Chapter: Business Science : Banking Financial Services Management : Credit Monitorning

Credit Monitorning

1 Credit Monitoring 2 Need for credit Monitoring 3 Signals of Borrowers financial sickness 4 Financial Distress prediction models 5 Rehabilitation process 6 Risk Management 7 Interest rate risk 8 Liquidity risk 9 Forex,Credit risk 10 Market risk 11 Operational &Solvency risk 12 Risk measurement process 13 Mitigation 14 Basic understanding of NPAs and ALM 15 ALM



1 Credit Monitoring

2 Need for credit Monitoring

3 Signals of Borrowers financial sickness

4 Financial Distress prediction models

5 Rehabilitation process

6 Risk Management

7 Interest rate risk

8 Liquidity risk

9 Forex,Credit risk

10 Market risk

11 Operational &Solvency risk

12 Risk measurement process

13 Mitigation

14 Basic understanding of NPAs and ALM

15 ALM




The credit monitoring in a bank is to ensure that the funds are utilized for the sanctioned purpose and at the same time complying with all sanction terms &conditions.

    To avoid the time lag and cost over runs


    warning the signals and symptoms of the sickness


    Intimate timely actions for recovery or rehabilitations


2 Need for credit monitoring

    Accurate & comprehensive credit reports


    Account details


    Significant events


    An Extra set of Eyes


    A drawing board for dealing with a bad or insufficient credit history

    Identify the theft protections


    Unauthorized user updates


    Project mapping & Planning


    Proof of collateral and assets


 Over all peace of mind Effective credit monitoring system

    Understand the financial position of the borrower


    Ensure that the funds are being used for the purpose for which they were sanctioned


    Confirming credit in compliance with the sanction terms


 Continuous monitoring of the projects cash flows that they are being realized by the borrowers


    Ensuring that securities are in conformity with the terms


 Identifying the potential bad loans so that action/corrective action can be initiated by the bank in time





    Sickness at birth


The project itself has become infeasible either due to faulty assumptions or a change in environment

Ø   Induced sickness

caused by the management in competencies (or) willful    default.


Ø   Genuine sickness

Where the circumstance leading to sickness are beyond the borrowers control has happened inspite of the borrowers sincere effort to avert the situations


Other signals &Guidelines to the banker know about sickness

    Warning signals can be sensed.


    Decline in production &poor turnover


    Changes in the repayment schedules


    Declining sales


 Bank should examine why the unit is not able meet its liabilities towards the banks Warning signals:


    Continuous irregularities in cash credit


    Failure to make timely payment of installments of principal &interest on term loans


    Non submission of statements


    Downward trend in credit summations


    Steep decline in production figures


    Raising the level of inventory


    Failure to pay statutory liabilities


    Wide variations in sales/receivables levels


    Delay in payment of installment due






Alman‟s  Z model





Ø   GAMBLER model

Alman‟sZ            model:    statistical        tool            &    used       to          predict  the                 financial               distress  of




Regression(use past data &predict future)


Discrimination(generating an index)


Discrimination function Z


Z=1.2 X1 +1.4 X2 +3.3 X3 +0.6 X4 +1.0 X5














The firm is classified


Financial sound Z> 2.99


Financial distress or bankrupt if z< 1.81




Operating leverage


Asset utilization




Firms equity is publically traded


Engaged only manufacturing activities




Score enables banks to appraise the risks involved in firms out side the manufacturing sector. Provide warning signals (3-5 years ) period to bankrptcy. Increasing score is a positive signal




Return on assets (percentage how profitable a company's assets are in generating revenue.) ROA can be computed asset net income/total average assets

    Earning stability


    Debt services



    Cumulative profitability


    Current ratio




    Size of business


EMS  Model(Emerging Market scoring model)


Applied in both manufacturing&non manufacturing companies origin from z score model


lack of credit worthiness


EM SCORE= 6.56 X1 +3.26 X2 +6.72 X3 +1.05 X4 +3.25













    To predict bankruptcy


 Networth(assets,liabilities) Bankruptcy is a legal status of a person or other entity that cannot repay the debts it owes to creditors


    Net cash flows(cash inflows&cash outflows)




Banks to detect the sickness at an early stage and facilitate corrective action for revival of the




Steps involved in Rehabitalization process

    To formulate a viability plan for the company


    Float the debt restructuring schemes


  Detailed presentations, site visits by the lenders and establishing the future viability of the business


    Borrower issued confirmation of the terms and sanction for the scheme


    Debt restructuring services would involve a lot of compliance & legal work


Parameters for grant relief from sickness


    Term loans


    Cash credit accounts


    Cash losses


    Additional working capital


    Contingency assistance


    Start up expenses and margin for working capital


    Promoters contributions


    Relief and concessions from other agencies/institutions


Rehabilitation should not consider for the followings

    Deliberate non payment of dues to the bank despite of adequate cash flow and net worth


    Misrepresentation /falsification of records (or)financial statements


    Removal of securities with out banks knowledge


    Fraudulent transactions by the borrowers



6 Risk management




It is a condition where there is a possibilty of an adverse deviation from a desired outcome that is expected or hoped for it.


