khadija handbook

7/30/2019 Khadija Handbook

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TABLE OF CONTENTS

FINANCIALSYSTEM AND STRUCTURE................................................... 2

1.1 INTRODUCTION: ........................................... ............................................... ....................... 3

1.2 CONCLUSION: ....................................................................................... .............................. 5

FINANCIAL CRISIS ....................................................................................... 6

2.1 INTRODUCTION: ........................................... ............................................... ....................... 7

2.2 CONCLUSION: ....................................................................................... .............................. 9

BANK MANAGEMENT ............................................................................... 10

3.1 INTRODUCTION: ........................................... ............................................... ..................... 11

3.2 CONCLUSION: ............................................... ................................................. ................... 13

CREDIT RISK MANAGEMENT.................................................................. 14

4.1 INTRODUCTION: ........................................... ............................................... ..................... 15

4.2 CONCLUSION: ............................................... ................................................. ................... 18

INDUSTRY RISK .......................................................................................... 19

5.1 INTRODUCTION: ........................................... ............................................... ..................... 20

5.2 CONCLUSION: ............................................... ................................................. ................... 22

FINANCIAL RISK MANAGEMENT ........................................................... 23

6.1 INTRODUCTION: ........................................... ............................................... ..................... 24

6.2 CONCLUSION: ............................................... ................................................. ................... 26

LIQUIDITY RISK MANAGEMENT ............................................................ 27

7.1 INTRODUCTION ............................................ ............................................... ..................... 28

7.2 CONCLUSION......................................... ................................................ ............................ 32

ASSIGNMENTS ............................................................................................ 33

8.1 ASSIGNMENT # 01 .......................................................... ........................................ ........... 34

8.2 ASSIGNMENT # 02 ................................................................ ........................................... .. 34

8.3 ASSIGNMENT # 03 .......................................................... ........................................ ........... 35

8.4 ASSIGNMENT # 04 .......................................................... ........................................ ........... 36

8.5 ASSIGNMENT # 05 .......................................................... ........................................ ........... 36

8.6 ASSIGNMENT # 06 .......................................................... ........................................ ........... 37

8.7 ASSIGNMENT # 07 ................................................................ ........................................... .. 38


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CHAPTER 1

FINANCIAL SYSTEM AND

STRUCTURE


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1.1 INTRODUCTION:

Thefinancial systemis a dense network of interrelated markets and intermediaries that allocates

capital and shares risks by helping convey resources from lenders to borrowers, and transfer risks

from those who wish to avoid them (risk averse) to those who are willing to take them (risk

takers). It also increases gains from trade by providing payment services and facilitating

intertemporal trade. It is a complex interactive system, events in one component of which can

have significant repercussions elsewhere.

A financial system is necessary because

very few businesses can rely on internal

finance alone (i.e. invest their own

money). Specialized financial firms are

better at connecting investors to

entrepreneurs and other economic

agents, like domestic households,

governments, established businesses and foreigners (with potentially profitable business ideas

but limited financial resources), than non-financial individuals and companies. Lenders or savers

include domestic households, business, government and foreigners with excess funds. Risk is

shared by the constituents of the financial system and capital is revolved in the society from

capital surplus to capital deficit. To achieve efficiencies of financial system; specialization and

economies of scale, are required.

Financial Markets-Financial markets come in a variety of flavors to accommodate the wide

array of financial instruments or securities that have been found beneficial to both borrowers and

lenders over the years. Primary markets are where newly issued instruments are sold for the first

time. Most securities are negotiable. In other words, they can be sold to other investors at will in

what are called secondary markets.

Financial systems are classified as money market, capital market and the derivative market.

Money markets are used to trade instruments with less than a year to maturity Examples include

the markets for T-bills, commercial paper, and bankers acceptances negotiable certificates of

Financialsystem

Spenders/

entrepreneursSavers/investors

Source: lecture notes


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deposit etc. Securities with a year or more to maturity trade in capital markets. Some capital

market instruments, called perpetuities, never mature or fall due. Derivativescontracts trade in a

third type of financial market called derivatives market. Derivatives allow investors to spread

and share a wide variety of risks, from changes in interest rates and stock market indices to

undesirable weather conditions.

Financial intermediaries- like financial markets link investors to borrowers. They are highly

specialized and do so by transferring assets. Intermediaries buy and sell instruments with

different risk, return, and/or liquidity characteristics.

Markets and intermediaries often fulfill the same needs, though in different ways. Borrower

Choice- borrower issuers typically choose the alternative with the lowest overall

cost, while investors and lenders Choice- investors choose to invest in the markets or

intermediaries that provide them with the risk-return-liquidity trade-off that best suits them. Risk

is a bad thing, while return and liquidity are good things. Therefore, every saver wants to invest

in riskless, easily saleable investments that generate high returns.

Asymmetric information-when there

is unequal information at end of

borrower as well as lender, oftenincorrect decisions are taken which

play a great role in reducing the

overall efficiency of the financial

system. There are two forms of

asymmetric information; adverse selection and moral hazard. Adverse selection occurs before a

contract is signed and moral hazard entails after signing contractual agreement.

