Muhammad Hamad Fa09-BBA-057 Department of management sciences COMSATS institute of information technology Islamabad

CHAPTER 1

FINANCIAL SYSTEM AND STRUCTURE

1.1

Introduction

A stereotype view of bankers and other financers is that they are evil genius, brilliant or both. There is no doubt that there are always black sheeps present in every department, and sector of the economy which due to greed or their vested interested did mistakes and took advantage of the system while hurting other stakeholders but normally financers and bankers like other people in society did a great job for the betterment of human race. To understand the financial system with all its glory and complexity one must be sharp enough to judge things happening in the economy on the basis of truth and ground realities. It must be kept in mind that financers and bankers are like other professional, politicians, scientists, professors, and government officials did mistakes in past and there is no guarantee that mistakes wont happen in future because no one on this planet is perfect; perfection lies with nature only. Adam Smith in his book An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776 said; But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their advantage to do for him what he requires of them. Economic development of a country depends on number of factors among all those factors financial system has a vital role to play for the economic development. As financial system connects the savers with investors and channelize funds from surplus units of the economy to deficit units. Creating a link between borrower and lenders is the function of financial system. Borrowers include inventors, entrepreneurs, government agencies, households and established businesses which have identified profitable projects but they dont have funds to capitalize on their idea (revenues < expenses). Lenders are those households, businesses, government and non government agencies which have excess funds meaning their revenues are greater than their current expenses. The financial system performs the important function of creating a bridge between these two units of economy, or savers to borrowers. If there is no existence of financial
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system the money will not flow from the surplus units to deficit units, as a result economic activity as well as circulation of money will be limited. And many productive activities wont be carried out due to lack of funds available. Financial system can be defined as it is a network of interconnected banks, intermediaries, markets and facilitators which perform three major functionsallocation of resources, sharing risk, and intertemporal trade as shown in fig 1.1. Sharing risks means that financial system shares risks attached with the initiation of new projects, new product development, going global, competition, and all those external and internal risks of business to which business is exposed. Allocation of capital is a process through which financial system provides funds to those sectors of economy which are in an urgent need to have funds to carry out profitable activities. Different sectors of economy compete with each other to get funds from financial system and it is the responsibility of financial system to allocate capital to most efficient units of economy to reap the benefits of their profitable activities, thus enhancing economic development. Third function of financial system is helping in intertemporal trade. Some time individual, small companies, and those dealing in growing markets have enough wealth to convert their ideas in to profitable activities that is internal financing but it is rare phenomena that any unit of economy has sufficient amount of funds available to meet their requirements. Most of the individual and companies has to seek the help of financial system to generate enough amount funds to finance their projects that is external financing. Now matter external financing is equity based or debt based one has to seek the help of financial system to full fill their current needs. Fig 1.2 shows the dual status of an individual in financial system. And this dual function is carried out by almost all the actors in the financial system at one time they are providers of funds and at times they seek funds from financial systems.
Figure1.1 Source: Lecture material

Sharing risks

Allocating capital

Intertemporal trade

Why we need a financial system is basic question? And why individuals and business cant raise funds without the help of financial system? Are some basic questions regarding the financial system and its importance? Answer to these questions is simple and discussed below. Argument for financial system there are number of reasons due to which financial system is required. Firstly it is difficult for lenders to find suitable borrowers which will use the funds of lender in right direction and will pay back the principle amount as well as cost of funds. Secondly the process of lending requires some fixed cost and these cost are greater than rewards
Figure 1.2 Source: Lecture material

stemming from lending for individual lenders or small group of lenders. Its not to say that small financial institutions and individual lenders cant do a great job but for a business it is necessary to achieve minimum efficient scale. Minimum efficient scale is that level of business that is necessary for a business to continue its operation. Financial system achieve efficiencies due to two reasons first one is specialization and second it economies of scale fig. Financial system is made up of banks and other financial institutions for which lending is prime function so they become specialized in advancing loans to deficit units and they achieve economies of scale by providing their services to a large number clients. Asymmetric information is a problem faced by financial system which limits its efficient working. Simply stating asymmetric information means that one party in the contract has superior information than other party; and the one with superior information exploits other party. Particularly for financial system it means when borrower has more information than lender. Two other issues which originate from asymmetric information are adverse selection and moral hazard consequences of asymmetric information are shown in fig 1.3. Adverse selection is pre
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contractual behavioral issue that those borrowers which have high level of risk offer higher interest rates to get the loans and most of the time they successfully raise funds. It is said that if lenders are aware of this selection bias they will never give their money out and take lending risk ever. Moral hazard is post contractual problem which states that there is change in intentions and behavior of borrower after receiving money from lender. For example a borrower raised funds to open a restaurant but after having money in hand he starts thinking of short cuts use money in gambling, and makes other speculative investment completely forgetting the interests of lender. Another example is that if someone has fire insurance they may be more likely to commit arson to reap of insurance. Financial system cant eliminate the problem of asymmetric information but it tries to minimize its effects. By the means of carefully screening the applicants for credit and insurance, and after the transaction by monitoring their activities. With asymmetric information business can raise funds on relatively cheap interest rates that allow them to be more efficient, and creative. By providing liquidity and capital to business through financial markets and intermediaries financial system overcome the problem of asymmetric information. Financial instruments also called financial securities are used to raise funds. Financial security is contract between lender and borrower which specifies the obligation of the borrower, the rewards of the lender, time of the contract. Simply saying a financial security describes who owes what to whom, under what condition payment become due and the mode of payment as well. There are three major classifications of financial instruments- debt, equity, and hybrid. Debt instruments are those instruments which show a lender borrower relationship and stats that after how much time the principle amount and interest payments become due. Equity instruments present ownership stake of an individual in a specific organization like shares. Hybrid financial instruments are those securities which have characteristics of both debt and equity instruments examples are preferred stock and convertible bonds.
Figure 1.3 Figure 1.3 Source: Lecture material
Adverse Selection Transaction with Asymmetric Information Moral Hazard

Financial markets can be grouped on the basis of issuance, and maturity of

Money Markets
Less than 1 year maturity T-bills Commercial paper L/Cs Bankers acceptances

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

Derivatives Markets
Options

instruments. On issuance base there are two types of financial markets- primary market and secondary market. Primary market is that market in which a company offers its securities for first time that is also called IPO initial public offering. Secondary market is that market in which

Futures

Swaps

Figure 1.4

Source: Lecture material

already issued securities are traded, secondary market is important in the sense that it provides investors the opportunity to sell their securities when they need cash or due to any other reason. Over the counter market is also becoming popular that is basically a network of brokers and deals worldwide, which helps in sale and purchase of securities. On the basis of maturity financial markets can be classified as money market, capital market, and derivative market fig 1.4. Money market is a market in which short term financial securities having maturity of one or less than one year like certificates of deposits, T- bills, commercial papers, and banker acceptance are traded. In capital market long term debt and equity instruments are traded which has maturity of more than one year. Example of capital market instruments are stocks, and bonds. Derivatives contracts trade in a third type of financial market which allows investors to spread and share a wide variety of risks the instruments involved are options, future, and swap. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that consolidates bank deposits and uses the funds to transform them into bank loans (Wikipedia); other examples include insurance agencies, dealers, and brokers. The definition of financial intermediaries given by Van Horne in his book financial management is; Financial intermediaries are financial institutions that accept money from savers and use those funds to make loans and other financial investments in their own name. They include commercial banks, saving institutions, insurance companies, pension funds, finance companies and mutual funds

Commercial banks are the most important source of funds for companies and individual, banks accept deposits from household, firms, and government, which are liabilities of bank and advance short, medium, and long term loans to deficit units of the economy. Insurance companies are in the business of collecting periodic payments called premium from those they insure in exchange for providing payouts if any adverse event occur. There are two types of insurance companies- property and casualty insurance; there other one is life insurance companies. Property and casualty insurance companies insure against thefts, accidents, fires, and other unpleasant events of similar nature. These institutions invest mostly in those securities which are tax exempt. They also invest partly in corporate stocks, and bonds. Life insurance companies insure against loss of life, these companies are tax exempted so they heavily invest in stocks, bonds, and make other long term investment which yield more than investing in tax exempted securities like municipal bonds. Other financial intermediaries include pension funds, mutual investment funds, and finance companies. The critical decision for borrowers is that whether to use financial markets to raise funds or they should go to financial intermediaries. This decision depends on the costs involved in obtaining funds. Which alternative offers low level of cost the will be selected. For example for a reputed organization it will be easy to raise funds by financial market through issuance of bonds at relatively low cost but a newly established firm found that it will beneficial to get a loan from bank. On the other side of picture lenders or investors face tradeoff between, risk, return, and liquidity. Investors want low risk but higher level of return and liquidity which in most of the cases is not possible. If an instrument offers high return the level of risk involved will also be high. Investors invest their savings in market or intermediaries depending upon how much risk they can take, what are their liquidity requirements, and the most important element is promised returns. Financial systems are complex mechanisms to channelize funds so there is need to have a watch dog over the participants so that the system delivers its best. Usually this regulatory authority is the central bank of the state which through its policies tries to maximize the effectiveness of the financial system. Regulatory authority plays four major functions. Firstly by ensuring transparency in system try to minimize the problem of asymmetric information. Secondly acts as lender of last resort when any participant get into trouble and no one lends money then regulatory authority lends money for the smooth functioning of system. Thirdly by ensuring the easiness of entry and

exit regulatory authority tries to enhance the efficiency. Fourthly through its policies protect the interests of lenders and borrowers.

