UNIT II

MANAGING BANK FUNDS/ PRODUCTS & RISK MANAGEMENT

Capital Adequacy – Deposit and Non-deposit sources – Designing deposit schemes and pricing
of deposit sources – loan management – Investment Management – Asset and Liability
Management – Financial Distress –Signal to borrowers – Prediction Models – Risk Management
– Interest rate – Forex – Credit market –operational and solvency risks – NPA’s – Current issues
on NPA’s – M&As of banks into securities market

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CAPITAL ADEQUACY

The capital adequacy ratio (CAR) is a measure of how much capital a bank has available,
reported as a percentage of a bank's risk-weighted credit exposures. The purpose is to establish
that banks have enough capital on reserve to handle a certain amount of losses, before being at
risk for becoming insolvent.

Calculating CAR

The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets.
The capital used to calculate the capital adequacy ratio is divided into two tiers.

 Tier-1 Capital

Tier-1 capital, or core capital, consists of equity capital, ordinary share capital, intangible assets
and audited revenue reserves. Tier-1 capital is used to absorb losses and does not require a bank
to cease operations. Tier-1 capital is the capital that is permanently and easily available to
cushion losses suffered by a bank without it being required to stop operating. A good example of
a bank’s tier one capital is its ordinary share capital.

 Tier-2 Capital
Tier-2 capital comprises unaudited retained earnings, unaudited reserves and general loss
reserves. This capital absorbs losses in the event of a company winding up or liquidating. Tier-2
capital is the one that cushions losses in case the bank is winding up, so it provides a lesser
degree of protection to depositors and creditors. It is used to absorb losses if a bank loses all its
Tier-1 capital.

The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's
capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans,
evaluating the risk and then assigning a weight. When measuring credit exposures, adjustments
are made to the value of assets listed on a lender’s balance sheet.

All of the loans the bank has issued are weighted based on their degree of credit risk. For
example, loans issued to the government are weighted at 0.0%, while those given to individuals
are assigned a weighted score of 100.0%.

 Risk-Weighted Assets

Risk-weighted assets are used to determine the minimum amount of capital that must be held by
banks and other institutions to reduce the risk of insolvency. The capital requirement is based on
a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of
credit is considered to be riskier and requires more capital than a mortgage loan that is secured
with collateral.

Importance of Capital Adequacy Ratio

The CAR is decided by central banks and bank regulators to prevent commercial banks from
taking excess leverage and becoming insolvent in the process. The CAR is important to ensure
that banks have enough room to take a reasonable number of losses before they become
insolvent and, as a result, lose depositors’ funds.

In general terms, a bank with a high CRAR/CAR is deemed safe/healthy and likely to fulfill its
financial obligations.

When a bank is winding-up, depositors’ funds are accorded a greater priority than the bank’s
capital, so depositors will lose their savings only if a bank has a loss higher than the capital it
has. So, the higher the CAR, the greater is the protection for depositors’ funds with the bank.
The CAR helps keep an economy’s financial system stable by ensuring that the risk of banks
going insolvent is low.

DEPOSIT AND NON-DEPOSIT SOURCES

 What Is a Deposit?

A deposit is a financial term that means money held at a bank. A deposit is a transaction
involving a transfer of money to another party for safekeeping. However, a deposit can refer to a
portion of money used as security or collateral for the delivery of a good.

 Deposit sources

There are several different types of deposit accounts including current accounts, savings
accounts, call deposit accounts, money market accounts, and certificates of deposit (CDs).

Types of Bank Deposits

Current (Demand Deposit) Account

A current account, also called a demand deposit account, is a basic checking account. Consumers
deposit money and the deposited money can be withdrawn as the account holder desires on
demand. These accounts often allow the account holder to withdraw funds using bank cards,
checks, or over-the-counter withdrawal slips. In some cases, banks charge monthly fees for
current accounts, but they may waive the fee if the account holder meets other requirements such
as setting up direct deposit or making a certain number of monthly transfers to a savings account.

Savings Accounts

Savings accounts offer account holders interest on their deposits. However, in some cases,
account holders may incur a monthly fee if they do not maintain a set balance or a certain
number of deposits. Although savings accounts are not linked to paper checks or cards like
current accounts, their funds are relatively easy for account holders to access.

In contrast, a money market account offers slightly higher interest rates than a savings account,
but account holders face more limitations on the number of checks or transfers they can make
from money market accounts.

Call Deposit Accounts

Financial institutions refer to these accounts as interest-bearing checking accounts, Checking
Plus, or Advantage Accounts. These accounts combine the features of checking and savings
accounts, allowing consumers to easily access their money but also earn interest on their
deposits.

Certificates of Deposit/Time Deposit Accounts

Like a savings account, a time deposit account is an investment vehicle for consumers. Also
known as certificates of deposit (CD), time deposit accounts tend to offer a higher rate of return
than traditional savings accounts, but the money must stay in the account for a set period of time.
In other countries, time deposit accounts feature alternative names such as term deposits, fixed-
term accounts, and savings bonds.

 Non-deposit sources

Different Sources of Non-Deposit Liabilities at a Bank

The most considerable importance of a bank is to offer loans to all qualified customers. If it does
not have sufficient funds, the bank should seek the cheapest cost of funding to meet its
customers’ needs. However, this may lead to poor-quality loans. Liability management involves
buying funds, especially from other financial institutions, to cover good-quality credit requests
and meet legal reserve requirements for deposits and other borrowings that may be required by
the law.

The most common non-deposit sources that financial institutions use include:

i. Federal Funds Market (“Fed Funds”)

ii. Repurchase Agreements
iii. Federal Reserve Banks
iv. Advances from Federal Home Loan Bank
v. Negotiable Certificates of Deposit
vi. Commercial Paper Market
vii. Eurocurrency Deposit market
viii. Long-Term Non-deposit Funds Sources
i. Federal Funds Market
Fed funds market is the most popular domestic source of borrowed reserves that allows
depository institutions that are short of reserves to meet their legal reserve requirement as well as
immediately usable funds from the other institutions who have idle funds temporarily.

Types of Federal Funds Market

Overnight loans are unwritten, often uncollateralized agreements usually negotiated over a
telephone and are payable the next day.

Term loans are long-term contracts, usually accompanied by a written contract. Term loans may
take days, weeks, or even months.

Continuing contracts have daily renewals unless either the lender or borrower decides to end
the contract. The agreements are commonly between smaller respondent institutions and their
more significant correspondents, where the latter automatically invests the smaller institution’s
deposits held with it in Fed funds loans until told to do otherwise.

ii. Repurchase Agreements

Repurchase agreements are viewed as collateralized fed fund transactions. In such an agreement,
one party agrees to sell high-quality assets such as T-bills to another party temporarily. At the
same time, the selling party issues an agreement to buy back those securities on a specific future
date at a predetermined price. These agreements are basically for overnight funds, though it can
be extended for days, weeks, and even months.

The interest cost for repurchase agreements is equivalent to:

iii. Borrowing from Federal Reserve Banks

Banks borrow from the federal reserve when they are unable to meet their reserve requirements
due to low cash at hand at the close of the day. When banks borrow from the government’s
central bank, they are making use of a discount window. There exist different types of loans
depending on the needs with different rates of interest. However, there are limits/restrictions on
the frequency of borrowing from the federal reserve.

Types of Federal Reserve Loans

Primary credit refers to loans available for the short-term and only to institutions in sound
financial conditions. The interest rate is higher than the federal funds rate.

