Credit Risk Assessment in Banking

Question 1: Credit risk and its assessment through quantitative and qualitative banking measures

Credit risk in the banking institution is considered as the borrowers or the counterparty will fail to meet the obligation in accordance with agreed terms. It is also considered as traditional lending activities where the banking institutions provide bonds and other financial instruments such as derivatives as well as on and off balance sheet. The banking institution must focus on credit risk and analyse it for successful portfolio management (Butaru et al., 2016; Cucinelli, and Patarnello, 2017). It is the risk of insolvency of the customers by the banks where the risks are such as debt, personal loan, capital lent and interact acquired. The banking institutions take precaution against managing the risk and in this there is relationship between the creditor and debtors in the financial terms and condition. Credit risk is hereby generated through the financial transactions and it is mandatory for the banking institutions to assess the borrower’s creditworthiness or the ability to repay the loans before and faster the loan has been sanctioned. The aim of the credit risk assessment is to minimise the losses in lending and through proper risk assessment, it is possible for the banking institutions to manage their credit risk and diversify it for gaining overall benefit of lending finance or the financial instruments to the borrowers. For proper credit risk assessment, the major factors are cost, quality of the credit and the information asymmetries which are mandatory to manage the risk and positively to gain higher (Chance, 2019). It further helps to ensure contribution of technology advances and the relationship lending vs. transaction ending. The credit risk can be calculated on the bases of the ability of the borrowers to repay the loan according to the original terms and condition and it is calculated through reviewing Cs which are credit history, capital, capacity to repay the loan, condition of the loan and the associated collateral.

Credit reporting is mandatory in this regard to assess the credit risk and in this regard the individual credit can be scored through credit bureaus such as Experian and Trans Union on a three-digit numerical scale using a form of Fair Isaac (FICO) credit scoring. Hence, the credit rating institutions provide proper rating after analysing the credit condition (Cucinelli, and Patarnello, 2017). Credit risk quantification of the process of measuring the risk associated with the agreement of transacting finance where improbability of default is calculated. In order to analyse credit risk, there are several variable which are required to be under consideration and these variables are such as financial status of the debtor, six of the credit extension, capital amount, seriousness of the default, historical tend of the defeat tariff and there are also a numbers of macroeconomic factors influencing credit risks such as interest rate and the economic growth (Bluhm, Overbeck and Wagner, 2016). When the banking institutions are forced to operate outside of the normal parting environment, there would be unexpected risk, which could not be analysed properly due to lack of understanding about the unfavourable situations in the unexpected environment. On the other hand, the BIS approach assumes that the balance sheet of the banking institution is effective to manage the expected loss, where the banks are operating under known environment (Koulafetis, 2017). There are some shortcomings, for which the banking institutions may face difficulties to assess the credit risk associated with the financial transactions of the banks and the shortcomings are such as unreliable environment, potentially biased decision making behaviour, unable to handle a large numbers of applicants, difficult to assess the personal needs, lack of automation system and rely on private sourcing information. In order to mitigate such shortcomings, the banks try to rely on the key factors for making sustainable credit decision which are analysing reputation by following borrowing leading history, market specific factors, business cycle, rate of interest, volatility of earnings and leverage (Witzany, 2017). It is important for the banking institutions to analyse the credit risk and make effective decision for credit activities. It is mainly known as qualitative risk assessment model, where the banking institutions find the risk through non-numerical models (Bluhm, Overbeck and Wagner, 2016). Apart from qualitative model, there are quantities measures through which the banking institutions try to manage their operations and credit risk activities. Quantitative risk assessment is the formal and systematic risk analysis approach to quantify the risk associated with the process where it is an efficient tool to support the understanding of exposure of risk to the employees, company asset and its reputation. Statistical models are utilised to quantify the risk associated with the credit and the models are such as linear probability model, logit model and linear discriminate model. In this care, probability model for estimating the probability of default is priority for credit risk management (Shaha, 2018). It is a logistic model with binary regression to analyse the potential risk factors related to the credit decision. LDA is another quantitative model to identify credit risk through frequency distribution. Credit pricing model and credit value-at-risk (VAR) models are also effective for the banking institutions to manage their risk and take corrective step for mitigating the risk. Concentration risk is another model through which the bank can concentrate on a particular counterparty, sector or country, where it is possible to track credit rating changes, setting concentration limit and develop effective decision for such credit (Cucinelli, and Patarnello, 2017). In the recent years, the technological advancement plays a crucial role in the banking institutions to apply the statistical model through software and analyse the credit risks and thus, technological innovation is beneficial for the banking sector to facilitate cross marketing, achieve mixed success, increase innovation in the financial products, allow exploitation of economies of scale and economies of scope (Bluhm, Overbeck and Wagner, 2016). Thus, the banking institutions in the recent era of digitalisation are successful to manage credit risk through proper analysis and evaluate which further influence the institutions to make effective decision to give credit to the borrowers (Belas et al., 2018).