1.2

Conclusion

A sound and established financial system is the prerequisite for economic growth. If financial system does not exist the savings of investors will not be sufficient enough to fulfill their future needs at the same time entrepreneurs wont be able to convert their ideas into physical goods restricting the improvements in standard of living. Financial system offers a lot of option to lenders and borrower to invest and to raise funds respectively depending upon their requirements. Asymmetric information is the biggest problem face by financial system its a constraint on smooth and efficient working of financial system. Central bank which is the regulatory authority for financial system tries to ensure transparency which reduces asymmetric information but government can only act as a helping hand for financial system.

CHAPTER 2

FINANCIAL CRISIS

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2.1

Introduction

Financial crisis is not a new phenomenon for the world economy, over past five hundred years many crisis have shacked the financial systems. Sometimes financial crisis even lead to major social and political developments like after the financial crisis of 17641768 and 1773 American Revolution started. And after her independence America faced many financial crisis in 1792, 18181819, 18371839, 1857, 1873, 1884, 18931895, 1907, 19291933, and 2008. The prime reason for the occurrence of financial crisis is the asymmetric information that leads to create a trust deficit among lenders and borrowers. Lenders no more show confidence in working of financial system and they start pulling out their monies. Financial crisis doesnt change the real

economy unless a recession or depression occurs. Interest rates raises, increases in level of uncertainty increases, government fiscal problems all have bad consequences on economy and this is termed as shocks. Five shocks alone or after certain time period may lead to financial crisis. Creation of asset bubbles may also lead to financial crisis. This chapter will focus on financial crisis, its types and reason, asset bubbles and how and why they are created, financial panics, the reasons behind current financial crisis, and the role of government to minimize the chances of occurrence of financial crisis in detail fig 2.1 shows a snap shot of
Figure 2.1 Source: Google images

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financial crisis. Financial crisis is defined as financial crisis is a situation in which one or more financial markets or intermediaries cease functioning or function inefficiently. There are two major types of financial crisis- systematic and non systematic financial financial crisis crisis. the

Systematic

affects

economy as a whole great depression is example of systematic financial crisis while non systematic financial crisis effects only to specific sectors of the economy i.e. saving crisis, credit crunch and etc. If non-systematic financial crisis are not properly controlled they become systematic financial crisis which hurts whole financial system fig 2.2 shows this phenomena. Either it is systematic financial crisis or non systematic financial crisis it hurt the flow of funds from savers to investors, and it also become more difficult to spread risk. The reasons for financial crisis are- increased uncertainty increase in interest rates, government fiscal problems, balance sheet deterioration, banking problems and panics. Increased uncertainty when investors have doubt about their future earnings by investing due to inflation and other reasons than to be on safe side they hold their money instead of investing in productive activities which lead to decrease in economic activity. Increase in interest rate when interest rate in economy increases it become expensive for borrowers to get loans. Increased interest rate also lead to adverse selection as most risky borrowers offer high interest rate to get loan, when these borrowers are unable to pat back default rate increase. For those businesses which hold government bonds increase in interest rate cause balance sheet deterioration decreasing the net worth of the business. Government fiscal problems those governments which spend more than they receive as tax have to borrow from financial markets and intermediaries. When the level of debt increase it become difficult for government to service debt, which lead to decrease in value of government securities and devaluation of currency. When currency devalues it become difficult for firms which have raised
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Figure 2.2 Source: Lecture material

finances from international market to meet their obligation and the result is default. Balance sheet deterioration when the net worth of companies fall due to decrease in value of assets or increased value of liabilities than most of the businesses tend to involve in riskier activities because they have less on stake. Due to balance sheet deterioration adverse selection and moral hazards occur agency problem also plays its role. Banking problems and panic banks are most important participants of financial system. When due to any reason balance sheet of bank got hurt, bank will reduce lending to avoid bankruptcy, or to meet the requirements of regulatory authority. Decreased lending hinders the flow of funds from investors to entrepreneurs reducing the economic activity. When a bank fails other banks in the system also suffer due to two major reasons, firstly banks often owe each other considerable sums and secondly when a bank fails customers of banking system lose confidence in banking system; they rush to their respective funds to with draw their money. The above discussed five points increases asymmetric information, and decrease economic activity. Exchange rate crisis occur and like an ice ball starts getting bigger and bigger, that is the point where recession turns to depression. Asset bubble means a rapid increase in value of an asset; assets might be a financial asset like bond, or any other form of security or any physical asset like real estate etc. causes of increase in value of asset are low interest rates, new technology, increase in demand, and leverage. Low interest rate there is inverse relation between interest rate and present value of asset. The fall in interest rate leads to increase in present value of any asset. According to present value formula that is PV = FV/(1 + i)n when i in formula gets smaller present value gets higher. Low interest rates can cause bubbles by lowering the total cost of asset ownership. Expectation for the invention of new technology increase g in Gordon growth model which ultimately leads to increased present value. Increase in demand of an asset may also cause asset bubble, demand increases when investors have expectations that future value will rise. When news about increase in price of asset affects economy rather than economy affecting demand this is the situation when asset bubbles are created. When investors use leverage that is borrow more than their own saving to maximize their return this can lead to creation of asset bubble, most leverage investors are not too much smart because higher the risk higher the return. Financial panic occurs when leveraged financial intermediaries must sell assets to meet lenders call. Lender ask their money back either due to increase in interest rates or decrease in value of
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collateral. Calls are normal every day part of business operations but due to burst of an asset bubble calls they come in such a way that borrower cant mange. During panic situation

Shock
Interest rates rise Asset values fall

Sell off/defaults

everybody sells and with a very few number of buyers, highly leveraged firm find it difficult to sell quickly or at fair price to meet the call and repay the money as result bank start suffering. Interest rates go up and lending reduced when due to panic situation
Figure 2.3

More sell off/defaults

Credit tightens
Interest rates rise Lending volume falls

Asset values fall

Source: Lecture material

deleveraging of system took place causing negative asset bubble. High interest rate and low value expectations drove prices low. During financial panic volume of lending is reduced hurting the real economy which cause unemployment to handle the situation lender of last resort plays its role by adding liquidity in the system, increasing money supply, lending to worthy investors and making up beat statement about economy fig 2.3. Most common form of lender of last resort is government central bank through which government implements its policies; though some other institutions like IMF tried to act as lender of last resort with a mixed level of success. Bailouts, by contrast, restore the losses suffered by one or more economic agents, usually with taxpayer money. The restoration can come in the form of outright grants or the purchase of equity but
often takes the form of subsidized or government-guaranteed loans. Nevertheless, if the lender of last

resort cannot stop the formation of a negative bubble or massive de-leveraging, bailouts can be an effective way of mitigating further declines in economic activity. The most recent crisis occur because of nonsystematic subprime mortgage crisis of 2006, when loans were advanced to even the individual who dont have job or any other source of income at a low interest rate. In 2008, the failure of several major financial services companies turned it into the most severe systemic crisis in the United States since the Great Depression. The troubles began with a major housing asset bubble and Mortgages which became much easier to obtain. Regulators allowed such practices in the name of affordable housing, even though six earlier U.S. mortgage securitization schemes had ended badly. In June 2006, housing prices peaked, and by the end of that year it
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was clear that the bubble had gone bye-bye. By summer 2007, prices were falling quickly. Defaults
mounted as the sale/refinance option disappeared, and borrowers wondered why they should continue paying a high mortgage on a house worth low than that. The government responded with huge bailouts of subprime mortgage holders and major financial institutions.

2.2

Conclusion

Many theories have been offered on the topics of how financial crisis occur and how to prevent them but there is a little consensus, and financial crisis is still a regular phenomena for the economies worldwide. Interest rate increase, balance sheet deterioration, government fiscal problems, banking problems and panics, and creation of asset bubbles all may lead to financial crisis. It is the responsibility of regulatory authorities to make policies in order to keep a check on smooth operations of financial system by decreasing level of uncertainty, and asymmetric information.

