Strengths and weaknesses of bank loan risk management

This article discusses the strengths and weaknesses of bank loan risk management. It highlights the importance of credit risk management in maintaining the stability and profitability of the bank. The article also explores the challenges faced by banks in managing loan risks and the potential benefits of effective risk management.

FINANCE ASSESSMENT 2

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
MAIN BODY...................................................................................................................................1
PART- A..........................................................................................................................................1
1. Calculation of the bank ratios..................................................................................................1
2. Strengths and weaknesses of bank loan risk management.......................................................4
PART- B..........................................................................................................................................5
5. Money laundering activities.....................................................................................................5
6. Shadow banking.......................................................................................................................7
CONCLUSION................................................................................................................................8
REFERENCES................................................................................................................................9

INTRODUCTION
The financial performance of the bank is important to derive the stability and prosperity
of the economy. Banks are the financial intermediaries that acts like mediator between the ones
having surplus finance and one who are in sheer need of it. The project shall be disclosing the
performance of the Crocked bank through the calculation of the various financial ratios. Apart
from that it shall be highlighting the strengths and weaknesses of the bank loan risk management
conducted by the banking officials. It shall also reflect reasons behind money laundering
activities that take place in the bank and various policies that are designed to abolish it. Lastly
the report will analyse the concept of shadow banking, it role and how it operates.
MAIN BODY
PART- A
1. Calculation of the bank ratios
S.NO RATIOS FORMULA
CALCULATION ( in £
bn)
1
Reserve
Ratio
Reserve maintained with Central bank /
Deposit liabilities 120/230*100= 52.17%
Cash and balances with Central bank 120
Customer deposits 214
Bank deposits 16
Total deposit liabilities 230
2
Net Interest
margin
(Investment returns- Interest paid) /
Average assets (7-0) / 701*100= 0.99%
Net Interest revenue 5
Net gains on trading and derivatives 2
Investment returns 7
Interest paid 0
Average assets 701
3
Earnings
Base
Average earning assets/ Average total
assets 541/701*100= 77.17%
Derivative financial instruments 229
Net loans and advances to customers 312
Average earning assets 541
Average total assets 701
4 Burden ratio
(Non interest expense- Non interest
income) / Total assets
(11-9) / 701*100=
0.285%
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Net fees and commission 4
Overheads 7
Non interest expense 11
Other operating income 6
Net gains on trading and derivatives 2
Net gain on assets at FV 1
Non interest income 9
Total assets 701
5
Efficiency
ratio
Non interest expense / (Operating Income-
Loan loss provision) 11 / (6-1)= 2.2
Net fees and commission 4
Overheads 7
Non interest expense 11
Operating income 6
Loan loss provision 1
Assumptions:-
 The total deposit liability that is imposed on the bank includes both the deposits made by
the customers and the deposit that are owed to other banks. In accordance with this the
reserve ratio of the bank is been calculated.
 The investment returns that are generated by the Crocked bank includes the interest
revenue on the loans and advances to the customer and the gains made on the derivative
financial instruments.
 The interest paid on the long term borrowings taken by bank is assumed to be nil, since
such expense is not reflected in the income statement of the bank.
 The average value of asset is taken as the total asset value as depicted by the balance
sheet of the Crocked bank, since the opening balance of the asset at the beginning of the
year is not given. Also, the averaging is not done because of the unavailability of the
opening balance of asset (Meriç, Kamışlı and Temizel, 2017).
 The average earning assets for the bank are the derivative financial instruments and the
loans and advances to the customers from the total assets that are owned by the company.
 The non-interest expense of the Crocked bank includes fees and commission paid and the
overheads incurred during the year as represented by the income statement of the
company.
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 The non interest income of the bank includes all the incomes except the interest revenues.
These are the operating income and the gains earned on the financial derivates and assets
of the business.
Reserve ratio- The reserve ratio of the bank shows the amount of the total deposit liabilities of
bank that are maintained with the Central bank in the form of reserves. The proportion of this
amount is decided by the Central bank and limit shall be followed by all the commercial banks.