One of the major functions of the financial system is to tangle with those devilish information

asymmetries. The adverse selection problem caused by asymmetric information can be reduced

through proper screening as well as private production and sale of information (which may arise

the free rider problem). Adverse selection can also be reduced by contracting with groups instead

of individuals. Moral hazard can be prevented through monitoring, adding the clause of

AdverseSelection

Transaction

withAsymmetricInformation

Moral Hazard



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restrictive covenants, or through collateral as well because initial screening is not enough. These

measures will not help kill asymmetry, but they usually reduce its influence enough to let

businesses and other borrowers obtain funds cheaply enough to allow them to grow, become

more efficient, innovate, invent, and expand into new markets. By providing relatively

inexpensive forms of external finance, financial systems make it possible for entrepreneurs and

other firms to test their ideas in the marketplace.

1.2 CONCLUSION:

The major concern for investors as well as the borrowers is the total cost of the financial system.

The main considerations here are government and self regulations.

Roles and Functions of regulations-regulation perform four main functions. First, they try to

reduce asymmetric information by encouraging transparency. That usually means requiring both

financial markets and intermediaries to disclose accurate information to investors in a clear and

timely manner. A second and closely related goal is to protect consumers from scammers,

shysters, and assorted other grafters. Third, they strive to promote financial system competition

and efficiency by ensuring that the entry and exit of firms is as easy and cheap as possible.

Finally, regulators also try to ensure the soundness of the financial system by acting as a lender

of last resort, mandatingdeposit insurance, and limiting competition through restrictions on

entry and interest rates.


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CHAPTER 2

FINANCIAL CRISIS


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2.1 INTRODUCTION:

Financial crisis refers to any unfortunate event with adverse effects that is inevitable. It occurs

when one or more financial markets and/or financial intermediaries are erroneous and not

functioning properly. Financial crisis could be

systemic or non-systemic.

A non-systemic crisis involves only one or a

few markets or sectors. A systemic

crisis involves almost the entire financial

system, such as during the Great Depression.

Financial crises are neither new nor

unusual. Sometimes, non-systemic crises burn

out or are brought under control before they

spread to other parts of the financial system.

Other times, as in 1929 and 2007, when not

contained, non-systemic crises spread like a

wildfire until they threaten to burn the entire

system and transform into systemic crisis. Both systemic and non-systemic crisis damage the real

economy by preventing the normal flow of credit from savers to entrepreneurs and making it

more difficult or expensive to spread risk.

Asset bubbles- rapid increases in the value of some asset, like bonds, commodities, equities, or

real estate is called asset bubble. Low interest rates, new and advanced technology,

unprecedented increases in demand for the asset, and easily accessible debt (leverage), typically

create bubbles. Low interest rates can cause bubbles by lowering the total cost of asset

ownership. Large increases in the demand for an asset occur for a variety of reasons. Demand

can be increased merely by investors expectations of higher prices in the future.

Financial Panic-a financial panic is a scenario under which financial intermediaries and other

investors must sell assets quickly in order to meet lenders calls. Lenders call loans, or ask for

repayment, when interest rates increase and/or when the value of collateral pledged to repay the



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loan sinks below the amount the borrower owes. Calls are a normal part of everyday business,

but during a panic, they all come at once due to some shock, often the bursting of an asset

bubble. Bubbles are bound to burst but nobody knows in advance when they will do so. A burst

is sometimes triggered by an obvious shock, like a natural catastrophe or the failure of an

important company. During a

panic, almost everybody

must sell and few can or want

to buy, so prices fall,

triggering additional calls,

and yet more selling.

Invariably, some investors,

usually the most highly

leveraged ones, cannot sell

assets quickly enough, or for a

high enough price, to meet the lenders call and repay their loans. Banks and other lenders

begin to suffer defaults. Panics often cause the rapid de-leveraging of the financial system, a

period when interest rates for riskier types of loans and securities increase and/or when a credit

crunch, ora large decrease in the volume of lending, takes place. Such conditions often usher in

a negative bubble, a period when high interest rates, tight credit, and expectations of lower asset

prices in the future cause asset values to trend downward. During de-leveraging, the forces that

once drove asset prices up now conspire to drag them lower.

Lender of Last Resort- Financial Panics often causes the rapid de-leveraging of the financial

system.The purpose of the lender of last resort is to stop financial panics and deleveraging by

adding liquidity to the financial system and attempting to restore investor confidence . The most

common form of lender of last resort today is the government central bank, or the Federal

Reserve. The International Monetary Fund (IMF) sometimes tries to act as a sort of international

lender of last resort, but it has been largely unsuccessful in that role. Lenders of last resort

provide liquidity, loans, and confidence. They make loans to solvent institutions that are not

facing inevitable bankruptcy but, temporary solvency problems due to the crisis. The restoration

can come in the form of outright grants or the purchase of equity but often takes the form of

Shock

Interest rates rise

Asse t values fall

Sell off/defaults

Credit tightens

Interest rates rise

Lending volume falls

More sell

off/defaultsAsset values fall



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subsidized or government-guaranteed loans. Unsurprisingly, bailouts (restoring losses with

taxpayer money) are often politically controversial because they can appear to be unfair and

because they increase moral hazard, or risk-taking on the part of entities that expect to be bailed

out if they encounter difficulties. 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.

2.2 CONCLUSION:

Financial crisis refers to any bad event that is inevitable. Efficient working of financial markets

and financial intermediaries is, thus, a prerequisite, for if there is an error it could lead to

financial crisis which could affect adversely the entire financial system. An asset bubble is

formed due to unexpected rise in the value of an asset and when the bubble is about to burst it

creates financial panics. Afterwards, a negative asset bubble is formed where interest rates are

high and value expectations are low. Lender of last resort is the government and as the title

suggests, it is the last option to combat financial crisis by adding liquidity and attemptingto

restore investor confidence.


