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A financial system can be defined as anything that constitutes a system and is related to finance or theoretically a densely interconnected network of intermediaries, facilitators, and markets that perform the activities related to finances. In the Global Era where 15% of the entire global population contains 80% of the global income and the rest of the 85% of the population relies on the funds that constitute to only 20% remaining part, the financial system serves as a hub between the surplus and the deficit groups. The financial system is thus necessarily very significant not at a national level but to the entire Global village. There has been a controversial reputation of the financial system and the people who run the system since the world is full of all types of people. Financiers being no different from normal human beings are also not innately good or evil but rather can be either or even both simultaneously.
Allocating Capital

However the role of financial system is yet more significant since it serves the three major purposes of allocating capital to the deficit group or the needy, sharing risks with the surplus group or the investors and facilitating all types of trades including intertemporal trade thus connecting the dots in the real world. The basic reason why the need for a financial system is there because the financial system constitutes of people
Sharing Risks

Financial System
Intertemporal Trade

Figure 1.1

specialized in the world of finances and is aware of the happenings in the market. They not only can remove the barriers for people to achieve success which otherwise they wouldn t be able to because of lack of funds thus their activities carries a level of social responsibility element. Also the parts of financial system are specialized in the field of finance because they learn from the failures of the past and are constantly engaged in a learning process which enhances their skills

through which they can efficiently perform their duties in a better way any lay man would perform. Other reason for a financial system to exist is because they have achieved the economies of scales in their respective areas through which again they can operate efficiently and can benefit the lenders and the spenders simultaneously. However a particular problem pertains to the financial system that is the element of asymmetry or asymmetric information. Asymmetric information is defined as the absence of complete information about a transaction or any dealing. The absence of such information affects the efficiency of the financial system that carries a huge responsibility on its shoulders and the transactions occur in the presence of secret motives and hidden truths. Dealing with this particular problem is where the financial system is best at but if it doesn t bother focusing on the lack of information this would lead to an adverse selection thus the transaction would occur and would ultimately have a high potential to turn into a moral hazard which can be at the end of either parties engaged in the transaction (Lenders and Spenders) which would obviously disturb the entire system as indicated in the picture below. Adverse Selection is the pre

contractual asymmetric information. It occurs before the contract is done or in other words before the loan is made whereas the post contractual asymmetric information can be considered as Moral hazard or it can be stated the outcome of asymmetric information or the aftermath of adverse selection. Financial markets have a variety of classifications where they can be termed as primary and secondary markets if grouped on the basis of issuance of securities for the first time in case of primary or secondary if the dealing of previously issues securities is being held. They can also be categorized on the basis of the types of securities in which they deal and their maturity time periods. On such basis financial markets are classified into three distinct markets namely Money, Capital and Derivative markets, where markets dealing in more liquid securities having a
Figure 2.2 Adverse Selection Transaction with Asymmetric Information Moral Hazard

maturity time period of less than a year are considered as money markets while other markets that particularly deal in a longer tenure are classified as capital markets based on the characteristics of the market the matching securities are dealt with respectively. Securities dealt in the money market usually are T-bills and commercial papers having a maturity period usually in months while other securities that may last long to decades such as Stocks and bonds are dealt in the capital market. Regulatory authorities come into action to ensure the soundness of the financial system by mandating deposit insurance and often by limiting rates. competition Regulators through to restrictions on entry and interest attempt
L/C s Banker s acceptances Government bonds Swaps Mortgages

Money Markets
Less than 1 year maturity T-bills Commercial paper

Capital Markets
More than 1 year maturity Equities (stocks) Corporate bonds

Derivatives Markets


maximize macroeconomic stability and transparency and to minimize investor risk. Regulators serve four major functions. First, they try to

Figure 3.3

reduce asymmetric information by encouraging transparency. A second and closely related goal is to protect consumers from scammers. Third, they strive to promote financial system competition and efficiency by ensuring that the entry and exit of firms is as easy and cheap as possible, consistent with their first two goals.