Question 2: Different financial derivatives and its advantages and adverse implications

In finance, derivatives are mainly known as the contract that derives its value from the performance of the underlying entity. The entity would be asset, index or interest rate and in this regard the banking institutions try to utilise different derivatives to diversity the risk and mitigate the calculated risk in the credit activities. The purpose of using derivatives in finance is tool increase exposure to price movements for speculations and getting access to trade or market. It is a contract between the parties, where the payment can be made successfully as per the terms and condition of the contract. The assets include the commodities, bonds, stocks and interest rate as well as currencies (Hutzenthaler, Jentzen and von Wurstemberger, 2019). In the economic point of view, the derivatives can be considered as cash flows of the institutions that are conditioned stochastically and discounted to the present values. Derivatives are hereby allowing the break up and ownership and partnership of the business in the market value of the asset. These are four parts of derivatives which are futures, forwards, options and swaps. Through these instruments, the banking institutions can manage their financial activities and manage credit in long run. It is useful for risk management purpose, where the derivatives provide a scope to the institutions to manage their risks and diversify their portfolio for gaining higher profit out of the portfolio investment.

Future derivative:

Future derivatives are the financial contracts in which the parties can transact the asset at a predetermined future date and price. It helps to quantify the return of the asset in future date and price and it facilitates future exchanges. Future contracts does not carry all the credit risk as clearing house acts a crucial role between both the parties to make the contract successful. The margins are necessary to be managed by the parties and it is a standardise contract between the parties traded on exchange at a certain period of time in future at a specified price. The counter party risk is low and stick exchange regulations are implemented to regulate both the parties actively (Martin et al., 2019). The settlement can be conducted on daily basis and for collateral; initial margin is required where the contracts size is fixed at a specific rate of interest.

Forward derivative:

Forward derivatives are the agreements between the parties and it is traded over the counter. Forward contract is a customised contract which is to buy or sell the underlying asset at specified date at agreed rate in future. The market for forward contract is huge as there are many multinational corporations us it to hedge currency and interest rate risk (Kahalé, 2017). Due to lack of rules and regulations in the forward contracts, there would be a series of defaults in the market. Hence, the counterparty risk is high and it is customised depending on the contact’s terms and condition. The settlement would be doe on the maturity date and it is self regulated.

Options derivative:

Options are also another type of financial derivatives, which provide the buyers the right but not the obligations to buy or sell an underlying asset at an agreed upon price and date. Call and put options are there to analyse the risk and manage the investment portfolio and financial planning. The banking institutions also utilise this derivative for managing their risk and diversity their portfolio for gaining higher asset. The options give the right to its holder to either purchase or sell an asset for a specified price on or before some expiration date. Call option writer standards to make profit of the underlying stock stays below the strike price and on the other hand, put option is where the trader can be profitable if the price stays above the strike price (Gruyter, 2018). The future return can be increased by certain investment decision through the option derivatives; no time decay, fixed upfront trading cost and easier pricing technique are the advantages of option derivative where the banking institutions can implement it for risk management practice.

Swaps derivative:

Financial swap is the derivative contract where one party can exchange the cash flows or asset for another. The banking institution can swap their contract for higher earning where the borrower can provide a fixed interest rate. The forward swap is try entre into the swap that starts at future date at an interest rate agree upon today. Swapping is hereby beneficial for the organisation to choose the best investment portfolio where the return would be maximised (Blanco and Wehrheim, 2017).

Benefits of derivatives:

The major benefits of derivatives are such as,

Reduce risk

Facilitates financial markets integration

Portfolio management

Enhancing price discovery process

Enhance liquidity of the underlying asset

These are the major benefits for the banking institutions to choose the financial derivatives for risk management and making effective portfolio investment decision. For example, if the banks found it profitable to invest in agreement B as compared to agreement A, it would be beneficial to invest in B with fixed interest rate at future date with the agreed interact date at today. It is known as interest rate swap where the banking institution finds it profitable to swap the agreement at a specific interest rate (Gupta, 2017).

Adverse implications of derivatives:

Higher numbers of bankruptcies

Increasing fraud due to lack of regulations in forward contract

Arising counterparty risks

Due to lack of understanding and information asymmetries, it is sometimes difficult for the banking institutions to utilise the appropriate financial derivatives and it is hereby risky for the institutions to make effective investment portfolio. It is important for the organisations to choose proper derivative for making successful investment where the return on the asset will be maximised (Hudson, 2017). Through effective management of financial derivatives, it is possible for the banking institutions to maximise their return, secure sustainability in business management, managing their clients efficiently and reducing the risk of portfolio investment.

