BANKS AND BANK MANAGEMENT

Banking sector is the lifeline in any modern economy as well as the oldest financial intermediaries
in the financial system. The banking system reflects the economic health of a country. In India the
Banking Regulation Act defines banking as the accepting, for the purpose of lending or
investment, of deposits of money from the public, repayable on demand or otherwise and
withdrawable by cheque, draft, order or otherwise. And banks are defined as any company that
transacts the business of banks in India. Thus, acceptance of deposits and lending of funds are the
two core activities of banking.

Functions of Banks
1. Deposits deposits are the main source of funds for commercial banks which are then lent in
the form of advances. The growth of deposits depends on savings. Banks are important
financial intermediaries between savers and borrowers. Deposits may be categorized into
demand deposits and time deposits. Demand deposits can be further classified as current bank
accounts and savings bank accounts. Time deposits are deposits which are repayable after a
fixed date or after a period of notice. Fixed deposits, recurring or cumulative deposits, cash
certificates and miscellaneous deposits are classified as time deposits. Recurring deposits and
cash certificates are very similar in nature where the deposit or certificate holder needs to
deposit funds on a regular interval for a specified period. At the maturity the depositor receives
the deposited amount and interest income on that. The primary difference between cash
certificates and recurring deposits is that the former asks for quarterly payment while the latter
requires monthly payment to the deposits. Deposits account for more than 80 percent of the
liabilities of scheduled commercial banks.
2. Lending of funds commercial banks mobilize funds from the savers and lend them to the
deficit sectors. They facilitate not only the flow of funds but also the flow of goods and services
from producers to consumers indirectly through their lending operations. Further, banks
facilitate the financial activities of the government sector as well.
3. Credit creation banks are creators of credit. Banks create deposits in the process of their
lending operations which leads to multiplication of the initial deposited amount in terms of
credit. This concept has already been discussed in the previous topic under money multiplier.
4. Ancillary functions beside the primary functions of loan creations and mobilization of
deposits, banks provide a range of ancillary services including transfer of funds, collection,
foreign exchange transaction, safe deposit locker, gift cheques and merchant banking.

Aside: Traditional merchant banks primarily perform international financing activities such as
foreign corporate investing, foreign real estate investment, trade finance and international
transaction facilitation. Some of the activities that a pure merchant bank is involved in may include
issuing letters of credit, transferring funds internationally, trade consulting and co-investment in
projects involving trade of one form or another. Generally, merchant banks operate on small scale
companies, which are too big for venture capital financing and too small to register with an
exchange for public issue of equities.
Scheduled Commercial Banks
Scheduled commercial banks are those included in the second schedule of the Reserve Bank of
India Act 1934. They are grouped under following categories:
i) Public sector banks
a. State Bank of India and its Associates
b. Nationalized banks
ii) Private sector banks
iii) Foreign banks in India
iv) Regional rural banks
There are currently 28 public sector banks, 23 private sector banks, 40 foreign banks and 56
regional rural banks (source: RBI website).

Public sector banks public sector banks are those in which the government has a major holding.
For instance, GoI holds 58.59% stake in SBI. The State Bank of India was originally known as
Imperial Bank of India. Imperial Bank was formed in 1921 by the amalgamation of three
presidency banks The Bank of Bengal, the Bank of Bombay and the Bank of Madras. The
Imperial Bank was nationalized under the State Bank of India (SBI) Act 1955 where RBI took
60% stake and the SBI came into existence on July 1, 1955. This is called the first phase of bank
nationalization in India. In 2008, the GoI took over the stake held by the RBI. The objectives for
nationalization were
To extend banking facilities on a large scale, particularly in the rural and semi-urban areas
To promote agricultural finance and to remedy the defects in the system of agricultural
finance
To help the Reserve Bank in its credit policies
To help the government pursue its broad economic objectives.
The SBI has five national subsidiaries: SB of Bikaner and Jaipur, SB of Hyderabad, SB of Mysore,
SB of Patiala and SB of Travancore. It has three foreign subsidiaries: SBI International (Mauritius)
Ltd., SBI (California) and SBI (Canada). It is not only the countrys largest bank, also the worlds
largest commercial bank in terms of branch network.

In 1969, in the second phase of nationalization, fourteen Indian joint stock banks in the private
sector were nationalized. The banks those were nationalized are Central Bank of India, Bank of
Maharashtra, Dena Bank, PNB, Syndicate Bank, Canara Bank, Indian Bank, Indian Overseas
Bank, Bank of Baroda, Union Bank, Allahabad Bank, United Bank of India, UCO Bank, and Bank
of India. And, again on August 15 1980, in the third phase of nationalization, six private
commercial banks with deposits over Rs 200 crore were nationalized. These were Andhra Bank,
Corporation Bank, New Bank of India, Oriental Bank of Commerce, Punjab and Sindh Bank and
Vijaya Bank. With this 80 percent of the banking sector came under government ownership.

