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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
Source: lecture notes
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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
Source: lecture notes
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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
Source: lecture notes
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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
Source: lecture notes
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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
Source: lecture notes
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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
http://www.businessdictionary.com/definition/market.htmlhttp://www.businessdictionary.com/definition/assessment.htmlhttp://www.businessdictionary.com/definition/tool.htmlhttp://www.businessdictionary.com/definition/provide.htmlhttp://www.businessdictionary.com/definition/business.htmlhttp://www.businessdictionary.com/definition/complexity.htmlhttp://www.businessdictionary.com/definition/industry.htmlhttp://www.businessdictionary.com/definition/industry.htmlhttp://www.businessdictionary.com/definition/complexity.htmlhttp://www.businessdictionary.com/definition/business.htmlhttp://www.businessdictionary.com/definition/provide.htmlhttp://www.businessdictionary.com/definition/tool.htmlhttp://www.businessdictionary.com/definition/assessment.htmlhttp://www.businessdictionary.com/definition/market.html7/30/2019 Khadija Handbook
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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_profit7/30/2019 Khadija Handbook
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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 to- day 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.