Question 3: Explaining the risk factors in the banks and role of IT to manage the cyber risk

On the recent era of globalisation, the banking institution face difficulties to manage risk factors as technological advances raise the cyber security risk ad issues to manage the protection of the clients in the banks. The world of finance is affected with the most common forms of cyber attack which is malware and it is considered as a targeted attacks. It has been explored that, a numbers of users infected by banking Trojans, and the principle of the attack is to steal the data and personal information of the clients (Eling and Wirfs, 2019). It further arise the major difficulties and risk for the banking institution to manage protection and safety of the customers, as it deteriorates the firm’s values and bank image in the market. There are other cyber security risks factors which are unencrypted data, third party services, data manipulation and spoofing, for which the image of the banking institutions has been hampered. Phishing is the technique of sending email purposefully to the banking, where email Id and password are necessary and through which the hackers try to hack the personal information and data of the institution. A denial-of-service attack (DoS attack) is a cyber-attack, where the machine access and network resource become unavailable to its intended users by temporarily disruption of the services of the host connected to the internet. It is important for the banking institutions to protect personalise data and information in order to maintain client privacy and manage their data and personalise information successfully (Linsley, Shrives and Wieczorek-Kosmala, 2019). In the recent era of digitalisation, IT infrastructure and technical advancement further enhance the banks’ performance where the institutions try to implement the latest technology and improve their data management system for future success, which in turn helps to protect the data and personal information of the clients and business data. Digital transformation is hereby the process of using digital technology to create and modify the system for creating effective culture, business model and customers experience. It is the responsibility of the banks to safeguard their cyber security issues and prospect against the cyber attacks from authorisation into access confidential information, disrupt service, and destroy data. In this regard, Fintech is one of the latest innovation to support the banking and financial services where the institutions try to manage their big data analysis and improve artificial intelligence to run their operations successfully. This change is effective to update the technology, create new portfolio of the business manage risk and equity generation (Dhir and Satpathy, 2016). It is further helpful for the baking institutions to reduce the risk of cyber attack, protect the personal data and information, and reduce transaction cost and achievement of the economies of scale. Basel Committee on Banking Supervision (BCBS) enhances the technological innovation in the banking institutions and in this regard the strategies such as crowd funding, lending marketplaces, mobile banking and credit sorting are effective to manage the credit, deposit and capital raising services. On the other hand, the retail banking management is also innovative under the technological advancement where the tactics of mobile website, digital currencies and peer to per transfer are effective tools to manage the customers and maximise their values in long run, where the cyber attack can be mitigated under proper supervision and control. On the other hand, the wholesale management can be possible value transfer networks, FX wholesale as well as digital exchange platforms are utilised for better management (Pucihar et al., 2018). The banking institutions also develop their technical system towards high frequency trading, e-trading, Robo advice and copy trading which are effective to handle the investment management services in the financial market.

On the other hand, here is other technological innovation, through which the banks try to protect their database and serve the customers in a better and unique way. The baking institutions are using own web portal and data aggregators to handle the database as well as ecosystem including the infrastructure development, APIs and open source management are also fruitful to run the banking institutions efficiently (Holotiuk et al., 2018). The innovative ideas of security management through customer identification, authentication is also one of the creative ways to protect the customers and create values for them. Cloud computing with effective hardware system and software tools provides a scope to the banks to manage their customer’s data and maintain privacy of the consumers. Mobile technology is also the latest innovative model, where the customers can handle their accounts through the mobile application of the banks and this required proper Id and password to handle it which also maximises customer’s protection. Block chain and smart contacts are useful to manage distributed ledger and artificial intelligence such as algorithms; bots and automation in finance are also effective to run the banking operations efficiently. For payments, clearing and settlement services, there are mobile wallets such as Apple Pay, Google Pay as well as P2P payments including PayPal, Facebook payment which are beneficial for the customers to make the payments by managing safety and security. Business to business payment is increasing over the years as well as there are digital currencies such as Bit coins and Ether which are also applicable in the banking institutions to protect the customer’s data and help them to make effective payments as per the requirements. Artificial intelligence (AI) and Machine Learning (ML) further raise efficiency of the banks to protect the data and reduce the cyber attack threats in the market (Duong, and Swierczek, 2019). Hence, the technological innovation and creativity is fruitful for the banking institutions to improve the banking services, raise creativity of data management system, managing financial stability and enhance competition among the institutions by performing efficiently. It is also beneficial for the customers to get better and more tailored banking services which further lowers the transaction cost and faster the banking services and hence, the all the financial institutions must incorporate the best technology for banking service innovation and protecting the data and personalise information.

Reference List

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Blanco, I. and Wehrheim, D., 2017. The bright side of financial derivatives: Options trading and firm innovation. Journal of Financial Economics, 125(1), pp.99-119.

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Cucinelli, D. and Patarnello, A., 2017. Bank credit risk management and risk culture. In Risk Culture in Banking (pp. 321-348). London: Palgrave Macmillan, Cham.

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Hutzenthaler, M., Jentzen, A. and von Wurstemberger, P., 2019. Overcoming the curse of dimensionality in the approximative pricing of financial derivatives with default risks. arXiv preprint arXiv:1903.05985.

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