There is no doubt that the nationalisation of banks led to credit being channelized to agriculture
and small and medium industries. Banks had to reserve as much as 40 percent of credit to the
priority sectors (agriculture and small and medium industries). The expansion of branches in rural
areas was particularly noteworthy. The figure rose from 8,261 in 1969 to a whopping 65,521 in
2000. Public sector banks have an edge over private sector banks in terms of size, geographical
reach and access to low cost deposits. Low cost deposits are current account and savings account
deposits. Huge size enables them to cater to the large credit needs of the corporates while
geographical reach increases their access to low-cost deposits and together they help them in
having diversified low risk portfolios. About 70 percent of the public sector bank branches are in
rural areas as against 25 percent for the new private sector banks. The nationalized banks are the
dominant segment in commercial banking in India. Beside the nationalised banks, IDBI and
Bhartiya Mahila Bank are included in the list of public sector banks.

Private sector banks after the 1969 nationalization for more than two decades setting up of
private sector banks were not allowed until the Narasimham Committee recommended
establishment of new banks in the private sector to increase competition to induce higher
productivity and efficiency in the banking sector. Thus, the banks set up in the 1990s are referred
to as new private sector banks. Therefore, the private sector banks are divided into two categories:
old private sector banks and new private sector banks. A list is given below of both. The new
private sector banks brought in state-of-the-art technology and aggressively marketed their
products, came up with innovative products and superior service. Given the greater efficiency of
private sector banks, the public sector banks started losing market share and had been doing so at
about one percent per annum specifically till the 2007-09 crisis.

Old Private Sector Banks New Private Sector Banks

City Union Bank Axis Bank
Dhanlaxmi Bank Development Credit Bank
Federal Bank HDFC Bank
Kotak Mahindra Bank ICICI Bank
Jammu & Kashmir Bank Indusind Bank
Karantaka Bank Yes Bank
KarurVysya Bank Bandhan Bank
Lakshmi Vilas Bank IDFC
Nainital Bank
Ratnakar Bank
South Indian Bank
Tamilnad Mercantile Bank
Catholic Syrian Bank

Foreign banks in India foreign banks have been operating in India for decades. Some of them
are having their operations for more than a century, e.g. ANZ Grindlays and Standard Chartered.
A total of 27 new foreign banks opened their branches in India following the liberalization of the
1990s. The presence of foreign banks in India has benefitted the financial system by enhancing
competition, transfer of technology and specialized skills leading to higher efficiency and greater
customer satisfaction. They have also enabled large Indian companies to access foreign currency
resources from their overseas branches in situations of foreign currency constraints. They are
active players in the money market and foreign exchange markets which has contributed to the
liquidity and deepening of these markets in terms of volume and products. For a foreign bank to
operate in India the minimum capital requirement is USD 25 million spread over three branches.
Additional branches are permitted after observing the performance of the existing branches. The
number of licenses is fixed at 12 per year for both new and expansion by existing banks. They
have to mandatorily lend 32 percent of their adjusted net bank credit (i.e. net bank credit plus
investment in non-SLR bonds) or credit equivalent of the off balance sheet exposures, whichever
is higher, to the priority sector. The off-balance sheet exposure includes guarantees, letters of
credit, derivatives and forex exposures. Foreign banks need to park 20 percent of their profits from
India operations with the RBI in terms of cash, or approved securities or both. Standard Chartered
is the undisputed leader among the foreign banks with more than 90 branches and assets over more
than Rs 30,000 crores, followed by Citibank which is a distant second. Foreign banks operate in
India only as branches with no subsidiaries, though subsidiaries are allowed to be set up.

Regional Rural Banks (RRBs) a new category of scheduled banks came into existence in 1975
when 6 RRBs were set up with the objective to develop the rural economy by providing credit for
agriculture, trade, commerce, industry and other productive activities in the rural areas. The
targeted groups were primarily small and marginal farmers, agricultural labourers, artisans and
small entrepreneurs. Various Grameen banks are examples of RRBs.

Commercial Banks Balance Sheets

A commercial Banks balance sheet has three components:

Total bank assets = Total bank liabilities + Bank capital

Banks obtain their funds from individual depositors and businesses, by borrowing from other
financial institutions and through financial markets which constitute their liabilities. They use these
funds to make loans, purchase marketable securities and hold cash that form their assets. The
difference between the assets and liabilities is the banks capital or net worth the value of the
bank to its owners. The banks profits come from service fees and from the difference between
what they pay for their liabilities and the return they earn on their assets.

