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Unit 9: Commercial Banking Services

Internet Sensitive Assets Notes

These risks are a part of either assets or liabilities or both of a bank them. Assets are managed
through money market instruments such as interbank lending, treasury bills and repos.
Shortening the maturity of these assets makes them interest sensitive. Shifting liabilities such as
interbank borrowing, issue of CDs while shortening the maturity of the liability side of the
balance sheet makes liabilities more interest-sensitive and increases the risk of the bank's
portfolio.

Credit Risk

The assets of a bank whether a loan or investment carries credit risk. Credit risk is the risk of
loosing money when loans default. Credit risk or default risk gives rise to problems of bank
management. The principal reason for bank failures is bad loans. Banks can raise their credit
standards to avoid high risk loans. Guarantees and collaterals can reduce risk. After the loan is
made, compliance can be ensured by monitoring the behaviour of the borrower which reduces
risk. Credit risk can be transferred by selling standardized loans. Loans portfolio can be diversified
by making loans to a variety of firms whose returns are not perfectly and positively correlated.

RBI Guidelines

RBI guidelines envisage that banks should put in place the loan policy covering the methodology
for measurement, monitoring and control of credit risk. Banks are also expected to evolve
comprehensive credit rating system that serves as a single point indicator of diverse risk factors
of counter parties in relation to credit and investment decisions.
Interest Rate Risk

Interest rate risk management may be approached either by on-balance sheet adjustment or off-
balance sheet adjustment or a combination of both. On-balance sheet adjustment involves changes
in banks portfolio of assets and liabilities, as interest rates change. When medium or long-term
loans are funded by short-term deposits, a rise in the rate of interest will increase the cost of
funds but the earnings on the assets will not, thereby reducing the margin or spread on the
assets. The problem could be resolved by adopting adjustable interest rate on loans on the assets
side of the balance sheet and increasing the maturity pattern of deposits on the liability side of
balance sheet. These decisions relating to banks portfolio of assets and liabilities represent
balance sheet adjustments.
The interest rate risk position can also be adjusted by the bank by making off-balance sheet
adjustments which involve the use of various non-traditional financial instruments referred to
as derivatives such as futures, options, swaps or creation of synthetic loans through use of
futures.

Liquidity Risk

Liquidity risk refers to the bank's ability to meet its cash obligations to depositors and borrowers.
A liability-sensitive position than to assets of interest rates reduces the liquidity position of a
bank. The mismatch between short-term liabilities and long-term assets creates a severe funding
problem as the liabilities mature. Again, if the duration of assets exceeds the duration of liabilities,
the ability to realize liquidity from the assets of the bank is reduced. Liquidity needs are
increasingly met by deposit and non-deposit sources of funds paying market rates of interest.
Banks have decreased the quantity of liquid assets they hold for the purpose of deposits withdrawal

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