Professional Certificate Program

‘Risk Management in Banking and Financial Markets’

- Prof. PC Narayan

Banking and Financial Intermediation: Concepts, Risks, Capital

and Regulation
Week 03 – Summary

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan


Overview of Risk Management
Risk management is about protecting the downside, that is, minimize the losses if the
future outcome turns out to be the opposite of the view taken by the decision maker.
The world of banking and financial markets is grounded in the concept of ‘risk-return
relationship’: higher the risk, higher the expected return; lower the risk, lower the
expected return.

Types of Risks:
There are various types of risks encountered in the world of banking and financial
markets. These include:

The failure of a borrower or an issuer of bonds to meet his contracted cash

Credit outflow obligations on a loan he has taken or a bond he has issued

Risk

The risk associated with assets and liabilities that are ‘contingent’ (i.e.
could result in claims in the future) on the financial institution and hence
Off-Balance-
Sheet Risk reported outside its balance sheet, as ‘off- balance’ sheet items.

Direct or indirect losses resulting from failed or inadequate internal

processes, people, break-down of information technology, etc
Opera&onal
Risk

The potential inability of any financial institution to generate additional

Liquidity liabilities to cope with the decline in its liabilities or increase in its assets
Risk

A financial institution not having adequate capital or net-worth to cope

Solvency with a sudden or steep decline in the mark-to-market value of its assets
Risk

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

The sensitivity of income and capital to volatilities in interest rates

Interest
Rate Risk

The gains or losses that arise due to fluctuations in the foreign exchange

Foreign rates
Exchange
Risk

The potential adverse impact on the price of financial assets such as

bonds and equity stocks due to of factors that are exogenous to the firm,
i.e., factors outside the firm's control, largely a result of macroeconomic
Market
changes. Market risk largely comprises of interest rate risk and foreign
Risk
exchange risk.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan


Risks in Retail Lending
Retail loans are small value loans given to large number of customers, usually running into
several thousands. Retail loans include home mortgages, loans to buy motor cars, personal
loans, credit cards, etc.
Given the large volume of loan applications that need to be processed, automated credit
scoring models are deployed to evaluate and approve these loans.
Banks evaluate and approve loans to consumers (retails customers) using automated credit
scoring models based on
A. The information elicited by the lender from the loan applicant including existing
mortgage payments, outstanding payment against credit cards, repayment towards
other personal loans, etc. and
B. The credit score obtained from credit bureaus such as Equifax, TransUnion, etc.,
Credit bureaus use sophisticated statistical models to compute the credit score for
every individual reflected in their database and make it available to lenders when
they request for such information. The loan applicant’s credit scores obtained from
the credit bureau serve as an additional input to the credit scoring model used by
each lending institution.

Precautions taken in Mortgage Loans

Ø Establishing the title and legality of the property against which the loan is being
extended
Ø Ensuring that all taxes on the property have been paid up-to-date
Ø Undertaking ‘title search’ to ensure that there are no other claimants against the
property that is being funded by the proposed loan
Ø Establishing through real estate appraisers, the market value of the property vis-à-vis
the price at which the purchase is being funded.

Precautions taken in Credit Card Outstanding

In the case of a credit cards, the potential delinquency is managed proactively (not re-
actively) based on what is popularly referred to as ‘revolving credit’ i.e. the revolving nature
of the outstanding amount and periodic repayments.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

If the amount repaid by the holder of the credit card is less than the amount billed in the
monthly credit card statement i.e. the payment rate is less than 100%, the customer is
charged interest on the unpaid amount. Persistent default could result in further penalties
and perhaps suspension of the credit card facility altogether.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan


Risks in Lending to SMEs
Lending to small and medium enterprises (SME’s) is often more difficult than lending to
individual customers because lenders are required to assess and ensure the credit-
worthiness of these businesses that are run by individuals. Furthermore, most of these
businesses are generally not publicly listed in the equity stock exchanges. As a result, the
level of disclosure and financial information available in the public domain about these firms
is not as exhaustive and as reliable as for listed firms.
Appraising the credit risk of such entities involves a combination of
(a) analysing the financial statement of the enterprises and
(b) behavioural analysis of the owners of the business generally achieved by what is
normally referred to as the ‘5 C's of credit’ detailed below

