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

Reasons for Liquidity Fluctuations in Indian Banking System

Liquidity risk is inherent in bank’s core business because banking organizations employ a significant amount of leverage in their business activities and need to meet contractual obligations in order to maintain the confidence of customers and fund providers. The first step in measuring and managing liquidity risk is the identification of the most important sources of risk.

In the Indian context of banking, unexpected liquidity fluctuations are driven mainly by the following items:

  • Behavior of non-maturity deposits: A large fraction of deposits, in an Indian bank, consists of low-cost current and savings deposits which do not have any contractual maturity. Moreover, the depositor has the option to introduce or withdraw funds at any point of time. This makes the analysis of future cash inflows and outflows quite difficult. However, it is extremely crucial because the main reason for the closure of banks has been the inability to pay depositors on sudden demand. Therefore, the bank needs to know how much of these deposits is volatile, i.e. likely to flow out at short notice and how much is core or stable, i.e. unlikely to leave the bank. In the absence of contractual maturity, the bank needs to analyze the behavioral maturity of these deposits.
  •  Renewal patterns of term deposits: If the actual proportion of renewal is more than what the bank expects, it is left with surplus funds which might have to be reinvested at lower rates. If the actual fraction is less than anticipated, the bank faces a liquidity deficit, which might entail higher financing costs.
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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

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

Bank Rate or Discount Rate – Bank Rate Policy Defined

Bank Rate or Discount Rate is one of the earliest methods of general credit control developed by the Bank of England and it was considered an effective method till the outbreak of First World War. After the war, Bank of England developed other methods as it found the bank rate policy to be not so effective. The essence of discount rate policy that commercial banks approach the central bank whenever they are in need of financial accommodation. They get the necessary assistance by re-discounting the eligible bills and other securities. The Central bank would re-discount these instruments at a rate which directly determines the volume of funds which the commercial banks can get through this method of financial accommodation. A revision of this re-discounting rate by the central bank will necessitate the commercial banks to change their rate of discounting of eligible bills and securities.  As a result the businessmen will be encouraged or discouraged in approaching the commercial banks to get financial accommodation. Hence, it could be understood that the re-discounting rate is very much linked with all the other market rates and discounting rate.

In order to understand the process let us take an example. Suppose a commercial bank has a discounted trade bill worth 2000 USD at 15% and given holder of he bill 1700 USD. Suppose the commercial bank is in need of funds it can approach the Central bank and get the same bill re-discounted. Suppose the re-discounting rate 10%, then the commercial bank will get after re-discounting the bill 1800 USD.… Read the rest