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CHAPTER 3

BANK MANAGEMENT

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3.1

Introduction

Balance sheet of an organization shows financial strength of firm at a particular date. Due to nature of business in which banks are involved i.e financial intermediation their financial statements are quite different from any other business. Financial statements of banks merely show the risk that banks take in performing their function. Table 1 shows simplified balance sheet of a typical bank. Liabilities Deposits Short term/ Demand Medium term Borrowings Capital and Surplus 65 20 5 10 Cash Loans and advances Short term Medium term/ long term Investments Fixed assets Total 100 Total Table 1 The above balance sheet shows following characteristics Sources of funds are primarily short term in nature with short term maturities. Financial leverage is very high, this is risky and can lead to earning volatility. Due to nature of business fixed assets are low. Interest rate change may hurt banks income because banks heavily invest in loans and advances which are subject to interest rate volatility. Operating leverage is relatively low due to comparatively lower fixed costs. 30 25 40 20 100 Assets 3

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Bank liabilities- bank liabilities are classified on the basis of maturity and interest rates. Major bank liabilities are demand deposits as shown in table 1. Banks assets on the other hand are made up of cash, loans and advances, investments and fixed assts. Loans and advances are most important component of
Figure 3.1

Have enough reserved to satisfy deposit outflows

Use efficiently enough to earn profit

Source: Lecture material

banks assets. Banks must ensure to manage assets and liabilities to develop right mix of liquidity and profitability. There is tradeoff between liquidity and profitability as shown in fig 3.1. A bank must make sure that it has enough reserves to meet customers demand for cash in a way that it doesnt hurt profitability. This is called liquidity management. Like goal of any organization banks are doing business to earn money, for this purpose banks have to create portfolio of its investment to earn maximum by using its assets this is known as asset management. Liability management refers to get funds at a minimum price. Capital adequacy management refers to the concept that bank must have net worth or equity capital to create a cushion against bankruptcy and any loss. To protect themselves from changes in interest rates banks involved in activities which are not shown on balance sheet that is fee based banking. Banks almost charge fee on any transaction now a days. Contingent liabilities are example of off balance sheet items that arises when a customer default on letter of credit etc. Income statement shows items that are sources of income and expense. The major source of earning for bank is interest on loans and expense is interest paid to depositors and other investors. To maximize earning bank must increase the spread that is difference between that rate of interest bank pays to investors and interest rate it receives from borrowers: this only possible when you get cheap funds and lend at high rate. Burden is difference between noninterest expense and non interest income typically noninterest income is not sufficient enough to cover noninterest expense creating burden for bank. Banks net income depends upon following factors Net interest income Burden Provisions for loan
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Profit or loss from sale of assets Tax

Comparison of banks is a difficult job. Which bank is working better and which is not? The answer of this question depends on the way we analyze banks. On method of analysis is DuPont approach. DuPont approach is four step decomposition process of return on equity by this approach analysts try find where a bank is lacking behind and what needs to be changed. Below DuPont approach given by David Cole in 1972 has been discussed. Step 1 Return on equity = Net income/ Average total equity Return on equity can be written as Return on equity = (Net income / Average total assets) X (Average total assets/ Average total equity) Return on equity = Return on assets X Equity multiplier Equity multiplier is a double edge sword. It states that using low level of equity is profitable, equity multiplier signifies the effect of return on asset it increase the earnings when bank is making profit but also signifies the loss when return on asset is negative. Step 2 Net income = Total revenue Total expense Taxes Total revenue is interest income plus noninterest income plus profit on sale of investments. Expense includes Interest expense plus noninterest expense plus provisions. The effect of dividing both sides by average total assets is to decompose return on asset (Net income / average total asset) = (Revenue/ average total assets) - (Expense/ average total assets) - (Taxes/ average total assets) Return on asset = Asset utilization expense ratio tax ratio

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This shows that to maximize return on asset bank has to maximize asset utilization and minimize expense and tax ratio. Step 3 We can decompose revenues as Revenues = Interest income + Noninterest income + Net profit or loss on sale of securities Dividing both sides of equation by average total asset (Revenues / average total asset) = (Interest income / average total asset) + (Noninterest income / average total asset) + (Net profit or loss on sale of securities / average total asset) Asset utilization= Yield on assets + non-interest income rate + profit rate on sale of securities Step 4 Expense = Interest expense + overhead expense + provisions Dividing both sides by average total assets (Expense / average total assets) = (Interest expense / average total asset) + (overhead expense / average total asset) + provision / average total asset) (Interest expense / average total asset) shows cost of funds, these ratios are expense related so lower the ratio is better. Provision rate signifies the asset quality of the bank. To keep expense low a bank can use following strategies Identify surplus expenses and eliminate them. Change product and service strategies to increase revenue. Increase non-interest income to reduce burden.

In this way every aspect of banks business can be analyzed and findings use for decision making purpose. Return on equity = Profit margin x asset utilization x equity multiplier

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Profit margin reflects expense control, tax management, pricing strategies, and effectiveness of marketing.

3.2

Conclusion

Banks are most important component of financial system and helps in development of economy. Banks made flow of funds easy then ever think transferring huge sum of amount from one place to other there are threats involved in transferring cash banks provide the services and transfer fund from one place to another in just few minutes. But there are complexities involved behind the scene bank have to earn profit, mange tax, and decrease burden. For analyzing banks operation DuPont approach provide a simple understanding of banking operations by decomposing return on asset.

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CHAPTER 4

CREDIT RISK MANAGEMENT

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4.1

Introduction

The primary function of the banks in traditional banking is to channelize funds from surplus to deficit units of the economy. Banks get funds from households, firms and sometimes from government institutions at a low interest rate and lend it to deficit units (households, firms); the difference between these two rates is the profit of the bank fig 4.1. Despite of increasing growth in modern banking that is fee based banking interest income remains the major contributor to the banks profit. So in performing its primary function of financial intermediary and extending loans to deficit units of the economy all the banks bear a specific type of risk that is termed as credit risk. There are two reasons for credit risk either borrower wants to pay but he is unable to pay or borrower is not an honest person, both of the conditions are risky as they can lead to serious losses to bank. Loss to the bank may be in the form of reduction in its portfolio or otherwise the actual loss to the bank may happen. If borrower is expecting to pay its obligation to the bank by future cash flows this will lead to the credit risk. Investors are compensated to take credit risk by interest payment, the rate of return is directly related to credit risk i.e. higher the risk higher the return the bonds issued by risky firm offer more interest rates on its debt instruments then issued by stable organizations. Credit risk is calculated by borrowers overall ability to pay this calculation involves character, collateral, and capacity. Just like the systematic risk attached with a non banking institution credit risk is attached with the bank for its entire life. A banks
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Figure 4.1 Source: Lecture material

performance is judged by its investment quality and if any borrower defaults the bank losses its reputation. Credit risk is attached with every single transaction being held by the bank and there is not even a single situation in which bank can say that there is no credit risk in this transaction. There is difference in credit risk involved in dealing with individuals and firms. There is greater probability that an individual will default on loan due to higher interest rates attached to consumer loans then an institution so that individuals are scrutinized more than firm but it must be kept in mind it is not to say there is no risk is advancing loans to firms. Credit risk can be defined as it is a risk that financial obligations to your bank will not be paid on schedule or in full as agreed by your customer, resulting in a possible loss to your bank. Or simply credit risk is the risk of loss of principle or loss of reward (interest amount) generating from a borrowers inability to repay loan or meet the contractual obligations. There are five types of credit risk which will be discussed briefly here. Lending risk- it is the risk that occurs by the extension of the credit or credit sensitive products such as loans and overdraft which are being given by the bank. Lending risk can be minimized by taking collateral which is the most secure mean to handle lending risk. Lending risk has further two types- direct lending risk and contingent lending risk. Direct lending risk occurs when bank directly deals with a customer in a straight forward transaction which is aimed at some kind of purchase i.e. car financing etc bank bears the full risk for the entire life of the transaction in car financing example bank bears the risk until all the installments (principle + interest) have been made by the borrower and car ownership is transferred to his name that is the life of transaction. On the other hand contingent lending risk occurs when a bank on behalf of his customer assures another party that his customer will meet the terms and conditions of the agreement and if he fails the banks will be responsible to make payments. So contingent lending risk arises when potential customer obligations become actual obligations to the bank. This risk is associated with transactions like letter of credit and guarantees. Issuer risk this risk occurs when bank is involved in underwriting activities: underwriting means that bank promises to an investor about the sale or purchase of securities at a specific price and within a specified period of time and if bank fails on agreement bank has to bear the loss. If the issuer of the securities defaults it will also result in loss to the bank. Mostly investment banks are exposed to this kind of risk as they are more frequently involved in underwriting activities. Issuer risk is interrelated with price risk. Counter party risk counter party is a customer with whom we have an agreement
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to pay each other agreed values at a specific future date. Counter party risk occurs when an organization will not be able to meet its obligations on bonds, derivative credit or on trade credit. The firms which have credit insurance may also face this risk either due to insurer liquidity problems or due to long term strategic issues of the insurance firm. Pre-settlement risk is the risk that a counter party will fail to meet its contractual obligations to the bank before settlement date of the contract. Pre-settlement risk is measured in terms of the current economic cost to replace

