Different Areas of Risk of a Financial Organization:

All financial activities involve a certain degree of risk and particularly, the
financial institutions of the modern era are engaged in various complex financial
activities requiring them to put proper attention to every detail. The success of the trading
business depends on the ability to manage effectively the various risks encountered in the
trading environment, and the organization’s policies and processes require development
over time to ensure that this is done in a controlled way.
The key risk areas of a financial institution can be broadly categorized into:
- Credit risk
- Market risk and
- Operational risk
2.1.1 Credit risk: - The main risks treasuries have to manage in the financial
markets are credit risk i.e. the settlement of transactions and market risk, which
includes liquidity risk and price risk. Some of the risks that are to be monitored and
managed by a treasury can be defined as follows:
Credit risk Arises from an obligor’s failure to perform as agreed.
(a) Interest rate risk - Arises from movements in interest rates in the market. The
interest rate exposure is created from the mismatches in the interest reprising tenors
of assets and liabilities of an organization. This risk is generally measured through
Earnings at Risk Measures (EAR) i.e. the potential earning impact on the balance
sheet due to interest rate shifts in the market.
(b) Liquidity risk - Arises from an organization’s inability to meet its obligations
when due. The liquidity exposure is created by the maturity mismatches of the
assets and liabilities of the organization. This risk is measured through tenor wise
cumulative gaps.
(c) Price risk - Arises from changes in the value of trading positions in the interest
rate, foreign exchange, equity and commodities markets. This arises due to changes
in the various market rates and/ or market factors.

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 (d) Compliance risk - Arises from violations of or non-conformance with laws,
rules, regulations, prescribed practices, or ethical standards.
(e) Strategic risk - Arises from adverse business decisions or improper
implementation of them.
(f) Reputation risk or franchise risk - Arises from negative public opinion
2.1.2 Market Risk:
Market risk is defined as the potential change in the current economic value of a
position (i.e., its market value) due to changes in the associated underlying market
risk factors. Trading positions are subject to mark-to market accounting, i.e.,
positions are revalued based on current market values and, for on-balance sheet
positions, reflected as such on the balance sheet; the impact of realized and
unrealized gains and losses is included in the income statement.
2.1.3 Operational risk:
The risk associated with operating certain type’s business activities is known as
operational risk. This is the risk of operating business activities. This risk may be
country risk i.e. risk of operating activities in a specific country and so on.

Policy for Credit Risk Management (Lending):

This section details fundamental credit risk management policies that are
recommended for adoption by all banks in Bangladesh. The guidelines contained herein
outline general principles that are designed to govern the implementation of more
detailed lending procedures and risk grading systems within individual banks. The
following this guideline in managing credit risks.

2.2.1 Lending Guidelines: -

All banks should have established Credit Policies (“Lending Guidelines”) that
clearly outline the senior management’s view of business development priorities and the
terms and conditions that should be adhered to in order for loans to be approved. The
Lending Guidelines should be updated at least annually to reflect changes in the
economic outlook and the evolution of the bank’s loan portfolio, and be distributed to all

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lending/marketing officers. The Lending Guidelines should be approved by the Managing
Director/CEO & Board of Directors of the bank based on the endorsement of the bank’s
Head of Credit Risk Management and the Head of Corporate/Commercial Banking.

Any departure or deviation from the Lending Guidelines should be explicitly identified in
credit applications and a justification for approval provided. Approval of loans that do
not comply with Lending Guidelines should be restricted to the bank’s Head of Credit or
Managing Director/CEO & Board of Directors.

The Lending Guidelines should provide the key foundations for account
officers/relationship managers (RM) to formulate their recommendations for approval,
and should include the following:

 Industry and Business Segment Focus

The Lending Guidelines should clearly identify the business/industry sectors that
should constitute the majority of the bank’s loan portfolio. For each sector, a clear
indication of the bank’s appetite for growth should be indicated (as an example,
Textiles: Grow, Cement: Maintain, Construction: Shrink). This will provide
necessary direction to the bank’s marketing staff.

 Types of Loan Facilities

The type of loans that are permitted should be clearly indicated, such as Working
Capital, Trade Finance, Term Loan, etc.

 Single Borrower/Group Limits/Syndication

Details of the bank’s Single Borrower/Group limits should be included as per
Bangladesh Bank guidelines. Banks may wish to establish more conservative
criteria in this regard.

 Lending Caps
Banks should establish a specific industry sector exposure cap to avoid over
concentration in any one industry sector.

 Discouraged Business Types

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 Banks should outline industries or lending activities that are discouraged. As a
minimum, the following should be discouraged:

- Military Equipment/Weapons Finance

- Highly Leveraged Transactions
- Finance of Speculative Investments
- Logging, Mineral Extraction/Mining, or other activity that is Ethically or
Environmentally Sensitive
- Lending to companies listed on CIB black list or known defaulters
- Counterparties in countries subject to UN sanctions
- Share Lending
- Taking an Equity Stake in Borrowers
- Lending to Holding Companies
- Bridge Loans relying on equity/debt issuance as a source of repayment.

