Credit Risk: Evaluation of Major Principles - Essay Example

Task Credit Risk When there is a counter-party failure in performing the repayment obligation on due it gives rise to low quality assets which in turn lead to Credit Risk. Like the interest rate risk and liquidity risk, credit risk is also an inherent feature of any from that is into the business of lending funds either to individuals or to a corporate ((ICMR), Credit Management, 2004). Effective management of credit risk involves the following key principles: Evaluation Pricing Monitoring By evaluating and sanctioning the proposal by appropriately pricing it, the credit risk management policy has indeed performed only half its job. While the measurement of the various ratios and other financial analyses is done with great accuracy, their interpretation is mostly not done. There has to be experience to scrutinize all the credit information and interpret the same. However good the analyses may have been, the bank will be in no position to distinguish a good borrower from a bad borrower, who has no intention of repaying the loan. Despite all the caution, bad loans do creep into the banks accounts. Thus, evaluation and pricing decisions should be followed up with periodic review of the account and the credit rating of the borrower. Any fall in the rating will increase the credit risk. Credit risks persist from the time the loan is granted throughout its life period and continuous review during this period will help in the early detection of the problem loans. The above information is for monitoring the credit risk exposure at a micro level. If a broader outlook of the credit risk exposure and its position is to be determined, then a macro level approach has to be adopted. This is made possible through the use of the Capital Adequacy Ration (CAR). The capital adequacy of a bank, which is the ratio of its capital to its risk weighted assets (RWAs), provides information about the extent to which the possible losses can be absorbed by the capital. Normally, the ultimate defense against credit risk that a bank possesses will be its equity capital or net worth. If from an earnings position, it turns out into an operating losses position, it would be the equity capital account that absorbs such losses, thereby giving management time to reach to the situation. Therefore, it can be said that the higher the CAR the better it is for the financial institution. The main aim of the credit policy of a bank will be to screen out the best proposals for acceptance. The Capital Adequacy rate provides a benchmark for monitoring the risk level considering the total assets of the company. Commercial banks provide capital market related services, depository services, advises on portfolio management or investment counseling, etc. Many banks have now started offering investment services to the retail customer, which is essentially advice and execution of mutual fund investments and redemptions. CAPITAL MARKET PRODUCTS Advice on debt and equity is restricted primarily to new issues, with secondary market investments being discouraged. There are no charges for this service; in fact, customers are paid incentives/commissions for investing through them. The bank essentially gets its income from the mutual fund/broker directly and also cross-sells other banking products. Arbitrage, stock lending are products, which are beyond traditional asset management but still many banks are offering them to retain their customers ((ICMR), Commercial Banking, 2003). Portfolio Management Services offered by banks can be differentiated into discretionary and non-discretionary services. Discretionary portfolio management allows the portfolio manager to take investment decisions on behalf of his/her clients within the broad parameters of asset allocation. Non-discretionary services of the type provided by banks essentially mean that the client has to authorize, every transaction done on his/her behalf. The non-discretionary services offered by a banker can be listed as follows: Advisory services - Flexible, unbiased investment advice customized to meet the client's needs. Transaction support - All transactions, both in the primary and secondary markets facilitated through a panel of brokers. Custodial services - Important from the point of view of removal of settlement hassles and efficient follow-up of all corporate actions. Commercial banks approach the brokers for information about the quotes of other commercial banks. The broker serves three important purposes in the foreign exchange markets. First, instead of hunting around in the market for quotes, one can approach a broker and find out these prices. Second, brokers help the prospective buyer or seller keep his identity secret till the deal is struck. This prevents the quote being affected by the inquirer's position, i.e. whether he needs to buy or to sell. Lastly, even when there is no buying or selling requirement, commercial banks can keep their quotes from going too far away from the quotes being given by other banks, by inquiring about the market quotes from the brokers ((ICMR), Financial Management for Managers, 2003). Investment banks help both the government and corporate in raising money by trading in the securities markets. Large investment banks deal in the market both to execute their clients', (both corporate and individuals) orders and on their own account. They act as market makers in the foreign exchange markets, i.e. they stand ready to buy or sell various currencies at specific prices at all points of time. The commercial banks give, on demand, a quote for a particular currency against another currency, i.e., the rate at which they are ready to buy or sell the former against the latter. At these rates they stand ready to take any side of the transaction (buy or sell) that the customer chooses. The maximum and the minimum amount of the currencies acceptable to the bank at these rates, though not specified at the time of making the quote, are generally understood according to the conventions of the market. These rates may not necessarily be applicable to amounts smaller or larger than those acceptable according to the going conventions. In the foreign exchange markets there are numerous market makers, and all of them would be giving different quotes for the same pair of