5 C’s of Credit
Character: The borrower’s intrinsic desire or ethical conduct to honor the terms and
conditions of the loan.
Capacity: The borrower’s ability to repay the principal and the interest as per the agreed
terms.
Capital: Quantum of equity capital and extent of 'leverage', i.e., the current debt to equity
ratio, as reflected in the company's financial statements.
Collaterals: The assets that the borrower will offer as security against the loan.
Country: The economic trends and developments both in the industry sector in which the
borrower’s business is positioned as well as the macro-economic context of the country
where the business is located.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan


Measuring and Managing Credit Risk: Corporate Borrowers
Measuring and managing credit risk for corporate borrowers, where the loan sizes are large
and the tenure of the loans are long duration, is different from managing credit risk of retail
borrowers or SME’s.
There are four time-tested methods used for this purpose.
1. Credit Appraisal

Credit appraisal involves a careful scrutiny and analysis of the prospective borrower covering
the following:
1) Ownership and management: Evaluating the ownership profile of the firm, i.e.,
whether the company is closely held or widely held. If closely held, assessing the
pedigree and profile of the promoters, (i.e. the major shareholders) as well as the
performance record of the top management of the firm, both past and present
2) Operating efficiency: Operating efficiency of the firm measured in terms of its
growth trajectory, market share, and operating profits
3) Financial efficiency: Financial efficiency includes the current financial leverage (i.e.,
the debt/equity ratio) of the firm, the ability of the firm to raise long term funds, its
cost of capital, its resilience in managing working capital, etc.
4) Industry specific or market specific factors: These include
Ø The business or industry cycle such as recession, inflation or deflation in the
economy
Ø Changes in the regulatory environment which could increase cost of
compliance
Ø Threat from substitutes to the company's products and potential shift in
consumer demand
2) Pricing of Credit Risk

A very important and proactive aspect of managing credit risk is pricing the loan. The price
(or interest rate) charged on a loan by a lending institution should cover
Ø The cost (i.e. the interest rate) at which the lending institution has raised financial
resources to fund the loan.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan


Ø The overheads i.e. the salary paid to its employees, rental and other infrastructure
costs
Ø The lender’s budgeted profit margin on the loan
Ø The expected losses on the loan due to potential default by borrowers.

Lending institutions arrive at the base rate based on the above factors that would be
identical for all borrowers from that lending institution’s perspective To that base rate, the
lending institutions adds a credit risk premium to arrive at the final lending rate for each
borrower.
The credit risk premium represents the additional interest rate that must be charged to the
borrower as a precaution against potential default on the loan. Credit-risk premium is
calculated based on the expected losses on the loan which could vary from borrower to
borrower. The credit risk premium for each borrower is computed based on the borrower’s
probability of default and the quantum that can be recoverd in case of default.
Credit Risk Premium is computed using the formula

Where,

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)

 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

3. Monitoring the performance of the loan

Monitoring of loans to proactively determine and manage default risk can be viewed both at
the micro level and at the macro level.
Ø Micro Level

Micro level monitoring of credit risk is normally achieved through ‘early warning
systems’, as they are popularly known. These include
I. Perceptible delays by the borrower in meeting his repayment obligations on the
loan.
II. The financial projections vis-à-vis the actual financial performance of the borrowing
firm or the project that has been funded by the loan.
III. ‘Credit turnover’ and ‘debit turnover’ in the account the borrower has with the bank
i.e. the lending institution.

4. Provisions for potential losses

Ø Macro level

At the macro level, mitigating credit risk is achieved through

I. Provisions in the balance sheet of the lending institution.
Provisions are computed based on the statistical likelihood of default. Such potential
losses are charged to the current year's profit and loss statement i.e. income
statement.
II. Capital adequacy ratio (CAR)
Also referred to as Capital to Risk Assets Ratio (CRAR), this ratio came into force
about two decades ago, based on the recommendations of the Basel committee, set
up by the Bank of International Settlements (BIS), and has been uniformly
implemented across countries as a robust measure to manage risk, particularly credit
risk.

**********

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the
Professional Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM
Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Indian Institute of Management
Bangalore (bfmrm-support@iimb.ac.in)