Assets or uses of funds a banks assets are divided into four broad categories: cash, securities,
loans and all other assets. Banks hold majority of their assets in securities and loans. Cash assets
are of three types: i) reserves which include reserves with the central bank plus cash in the banks
vault called vault cash; ii) cash items in process of collection includes all deposits through checks
that a bank is expecting to receive from other banks within a few days; and iii) correspondent bank
deposits that include the balances of the accounts that banks hold at other banks.

One of the major components of banks assets is securities, which are mostly very liquid. Since
they can be sold quickly when the banks need cash, they are sometimes referred to as secondary
reserves. The other major component of banks assets is loans which can be divided into five broad
categories: real estate loans, consumer loans, business loans, interbank loans and other loans
which include all other types of loans like loans for purchasing securities. The last category mostly
includes buildings and equipment and also collateral repossessed from borrowers who defaulted.

Liabilities or sources of funds as already mentioned sources of funds are primarily deposits and
borrowings. To entice individuals and businesses to place their funds with the banks, a range of
deposit accounts are offered that provide safekeeping, and accounting services, access to the
payment systems, liquidity, diversification of risk and interest payment on the balance.

Let us consider the balance of sheet of SBI to explain the various components of the capital and
liabilities, though very briefly.

Components of Capital and Liabilities

Capital capital consists of equity capital that are subscribed and fully paid up. Equity
capital that are not fully paid up are not included
Reserves & Surplus consists of
 i) Statutory reserves the reserves the banks mandatorily hold with the central bank
ii) Capital reserves they are primarily reserves set aside to finance long term capital
projects which are well anticipated and incorporated in the future business plan
iii) Share premium this refers to the difference between the subscription or issue price of
a share and its par value or the cost of the share
iv) Foreign currency translation reserves most banks hold foreign currencies and their
values change because of changes in exchange rate of the domestic currency vis--vis
the foreign currency. The change in the value of foreign currencies held by a bank
because of change in exchange rate is known as foreign currency translation reserve.
v) Revaluation reserves this refers to an increase in the reserves caused by revaluation
of an asset owned by the bank due to an increase in the price of the asset. Most often
real estate and land valuation lead to an increase in the revaluation reserve.
vi) Revenue & other reserves this include undistributed revenue profit which is set
aside for future expenses including dividend payments to the shareholders.
vii) Balance in profit & loss account this refers to the carried forward profit or losses
from the previous financial year.
Deposits bank deposits are demand and term deposits held by the bank
Borrowings borrowings by a bank can be from the following sources and they are
separately mentioned for each financial year
i) RBI
ii) Other banks
iii) Other institutions & agencies (non-banking financial companies)
iv) Capital instruments borrowings through issue of bonds and other capital market
instruments
Other Liabilities & Provisions accrued interest, deferred tax liabilities etc.

Components of Assets

Components of assets are as follows:

Cash & balances with the RBI

Cash in hands including foreign currency & gold
Balances with RBI
Balances with banks & money at call & short notice
Investments
Govt. securities
Other approved securities
Shares & bonds
Subsidiaries & associates
Others like mutual funds commercial papers etc.
Advances (loan given)
Bills purchased and discounted (e.g. commercial bills)
Cash credits, overdrafts etc.
 Term loans
Secured by tangible assets (collateralized loans)
Covered by bank/govt. guarantees - e.g. loans extended to MSMEs covered under
Credit Guarantee Scheme (CGS) by CG Fund Trust for Micro and Small
Enterprises (CGTMSE). Under this scheme, bank credit is made available to the
MSEs without any collateral or third party guarantee. The corpus of CGTMSE is
contributed in the ratio of 4:1 by GoI and SIDBI.
Unsecured (non-collaterilized loans)
Fixed assets premises, furniture & fixtures, leased assets and assets under construction
Other assets interest accrued, tax paid in advance, claimed non-banking assets, deposits
placed with NABARD/SIDBI etc.

Other than assets and liabilities, an important component on the balance sheet is contingent
liability. This primarily refers to liabilities or expenditure that is coming or is expected in near
future and the bank is quite certain about the amount of transaction. Contingent liability generally
consists of
Claims against the group not acknowledged as debt
Liability for partly paid investments
Liability on account of outstanding forward exchange contracts
Guarantees given on behalf of constituents
Others

Next we consider different types of income streams and costs:

Interest income - interest income or net interest income (NII) is the main source of revenue for
majority of the banks worldwide. NII is generated from lending activities and interest bearing
assets. Net return is the interest income minus the cost of funding the loans. Funding is obtained
from a variety of sources like retail deposits which are the cheapest and a key source for many
banks. However, they are short term in nature and are often supplemented with long term funding
like bonds, money market papers etc.