the defaulted contract with another customer plus the possible increase in the economic replacement cost due to future market volatility. (Source: Lectures material) Settlement risk is the risk that a counter party will fail to meet its contractual obligations to the bank on settlement date of the contract. It occurs on maturity date when bank exchange funds with other party and may cause serious problems due to timing difference if price fluctuates it may cause more than 100% loss. Principals involved in credit risk management- There are some principles involved in credit risk management that guides credit officers. Firstly before extending any type of credit a sound evaluation of the customer and facility must done to better understand customers funds requirements and his ability and willingness to pay principle as well as interest amount when they become due. Secondly there must be an effective credit management unit that ensures the safety of funds and recovery. Thirdly senior management must define the criteria for lending to help credit officers and set limits about the extension of credit to specific industries according to prevailing economic conditions. Finally internal risk rating must be performed to keep macro risk levels within acceptable limits. Traditional model of Credit risk analysis- Traditional model of credit risk analysis is also known as five Cs approach to check the credit worthiness of the customer. Traditional model of Credit risk analysis is a method for judging a customer on the basis of character, capacity, capital, collateral, and conditions. First C character shows the credit history of the borrower and his willingness to pay it might be measured by looking at trend in credit card bills payment and much other such kind of ways. Second C suggests the ability of the borrower to generate cash flows to meet its future obligations. Third C capital is about the wealth saved by the borrower the more the wealth the more will be the confidence of credit officer in lending money. Fourth C tells about the collateral which the borrower will offer to the bank as the security to pay back
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principle as well as interest payment. The liquidity of the collateral is an important aspect for credit officer. Fifth C is about condition of the market especially downside. Safety of funds safety of the funds being advanced is very much important for the credit officer. While lending and advancing loans bank must be sure that money is going in right hands that is the borrower will use this money in a legal productive activity and will generate enough cash flows to pay back principle amounts and cost of capital. If borrower is not trust worthy and he misuse the borrowed amount by investing in bad portfolio it may lead to the liquidity problems for the bank. New model of credit risk analysis -The new model of credit risk analysis along with considering individual characteristics of borrower also consider the surrounding environment to make decision whether the conditions are feasible to advance loan or not. There are four factor involved in new model of credit risk analysis. First one is External environment not only includes the firm or individual which is applying for funds but also all the other actors playing their role in the environment. Credit officer have to know how this environment affects the borrower and his cash flow generating ability. Second factor is Industry risk- bank has to evaluate the specific risks of the industry in which business is operating. Whether the industry is exposed to high level of risk or not is the basic question for bank. Internal risk internal risks are firm specific risks, internal risk may arises due to management structure of the organization, its policies and etc. Financial risk is most important among four factors of new model of credit risk analysis as it is the risk that increase the credit risk of the firm. By paying attention to all these factors and evaluating the borrower on these parameters it would be easier for the bank to make any decision regarding credit risk involved in the transaction. The new model for credit risk analysis adopt the approach of analysis of broad to narrow that is it analyze the external risk first and then industry risk, internal risk, and financial risk respectively. Business cycle-Business cycle shows economic fluctuation over a period of time. It has for components recession, trough, recovery, and peak as shown in fig 4.2. Recession shows a tendency of economic problems, it is said that if the economic growth is negative in two consecutive quarters the economy is facing recession. At this stage Bankruptcies occur and weak business find it difficult to remain in business. Governments try to avoid recessionary trends by proper use of fiscal and monetary policies. At trough things are worst; trough is characterized by high level of unemployment along with lowest level of production, bankruptcies of banks and
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other financial intermediaries happen due to heavy bad loans. At the recovery stage economy start showing improvements,

employment level increase, stock prices goes up, and business confidence returned,

economy looks much better than trough because the prices which have achieved their lowest stop falling further. At peak economy shows its best with minimum unemployment, level of production increases firms achieve economies of scale and economies of scope, demand level also increase. These fluctuations have special importance for analyst to access the level of risk present in the economy. These fluctuations are measured by changes in national income. National income and its measures are best parameters to analyze the economic condition of a country. Gross national product (GDP) and gross national product (GNP) are the frequently used measures of national income. GDP is defined as the total market values of goods and services produced within the geographical limits of a country; GNP is a better approach to measure national income as it includes GDP plus remittances. GNP is measured by formulae given below. Y =C+I+G+(XM), where Y = National income, C = Consumption, I = Investment, G = Government spending, X =Exports, and M = Imports. After calculation of GNP per capita income is calculated by dividing gross national product by total population. The rate of change in national income has important implications for the business as it shows which sectors are growing in the economy and the yearly variations in the components of national income exhibits trends which may cause threats or create opportunities for business to make more profits. If there is an increase in per capita income this shows that people will demand more as their purchasing power is increasing so this will business confidence in economy. Change in price level is measured by Consumer price index and wholesale price
27
Figure 4.2 Source: Lecture material

index and it is an external risk for both lender and borrower. Inflation is rise in general price level 4% to 5% of inflation is considered healthy for the economy as it promises the suppliers in economy a gradual increase in their revenues thus enhancing economic activity on the other hand deflation has negative impacts on economy. Balance of payment is the difference between receipts and payments of a country due to import and export activities. Study of balance of payment shows the condition of industries that are directly or indirectly attached to imports and exports. If exports are high the demand for the currency of that particular country will also be high that will lead to appreciation of currency if imports are high it will lead to depreciation of currency. A stable political environment, peace and rule of law enhance business activities and growth of business as well, terrorism, civil war, injustice, and riots hurt business badly and this shows external risk for the business. An analyst must pay attention to fiscal policy of the government as fiscal policy describes how and from where government will gerenerate its revenue and where it will spend, which industries are being promoted by the government shows both threats and opportunities for business. Monetary policy shows the interest rates and how government will control the money supply in economy this is given by the central bank to achieve certain goals like stability of price level and exchange rates. Changing patterns in demographics may also pose threats to an existing business the composition of population is changing now young generation demands more than earlier generation. Change in demographics shows demand for particular industries and their earning potential. Culture, social customs, norms and values must be kept in mind while analyzing the riskiness of a specific industry. Regulatory framework also is threat for business operation if the cost of non compliance is high then the risk level of that particular industry is also high. In Pakistan government policies encourage trade but create hurdles for manufacturing concerns. An effective legal system minimizes the risk of the business by ensuring the businessman the right of property both physical and intellectual; this increases the level of confidence of businessman and increase economic activity. Technological industries are the most risky than all other industries because today technology changes over night creating pressures to change every moment for the businesses operating in technological industries. Strong labor union can also cause problems for business enterprise by exercising their hold on labor market which leads to decrease in efficiency of business.

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4.2

Conclusion

There is always some risks attached to any business activity, risk is defined as the actual outcome will differ from expected outcomes. In case of banks it is the responsibility of credit officer to collect the maximum information about the borrower and then use both qualitative and quantitative methods to make decision whether to extend credit or not. While making this decision external threats and risk attached to the working of economy must also be considered because if borrower will default due to economic downside and other external threats it will lead to his in capability to pay back principle and interest amount to bank which lead to serious loss to bank and can even be a threat to very existence of the banks. So it is the responsibility of credit officer to keep in mind all circumstances which can hurt the borrower and then bank respectively.

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CHAPTER 5

INDUSTRY RISK

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5.1

Introduction

In todays rapidly changing environment where every day there are opportunities for business enterprise to make money there are also threats for existing businesses. A number of products have vanished and new products have taken their place. Think of type writers at times they were one of the important assets of organization but after that computers have took over, now computer technology is used in many creative ways which also require change for companies to survive. Like human industries also have life cycle and face critical events in their life cycle. Stages of life cycle of an industry are start, growth, maturity, stability and decline. Every stage has its own challenges but start and decline stages are most important for a credit risk analyst. Because business get funds from banks so it is important for credit officer to fully understand the nature of industry in which business is operating, and the specific risks attached to that industry. If industry is not doing well bank will face loss which might threaten its very existence. To have a better understanding of industry risk it is important to differentiate between types of industry risks. There are two types of industry risk one is risk from external environment- risk from external environment effect all the businesses in economy for example political instability, tax, and legislation. Other type is industry specific risk- these are the risks and pressures faced by a specific industry only for example tobacco products manufacturing companies are
Figure 5.1 Source: Lecture material

facing a great pressure from

society and government. Fig 5.1 shows industry life cycle.

