Types of Risks in

Banking Sector
Dr.SM
 Risks in
Banking

Non-
Financial Risk
Financial Risk

Interest Rate Operational

Credit Risk Liquidity Risk Market Risk
Risk Risk
RISKS IN COMMERCIAL BANKING
Credit Risk Management & Internal
Controls
Interest Rate Risk
Foreign Exchange Lending Operations
Risk
Liquidity Risk
Operation Risk Market Operations, ALM
EDP Risk
Systemic Risk Business Operations
Management Risk MANAGEMENT 3
 Credit Risk

• The Potential of a bank borrower or counterparty to

fail to meet its obligations in accordance with
agreed terms.
• For most banks, loans (Advances - S - 9) and
Corporate bonds (Investments – S-8) are the largest
and most obvious source of credit risk.
 Types of Bank Loans
1. Home Loan
2. Personal Loan
3. Business Loans (Corporate Loans)
1. Term Loans
2. Bank Overdraft Limits
3. Bills Discounting
4. Letter of Credit
4. Education Loan
5. Vehicle/ Car Loan
6. Agricultural loan
 Schedule 9: Advances
Particulars Amount Rs
A. Loans & Advances
• Bills Purchased and Discounted
• Cash Credits
• Overdrafts
• Loans Repayable on Demand
• Term Loans
B. Secured / Unsecured
• Secured by Tangible Assets
• Secured by Bank/Government Guarantees
• Unsecured
C. Types of Advances
• Priority Sectors
• Public Sectors
• Banks
• Others
D. Advances outside India
-------------------------
--------------------------
 A Typical Example of ? Risk
Suppose, I take a loan of Rs.1,00,00,000 from Citibank at the
interest rate of 5% per annum for a period of 5 years.

I start repaying for the first 6 months and then stop

servicing the loan on the 7th Month because I have made
other commitment elsewhere.

(a) How to study / assess the loans (assets)?

(b) What is the risk for the Citibank?
(c) How it would impact on the liquidity of the bank?
As per guidelines
issued by the RBI,
banks classify an
account as NPA only if
the interest due and
charged on that
account during any
quarter is not serviced
fully within 90 days
from the end of the
quarter.
 Classification of NPA
1. Substandard Assets – If an account remains as
NPA for a period less than or equal to 12
months
2. Doubtful Assets – An asset would be classified
as doubtful if it has remained in the
substandard category for 12 months.
3. Loss Asset – A loss Asset is one where loss has
been identified by the bank’s internal or
external auditors or upon an RBI inspection.
 Credit Risk
• It is also known as default risk which checks the
inability of an industry, counter-party or a customer
who are unable to meet the commitments of
making settlement of financial transactions
• Internal and external factors both influences credit
risk of bank portfolio
• Credit risks involve borrower risk, industry risk and
portfolio risk. As it checks the creditworthiness of
the industry, borrower etc.,
Conti..
• Internal factors consist of lack of appraisal of
borrower’s financial status, inadequate risk pricing,
lending limits are not defined properly, absence of
post sanctions surveillance, proper loan
agreements or policies are not defined etc.,
• Whereas external factor comprises of trade
restrictions, fluctuation in exchange rates and
interest rates, fluctuations in commodities or
equity prices, tax structure, government policies,
political system etc.,
Types of Credit Risk

Credit Risk

Counterparty
Country Risk
Risk
 1.Counterparty Risk

• It is related to non-performance of the trading

partners due to counterparty’s refusal and or
inability to perform.
• The counter-party risk is generally viewed as a
transient financial risk associated with trading
rather than standard credit risk.
 2.Country Risk

• Non-performance by a borrower or counter-party

arises due to constraints or restrictions imposed by
a country.
• Here reason for non-performance is external
factors on which the borrower or the counterparty
has no control.
How banks manage this risk?
• In a loan policy of banks, Risk management process
should be articulated
• Through credit rating or scoring the degree of risk can
be measured
• It can be quantified through estimating expected and
unexpected financial losses and even risk pricing can
be done on scientific basic
• Credit Policy Committee should be formed in each bank
that can look after the credit policies, procedures and
agreements and thus can analyze, evaluate and
manage the credit risk of a bank on a wide basis.
How banks manage Credit risk?