Fees and commissions banks generate fee income by providing various services to its customers.
Fee income is very popular with bank management since it is less volatile and is often paid up
front. Thus, it carries no market risks and credit risks. However, there might be operational risks
associated with it.

Trading income trading income is generated through trading activities in financial products such
as equities, bonds and derivative instruments. This includes acting as a dealer or market makers in
these products.Trading income is the most volatile income source for any bank. Many banks use
the value-at-risk (VAR) methodology to measure the risk arising from trading activity.

Costs bank operating costs comprise of staff costs, as well as other costs such as regulatory costs,
premises, information technology and equipments costs. Further, significant costs are provisions
for loan losses which are charges against the loan revenues of the bank.
Bank capital and profitability bank capital or equity capital is the owners stake in the bank.
Bank capital is the equity of the bank.If the owners sell all the assets and use the proceeds to repay
all the liabilities, capital is what would be left. It is important because it provides the cushion that
enables a bank to avoid insolvency during periods of market correction or economic downturn.
When a bank suffers a loss the capital is used to absorb the loss. An important component of bank
capital is loan loss reserves. This is an amount that the bank sets aside to cover potential losses
from defaulted loans. For a defaulted loan, the loan is written off from the banks balance sheet
and the loan loss reserve is reduced by that amount. This can be done by eating into reserves,
freezing dividend payment or writing down equity capital. Total capital is comprised of i) equity
capital, ii) reserves, iii) retained earnings, iv) preference share capital, v) hybrid capital instruments
and vi) subordinated debt.

Capital is split into Tier 1 and Tier 2 capital. The first three items above comprise Tier 1 or core
capital and remaining three form Tier 2 capital. The quality of a banks capital is reflected in the
mix of Tier 1 and Tier 2 capital. Tier 1 is the highest quality capital as it is not obliged to be repaid.
Tier 2 is considered to be of lower quality because it is repayable and also of shorter term than
equity capital. Often the financial strength and quality of a particular banking institution is assessed
using key capital ratios for the bank and comparing these with market averages or other
benchmarks. Some of the more common key ratios are listed below.

Ratio Calculation

Core capital ratio Tier 1 capital/Risk-weighted

assets

Tier 1 capital ratio Eligible Tier 1 capital/Risk-

weighted assets

Total capital ratio Total capital/ Risk-weighted

assets

Off-balance sheet risk to total Off-balance sheet and

capital contingent risk/Total capital

Profit and loss report

The income statement for a bank is the P&L report. It records all the income and losses during a
specified period of time. A bank income statement would show revenues that can be accounted for
as NII, fees, commissions and trading income. The precise mix of these sources will reflect the
type of banking institution and the business line it operates in. Revenue is offset by operating (non-
interest) expenses, loan loss provisions, trading losses and tax expenses. A more traditional
commercial bank will have a much higher dependence on interest revenues than an investment
bank that engages in large-scale wholesale capital market business.
There are several basic measures of bank profitability. The first one is called return on assets
(ROA) which is measured as

ROA =

This measures how efficiently a particular bank invests its assets. However, return on their own
investment is more important for the owners of the bank. Therefore, the banks returns to its owners
are measured by return on equity (ROE).

ROE=

RoE is probably the most common measure of performance and is usually integrated into bank
strategy with a target RoE level stated explicitly in management objectives. However, both these
measures are bland calculations of absolute values and do not make any adjustment for relative
risk exposure which differ from bank to bank depending on the specific type of business activities
a bank takes up. Another measure of bank profitability is net interest income which is the
difference between the interest payment made on deposits and borrowings and the interest income
received on loans and securities. The average difference between the interest rate received on
assets and interest rate paid on liabilities is called banks interest rate spread. Net interest income
expressed as a percentage of total assets is referred to as net interest margin.

Measuring return
Consider the following hypothetical bank income statement and balance sheet:

Income statement (million) Balance sheet

Interest income 120 Assets Liabilities
Fees and services 65 Loans 1200 Deposits 1080
Interest expense 90 Equity 100
Operating expenses 60 Retained 20
profits
Loss provisions 12
Operating profit 23
Taxation 4.6
Profit after tax 18.4

Using the values in the above mentioned table, we can calculate the following ratios:
Return on equity = 18.4/100 = 18.4%
Return on capital = 18.4/120 = 15.3%
Return on assets = 18.4/1200 = 1.53%
Earnings on assets = (120+65-12)/1200 = 14.4%
Leverage ratio = 1080/100 = 10.8%
Average cost of debt = 90/1080 = 8.3%
Operating expenses = 60/1200 = 5%
Operating margin = 14.4% - 8.3% = 6.1%
Taxation rate = 4.6/23 = 20%
We can see that a higher a leverage produces a higher RoE which tempts the senior management
to take more debt in an effort to generate higher shareholders returns. This is a very risky strategy,
because in a market downturn, a high level of borrowing causes debt-servicing problem. Thats
why targeting RoA is a preferred measure.