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CHAPTER 3

BANK MANAGEMENT


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3.1 INTRODUCTION:

The main functions of bank are to accept deposits and give loans. Both transactions involve

inclusion of interest which ultimately has a huge impact on the banks' financial statements. The

difference between interest charged and interest paid is called spread.Their ability to pool

deposits from many sources that can be lent to many different borrowers creates the flow of

funds inherent in the banking system.At the broadest level, banks and other financial

intermediaries engage in asset transformation. In other words, they sell liabilities with certain

liquidity, r isk, return, and denominational characteristics and use those funds to buy assets with a

different set of characteristics. More specifically, banks turn short-term deposits into long-term

loans. Banks' Financial statements are, therefore, very tricky to understand for a layman.

Balance sheet-the balance sheet is a

financial statement that provides a

snapshot of what a company owns i.e.

its assets or uses of funds and what it

owes i.e.its liabilities or sources of

funds. The key equation for a banks

balance sheet is the same as used for

any other balance sheet: assets =

liabilities + owners equity.

Bank assets and liabilities-major

banks assets include reserves, loans,

investments and other assets. Reserves

are cash in the vault and deposits with

the central bank. Loans include loans

to other banks, securities dealers,

nonbank businesses and consumers.

Other assets include branches and

computer systems etc.Banks bread-

and-butter asset is, of course, their loans. They derive most of their income from loans, so they


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must be very careful who they lend to and on what terms. Some loans are uncollateralized, but

many are backed by real estate.Major banks liabilities include transaction deposits, non

transaction deposits, borrowings and equity. Transaction deposits are those that can be

withdrawn immediately in person at the bank, at an ATM, via debit card or by check.

Nontransaction deposits are those that can be withdrawn without penalty only after the passage

of a predetermined amount of time or that are not accessible by check. Borrowings are loan from

central or other banks. Equity is the book value of the bank.Equity originally comes from

stockholders when they pay for shares in the banks initial public offering (IPO) or direct public

offering (DPO). Later, it comes mostly from retained earnings, but sometimes banks make a

seasoned offering of additional stock.

DuPont Analytical Approach- it is a method of performance measurement that was started by

the DuPont Corporation in the 1920s. Return on equity (ROE) is one of the most important

indicators of a firms profitability and potential growth. DuPont analysis tells us that there are

three components in the calculation of return on equity; the net profit margin (measuring the

operating efficiency), asset turnover (measuring the asset use efficiency), equity multiplier

(measuring the financial leverage). By examining each input individually, we can discover the

sources of a company's return on equity and

compare it to its competitors. If ROE is

unsatisfactory, the DuPont analysis helps

locate the part of the business that is

underperforming.

Problems faced by financial manager-Bankers

must manage their assets and liabilities to ensure

that it has enough reserves on hand to pay for any

deposit outflowswithout rendering the bank unprofitable, earns profits, and obtains its funds as

cheaply as possible. To earn profits and manage liquidity and capital, banks face two major risks:

credit risk, the risk of borrowers defaulting on the loans and securities it owns, and interest rate

risk, the risk that interest rate changes will decrease the returns on its assets and/or increase the

cost of its liabilities.

Have enough

reserved to

satis fy depositoutflows

Use effici ently

enough toearn profit



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3.2 CONCLUSION:

Banks financial statements are different from the financial statements of firm in any other

industry. A financial manager should be well aware of the possible financial risks and how to

manage those. The major risks are credit risk and the interest rate risks. Along with these is also

the liquidity risk. Asymmetric information is one of the causes of the financial risk so financial

manager should be well aware of it and its consequences so that he can manage it efficiently and

effectively.


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CHAPTER 4

CREDIT RISK MANAGEMENT


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4.1 INTRODUCTION:

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail

to meet its obligations in accordance with agreed terms. 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. Credit risk arises from the potential that an obligor is either; unwilling

to perform on an obligation or, its ability to perform such obligation is impaired, which is why it

is a customer related risk. Losses may result from reduction in portfolio value due to actual or

perceived deterioration in credit quality. Credit risk emanates from a banks dealing with

individuals, corporate, financial institutions or a sovereign. For most banks, loans are the largest

and most obvious source of credit risk; however, credit risk could stem from activities both on

and off balance sheet. The goal of credit risk management is to maximize a bank's risk-adjustedrate of return by maintaining credit risk exposure within acceptable parameters.

Types of Credit Risk-there are five types of credit risk. Lending risk-Lending risk is associated

with extensions of credit and/or credit sensitive products, such as loans and overdrafts, where the

bank bears the full risk for the entire life of the transaction. There are two types of lending risk:

direct and contingent. Direct lending risk: Direct lending risk is the risk that actual customer

obligations will not be settled on time. Direct lending risk occurs in products ranging from loans

and over drafts to credit cards and residential mortgages. It exists for the entire life of the

transaction. Contingent lending risk: Contingent lending risk is the risk that the potential

customer obligations will become actual obligations and will not be settled on time. Contingent

lending risk occurs in such products as letters of credit and guarantees. It exists for the entire life

of the transaction. Issuer risk: Issuer risk occurs in underwriting activities when the bank

commits to purchase an equity security or other debt instrument from an issuer or seller and there

is a risk that the instrument cannot be sold within a predetermined holding period to an investor

or purchaser. Issuer risk is interrelated with price risk. Counter party risk-counterparty is acustomer with whom we have a contract to simultaneously pay each other agreed va lues at a

stated future date. Pre-Settlement risk-Pre-settlement risk is the risk that counterparty may

default on a contractual obligation 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


