Page 133 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 11. The rate of interest in each leg could either be a fixed rate, or a floating rate indexed to
some ……………., like the LIBOR.

9.4 Credit Risk

This risk takes place when any of the counter party to the swap deal defaults on their payment
obligations thereby forcing the intermediary to pay the other party. This risk along with market
risk is known as default risks of the intermediary (swap bank).

Credit risk or default risk may be defined as the potential that a bank borrower or counterparty
will fail to meet its obligations in accordance with the agreed terms. Sources of credit risk exist
throughout the activities of the bank. These are:
1. Loans: Which are the largest and most important source of credit risk. Loans and advances
constitute nearly 55% of the total assets of the scheduled commercial banks in India at the
end of any normal financial year.
2. Investment (in non-SLR instruments): Including certificate of deposits, commercial paper,
equity shares of PSUs and private corporate sector, bonds /debentures/ preference shares
issued by PSUs and private corporate sector etc. The exposure to such investments in
respect of the scheduled commercial banks of India is 7-9% of the total assets as at the end
of March of any normal financial year.

3. Off balance sheet activities /items: These items are not booked on the balance sheets and
are of a contingent nature, and hence carry a definite element of risk although they generate
a fee income for the banks. Indian banks are presently exposed to the off-balance sheet
items such as foreign exchange contracts, guarantees, acceptances etc. These, put together,
constitute 6-7% of the total assets in respect of the scheduled commercial banks in India at
the end of the March of any normal year. With further liberalization, banks are taking up
new types of off-balance sheet exposures such as future, swaps, options, etc.

4. The remaining 25 to 30% of demand and time liabilities of the banks is locked up by way
of Cash Reserve Ratio (CRR) on Saturday Liquidity Ratio (SLR). Credit risk is generally
made up of transaction risk or default risk and portfolio risk. Transaction risk arises from
individual credit transactions of the bank at a micro-level and is evaluated through technical,
financial and economic analyses of individual borrowers, Project. Whereas, portfolio risk
arises out of the total credit exposures of the bank at a macro-level. Portfolio risk may be
intrinsic, e.g. a particular group or type of customers or industry may have a higher risk
profile as compared to the other groups or types. Portfolio risk may also arise out of
undue concentration of credits to single borrowers or counterparties, a group of connected
borrowers or counterparties, particular industries/sectors, borrowers in a particular
geographic location, etc. In the event that a particular group or industry experiences a
downturn, the entire portfolio may turn into non-performing assets, at least at that point
of time.

Self Assessment

Fill in the Blanks:
12. Credit risk or ………….may be defined as the potential that a bank borrower or
counterparty will fail to meet its obligations in accordance with the agreed terms.
13. Credit risk along with ….....……is known as default risks of the intermediary (swap
bank).

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