• Credit Risk Management consists of many

management techniques which helps the bank to
curb the adverse effect of credit risk.
• Techniques includes: (a)sound underwriting standards,
(b) an efficient and balanced approval
• Credit approving authority process, and
• Risk rating (c) a competent lending staff.
• Prudential limits
• Loan review mechanism
• Risk pricing
• Portfolio management etc
 Credit Risk Management in Banking Industry

Borrower

Submission Approval/Rejection

Credit Application
or Origination

•Capital * Capacity
•Character * Collateral
* Consideration

Credit Analysis
& Assessment
*Credit Structuring •Credit Policy
*Credit Sanctioning •Credit Limit
•Credit Pricing
Credit Management
& Administration
•Capital (Economic, and Regulatory)
•Provision for Default
•Provision for Risk Sharing (e.g. co-financing)
 CREDIT RISK MANAGEMENT -
OVERVIEW
• Origin – Client request, Prospect discovery, Outside
referral
• Evaluation – Purpose, Business, Management
• Negotiation – Tenor, Repayment, Covenants, Security
• Approval
• Documentation – Legal drafting, Collateral
• Disbursement
• Administration – Repayment, Unforeseen events,
Compliance of terms and conditions
• Reviews – early recognition, Recovery Strategy
• Repayment
 METHODS - REDUCTION OF CREDIT
RISKS

• Raising credit standards to reject

• Obtain collateral and Guarantees
• Ensure compliance with loan agreement
• Transfer credit risk by selling standardized loans
• Transfer risk of changing interest by Hedging,
financial futures, options
• Opt for loan syndication
(process of involving several different lenders in providing various portions of a loan)
Sound credit risk analysis would depend on a number of
Critical piece of information such as;

 Purpose of the loan/credit,

 Amount required,
 Repayment capacity of the borrower,
 Duration of the loan/credit,
 Borrower’s contribution,
 Security aspects & insurance protection,
 Borrower’s character,
 Business plan & projections,
 Environmental considerations, and
 Other considerations.
 Norms
• Central Bank Norms
• BASEL Norms
Computation of Capital Adequacy
Ratio (CAR)
• Capital adequacy is the ratio of capital
funds available in the Bank to the assets
(Loans plus Investment) acquired and
reflected in the Balance sheets.
• Objectives : to strengthen soundness and
stability of banking system; Standardised
Approach for credit risk and Basic
Indicator Approach for operational risk

(CAR)
 CREDIT DERIVATIVES

• Unbundling of credit risk - Off-balance sheet financial

instruments that permit one party to transfer credit risk of a
reference asset, which it owns, to another party without actually
selling the asset
• It is a bilateral contract between a protection buyer (Lending
bank) and a protection seller (Credit Risk Buyer or Guarantor )
• Upon happening of credit event – Protection Seller will make
contingent payment (difference between full face value and
current resale value of a particular bank loan)
• Condition that trigger payout – payment default, insolvency,
rating downgrading [ 8 different types of credit events stipulated
by International Swaps and Derivatives Association]
• Protection buyer will pay - periodic fee to protection seller
 CREDIT RISK IN INDIA AND
SARFAESI ACT 2002
• Credit Risk: The risk of non-payment of principal and/or interest
to investors can be at two levels:
a) SPV; and
b) underlying assets.
• SPV is normally structured to have no other activity apart from
the asset pool sold by the originator
• Credit risk principally lies with the underlying asset pool.
• A careful analysis of the underlying credit quality of the Obligors
and the correlation between the obligors needs to be carried out
to ascertain the probability of default of the asset pool.
• A well diversified asset portfolio can significantly reduce the
simultaneous occurrence of default
 SARFAESI Act, 2002
• The Securitisation and Reconstruction of Financial Assets
and Enforcement of Security Interest Act, 2002 (also known
as the SARFAESI Act) is an Indian law. ... Under this act
secured creditors (banks or financial institutions) have
many right for enforcement of security interest under
section 13 of SARFAESI Act, 2002.
• SARFAESI is effective only for secured loans where bank
can enforce the underlying security eg hypothecation,
pledge and mortgages. In such cases, court intervention is
not necessary, unless the security is invalid or fraudulent.
However, if the asset in question is an unsecured asset, the
bank would have to move the court to file civil case against
the defaulters.