A financial system has become the need of the global village where it facilitates both spenders and lenders by using its skills and specialization qualities through which it can ensure the minimization of risks pertaining to the system. The biggest challenge it faces is the absence or lack of information that can make the smooth ride really bumpy, thus regulatory authorities jump in and try to develop rules and policies that ensure, if not the elimination of asymmetric information, the minimization of the hidden motives thus creating the environment transparent and efficient.



Q. Why is most external finance channeled through financial intermediaries rather than financial markets? It s simple to understand that financial markets are unable to channelize more funds as compared to financial intermediaries such as banks. The ground reasons behind it are the presence of Transaction costs and asymmetric information. Transaction cost being the strongest reason of the issue since most individuals do not control enough funds to invest profitably given the fact that fixed costs are very high or in simple words it costs an individual the same amount of fee whether he plans to buy 10 shares or 10,000, whereas in case of banks and intermediaries no such limitations exist and one can even invest in thousands and still generate revenues. The other reason behind the curtain is the presence of asymmetric information in the financial markets since not all are specialized forecasters who can predict the outcomes in the financial market where as the financial intermediaries are more transparent to the society and have been very successful in building customer confidence. That is also the reason that only the large cap or high performing companies are able to gather funds directly from the market on the basis of their reputation and goodwill whereas lower cap companies are often found taking the services of financial intermediaries themselves for creating the pool of their funds. Q. What are the effects of Asymmetric information? Asymmetric or simply the lack of information is the biggest challenge posed to the financial system as a whole and it makes the efficiency of the system to suffer. The pre-contractual stage of asymmetric information is the adverse selection where the issuer/receiver opts for the transaction without having complete information about the other party; resultantly the adverse effects are most likely to occur. Whereas the later or the post-contractual stage is when the adverse event occurs resulting in a moral hazard which can impact either of the parties involved in the transaction. Both the pre and post contractual phase of asymmetry is a threat to the efficiency of the financial system which results in the loss of money of the equity owners.



Financial crisis can be defined as the bad events that negative impact the financial system. However any financial crisis comes into being because of the deficiencies of the financial system or due to loop holes in the system or it can be said that a financial crisis occurs when one or more financial markets or intermediaries cease functioning or function inefficiently. There are certain levels or types of financial crisis that gradually evolve if not catered for in the early stages and ultimately impact the entire system. First type of financial crisis is known as the non-systemic crisis which occurs due to the deficiency of few markets and thus the effects of those crisis are felt only in those deficient areas and if such crisis are spotted and catered it avoids any larger impacts, whereas if the small problems or deficiencies are not catered for the small flames eventually become fire and engulf the entire financial system in the fire along with it this stage of financial crisis is referred to as the Systemic Crisis as indicated in the image. If the financial crisis occurs it effects the entire financial system thus reduces the flow of credit in the economy and due to the riskiness of the situation investors withdraw their investments which further crushes the financial condition of the economy creating a further negative impact. The earliest stage of the crisis is when asset bubbles start taking shapes, which can be defined as the rapid increases in the value of asset like bonds, commodities equities or real estate resulting in the increment in the demand of the particular assets and thus as the demand price relation suggest prices move
Figure 2.1

above the actual value of the product. It is caused when there is a decline in interest rates because the people are willing to take loan when interest rates are low and also when there is easy access to debt and even events usually news forecasts result in the unprecedented increase in the demand of assets due to investor s expectations of rise in the value in the near future forming the bubble which would eventually burst. Before the bursting of asset bubble there is a call for

investors that they should immediately sell off the assets this call is called financial panic. The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. Lenders call loans, or ask for repayment, when interest rates increase or when the value of collateral pledged to repay the loan sinks below the amount the borrower owes. After the bubble bursts and the financial crisis has hit the system it gives rise to a need of funds injection in the affected areas to maintain its operations so that it would again contribute to the growth rather than becoming a burden on it. It also is significant to retain the foreign and local investors from withdrawing funds from the system which would otherwise magnify the impact and the system would take much longer to recover from the adverse event. All these responsibilities are fulfilled by the lender of last resort which in most cases would be the government of a country or the central bank (State Bank of Pakistan) to avoid bankruptcies. A lender of last resort is an institution willing to inject funds when no one else will. The purpose of lender of last resort is to stop panics and deleveraging by adding liquidity to the financial system and attempting to restore investor confidence. They add liquidity by increasing the money supply, reducing interest rates and making loans to wealthy borrowers.
Figure 2.2
Asset values fall More sell off/defaults Shock
Interest rates rise Asset values fall

