Net sales of $10 million may appear as a good performance, but conclusions can be made

unless they are compared with the total assets. These ratios are helpful in the way that when

analyst compares a specific ratio with the industry standards then he can evaluate performance in

the competitive market. Thats why a single ratio is meaningless unless compared to other firms

ratios or industry benchmark ratio. Financial ratio analysis help analyst to dig down to the

operations of a firm and find its strengths and weaknesses.

Methods of Comparison- there aredifferent ways through which companys performance are

analysed. Historical standards are based on the record of the past financial and operating

performance of individual subject business concern. When compared with other years


38/56

38

performance then it gives effective meaning. Industry Comparison is comparing firms

performance with industry standards going in the market. Comparisons with Industry averages

are most valuable for judging the financial health of a Company. Regulatory Requirements are

the standards set by the regulatory authorities of the country. State Bank Prudential regulations

lay down Minimum Current Ratio that should appear at the time finance is granted. Budget

Comparison also called budget standards are developed by Senior Company Management and

monitored by them to judge the Company Performance. Such ratios are based on past experience

modified by anticipated changes during the account period. Actual ratios are accomplishment of

the anticipated targets. Study of the Budgeted and Actual Ratios is also helpful to the credit

analyst due to the reason that budget gives understanding of future and current ratios shows

financial strength of the organization.Broad Categories-There is four main categories of ratio

analysis. Liquidity ratios indicate the borrowers ability to meet short-term obligations, continue

operations and have sufficient cash available to meet day to day expenses. Profitability ratios

indicate the earnings potential and its impact on shareholder returns. Leverage ratios indicate the

financial risk in the firm as evidenced by its capital structure, and the consequent impact on

earnings volatility. Operating ratios demonstrate how efficiently the assets are being utilised to

generate revenue. Cash flow analysis- It is the study of the cycle of business cash inflows andoutflows, with the purpose of maintaining an adequate cash flow for your business, and to

provide the basis for cash flow management. However for a lending banker cash flows are more

important because the loans are repaid from cash flows. Bank must make sure that the company

is managing its cash flows in a prudent manner. Bank will see the borrower capacity to repay the

money and cash flow denotes that. Typically, the statement of cash flows is divided into three

parts- Cash from operating activities, Cash from investing activities, Cash from financing

activities. From the cash flow analysis analyst determine how much cash is generated from the

firms activities, and whether it is sufficient to cover loan repayments and interest payments and

how efficiently the firm is meeting its long-term and short term obligations with available

sources. Sensitivity analysis- is technique used to determine how different values of an

independent variable will impact a particular dependent variable under a given set of

assumptions. This technique is used within specific boundaries that will depend on one or more

input variables, such as the effect that changes in interest rates will have on a bond's price.

Sensitivity analysis gives us an idea that which one factor mostly affects the firms or banks


39/56

39

performance. Credit Risk Assessment- Credit risk assessment gives us an idea why and how is to

be used. The purpose of facility mentions why the financing is required, firstly it must be

satisfactory from the banker's view and secondly there should not be any restraint from

government control, which makes a particular advance impossible. Speculative purpose advances

must be avoided. Amount must be reasonable with the borrowers resources. Duration must be

according to the business either short term or long term. Credit Information Reports tells us

about the past borrowers record. Competence of Management is checked whether they are

competent enough to go with right decisions and earn profit for their company. Profitability of

the bank, bank ensures its safe side by ensuring that the rate of interest and other Commissions

and Fees agreed with the customer provide a satisfactory return to the lending institution. Despite

of the fact all these points are considered banks take security from the borrower. Some of the

securities frequently offered to the financial institutions are:

Lien on Customers own rupee and foreign currency accounts and fixed deposits, Fully

negotiable Stock Exchange Securities i.e. bearer bonds, scripts to bearers and government

promissory notes, Not negotiable securities, e.g. inscribed stocks or registered stocks and shares,

Goods and documents of title to goods, Life Insurance policies, debentures, book debts and

ships, Post office and National saving certificates, Gold or silver bullions and ornaments,

Mortgage of Landed property including industrial, commercial and residential building, Plant

and Machinery. A prudent lending officer should always give due importance to the security

aspect of an advance with proper documentation for perfection thereof. The guidelines given by

the head offices are duly followed by the branches all over the country for credit control. The

salient features of an effective credit control are; the credit facilities must be approved from all

the higher authorities of the bank. Sufficient discretionary powers should be given to the branch

as well as regional management to enable them to meet local requirements. Credit committees at

various levels are important in order to exercise effective control over advances portfolio. Proper

record of all advances allowed from time to time should be carefully kept for future reference,

examination, reviews and analysis. Recoveries of delinquent loan, recovery of defaulted loan

through the Special Assets Management (SAM).