Secondary credit is available to institutions that do not qualify for primary credit but at a higher
interest rate. Secondary credit is, however, tracked by the central bank to avoid excess risk.

Seasonal credit is loans that cover more extended periods relative to primary credit. They are
mostly utilized by small and medium firms that experience seasonal fluctuations in deposits and
loans.

In summary, secondary credit attracts the highest interest rates, followed by primary credit, and
finally, seasonal credit with the lowest interest rates.

iv. Advances from Federal Home Loan Banks

Federal Home Loan Bank lends substantial amounts of money, allowing institutions to use home
mortgages as collateral for advances. These loans are utilized as a way of improving the liquidity
of home mortgages at the same time motivating more lenders to provide credit. The maturity for
federal home loan banks ranges from overnight to more than 20 years.

v. Negotiable CDs

A negotiable CD is a source of short-term funds for commercial banks developed to tap

temporary surplus funds held by large corporate and wealthy individual customers. It is an
interest-bearing receipt evidencing the deposit of funds in the bank for a specified period for a
specified interest rate. It is a hybrid account since it is legally a deposit.

Types of Negotiable CDs

Domestic CDs are issued by U.S institutions, which are inside the U.S territory.
Dollar-denominated CDs are issued by banks outside the U.S and are also known as EuroCDs.

A Yankee CD is a foreign certificate of deposit usually denominated in the U.S dollars.

Thrift CDs are certificate of deposits sold by non-bank institutions

The interest rates of fixed-rate CDs are quoted based on their interest-bearing, where the rate is
computed based on a 360 days year. The advantage of negotiable CDs I that they offer a way to
attract large amounts of funds quickly and for a known period. However, these funds are
incredibly sensitive to interest and often are withdrawn as soon as the maturity date arrives
unless management aggressively bids in terms of yield to keep the CD.

vi. Eurocurrency Deposit Market

The Eurocurrency deposit market is the most significant unregulated financial market place in
the world. It involves a group of banks that accept deposits and also make loans in foreign
currencies outside their country of issue. They were initially developed in Western Europe to
provide liquid funds to swap among institutions or act as loans to customers. The Eurodollar
market is one of these markets. Eurodollars are dollar-denominated deposits placed in banks
outside the United States.

Access to the Eurocurrency market is obtained by contacting correspondent banks by telephone,

wire, or cable

vii. Commercial Paper Market

The commercial paper market involves short-term notes with a maturity period ranging from
three or four days to nine months, issued by well-known companies to raise working capital.
They are sold at a discounted price from their face value.

Types of Commercial Paper

Industrial paper is used by non-financial institutions to finance purchases of inventories and to

meet immediate financial needs. The inventories include goods or raw materials.

Finance paper is mostly issued by finance companies and the associates of a financial holding
company. Issuing this paper provides the income useful for purchasing loans off the books of
other financial firms within the same organization. This results in the firm creating additional
funds for giving loans.

Note that banks do not issue commercial paper directly. However, its associates can issue them.

viii. Long-Term Non-deposit Fund Sources

Long-term non-deposit funding sources involve loans that are extended for a period beyond one
year. These loans include mortgages to fund the construction of new buildings, debentures, and
capital notes. They range from a period of 5-12 years and supplements the owners’ capital or
equity.

Note that, despite the mismatch created by long-term funding sources as most assets and
liabilities held by depository institutions are short-term to medium-term, larger financial firms
find long-term funding attractive due to the leverage effects of such debts.

DESIGNING DEPOSIT SCHEMES

Step One: Assess Your Competitive Market

You can’t grow deposits if you don’t know your competitive environment. Identify those
companies that can lure away your existing depositors with similar products. This will likely
include credit unions, online banks, and local, regional and national financial institutions. Audit
your competitors’ products, marketing tools and resources—how does your bank measure up?

Once you have identified your competitors, take your bank through an exhaustive SWOT
analysis, which identifies the strengths and weaknesses of your organization, as well as its
opportunities and threats. This analysis will arm you with the information necessary to put
strategies in place to win new depositors away from your competitors.

Step Two: Define Your Depositors—Both Existing and Potential

Data is power in both acquiring and retaining depositors. You must understand who these
depositors are and what they value. For example, small businesses need remote capture and
treasury services, while more and more consumers are looking for convenience through
technology and apps.

Step Three: Assess Existing Deposit Products and Formulate New Products
After conducting your competitive analysis and zeroing in on your target market, you should
identify weaknesses in your existing deposit products and address those deficiencies. An
important part of an effective deposit strategy is to formulate new products to place on the shelf
to have as offensive or defensive weapons in changing environments. Having these products
diminishes the risk of cannibalizing other deposits—specifically low-cost deposits—within your
bank and allows you to pursue new deposits attracted by higher rates.

Step Four: Assign Accountability, Set Measurable Goals and Allocate Appropriate
Resources

Your deposit strategy plan is only as good as the talent and resources you’ve put in place to
execute it. If you raise deposit rates but don’t market the rates to potential customers, you will
gain nothing except an increase in cost and, perhaps, existing deposits. Traditionally, community
banks have not had to focus on marketing. Times have changed. To execute an effective deposit
acquisition campaign today, it’s imperative that you invest in an experienced, forward-thinking,
in-house or contract marketing team with a sustainable budget and measurable goals.

Step Five: Repeat Quarterly

Revisiting this exercise quarterly will keep your team focused and allow management to update
and adapt to new opportunities and threats in the marketplace. More importantly, it will ensure
your institution will thrive in any environment.

Methods Used to Determine the Pricing of Deposits

Methods of calculating the price of a deposit account are discussed below:

1. Pricing Deposits at Cost Plus Profit Margin

Cost-plus deposit pricing encourages banks to determine the costs they incur in labor and
management time, materials, among others, in offering each deposit service. Cost-plus pricing
typically calls for a bank to charge deposit service fees enough to cover all the costs of providing
the service in addition to a small margin for profit.
Every deposit service may be priced high enough to recover all or most of the cost of offering
that service, using the following cost-plus pricing formula:

The above equation ties deposit pricing to the cost of deposit-service production, which has
encouraged deposit providers to keenly match prices and expenses and eradicate many formerly
free services.

Nowadays, most depository institutions charge for excessive withdrawals, customer balance
inquiries, bounced checks, and ATM usages, as well as raising required minimum deposit
balances, among others. These trends have been favorable to depository institutions.

2. Using Marginal Cost to Set Interest Rates On Deposits

Many financial analysts would argue that the marginal cost, and not the historical average cost,
should be used to price deposits and funding sources. This is because frequent fluctuations in
interest rates make historical average cost an unreliable standard for pricing.

The marginal cost formula is as follows:

 3. Conditional Pricing

Depository institutions, particularly banks, use conditional pricing as a tool to attract the kind of
depositors they want to have as customers. In this case, a depository institution sets up a schedule
of fees in which the customer pays a low fee or no fee given that the deposit balance is above
some minimum level. However, the customer is liable to higher charges if the average balance
drops below that minimum level. In other words, the customer pays the price conditional on how
they use a deposit account.

Conditional pricing is based on one or more of the following factors:

 The average balance in the account during the period;

 The maturity of the deposit; and/or

 The number of transactions going through the account. For example, the number of
deposits made, or notices of insufficient funds issued.

The customer chooses the deposit plan that accrues the lowest fees possible and maximum yield,
or both, given the number of checks he or she plans to write, the expected number of deposits
and withdrawals he plans to make, and/or the anticipated average balance he plans to keep in
his/her account.