currencies simultaneously, at any point of time. It would be very difficult for a player to keep track of all the quotes available in the market, and hence choose one which is considered the most favorable. As a result, a number of trades may be taking place simultaneously at different exchange rates. The market making activity of the commercial banks, along with speculation, makes markets extremely liquid, especially for the major currencies of the world. The market in which the commercial banks deal with their customers (both individual and corporate) is called the retail market, while that in which the banks deal with each other is called the wholesale or the interbank market. The size of the deals in the retail market is much smaller than that in the interbank market. Securities markets have become increasingly important in providing funding to businesses and banks are involved in the issue of securities of various corporations and institutions. Investment banks possess the expertise necessary to manage issues successfully, to attract potential investors, to maintain a securities market, and to hedge or underwrite possible risks. As regards the trade in shares, bonds, and derivatives, banks increasingly focus their activities on executing customers' orders, speculate on market developments, and engage in proprietary trading. Activities of this kind would generate additional commission income for the banks. Competition between the Commercial and Investment banks The level and intensity of competition has increased in the financial services industry or the capital market industry as banks and their competitors in the market have expanded the services that are being offered by them. The local banks offering business and consumer credit, saving and retirement plans and financial counseling faces direct competition from other banks, non-banking financial institutions, credit unions, securities firms, financial markets, insurance companies, etc. Such amount of cut-throat competition in the market results in the commercial banks lowering the charges on the financial advice service. There has been a rapid expansion in the menu of financial services that are being offered by the commercial and investment banks in the recent past. This proliferation of services has accelerated over the years under the pressure of increasing competition from other financial firms. It has also increased bank costs and posed a greater risk of bank failure. The new services have has a positive affect in the industry through a new source of bank revenue called as non-fund based income, which are likely to grow relative to the more traditional sources of bank revenue (interest income.) For efficient credit risk management the acceptable levels of credit risk should be laid. Along with this, a quality index for credit approvals should also be generated, since sound credit policy will always be of competitive advantage to the company. Task 2 Risk and return go hand in hand in investments and finance. One cannot talk about returns without talking about risk, because, investment decisions always involve a trade-off between risk and return. Risk can be defined as the chance that the actual outcome from an investment will differ from the expected outcome. This means that, the more variable the possible outcomes that occur i.e. the broader the range of possible outcomes, the greater the risk. An investment portfolio refers to the group of assets that is owned by an investor. It is possible to construct a portfolio in such a way that the total risk of the portfolio is less than the sum of risk of the individual assets taken together. Generally, investing in a single currency is riskier that investing in a portfolio, because the returns to the investor are based on the future of a single asset. Hence, in order to reduce risk, investors hold a diversified portfolio which might contain equity capital, bonds, real estate, savings account, bullion, collectibles and various other assets. In the recent times, most of the worlds' financial institutions have pushed the concept of risk management a few steps ahead the corporate agenda and also they regard the same to be the greatest threat to their market value. Yet, it is the quantifiable risks, such as credit and market risk, which still absorb the most attention amongst financial institutions (Continuity Central, 2004). In a survey of more than 130 senior executives in financial institutions worldwide, 82 percent agreed that awareness of risk is now more pervasive in their organisations than it was two years ago and 73 percent agreed that their organisations define their appetite for risk more clearly. However, there are yet certain significant concerns that are covered by these encouraging results. Risk management can be defined as "the identification, analysis and economic control of those risks that threaten the assets or earning capacity of an enterprise." Risk management remains primarily focused on meeting regulatory requirements and only secondarily on protecting and enhancing the value of the franchise. The following are the reasons for doing so: - A culture of risk awareness has yet to emerge - Compliance is not being turned into competitive advantage - the importance of governance is underestimated - Quantifiable risks are still the focus of too much attention. The evolution of risk management in the financial services industry', also revealed that many central risk groups did not have much input into strategic decision-making. Commercial organizations devote a lot of time, energy and money to risk management. They frequently have a risk manager whose role is to control this function and hopefully eliminate or at least reduce every perceived threat to the organization. There are three steps involved in managing risk. They are: Risk identification Risk Analysis Risk control Risk identification - Risk identification involves discovering what threats exist or may at some time exist. There are many methods available to help identify risk. Risk Analysis - By examining past data, the risk identifier assesses the risk and discovers the likely frequency and severity of the identified risk or risks, how often will they occur and if do occur, and then what is the likely financial consequence. Risk control - The final stage is the risk control. It may be