Credit tightens Sell off/defaults

Interest rates rise Lending volume falls

When one or few financial institutions perform their duties inefficiently it gives rise to nonsystemic crisis which if not catered would turn into systemic crisis that would envelop the entire system into the crisis and the institutions would be in a state of need of severe financial help which is offered by the lender of last resort which provides the funds at the time when the credit environment is severely tightened to ensure that the firms do not bankrupt and the investors don t lost faith in the system.



Q. What are subprime crisis? The U.S. subprime mortgage crisis was a set of events and conditions that led to the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages. The crisis was a direct response to the actions of banks and other lending institutions that advanced loans to those individual with a poor credit history. The earlier stock market crisis had demotivated the people to make investments in the financial markets and mostly turned to lose a great deal of money and were unable to make investments in other areas because of lack of funds. Real Estate became the center of attention of many of these sufferers that offered a relatively lower risk but the returns from such investments were only sufficient enough to compensate the risk. Banks and other institutions started lending in the tight credit environment using adjustable mortgage rate loans (ARMs) a type of loan that initially charged a very small amount of interest but if the borrowers were unable to make the timely payments then the banks were empowered to increase the interest they charged to those people. An asset bubble started building in the U.S. real estate market and due to which the prices of real estate started rising that peaked in 2006! As for the investors this seemed to be a very healthy investment since they could easily get loans and earn higher returns but eventually due to saturation of the market the demand of Real estate started to decline creating a panic in the market and the banks and the investors started to sale off the mortgaged houses that caused the prices to fall even below due to increase in the supply and ultimately people started applying for defaults and the large investors also felt the impact who had bought many ARM bundles from banks thus creating a global impact. By early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30 35% potential drop. The total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total $8.3 trillion


A balance sheet is a financial statement that reflects the financial condition of the company at a given date. It provides a snapshot of the entire sources and uses of cash that a bank has by enlisting the amount a bank owes to people (Source of Cash) and tells what does the bank own which would be its assets. A bank being a part of the financing family holds most of its assets in the form of reserves, secondary reserves, loans, and other assets. Reserves is the cash and deposits at the Federal bank while Secondary reserves are investment in Government and liquid securities , Loans are made to commercial, consumer, to other banks via Fed Funds or check clearing and fixed assets include building and equipment of the bank. Major bank liabilities include deposits, borrowings, and shareholder equity. Deposits includes the amount that a bank has borrowed from the depositors (public) which is the largest source of cash for the bank while borrowings includes borrowings from banks via Fed Funds. Equity includes Shareholders equity, Common stock, Preferred stock And Retained earnings. Banks derive most of their income in the form of interest from loans, so they must be very careful who they lend to and on what terms. Banks lend to other banks via the federal funds they generate their cash resources from depositors as interest and on then the lend to borrowers who in turn give income principal

Buy bonds or finance


Borrow long Lend short

Short-term loans

borrowed. Since banks generate most of their deposits from debt they are liable to manage the funds in a way that they maintain a level of cash reserves that


Figure 3.1

are sufficient enough to repay the depositors along with the premium. However a concerning point for the banks here is to maintain a fit where the level of reserves don t affect the profitability of the bank by creating idle cash reserves. This process is known as liquidity management.

Bank s nowadays have become smart and they know that putting all eggs in one nest would only expose them to a higher level of risks so to ensure profitability they must secure a diversified portfolio of remunerative assets. Where the banks not only advance loans they also purchase and sale securities earning dividends and capital gains and much more. This activity of diversifying the asset portfolio is known as asset management. On the other end to ensure higher spread gains a bank must obtain cheaper funds and the act of sustaining the cost of funds at the minimum level is known as liability management. Their bank has sufficient net worth or equity capital to maintain a cushion against bankruptcy or regulatory
Figure 3.2

