You are on page 1of 27

Risk management in banks

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

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

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

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

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

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

and procedure relating to granting credit.  Principle 14: Banks must have an independent risk management system and possess which should be communicated to the board of directors  Principle 15: Banks must see that giving credit is probably managed and have internal controls to check any or check the expectations are reported on time.  Principle 11: Banks must have information system analytical techniques to measure credit risk in all activities.  Principle 12: Banks must have a system to monitor the quality and composition of the credit portfolio  Principle 13: Banks must consider the possible future changes in economic condition and then asses and check the credit risk.  .  Principle 17: Supervisors should conduct independent evaluation of banks strategies.  Principle 10: Banks must develop and use an internal Risk Rating system.  Principle 16: Banks must have the system for quick remedial action on any credit related problems.Principle 8: Banks should have system to administer all risky portfolios. policies.    Principle 9: Banks should have a system to administer condition of individual credit.

The quality of credit management determines success and failure of bank   2. availability of funds. balance and structure of liabilities. Their national policies are: To allocate the financial resources efficiently to pramote economic growth Credit policy includes the regulatory environment. losses and earn profit for share holders. The institutional objectives are To have adequate liquidity of assets for withdrawal. The elements are: Well developed credit policies and process Strong portfolio management Effective credit control Well trained staff 3. loan portfolio.The objective of credit and risk management            1. expenses. risk selection. .

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

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

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

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

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

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

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

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

A major part of the finance is bad debt.t. seeds. have fixed interest rates to be repaid in EMIs.  Non fund based credit They are letter of credit and letters of guarantee. The major mode is term loan.  Loan for infrastructure/project finance:  It involves creation of legally independent project company with equity for about 5 to 7 years. Interest rates are higher default risk.  Loans to consumers or retail lending: individual customers’ need banks finance to buy consumer durable goods. housing e.c and the revenue is generated after crops are sold. The banks extend these loans for one to five years and can be longer. education. fertilizers e. Long term loans are for buying land equipment or life stock and these are paid out of sales cash flows. syndicated loans or by issuing bonds.Loans for agriculture:  These loans are mostly short term for purchase of inventory.t.  .c. They carry equal or more risks because the banks has to pay the beneficiary if the borrower fails to pay.

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

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

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

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

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

  The industries where credit off take has picked up were gems and jwellery. According to RBI.2 compared to 10. At the same time food credit contracted by 7. One of the main reasons strong growths in credit off take from these sectors is because exports have growth significantly. textiles and computer software.8% in the period between April to December FY 03 compared to the same period last year. the gross credit to the industrial sector has grown by 9. steel. Net non food credit has given 15.9%.7% in the period between FY 03.  .9% in the same period.The changing trends in bank credit      Till financial year 2002-2003 banks were very profitable and growth was strong due to increase In credit lending 12.

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

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

Focuses on input and output    Routine collection of information  Tracking implementation progress  Measuring efficiency  Steps to design monitoring system:  Plan for monitoring  Developing the results framework  Develop information sources and design  Complete and test the system  Annual self assessments and periodic external evaluation  Establishing monitoring unit  Centralized/project specific  Collaboration across co-implementing institution  Need for successful monitoring:  Monitoring must have strong ownership support from leaders.  Management requires expert support  Monitoring needs broad stakeholder’s consultation in defining and setting target indicators  Monitoring training is essential for success  Monitoring system use to be user friendly . Monitoring:  The gathering of evidence to show what progress has been made in implementation of programmes.