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to future market volatility (known as the maximum likely increase in value).Settlement risk-

Settlement risk occurs on the maturity date when the bank simultaneously exchanges funds with

a counterparty for the same value date and cannot verify that payment has been received until

after the banks side of the transaction has been paid or delivered. In today's international banking

environment, the different time zones between countries make it difficult to achieve a

simultaneous exchange between counterparties. In this situation, at least 100% of the principal

amount is at risk. The risk may be larger than 100% if, in addition, there has been an adverse

price fluctuation for us between the contract price and the market price.

Credit Risk Assessment-there are traditional and new models for credit risk assessment, they are

qualitative as well as quantitative. One of the important credit risk assessment method is the

traditional 5Cs model. It is a qualitative model. 5Cs stand for Character: this C is indicative ofthe obligors character, if he is a good citizen there are more chances that he will return the

amount and on time, Capacity: if the obligor company has good cash flows there is fewer risk of

being default, Capital: a person having good amount of wealth will be able to pay off in case of

losses in the business, Collateral security and Conditions when external conditions are bad,

economic especially downside then more risk is involved.

Key Areas for assessment are purpose of facility, amount and duration. In purpose of facility,

funds are monitored, their movement is closely observed. Amount should meet the need for

which loan is issued and it should match the purpose. In addition to models and areas of

assessment, lending principle and safety of funds are also considered. The applicant's borrowing

capacity and legal status must be examined. Safety first should be the first guiding principle of a

lending officer, because the very existence of a financial institution depends on the recovery of

its outstanding, which can never be sacrificed to the profit earning capacity.


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New Model of Credit Risk Analysis-

involves the in depth analysis of the

External Risks facing all the industries

and firms, The Industry risks specific to

the industry in which our borrower falls,

The Internal Risks which are unique to

our borrower like management,

technology and capacity. In addition to

the above we analyze the most important

risks -Financial Risks to which the firm is

exposed. We make a judgment on theCredit Worthiness of the customer after

carefully evaluating all the above risks. Business Cycle is another way of understanding credit

risk. In order to mitigate the credit risk for the bank the lending banker should study the state of

the economy and analyse the phase of the business cycle through which the country is currently

passing with special emphasis on its effects on the potential viability of the business proposed to

be financed. Includes four phases; recession, trough, recovery and peak. In Recession stage of

the cycle Bankruptcies increase as weaker firms find it difficult to cope. It is the widely held

view that if the economic growth is

negative in two quarters, the economy is

in recession. In trough, things look like

they are at their worst. High levels of

unemployment, general gloom, lowest

production levels in the recent history of

the economy, bottomed stock market and

bankruptcies of banks and other financial

intermediaries due to heavy bad loans are

some of the symptoms. In recovery,

things begin to look a little better, with business confidence returning and economic activity

picking up. Stock prices and employment levels start rising while investments and profits



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increase.In peak, the economy puts up very strong performance with low unemployment levels.

While most business do well in economic growth (which can be linked to the recovery and boom

phase in a business cycle), economic decline (recession/trough in the cycle) causes bankruptcies

and credit losses. The majority of the business firms tend to do poorly in recession. Probably the

only ones who thrive in a recession are scrap metal dealers and bankruptcy lawyers.

4.2 CONCLUSION:

Since exposure to credit risk continues to be the leading source of problems in banks world-wide,

banks and their supervisors should be able to draw useful lessons from past experiences. Banks

should now have a keen awareness of the need to identify, measure, monitor and control credit

risk as well as to determine that they hold adequate capital against these risks and that they are

adequately compensated for risks incurred. Today organizations should focus on: Establishing an

appropriate credit risk environment; operating under a sound credit-granting process;

maintaining an appropriate credit administration, measurement and monitoring process; and

ensuring adequate controls over credit risk.


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CHAPTER 5

INDUSTRY RISK


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5.1 INTRODUCTION:

Industry risk analysis is a market assessment tool designed to provide a business with an idea of

the complexity of a particular industry. It is an indispensable part of credit risk analysis. It refers

to the dangers to a particular stock that stem not from problems with the company but rather

from far more wide ranging issues involving the entire industry that the company belongs to.

Types of Industry Risks-before getting down to the details of industry analysis, its better to

bifurcate, to divide into separate parts, the operating risk as follows; risk emanating from

external environment and industry specific risk. External risk includes risk because of change in

political, social, economic, technological, regional and climatic changes. Industry specific risk is

the risk specific to a particular industry; all the firms in the industry are prone to it. It has equal

impact on all in that industry but one having better combination of forces or better strengths

strives best other have to strive in the industry. External risk have different impact on different

industries, its not specific to a particular industry.