The maintenance of the reserve ratio with the Central bank is relevant and significant for all the
commercial banks as it shall help them meet their short term liabilities smoothly and efficiently
(Chiaramonte and Casu, 2017). Apart from that the reserve is highly liquid in nature and can be
accessed when in need. The amount maintained with the Central bank is highly secured and
maintains the credibility of the business.
Net interest margin- The net interest margin of the bank shows the profitability of the company
in respect of interest in deducting the interest paid from the amount of interest received. It also
depicts the performance regarding the choice of investment by the bank apart from managing the
debtors of the company. It is relevant to calculate this ratio so that it is ensured that the cost of
finance is covered by the returns generated from its investment.
Earnings base- This ratio of bank represents the fraction of assets that are generating income for
the institution relative to the total assets that are employed in the business. It can also be referred
as the earning assets to total asset ratio depicting the earning assets like the advances or any other
financial instruments in which the management has invested (Smaoui, Salah and Diallo, 2020). It
is necessary to calculate the ratio to know the potential of the assets owned.
Burden ratio- The burden ratio of the company calculates the difference between the non interest
expenses and the non interest incomes. It can be improved by reducing the amount of operating
costs of the business. Lower the burden better it is for the banks showing that the assets are
capable of covering all the non interest expenses of the business.
Efficiency ratio- The efficiency ratio of the bank shall be showing that how efficiently the assets
and liabilities of the company are used to generate the profitability of the business. This helps in
knowing the performance of the bank and also facilitates the comparability with other
competitors in the industry. It possesses relevance for the bank so that the inefficiencies can be
removed and the future growth prospects can be developed.
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2. Strengths and weaknesses of bank loan risk management
The bank loan risk for any organization are the chances or the probability of the losses
that arise due to the failure of the repayment by the borrower. The loans that are extended by the
bank are their assets but in case there is failure of these payments then these assets become non-
performing for the bank. Such NPA's deteriorate the performance of banks and lead them into
the position of tight liquidity. The bank might end up in a position where it is unable to meet it
obligations and liabilities.
This generates the need to conduct the bank loan risk management or credit risk
management which is concerned with mitigating such losses on account of checking the
adequacy of the bank capital and the loan loss reserves or provisions (Taiwo and et.al., 2017).
The maintenance of the sufficient capital and the reserves at all point of time is one of the major
challenges that are faced by the company. This is also one of the regulatory requirements of the
company, where they have to transparently depict risky liabilities and simultaneously the risk
management by creating the loan loss provisions.
Prior to providing the loans also the company must ensure the credibility and the
financial strength of the company. After a complete analysis only the company can extend loan
with assuming the collateral security which can be liquidated in case of non repayment of the
liabilities of the company (Credit Risk Management, 2021). Post financing the loan the bank has
to stay updated with the performance of the borrower and as soon as the borrower fails to make
payment the capital must be checked and the reserves created. If the credit risk management of
the company is conducted in an efficient manner in that case the company shall be successful in
boosting the overall, performance of the company.
Strengths:-
 One of the major significance is that the credit risk management shall be assisting in the
decision-making process of the management. It shall help in knowing the amount of
liquidity that is to be maintained, the investments undertaken on account of the idle
funds, the liquidation of the collateral security, loan loss reserves or provision that are to
be created, the capital adequacy that is required and the steps that are to be taken to
maximize the overall performance of the company.
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 It helps in reducing the risks and mitigating the losses that are going to arise in future. It
will essential role in generating credibility of the banking business and maintain the
consistency of the profitability (Belás and et.al., 2018).
 The bank loan risk management will be leading to the effective data mining of the
various customers which shall be facilitating comparison and identifying the actual
potential customers.
 The effective tools and techniques that are used for the risk management shall be
generating competitive advantage in the business and boost the market share of the
business.
Weaknesses:-
 The most significant weakness of conducting this risk management is that it is time-
consuming, involves high cost, which can pose limitation in case of limited availability of
the resources.
 Also, another weakness is that it requires specialized knowledge by the workforce to
analyse the credibility of the borrowers and assess the risk that is involved in the
liabilities of the organization (Bülbül, Hakenes and Lambert, 2019).
