Class 17

Integrating credit risk with other core risks in bank:

Banking operation: Banks operate in a loop. The loop starts with a lender who deposit their money in
the bank asking for a return on it at a certain lending rate. The bank then uses that money to lend it to
borrowers asking them to return it with interests at the borrowing rate which is higher than the lending
rate. When the borrower returns the loan plus interest, the bank uses that money to pay off the
depositor’s loan plus interest. Since the borrowing rate is higher, the bank retains an amount of money
which is the bank’s profit. Hence one of the most significant variables for a bank is the interest rate.

Lending interest rate = Base Rate + Risk Premium

Base rate = Cost of funds + cost of administration + cost of equity

One of the most important performance variables for a bank is the amount of non-performing loans. The
lower the amount of NPLs, the lower is the cost of fund. So, banks like SCB can charge lower lending
rates and would still make profit. Cost of funds also decrease if the bank’s corporate banking is strong.

What is credit risk?

Credit risk is the risk associated with the bank defaulting – meaning the bank’s failure to repay its
debtors. The part where bank lends money to its borrowers is the part where the credit risk arises first. If
borrowers are not properly evaluated and sub prime loans are given out, it will increase the risks of their
defaulting. This is known as adverse selection. To solve this issue, credit rating is a mechanism that could
be used. However asymmetric information could also lead to moral hazard – where borrowers do not
use the funds for which it was taken for. That also subsequently increases the risk of defaulting and
hence credit monitoring is done to solve this issue.

However, credit risks is the final hurdle of the whole progression. Before getting to the credit risk, the are
some other risks that contribute to it. If borrowers can’t pay back money, it leads to maturity mismatch
or maturity risk. This will cause banks to manage money from other sources to back the depositors. The
bank will ask for money from different sources which will trigger the interest rate and hence the interest
risk. Even then if enough money isn’t managed, it will lead to a reputation risk. As depositors’ trust on
the bank diminishes, they will start withdrawing their funds leading to capital risk. When no more
money is left, the bank will fail to repay its depositors – represented by the credit risk.

The bank should target having lower credit risks because lower credit risk increases credit quality which,
in turn, reduces the capital requirement that ultimately reduces the overall cost of capital.

The bank needs to keep minimum capital which is the higher of TK400 cr or 10% of Risk-Weighted Asset.

Customer segment:

1. Retail Banking (B2C)

2. Corporate Banking/Wholesale Banking (B2B)

Banking Operation:

1. General banking: Deals with dishonored cheques, cheque forgeries, cashiers, etc
2. Credit division: Credit risk management, credit recovery, loan and advance, etc
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3. Treasury division: Asset liability management, capital management, risk management, foreign
exchange.
4. ITPF: LCs
5. Financial reporting and ICC: Reporting and auditing, Compliance
6. HR
7. IT: Credit card systems, etc
8. Shariah Banking

In addition to the general 5 financial documents, bank must also make documents of OFF BALANCE
SHEET ITEMS and LIQUIDITY STATEMENT.

How can banks maximize profit?

Banks can maximize profit either by increasing revenue or decreasing expenses. Revenue could be
increased by increasing the borrowing rate. However, that increases the risk as well and so banks
generally don’t work in this scope. They focus more on decreasing the deposit rate to obtain cheaper
sources of fund.

CASA ratio: (Current A/C + Saving A/C)/Total deposit

Banks also prefer opening current accounts more than Savings accounts and FDRs, because there’s no
interest in current account whereas Savings accounts require medium interest rates and FDRs require
high interest rates.
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