Risk management in banks

Risk refers to unexpected loss in finance due to uncertainties. Risk in banks is of

three types they are
Credit Risk
Market Risk
Operational Risks
Credit risk: It is the risk that occurs if a bank borrower fails to meet his obligation. It
results in losses from default, change in portfolio value. The Risk management aims
to minimize the risk and
Maximize banks risk adjusted rate of return. Credit risk consists of quantity and
quality of risk incase of default. Risk management includes measurement through
rating; quantifying expected loan loses scientific pricing and controlling through
portfolio management.
A Basic model: Simple method of estimating credit risk is to asses the impact of non
performing assets on the banks profit. This can be achieved through dividing the
profit before tax by Npv so the formula is
Profit before tax
NPA
If by using this formula the answer comes 0.7. It simply means that 70% of NPA turns
into losses the profit before tax would be eroded completely

There are various approaches have been given credit risk

analysis such as
Credit mitigation approach
Option pricing approach
Actuarial approach
Credit risk transfer: Hedging Reduces portfolio by offsetting one
risk another. Loan sales has become one of the important tool
for credit risk transfers some prominent forms of loan sales
includes the following.
Syndication: Syndication means a borrower want a loan of
10000 crore rupees for a large project.
If x bank is nominated as the load bank for syndication x will
navigate the syndication x will navigate the documents with the
borrower and solicit a group of banks to share the credit risk.

Novation: In the previous example x bank can assign its right

to one or more buyer bank. These buyer banks then become
original signatories to the loan agreement. Thus the borrower
would have contracted with bank acts for 10000 crore rupees
loan and pass novation. Then the x bank would hold say 2000
to the borrower and example ABC would hold the remaining
8000 crore rupees risk by mutual agreement.
Participation: In this case x bank transfers to other
participating banks ABC. The right to receive prorata payment
from the borrower.
Securitization: Originator- Obligors Reinvestment
Contrary-SPV Proceeds sales of securities
Reinvestment liquidity buffer- Coupon of and find payment
Senior investors-Junior investors-transfers

Risk based capital standards and

requirement in banking operations
The bank capital standard focus on maintaining safety
and sound functioning of banks, protecting customers,
help to reduce failures and protect claims by life insurers.
So the banks calculate their capital on a continuous basis
as the major challenge is credit risk and market risk.
So the banks adopt certain rules or standards and also
modify them to highlight the actual risk take advantage
of risk measurement techniques.
It ensures that banks will have pool of liquid assets
variable daily to meet the obligations to customers.
The capital standard or requirement differs from industry
to industry but the rules are similar. It is because the
activities are different and their purposes are different.

The application of capital

adequacy to banks in India

In 1990s capital ratio of Indian banks was very low so RBI adopted Basel
framework to fix 9% on Risky assets for all banks in India.
Accordingly RBI instructed all commercial bank to adopt standardized approach for
credit Risk, market risk and basic indicator approach for operational risk at global
level in a phased manner.
RBI will asses the risk profile and management systems of Individual banks and
invests capital if the banks cannot keep 9%
The banks will maintain capital tier 1 and tier 2 of atleast 6%
Eligible Tier1 capital funds
Credit RWA add market value
RWA add operational risk RWA
TIER 1 capital:: Incase of India banks Tier 1 capital of the following
Paid up capital
Statutory reserves
Other disclosed free reserves
Capital reserves representing surplus arising out of sales proceeds of assets
Innovative perpetual debt invest<ipdi>
Perpetual non cumulative preference share {PNCPS}

The principles of credit risk

management

The banks face difficulties due to loose credit rules for borrower, poor
portfolio risk of credit or lack of attention to the economic changes. So the
Basel committee has the following principle for effective management.
Principle 1: The board of directors must approve and review the credit
strategy and policies according to profitability.
Principle 2: The senior management should implement the credit strategy
and develop policies to identify measure, monitor and control credit risk.
Principle 3: Banks should identify and manage credit risk in all products
and activities.
Principle 4: Banks must operate in proper, well defined criteria with
complete understanding of the borrowers purpose and source of
Repayment.
Principle5: Banks should fix with credit limit for all borrowers
Principle 6: Banks should have proper process for approving credits,
renewal and Refinancing
Principle7: All extensions of credit must be with in a limit authorized and
monitored to control risk

Principle 8: Banks should have system to administer all risky portfolios.