Definition (Risk)


possibilities of adverse results flowing from any circumstances.


Risk management


It is the identification, assessment and prioritization of risks followed by co ordinated and economical application of resources to minimize,monitor and control the probability of unfortunate events.




According to Jorion,risk management is the process by which various risk exposures are identified, measuredand controlled.


Objectives of risk management

    To achieve the corporate objectives & strategy


    Provide a high quality service to customers



    Initiate action to prevent the adverse effect of risk


    Minimize the human costs of risks, where reasonably practicable


    Meet the statutory/ legal obligations


    Minimize the financial  & other negative consequences of losses


    Minimize the risk associated with new development & activities


    Be able to inform decisions and make choices on possible outcomes


6.1 Risk management process


Banks to detect the sickness at an early stage and facilitate corrective action for revival of the firm


Steps involved in Rehabitalization process

   To formulate a viability plan for the company


   Float the debt restructuring schemes


   Detailed presentations, site visits by the lenders and establishing the future viability of the business


   Borrower issued confirmation of the terms and sanction for the scheme


   Debt restructuring services would involve a lot of compliance & legal work







3.7Interest rate risk(IRR)




It is the exposure of a banks financial condition to adverse movements in interest rates.



    The earning perspectives(short term earning)


    Economic perspectives (long term earning)


7 Sources/types of interest rate risk


1.Repricing /Gap or mismatch risk:


Holding of assets &liabilities in off balancesheet with different principal amounts,maturity date(change in level of market interest rate)


2.Basis risk(banks have a different base rate)



composite assets& composite liabilities.


3.Embedded option risk(changes in market rate create some risk in the options)


4.Yield curve risk(movement in yield curve)


5.Price risk(assets are sold before it‘s maturity)- related to trading book&p/l account 6.Reinvestment risk(future cash flows are again reinvested)


7.Net interest position risk(non paying liabilities)



Effect of interest rate risk

    Earnings perspective


    Economic perspective


    Embedded losses


Internal risk measurement models.


Maturity gap analysis

    Simple tools


    Fixed rate &floating rate


    Earning at risk


    Evaluate earning exposure


 Earning at risk ( EaR) Duration GAP analysis

    Managing the economic value of banks


    Off Balance sheet


 Different weights and interest rate to the assets Simulation methods


Assumption about future path of interest rates, shape of yield curve, changes in the business activity Pricing etc



    Current&expected periodic gaps


    Duration gap




sheet &income statement performance measures





    Financial reports


8 Liquidity risk


It is a risk that a company or bank may be unable to meet short term financial demands.this is usually occur due to the inability to convert the securities or assets to cash with out loss of capital or income in the process.



    Incorrect judgement or attitude of the bank towards timing of it‘s cash inflows &outflows


    Unanticipated changes in the cost of capital(coc) or availability of funds


    Abnormal behaviour of financial market under stress


    Range of assumption used in predicting cash flows


    Risk activation by secondary sources


    Break down payment in settlement system


    Macro economic imbalances


Types of liquidity risk


 Funding risk(failure to replace net outflows due to withdrawal of retail deposits&renewal of deposits)


 Time risk (non receipt of expected inflows of fund) where the borrowers fail to meet their commitments.


    Call risk(probability of loss due to redemption of bond or other debt securities by its issuer


before it‘s maturity)

    Opportunity risk


Bank can only grow big if their customers are also prospering



    To prevent the business from losses


    Control over liquidity &cashflows


    Close the liquid gap through reserves


    Fair value of maturity of assets


    Analysis the actual liquidity &evaluation of risk


    To make recommendation for necessary changes



    Develop a new methodology for evaluating the deposits


    Develop and improve liquidity contingency plans under the crisis conditions


    Evaluation of assets &liability management


9 Forex and credit risk


It is the exposure of an institution to the potential impact of movements in foreign exchange rates.


Types Of Foreign Exchange Risk

    Translation exposure.


    Economic exposure


    Transaction exposure.


