Different Types of Risks Faced by Banks Today

All companies which have a profit maximizing objective hold a certain degree of risk whether through microeconomic or macroeconomic factors. Banks also face a number of risks atypical of non financial companies due to the payment and intermediary function which they perform. Recent changes in the banking environment has lead to an increased pressure to maximize shareholder value, this means that banks take on a higher risk in order to gain a higher return. It is due to this increased pressure and market volatility that banking risk needs such effective management to ensure the banks continued solvency. Risk can be defined as an “exposure to uncertainty of outcome” measured by the volatility (standard deviation) of net cash flow within the firm. Banks aim to add equity to the bank by maximizing the risk adjusted return to shareholders highlighting the importance of fully considering the risk and return business equation. Exposure to risk does not always lead to a loss, pure risk only has a downside from the expected outcome but speculative risk can produce either a better or worse result that expected.

Credit risk is the risk that the counterparty will fail to repay the loan in part or full. This includes delayed payments or any default on the loan agreement. It is widely know that credit risk is one of the most damaging risks to banks, for this reason there is usually a separate credit department run around a credit culture of the management’s views. The objective of the credit department will be to maximize shareholder value added through credit risk management.… Read the rest

Term Loan Appraisal

The primary task of a lending institutions before granting a term loan is to  assure itself that the anticipated rise in the income of the borrowing unit would materialize, thus providing the necessary funds for repaying the loans according to the terms of amortization. The liquidity of term loans depends not so much on the short-run sale ability of the goods and commodities as on the increased term loan income of borrowing units resulting from a higher level of utilization of existing installed capacity. For assessing the risks involved in term lending, the normal criteria used for judging the soundness of short-term loans are often unreliable and inadequate. The methods of analysis and the standard to be adopted for appraisal of term loans are more similar to investment decisions than to short-term lending. Appraisal of term-loans requires a dynamic approach involving, inter alia, a projection of future trends of output, sales, and estimates of costs, returns and flow of funds. Appraisal of term loans depends to a large extent on estimates of forecasts. Its purpose is not to set down a categorical statement of the long-range prospects of an industrial unit but only to provide broad guide outlines to the financial institutions.

The practice of making an appraisal of term loan applications on modern scientific lines has not made much progress in India. This is partly due to the fact that mainly the larger banks give such loans to highly credit-worthy constituents and hence no elaborate enquiry is considered necessary.… Read the rest

Loan Against Securities

Considerations of security form an important basis of lending. In fact, they constitute necessary adjunct to financial appraisal. Lending institutions have to examine the loan proposals from the point of view of nature and extent of security offered. Sometimes, there is a greater reliance on security due to inadequate financial appraisal, which in its turn may be due to non-availability of the necessary data. The security cover of the loan should, however, not be regarded as a substitute for an adequate financial assessment.

Security considerations are of particular importance in less developed countries like India where information on the character, integrity and credit-worthiness of the borrowers is not readily available and much ground work has yet to be done in the establishment of credit information bureaus. A prudent term lending institution, therefore, secures its loan by adequate collateral and, where necessary, guarantees. It also embodies in the loan agreement suitable protective and restrictive covenants such as maintenance of certain minimum financial standards, supplying to the lender adequate financial information, earlier repayment of loans under certain conditions, restriction on the payment of dividend and any other payments like managing agency or selling agency commission. Taking of adequate security infuses the necessary responsibility in the borrower. A general tendency exists among term lending institutions in India to depend more on collateral for the repayment of loans than on the integrity and policy of management and the borrowing concern’s past and prospective earnings..

The types of security generally accepted by the term lending institutions are the existing industrial assets as well as those to be acquired out of the granted loans.… Read the rest

Measures of Selective Credit Control for Banking

Qualitative or selective credit control policy refers to the set of policies implemented by the central bank in order to channelize the available credit in-the desired direction. For example, suppose in India the agricultural and small scale industry sectors are to be encouraged, then the RBI may direct the commercial banks to be more liberal in lending to these sectors and be strict while lending to other sectors. This will help the economy to provide ample opportunities for the priority sectors to grow. In other words, in every country the government determines in advance the priorities and to ensure that the banks conform to the priorities in their lending policies, the selective credit control policies are implemented. Hence, while the quantitative credit control policies aim at controlling the volume of credit created, and the money supply in the economy, the qualitative credit control policies help in using the available funds only for the important purposes and discourage unnecessary lending by commercial banks.

Objectives of Selective Credit Control

The objectives of the selective credit control policies are :

  1. To divert available funds only to the urgent and desirable purposes,
  2. To control and regulate a particular sector an economy without affecting the entire economy as a whole
  3. To discourage wasteful and uneconomical consumer expenditure on non-essential items.
  4. To correct the unfavorable balance of payments of a country and
  5. To control and regulate even the non-banking financial houses or intermediaries.
Methods of Selective Credit Control

The important methods of selective credit control policies are discussed in detail.… Read the rest

Variable Cash Reserve Ratio and Credit Control

Considering the limitations of the bank rate policy and the open market operations, the need to develop a very effective method of credit control was felt. Especially the need was to directly control the power of the commercial banks to create credit, Variable cash reserve ratio was suggested as one more method of quantitative credit control by Keynes. Further this method is considered necessary for promoting the overall liquidity and solvency of the banking system, apart from improving the public confidence on the banking system.

The process of working of this method of credit control can be easily understood with an example. Suppose in an economy there is over expansion of credit which is possible with excessive cash reserves with the commercial banks. To check this, the central bank may raise the cash reserve ratio say from 20% to 25% Then this will bring down the availability of cash reserve with the commercial banks. With lesser cash reserve they can only create lesser credit. Similarly, suppose the central bank wants to expand the credit creation by the commercial banks. Then it will bring down the cash reserve ratio say from 25% to 20%. This will enable the Commercial banks to have more cash reserve with which they can create more credit. It should be noticed that the cash reserve ratio determines the credit multiplier in an economy. An increase in former will contract credit through multiplier effect and reduction in the former will expand credit through multiplier.

In India the variable cash reserve ratio is slightly altered and it is called Statutory Liquidity Ratio (SLR).… Read the rest

Open Market Operations by the Central Bank

The open market operations as a method of quantitative credit control are interpreted in two ways. In a broad sense, it refers to the buying and selling of government securities as well as other eligible papers like bills and securities of private concerns by the central bank. In a narrow sense it means the buying and selling of only government securities by the central bank in the money market. The process of open market operations affects the volume of credit, the level of business activity and the internal price level. The process is explained below.

Suppose in an economy there is inflationary tendency and the expansion of credit is very high and the central bank wants to control this. Then the central bank will start selling securities in the open market to both the banks as well as the private individuals. When these securities are bought, payment is made in terms of cash. This will bring down the cash reserve of the commercial bank with which they can only crease lesser credit. As a result the expansion of credit will be reduced. Similarly, suppose the central bank wants to expand credit in order to revive an economy in deflationary situation. Then it will start buying securities in the open market from the commercial banks and others. This means, the central bank will pay them cash adding to their cash reserve. This will enable commercial banks to create more credit. Apart from expanding or contracting credit creation, open market operation can also influence the interest rate.… Read the rest