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Permanence of industry is a phenomenon related to the product and technology of the industry. Most of the industries have the permanence which could not be removed but the participants though changes. Sometimes an industry is eliminated from the market scene because of another replacement industry that diminishes or eliminates the need for the original industry. The factor of permanence assumes considerable importance in assessing the prospects of hi-tech industries. Attitude of the government for a specific industry may increase or decrease level of risk attached to a specific industry if government is trying to promote an industry it will extend subsidies provide protection, give tax benefits, and extend loans at low level of cost all will contribute to decrease the level of risk involved on the other hand if government dont want an industry to flourish it just by increasing legal issues involved can limit the operation creating risk for the bank extending loan to such industry and for sure for the industry as well. Factors of production and industry has a strong relationship the four factors of production land, labor, capital and entrepreneurship, there availability and quality create risk as well as opportunities. Land include the free gifts of nature to every one for example water but today the availability of these free gifts are not easy think of beverage companies making drinks how much for them is water. Labor is human basically performing a mental or physical job for monetary reward finding quality labor is also a big issue. Capital is finances available for a credit risk analyst it important to check all the available sources of funds to business. Last factor of production entrepreneur or management is most important if quality factor of productions are available but management dont have necessary skills to produce well by using these resources it will increase risk. Business cycle and industry- Some industries are cyclical while others are not. By cyclical industries we mean those industries which operate only for a specific period of time in a year for example construction firms. On the other hand food industry is not effected by business cycle so it not a cyclical industry. Cyclical industry has more risk than non cyclical industries. Profitability of industry differs from on industry to other depending on demand for products and some other factors discussed next. Competition among the existing firms in the industry- if competition within industry is high then the level of profits will be low, participants may involve in price war like telecom industry in Pakistan. Competition among the existing firms in the industry can be further divide in growth rate, number of rivals, differentiation, switch costs, level of fixed cost, and exit barriers. High growth means low competition as demand is high as every participant is getting its fair share. Higher the number of rivals higher the competition. But if
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products are differentiated by means of branding and other marketing tools than competition will be low. Switch costs are also important is clients has to bear high level of costs to switch from one product to other than competition will be low. High level of fixed cost require producer to produce more for the purpose of decreasing per unit fixed cost, increased production means excess supply and as result high level of competition. Exit barrier which states that the Market rivalry tends to be more vigorous when it costs more to get out of a business than to stay in and compete. Threat of new entrants- states that if it is difficult for new firms to enter the industry it will work for the advantage to existing enterprises. Threat of new entrants depends on economies of scale, first mover advantage, Channels of distribution and relationships, and legal barriers. Threat of substitute also effects the profitability if substitute products are available, then the industry profitability is affected by the factors influencing the substitutes. Take the example of tea and coffee tea producers cant charge too much because people will switch to coffee. Relative price, satisfying ability, and willingness of customer to pay for substitute are those factors which direct threat of substitute and these factors differ from industry to industry. Bargaining power of buyers affect the competitive environment of any industry if buyers have more bargaining power than they will put pressures on participants of the industry for low price, high quality and more value added services, all these add to costs of seller decreasing its profitability. Bargaining power of suppliers also affect the profitability of industry if suppliers are strong they by raising prices, lower quality, and hindering availability of raw material can affect the profits of industry to a larger extent. In this case industry is client and suppliers are sellers. Competitor analysis in the framework of industry analysis is very helpful in giving insight about what other players are doing in industry. Competitor analysis highlights blue oceans the areas and opportunities which have not been discovered yet. Company analysis studies internal risks which generate from firms weaknesses. Decision-making skills, policies and competencies define certain crucial risks that can make or break a business enterprise. For survival of an enterprise strategy, methods, technology, and motivation are key factors. In company analysis firm ask itself different questions and try to answer them to improve its competitive strengths. Understanding of business activity plays important role in study of internal risk. Understating business activity includes the study of products, processes, and operations, raw materials and technology and the ways to increase the efficiency of business. A companys ability to manage risk is shown by past data put previous data alone cant guarantee efficient risk management in
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future. In peer analysis firm compares it performance with those having same nature of business. And with the help of SWOT Analysis Company finds what its strengths are and how it can earn money by using these strengths and overcome weaknesses so that these weaknesses doesnt become threats in future. Management analysis shows performance of company with respect to its management practices. Despite having excellent technology and quality raw material if management is not good than firm will fail. Management risk include One-man rule, Joint Chairman/CEO/MGD position, imbalance in top management team, weak finance function, lack of skilled managers, disharmony in management, change in ownership, cultural rigidity, lack of internal controls, low staff morale, fraudulent management, myopic vision (nearsightedness), and inadequate response to change.

5.2

Conclusion

Different industries have different level of risk attached for a credit risk analyst it is very important to understand those risks. Understanding of industry life cycle gives credit risk analyst information about risk because the start and decline stage of industry life cycle are critical with high level of risks. Poter Diamonds five forces explain level of competition in industry high level of competition shows high level of risks. Internal risk along with industry risk must also be kept in mind while advancing loans, because this ensures the safety of funds.

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CHAPTER 6

FINANCIAL RISK

35

6.1

Introduction

Financial risk is the possibility that owners stockholders will lose money by investing in the firm which is using more debt. By using debt a firm maximizes its return on equity with equity multiplier effect. If a firm is using debt then there is possibility that firm may not be able to repay its fixed interest expense if future cash flows are disturbed. If liquidation occurs than the claims of creditors are settled first than stock holder so more financially leveraged firm are more risky the cost of equity also goes up as investors demand more compensation for taking risk. Financial analysis helps to find out the risk attached to an organization which is using debt financing and these findings help to take decision whether to extend loan or not fig 6.1 shows types of financial risks. Importance of financial statements financial statements shows health of any organization at a specific period of time. Financial statements include balance sheet, income statement, statement of cash flow, and statement of owners equity. By using financial statements analyst can analyse the credit risk of the firm and then take lending decisions and monitor the lending portfolio. Audited financial statements are the major source of information to conduct financial analysis because they contain data related to land, building, machinery, vehicles, stock, receivables, cash, bank deposits and borrowings, capital, external creditors, tax liabilities, sales, cost of sales, selling expenses, other overheads, interest costs and cash flows/funds flows, among others. By using previous data of at least five years a credit analyst can check the credit worthiness of an organization and make future prediction. Balance sheet shows the financial position of the firm on a particular date say yearly, semi annually, quarterly or monthly. Balance sheet explains lot of
Figure 6.1 Source: Google images

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queries regarding the borrowers creditworthiness. Balance sheet helps in knowing the capital structure, short-term and long-term liabilities of the business, credit provided by trade suppliers, taxation and other statutory liabilities outstanding, amount of fixed assets and are they put to their best use. Besides looking at the balance sheet and other financial analysis credit executive looks at the borrower from a different angle. Following are the credit executive assessment criteria to look from another angle. Intangibles like good will often contribute to a large extent to firms total assets so it is important for analyst to deduct good will from total assets to exactly know the net worth of firm. Another important component is unsubordinated shareholders loan if unsubordinated shareholders loans are included as part of the equity or shareholders funds this item should be excluded, especially in the case of limited liability companies. Dividends payable must be treated as a current liability rather part of shareholders equity. For more understanding qualitative analysis is done to find out the financial health of the firm through financial appraisal which is the use of financial evaluation techniques to determine which of a range of possible alternatives are preferred. Financial ratio analysis- Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. The level and historical trends of these ratios can be used to make inferences about a company's financial condition, its operations and attractiveness as an investment.Standard Ratios, The relationship between items, or group of items, appearing on the financial statements can be expressed mathematically in the form of Proportions, ratios, rates or percentages. The need of the financial statement analysis arises from the fact that only numeric values dont give the accurate information to the stakeholders of the firm, thus ratios are needed.Net sales of $10 million may appear as a good performance, but conclusions can be made unless they are compared with the total assets. These ratios are helpful in the way that when analyst compares a specific ratio with the industry standards then he can evaluate performance in the competitive market. Thats why a single ratio is meaningless unless compared to other firms ratios or industry benchmark ratio. Financial ratio analysis help analyst to dig down to the operations of a firm and find its strengths and weaknesses. Methods of Comparison- there are different ways through which companys performance are analysed. Historical standards are based on the record of the past financial and operating performance of individual subject business concern. When compared with other years