Country risk


a domestic banking institution may transform itself in to an international one when it starts lending across its borders are invests in instruments in issued by foreign business.


Types of country risk.

  Economic factors


  Political factors.


  Social community factors.


  Legal frame work.


Value at risk (VaR)


It measure the potential of economic losses


VaR corresponded to a presently of portfolio P&L


And can be expressed as potential loss from the current value of the portfolio or as the loss from the expected value at the horizon.


Procedure of measuring interest rate risk.


Step 1: recording assets liabilities


Step 2: calculating gap in each time band by netting the positions of asset, liabilities and net off balance sheet position in the time band.


Step 3: calculate cumulative gap.


Step 4: evaluating impact on earnings from interest rate.



Step 5: the exposure of interest rate risk in banking book is equal to the sum of impact on


earnings from interest rate.


Step 6: comparing the interest rate risk.


Value At Risk Models /Method For Computing Value At Risk

    Historical simulation


    Monte carlo simulation


    Parametric modeling



    Step-1: Generate Scenarios`


    Step-2: Revalue portfolio.


    Step-3: Summarize results.


10 Market risk

    Market risk is the risk of losses due to movement in financial market variables.


    Interest rate , foreign exchange rate , security prices etc.


    Market risk is the risk of fluctuations in portfolio value because of movement in such variable.


    Adverse changes in interest rates, foreign exchange rates, commodity prices, or equity prices.


    To identify, measure, monitor, and control exposure to market risk.


    Non trading positions.


Management Of Market Risk

    Clearly defined responsibilities and authorities.


    Specialized committee set-up by the board.


    Risk taking and operational units.


    Be supported by an effective risk management information system.


    Be provided adequate resources and competent personal to perform its duties.



1 Price risk


a seller who wants to sell it in the future is thus concerned about the potential fall in the price and a reduction in the realization or profits of the transactions.


Types of price risk.


symmetrical versus unsymmetrical


movement of an asset price in either direction leads to a corresponding impact on the position value.


Absolute risk various relative risk


Absolute risk is measured with reference to the initial investment. Relative risk is measured relative to the benchmark index


Asset liquidity risk


large number of stock listed on a stock market


Credit spread risk


credit risk is the risk that yield on duration matched credit sanctity bonds and treasury bonds could move differently


Volatility risk.


volatility refers to the degree of unpredictable change in a financial variable over period of time.



Systematic risk.


Systematic risk can arise in the context of a failiure of a major and market system or institution, some times called the ‗domino effect ‗


11Operational and Solvency risk


Operational risk can be summarized as human risk; it is the risk of business operations failing due to human error.


TYPES of operational risk:


PEOPLE RISK: People risks typically result from staff constraints, incompetence, dishonesty, or a corporate culture that does not cultivate risk awareness.


SYSTEM RISK: As technology has become increasingly necessary, in more and more areas of business, operational risk events due to systems failure have become an increasing concern.


EVENT RISK: Risk due to single event.


BUSINESS RISK: Business risk is the risk of loss due to unexpected changes in the competitive environment. It includes ―front-office‖ issues such as strategy, client management, product development, & pricing and sales, and is essentially the risk that revenues will not cover costs within a given period of time.



12 Risk measurement process.


Step:1 Communication and consult

    Assessment of risk


    Identification,analysis and evluation of risk


    Eliciting the risk information


    Managing stakeholder perceptionfor management of risk


Step: 2 Establish the context

    Objectives and goals of bank


    Needs should be considered


    Environmental factors must be considered


    Rules & regulation of the bank


Step :3 identisy the risk

    To identify the risk involved in the banks


    Identify the prospetive risks


    Nature of activity must be considered


Step :4 analyse the risk

    Combination of possible consequences/event


    Risk=consequences* likelihood


    Adopting quantitative  &qualitative methods to analyse the risks


Step :5Evaluate the risk

    analyse &evaluate the risk


    to decide whether risks are acceptable or need treatment


Step:6 Treat the risks


Ø it is about considering optiona for treating risks that were not considered acceptable or



Step :7 Monitor & review


Ø monitor the effectivenessof risk management , plan,strategies,management system


13 Mitigation/managing the risk/methods to handling the risk




Elimination of risk


Loss control


reducing the probability of risks & minimizes the loss


Risk retention(active retention/risk assumptions)


it is retaining the risk because it is unknown &it consider a lesser risks what actually is


Non insurance transfers

    Contract (transfering risks through contract)


    Hedging(reducing portfolio risk)


    For business risk by incorporating( limited company)





Non performing assets(NPA)


Former principal+ interest (180 days)


March 2004(default status – dues not paid for 90 days)


The securitization reconstruction of financial assets and enforcement of security interest


act 2002 ,


Non performing assets as an asset or account of a borrower which has been classified by the bank or financial institutions as sub standard ,doubtful or loss assets in accordance with the directions or guidelines relating to assets classification issued by the RBI.