that the risk is perceived to be so small that no action is taken. However, if a risk has any potential consequences some reaction should be apparent. There are two likely courses of actions to be taken concurrently, one, the physical control measure and the other, the financial controls. In the recent times, most of the market risk management in financial institutions had its main focus on the concept of Value-at-Risk and its appropriateness. The Value-at-Risk is a calculation which, for a given trading portfolio estimates the maximum amount that would be lost by the financial institution over a given period of time with a given probability. Hence, the Value-at-Risk provides a summary measure of the total risk exposure of the financial institution generated through that particular portfolio. A brief description of Value - at - Risk Value at Risk is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time. It is commonly used by security houses or investment banks to measure the market risk of their asset portfolios (market value at risk), although Value at Risk is a very general concept that has broad applications. Value at Risk is widely applied in finance for quantitative risk management for many types of risk. Value at Risk does not give any information about the severity of loss by which it is exceeded. The following are three parameter of Value at Risk: The time horizon (period) to be analyzed may relate to the time period over which a financial institution is committed to holding its portfolio, or to the time required to liquidate assets. Typical periods using VaR are 1 day, 10 days, or 1 year. A 10 day period is used to compute capital requirements under the European Capital Adequacy Directive (CAD) and the Basel II accords for market risk, whereas a 1 year period is used for credit risk. The confidence level is the probability at which the VaR will not be exceeded by the maximum loss. Commonly used confidence levels are 99% and 95%. Value at risk (VaR) is given in a unit of the currency. The fact that returns on stocks do not move in perfect tandem means that risk can be reduced by diversification. But the fact that there is some positive correlation means that in practice risk can never be reduced to zero. So, there is a limit on the amount of risk that can be reduced through diversification and other possible measures of risk reduction. There can be two possible reasons for this to happen, one the degree of correlation and the other the number of stocks in the portfolio. It is a known fact that the amount of risk reduction depends on the degree of positive correlations between stocks. The lower the degree of positive correlation, the greater is the amount of risk reduction that is possible. The amount of risk reduction achieved by diversification also depends on the number of stocks in the portfolio. As the number of stocks increases, the diversifying effect of each additional stock diminishes. Another possible way of measuring the risk associated with the stocks in the portfolio is the standard deviation which is indeed a good indicator of its risk to the extent that, if addition of a stock to the portfolio increases the portfolio's standard deviation, the stock adds risk to the portfolio. But the risk that a stock adds to a portfolio will depend not only on the stock's total risk, its standard deviation, but on how that risk breaks down into diversifiable and non-diversifiable risk. If an investor holds only one stock, there is no question of diversification, and his risk is therefore, the standard deviation of the stock. For a diversified investor, the risk of a stock is only that portion of the total risk that cannot be diversified away or its non-diversifiable risk. Beta coefficient is the measure which gives the relative risk associated with any individual portfolio as measured in relation to the risk of the market portfolio. The market portfolio represents the most diversified portfolio of risky assets an investor could buy since it includes all risky assets. The relative risk can be expressed in the following manner: j = Thus, the beta coefficient is a measure of the non-diversifiable or systematic risk of an asset relative to that of the market portfolio. A beta of 1.0 indicates an asset of average risk. A beta coefficient greater than 1.0 indicates above average risk stocks whose returns tend to be more risky that the market. Stocks with beta coefficients less than 1.0 are below average risk i.e. less riskier than the market portfolio. An important point to note here is in the case of the market portfolio, all the possible diversification has been done - thus the risk of the market portfolio is non-diversifiable which an investor cannot avoid. Similarly, as long as the asset's returns are not perfectly positively correlated with returns from other assets, there will be some way to diversify away its unsystematic risk. As a result of this, beta depends only on non-diversifiable risks. With respect to the Value - at - Risk concept, there is also strong evidence that large changes tend to occur with regard to market prices more frequently than predicted by a normal distribution (Reserve Bank of Australia Bulletin, 1996). The major benefit of using the Value - at - Risk method as presumed by its proponents is its ability to summarize the estimated level of risk faced by an institution from its trading activities, all in a single figure. Hence, it can be undoubtedly stated that the Value - at - Risk model of calculating market risk is an efficient and the most powerful management tool. It is also just as important for financial institutions to protect themselves from potential liabilities and reputational harm stemming from their external relationships with customers, suppliers and partners. References 1. (ICMR), I. C. (2003). Commercial Banking. Hyderabad: ICFAI Center for Management Research. 2. (ICMR), I. C. (2004). Credit Management. Hyderabad: ICFAI Center for Management Research (ICMR). 3. (ICMR), I. C. (2003). Financial Management for Managers. Hyderabad: ICFAI Center for Management Research . 4. Continuity Central. (2004). Financial institutions see Risk as the greates threat. UK: Portal Publishing limited. 5. Reserve Bank of Australia Bulletin. (1996). Managing Market Risk in Banks. Reserve Bank of Australia Bulletin , 1-2. Read More