Have enough reserved to satisfy deposit outflows

Use efficiently enough to earn profit

attention but not so much that the bank is unprofitable. This second tricky trade-off is called capital adequacy management. Bankers must manage their bank s liquidity capital, assets, and liabilities to secure profits at the end of the year to remain competitive in the market as well as generating sufficient returns on the investor s money to compensate for the risks that they undertake while financing the bank, thus banks need to account much more than just lending bloodlessly. Off the balance sheet is another very important aspect of the bank management. Sometimes to protect them against interest rate fluctuation especially the increases, banks go off road, engaging in activities that do not appear on their balance sheets. For that the banks charge customers all sorts of fees, and not just the little ones that they sometimes slap on retail checking depositors, they also charge fees for loan guarantees, backup lines of credit, and foreign exchange transactions. Banks also now sell some of their loans to investors.

Bank is one of the financial institution that is based on debts as indicated by the bank s balance sheet that indicates how well has the bank been performing over the years and also it indicates how the bank is financed highlighting various liabilities and equity proportions. The banks nature of higher financial leverage gives rise to managing the assets, liabilities, liquidity and capital to show positive net income figures at the end of the year.


Q. What is a balance sheet and what are the components in the case of banks? A balance sheet is a financial statement that lists what a company owns, its assets or uses of funds, and what it owes, its liabilities or sources of funds. Major bank assets include reserves, secondary reserves, loans, and other assets. Major bank liabilities include deposits, borrowings, and shareholder equity. Q. In five words, what do banks do? How they transform assets? Banks lend long and borrow short. Like other financial intermediaries, banks are in the business of transforming assets, of issuing liabilities with one set of characteristics to investors and of buying the liabilities of borrowers with another set of characteristics. As mentioned earlier banks usually acquire short term liabilities mostly in the form of Deposits which is the banks biggest source of cash and is cost efficient as well and banks then later invest in long term assets where they can secure high profits and compensate the depositors at the same time.


Credit risk is the risk of economic loss and arises when the borrower defaults or in simple words fails to repay the amount on agreed time. This might occur due to a variety of reason i.e. either inability to do so or unwillingly but whether the case it could be, the end result is the loss to the bank. So Credit risk is a severe threat to the bank and needs to be carefully managed in order to avoid any losses. The actual loss to the bank could be due to the decline in the portfolio value of the bank and either the loss could have actually happened or it could be perceived but either the state means loss to the bank. The credit risk could be higher and lower in each transaction but there is not any one deal in which bank could judge it to be risk free and these activities are for profit earning and stem from investing or dealing with the individuals, corporate, financial institutions and sovereign. The most risky investment is the loan given to the individuals and the credit risk is high in it, so it would require the thorough investigation so as to reduce the risk. However, it does not mean that the other activities are risk free, every activity have credit risk involved with it either it is investment or incognito leverage. There are some types of credit risk based on small differences they can be classified as lending risk, direct lending risk, contingent lending risk, issuer risk, counter party risk, pre-settlement risk and settlement risk. Lending risk is the risk that occurs by the extension of the credit or credit sensitive products such as loans and overdraft which are being barred by the bank. However the bank reduced its risk by taking collateral but now these are the most secured or less risky components as compared with the other functions of the bank. Lending risk can be further divided into two categories which are direct lending risk and contingent lending risk. The Direct lending risk is the risk that occurs in those transactions which are straight forward to any purchase such as car loan and this would be risk for the life time of transaction. Contingent lending risk is the risk that asserts when the bank on the behalf of the customer write down an agreement or guarantee letter to insure that if the customer would be unable to pay on agreed date than the bank would be liable to pay for it. Another category of risk is the issuer risk the type of risk that involves in the securities and underwriting instruments that would be caused by issuer being default or the bank would be unable to sell those instruments on agreed date than it would be a loss to the bank.