Calculation of NPA


To maintain NPA‘S both on gross/net basis


It is expressed in term of %


NPA‘s = gross or net NPA‘s


Total Advances        *  100


Net NPA‘s = gross NPAs- Provisions for NPA‘s


Net NPA‟S are obtained from gross NPA

    Balance in interest suspense account ,interest but not received


    Claims received from credit guarantors and kept in suspense account account



    Part payment received and kept in suspense account


    Total provisions held on trend and progress of banking in india


Classification of assets


Performing assets(standard assets)


These assets (advances) which continue to generate( interest )on regular basis with out any default


Non performing assets


Sub standard assets( march 31/2005)


SSA are those assets which have been classified as NPA for a period less than or equal to 12months


Not recover the due


Doubtful assets


An assets would be classified doubtful if it remained in the substandard category for 12 months


Loss assets


These are considered ucollectable.


Factors for risein NPA‘S



    Defective lending process


    Inappropriate technology


    Improper SWOT analysis


    Poor credit analysis system


    Managerial deficiencies


    Absence in regular industrial visits& Reloaning process



    In Effective recovery tribunals


    willfull defaults


    Natural calamities


    Industrial sickness


    Lack of demand



Ø Change on government policies

Problems /impact of NPA‟S


Impact on the bank

    do not generate any income


    Banks has to make provisions for NPA out of its profits


    Capital is blocked


    Customer confidence will low & high cost


Impact on the depositors

    Owners do not receive a market return on their capital


    Depositors do do not receive a market return on saving


    charging high Interest rate


    Misallocation of capital





    Credit Assessment &risk management mechanism


    Organizational restructuring


    Reduce dependence on interest


    Potential and borderline NPA‘s under check



    Debt recovery tribunals(DRT)


    Asset reconstruction company (ARC)


15 ALM


The traditional ALM programs focus on interest rate risk and liquidity risk because they represent the most prominent risks affecting the organization balance-sheet (as they require coordination between assets and liabilities).


But ALM also now seeks to broaden assignments such as foreign exchange risk and capital management. According to the Balance sheet management benchmark survey conducted in 2009 by the audit and consulting company PricewaterhouseCoopers (PwC), 51% of the 43 leading financial institutions participants look at capital management in their ALM unit.


Scope of the ALM function



Liquidity risk


The current and prospective risk arising when the bank is unable to meet its obligations as they come due without adversely affecting the bank's financial conditions. From an ALM perspective, the focus is on the funding liquidity risk of the bank, meaning its ability to meet its current and future cash-flow obligations and collateral needs, both expected and unexpected. This mission thus includes the bank liquidity's benchmark price in the market.


Interest rate risk


The risk of losses resulting from movements in interest rates and their impact on future cash-flows. Generally because a bank may have a disproportionate amount of fixed or variable rates instruments on either side of the balance-sheet. One of the primary causes are mismatches in terms of bank deposits and loans.


Currency risk management


The risk of losses resulting from movements in exchanges rates. To the extent that cash-flow assets and liabilities are denominated in different currencies.


Funding and capital management


As all the mechanism to ensure the maintenance of adequate capital on a continuous basis. It is a dynamic and ongoing process considering both short- and longer-term capital needs and is coordinated with a bank's overall strategy and planning cycles (usually a prospective time-horizon of 2 years).


Treasury and ALM


For simplification treasury management can be covered and depicted from a corporate perspective looking at the management of liquidity, funding, and financial risk. On the other hand, ALM is a discipline relevant to banks and financial institutions whose balance sheets present different challenges and who must meet regulatory standards.


ALM governance


The responsibility for ALM is often divided between the treasury and Chief Financial Officer (CFO). In smaller organizations, the ALM process can be addressed by one or two key persons (Chief Executive Officer, such as the CFO or treasurer).The vast majority of banks operate a centralised ALM model which enables oversight of the consolidated balance-sheet with lower-level ALM units focusing on business units or legal entities.



   To ensure adequate liquidity while managing the bank's spread between the interest income and interest expense

   To approve a contingency plan


   To review and approve the liquidity and funds management policy at least annually


   To link the funding policy with needs and sources via mix of liabilities or sale of assets.


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