4. Relationship Pricing
Depository institution prices deposits according to the number of services purchased or utilized.
The depositor may be given lower fees or have a part of the cost waived if they have used two or
more services – for example, having a checking account, a savings account, and his/her mortgage
at the same financial institution.

LOAN MANAGEMENT

A loan management system is a digital platform that helps automate every stage of the loan
lifecycle, from application to closing.

The traditional loan management process is meticulous, time-consuming, and requires collecting
and verifying information about applicants, their trustworthiness, and their credibility.

Benefits of Loan Management

1. Benefits for Banks

 Automation

Our Loan Management System (LMS) provides an automated end-to-end solution that enables
banks the opportunity to originate, underwrite and monitor SBLOCs at scale.

 Diversification

Underwriting SBLOCs through LMS can help banks to diversify their loan portfolios by asset
class, geography and business line without requiring any additional lending infrastructure.

 Flexibility

SBLOCs can be fixed or floating rate and categorized as either commercial or consumer
depending on the borrower type. Credit policies can be tailored to match the bank's risk profile.

 Local Impact

Certain business loans may qualify for Small Business Administration (SBA) treatment and/or
Community Reinvestment Act (CRA) credit.
  Security

TBS maintains policies and procedures that meet or exceed the latest data privacy standards and
provides secure access to historical credit file information to demonstrate compliance with all
consumer lending laws.

 Support

TBS has the industry experience, financial intermediary relationships, wholesale product training
and in-field sales to support your business.

2. Benefits for Source Institutions

 Automation

Our Loan Management System (LMS) is an end-to-end solution that automates the entire
origination, underwriting and collateral monitoring process.

 A Competitive Edge

Providing advisors with a comprehensive “wealth management” offering, including best-of-

breed securities-based lending capabilities, can help attract and retain experienced financial
advisors.

 Flexibility

Our modular design can be configured to support your unique business needs and integrate with
both internal and external systems seamlessly.

 Scalable Recruiting

LMS automates the transition of existing pledged accounts. Broker Dealers can now simplify the
recruiting process, seamlessly on-boarding advisors and their clients.

 Security

TBS maintains policies and procedures that meet or exceed the latest data privacy standards and
provides secure access to historical credit file information to demonstrate compliance with all
consumer lending laws.

 Support
TBS has the industry experience, network of lenders, wholesale product training and experienced
in-field sales professionals to grow and support your business.

Features of a loan management system

Digital and cloud-based lending solutions are scalable. They can help you manage the loan
lifecycle. Alternatively, you can also use the software for a single task such as tracking
repayments. They can also be complete systems that can validate loan applications and determine
eligibility. Here are some of the remarkable features of a loan management system.

 Loan Origination

Loan origination is the process where a borrower applies for a loan, and the lender processes it.
Lending CRM can help evaluate the risk or make a decision.

Loan origination functionalities of a lending CRM can help lookup the credit history of an
individual or an organization. They can also suggest what loans are suitable for the client. The
loan origination system can analyze the application and provide insights to service the loan. A
digital solution will take a few seconds to do the tasks, whereas a manual workflow may take
days.

 Loan Servicing

The loan servicing feature will help you manage loans. Every loan is different: they have
different interest rates, payment dates, and more. You can track all these loans and ensure that
you receive payments on time. It allows you to calculate interests, fees, and more. A loan
management solution can also assist you in automatically collecting funds via wire transfers,
credit cards, and more. (More on the types of loans that loan management software can handle in
the subsequent section.)

 Debt collection

Collecting back the payment is essential for lending businesses. A digital lending platform can
notify you when accounts become delinquent. You can also get notified when the borrower pays
back or when a repayment is due. The collection system can even calculate late fees for you.
Debt collection software keeps everyone in the team on the same page. You can track all the
communication your employees are having with your clients. It becomes much easier to look up
a debtor’s payment history and make modifications or arrange new terms of payment.

 Reporting and Analytics

An essential feature of loan management software is the reporting module. You can get
comprehensive reports on the cash flow. You can create reports based on interactions with a
single individual or business. Or you can look at how profitable offerings are for you. Reporting
allows you to visualize and understand in which direction your business is moving.

Types of loans

 Personal Loans

These are loans that are for personal or non-commercial use. Organizations look up the credit
history of the individual before giving out the loan. Loans can either be secured or unsecured.
For instance, a car loan is a secured loan, whereas a student loan is an unsecured loan. Also, it is
possible to co-sign such loans. In these cases, the borrower has another individual to sign the
loan, who will pay the loan in case the borrower fails.

 Commercial Loans

Commercial loans are for business use only.

Financial organizations provide these loans to startups and businesses. The funding is for the
expenses an organization cannot afford. Usually, companies/startups will use this funding for
growth or expansion. They need to provide documents beforehand, showing that they can pay
back the loan. Solutions such as lending CRM can automatically process and store the
documents.

 Student Loans

Student loans are expenses related to attending any educational institution. The funding can be
for tuition fees or accommodation. Both government and private organizations provide these
loans. In the case of federal loans, the interest rate is government regulated.

 Syndicated Loans
A syndicated loan is a loan where multiple lenders provide a loan to several borrowers under the
same term. A group of lenders gives out this type of loan when the credit amount is too large for
one lender to manage. Usually, larger organizations and banks give out such loans. These loans
also have a middleman arranging the entire transaction.

 Mortgage Loans

Lenders provide this type of loan to both individuals as well as businesses for purchasing real
estate. These are secured loans. Moreover, these loans have longer-term. If the borrower stops
paying, the lender can acquire the property.

 Payday loans

These are short-term loans with high-interest rates. Payday loans are often availed by individuals
to cover for certain expenses until the upcoming payday.

INVESTMENT MANAGEMENT

Investment management refers to the handling of financial assets and other investments—not
only buying and selling them. Management includes devising a short- or long-term strategy for
acquiring and disposing of portfolio holdings. It can also include banking, budgeting, and tax
services and duties, as well.

Process of Investment Management

The main steps in the investment process are given below:

  To set goals and objectives: The first step in the investment process is to identify the
goals and objectives f the investors. A systematic investment decision requires the
formulation of a set of long-term or short-term goals which can serve as a guide for
managerial decisions. This step also includes the determination of the quantum of
investment in different shares and debentures quoted in the capital market.
 To determine appropriate risk level: The second step in the investment process is to
determine the amount of risk that an investor is willing to assume to achieve the
investment objective. This step will largely determine the mix of assets to be held in the
investment portfolio and attempt will be made to quantify the risk and measurement of
the same by applying appropriate tools.
 To estimate the risk and return: The third step in the investment process is to estimate
the risk and return for the investors to take their decisions, because risk and return go
hand in hand. Investors must balance risk with return.
 To form optimal portfolio: The fourth step in the investment process is to construct
optimal portfolio which includes estimate of risk and return for individual securities and
to maintain relationship between securities, portfolios and the like. An investment
portfolio is the list of investment securities both common stock and bonds that an investor
owns.
 To make the analysis of the performance: The fifth and the last step in the investment
process is to analyze the performance of the vendor company’s financial statement in
order to take investment decision. The investor should monitor the results of their
portfolios for determining the goals and objectives and review the performance of the
portfolios. This may provide some insights which will improve their security analysis and
portfolio selection techniques.