Principle 9: Banks should have a system to administer condition of individual
credit.
Principle 10: Banks must develop and use an internal Risk Rating system.
Principle 11: Banks must have information system analytical techniques to
measure credit risk in all activities.
Principle 12: Banks must have a system to monitor the quality and composition
of the credit portfolio
Principle 13: Banks must consider the possible future changes in economic
condition and then asses and check the credit risk.
Principle 14: Banks must have an independent risk management system and
possess which should be communicated to the board of directors
Principle 15: Banks must see that giving credit is probably managed and have
internal controls to check any or check the expectations are reported on time.
Principle 16: Banks must have the system for quick remedial action on any credit
related problems.
Principle 17: Supervisors should conduct independent evaluation of banks
strategies, policies, and procedure relating to granting credit.

The objective of credit and risk

management

1. The quality of credit management determines success and failure of

bank
2. The elements are:
Well developed credit policies and process
Strong portfolio management
Effective credit control
Well trained staff
3. The institutional objectives are
To have adequate liquidity of assets for withdrawal, expenses, losses
and earn profit for share holders.
Their national policies are:
To allocate the financial resources efficiently to pramote economic
growth
Credit policy includes the regulatory environment, availability of funds,
risk selection, loan portfolio, balance and structure of liabilities.

Bank credit and what is it role

in banking operation
Bank credit is the main and cheapest source of debt financing for
consumers and producers that is buying consumer goods and for
investments
Financing the consumer is called retail banking and for supply
side it is called corporate banking
A bank credit is profitable asset if it is good which means
borrower does not default in repayment.
The banks use its credit fund to earn maximum returns or profits
or income which comes from interest or loans and providing paid
services
The credit money increases which lead to more money creation
but default risk can arise due to down turns and business cycle or
mismanagement e.t.c
Bank credit decision is also affected by fluctuation in interest
rates, loan maturities and method of repayment.

Types of lending

There are three types of lending:

Fund based lending: it is a direct form and is given as a
loan or advance having an actual flow of cash by the
bank.
E.g. Short term loan, long term loan, and revolving
credit,
Non fund based lending: There are no funds flow
between the banks and the borrower examples are
letters of credit, bank guarantees.
Asset based lending: the bank lends money by looking
at the earning potential or capacity of the assts. Which
are financed for example project finance, securitization
e.t.c.

The credit process of the

banks
The banks profit depends on credit decision which involves risk so every bank
develops systems and controls so that they can face and survive in the
industry.
The elements of credit process are:
Loan policy:
Banks make loan policies which are guidelines for lending. It also includes the
overall strategy, identifies loan qualities, procedure for sanctioning, granting,
dehumanization and reviewing loans
Business development:
Every bank aims at business development and credit development by good
loans and not any loan. It is followed by campaigning to attract target
customers. The credit officer identifies the customers, get formal loan request,
collects documents to asses the borrowers credit worthiness and risk analysis
system for the customer is done which leads to the decision to lend or not
There are major risk factors which are called cancers for lending or five Cs.
They are as followsCapacity, capital, collateral, conditions, character

The steps for credit evaluation to determine

risks in granting credit to borrowers

Risk evaluation means that the banks lends only if he is satisfied that risk is minimized or
reduced so that borrowers cash flows are not affected
Steps:
Building the credit file
It will have information about borrower credit history and track record, past and present
financial statement, cash flow forecasts, future plans, insurance detail and security document
Project and financial appraisal
Is done to asses the companies performance of the market value and management capability.
It includes past financial statements, cash flow statement, liquidity position, financial risk in
terms of debt and strength of collateral securities to determine the loan amount
Qualitative analysis of management
Due diligence
It includes checking the address, inspection of the work place and interviews with the
borrowers, customers, employees and review of technology, expenditures obligation e.t.c
Risk assessment
All potential internal and external risks are identified and asses its impact or borrower future
cash flow and debt service capacity
Making recommendation by credit offer
Who examines and approve or reject. Some times he may revise credit proposal old customers
to approve the loan.

The importance of financial appraisal or credit decision

The following techniques are used for checking various

categories of loans and credit decision
Financial ratio analysis
The credit decision depends on 5 types of ratios they are
Liquidity ratio, profitability ratio, leverage ratio, operating ratio
and valuation using the balance sheet, income statement data
of past and future to compare easily.
Liquidity ratios show the borrowers ability to meet short term
obligations.
Profitability ratios show earning potential and effect on
shareholders returns.
Leverage ratios show the financial risk in the firm
Operating ratios show the degree of efficient use of assets
Valuation ratios show the real value of the borrower

Common sized ratio comparison

These comparisons are valuable as they are not
dependent on the firm size and helps in comparing firms
in the same industry. It is used with ratio analysis to get
better idea about the borrowers financial health.
Cash flow analysis
In this the banks convert the income statement into a
cash flow statement. As cash flows in a firm are from
operating activities, investments and financing
activities, this analysis makes accounting profit from net
income and other activities. It helps to know the amount
of liquid stocks and receivables for short term loans and
amount of surplus cash to meet long term loans.