Internal and External Audit department by its annual audit identifies and manages the banks

risk. Audit functions to avoid errors, frauds and forgeries. Board and senior management approve


40/56

40

banks credit risk strategy and significant policies relating to credit risk and its management

which should be based on the banks overall business strategy. The overall strategy has to be

reviewed by the board, preferably annually. The responsibilities of the Board with regard to

credit risk management shall, include; Delineate banks overall risk tolerance in relation to credit

risk, Ensure that banks overall credit risk exposure is maintained at prudent levels and

consistent with the available capital, Ensure that top management as well as individuals

responsible for credit risk management possess sound expertise and knowledge to accomplish the

risk management function, Ensure that the bank implements sound fundamental principles that

facilitate the identification, measurement, monitoring and control of credit risk, Ensure that

appropriate plans and procedures for credit risk management are in place.

Risk Tolerance of Bank-The banks purpose is to calculate how much risk can be tolerated and

then return earned within limits. The institutions plan to grant credit based on various client

segments and products, economic sectors, geographical location, currency and maturity, Target

market within each lending segment, preferred level of diversification/concentration and Pricing

strategy. The credit procedures should aim to obtain an in-depth understanding of the banks

clients. The strategy should provide continuity in approach and take into account cyclic aspect of

countrys economy. The strategy would be reviewed periodically and amended, as deemed

necessary; it should be viable in long term and through various economic cycles.

Credit Policys Credibility-The senior management of the bank should develop and establish

credit policies which shall provide guidance to the staff on various types of lending including

corporate, SME, consumer, agriculture, etc. At minimum the policy should include; Detailed and

formalized credit evaluation/ appraisal process, Credit approval authority at various hierarchy

levels including authority for approving exceptions, Risk identification, measurement,

monitoring and control, Risk acceptance criteria, Credit origination and credit administration and

loan documentation procedures, Roles and responsibilities of units/staff involved in origination

and management of credit and guidelines on management of problem loans. Sound risk

management structure with institutions size, complexity and diversification of its activities. It

must facilitate effective management oversight and proper execution of credit risk management

and control processes. It must facilitate effective management oversight and proper execution of

credit risk management and control processes. Credit Risk Management Committee (CRMC),


41/56

41

ideally comprising of heads of credit risk management Department, credit department and

treasury. The CRMC should be mainly responsible for; The implementation of the credit risk

policy / strategy approved by the Board, Monitor credit risk on a bank-wide basis and ensure

compliance with limits approved by the Board, Recommend to the Board, for its approval, clear

policies on standards for presentation of credit proposals, financial covenants, rating standards

and benchmarks and Decide delegation of credit approving powers, prudential limits on large

credit exposures, standards for loan collateral, portfolio management, loan review mechanism,

risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning,

regulatory/legal compliance, etc. Banks should institute a Credit Risk Management Department

(CRMD). Typical functions of CRMD include:

To follow a holistic approach in management of risks inherent in banks portfolio and ensure the

risks remain within the boundaries established by the Board or Credit Risk Management

Committee, The department also ensures that business lines comply with risk parameters and

prudential limits established by the Board or CRMC, Establish systems and procedures relating

to risk identification, Management Information System, monitoring of loan / investment portfolio

quality and early warning. The department would work out remedial measure when

deficiencies/problems are identified. The Department should undertake portfolio evaluations and

conduct comprehensive studies on the environment to test the resilience of the loan portfolio.

Credits should be extended within the target markets and lending strategy of the institution.

Before allowing a credit facility, the bank must make an assessment of risk profile of the

customer/transaction. This may include; Credit assessment of the borrowers industry, and

macro- economic factors, purpose of credit and source of repayment, track record / repayment

history of borrower, Assess/evaluate the repayment capacity of the borrower, proposed terms

and conditions and covenants, Adequacy and enforceability of collaterals, Approval from

appropriate authority. In case of new borrower the repute of the counter party must be

considered. Prior to credit agreement bank gets familiar with credit worthiness of individual orfirm. However, a bank must not grant credit simply on the basis of the fact that the borrower is

perceived to be highly reputable i.e. name lending should be discouraged.Loan syndication- It is

the process of involving several different lenders in providing various portions of a loan. Loan

syndication most often occurs in situations where a borrower requires a large sum of capital that

may either be too much for a single lender to provide, or may be outside the scope of a lender's


42/56

42

risk exposure levels. Thus, multiple lenders will work together to provide the borrower with the

capital.

6.2 Conclusion

Banks due to their nature of business are exposed to more financial risks than any other industry.

To make profit it is necessary for the bank to find out the potential financial risks and ways to

management. Most of the organization fails only because they cant find the potential risks. It is

necessary to estimate future cash efficiently because these cash flows are used to pay fixed

interest expense along with the use of quantitative and qualitative analysis techniques.