Pros of Investment Management

 Professional analysis
 Full-time diligence
 Ability to time or outperform market
 Ability to protect portfolio in down times

Cons of Investment Management

  Sizeable fees
 Profits fluctuate with market
 Challenges from passively managed vehicles, robo-advisors

ASSET MANAGEMENT

Asset management is the practice of increasing total wealth over time by acquiring, maintaining,
and trading investments that have the potential to grow in value. Asset management
professionals perform this service for others. They may also be called portfolio managers or
financial advisors

Importance of Asset Management

There are several reasons why businesses should be concerned about asset management,
including:

1. Enables a firm to account for all of its assets

The process makes it easy for organizations to keep track of their assets, whether liquid or fixed.
Firm owners will know where assets are located, how they are being put to use, and whether
there have been changes made to them. Consequently, the recovery of assets can be done more
efficiently, hence, leading to higher returns.

2. Helps guarantee the accuracy of amortization rates

Since assets are checked on a regular basis, the process of asset management ensures that the
financial statements record them properly.

3. Helps identify and manage risks

Asset management encompasses the identification and management of risks that arise from the
utilization and ownership of certain assets. It means that a firm will always be prepared to
manage any risk that comes its way.

4. Removes ghost assets in the company’s inventory

Instances exist where lost, damaged, or stolen assets are erroneously recorded on the books. With
a strategic asset management plan, the firm’s owners will be aware of the assets that have been
lost and will eliminate them in the books.

Benefits of Asset Management

There are many benefits of adopting an asset management strategy, such as:

1. Improving acquisition and use

By keeping tabs on a company’s assets throughout their life cycle, a firm owner can improve
their technique of acquiring and utilizing assets. A good case in point is Cisco Systems, which
was able to reduce costs by executing PC asset management. When implementing such a
strategy, the company discovered wasteful purchasing practices, which it solved by developing a
better process for buying the equipment needed by workers.

2. Improving compliance

Government agencies, non-profit organizations, and companies are required to provide

comprehensive reports on how they acquire, utilize, and dispose of assets. To ease the reporting
process, a majority of them record their asset information in a central database. In such a way,
when they need to compile the reports at the end of their financial year, they can easily access all
the information they need.

LIABILITY MANAGEMENT

Liability management is the process of managing the use of assets and cash flows to reduce the
firm's risk of loss from not paying a liability on time.

Well-managed assets and liabilities involve a process of matching offsetting items that can
increase business profits.

ASSET / LIABILITY MANAGEMENT

An asset/liability management is the process that is defined as paying off liabilities from assets
and cash flows of a company, and its proper implementation reduces the risk of loss for not
paying the liabilities on time.
Companies must ensure that assets and cash flows are there available on time when needed to
avoid additional interest and penalties.

Better asset/liabilities management helps make an additional business profit.

Techniques Used for Asset Liability Management

1) Gap Analysis in Asset and Liability

A gap is defined as the difference between rate-sensitive assets and rate-sensitive liabilities.

GAP = Rate Sensitive Asset – Rate Sensitive Liabilities

GAP Ratio = Rate Sensitive Asset/ Rate Sensitive Liabilities

2) Asset Coverage Ratio

Another important ratio to manage the asset and liabilities is the asset coverage ratio, which
determines the number of assets available to pay off the debts.

Asset Coverage Ratio = ((Total asset- intangible asset) – (current liabilities- short term
debt))/total debt

The higher the asset coverage ratio, the more assets the company has to pay off its debt.
Companies should at least have this ratio as more than 1.

Benefits of Asset Liability Management

Following are the benefits:

 It helps in risk measurement and management for companies.

 Effective asset-liability management ensures liquidity risk management.
 Effective ALM protects and enhances the profit and net worth of a company.
 It increases the net interest income of the banking institution.
 ALM is used to quantify the various kinds of risks in the company.
 It helps in finalizing the short-term and long-term planning for a company.
 It helps in strategizing the introduction of new products in the market

Limitation of Asset Liability Management

Below point is the limitation:

 Other criteria need to be looked upon to check the risks of a company apart from asset-
liability management.
 It can be misleading sometimes.
 Sometimes having risk is better because high risk gives higher returns.

FINANCIAL DISTRESS

Financial distress is a condition in which a company or individual cannot generate sufficient

revenues or income, making it unable to meet or pay its financial obligations. This is generally
due to high fixed costs, a large degree of illiquid assets, or revenues sensitive to economic
downturns.

Causes with Examples

It is something that happens at the time of running the business, which led to this situation. The
causes of this situation are as below-

1. Technological Changes

If any company cannot adapt to the technological changes and cannot upgrade itself, it will get
thrown out of the market. Its market share will drastically decrease, and ultimately revenue will
get lower down along with static fixed costs. Gradually this will lead to financial distress.

For example, Nokia in 2012 could not adopt new technology and had to face such distress.

2. Improper Management

Improper management leads to inefficient decision-making and eventually a lower down of

revenue.

Due to some inappropriate decisions of the CFO the company had to file bankruptcy. For
example, Lehman Brothers was the fourth-largest investment bank in America, but in September
2008, the company filed for bankruptcy. With $639 billion in assets and $619 billion in debt, the
bankruptcy was the largest in history.

3. Fraud in the Company

Any planning of fraud may lead to diverting the organization’s objective to maximize
shareholder’s wealth to the intention of the fraud maker. All the key resources are not used for
the organization’s benefit and lead to financial distress.E.g., Fraud in Satyam Computers in 2009.
Fictional expenses were booked; profits were falsified. It led to the total shutdown of the
company.

4. Improper Investment Plans

It is necessary to maintain proper cash flow and fixed income from investments. If budgeting is
not done correctly, either there will be a cash crunch or idle funds. It sometimes leaves the
company taking debt over what is required and ultimately leads to distress.

Period of Financial Distress

Technically, “A period of a company during which its market price of a share falls or value of its
assets decreases usually as a reason for cash crunch and inaccurate projections.” An example of
it is the US Recession in 2007-2008.

In this period, the company faces severe problems in cash flow which impacts and lowers the
quality of its products and services. It enables existing customers to buy from their competitors.
It declines the revenue, and the situation gets worse. Suppliers will cut short the credit period and
contract terms will get stringent. Ultimately there will be a problem paying salaries to the
employees, and the company will do layoffs. The period during which all these situations occur
is known as financial distress.

Calculate the Cost of Financial Distress

When the company is in distress, its assets don’t cost more, and its debts become more
expensive. The rate of interest charged by the bank to the company is higher than what is
charged to other companies in the same industry (Cost of Debt of AAA Rated company).

1. Calculate the Weighted Average Cost of Debt. Example 10.5%

2. Take the cost of Debt of an AAA-rated Company. Example 7%

3. If the debt of the company is 100 million

Cost of Financial Distress = Difference of Rates in Step 1 * Total Debt of the company
= (10.5 – 7) % *100 million = 3.5 million

PREDICTION MODELS

Predictive modeling is a commonly used statistical technique to predict future behavior.

Predictive modeling solutions are a form of data-mining technology that works by analyzing
historical and current data and generating a model to help predict future outcomes.

Applications of Predictive Modeling

Predictive analytics uses predictors or known features to create predictive models that will be
used in obtaining an output. A predictive model is able to learn how different points of data
connect with each other. Two of the most widely used predictive modeling techniques are
regression and neural networks.

In the field of statistics, regression refers to a linear relationship between the input and output
variables. A predictive model with a linear function requires one predictor or feature in order to
predict the output or outcome. For example, a bank that hopes to detect money laundering in its
early stages might incorporate a linear predictive model.