Types of loans extended by

banks to the businesses
In the banks balance sheet there are many types of loans exist with the different
features as follows
Loans for working capital: Working capital is current assets current liabilities. If
the working capital is positive it means assets are more than liabilities as asset
are financed by creditors, short term bank debt and a part by equity. It is a
healthy sign for the firm. In the beginning every firm invests in current assets
and there is always a time lag between investment and revenue which depends
on working capital cycle. If the cycle is long then continue production it has to
take loans or bad debt
Features:
It is a major source of funding working capital.
The amount of loan depends on the length of working capital cycle.
It is shown as current asset in balance sheet
It will always be given with the margin
working capital fluctuates due to unexpected changes in demand, seasonal
change e.t.c
These loans granted against securities/ credit limit and pricing {interest rate
changed} depends on availability of collateral and credit score.

Loans for capital expenditures:

Firms need to invest in business to expand, modernize or diversify the business
so they prefer term loans but banks do not prefer it due to mismatch between
asset and liability maturities and repayment takes long time which may create
liquidity problem
Features:
It depends on the use of loan amount. If it is to purchase capital asset then full
money is lent.
The interest rate depends on the default risk of the borrower.
Principle amount is repaid in equal installments.
In the case of balloon repayments the borrower may only pay the interest rate
periodically
Loan Syndication
Syndication means a borrower want a loan of 10000 crore rupees for a large
project.
If x bank is nominated as the load bank for syndication x will navigate the
syndication x will navigate the documents with the borrower and solicit a group
of banks to share the credit risk.

Loans for agriculture:

These loans are mostly short term for purchase of inventory, seeds,
fertilizers e.t.c and the revenue is generated after crops are sold. Long
term loans are for buying land equipment or life stock and these are paid
out of sales cash flows.
Loan for infrastructure/project finance:
It involves creation of legally independent project company with equity
for about 5 to 7 years. A major part of the finance is bad debt, syndicated
loans or by issuing bonds. The major mode is term loan.
Loans to consumers or retail lending: individual customers need banks
finance to buy consumer durable goods, education, housing e.t.c. The
banks extend these loans for one to five years and can be longer, have
fixed interest rates to be repaid in EMIs. Interest rates are higher default
risk.
Non fund based credit They are letter of credit and letters of guarantee.
They carry equal or more risks because the banks has to pay the
beneficiary if the borrower fails to pay.

The steps of the loan pricing

model

In the current situation the banks have intense price competition due to deregulated interest
rates so they have to charge suitable price to earn profits and also balance risk. So credit or
loans are priced in the same way as a product that is first it should cover the variable cost and
then fixed cost. The variable cost for the loan is the cost of the banks liabilities and the fixed
cost include the cost of maintaining and monitoring the account. Loan pricing must consider
quantification of the risk and depends on the profitability of the customer to the bank.
Loan pricing model have the following steps
Step1:
Calculate the cost of funds which may be average cost of the deposits and borrowings or the
cost of arranging the loan
Step2:
Determine the servicing cost for the customer. To find out the services used by the customer
then find out the cost of providing each service and multiply both to get the total cost for the
customer. It also depends on the loan size.
Step3:
Asses default risk it is done by a credit scoring system to decide approval and also assigning a
value to the risk of lending to the borrower.
Step4:
Fixing the profit margin: Banks can use ROE as a determinant to fix profits. ROE=ROA X EM
[EQUITY MULTIPLIER]

Customer profitability analysis in

decision making
This analysis is used to check if the net gains from a borrower are
according to banks profit expectations. It involves comparing the
revenues with the costs. The steps of the analysis are:
Step1:
Identify all the Services used by the customer.
Step2: Identify per unit cost of providing each service.
Step3: Identify the estimated cost for non credit services.
Step4: Identify actual cash expenses in interest payments to the source
of funds.
Over head cost, wages, maintaining accounts and collateral costs
Step5: Asses default risk expenses and the impact of default.
Step6: Calculate revenue generated and income by detecting average
transactions and reserve requirements from the average deposit balance.
Step7: Asses the fee based income generated which includes processing
fees for loans, commitment and conversion fees
Step8: Asses the revenue from loans

Modes of credit delivery

The credit delivery modes are designed to help the borrower to carry on
operations without interruption.
The methods or modes of credit delivery by banks are:
Cash credit: In it the banks gives a credit limit against collaterals,
guarantees or receivables. The customer withdraws funds from the
account and then deposit from its inflows. It provides very flexible and
convenient to the borrowers but expensive for the bank.
Working capital demand loan: Banks may increase or reduce the cash
credit limit for the firms by offering incentives like lower rate of interest
and in volatile industries it may prevent or reduce loans considering the
impact on cash and liquidity.
Overdraft: these are like cash credit as borrowers allowed withdrawing
over and above the borrowers credit balance in this current account. It is
given by the bank to meet urgent credit requirements.
Bills financing: It occurs when bills of exchange are discounted by the
bank. Its methods are purchase of bills, discounting of bills, drawee bill
acceptance and bills co acceptance.