Counter party risk is a risk that arises when the bank and the customer agreed upon exchanging transactions on a settled date and either the value decrease or the customer unable to fulfill agreement causing the loss to the bank. The pre-settlement risk is the risk that one party of a contract will fail to meet the terms of the contract and default before the contract's settlement date thus prematurely ending the contract. The settlement risk is the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. Settlement risk can be the risk associated with default at settlement and any timing differences in settlement between the two parties. This type of risk can lead to principal risk. Principals involved in credit risk management constitutes that the before taking any credit risk the bank should consider the high analysis criteria so to undertake the risk with a known factors in order to have awareness about the detail of the risk. Bank management should develop an administration which should have ensured the criteria on what certain conditions the bank would undertake the risk. Whereas the senior management can establish the limit of how much credit should be exposed and what sort of actions and risk should be taken. The internal risk criteria will develop the control on the outside risk evaluation criteria. Credit risk assessment based on the old traditional model in which it considers only the borrower condition and qualitative study of the borrower known as the five C s . These five C s are Character, capacity, capital, collateral and conditions which were used or analyzed together to assess the degree of credit risk so that it could be minimized and also lending principles should be developed which can assist the credit officer in the lending of advances. Lending principles states that the thorough study of the borrower would is the best illustration to consider the credit risk involved and this acknowledgment of risk could increase the good functioning of the financial institutions. Every aspect should be examined, even the legal status of the borrower to ensure the safety of funds which is the most important principle of good lending. When a banker lends, he must feel certain that the advance is safe; that is, the money will definitely come back. If, for example, the borrower invests the money in an unproductive or speculative venture, or if the borrower himself is dishonest, the advance would be in jeopardy. Similarly, if the borrower suffers losses in his business due to his incompetence, the recovery of the money may become difficult. The banker ensures that the money advanced by him goes to the right type of borrower and is utilized in such a way that it will not only be safe at the time of lending but will remain so throughout, and after serving a useful purpose in the trade or industry where it is

employed, is repaid with interest. New model of credit risk analysis have a new agenda in which it does not only focuses on the wellbeing of the borrower but also the environment and conditions around it. This new model illustrates not only the condition of the borrower but also the factors that create those conditions. New model consist of four aspects in which a borrower lies. First one is the External environment and any change in the environment not only affecting the borrower but all the industries and firms. We would require studying the impact of the external environment on the borrower and from which sense it is affecting. The second factor is the Industry risk in which the borrower falls and any changes in the term or condition regarding the industry would affect the borrower as it should be acknowledge that from which industry our borrower is dealing in and what s the current condition and situation of the industry. Either the industry is making enough profit although what stage is the industry lies in, because mature industries would be having risk to decline in the future. The third one is the Internal risk in which comes the operational risk, management structure and capacity whereas Financial risk is the most concerning for the bank to study as it would be the risk that increases the credit risk of the firm. All the thorough study of the borrower made above would justify the bank to either take the credit risk or not. Business cycle consists of four patterns through which we can analyze the current profitability situation of the business and thus it carries all the more importance. First stage is the Recession which is a business cycle contraction, a general slowdown in economic activity. Macroeconomic indicators such as GDP, employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise. The second one Trough is a low turning point or a local minimum of a business cycle. The time evolution of many
Figure 4.1

External Risks

Industry Risks

Interanl and Financial Risks

parameters of economics exhibits a wave like behavior with local maxima followed by local minima. A business cycle may be defined as the period between two consecutive peaks. Third one economic Recovery is the phase of the business cycle following a recession, during which an economy regains and exceeds peak employment and output levels achieved prior to downturn. A recovery period is typically characterized by abnormally high levels of growth in real gross domestic product, employment, corporate profits, and other indicators. Last stage is the Peak which is high point of the business cycle of some particular phase of economic activity. For example, summer is the time of peak electrical demand for utilities as people run their air conditioners. Benefits of study of business cycle is that it would be helpful in creating the credit risk analysis when you know that at what stage is the economy in which the borrower is running business and how much should be lend. The national income and gross national product are the best factors to analyze the economic condition of a country. The per capita income is the national income divided by the total population and the rate of increase in these factors defines the future prediction of the businesses and industries that would be profitable if the national income is growing high. Although business cycles all pass through the same phases, they vary greatly in duration and intensity. Many economists prefer to talk of business fluctuations rather than cycles because cycles imply regularity while fluctuations do not.
Figure 4.2

Credit Risk carries a strong threat to the banking sector since they deal in borrowing and lending of money. The threats that pose to the credit risk environment vary in greater number however they would be a threat to the bank s funds eventually. Traditional models have been practiced since long time which included the assessment of individuals on the basis of different models however the new model suggests taking a broader view of the system by analyzing external

threats, industry threats and then if every checkpoint gives a green signal then the borrower himself needs to be analyzed to ensure the security of funds.