Industry Life Cycle-industry can be

captured by five-stage model starting

from pioneering stage and moving from

Rapid Growth toMaturity to Stability andending atDecline. Pioneering stage is the

lengthy stage as most of the research and

development work is done here. Risk is

higher as uncertainties regarding future

performance and conditions are quite

high. Rapid growth is the stage where

industry starts getting some profits; it is

the stage of active activity. In maturity stage the sales become constant either because of

saturation or substitutes arrival. Stability is the stage where risk is minimum and overall

combination and condition of the industry is constant. Decline is the last stage of the industry life

cycle where profit goes down, industry is at the lower end. Here industry is towards the down

end with high risk. The growth to stabilization stage can be considered to be low/moderate risk
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stages, the pioneering and decline stage are high-risk categories. Certain types of industry enjoy

a life spanning centuries like shipping, insurance, banking and railways.

Business Cycle and Industry-some industries like food industries are non-cyclical industries

while other like rubber industry and the paper industry are cyclic in nature. These industries

move in tandem with the business cycle. A business being cyclic or not also effect the risk of the

industry and so are important to consider while doing an analysis.

Industry Profitability and Porters five forces model-profitability and cash generation capacity

of a particular industry depends on; competition among the existing firms within the industry,

threat of new entrants, threat

of new substitutes, bargaining

power of buyers and the

bargaining power of suppliers.

Attractiveness in this context

refers to the overall industry

profitability. An "unattractive"

industry is one in which the

combination of these five

forces acts to drive down

overall profitability. A very

unattractive industry would be

one approaching "pure

competition", in which available profits for all firms are driven to normal profit. Three of

Porter's five forces refer to competition from external sources. The remainder is internal threats.

Porter referred to these forces as the micro environment, to contrast it with the more general

term macro environment. They consist of those forces close to a company that affect its ability to

serve its customers and make a profit. A change in any o f the forces normally requires a business

unit to re-assess the marketplace given the overall change in industry information. The overall

industry attractiveness does not imply that every firm in the industry will return the same

profitability. Firms are able to apply their core competencies, business model or network to

achieve a profit above the industry average.
http://en.wikipedia.org/wiki/Profit_(economics)#Normal_profithttp://en.wikipedia.org/wiki/Marketing#Marketing_environmenthttp://en.wikipedia.org/wiki/Environmental_scanninghttp://en.wikipedia.org/wiki/Companyhttp://en.wikipedia.org/wiki/Profit_(economics)http://en.wikipedia.org/wiki/Marketplacehttp://en.wikipedia.org/wiki/Industry_informationhttp://en.wikipedia.org/wiki/Firmhttp://en.wikipedia.org/wiki/Core_competencieshttp://en.wikipedia.org/wiki/Business_modelhttp://en.wikipedia.org/wiki/Business_modelhttp://en.wikipedia.org/wiki/Core_competencieshttp://en.wikipedia.org/wiki/Firmhttp://en.wikipedia.org/wiki/Industry_informationhttp://en.wikipedia.org/wiki/Marketplacehttp://en.wikipedia.org/wiki/Profit_(economics)http://en.wikipedia.org/wiki/Companyhttp://en.wikipedia.org/wiki/Environmental_scanninghttp://en.wikipedia.org/wiki/Marketing#Marketing_environmenthttp://en.wikipedia.org/wiki/Profit_(economics)#Normal_profit


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5.2 CONCLUSION:

Industry analysis involves reviewing the economic, political and market factors that influence the

way the industry develops. Major factors can include competitors power, the possibility of new

entrants, power of suppliers and buyers and substitutes. Several key factors must be considered

while analyzing an industry; geographical, industry, its size, trends and outlook, product, buyers

that are the target customers and the company information. The life stage, composition, nature,

characteristics and structure of an industry are to be studied to find profitability d ifference among

various industries, risk difference among various industries and reason for consistency of profits

among various industries. F ive forces of porter determine the level of competition in an industry.

The attractiveness of the industry depends upon the combination of these forces. Along with all

this management analysis is of key concern as a bad management can drown a successfulbusiness.
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CHAPTER 6

FINANCIAL RISK MANAGEMENT


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6.1 INTRODUCTION:

Many businesses fail not because of lack of business opportunities, but due to poor or improper

management of financial affairs. F inancial risk refers to the chances of collapse of a business due

to wrong financing polices/decisions/strategies such as lopsided capital structure and asset-

liability mismatch.So the managers should be aware of the risks involve and try to combat them.

Financial analysis helps in investigating the risks, to identify and avail opportunities and to

determine the extent of financial support needed. Hence its of vital importance for the managers

especially of intermediaries like bank.

Managing Credit Risks-when credit risk is identifies it needs to be handled as to mitigate its

effect. Financial analysis serves three main purposes; first, it digs deep and brings out financial

risks. Second, it triggers questions that would lead to a meaningful operating/business analysis.

This explains why financial details get prominence among the information called for by credit

providers. And thirdly, especially for financial intermediaries such as banks, it is also useful to

determine the extent of financial support needed by the prospective borrower.

Credit AppraisalInterpretation of Financial Statements-Financial statements, the end product

of accounting, are viewed as proxies (evidence or indicator.) of economic activities and

business performance. Analysis of financial statements enjoys a prominent place in theassessment of the study of credit risks, lending decisions and ongoing monitoring of the lending

portfolio. Financial statements, preferably audited, 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.

Financial Analysis-studying ten years financials is ideal; at least five years financial data is

needed for a new credit prospect, unless the firms age is lesser. Financial analysis should strive

to recognize and identify early warning signs and other financial risks and suggest suitable

defensive strategies and practical solutions to mitigate risks and protect the credit asset from

potential problems and credit losses.