Modes of charging securities

granted by banks
Securities are of two types: They are primary and collateral. Primary securities are created
by the borrower using the loan granted.
Collateral securities are an additional security lower for the loan.
The banks accept either of both securities based on marketability, stability, durability,
e.t.c it always keeps a margin of safety based on fluctuations in its value.
To protect against any default by the borrower, the bank imposes various charges which is
legal and protect to recover loan.
There are six modes of charging securities:
Pledge: It is bailing of goods by the debtors to the creditor to create a charge as security
for the loan.
Its advantage is that the goods are possessed by the banks which prevent borrowers to
dilute or sell the assets and the disadvantage is there is a risk in taking care of the goods
of loss it is compensated.
Assignment: It is transferring a right, property or debt from one person {Assignor} to
another person {Assignee}
Lien: It is the right of the bank to keep the securities given by the borrower till the entire
loan is repaid. The bank cannot sell these goods. It may be general or particular debt but
does not include items in the lockers to get specific loans e.t.c.
Setoff: It is the right of the banks to adjust the credit balance in one account with the debt
balance in another account of same customer.

Hypothecation: of the Hypothecation is a legal transaction involving, movable assets,

amounting to a charge on the assets. In hypothecation the security remains in the
possession of the borrower and is charged in favour of bank through document
executed by the borrower. The document contains a clause that obligates the borrower
to give possession of goods to the bank demand. One possession over the goods
relinquished by the borrower hypothecation becomes similar to pledge.
Mortgages:
Mortgage is the transfer of interest in specific immovable property for the purpose of
securing the payment of money advanced or to be advance by way of loan on existing
or future debt or the performance of an engagement which may give rise to preventing
liability.
The transfer property act recognizes six types of mortgages:

Simple mortgage
mortgage by way of conducting sale
usufructuary mortgage
English mortgage
equitable mortgage
Anomalous mortgage

The changing trends in bank

credit

Till financial year 2002-2003 banks were very profitable and

growth was strong due to increase
In credit lending 12.2 compared to 10.9%.
Net non food credit has given 15.7% in the period between
FY 03. At the same time food credit contracted by 7.9% in
the same period.
According to RBI, the gross credit to the industrial sector has
grown by 9.8% in the period between April to December FY
03 compared to the same period last year.
The industries where credit off take has picked up were
gems and jwellery, steel, textiles and computer software.
One of the main reasons strong growths in credit off take
from these sectors is because exports have growth
significantly.

In retail segment robust growth in the credit

requirements for housing industry continues to favour
the banking sector.
The industries where credit off take has picked up were
gems and jwellery, steel, textiles and computer
software. One of the main reasons strong growths in
credit off take from these sectors is because exports
have growth significantly.

In retail segment robust growth in the credit

requirements for housing industry continues to favour
the banking sector.

Recovery management and

monitoring

Banks were never so serious in their efforts to ensure timely recovery and
consequent reduction of NPAS as they are today. The management process
needs to start at loan imitating stage itself.
Bank deserves to be paid for their products and services the collection
professnals in recovery management system will work to see that
reasonable fees with no up front cost. They get paid only when it is
collected.
Recovery management system will design a collection strategy to meet
banks objective. Bank can recover the debt without loosing customers
monthly statement meaning full reporting status updates on demand.
Extensive expensive obtaining and collecting money judgments recovery
management will systems will collect when legal activities are only option.
Monitoring of banks:
Improve design and implementation during project
Planning and allocating resources
Measure and demonstrate results

Monitoring:

The gathering of evidence to show what progress has been made in implementation of
programmes. Focuses on input and output

Routine collection of information

Tracking implementation progress

Measuring efficiency

Steps to design monitoring system:

Plan for monitoring

Developing the results framework

Develop information sources and design

Complete and test the system

Annual self assessments and periodic external evaluation

Establishing monitoring unit

Centralized/project specific

Collaboration across co-implementing institution

Need for successful monitoring:

Monitoring must have strong ownership support from leaders.

Management requires expert support

Monitoring needs broad stakeholders consultation in defining and setting target indicators

Monitoring training is essential for success

Monitoring system use to be user friendly