Q. Define Credit Risk, how it arises and how can it be minimized? Credit risk 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. It arises when from the potential that an obligor is either; Unwilling to perform on an obligation or, Its ability to perform such obligation is impaired resulting in economic loss to the bank.

For banks, loans are the largest and most obvious source of credit risk, which they need to minimize to avoid any future losses. In economic context non-performing assets are also viewed as credit risk in a sense of opportunity costs, because non-performing assets are just the burden of a bank and eventually the bank needs to compensate the lenders so if the assets are idle they would not generate revenues and thinking broadly it would obviously make problems for the bank. On the other end of the story if a bank tries to utilize these resources but fails to ensure the safety of funds then again it would be eating out the profits at the end in the form of bad debts and losses. Thus banks need to ensure the safety of funds and the quality of credit for which credit officers are trained with many quantitative and qualitative tools and techniques for the assessment of their borrowers. The old Traditional model emphasized only for the assessment of the borrowers to serve the cause but as the financial system grew and developed the focus shifted on wider areas such as the external risks, industry risks and internal plus financial risks, which can be used by the credit officers as proposed by the new model. Thus officers trained in these areas get their homework to research on these broader areas which if show less signs of any uncertain events to occur would show a green signal for lending and the final task would be the assessment of the borrower using financial statements and other resources that reflect his/her credit history and worthiness. Through such measures credit officers can reduce the credit risks up to a certain level where it doesn t pose a serious threat to the bank.


A view of the giant typewriter industry which just vanished overnight getting replaced by the new digital machines that performed the tasks more efficiently and you could even make millions of mistakes while typing and then conduct a spell check at the end and that would rectify the errors, gave the glimpse of how rapidly technology evolves and obsoletes. But if I had invested my funds in the typewriter industry at that time I would ve lost my money by now so a need arose as how to analyze whether the industry has the potential to move forwards or is it going to experience falling sales. A concept relating to the different stages an industry will go through, from the first product entry to its eventual decline. There are typically five stages in the industry lifecycle as shown in the figure below. The very first stage in the industry life cycle is the stage of Pioneering which includes the alternative product design and positioning, establishing the range and boundaries of the industry itself. The second stage in industry life cycle is rapid growth stage. The second stage
Figure 5.1

of the life cycle is when the growth of the product is started the market share of industry is increased due to the acceptance of that product in the market. This is a favorable stage for the investors to invest in certain industry because the product is being accepted in the market by the buyers and there is less risk involved in investing in that industry. Maturity: Growth is no longer the main focus; market share and cash flow become the primary goals of the companies left in the space. If industry is facing this stage it is not favorable for the investors to invest in because now market is getting saturated and it is the time for introducing an innovative product which would be accepted by the buyers. Stability is when the industry remains stable in this stage but you do not know when your industry will move towards the decline stage and there is a risk involved for the investors. While Decline is when the high risk is involved because the industry is near to shut down. Government s role towards an industry could be encouraging or

discouraging for example most governments are against the tobacco industry and devise policies discouraging smoking and other forms of tobacco consumption. Each stage carries a certain level of risk associated to the lending process and can be used by the credit analyst as a criteria to base the lending decision on, where the pioneering and Decline are the most unfavourable stages in the industry life cycle since it carries the highest level of risk and lending in these stages might not make sense. However other stages involving the stage of rapid growth, maturity and stability are when the industry or the firm in the industry have stabilized thus it makes these stages the most favourable of the stages to lend advances.

Industry life cycle serves as an element of a wider model that assists the credit officer in judging g where the industry stands in its life cycle since all the stages have distinct properties and characteristics it makes it very easy for the credit officer to make sound decisions and to avert the overall credit risk.


Q. What are the implications of industry risks? 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 economy for 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. 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. Potter Diamond s 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. Q. Will an industry that performed well in one time period continue to do well in future? Industries working well today might not show same performance in future due to political, economic, social, technological, environment, and legal issues. Political instability is major threat for industries, if political and law and order situation is not good than profits will go down. Likewise change in any of these factors creates problems for business enterprise.

