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Risk management in banks

Table of contents

1.      Break even rate. 4

2.      Risk adjustment strategy for performance assessment 5

3. Factors for loaning. 9

3.1 Factors for evaluation. 9

4.Strategic economic allocation and value creation. 11

5. Recommendations for approving loan. 12

Bibliography. 12

Risk management

Risk management is used by banks and financial institutions for assessing the credit repayment capacity of the borrowers and the most important part of credit monitoring is the identification of right borrower. Costa Plc. is applying for loan at Marfin Bank and bank needs to manage financial risk without risk management. Bank will measure the risk using break even rate.  . Marfin Bank has adopted the risk controlling measures like controlling debt defaults. Bank can also check financial position of companies. According to the Basel accord that developed different risk controlling measures related to capital adequacy ensuring the operational functions can be performed within the available capital. Marfin Bank will avoid loan expansion to low performing companies (Meyer, 2000).

Assets Liability/ equity
Cash £20 Accounts payable £30
Accounts receivable 90 Notes payable 90
Inventory 90 Accruals 30
Plant and equipment 500 Long term debt 150
    Equity (retain earnings) 400
Total assets £700 Total liabilities & equity £700
Sales Cost of goods sold Operating expenses Taxes Interest payments Net income Dividend payout ratio Medium term loan in 3 years 500 360 80 24 30 34 50% 10m

1.      Break even rate

It is difference between yield on fixed rate bonds and yield on inflation linked bonds.

It is important for Marfin bank to calculate break-even point on bonds that is the total time taken for equalizing expected cash interest payments to amount invested in bonds. High interest rate and low bond price will allow bonds o reach break- even point in shorter duration.

2- Year bond yield 3- Year bond yield     Break-even interest rate (1 + 0.51)* 2 = 3.02 (1 + 0.47)*3 = 4.41 4.41/ 3.02 = 1.46 1.46 ^ (1 / (3-2) 1.46%  

2.      Risk adjustment strategy for performance assessment

The framework of capital measurement and capital standards has been developed by Basel committee involved in managing banking risks through adoption of effective Internal Rating Based (IRB) approach. The borrowers’ probability and the chances of defaulting are calculated by the IRB approach that allows Marfin Bank to determine risks that are converted to risk weight formulas determined by Basel accord (Bank for International Settlements , 2005).. The losses are presented in percentage as; EL = PD* EAD* LGD

EL= expected loss

PD=Probability of default

Considering the regulations of Basel committee Marfin Bank has developed certain models for determining changes in unexpected losses and helps in reducing the levels of such risks. The expected losses are taken as risk weighted assets and amounts of provision are created that are used for reduction of risk weighted assets. There is need for creating adequate provisions against EL and the risk weighted assets are used for assessing the distance between the VaR( Value at risk) and EL.

Risk weighted asset represents the assets weighted according to risk that is used for calculating capital adequacy ratio CAR.

The estimations of the Costa Plc are presented below;

CAR = tier one capital + tier 2 capital/ risk weighted assets

Risk weighted asset = EL = 50- 30= 20

Equity = 400 and retained earnings 0 million, so its tier 1 capital is 400 million. Marfin Bank has risk-weighted assets of 20 million. Consequently, its tier 1 capital ratio is 3% (400 million/20million), and it is considered to be well-capitalized compared to the minimum requirement.
Total risk-adjusted assets for credit risk, RAAC = 1,200 million

Return on risk adjusted capital RORAC = total revenue – total expenses/ risk weighted assets

= £500- £80/ 20

= £21

Market risk capital requirement, CRM = £40 million

Operational risk capital requirement, CRO = £60 million

Marfin Bank has the following capital:

Tier I capital: £150 million

Tier II capital: £110 million

Tier III capital: £0

Deductions (goodwill): 10 million

RAATOTAL= 21 ´(40+60) = £2100 million

Eligible capital:  RC=150+110-10 = £250 million

Regulatory capital ratio= 2100/ 250 = 8.4% >8%

Allocation of equity loan = 5%

Cost of equity = 8%

Tax paid by bank = 26%

Capital expansion for loan = 10 m

Factors for loaning

The main factors that Marfin Bank considers before approving loan extension are; credit history of Costa Plc, history of cash flow statements and business projections, collateral security that company provides, reputation of the company and loan documentation. The credit history of Costa Plc is considered that provides idea about its credibility. Break even rate is also used to analyze the companies credibility. Indicators of cash flow statement such as income, expenses, sales, interests and long term debts are also considered. The longer maturity can be used for paying long term debts. As the dividend payout ratio of Costa Plc. is 50% that is an indicator that it is having capacity of returning 50% shares to stakeholders.

