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

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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

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

 

Meaning:

 

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

 

 

3 SIGNALS OF BORROWERS FINANCIAL SICKNESS

 

    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

 

 

4 FINANCIAL DISTRESS PREDICTIONMODELS

 

 

Alman‟s  Z model

    ZETA

 

    EMS

 

Ø   GAMBLER model

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

 

manufacturingcompany

 

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

 

Where

 

X1 - WORKING CAPITAL/ TOTAL ASSETS(%)

 

X2- RETAINED EARNING / TOTAL ASSETS(%)

 

X3- EBIT/ TOTAL ASSETS(%)

 

X4- MARKET VALUE OF EQUITY / BOOK VALUE OF DEBT(%)

 

X5- SALES TO TOTAL ASSETS(TIME)

 

The firm is classified

 

Financial sound Z> 2.99

 

Financial distress or bankrupt if z< 1.81

 

Attributes

 

Operating leverage

 

Asset utilization

 

Assumptions

 

Firms equity is publically traded

 

Engaged only manufacturing activities

 

ZETA

 

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

 

Variables

 

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

 

    Capitalization

 

    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

 

Where

 

X1 - WORKING CAPITAL/ TOTAL ASSETS(%)

 

X2- RETAINED EARNING / TOTAL ASSETS(%)

 

X3- OPERATING INCOME/ TOTAL ASSETS(%)

 

X4- BOOK VALUE OF EQUITY / TOTAL ASSETS(%)

 

GAMBLER model

    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)

 

5 REHABITALIZATION 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

 

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

 

Risk(meaning)

 

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.

 

Definition

 

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)

 

Meaning:

 

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

 

Perspectives

    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

 

Provide

    Current&expected periodic gaps

 

    Duration gap

 

    Balance

 

sheet &income statement performance measures

 

 

    Budget

 

    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.

 

Sources

    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

 

Need/features

    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

 

STEPS FOR STRESS TESTING

    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

tolerable

 

Step :7 Monitor & review

 

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

 

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

 

Avoidance:

 

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)

 

 

14BASIC UNDERSTANDING OF NPAS

 

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

 

INTERNAL FACTORS

    Defective lending process

 

    Inappropriate technology

 

    Improper SWOT analysis

 

    Poor credit analysis system

 

    Managerial deficiencies

 

    Absence in regular industrial visits& Reloaning process

 

EXTERNAL FACTORS

    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

 

MANAGEMENT OF NPA

 

PREVENTIVE MANAGEMENT

    Credit Assessment &risk management mechanism

 

    Organizational restructuring

 

    Reduce dependence on interest

 

    Potential and borderline NPA‘s under check

 

CURATIVE MANAGEMENT

    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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