 The element of human errors in the calculations can give false results and accordingly the
situation of risk is understated or overstated.
 The data mining activity that is undertaken by the company can violate the privacy or
personal space of an individual and this shall lower down the satisfaction level of the
customers of banking business and force them to shift their preference.
 Hampers the daily operations of the business and the reserves that are created shall
undermine the current profitability of the company.
PART- B
5. Money laundering activities
Money laundering in reference to the bank refers to the act of disguising the illegal
source of income and converting it to the legitimate or legal source. It takes place in different
stages where firstly it gets placed in the banking system of the economy. Secondly it shall get
mixed among the legal sources of the income. And lastly it shall be flowing back to the
beneficiary. There are several methods through which money laundering is taking place like bulk
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cash smuggling, shell company formation, cash intensive businesses and credit card laundering
and gambling.
Some illegal sources through which the money could be generated are drug trafficking,
criminal and terrorist activities (Chao and et.al., 2019). The money that is earned through these
sources is dirty and money laundering cleans it by converting it legitimate. There are strict
controls that are implied these days like the requirement of KYC regulating and combatting these
illegal activities.
The money laundering activities give rise to the terrorism, crime, corruption and illegal
activities which shall cause slow economic growth of the country and this shall ultimately impact
the banking system and its efficiency. If the bank formulates strict policies in order to combat the
money laundering then in that case it can develop growth prospects for itself and the economy.
The clean money shall lead to better profitability by rotating in the system.
The major motives are behind the money laundering activities that are carried out in a
bank are funding the terrorist groups and programs, corruption, under the table deals, various
crimes, human and drug trafficking etc. All these activities and the illegal income that can be
gained from these sources motivate the money laundering activities. The banking officials who
are associated in entering the dirty money in the banking system and provide the beneficiary with
the pure funds, also may be getting proportion of the funds. They bank authorities might be
charging fees or commission for providing white money to the beneficiary and hide the illegal
activities that have been undertaken. Some of these financial perks are the reason that workforce
of the bank engage with individuals and plan a sequence of complex events and transactions that
shall help in conversion of the black money into the white money.
In order to combat the money laundering activities there are several anti-money
laundering policies that are framed and are to be compulsorily complied by the organizations
such that these activities are avoided (Vandezande, 2017). There are several rules and regulations
that have been notified so that the policies can be effectively implied in the banks. One of the
major policy is know your customer (KYC) that should be applied by all the banks where the
activities and transactions of the customers are monitored closely and as soon as some distortions
are made red flags are raised over their disguised and doubtful status.
The policies are framed such that terrorism and criminal acts are avoided at the first
place, such that the money laundering acts do not take place. The banking businesses have to
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maintain the transparency in their transactions and also manage the records properly and filter all
the software properly so that there are no loopholes in the business. The regulation related to the
holding period is imposed where the client has to maintain the balance that is deposited for at-
least the holding period that is specified.
Also, with the development in the artificial intelligence and the advancement of
technology, the tracking and detecting of such activities has become very easy for the business.
The violation of this code of conduct shall impose strict charges and legal actions against the
person and the company involved.
6. Shadow banking
Shadow credit intermediation or shadow banking in the system which includes various
financial intermediaries that creates credit across the financial system. These intermediaries stay
outside the purview of the regulatory bodies that are established to govern and monitor the
activities of the various financial institutions functioning within the economy. The non banking
financial companies are the types of shadow banks that are created to make the basic banking
services accessible to all the citizens. They have been successfully contributing to the growth and
development of the economy through extending loans to those who are in need of it. For example
the loans raised in the form of housing finance by these unregulated intermediaries is one of the
example of shadow banking system (Slepov and et.al., 2019).
The shadow banks have been established to provide the intermediary services like the
credit creation, factoring, bill discounting etc. The major reason that such institutions were
established was so that banking function and its utilities could be accessed all over the globe,
even the extremely isolated and rural regions of the society. It plays the major role in rotating the
money within the financial systems so that the finance can be provided to those who are in need
of from those who have excess money. The commercial banks are not able to cater to each and
every region so these institutions have to be set up which are non regulated and don't have much
formalities in respect of commencement of the business.