Q. What are the reasons for consistency in profitability in certain industries while others show wide fluctuations? Some industries are cyclical while others are not and that is the prime reason for consistency in profitability in certain industries and also for fluctuations. By cyclical industries we mean those industries which are highly affected from fluctuations in business life cycle. Think of food industry, as food is the basic necessity of mankind so demand for products of food industry not that much affect by business life cycle fluctuation. On the other hand cyclical industries like construction got hurt by business life cycle fluctuation if economy is going down than the profitability of cyclical industries will also go down.


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. Financial statements, which include balance sheet, income statement, statement of cash flow, and statement of owners equity, show the health of an organization at a specific period of time. Financial 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 sheet shows the financial position of the firm on a particular date say yearly, semiannually, quarterly or monthly. Balance sheet explains lot of queries regarding the borrower s 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 which is 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 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 don t give the accurate information to the stakeholders of the firm, thus ratios are needed. 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. That s why a single ratio is meaningless unless compared to other firm s 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. There are different ways through which company s 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 year s performance then it gives effective meaning. Industry Comparison is comparing firm s 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. There are four main categories of ratio analysis. Liquidity ratios indicate the borrower s 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 is the study of the cycle of business cash inflows and outflows, 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
Figure 6.1



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 firm s 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 the technique which is 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 performance. 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 borrower s 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: Based on Customer s 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. Internal and External Audit department by its annual audit identifies and manages the bank s risk. Audit functions to avoid errors, frauds and forgeries. Board and senior management approve bank s credit risk strategy and significant policies relating to credit risk and its management which should be based on the bank s 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 bank s overall risk tolerance in relation to credit


Ensure that bank s 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. 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 institution s 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. The Credit Risk Management Committee (CRMC), 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.

Bank is a bank because it loans out to the public and its major source of income is thus the interest earned from carrying out these practices. However being a part of service industry where on one hand the bank has a lower operating leverage it bears a heavy financial leverage that exposes it to various risks that if not considered would lead to default. The role of the credit officers and the senior management is to minimize this risk which they do by creating a diversified portfolio and by using various tools and techniques that help in the reduction of these potential threats.


Q. What are the tools a bank can use to reduce the financial risk? Financial risk is the risk that investors would lose their money because the bank relies more on debt than equity which exposes them to a higher chance of default. For the purpose of assessing the degree to which the bank is exposed to financial risk and to develop policies to reduce the financial risk, there are three methodologies. 1. Ratio Analysis 2. Cash Flow Analysis 3. Sensitivity Analysis The Ratio analysis covers four major categories of Profitability ratios, Leverage ratios, operating ratios and liquidity ratios. Each one of which is significant and needs to be accounted for minimizing the effects of financial risk which a bank can do by managing the assets and liabilities in context of achieving the idle figures of ratio analysis. Cash flow analysis is another method through which a bank can reduce the financial risks since it highlights the inflow and outflows of cash of the bank it gives the policy makers the opportunity to retain the cash outflows up to the level where the bank can easily pay off its obligations and invest the rest in longer term projects to reduce idle capital and promote asset utilization. The third tool available for the assessment and reduction of financial risk is the sensitivity analysis that gives an overview of how a change in one variable would impact another, like for example the impact of rise of 1.00% inflation would result in an increase of 0.5 % in the cost of funds because of the change in the value of money, thus it provides a measure for the bank to estimate the future events and being proactive to respond to changes before they start effecting the banks operations.