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Credit Worthiness- credit risk analyst undertakes financial analysis, primarily for ensuring the

creditworthiness of customers. It denotes checking whether the prospective borrower is worthy

to receive credit. It is similar to the term of seaworthiness of a ship, which is a normal clause in

marine insurance policies. It is to avoid the credit risk, inability or unwillingness of the customer

to pay.

Financial Appraisal for the Credit Decision-Though several qualitative factors play a role in a

credit decision, a major influencing factor is the financial health of the borrower as brought out

by the financial appraisal. Credit officer uses techniques such as financial ratio analysis, cash

flow analysis and sensitivity analysis to assess the credit worthiness of the borrowing

companies.

Financial Ratio Analysis-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 necessity of expressing the relationship between

related items in the form of ratios or percentages arises from the fact that absolute Rupee data are

incapable of revealing the soundness or otherwise of a company's financial position or

performance. For instance, finding a ratio between total revenue and total Assets used to generate

the revenues show the efficiency of the company in utilizing the assets and Industry comparison

shows if the particular enterprise is well managed or not as per industry standards. However, a

single ratio in itself is meaningless because it does not provide a complete picture of a company's

financial position.

Methods of Comparison-Ratios and percentages have little significance unless they can be

compared with, or matched against, appropriate standards. Historical Comparison- Historical

standards are based on the record of the past financial and operating performance of individual

subject business concern. Comparison of historical ratios throws more light on the companys

performance than just one years data. Industry Comparison- Horizontal, Peer Group, or Industry

standards represent ratios and percentages of selected competing companies, especially the most

progressive and successful ones, or of the industry averages of which the individual company is a

member. Comparisons with Industry averages are most valuable for judging the financial health

of a Company. Regulatory Requirements- Sometimes Regulators lay down standards which must


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be met before financing is allowed by supervisors. State Bank Prudential regulations lay down

Minimum Current Ratio that should appear at the time finance is granted. Budget Comparison-

Budgeted standards, or "goal ratios" as they are sometimes called. These 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.

Categories-Most credit analysts use four broad categories of ratios; liquidity, profitability,

leverage, and operating. Liquidity ratios indicate the borrowers ability to meet short-term

obligations, continue operations and remain solvent. Profitability ratios indicate the earnings

potential and its impact on shareholder returns. Leverage ratios indicate the financial risk in thefirm 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.

Sensitivity Analysis-It involves creating a mathematical model generally on a spreadsheet of any

business results or other phenomena based on certain assumptions say about prices or rates of

interest or government duties and then seeing how any possible changes in the variables affect

the overall results in a positive or negative manner.

6.2 CONCLUSION:

Financial risk refers to the chances of collapse of a business due to wrong financing

polices/decisions/strategies such as lopsided capital structure and asset-liability mismatch.So the

managers should be aware of the risks involve and try to combat them. Financial analysis helps

in investigating the risks, to identify and avail opportunities and to determine the extent offinancial support needed.


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CHAPTER 7

LIQUIDITY RISK MANAGEMENT


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7.1 INTRODUCTION

Liquidity of an asset is its ability to 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 obligat ions

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 can be triggered by credit risk and market risk. Banks with large off-balance sheet

exposures or the banks, which rely heavily on large corporate deposit, have relatively high level

of liquidity risk. Liquidity risk may not be seen in isolation, because financial risk are not

mutually exclusive and liquidity risk often triggered by consequence of these other financial

risks such as credit risk, market risk etc.

Early Warning indicators of liquidity risk-some of the early indicators of the liquidity risks are;

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 ofoff-balance sheet exposure and deteriorating third party evaluation about the bank.

Effective liquidity risk management-Generally speaking, if any of the above mentioned

indicators are prevailing, the board of a bank is responsible: firstly, to position banks strategic

direction and tolerance level for liquidity risk. Secondly, to appoint senior managers who have

ability to manage liquidity risk and delegate them the required authority to accomplish the job.

Third, to continuously monitors the bank's performance and overall liquidity risk profile. finally,

to ensure that liquidity risk is identified, measured, monitored, and controlled.

Senior managers 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. They should also adhere to the lines of

authority and responsibility that the board has established for managing liquidity risk. Senior


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management mustoversee the implementation and maintenance of management information and

other systems that identify, measure, monitor, and control the bank's liquidity risk, establishing

effective internal controls over the liquidity risk management process.

Liquidity Risk Strategy-there are three strategies to deal with liquidity some of them are

Composition of Assets and Liabilities, Diversification and Stability of Liabilities andAccess to

Inter-bank Market. Composition of Assets and Liabilities- The strategy should outline the mix of

assets and liabilities to maintain liquidity. Diversification and Stability of Liabilities.-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 comprehensively analyze the stability of

liabilities/funding sources the bank need to identify: Liabilities that would stay with the

institution under any circumstances;

Liabilities that run-off gradually if problems arise; and thatrun-off immediately at the first sign o f problems. Access to Inter-bank Market.-The inter-bankmarket can be important source of liquidity. However, the strategies should take into account the

fact that in crisis situations access to interbank market could be difficult as well as costly.

Liquidity policy- the key elements of any liquidity policy include: General liquidity strategy

(short- and long-term), specific goals and objectives in relation to liquidity risk management,

process for strategy formulation and the level within the institution it is approved; Roles andresponsibilities 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 riskmanagement structure for monitoring, reporting and reviewing liquidity; Liquidity risk

management tools for identifying, measuring, monitoring and controlling liquidity risk

(including the types of liquidity limits and ratios in place and rationale for establishing limits and

ratios); Contingency plan for handling liquidity crises.