They are not regulated by the regulatory bodies and are not exposed to the compliance of
many rules and regulations, because they are not allowed to collect deposits from the customers.
This is the reason that several NBFC's have been exposed related to the fraud that they have
conducted. Since they don't collect the deposits, so they do not have to maintain the reserves with
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the central bank and with themselves. This leads to lack of control over their operations and
leads to frauds in the financial system. It is also difficult for the customers to believe and stay
loyal with these institutes as the safety and security is not ensured by regulation of the authority.
Zamindari system and such illegal lending was also a reason to formulate these companies who
can extend loans at proper rates that are identified by the government as per the conditions of the
economy (Chen, He and Liu, 2020).
The shadow banks operate without taking the deposits from the customers and only
extending the loans. They have to gather finance either by investing their own capital or by
borrowing it from the market and further extend it in the form of loans to the prospective
borrowers. They manage this through several transformations of the form of money and its state.
One of the way is that they borrow short term funds and invest them in the long term assets of
the business. This is called maturity transformation in which the short term borrowings shall be
repaid by the periodic payments on the long term assets.
Another way is that the highly liquid liabilities are used to buy the hard to sell assets like
loans. This is referred to as the liquidity transformation. One way to operate the business is
through the technique of leveraging where borrowings are made to purchase the fixed assets.
And transferring the risk on the third party are some ways of arranging the finance from outside
and then investing it in the appropriate opportunity. This is how the shadow banks operate in the
market by acquiring funds from where it is access and giving to the ones who are in need of it for
smooth functioning in the business.
CONCLUSION
It can be summarized from the above project that banking is an essential function which
contributes to the prosperity of the economy. The various ratios are calculated by the banking
company to know the efficiency of its performance, the contribution of its assets to the income
that is earned and the covering of the expenses by rightfully employing the assets of the
company. Apart from that the credit risk management poses some strengths and weaknesses for
the business but is essential to maintain the profitability and credibility of the company. The
money laundering activities lead to disruptions in the processing of the business. Shadow banks
are very important for the access of the banking services but must be regulated by proper
authorities to avoid fraud.
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REFERENCES
Books and Journals
Belás, J. and et,al., 2018. The impact of social and economic factors in the credit risk
management of SME. Technological and Economic Development of Economy. 24(3).
pp.1215-1230.
Bülbül, D., Hakenes, H. and Lambert, C., 2019. What influences banks’ choice of credit risk
management practices? Theory and evidence. Journal of Financial Stability. 40. pp.1-14.
Chao, X. and et,al., 2019. Behavior monitoring methods for trade-based money laundering
integrating macro and micro prudential regulation: a case from China. Technological and
Economic Development of Economy. 25(6). pp.1081-1096.
Chen, Z., He, Z. and Liu, C., 2020. The financing of local government in China: Stimulus loan
wanes and shadow banking waxes. Journal of Financial Economics. 137(1). pp.42-71.
Chiaramonte, L. and Casu, B., 2017. Capital and liquidity ratios and financial distress. Evidence
from the European banking industry. The British Accounting Review. 49(2). pp.138-161.
Meriç, E., Kamışlı, M. and Temizel, F., 2017. Interactions among Stock Price and Financial
Ratios: The Case of Turkish Banking Sector. Applied Economics and Finance. 4(6).
pp.107-115.
Slepov, V. A. and et.al., 2019. Shadow banking: Reasons of emergence and directions of
development. International Journal of Civil Engineering and Technology. 10(2). pp.1747-
1754.
Smaoui, H., Salah, I. B. and Diallo, B., 2020. The determinants of capital ratios in Islamic
banking. The Quarterly Review of Economics and Finance. 77. pp.186-194.
Taiwo, J. N. and et,al., 2017. Credit risk management: Implications on bank performance and
lending growth. Saudi Journal of Business and Management Studies. 2. pp.584-590.
Vandezande, N., 2017. Virtual currencies under EU anti-money laundering law. Computer law &
security review. 33(3). pp.341-353.
Online
Credit Risk Management. 2021. [Online] Available through:
<https://www.sas.com/en_in/insights/risk-management/credit-risk-
management.html>
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