3. Factors for loaning

3.1 Factors for evaluation

Working capital= current assets – current liabilities =200-150 = £50

Retained earnings/ total assets ratio = 0/ 700 = 0

Sales/ total asset ratio = 500/ 700 = 0.74

Market value of equity/ long term debt ratio = 400/ 150 = 2.66

Risk is evaluated from Z score as;

X1 = 8/ total assets

= 8/ 700 = 0.114

X2 = retained earnings/ total assets

= 34*(1-0.5)/ 700 = £0.00

X3 = earnings before interest / total assets

Earnings before interest = 34

= 34/ 700 = 0.04

X4= total book equity/ total long term debt ratio = 400/ 150 = 2.66

Total book equity= 400

X5= Sales/ total assets ratio = 500/ 700 = 0.714

As the Z score rating scores are represented as;

AAA = 8.15 AA = 7.30 A= 6.65 BBB= 5.85 BB = 4.95 B = 4.15 CCC = 3.20 D = 3.19

Z score = 1.2 (X41) + 1.4 (X2) + 3.3 (X3) + 0.6 (X4) +1.0 (X5)

= 1.2(0.114) + 1.4(0.00) + 3.3(0.04) + 0.6 (2.66) + 1.0 (0.714)

= 2.57%

The Z score value reflects the score ratings for Costa Plc’s default as it is a critical tool used by Marfin bank for measuring the financial health of the borrower. The score indicates the chances for loan defaults and determines credit worthiness. Z score of A represents the failure rate of 0.03% to 0.82% and the BBB rating represents the failure rate of 9.36% and failure rate for BB, B and CCC increases to 19.6%. The estimated score for Costa Plc is 2.57%

The bank must not approve redit expansion to the customer due to low earnings and the only case for which bank will approve the expansion request are the improvements in the earnings of the company.

4.Strategic economic allocation and value creation  

The main risks that financial institutions face while crediting the companies involve the market risks, credit risks, liquidity risks and operational risks. Financial statement, cash flow statement and income statement of companies are used for assessing their current financial standing and repayment capacity. Determination of sovereign risk is important for depicting the financial stability of the borrower fluctuations in investor’s base is helpful in finding the yield  (Anderson, Silva, & Velandia-Rubiano, 2010). The stability of investor is reflected from fluctuations in balance sheet and investors that are highly leveraged are capable of liquidating their positions more rapidly compared to low- leveraged investors (Das, Oliva, & Tsuda, 2012). The factors affecting the credit risks include systematic risks, interest rate risks, foreign exchange risks, commodity price risks, industry concentration risks and counter party risks. The credit risk is determined from inability and unwillingness of the borrower to perform according to the pre- committed contract. One of the critical risks faced by banks is the interest rate risk that bank needs to manage before giving capital expansion to its borrowers. As banks earnings are affected by fluctuations in interest rate changing the value of net interest income and other income. High interest rate is good for banks because it increase the income. Bank charges high interest rate from the debtors.  This affects the financial statement including the assets, liabilities and cash flow. Interest rate risks are managed on consolidated basis that involves the evaluation of risks through systematic techniques and reducing to minimum levels.

5. Recommendations for approving loan

Marfin bank will pay principal amount of bond to the investor at a future date and in present case there is no zero coupons that is an indicator that all coupons can be repaid. As dividend payout ratio of Costa Plc. is 50% that is an indicator that it is having capacity of returning 50% shares to stakeholders so Marfin Bank will approve loan expansion of £ 10 m. keeping in view the recouping capacity in case of Costa Plc’s default Marfin Bank will be able to recover 96% credit amount in first year, 93% in second year and 90% in third year. Marfin Bank will approve the loan expansion request of £ 10 m. The Z score estimation also reflects the credit scoring is BBB that reflects chances of loan default are 9.63%.


Anderson, P. R., Silva, A. C., & Velandia-Rubiano, A. (2010). Public Debt Management in Emerging Market Economies: Has this time been different? World Bank Working Paper 5339.

Bank for International Settlements . (2005). An Explanatory Note on the Basel II IRB Risk Weight Functions . Bank for International Settlements .

Carey, M., & Stulz, R. M. (2007). Introduction to “The Risks of Financial Institutions”. University of Chicago Press.

Das, U. S., Oliva, M. A., & Tsuda, T. (2012). Sovereign Risk: A Macro-Financial Perspective. ADBI.

Meyer, M. L. (2000). Laurence H Meyer: Why risk management is important for global financial institutions. Bankok.

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