Further, often banks have more than one business line. So it is necessary to calculate returns
adjusted for the amount of risk exposure each business creates and the amount of capital it uses.
business line profit
The standard calculation is the risk-adjusted return on capital or RAROC = business line equity allocation
Use of RAROC enables senior management to compare the genuine value added by each business
line.

Loan valuation
RoE is an important strategy variable because the bank shareholders will not continue to hold
shares unless its target return is met. If bank is not able to meet this target then it implies that it is
not creating value. In other words, businesses must generate a return that exceeds the target RoE.
A simple example is given below to illustrate how banks price loans. First consider the simplified
balance sheet
Asset Liabilities
Loan 100 Deposit 90
Equity 10
Assumptions
Loan maturity 1 year
Customer deposit pay rate 5%
Target RoE 10%
Corporate tax rate 20%
Loan interest rate x%

The main principle is that the loan must create value that exceeds the RoE target of equity invested.
So, we set the following relationship that equates the capital employed (i.e. equity and retained
profits) with the after tax discounted cash flow of the business:
[(120%)((%100)(905%))]+10090
10 = 1.10
Solving for x we get x = 5.75%. This implies that by setting an interest rate of 5.75% the present
value of the revenue earned on the loan after tax is equal to 10 which is the capital set aside for
loan. Therefore, the interest rate must be set above 5.75%. At this rate or below there is zero value
creation; this is the break even loan rate. And the difference between the break even loan rate and
the funding rate of 5% is called the break-even margin.

The above example shows that the break even interest is a function of banks funding rate, its RoE
and the corporate tax rate. This is a very simple example. In reality, the amount of capital required
will depend on the risk weighting of the asset. In this example, the loan is backed by the full capital
base. But for businesses that do not require any capital, for example AAA-rated govt. bonds, the
margin can be lower. Let us take another example more like the real world. The balance sheet
remains the same. Consider the following assumptions:
Loan maturity 2 years
Customer deposit pay rate 5% (fixed)
Target RoE 10%
Corporate tax rate 20%
Loan default probability (Year 1) 0%
Loan default probability (Year 2) 5%
Recovery rate 40%
Loan interest rate x%

The same principle applies again that the break-even loan rate of x% must be set such that the
present value of the expected cash flow of the loan, after tax, equates the value of the equity used
to back the loan. Thus, we have
[(100) (905%)](1 0.2) (1 0.2)100 + 100
10 = + 95%
1.10 1.102
40 + (0.260) 905%(1 0.2) + 90
+ 5%
1.102 1.102
Rearranging for x we obtain an interest rate of 7.72% which is the break-even loan rate.

So in the above example, a possibility of default in the second year is allowed. Should a default
occur the bank will recover 40 cents on the dollar. A tax recovery on the amount that is lost in the
event of default is also allowed. So, now there are two important parameters; that are the default
probability of the loan and the recovery rate. However, this introduces an element of subjectivity
in the calculation. The recovery rate is an assumed value and is never known with certainty.
However, one can infer this by observing the prices of loans and bonds in the market. This example
also highlights the issue of setting aside part of each years profit to cover for future loan defaults.
The calculation of this amount also uses the default probability and recovery rate parameters. For
example, suppose the loan is held for one year and the loan interest rate is 11.1 percent. The net
loan value after one year will be

100 + 11.1(1 0.20) 40 + 0.260 900.05(1 0.20) + 90

0.95 + 0.05 = 9.305
1.10 1.10 1.10
Interest margin after tax: (1 0.20)[(11.1%100) (5%90)] = 5.28

Attributable profit: Post-tax interest margin fall in loan value = 5.28 0.695 = 4.585

At loan origination, the net loan value was (loan deposit = 100 90 =) 10. So, the loan value has
fallen by (10 9.305 =) 0.695. The fall in the net value of the loan at the end of the year is used to
calculate the amount of interest income that should set aside as loan loss provision and the part
that can be attributed as profit. Therefore, to arrive at a sensible lending rate for any type of
business, a bank must have a good idea of its cost base and the expected frequency of bad loans in
the following 12 months. It also needs to set a target RoE. The interest rate on a loan is then set as
a spread over the banks funding cost, a credit spread to cover anticipated loan losses and any
additional spread to cover its operating expenses.

