QUESTION 3
As financial intermediaries banks play a valuable role in the economy. The bank’s relevance to the economy depends on its ability to mobilize credit as well as issue credit to various actors of the economy. Bank institution gets its revenue from lending operations.
Administration of credit is one of the most important roles of the banking sector. The industry is most risky and the same time profitable role performed by banks. The performance of the bank depends on its ability to manage credit risk. credit risk refers to the risk associated with default on a debt that often occurs when the borrower fails to make the required payment. Credit risk poses a serious threat to bank performance and if it is not checked would result in the collapse of the banks.
Liquidity risk refers to the risk that a bank or company will not be able to meet its short term financial obligations. Liquidity risk occurs as a result of the inability of a business to convert hard assets to cash of income and/ or capital in the process. With unsound control policy and risk assessment, liquidity risk may slow the performance of the banks. Both credit risk and liquidity risk play a significant role in the success or failure of bank institutions.
Credit risk significance
Credit risk can be classified as default risk, credit spread risk, and downgrade risk. Default risk is the risk that arises when borrowers are unable to make contractual payments. Credit spread risk occurs as a result of volatility in the difference between the risk-free return rate and investment interest rates. It is the risk that occurs as changes in risk-free rate and risk of investment. Finally, downgrade risk is due to downgrades in the issuer risk rating.
According to the Basel
- bank
of Banking Supervision, credit risk is the probability of losing outstanding loans due to default risk (credit event). Credit event includes failure to pay the obligation, bankruptcy, and credit rating restructure or change. Credit risk impacts the performance of the financial institution as the default of customers to pay loan decrease the profitability of the bank and may also result in bankruptcy. Unsuccessful credit risk management may result in liquidity challenges in the banking sector and hence affecting business continuity. According to a study by Isanzu (2017), high credit risk increases the customers to make more investment. The rate of return is assumed to increase as investors make more investment. To do such investment it means that investor will require to source for financial institutions, hence as the credit risk increase the level of investment increase. These, therefore, increase profitability in business and hence increase business opportunities for financial lending institutions.
Bank customers are concerned with the safety of their money deposited in the bank. As a result of this, the bank needs to access the customer before extending credit to them as this may affect the performance of the bank. Poor administered and week credit policy my result in bad debt the bank loan portfolio. Credit risk affects the asset performance hence posing liquidity threat to the financial institutions. According to Pandey (2011) monitoring, planning, management, and collection of the funds lent are valuable for the credit management department which as they play a critical role in bank industry survival.
An increase in the volume of credit risk results to increase in the number of doubtful and bad debt. in the long-run, this will result in writing off this bad debt. if credit risk not regularly monitored, the bank profitability will decrease with each transaction. Credit risk also has a negative effect on bank operational performance.
Measurement of credit risk
Credit risk is measured based on the borrower’s ability to pay the loan as per the original terms. To compute the credit risk on loan consumers, lenders are interested in the five Cs capacity to repay, credit history, associated collateral, the loan conditions, and the loan’s conditions.
Most banks have established departments for evaluating the credit risk of the current and potential loan consumers. Technology has made it easy for the bank to analyze information applied to assess the customer risk profile. Banks are also able to share the customer crediting rating based on their history with other lenders.
Before issuing a loan to a customer bank analyzed his or her creditworthiness. The customer crediting rating validity is based on one-year data. Based on the customer financial statement in the past one year, the banks can measure whether the customer can repay a loan or not. The customer credit rating is adjusted based on the current environment. Based on the customer credit rating the bank can calculate the probability of default.
Liquidity risk significance
Liquidity refers to the business ability of the business to meet its short term obligation. Cash is considered to be the most critical asset in any business operation. It plays an important role in the continuous operation of the business. Banks are required to have cash or liquid assets that can be easily be converted into cash if a need arise. Different types of assets are found in bank institutions including treasury bills, deposit with the central bank, and cash. Hence for banks to remain operational in financial intermediation business, must formulate procedures and policy to promote the availability of liquid asset and cash in the bank asset portfolio. Liquidity risk reduces the bankability to meet its short-term financial obligation when they fall due. In case of credit risk, there is the possibility of the bank losing customers leading to a reduction in deposit volume. The decrease in customer deposit results in insufficient funds for investment hence reducing the level of bank profitability significantly. High liquidity risks affect the bank negatively.
Liquidity risk consists of time risk, funding risk, market risk, and call liquidity risk. time risk refers to the need for compensating for non-receipt of expected inflow funds, in other words, it refers to turning performing assets into non-performing assets. Funding risk refers to the replacement of one outflow into unanticipated non-renewal or withdrawal of deposit. This means that the bank does not have the finance to meet cash flow obligations. Market risk occurs when the bank is not able to perform a larger transaction to be specific financial instruments traded in the financial market at the current market price. Call risk is when the bank has the finance to engage in profitable business opportunities when they arise.
Measure liquidity risk
Current ratio application one of the main measurement of liquidity risk. the current risk refers to the ratio of current assets to the current liabilities. The ratio measures the bank’s ability to pay current obligation or short-term liabilities due within not more than one year. The current ratio explains to the analysts and investors how businesses can minimize their current assets to satisfy the current liabilities and other payables. Lower current ratios indicate that the bank is at high risk of not meeting the short-term obligations.
Other measurements of liquidity risk include bid-offer spread, market depth, immediacy, and resilience. Market participants apply bid-offer spread as a measure of asset liquidity. The bid price is used to compare different product spread ratio to bid price. A low lever of bid-offer spread ratio indicates higher liquidity and hence the company is considered to be less risky. This spread consists of processing, administrative and operation cost, and the payment needed to facilitate trade.
Market depth refers to the number of assets that can be purchased and sold to different bid-ask spreads. Flow traders are required to take into account the impact of implementing a large order on the market as well as adjusting the bid-ask spread. The liquidity cost is calculated as the difference between the initial execution price and execution price.
The securitization market involves the consolidation of a group of assets (illiquid asset) with other assets so a create a more liquid asset. Liquidity is described as the degree at which a company can readily sell its assets without affecting its price. Transformation of illiquid assets into assets can be easily sold on the market increase liquidity. The securitization market can be used to convert the mortgage portfolio into cash or more liquid asset. This helps in decreasing the liquidity risk of the bank. Transformation of illiquid assets into marketable security increases the available fund that helps the banks to cover its short term financial obligations. It also helps the financial institution to have sufficient funds available for issuing the loan. This increases business profitability.