The bank wants to identify which of its customers are likely to engage in money laundering
activities at some point in time. Using the bank’s customer data, a predictive model is built
around the dollar amount of money transfers that customers made during a period of time.

The model is taught to recognize the difference between a money laundering transaction and a
normal transaction. The optimal outcome from the model should be a pattern that signals which
customer laundered money and which didn’t. If the model perceives that a pattern of fraud is
emerging for a particular customer, it will create a signal for action, which will be attended to by
the bank’s fraud prevention unit.

Predictive Modeling Tools

Predictive models are also used in neural networks such as machine learning and deep learning,
which are fields in artificial intelligence (AI). The neural networks are inspired by the human
brain and are created with a web of interconnected nodes in hierarchical levels, which represents
the foundation for AI. The power of neural networks lies in their ability to handle non-linear data
relationships. They are able to create relationships and patterns between variables that would
prove impossible or too time-consuming for human analysts.

On the one hand, a bank can input known variables, such as the value of transfers initiated by its
customers into its model to determine who is likely to engage in money laundering. On the other
hand, a neural network can create a more powerful pattern by creating a relationship between
input variables. These input variables could include time logged in, geographic location of the
user, IP address of the user’s device, recipient or sender of the funds, and any other variable or
behavior that is likely to be involved in money laundering activity.

Other predictive modeling techniques used by financial companies include decision trees, time
series data mining, and Bayesian analysis. Companies that take advantage of big data through
predictive modeling measures are better able to understand how their customers engage with
their products and can identify potential risks and opportunities for the company.

RISK MANAGEMENT
 In the financial world, risk management is the process of identification, analysis, and
acceptance or mitigation of uncertainty in investment decisions.
 Essentially, risk management occurs when an investor or fund manager analyzes and
attempts to quantify the potential for losses in an investment, such as a moral hazard, and
then takes the appropriate action (or inaction) given the fund's investment objectives and
risk tolerance.

Types of Financial Risk

1. Market Risk

As clear from its name, the risk which is related to the marketplace in which the business
activities take place, is known as market risk. For example, if you are running a brick-and-mortar
clothing store, then the rise in customers' tendency to online shopping would be a market risk. In
this situation, only those businesses can survive which can adapt to the online selling system and
serve the online crowd. On the other hand, the businesses who stuck to the offline business
model will bear losses.

Every business sector faces the risk of being outpaced by competitors. The market conditions
and customers' demands and preferences change rapidly. So it is a must for a business to keep up
with market trends and pricing demands to grab the market and compete with other producers.

2. Foreign Exchange Risk

Foreign exchange risk refers to the risk associated with any financial instrument denominated in
a foreign currency. For example, if an American company invests in India and the domestic
investment does well in rupee terms, the American company may nevertheless lose money since
the rupee's value has declined against the US dollar. As a result, when the firm redeems its
investment at maturity, it will receive fewer US Dollars.
The rupee has dropped dramatically in recent years due to the pandemic. Because of which our
country's forex risk as an investment destination has skyrocketed.

3. Credit Risk

Credit risk refers to the possibility of losing money because the performance of a creditor is not
as per the terms of the contract. Such debts are categorized as bad debts. For example, if the
goods are delivered to customers on 30-days payment terms and the customer couldn't pay the
invoice on time (or in the future also), then the company will suffer a credit risk. This risk can
also increase the possibility of a cash flow shortage. So, it is advisable to retain sufficient cash
reserves to cover the company's accounts payable.

4. Liquidity Risk

Liquidity risk includes all those risks that arise when the organization tries to sell assets or raise
funds. This risk is also known as funding risk. If something is becoming a barrier in the path of
raising funds fast, then it will be called liquidity risk. For example, a seasonal business can suffer
from a shortage of cash flow during the off-season. So here the financial manager should figure
out, does the company has enough cash available to meet the potential liquidity risk? And how
quickly the company can dispose of old inventory or assets to regulate the cash flow in the
business?

Interest rate and currency risk are both examples of liquidity risk. As a result, the financial
manager must be aware of the impact of a rapid shift in interest rates or exchange rates on the
cash flow of the organization.

5. Operational Risk

All other risks that the business can face in its daily operations are called operation risks. These
risks include staff turnover, fraud, poor budgeting, theft, unrealistic financial projections,
lawsuits, and improper market plans. All these risks can affect the bottom line of the business if
they are not dealt with and handled carefully.

6. Other Risks
Some other types of risks are legal risk, equity risk, reputational risk, interest rate risk,
reinvestment risk, country risk, inflationary risk, political risk, valuation risk, model risk, IT risk,
etc.

Process of Financial Risk Management

Every organization has its ways to deal with financial risks. These ways or processes are based
on what the business does, what is the target market of the business, and how much risk the
business can bear. In this sense, it's the responsibility of the financial manager of the company to
identify and assess the risks and decide how the company will manage them.

Three stages included in the process of financial risk management are:

1. Identifying the Risk Exposure

The first step in the process of financial risk management is to identify the risks and their sources
or causes. To start the process of identification, the financial manager can first check the balance
sheet of the company. It will be helpful in getting a snapshot of the liquidity, debt, interest rates
risk, foreign exchange exposure, and the vulnerability of commodity prices that the company is
suffering from. After it, the manager should go for the income statement and the cash flow
statement also to figure out the risk exposure. These statements will be helpful in understanding
the fluctuations of income and cash flow over time and how does it affect the risk profile of the
organization.
In this step, the financial manager should collect the answer to the following questions:

 What are the sources of the revenue of the business?

 Which customers are getting credit from the company and what are the credit
terms for them?
 Does the company have long-term debt or short-term debt?
 What change will occur if the interest will be increased?
2. Quantifying the Exposure

In the second step, the financial manager tries to quantify the risk exposure, i.e., put a numerical
value for the identified risk. However, due to the uncertainty of risk, an exact numerical value
can't be put on risk exposure. Statistical models such as the regression method and standard
deviation method are used by the analysts to find out the exposure of the company to various risk
factors. With the help of these tools, the amount by which the data points differ from the average
to the mean is measured.

For example, the financial manager can use computer software like MS Excel in the case of
small enterprises to make some straightforward analysis efficiently and accurately. The general
rule to quantify the exposure, in this case, is: the risk associated with the data point or cash flow
will be greater with the greater standard deviation.

3. Making a 'Hedging' Decision

This is the third and last step in the process of financial risk management. In this step, the
financial manager decides how to deal with the information that is collected after analyzing the
sources of risk. Can the organization run with the risk exposure? Is it required to mitigate the risk
or hedge against it? This decision is taken with the help of multiple factors such as the goals of
the organization, business environment, its risk appetite, and whether the cost of mitigation
justifies the decrease in risk.

Generally, the financial manager can consider the following action steps:

 Decreasing the volatility of cash flow.

 Proper management of operating costs.
 Proper management of the company's payment terms.
  Fixing interest rates on loans to get more certainty in the company's financing costs.
 Eliminating those customers who regularly break the credit terms of the organization.
 Putting rigorous billing and credit control procedures.
 Appointing the right people for the right job with the right qualification so that the risk of
fraud and inefficiency can be reduced.
 Showing due diligence on projects, for example, it is necessary to look at the
uncertainties linked with a partnership or joint venture.
 Understanding the commodity price exposure of your goods or services, i.e., the
company's susceptibility to fluctuations in the raw materials' price. For example, a
haulage industry can suffer from the situation of increased costs of raw materials and
reduced profit if there is a rise in the prices of oil.