Capital requirement
In principle, the amount of capital that a bank should hold is the amount which is sufficient to
preserve it as a going concern in the event of losses; i.e. the capital must be able to absorb all
expected losses, certain level of unexpected losses, and leave enough for the banks to continue
operating. This implies
The bank must have a reasonable estimate of its expected losses as well as an add-on for
unexpected losses; call this amount X.
The level of capital must be at least X more than the minimum level required by the
regulatory authority.
The second requirement suggests that if the level of capital in place is the minimum required, and
the bank suffers X losses, then it will be under-capitalized for regulatory purposes, which may
result in a loss of confidence, a bank run and either bankruptcy or a bailout. The starting point for
capital allocation is the regulatory requirement. The regulatory capital amount required can be
compared to the earnings-at-risk (EaR) approach for measuring capital. This method involves
observing the historical distribution of earnings, and its volatility to determine the extent of
earnings risk. The volatility level of earnings then drives the capital requirement. EaR is measured
in different ways like, loan revenue, interest margin, mark-to-market volatility, accounting profit
and so on.

Bank risk
Any transaction or undertaking with an element of uncertainty as to its future outcome carries an
element of risk; risk can be thought of as uncertainty. Banking is a risky business because of its
nature of activities and also because it is highly leveraged. It is useful to define risk in terms of
horizon, the point at which an asset will be realised or turned into cash. A working definition of
risk is the uncertainty of the future total cash value of an investment on the investors horizon date.
The risk includes the possibilities that the depositors will suddenly withdraw their balances, the
borrowers will default, interest rate will change adversely and the banks trading operations in
securities will do poorly etc.

Credit riskalso called issuer risk is the primary risk in banking. It is the risk that a customer will
default on a loan. It is also the risk that the credit quality of the obligator will deteriorate which
increases the probability of default. Credit risk exists in the banking portfolio and trading portfolio.
Credit risk is described by exposure or value at risk, probability of default and loss in the event of
default. The most common measure of credit risk is the formal credit rating. However, all banks
will rate their customers according their own internal rating methodology as a part of their credit
analysis process, because most bank customers do not have a formal public credit rating.
Sovereign risk is a type of credit risk specific to government debt. It arises when foreign borrowers
fail to repay their loans, not because they are unwilling, but because their government may prevent
them from doing so. This happens specifically when a country experiences financial crisis and
restrict foreign currency denominated payments on its loans. It is difficult to manage sovereign
risks since it is difficult to predict financial crisis. Nevertheless, banks should spread their business
all across the world and avoid too much exposure to any country where a crisis might arise. Also,
derivatives can be used to hedge against sovereign risks.

Related to credit risk is performance risk, which is the risk of underperformance by the borrower
on a specific transaction primarily related to OTC derivative instruments. A bank will have credit
risk at an individual level, to each borrowing customer, as well as at the aggregate portfolio level.
Portfolio risk needs to take into account the diversification impact of a group of loans. Portfolio
risk will differ according to the number of borrowers and their variation across industries, sectors
and geographical regions.

To manage the credit risk of loan defaults banks use a variety of tools. The most basic are
diversification, in which the banks make a variety of different loans to spread the risk and do credit
risk analysis in which the bank examines the borrowers credit history to determine the appropriate
interest rate to charge. If a bank lends only in one geographic area or to only one industry, then it
exposes itself to risks that are local or industry specific. This calls for diversification.

Liquidity risk this refers to two different but related issues: for a treasury or money market person
it is the risk that a bank has insufficient funding to meet commitments as they arise. Thus, liquidity
risk for a bank is the risk of not being able to meet obligations in terms of funds demanded by its
clients. This is also known as rollover risk. Funding risk can be affected by events in the market
affecting a large number of banks or by events specific to the individual bank. For a securities or
derivatives trader, liquidity risk is the risk that the market for assets becomes too thin to enable
fair and efficient trading. Therefore, liquidity risk arises when assets cannot be bought or sold as
and when required.