43/56

43

CHAPTER 7

LIQUIDITY RISK


44/56

44

7.1 Introduction

An asset is said to be liquid if it can be readily converted into cash without significant loss of

value. Liquidity risk is defined as the potential for loss to an institution arising from either its

inability to meet its obligations or to fund increases in assets as they fall due without incurring

unacceptable cost or losses. When a bank doesnt have enough liquid assets to meet obligationsliquidity risk arises. And it may become necessary for the bank to meet its liquidity requirements

from the markets where costs are high and that can lead to loss. If a bank relays more on

corporate deposits than core individual deposits it can cause liquidity risk. Liquidity risk may

also be caused by credit risk and market risk. Large off balance sheet exposures like contingent

liabilities may also lead to liquidity risk along with financial, market, and credit risk. That means

liquidity risk doesnt come alone.

There are some indicating situations that warn about liquidity risk but their existence doesnt

surly mean liquidity risk. These alarming situations include a negative trend or significantly

increased risk in any area or product line, Concentrations in either assets or liabilities,

Deterioration in quality of credit portfolio, a decline in earnings performance or projections,

Rapid asset growth funded by volatile large deposit, a large size of off-balance sheet exposure,

Deteriorating third party evaluation about the bank. If any of these situations are prevailing than

board of the bank is responsible for managing the liquidity risk. It is the responsibility of board

to set the strategic direction for the bank when liquidity risks have been identified. Board than

appoint the senior managers who have ability to manage liquidity risk and delegate them

required authority to perform their job. Board constantly monitors the bank's performance and

overall liquidity risk profile. Senior manager should develop and implement procedures and

practices that translate the board's goals, objectives, and risk tolerances into operating standards

that are well understood by bank personnel and consistent with the board's intent, Adhere to the


45/56

45

lines of authority and responsibility that the board has established for managing liquidity risk,

Oversee the implementation and maintenance of management information and other systems that

identify, measure, monitor, and control the bank's liquidity risk, Establish effective internal

controls over the liquidity risk management process. Senior managers are appointed to deal with

liquidity risk, so they evaluate certain factors. Assets and liabilities mix- liquidity risk strategy

must outline the best mix between banks assets and its liabilities to maintain liquidity.

Diversification and stability of liabilities- means that there must not be one major source for

funds of the bank because if things went wrong and there is only one major source bank will

have to face liquidity risk. A funding concentration exists when a single decision or a single

factor has the potential to result in a significant and sudden withdrawal of funds. To know the

stability of liability funding source of banks needs to be identified, there are liabilities that would

stay with bank during any circumstances, liabilities that run off gradually when problem arise,

and finally liabilities that immediately run off as the sign of problem starts appearing.Access to

interbank market- other banks is good source of liquidity in hard time but as a matter of fact that

should take into account that meeting liquidity needs from interbank market can be difficult in

crisis situation and costly as well.

Liquidity policy- liquidity policy is the policy

adapted by the bank to deal with risk attached

with liquidity requirement of the bank. A

liquidity policy includes, general liquidity

policy which includes specific short term and

long term goal and objectives in relation to

liquidity risk management, process for strategy

formulation and the level within the institution

it is approved. Roles and responsibilities of

individuals performing liquidity riskmanagement functions, including structural balance sheet management, pricing, marketing,

contingency planning, management reporting, lines of authority and responsibility for liquidity

decisions. Liquidity risk management structure- for monitoring, reporting and reviewing

liquidity. Liquidity risk management tools- for identifying, measuring, monitoring and

Figure 7.1 Source: Google images


46/56

46

controlling liquidity risk (including the types of liquidity limits and ratios in place and rationale

for establishing limits and ratios) fig 7.1 shows process involved in liquidity risk management.

And contingency plans to deals with crisis of liquidity. Asset liability committee (ALCO) is

comprised of senior management and treasury function, and risk management department have

the responsibility of managing overall liquidity of the bank. Availability of real time information

to decision makers is very important for handling banks liquidity position. Existence of effective

management information system provide basis for liquidity management decisions. Information

should be readily available for day today liquidity management and risk control, as well as

during times of stress.Certain information can be effectively presented through standard reports

such as "Funds Flow Analysis," and "Contingency Funding Plan Summary". To achieve this goal

management should develop systems that can capture significant information. The content and

format of reports depend on a bank's liquidity management practices, risks, and other

characteristics. The reports enhancing the flow of information must be tailored carefully so that

they help to manage liquidity of the bank. Reports include list of large fund providers, cash flow

or funding gap report, funding maturity schedule, limit monitoring report and exception report.Based on information of maturities of all advances and Loans to other banks, maturities of all

deposits and borrowings from other banks it is possible to calculate gaps i.e. the surplus or

excess of (cash) liquidity expected in the various time slots in the future. ALCO can then think

and plan the ways and means of dealing with the gaps, contingency funding plans, blue prints for

handling difficulties in handling deficit funding.

Contingency funding plan (CFP) - is set of policies and procedures that serve as blue print for the

bank for managing its funding needs in timely fashion. Projection of future cash flows and

funding sources of a bank under market scenarios including aggressive asset growth or rapid

liability erosion is shown in contingency fu

credit management handbook

Documents