ALCO/Investment Committee- The responsibility for managing the overall liquidity of the bank

should be delegated to a specific, identified group within the bank. This might be in the form of

an Asset Liability Committee (ALCO) comprised of senior management, the treasury function or

the risk management department.


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Management Information System- An effective management information system (MIS) is

essential for sound liquidity management decisions. Information should be readily available for

day today liquidity management and risk control, as well as during times of stress. 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.

However, certain information can be effectively presented through standard reports such as

"Funds Flow Analysis," and "Contingency Funding Plan Summary". These reports should be

tailored to the bank's needs. Other routine reports may include; a list of large funds providers, a

cash flow or funding gap report, a funding maturity schedule, and a limit monitoring report and

exception report. Based on information of maturities of all advances, 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

and Blue print are for tackling deficit in funding.

Contingency Funding Plans (CFP)- (CFP) is a set of policies and procedures that serves as a

blue print for a bank to meet its funding needs in a timely manner and at a reasonable cost. A

CFP is a projection of future cash flows and funding sources of a bank under market scenarios

including aggressive asset growth or rapid liability erosion. Use of CFP for Routine Liquidity

Management- 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 and

Management of access to funding sources. Use of CFP for Emergency and Distress

Environments- 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 reputation.

Scope of CFP- CFP should anticipate all of the bank's funding and liquidity needs by

Analyzing and making quantitative projections of all significant on- and off balance- sheet funds

flows and their related effects. CFP can also analyze by Matching potential cash flow sources

and uses of funds and establishing indicators that alert management to a predetermined level of


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potential risks. The CFP should 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. While 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.

The Ratios Approach-Some Key Liquidity Ratios include; - Loan to deposit ratio =Performing

loans outstanding / Deposit balances outstanding, this is a simple measure to understand and

compute. Indicates the extent to which relatively illiquid assets (loans) are being funded by

relatively stable sources (customer deposits). It can also show 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. Incremental loan to deposit ratio = Incremental loans made during the period / Incremental

deposit inflows during the same period , In addition to the above, the ratio also 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. 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.Cash flow coverage ratio = Projected cash inflow / Projected cash outflow, A

higher ratio indicates lower liquidity risk. 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. - On handliquidity to total liabilities =On hand liquidity - cash in hand + near cash assets / Total

liabilities, A higher ratio signifies higher liquidity, but carries the risk of lower profitability .

Contingent Liabilities Ratio =Contingent Liabilities / Total Loans, A higher ratio indicates a

higher potential Risk.


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7.2 CONCLUSION

Liquidity risk arises when the liquid assets are not sufficient enough to meet its obligation.

Liquidity risk can be triggered by credit risk and market risk. Banks with large off-balance sheet

exposures or the banks, which rely heavily on large corporate deposit, have relatively high level

of liquidity risk. Liquidity risk may not be seen in isolation, because financial risks are not

mutually exclusive and liquidity risk often triggered by consequence of these other financial

risks. Along with other specific issues that banks face liquidity is one of the major concerns for

the banks board. Due to the 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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8.1 ASSIGNMENT # 01

Why does profitability differ among various industries?

Profitability differs among various industries according to the type of industry and the stage of

their lifecycle. For instance, in Pakistan telecommunication industry is more profitable than anyother, so it depends upon the type of the product industry specialize in and the need for that

product. Some industries are consistently getting profits while other show fluctuation because

some are at growth and maturity stage of the life cycle while others are at decline. Their

difference in cost of production, availability of factors of productions, and competition also play

an important role. 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.

8.2 ASSIGNMENT # 02

What is the subprime crisis?

Sub Prime as the word defines, means subordinate to primary. It refers to the credit status of the

borrower (being less than ideal), not the interest rate on the loan itself. The word is used in the

lending industry to define a borrower who does not have a good credit history and hence is not

able to qualify for best market rates vis--vis the prime category borrower. Potential sub-prime

borrowers may comprise of individuals who have experienced severe financial problems and are

usually labeled as higher risk and therefore have greater difficulty obtaining credit, especially for

large purchases such as automobiles or real estate. Hence to offset the higher degree risk to an

extent the subprime lenders increase the interest rates.

In 1994, less than 5% of total mortgages were subprime in US. But within 2005, that figure went

up to 20%. The sudden changes in the banking system were mainly the reasons behind it. Earlier,

mainly the commercial banks were used to serve the American communities and they offered

fixed rate mortgages. As the competition increased several mortgage products and choices, such

as sub prime loans of different varieties for the consumers were offered along with adjusted rate

mortgages. However, in 2005, the rates of interest began to increase. Therefore, demand for


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home came down which also brought down the property prices leading to start of sub prime

crisis.

The sub prime home loans were given at floating rate of interests. So as interest rates increased,

the rates on floating home loans too went up, and so did the monthly installments needed toservice these loans. Simultaneously, the property prices declined hitting the sub prime borrowers

who started defaulting. Once, more and more sub prime borrowers started defaulting, payments

to the institutional investors who had bought the financial securities stopped, leading to huge

losses. The impact was so strong that the government feared an entire financial failure it is

estimated that a global loss of almost $6.9 trillion incurred in the crisis.