This applies to both sides of the banks balance sheet; i.e. withdrawals of deposits and loans drawn
by borrowing clients. If a bank fails to meet customers requests for immediate funds, it faces the
risk of running out of business. So, liquidity risk management is an important aspect of bank
management. Holding excess reserves to meet liquidity requirement is expensive since the banks
forgo interest income by holding excess reserves. Suppose one day there is sudden demand for Rs
5 million. Banks can respond to the requirement or shortfall by adjusting either assets or liabilities.
On the asset side the options are i) to sell a portion of their most liquid securities or ii) to sell some
of its loans to another bank. Not all loans are marketable, but some are. However, bankers do not
prefer to reduce their asset side since that shrinks the size of the bank and its profits. There are two
alternative ways to adjust the liability side by attracting additional funds: i) they can borrow from
the central bank or from other banks and ii) to attract additional deposits by issuing large
denomination CDs.
Market riskToday banks not only engage in sophisticated asset and liability management, they
also hire traders to actively buy and sell securities, loans and derivatives for making additional
profits. But trading financial instrument is risky. The risk that financial instruments price may go
down rather than up is called trading risk or market risk. Therefore, market risk is the decline in
the market value of the financial securities and does not apply to non-trading assets held in the
banking book. Types of market risks are FX risk, interest rate risk and basis risk. The key market
risk for banks is the interest rate risk and it is often measured and reported separately to other
market risks.

Traders generally have their share if banks make profit from good investment, but the banks pay
for the losses. Thus, the traders have incentive to take more risks than the bank managers would
like. The managers therefore, should limit the amount of risk a trader is allowed to assume and
monitor each traders holdings closely at least once a day. Moreover, the higher the risk inherent
in the banks portfolio, the more capital the bank will need to hold to make sure that the institution
remains solvent. Specific market risk will differ according to the type of asset under consideration.

Interest rate risk is the risk of loss of earnings due to movement in interest rates. A significant
share of bank earnings arises as a result of interest earnings on assets. Hence, this is a significant
risk. Banks liabilities are short term while assets are generally long term. Therefore, the interest
rates on them also vary accordingly. This creates the interest rate risk. Interest rate risk is defined
as the risk of banks expected earnings being influenced negatively by changes in the pattern and
structure of interest rate. Even in a banking book fixed rate assets will produce lower profit if the
interest rate payable on liabilities funding the asset rises. For example, when interest rates rise, the
price of assets and hence, value of assets falls. Longer term bonds face higher fluctuations.
Therefore, asset value will fall more than the value of liabilities. On the other hand, if assets include
long term loans where the interest income does not vary with change in interest rates, but short
term liabilities require higher interest payment to be made with increase in interest rate, then this
lowers banks profits and increases interest rate risk. Interest rate risk includes reset risk, the risk
of rates changing in between re-fixing dates on a floating rate asset or liability.

The first step in managing interest rate risk is to determine how sensitive the banks balance sheet
is to a change in interest rate. Managers must compute an estimate of the change in banks profit
for each one-percentage-point change in the interest. This is called gap analysis, because it
highlights the gap between the yield on interest rate sensitive assets and the yield on interest rate
sensitive liabilities.

Currency (or foreign exchange) risk arises from exposure to movements in FX rates. Currency
risk is divided into transaction risk where currency fluctuations affect the proceeds from day-to-
day transactions, and translation risk, which affects the values of assets and liabilities on a balance
sheet. This risk can be managed in two ways: attracting deposits in the same denomination in
which the bank holds loans and use of foreign exchange futures and swaps to hedge the risk.
Equity risk affects anyone holding a portfolio of shares which will rise and fall with the level of
share prices and the stock market.

Prepayment and reinvestment risk are essentially interest rate risk. If an asset makes any payment
before the investors horizon the cash flows have to be reinvested until the horizon date. Since the
reinvestment rate is unknown when the asset is purchased, the final cash flow is also uncertain.
Prepayment risk is specific to mortgaged assets. For example mortgage lenders allow the home
owner to repay outstanding debt before the stated maturity. If interest rates fall, prepayment will
occur. This will force reinvestment at rates lower than the initial yield.

Model risk relates to complex mathematical models used to develop latest financial instruments.
If the model is incorrectly specified, is based on questionable assumptions or does not accurately
reflect the true behaviour of the market, banks trading these instruments could suffer extensive
losses.

Other market risks include volatility risk that affects option traders and basis risk that arises when
one kind of risk exposure is hedged with an instrument that behaves in a similar but not identical
manner.

Other types of risks are operational risk and strategic risk. Operational risk is the risk of loss
associated with non-financial matters such as fraud, system failure, accidents and ethics; like if the
computer system fails or buildings are damaged. Strategic risk arises on account of poor
implementation of business decisions or a failure to adapt to changes in the economic environment
which has an adverse impact on capital and earnings. Each bank has its unique definition of
operational risk. Some of them are
Information technology systems risk banks these days rely heavily on information
technology for smooth functioning of their businesses. Information technology systems
risk is defined as a breakdown in the information systems hardware and/or software that
renders the retrieval of information difficult or delayed which may cause cessation or delay
in business.
Human resources risk - Risk that a bank may incur losses due to drain or loss of personnel,
deterioration of morale, inadequate development of human resources, inappropriate
working schedule, inappropriate working and safety environment, inequality or inequity in
human resource management or discriminatory conduct
Reputation risk this is associated with loss incurred due to damage in reputation or
credibility of a bank
Legal and documentation risks legal risk is associated with violation of laws and
regulations, breach of contract and other legal factors. On the other hand, documentation
risk arises out of complexity in commercial matters which may render a legal agreement
insufficient, incomplete and unenforceable.
External risks external risks are risk associated with factors that are external to an
organization and hence, are beyond its control.
Operational risk can be mitigated by defining strict procedure for all aspects of a banks business
functions, from front to back office, and ensuring adherence to them.