37

performance then it gives effective meaning. Industry Comparison is comparing firms performance with industry standards going in the market. Comparisons with Industry averages are most valuable for judging the financial health of a Company. Regulatory Requirements are the standards set by the regulatory authorities of the country. State Bank Prudential regulations lay down Minimum Current Ratio that should appear at the time finance is granted. Budget Comparison also called budget standards are developed by Senior Company Management and monitored by them to judge the Company Performance. Such ratios are based on past experience modified by anticipated changes during the account period. Actual ratios are accomplishment of the anticipated targets. Study of the Budgeted and Actual Ratios is also helpful to the credit analyst due to the reason that budget gives understanding of future and current ratios shows financial strength of the organization. Broad Categories-There is four main categories of ratio analysis. Liquidity ratios indicate the borrowers ability to meet short-term obligations, continue operations and have sufficient cash available to meet day to day expenses. Profitability ratios indicate the earnings potential and its impact on shareholder returns. Leverage ratios indicate the financial risk in the firm as evidenced by its capital structure, and the consequent impact on earnings volatility. Operating ratios demonstrate how efficiently the assets are being utilised to generate revenue. Cash flow analysis- It is the study of the cycle of business cash inflows and outflows, with the purpose of maintaining an adequate cash flow for your business, and to provide the basis for cash flow management. However for a lending banker cash flows are more important because the loans are repaid from cash flows. Bank must make sure that the company is managing its cash flows in a prudent manner. Bank will see the borrower capacity to repay the money and cash flow denotes that. Typically, the statement of cash flows is divided into three parts- Cash from operating activities, Cash from investing activities, Cash from financing activities. From the cash flow analysis analyst determine how much cash is generated from the firms activities, and whether it is sufficient to cover loan repayments and interest payments and how efficiently the firm is meeting its long-term and short term obligations with available sources. Sensitivity analysis- is technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bond's price. Sensitivity analysis gives us an idea that which one factor mostly affects the firms or banks
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performance. Credit Risk Assessment- Credit risk assessment gives us an idea why and how is to be used. The purpose of facility mentions why the financing is required, firstly it must be satisfactory from the banker's view and secondly there should not be any restraint from government control, which makes a particular advance impossible. Speculative purpose advances must be avoided. Amount must be reasonable with the borrowers resources. Duration must be according to the business either short term or long term. Credit Information Reports tells us about the past borrowers record. Competence of Management is checked whether they are competent enough to go with right decisions and earn profit for their company. Profitability of the bank, bank ensures its safe side by ensuring that the rate of interest and other Commissions and Fees agreed with the customer provide a satisfactory return to the lending institution. Despite of the fact all these points are considered banks take security from the borrower. Some of the securities frequently offered to the financial institutions are: Lien on Customers own rupee and foreign currency accounts and fixed deposits, Fully negotiable Stock Exchange Securities i.e. bearer bonds, scripts to bearers and government promissory notes, Not negotiable securities, e.g. inscribed stocks or registered stocks and shares, Goods and documents of title to goods, Life Insurance policies, debentures, book debts and ships, Post office and National saving certificates, Gold or silver bullions and ornaments, Mortgage of Landed property including industrial, commercial and residential building, Plant and Machinery. A prudent lending officer should always give due importance to the security aspect of an advance with proper documentation for perfection thereof. The guidelines given by the head offices are duly followed by the branches all over the country for credit control. The salient features of an effective credit control are; the credit facilities must be approved from all the higher authorities of the bank. Sufficient discretionary powers should be given to the branch as well as regional management to enable them to meet local requirements. Credit committees at various levels are important in order to exercise effective control over advances portfolio. Proper record of all advances allowed from time to time should be carefully kept for future reference, examination, reviews and analysis. Recoveries of delinquent loan, recovery of defaulted loan through the Special Assets Management (SAM). Internal and External Audit department by its annual audit identifies and manages the banks risk. Audit functions to avoid errors, frauds and forgeries. Board and senior management approve
39

banks credit risk strategy and significant policies relating to credit risk and its management which should be based on the banks overall business strategy. The overall strategy has to be reviewed by the board, preferably annually. The responsibilities of the Board with regard to credit risk management shall, include; Delineate banks overall risk tolerance in relation to credit risk, Ensure that banks overall credit risk exposure is maintained at prudent levels and

consistent with the available capital, Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function, Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of credit risk, Ensure that appropriate plans and procedures for credit risk management are in place. Risk Tolerance of Bank- The banks purpose is to calculate how much risk can be tolerated and then return earned within limits. The institutions plan to grant credit based on various client segments and products, economic sectors, geographical location, currency and maturity, Target market within each lending segment, preferred level of diversification/concentration and Pricing strategy. The credit procedures should aim to obtain an in-depth understanding of the banks clients. The strategy should provide continuity in approach and take into account cyclic aspect of countrys economy. The strategy would be reviewed periodically and amended, as deemed necessary; it should be viable in long term and through various economic cycles. Credit Policys Credibility-The senior management of the bank should develop and establish credit policies which shall provide guidance to the staff on various types of lending including corporate, SME, consumer, agriculture, etc. At minimum the policy should include; Detailed and formalized credit evaluation/ appraisal process, Credit approval authority at various hierarchy levels including authority for approving exceptions, Risk identification, measurement, monitoring and control, Risk acceptance criteria, Credit origination and credit administration and loan documentation procedures, Roles and responsibilities of units/staff involved in origination and management of credit and guidelines on management of problem loans. Sound risk management structure with institutions size, complexity and diversification of its activities. It must facilitate effective management oversight and proper execution of credit risk management and control processes. It must facilitate effective management oversight and proper execution of credit risk management and control processes. Credit Risk Management Committee (CRMC),
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ideally comprising of heads of credit risk management Department, credit department and treasury. The CRMC should be mainly responsible for; The implementation of the credit risk policy / strategy approved by the Board, Monitor credit risk on a bank-wide basis and ensure compliance with limits approved by the Board, Recommend to the Board, for its approval, clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks and Decide delegation of credit approving powers, prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Banks should institute a Credit Risk Management Department (CRMD). Typical functions of CRMD include: To follow a holistic approach in management of risks inherent in banks portfolio and ensure the risks remain within the boundaries established by the Board or Credit Risk Management Committee, The department also ensures that business lines comply with risk parameters and prudential limits established by the Board or CRMC, Establish systems and procedures relating to risk identification, Management Information System, monitoring of loan / investment portfolio quality and early warning. The department would work out remedial measure when deficiencies/problems are identified. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio. Credits should be extended within the target markets and lending strategy of the institution. Before allowing a credit facility, the bank must make an assessment of risk profile of the customer/transaction. This may include; Credit assessment of the borrowers industry, and macro- economic factors, purpose of credit and source of repayment, track record / repayment history of borrower, Assess/evaluate the repayment capacity of the borrower, proposed terms and conditions and covenants, Adequacy and enforceability of collaterals, Approval from appropriate authority. In case of new borrower the repute of the counter party must be considered. Prior to credit agreement bank gets familiar with credit worthiness of individual or firm. However, a bank must not grant credit simply on the basis of the fact that the borrower is perceived to be highly reputable i.e. name lending should be discouraged. Loan syndication- It is the process of involving several different lenders in providing various portions of a loan. Loan syndication most often occurs in situations where a borrower requires a large sum of capital that may either be too much for a single lender to provide, or may be outside the scope of a lender's
41

risk exposure levels. Thus, multiple lenders will work together to provide the borrower with the capital.

6.2

Conclusion

Banks due to their nature of business are exposed to more financial risks than any other industry. To make profit it is necessary for the bank to find out the potential financial risks and ways to management. Most of the organization fails only because they cant find the potential risks. It is necessary to estimate future cash efficiently because these cash flows are used to pay fixed interest expense along with the use of quantitative and qualitative analysis techniques.