Tools to Control Financial Risk

A person, a corporation, or the government can use a variety of tools to evaluate the amount of
financial risk that may occur. Some of the most prevalent strategies for analyzing risks linked
with long-term investments or the stock market are presented below:

 Fundamental Analysis: In this method, the intrinsic value of the security is measured by
evaluating all aspects of the underlying business. It includes the assets and earnings of the
firm.
 Technical Analysis: In this method, the evaluation of securities by using statistics and
checking the historical returns, share prices, trade volumes, and other performance data is
done.
 Quantitative Analysis: In this method, the financial manager evaluates the historical
performance of the firm with the help of specific financial ratio calculations.

When financial management assesses a company, for example, he or she can use the debt-to-
capital ratio to determine the proportion of debt utilized in relation to the entire capital structure.
If the proportion of debt is high then it means the investment is risky and vice versa. Another
ratio called the capital expenditure ratio is used to divide cash flow from operations by capital
expenditures. It helps in calculating the money left with the business for its operating activities
after paying the debts.
INTEREST RATE

Interest rate is the amount charged over and above the principal amount by the lender from the
borrower. In terms of the receiver, a person who deposits money to any bank or financial
institution also earns additional income considering the time value of money, termed as interest
received by the depositor.

Interest rates on borrowings and deposits may defer considering the purpose and to whom the
amount is given.

Influencing factors Interest rate

Interest rates vary according to:

 the government's directives to the central bank to accomplish the government's goals
 the currency of the principal sum lent or borrowed
 the term to maturity of the investment
 the perceived default probability of the borrower
 supply and demand in the market
 the amount of collateral
 special features like call provisions
 reserve requirements
 compensating balance

Reasons for changes

 Political short-term gain: Lowering interest rates can give the economy a short-run
boost. Under normal conditions, most economists think a cut in interest rates will only
give a short-term gain in economic activity that will soon be offset by inflation. The
quick boost can influence elections. Most economists advocate independent central banks
to limit the influence of politics on interest rates.
 Deferred consumption: When money is loaned the lender delays spending the money on
consumption goods. Since according to time preference theory people prefer goods now
to goods later, in a free market there will be a positive interest rate.
  Inflationary expectations: Most economies generally exhibit inflation, meaning a given
amount of money buys fewer goods in the future than it will now. The borrower needs to
compensate the lender for this.
 Alternative investments: The lender has a choice between using his money in different
investments. If he chooses one, he forgoes the returns from all the others. Different
investments effectively compete for funds.
 Risks of investment: There is always a risk that the borrower will go bankrupt, abscond,
die, or otherwise default on the loan. This means that a lender generally charges a risk
premium to ensure that, across his investments, he is compensated for those that fail.
 Liquidity preference: People prefer to have their resources available in a form that can
immediately be exchanged, rather than a form that takes time to realize.
 Taxes: Because some of the gains from interest may be subject to taxes, the lender may
insist on a higher rate to make up for this loss.
 Banks: Banks can tend to change the interest rate to either slow down or speed up
economy growth. This involves either raising interest rates to slow the economy down, or
lowering interest rates to promote economic growth.[13]
 Economy: Interest rates can fluctuate according to the status of the economy. It will
generally be found that if the economy is strong then the interest rates will be high, if the
economy is weak the interest rates will be low.

FOREX
The foreign exchange (also known as forex or FX) market is a global marketplace for
exchanging national currencies. Because of the worldwide reach of trade, commerce, and
finance, forex markets tend to be the largest and most liquid asset markets in the world.
Currencies trade against each other as exchange rate pairs.

Uses of the Forex Markets

 Forex for Hedging

Companies doing business in foreign countries are at risk due to fluctuations in currency values
when they buy or sell goods and services outside of their domestic market. Foreign exchange
markets provide a way to hedge currency risk by fixing a rate at which the transaction will be
completed.

To accomplish this, a trader can buy or sell currencies in the forward or swap markets in
advance, which locks in an exchange rate. For example, imagine that a company plans to sell
U.S.-made blenders in Europe when the exchange rate between the euro and the dollar
(EUR/USD) is €1 to $1 at parity.

The blender costs $100 to manufacture, and the U.S. firm plans to sell it for €150—which is
competitive with other blenders that were made in Europe. If this plan is successful, then the
company will make $50 in profit per sale because the EUR/USD exchange rate is even.
Unfortunately, the U.S. dollar begins to rise in value vs. the euro until the EUR/USD exchange
rate is 0.80, which means it now costs $0.80 to buy €1.00.

The problem facing the company is that while it still costs $100 to make the blender, the
company can only sell the product at the competitive price of €150—which, when translated
back into dollars, is only $120 (€150 × 0.80 = $120). A stronger dollar resulted in a much
smaller profit than expected.

The blender company could have reduced this risk by short selling the euro and buying the U.S.
dollar when they were at parity. That way, if the U.S. dollar rose in value, then the profits from
the trade would offset the reduced profit from the sale of blenders. If the U.S. dollar fell in value,
then the more favorable exchange rate would increase the profit from the sale of blenders, which
offsets the losses in the trade.

Hedging of this kind can be done in the currency futures market. The advantage for the trader is
that futures contracts are standardized and cleared by a central authority. However, currency
futures may be less liquid than the forwards markets, which are decentralized and exist within
the interbank system throughout the world.

 Forex for Speculation

Factors like interest rates, trade flows, tourism, economic strength, and geopolitical risk affect
the supply and demand for currencies, creating daily volatility in the forex markets. An
opportunity exists to profit from changes that may increase or reduce one currency’s value
compared to another. A forecast that one currency will weaken is essentially the same as
assuming that the other currency in the pair will strengthen because currencies are traded as
pairs.

Imagine a trader who expects interest rates to rise in the United States compared to Australia
while the exchange rate between the two currencies (AUD/USD) is 0.71 (i.e., it takes $0.71 USD
to buy $1.00 AUD). The trader believes higher U.S. interest rates will increase demand for USD,
and the AUD/USD exchange rate therefore will fall because it will require fewer, stronger USDs
to buy an AUD.

Assume that the trader is correct and interest rates rise, which decreases the AUD/USD exchange
rate to 0.50. This means that it requires $0.50 USD to buy $1.00 AUD. If the investor had
shorted the AUD and went long on the USD, then they would have profited from the change in
value.

How to Start Trading Forex

Trading forex is similar to equity trading. Here are some steps to get yourself started on the forex
trading journey.

1.    Learn about forex: While it is not complicated, forex trading is a project of its own and
requires specialized knowledge. For example, the leverage ratio for forex trades is higher than
for equities, and the drivers for currency price movement are different from those for equity
markets. There are several online courses available for beginners that teach the ins and outs of
forex trading.

2.    Set up a brokerage account: You will need a forex trading account at a brokerage to get
started with forex trading. Forex brokers do not charge commissions. Instead, they make money
through spreads (also known as pips) between the buying and selling prices.

For beginner traders, it is a good idea to set up a micro forex trading account with low capital
requirements. Such accounts have variable trading limits and allow brokers to limit their trades
to amounts as low as 1,000 units of a currency. For context, a standard account lot is equal to
100,000 currency units. A micro forex account will help you become more comfortable with
forex trading and determine your trading style.
3.    Develop a trading strategy: While it is not always possible to predict and time market
movement, having a trading strategy will help you set broad guidelines and a road map for
trading. A good trading strategy is based on the reality of your situation and finances. It takes
into account the amount of cash that you are willing to put up for trading and, correspondingly,
the amount of risk that you can tolerate without getting burned out of your position. Remember,
forex trading is mostly a high-leverage environment. But it also offers more rewards to those
who are willing to take the risk.  