Country risk a bank that undertakes operations outside its home country is exposed to the risk of
a crisis or other market event in a country. Examples include war, revolution, sovereign downgrade
or balance of payment crisis. General economic deterioration like high inflation is also an example
of country risk.

The following table shows various banking activities and the type of risk exposure they present:

Service or function Revenue generated Risk

Lending

- Retail Interest income, fees Credit, Market

- Commercial
- Mortgaged Interest income, fees Credit, Market
- Syndicated
Interest income, fees Credit, Market

Trading, Interest income, fees Credit, Market

Credit cards Interest income, fees Credit, Operational

Project finance Interest income, fees Credit

Trade finance Interest income, fees Credit, Operational

Cash management

- Processing Fees Operational

- Payments
Fees Credit, Operational

Custodian Fees Credit, Operational

Private banking Commission income, Interest Operational

income, fees

Asset management Fees, performance payments Credit, Market, Operational

Capital markets

- Investment banking Fees Credit, Market

- Corporate finance
- Equities Fees Credit, Market
- Bonds
Trading income, fees Credit, Market
- Foreign exchange
 - Derivatives Trading income, Interest Credit, Market
income, fees

Trading income, fees

Credit, Market
Trading income, fees
Credit, Market

Off-balance-sheet activities
Banks exist to reduce transaction cost, information cost and to reduce risks. When they perform
these services they earn fees. Many of these activities do not appear as either assets or liabilities
and hence, do not form part of their balance sheet. These are termed as off-balance-sheet activities
and they are important contributors to banks profits. For example, banks often provide trusted
customers with lines of credit with a credit limit where the firm can take loan on a short notice by
drawing down the credit line. For this agreement, the banks receive payment for service to be
provided and the firms receive a loan commitment. However, until the firm draws down the credit
line, nothing appears on the balance sheet, though the bank has already made some profit.

Some of the important off-balance sheet activities of banks are listed below:
Financial Guarantees
o Standby letters of credit (SLCs) - SLCs obligate the bank to pay the beneficiary if
the account party defaults on a financial obligation or performance contract. SLCs
are considered loans. They may be collateralized. Liquidity risk (or funding risk),
capital risk, interest rate risk, and legal risk are inherent in these instruments. Banks
need to diversify, limit credit risk, and increase capital to manage these risks.
o Bank loan commitments these are promises by a bank to a customer to make a
future loans under certain conditions. Most commercial and industrial loans are
made under some form of guarantee (informal or formal). Loan commitments are
of two types: line of credit is an informal commitment of a bank to lend funds to a
client firm. And, revolving line of credit is a formal agreement by a bank to lend
funds on demand to a client firm under the terms of the contract. These activities
are associated with funding risk which occurs when many borrowers take down
commitments at the same time and thus, strain bank liquidity. It is also known as
quantity risk. Most likely to occur during periods of tight credit.
o Note issuance facilities (NIFs) - NIFs are medium-term (2-7 years) agreements in
which a bank guarantees the sale of a firms short-term debt securities at or below
pre-determined interest rates. Contingent risks to banks here as underwriters are
credit risk and funding risk.
Derivatives
Other off-balance sheet activities
o Loan sales: Banks can sell loans to a third party as a source of funds. For a fee the
selling bank often continues to service the loan payment and handle other
 responsibilities of the loan. This allows banks to make loans without relying on
deposits and converts traditional lending to a quasi-securities business.
o Trade finance: Some international off-balance sheet activities of trade finance are:
Commercial letters of credit -- a letter of credit (LOC) issued by a bank is a
guarantee that the banks customer will pay a contractual debt. Banks bear
credit risk and documentation risk.
Acceptance participations - Bankers acceptances for foreign exchange
trading and hedging activities are off-balance sheet. Advisory and
management services that earn service fees.
Networking - Linkages between firms based on comparative advantages,
otherwise known as a strategic alliance. For example, a bank may refer a
customer to a brokerage firm and earn part of the customer fee.