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CHAPTER 7

LIQUIDITY RISK

43

7.1

Introduction

An asset is said to be liquid if it can be readily converted into cash without significant loss of value. Liquidity risk is defined as the potential for loss to an institution arising from either its inability to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable cost or losses. When a bank doesnt have enough liquid assets to meet obligations liquidity risk arises. And it may become necessary for the bank to meet its liquidity requirements from the markets where costs are high and that can lead to loss. If a bank relays more on corporate deposits than core individual deposits it can cause liquidity risk. Liquidity risk may also be caused by credit risk and market risk. Large off balance sheet exposures like contingent liabilities may also lead to liquidity risk along with financial, market, and credit risk. That means liquidity risk doesnt come alone. There are some indicating situations that warn about liquidity risk but their existence doesnt surly mean liquidity risk. These alarming situations include a negative trend or significantly increased risk in any area or product line, Concentrations in either assets or liabilities, Deterioration in quality of credit portfolio, a decline in earnings performance or projections, Rapid asset growth funded by volatile large deposit, a large size of off-balance sheet exposure, Deteriorating third party evaluation about the bank. If any of these situations are prevailing than board of the bank is responsible for managing the liquidity risk. It is the responsibility of board to set the strategic direction for the bank when liquidity risks have been identified. Board than appoint the senior managers who have ability to manage liquidity risk and delegate them required authority to perform their job. Board constantly monitors the bank's performance and overall liquidity risk profile. Senior manager should develop and implement procedures and practices that translate the board's goals, objectives, and risk tolerances into operating standards that are well understood by bank personnel and consistent with the board's intent, Adhere to the
44

lines of authority and responsibility that the board has established for managing liquidity risk, Oversee the implementation and maintenance of management information and other systems that identify, measure, monitor, and control the bank's liquidity risk, Establish effective internal controls over the liquidity risk management process. Senior managers are appointed to deal with liquidity risk, so they evaluate certain factors. Assets and liabilities mix- liquidity risk strategy must outline the best mix between banks assets and its liabilities to maintain liquidity. Diversification and stability of liabilities- means that there must not be one major source for funds of the bank because if things went wrong and there is only one major source bank will have to face liquidity risk. A funding concentration exists when a single decision or a single factor has the potential to result in a significant and sudden withdrawal of funds. To know the stability of liability funding source of banks needs to be identified, there are liabilities that would stay with bank during any circumstances, liabilities that run off gradually when problem arise, and finally liabilities that immediately run off as the sign of problem starts appearing. Access to interbank market- other banks is good source of liquidity in hard time but as a matter of fact that should take into account that meeting liquidity needs from interbank market can be difficult in crisis situation and costly as well. Liquidity policy- liquidity policy is the policy adapted by the bank to deal with risk attached with liquidity requirement of the bank. A liquidity policy includes, general liquidity policy which includes specific short term and long term goal and objectives in relation to liquidity risk management, process for strategy formulation and the level within the institution it is approved. Roles and responsibilities of individuals performing liquidity risk

management functions, including structural balance sheet management, pricing, marketing, contingency planning, management reporting, lines of authority and responsibility for liquidity decisions. Liquidity risk management structure- for monitoring, reporting and reviewing liquidity. Liquidity risk management tools- for identifying, measuring, monitoring and

Figure 7.1

Source: Google images

45

controlling liquidity risk (including the types of liquidity limits and ratios in place and rationale for establishing limits and ratios) fig 7.1 shows process involved in liquidity risk management. And contingency plans to deals with crisis of liquidity. Asset liability committee (ALCO) is comprised of senior management and treasury function, and risk management department have the responsibility of managing overall liquidity of the bank. Availability of real time information to decision makers is very important for handling banks liquidity position. Existence of effective management information system provide basis for liquidity management decisions. Information should be readily available for day to- day liquidity management and risk control, as well as during times of stress. Certain information can be effectively presented through standard reports such as "Funds Flow Analysis," and "Contingency Funding Plan Summary". To achieve this goal management should develop systems that can capture significant information. The content and format of reports depend on a bank's liquidity management practices, risks, and other characteristics. The reports enhancing the flow of information must be tailored carefully so that they help to manage liquidity of the bank. Reports include list of large fund providers, cash flow or funding gap report, funding maturity schedule, limit monitoring report and exception report. Based on information of maturities of all advances and Loans to other banks, maturities of all deposits and borrowings from other banks it is possible to calculate gaps i.e. the surplus or excess of (cash) liquidity expected in the various time slots in the future. ALCO can then think and plan the ways and means of dealing with the gaps, contingency funding plans, blue prints for handling difficulties in handling deficit funding. Contingency funding plan (CFP) - is set of policies and procedures that serve as blue print for the bank for managing its funding needs in timely fashion. Projection of future cash flows and funding sources of a bank under market scenarios including aggressive asset growth or rapid liability erosion is shown in contingency funding plans. CFP is an extension of ongoing liquidity management and formalizes the objectives of liquidity management by ensuring, a reasonable amount of liquid assets are maintained, measurement and projection of funding requirements during various scenarios, management of access to funding sources. In case of a sudden liquidity stress it is important for a bank to seem organized, candid, and efficient to meet its obligations to the stakeholders. A CFP can help ensure that bank management and key staffs are ready to respond to such situations. Bank liquidity is very sensitive to negative trends in credit, capital, or
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reputation. Contingency funding plan has a wide scope it must anticipate banks funding and liquidity needs by analyzing and making quantitative projections of all significant on- and off balance- sheet funds flows and their related effects, Matching potential cash flow sources and uses of funds, establishing indicators that alert management to a predetermined level of potential risks. CFP must also include asset side as well as liability side strategies to deal with liquidity crises. The asset side strategy may include; whether to liquidate surplus money market assets, when to sell liquid or longer-term assets etc. On the other hand liability side strategies specify policies such as pricing policy for funding, the dealer who could assist at the time of liquidity crisis, policy for early redemption request by retail customers, use of SBP discount window etc. Another valuable approach to deal with banks liquidity issues is the use of ratios. Ratios not only help to measure current position but also help in anticipating future events. The first ratio in this regard is Loan to deposit ratio = Performing loans outstanding / Deposit balances outstanding. It is a simple measure to understand and compute. It indicates the extent to which relatively illiquid assets (loans) are being funded by relatively stable sources (customer deposits). It also shows overexpansion of the loan book. The limitation of this ratio is that it does not take into account the extent to which loans are funded by alternative stable funding sources, such as equity capital or long-term debt. Second ratio is Incremental loan to deposit ratio = Incremental loans made during the period / Incremental deposit inflows during the same period. This ratio shows how additional sources of funds are being deployed. The differences between the above mentioned overall ratio and the incremental ratio would throw up any significant shifts in the bank's funds utilisation strategy. Third ratio is Medium- term funding ratio = Liabilities with maturity of one year / Assets with maturity of over one year. This ratio focuses on the medium term liquidity profile of a bank. It also highlights the extent to which medium term assets are being funded by rollover of short-term liabilities. Hence, a lower ratio would signify higher funding of medium-term assets by shorter term liabilities, which could lead to liquidity risk. A higher ratio indicates lower liquidity risk. Fourth ratio is Cash flow coverage ratio = Projected

cash inflow / Projected cash outflow. Higher the ratio shows low liquidity. Fifth ratio is Net short-term liabilities to assets = Net short-term liabilities / Total assets. A variation of the

medium term funding ratio given above. If the ratio shows an increasing trend over time, the bank may be exposed to refinancing risk. Sixth ratio is On hand liquidity to total liabilities = on hand liquidity - cash in hand + near cash assets / Total liabilities. Higher ratio shows higher
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liquidity but has the risk of low profitability. Seventh ratio is Contingent Liabilities Ratio = Contingent Liabilities / Total Loans. The higher this ratio higher is the risk.

7.2

Conclusion

Along with other specific issues that banks face liquidity is one of the major concerning point for the banks board. Because there is a tradeoff between liquidity and profitability decisions regarding liquidity position of the bank demands more attention. Asset liability committee is responsible for formulation of liquidity policy and its execution.

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CHAPTER 8

ASSIGNMENTS

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Assignment 1
What is a financial system and why do we need one? Economic development of a country depends on number of factors among all those factors financial system has a vital role to play for the economic development. As financial system connects the savers with investors and channelize funds from surplus units of the economy to deficit units. Creating a link between borrower and lenders is the function of financial system. Borrowers include inventors, entrepreneurs, government agencies, households and established businesses which have identified profitable projects but they dont have funds to capitalize on their idea (revenues < expenses). Lenders are those households, businesses, government and non government agencies which have excess funds meaning their revenues are greater than their current expenses. The financial system performs the important function of creating a bridge between these two units of economy, or savers to borrowers. If there is no existence of financial system the money will not flow from the surplus units to deficit units, as a result economic activity as well as circulation of money will be limited. And many productive activities wont be carried out due to lack of funds available. Financial system can be defined as it is a network of interconnected banks, intermediaries, markets and facilitators which perform three major functions- allocation of resources, sharing risk, and intertemporal. Sharing risks means that financial system shares risks attached with the initiation of new projects, new product development, going global, competition, and all those external and internal risks of business to which business is exposed. Allocation of capital is a process through which financial system provides funds to those sectors of economy which are in an urgent need to have funds to carry out profitable activities. Different sectors of economy compete with each other to get funds from financial system and it is the responsibility of
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financial system to allocate capital to most efficient units of economy to reap the benefits of their profitable activities, thus enhancing economic development. Third function of financial system is helping in intertemporal trade. Some time individual, small companies, and those dealing in growing markets have enough wealth to convert their ideas in to profitable activities that is internal financing but it is rare phenomena that any unit of economy has sufficient amount of funds available to meet their requirements. Most of the individual and companies has to seek the help of financial system to generate enough amount funds to finance their projects that is external financing. Now matter external financing is equity based or debt based one has to seek the help of financial system to full fill their current needs.