8.3 ASSIGNMENT # 03

How does a banks balance sheet differ from the typical balance sheet?

A balance sheet is often described as a "snapshot of a company's financial condition". A bank's

balance sheet is different from that of a typical company. There is no inventory, accounts

receivable, or accounts payable. Instead, under assets, there are mostly loans and investments,

and on the liabilities side, there are deposits and borrowings.

The main functions of bank are to accept deposits and give loans. Both transactions involve

inclusion of interest which ultimately has a huge impact on the banks' financial statements. The

difference between interest charged and interest paid is called spread. Their ability to pool

deposits from many sources that can be lent to many different borrowers creates the flow of

funds inherent in the banking system. At the broadest level, banks and other financial

intermediaries engage in asset transformation. In other words, they sell liabilities with certain

liquidity, r isk, return, and denominational characteristics and use those funds to buy assets with a

different set of characteristics. More specifically, banks turn short-term deposits into long-term

loans. Banks' balance sheets are, therefore, very tricky to understand for a layman.


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8.4 ASSIGNMENT # 04

What is the difference between credit risk and financial risk?

Financial risk is an umbrella term for any risk associated with any form of financing. Typically,

in finance, risk is synonymous with downside risk and is intimately related to the shortfall or the

difference between the actual return and the expected return (when the actual return is less).

Financial risk is a broader term that includes a variety of risks such as market risks (including

foreign currency exchange risk and interest rate risk), credit risk, liquidity and capital risk.

Credit risk, however, is the part of it which refers to the risk of loss by a person or entity that has

extended credit to another party, if that other party does not pay the specified amount within the

appointed time period. The credit being extended is usually in the form of either a loan or an

account receivable. In the case of an unpaid loan, credit risk can result in the loss of both interest

on the debt and unpaid principal, whereas in the case of an unpaid account receivable, there is no

loss of interest.

8.5 ASSIGNMENT # 05

What are the forces determining the level of competit ion in an industry?

Forces determining the level of competition in an industry are:

Competition among the existing firms in the industry- if competition within industry ishigh 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. 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. 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 barriers- Market rivalry tends to be more vigorous when it costs more to get out of abusiness than to stay in and compete.


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Threat of new entrants- states that if it is difficult for new firms to enter the industry itwill 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 substitutes- also effects the profitability if substitute products are available, thenthe industry profitability is affected by the factors influencing the substitute s. Relative

price, sat isfying 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. 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.

Bargaining power of buyers- it affect the competitive environment of any industry ifbuyers 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- it also affect the profitability of industry if suppliers arestrong 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.

Will an industry that performed well in one time period continue to do well in future?

Industries working well today might not show same performance in future due to political,

economic, social, technological, environment, and legal issues. Political instability is major

threat for industries, if political and law and order situation is not good than profits will go down.

Likewise change in any of these factors creates problems for business enterprise.

8.6 ASSIGNMENT # 06

What are the tools a bank can use to reduce the financial risk?

Financial risk is an umbrella term for any risk associated with any form of financing. Typically,

in finance, risk is synonymous with downside risk and is intimately related to the shortfall or the


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difference between the actual return and the expected return (when the actual return is less).

Financial risk is a broader term that includes a variety of risks such as market risks (including

foreign currency exchange risk and interest rate risk), credit risk, liquidity and capital risk.

Financial risk is the risk that investors would lose their money because the bank relies more ondebt than equity which exposes them to a higher chance of default. For the purpose of assessing

the degree to which the bank is exposed to financial risk and to develop policies to reduce the

financial risk, there are three methodologies.

1. Ratio Analysis2. Cash Flow Analysis3. Sensitivity Analysis

The Ratio analysis covers four major categories of Profitability ratios, Leverage ratios, operating

ratios and liquidity ratios. Each one of which is significant and needs to be accounted for

minimizing the effects of financial risk which a bank can do by managing the assets and

liabilities in context of achieving the idle figures of ratio analysis. Cash flow analysis is another

method through which a bank can reduce the financial risks since it highlights the inflow and

outflows of cash of the bank it gives the policy makers the opportunity to retain the cash

outflows up to the level where the bank can easily pay off its obligations and invest the rest in

longer term projects to reduce idle capital and promote asset utilization. The third tool available

for the assessment and reduction of financial risk is the sensitivity analysis that gives an

overview of how a change in one variable would impact another, like for example the impact of

rise of 1.00% inflation would result in an increase of 0.5 % in the cost of funds because of the

change in the value of money, thus it provides a measure for the bank to estimate the future

events and being proactive to respond to changes before they start effecting the banks operations.

8.7 ASSIGNMENT # 07

What is the liquidity and how does it impact a firms profitability?

Liquidity is a precondition to ensure that firms are able to meet its short-term obligations.

Profitability is a measure of the amount by which a company's revenues exceeds its relevant


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expenses. A firm is required to maintain a balance between liquidity and profitability while

conducting its day to day operations. A company that cannot pay its creditors on time and

continues not to honor its obligations to the suppliers of credit, services and goods could result in

losses on account of non-availability of supplies and lead to possible sickness or insolvency.

Also, the inability to meet the short term liabilities could affect the company's operations and in

many cases it may affect its reputation as well. Lack of cash or liquid assets on hand may force a

company to miss the incentives given by the suppliers of credit, services, and goods as well. Loss

of such incentives may result in higher cost of goods which in turn affects the profitability of the

business.

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