4.    Always be on top of your numbers: Once you begin trading, always check your positions
at the end of the day. Most trading software already provides a daily accounting of trades. Make
sure that you do not have any pending positions to be filled out and that you have sufficient cash
in your account to make future trades.

5.    Cultivate emotional equilibrium: Beginner forex trading is fraught with emotional roller

coasters and unanswered questions. Should you have held onto your position a bit longer for
more profits? How did you miss that report about low gross domestic product (GDP) numbers
that led to a decline in overall value of your portfolio? Obsessing over such unanswered
questions can lead you down a path of confusion. That is why it is important to not get carried
away by your trading positions and cultivate emotional equilibrium across profits and losses. Be
disciplined about closing out your positions when necessary.    

Forex Terminology

The best way to get started on the forex journey is to learn its language. Here are a few terms to
get you started:

 Forex account: A forex account is used to make currency trades. Depending on the lot
size, there can be three types of forex accounts:

1. Micro forex accounts: Accounts that allow you to trade up to $1,000 worth of currencies
in one lot.

2. Mini forex accounts: Accounts that allow you to trade up to $10,000 worth of currencies
in one lot.
3. Standard forex accounts: Accounts that allow you to trade up to $100,000 worth of
currencies in one lot. 

 Ask: An ask (or offer) is the lowest price at which you are willing to buy a currency. For
example, if you place an ask price of $1.3891 for GBP, then the figure mentioned is the
lowest that you are willing to pay for a pound in USD. The ask price is generally greater
than the bid price.
 Bid: A bid is the price at which you are willing to sell a currency. A market maker in a
given currency is responsible for continuously putting out bids in response to buyer
queries. While they are generally lower than ask prices, in instances when demand is
great, bid prices can be higher than ask prices.
 Bear market: A bear market is one in which prices decline among currencies. Bear
markets signify a market downtrend and are the result of depressing economic
fundamentals or catastrophic events, such as a financial crisis or a natural disaster.
 Bull market: A bull market is one in which prices increase for all currencies. Bull
markets signify a market uptrend and are the result of optimistic news about the global
economy.
 Contract for difference: A contract for difference (CFD) is a derivative that enables
traders to speculate on price movements for currencies without actually owning the
underlying asset. A trader betting that the price of a currency pair will increase will buy
CFDs for that pair, while those who believe its price will decline will sell CFDs relating
to that currency pair. The use of leverage in forex trading means that a CFD trade gone
awry can lead to heavy losses.
 Leverage: Leverage is the use of borrowed capital to multiply returns. The forex market
is characterized by high leverages, and traders often use these leverages to boost their
positions.
Example: A trader might put up just $1,000 of their own capital and borrow $9,000 from
their broker to bet against the EUR in a trade against the JPY. Since they have used very
little of their own capital, the trader stands to make significant profits if the trade goes in
the correct direction. The flipside to a high-leverage environment is that downside risks
 are enhanced and can result in significant losses. In the example above, the trader’s losses
will multiply if the trade goes in the opposite direction.
 Lot size: Currencies are traded in standard sizes known as lots. There are four common
lot sizes: standard, mini, micro, and nano. Standard lot sizes consist of 100,000 units of
the currency. Mini lot sizes consist of 10,000 units, and micro lot sizes consist of 1,000
units of the currency. Some brokers also offer nano lot sizes of currencies, worth 100
units of the currency, to traders. The choice of a lot size has a significant effect on the
overall trade’s profits or losses. The bigger the lot size, the higher the profits (or losses),
and vice versa.
 Margin: Margin is the money set aside in an account for a currency trade. Margin money
helps assure the broker that the trader will remain solvent and be able to meet monetary
obligations, even if the trade does not go their way. The amount of margin depends on the
trader and customer balance over a period of time. Margin is used in tandem with
leverage (defined above) for trades in forex markets.
 Pip: A pip is a “percentage in point” or “price interest point.” It is the minimum price
move, equal to four decimal points, made in currency markets. One pip is equal to
0.0001. One hundred pips are equal to 1 cent, and 10,000 pips are equal to $1. The pip
value can change depending on the standard lot size offered by a broker. In a standard lot
of $100,000, each pip will have a value of $10. Because currency markets use significant
leverage for trades, small price moves—defined in pips—can have an outsized effect on
the trade.
 Spread: A spread is the difference between the bid (sell) price and ask (buy) price for a
currency. Forex traders do not charge commissions; they make money through spreads.
The size of the spread is influenced by many factors. Some of them are the size of your
trade, demand for the currency, and its volatility.
 Sniping and hunting: Sniping and hunting is the purchase and sale of currencies near
predetermined points to maximize profits. Brokers indulge in this practice, and the only
way to catch them is to network with fellow traders and observe for patterns of such
activity.

CREDIT MARKET
Credit market refers to the market through which companies and governments issue debt to
investors, such as investment-grade bonds, junk bonds, and short-term commercial paper.

Factors that affect the credit market

The following are the factors that affect the credit market internally and externally.

Internal factors

 RBI economic policies

 Liquidity in the market

 Interest rate movement 

 Inflation rate

 Demand for money

 Supply of money

 Government borrowings to tide over its fiscal deficit

 The credit quality of the issuer

External Factors

 Global economic conditions and their impact

 Foreign exchange

 Fed rates

 Crude oil prices

 Economic indicators

Above all, the primary indicators for the health of the credit market are – prevailing interest rates
and investors demand. Therefore, one must analyze and study the spread between the interest
rates on bonds. For instance, bonds like treasury bonds and corporate bonds or investment-
grade bonds or junk bonds. 
Usually, the treasury bonds offer the lowest interest rates in comparison to other bonds. Hence,
there is the lowest default risk associated with treasury bonds. Comparatively,
corporate bonds have higher interest rates and are riskier by default. Therefore, as an investor, it
is essential to understand the spread between the interest rates of these bonds. When the spread
between the bonds widens, i.e., government bonds are in favor over corporate bonds,
Accordingly, this is a signal for the economy. Meanwhile, analysts expect that the economy is
entering a recession where corporate bonds are riskier. 

Types

The credit market can be classified into two categories – 

Government Securities Market

This is one of the significant sources of borrowing funds by the central and state governments.
The government issues short term and long-term securities to raise funds from the general public.
However, these securities do not carry any risk. The reason being, the government promises the
payment of interest and repayment of the principal amount. These securities are also known as
gilt-edged securities. Thus, the government securities market is the major market in any
economic system. 

Corporate Bond Market

The corporate bond market is a similar financial market where the private and public
corporations issue bonds and debt securities. Likewise, the companies issue bonds to raise
money for a variety of purposes. For instance, building a plant, purchasing equipment or
business expansion. When these bonds are sold to the investors, the company gets its capital
required. In return, the company pays a pre-established number of interest payments at either a
fixed or variable interest rate. Lastly, on the maturity of the bond, the issuer pays the principal
and interest to the investor.

Generally, the bonds are issued first in the primary market as a ‘new issue’. Here, the issuers sell
the bond to investors to raise capital. Sometimes the investors might also sell the bonds to the
existing investors, which is the secondary market. Thus, investors can buy and sell
existing securities. 