Liquid assets can be simply defined as the assets that can be easily converted into cash at a short note without loss of any value. Liquidity risk arises when a bank doesn t have enough liquid assets to meet obligations. 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. Initial warnings that alert the bank about liquidity risk 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 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. The first and foremost important strategy to ensure minimum risk is the outlining of the best mix between banks assets and its liabilities to maintain liquidity. Other strategies include Diversification and stability of liabilities, which 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. The last but very significant strategy is the Access to interbank market which can be a source of funds for the bank but one consideration needs to be accounted that meeting liquidity needs from interbank market can be difficult in crisis situation and costly as well. Considering the potential threats and the strategies available for a bank to bail out from liquidity risks give rise to the Liquidity policy that is 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 risk management functions, including structural balance sheet management, pricing, marketing, contingency planning, management reporting, lines of authority and responsibility for liquidity decisions. The Liquidity policy contents also include the Liquidity risk management structure, for monitoring, reporting and reviewing of liquidity and banks have various tools for managing for identifying, measuring, monitoring and controlling liquidity risk. The last significant content is the contingency plans to deals with crisis of liquidity. Considering the risk associated with liquidity an Asset liability committee (ALCO), comprising of senior management and treasury function, and risk management department are developed who take 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
Figure 7.1
Roles of Individuals Liquidity Risk management Tools Contingency Plan Liquidity Risk Management Structure General Liquidity Strategy

Liquidity Policy

of effective management information system provide basis for liquidity management decisions. Information should be readily available for day to- day 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 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 funding plans. CFP is an extension of ongoing liquidity management and formalizes the objectives of liquidity management by ensuring, a reasonable amount of liquid assets are maintained, measurement and projection of funding requirements during various scenarios, management of access to funding sources. In case of a sudden liquidity stress it is important for a bank to seem organized, candid, and efficient to meet its obligations to the stakeholders. A CFP can help ensure that bank management and key staffs are ready to respond to such situations. Bank liquidity is very sensitive to negative trends in credit, capital, or reputation. Contingency funding plan has a wide scope it must anticipate banks funding and liquidity needs by analyzing and making quantitative projections of all significant on- and off balance- sheet funds flows and their related effects, Matching potential cash flow sources and uses of funds, establishing indicators that alert management to a predetermined level of potential risks. CFP must also include asset side as well as liability side strategies to deal with liquidity crises. The asset side strategy may include; whether to liquidate surplus money market assets, when to sell liquid or longer-term assets etc. On the other hand liability side strategies specify

policies such as pricing policy for funding, the dealer who could assist at the time of liquidity crisis, policy for early redemption request by retail customers, use of SBP discount window etc. An approach to deal with bank s liquidity issues is the use of ratios. Ratios not only help to measure current position but also help in anticipating future events. 1. Loan to deposit ratio = Performing loans outstanding / Deposit balances outstanding. 2. Incremental loan to deposit ratio = Incremental loans made during the period / Incremental deposit inflows during the same period. 3. Medium- term funding ratio = Liabilities with maturity of one year / Assets with maturity of over one year. 4. Cash flow coverage ratio = Projected cash inflow / Projected cash outflow. 5. Net short-term liabilities to assets = Net short-term liabilities / Total assets. 6. On hand liquidity to total liabilities = on hand liquidity - cash in hand + near cash assets / Total liabilities. 7. Contingent Liabilities Ratio = Contingent Liabilities / Total Loans. The higher this ratio higher is the risk. These ratios can be used by the Asset liability committee which can make decisions accordingly at the time of need and bail the bank out of the liquidity issues.

Liquidity is one of the major concerning points for the bank s board, since there is a tradeoff between liquidity and profitability decisions regarding liquidity position of the bank demands more attention. Asset liability committee is responsible for formulation of liquidity policy and its execution.


Q. How banks manage their liquidity while assuring high profits at the same time? Liquidity and Profitability are the two faces of the same coin, meaning there is tradeoff relation between the two. However both these belong ratios are associated with the broader risk associated with the operation of the banks. Thus banks try to achieve an optimal point where they can assure the payment of their short term obligations by investing in liquid securities or by keeping raw money at hand at the same time they monitor the level of liquidity as to affecting the profitability of the bank. Thus practically bank undertake the policies of creating an asset liability match and avoid concentration on any one single asset or liability (diversification) with the involvement of the senior management of the bank, who devise a liquidity policy comprising of the following General Liquidity Strategy Liquidity Risk Management Structure Liquidity Risk management Tools Roles of Individuals Contingency Plan

Through the Liquidity Policy the bank not only plans for the management of risks pertaining to liquidity but also consider different alternatives that would be available to the bank in case of any uncertain future event for gathering resources sufficient enough to make the payment of the obligations while keeping the cost of borrowing at the minimum possible level.