Assignment 2
What is a financial crisis? Describe the reasons behind occurrence of financial crisis? Financial crisis is not a new phenomenon for the world economy, over past five hundred years many crisis have shacked the financial systems. Sometimes financial crisis even lead to major social and political developments like after the financial crisis of 17641768 and 1773 American Revolution started. And after her independence America faced many financial crisis in 1792, 18181819, 18371839, 1857, 1873, 1884, 18931895, 1907, 19291933, and 2008. The prime reason for the occurrence of financial crisis is the asymmetric information that leads to create a trust deficit among lenders and borrowers. Lenders no more show confidence in working of financial system and they start pulling out their monies. Financial crisis doesnt change the real economy unless a recession or depression occurs. Interest rates raises, increases in level of uncertainty increases, government fiscal problems all have bad consequences on economy and this is termed as shocks. Five shocks alone or after certain time period may lead to financial crisis. Creation of asset bubbles may also lead to financial crisis. This chapter will focus on financial crisis, its types and reason, asset bubbles and how and why they are created, financial panics, the reasons behind current financial crisis, and the role of government to minimize the chances of occurrence of financial crisis. Financial crisis is defined as financial crisis is a situation in which one or more financial markets or intermediaries cease functioning or function inefficiently. There are two major types of financial crisis- systematic and non systematic financial crisis. Systematic financial crisis
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affects the economy as a whole great depression is example of systematic financial crisis while non systematic financial crisis effects only to specific sectors of the economy i.e. saving crisis, credit crunch and etc. If non-systematic financial crisis are not properly controlled they become systematic financial crisis which hurts whole financial system. Either it is systematic financial crisis or non systematic financial crisis it hurt the flow of funds from savers to investors, and it also become more difficult to spread risk. The reasons for financial crisis are- increased uncertainty increase in interest rates, government fiscal problems, balance sheet deterioration, banking problems and panics. Increased uncertainty when investors have doubt about their future earnings by investing due to inflation and other reasons than to be on safe side they hold their money instead of investing in productive activities which lead to decrease in economic activity. Increase in interest rate when interest rate in economy increases it become expensive for borrowers to get loans. Increased interest rate also lead to adverse selection as most risky borrowers offer high interest rate to get loan, when these borrowers are unable to pat back default rate increase. For those businesses which hold government bonds increase in interest rate cause balance sheet deterioration decreasing the net worth of the business. Government fiscal problems those governments which spend more than they receive as tax have to borrow from financial markets and intermediaries. When the level of debt increase it become difficult for government to service debt, which lead to decrease in value of government securities and devaluation of currency. When currency devalues it become difficult for firms which have raised finances from international market to meet their obligation and the result is default. Balance sheet deterioration when the net worth of companies fall due to decrease in value of assets or increased value of liabilities than most of the businesses tend to involve in riskier activities because they have less on stake. Due to balance sheet deterioration adverse selection and moral hazards occur agency problem also plays its role. Banking problems and panic banks are most important participants of financial system. When due to any reason balance sheet of bank got hurt, bank will reduce lending to avoid bankruptcy, or to meet the requirements of regulatory authority. Decreased lending hinders the flow of funds from investors to entrepreneurs reducing the economic activity. When a bank fails other banks in the system also suffer due to two major reasons, firstly banks often owe each other considerable sums and secondly when a bank fails customers of banking system lose confidence in banking system; they rush to their respective
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funds to with draw their money. The above discussed five points increases asymmetric information, and decrease economic activity. Exchange rate crisis occur and like an ice ball starts getting bigger and bigger, that is the point where recession turns to depression.

Assignment 3
Why does profitability differ among various industries? Profitability of different industries differs due to many factors. Because of their cost of production, availability of factors of productions, and competition. Competition is a major constraint on profitability of industries and competition depend upon, competition among existing participants, growth rate, number of participants, differentiation, switching costs, entry and exit barriers , availability of substitute products, buyers and suppliers bargaining power.

Assignment 4
What are the reasons for consistency in profitability in certain industries while others show wide fluctuations? Some industries are cyclical while others are not and that is the prime reason for consistency in profitability in certain industries and also for fluctuations. By cyclical industries we mean those industries which are highly affected from fluctuations in business life cycle. Think of food industry, as food is the basic necessity of mankind so demand for products of food industry not that much affect by business life cycle fluctuation. On the other hand cyclical industries like construction got hurt by business life cycle fluctuation if economy is going down than the profitability of cyclical industries will also go down.

Assignment 5
How do operating risks differ from one industry to another? Operating risk is the risk stemming from the activities of organization. Broad categories from which operating risks generate are people, technology, and process through which organization
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operates. Along with internal issues external environment also pose operating risks for an organization. Operating risk differ from industry to industry due to nature of business. For example an organization operating in mining industry has different risk than organization operating in financial industry. For mining industry issues are more human and technology related and in financial industry risk generate from market like interest rates, and inflation.

Assignment 6
What are the implications of industry risks? Think of type writers at times they were one of the important assets of organization but after that computers have took over, now computer technology is used in many creative ways which also require change for companies to survive. Like human industries also have life cycle and face critical events in their life cycle. Stages of life cycle of an industry are start, growth, maturity, stability and decline. Every stage has its own challenges but start and decline stages are most important for a credit risk analyst. Because business get funds from banks so it is important for credit officer to fully understand the nature of industry in which business is operating, and the specific risks attached to that industry. If industry is not doing well bank will face loss which might threaten its very existence. To have a better understanding of industry risk it is important to differentiate between types of industry risks. There are two types of industry risk one is risk from external environment risk from external environment effect all the businesses in economy for example political instability, tax, and legislation. Other type is industry specific risk these are the risks and pressures faced by a specific industry only for example tobacco products manufacturing companies are facing a great pressure from society and government. Different industries have different level of risk attached for a credit risk analyst it is very important to understand those risks. Understanding of industry life cycle gives credit risk analyst information about risk because the start and decline stage of industry life cycle are critical with high level of risks. Poter Diamonds five forces explain level of competition in industry high level of competition shows high level of risks. Internal risk along with industry risk must also be kept in mind while advancing loans, because this ensures the safety of funds.

Assignment 7
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What are the forces determining the level of competition in an industry? Forces determining the level of competition in an industry are discussed next in detail. Competition among the existing firms in the industry- if competition within industry is high then the level of profits will be low, participants may involve in price war like telecom industry in Pakistan. Competition among the existing firms in the industry can be further divide in growth rate, number of rivals, differentiation, switch costs, level of fixed cost, and exit barriers. High growth means low competition as demand is high as every participant is getting its fair share. Higher the number of rivals higher the competition. But if products are differentiated by means of branding and other marketing tools than competition will be low. Switch costs are also important is clients has to bear high level of costs to switch from one product to other than competition will be low. High level of fixed cost require producer to produce more for the purpose of decreasing per unit fixed cost, increased production means excess supply and as result high level of competition. Exit barrier which states that the Market rivalry tends to be more vigorous when it costs more to get out of a business than to stay in and compete. Threat of new entrants- states that if it is difficult for new firms to enter the industry it will work for the advantage to existing enterprises. Threat of new entrants depends on economies of scale, first mover advantage, Channels of distribution and relationships, and legal barriers. Threat of substitute also effects the profitability if substitute products are available, then the industry profitability is affected by the factors influencing the substitutes. Take the example of tea and coffee tea producers cant charge too much because people will switch to coffee. Relative price, satisfying ability, and willingness of customer to pay for substitute are those factors which direct threat of substitute and these factors differ from industry to industry. Bargaining power of buyers affect the competitive environment of any industry if buyers have more bargaining power than they will put pressures on participants of the industry for low price, high quality and more value added services, all these add to costs of seller decreasing its profitability. Bargaining power of suppliers also affect the profitability of industry if suppliers are strong they by raising prices, lower quality, and hindering availability of raw material can affect the profits of industry to a larger extent. In this case industry is client and suppliers are sellers.

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