Usually, corporate bonds are riskier than government bonds. Hence, they carry additional risk
and offer higher interest rates. Also, the highest quality bonds are termed as ‘Triple-A’(AAA)
rated bonds while the least creditworthy bonds are referred to as junk bonds. Therefore, investors
should check the credit quality of these bonds before investing. 

Who are the market participants in the credit market?

The following are the market participants in credit market.

 Banks
 Financial institutions
 Primary dealers
 Insurance companies
 Provident funds
 Mutual fund houses
 Corporates
 Foreign institutional investors (FIIs)
 Trusts

OPERATIONAL RISKS
“Operational Risks” is a risk that includes errors because of the system, human intervention,
incorrect data, or because of other technical problems. Every firm or individual has to deal with
such an operational risk in completing any task/delivery.

Types of Operational Risks

The following are types of operational risks.

1 – Human Error

We can also refer to this as a fat finger input error. This error is the most common and significant
risk to the organization or individual. It may also relate to the skill issue of the processor. This
type of error evolves when incorrect input is because of human error. The reasons for incorrect
input may be multiple, including incomplete information, incomplete understanding, insufficient
knowledge, inconsistent processing, genuine input error, or more. However, processing such an
error may affect the output seriously and may also lead to a loss.

2 – Technical Error

This includes system glitches. Even though everything is perfect, there are sometimes system
issues like a slowdown, connectivity, system crashes, incorrect calculation by application, or a
new missing bridge. Sometimes, the output received may be off from the expected result, but
because of unknown technical defects, it may be challenging to catch.

3 – Gap in Flow

Sometimes, information is missing from the source itself because of data lag or restrictions. In
such cases, the output gets affected. The required production varies from that desired and may
put the process at risk.
4 – Uncontrollable Events

These include effects from an external environment like political scenarios, weather changes,
syndromes affecting living beings, outdated technology, etc., which affect the performance and
quality of processors and put the output at risk.

5 – Intentional Frauds

There have been cases where intentional conflict of interests has arisen, resulting in an illegal
profit to trade executors. Most organizations have a clause in their policies that the employees
have to abide by fighting against conflict of interests and fraudulent practices, failing which they
meet with extreme consequences. However, if such an event occurs, the firm has to bear
monetary and defame losses, which are sometimes irrecoverable. 

Disadvantages

 Effects due to operational risks may create irrecoverable losses. Sometimes, the losses
can also lead to the cancellation of licenses for the responsible employee and the
organization.

 It creates damage to the brand name of the employee as well as to the organization. It can
lead to lifetime losses and trust in the market for such employees and the organization.

Limitations

 The effect created due to operational risk can be identified and assessed only after
significant losses are met. Every organization has a bar for immaterial losses incurred
only when the cause of a material loss is investigated.

 Once an error is noticed, it may or not be reversible and corrected. Even if it can be
reversed, there are chances of losses already incurred. Hence, it is best to create proper
control checks at all steps of any process.

SOLVENCY RISK

Solvency risk is the risk that the business cannot meet its financial obligations as they come due
for full value even after disposal of its assets. A business that is completely insolvent is unable to
pay its debts and will be forced into bankruptcy.
NPA
A non-performing asset (NPA) is a classification used by financial institutions for loans and
advances on which the principal is past due and on which no interest payments have been made
for a period of time.

Sub-Classifications for Non-Performing Assets (NPAs)

Lenders usually provide a grace period before classifying an asset as non-performing. Afterward,
the lender or bank will categorize the NPA into one of the following sub-categories:

1. Standard Assets

They are NPAs that have been past due for anywhere from 90 days to 12 months, with a normal
risk level.

2. Sub-Standard Assets

They are NPAs that have been past due for more than 12 months. They have a significantly
higher risk level, combined with a borrower that has less than ideal credit. Banks usually assign
a haircut (reduction in market value) to such NPAs because they are less certain that the
borrower will eventually repay the full amount.

3. Doubtful Debts

Non-performing assets in the doubtful debts category have been past due for at least 18 months.
Banks generally have serious doubts that the borrower will ever repay the full loan. This class of
NPA seriously affects the bank’s own risk profile.

4. Loss Assets

These are non-performing assets with an extended period of non-payment. With this class, banks
are forced to accept that the loan will never be repaid, and must record a loss on their balance
sheet. The entire amount of the loan must be written off completely.

Significance of NPAs

It is important for both the borrower and the lender to be aware of performing versus non-
performing assets. For the borrower, if the asset is non-performing and interest payments are not
made, it can negatively affect their credit and growth possibilities. It will then hamper their
ability to obtain future borrowing.

For the bank or lender, interest earned on loans acts as a main source of income. Therefore, non-
performing assets will negatively affect their ability to generate adequate income and thus, their
overall profitability. It is important for banks to keep track of their non-performing assets
because too many NPAs will adversely affect their liquidity and growth abilities.

Non-performing assets can be manageable, but it depends on how many there are and how far
they are past due. In the short term, most banks can take on a fair amount of NPAs. However, if
the volume of NPAs continues to build over a period of time, it threatens the financial health and
future success of the lender.

 issue with NPA?

 The total size of the banking sector’s NPAs is estimated at over Rs 6.7 lakh crore, of
which no less than Rs 6 lakh crore is accounted for by state-owned banks or public sector
banks (PSB).
 Approximately 16% of loans and advances of banks are stressed assets (NPA +
restructured accounts + write offs).
 This is higher than BRICS partners except for Russia.
 This is alarming given that capital adequacy ratio threshold for banks is prescribed at
12%.
 Stressed assets for public sector banks are 17% while for private banks, it is 7% and for
foreign lenders it is 6%.
 The asset quality of PSU banks is the worst amongst the lot.
 In the boom years, Indian companies took on significant loans to ramp up capacities.
 But while debt galloped, underlying assets did not grow at the same pace.
M&A
The term mergers and acquisitions (M&A) refers to the consolidation of companies or their
major business assets through financial transactions between companies.

M&A’s of banks into securities market

After a tough 2020, banking M&A rebounded with 210 announced transactions as of December
31, 2021—an 89% increase from the prior year’s 111 deals—and an average deal value of $693
million, a healthy rise from 2020’s average $546 million. 2021 also had the largest number of
transactions over $500 million in enterprise value since the financial crisis going back to 1998.
And 2021 was a banner year for megadeals as banks sought scale, capabilities, business lines,
and markets to compete against larger rivals. The five largest announced deals all topped the $5
billion mark.

Investment management (IM) and wealth management (WM) deal volume as of December 31
increased 50% year over year—316 deals versus 210 in 2020. Volume again skewed heavily to
asset management and wealth management versus broker-dealer transactions. Compared with
2020’s megadeals, IM/WM transactions were smaller, accretive acquisitions by firms seeking
greater scale in current markets or expanding into areas offering higher returns. This focus is
reflected in 2021 average deal value, which fell from 2020’s record-setting high of $1.08 billion
to a more modest $536 million.

2021 M&A activity—both among fintechs and between banks and fintechs—again trended
upward. Deal value for US-based targets as of December 31 increased 12% year over year to
$1.16 billion, compared to $1.03 billion in 2020; deal volume rose 31% year over year, from 164
to 216 transactions. Investor groups were responsible for 2021’s largest announced US-based
fintech deals, with fintechs offering insurance and health care technology, security technology,
financial media and data solutions, and human resources and payroll technology popular targets.