 Loan Facility Parameters

Facility parameters (e.g., maximum size, maximum tenor, and covenant and security
requirements) should be clearly stated. As a minimum, the following parameters
should be adopted:

- Banks should not grant facilities where the bank’s security

position is inferior to that of any other financial institution.
- Assets pledged as security should be properly insured.
- Valuations of property taken as security should be
performed prior to loans being granted. A recognized 3rd party professional
valuation firm should be appointed to conduct valuations
 Cross Border Risk
Risk associated with cross border lending. Borrowers of a particular country may be
unable or unwilling to fulfill principle and/or interest obligations. Distinguished
from ordinary credit risk because the difficulty arises from a political event, such as
suspension of external payment

- Synonymous with political & sovereign risk

- Third world debt crisis

Policy for Foreign exchange risk management:

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 All foreign exchange transactions invariably involve two or more parties and two or
more currencies. Commercial banks act as intermediaries for settling payments between
parties located in different countries. Commercial bank dealing in foreign exchange has
a specialized department know as the Foreign Exchange Department, manned by one or
more senior officials who are specialists in this purpose. The function of this
department is primarily to convert foreign currency into home currency and vice versa
for customers and for other banks with which the bank concerned my enter into deals
for certain business purposes.
A transaction involving foreign exchange i.e., conversion or exchange of currencies is
known as “Foreign Exchange Transaction”. The policy guidelines that a bank needs to
follow in foreign exchange can be given as:

2.3.1 Dealing Limit: -

As a dealer develops his/ her expertise and dealing instincts over time, it is the
management’s responsibility to assess his/ her dealing capabilities and based on that a
specific dealing limit can be allocated to an individual dealer. In doing this, the
management also keeps in mind the dealer’s dealing limit requirement in relation to the
market and according to the organization’s own size, need and market risk appetite.
2.3.2 Mandatory Leave: -
The dealing functions are extremely sensitive involving wholesale and large amounts
with exposures to adverse market movements. There is also risk of mistakes not being
unearthed. As a result, for a particular dealer’s functions to be run by a different dealer,
all dealers are required to be away from their desks for a certain period of time at one
stretch during a year. During this period, dealers are not expected to be in contact with
their colleagues in the treasury area. Typically, this period is defined as a continuous two
weeks period.
2.3.3 Position Reconciliation: -
All dealers’ positions must be reconciled with the positions provided by the treasury
back-office. This must be done daily prior to commencement of the day’s business.

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Unreconciled positions may lead to real differences in actual positions exposing the
organization to adverse market changes and real losses.
2.3.4 Nostro-Account Reconciliation: -
Banks maintain various nostro accounts in order to conduct operations in different
currencies including BDT. The senior operations manager of the organizations set limits
for handling nostro account transactions that include time limits for the settlements of
transactions over the various nostro accounts and the time and amount limits for items
that require immediate investigation after receipt of the account statements.
Overdraft interest for “our accounts” must be calculated for each day the branch is in
overdraft in accordance with its records. The operations manager sets the time and
amount limits for liquidation of open items or differences found unreconcilable. These
items must be investigated as far as is practicable and if they are found unreconcilable,
the operations manager may authorize liquidation through appropriate entries as
established as per their accounting policies.
However, the items in question must be amply identified and corrective steps taken to
prevent recurring differences. At least quarterly, a comprehensive review of all “our
accounts” must be made by an officer independent of transaction processing and
authorization functions to ensure that each account continues to be operated with a valid
business purpose and that reconciliations and other controls continue to be in place and
are effective.
The following table shows the maximum time limit after which unmatched items must be
referred to the operations manager.
Type of Transaction Transit Time
L/C payments 3 days, ACU - 7 days
Foreign exchange settlements Nil. Immediately notify
respective department if
settlement does not occur on
value date
TC encashment 21 days
Outward remittances 3 days
Draft payments 30 days
ACU cover funds sent through 7 days

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Bangladesh Bank
Credits to our accounts with 20 days
insufficient details
ACU cover funds sent through 7 days
Bangladesh Bank
Credits to our accounts with 20 days
insufficient details
Correspondent bank charges 20 days
recoverable from our customers or
otherwise

Correspondent bank charges 30 days

recoverable from our customers or
otherwise
Any other credits to our accounts, 7 days
where we have not passed
corresponding debit entry
Any other transactions where we 7 days
have debited, but they do not credit
Any other transactions where they 7 days
have debited, but we do not credit
Any other transactions where we 7 days
have credited, but they do not debit

It would be appropriate if banks resolve that L/C related unmatched items equivalent to
USD 200,000 and above outstanding for more than a day would be brought to the
attention of the operations manager for review.
Similar process could be adopted for other than L/C related unmatched items equivalent
to USD 50,000 and above outstanding for more than a day.
2.3.5 After-hours Dealing: -
After-hours dealing is that which initiated when the dealer’s own trading room is closed.
For specific business reasons, an organization may decide to allow its treasury to engage
in after-hours dealing. In such cases the organization must have properly laid down
procedures detailing the extent to which they want to take risk during after-hours and
which dealers to have dealing authority and upto what limits they can deal during after
hours.
2.3.6 Off-premises Dealing: -

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A dealing transaction done by a dealer who is not physically located in the dealing
premises (irrespective of the time of day) is an off-premises deal. An off-premises deal
needs to be treated separately from a deal done from within the dealing room due to it
being done using communication tools that are not as special as those of the dealing
room. For example, an off-premises deal done on the phone is generally not recorded and
thus there is no record in case of any future dispute. Also, deals done from within the
dealing room get recorded immediately updating positions and allowing treasury back-
office to take immediate actions (confirmation, settlement etc.), which is not the case for
off premises deals. As such, an organization must have detailed laid down procedures for
the off-premises deals describing how these deals would be accounted for with least
possible delay. Typically, organizations would designate particular dealer(s) with the
authority for off-premises dealings in case they decide to carry out such activity for some
specific business reason/ justification.
2.3.7 - Stop Loss Limits: -
Based on the comfort on each dealer and/ or the treasury as a whole, the management
allocates dealing limits. However, there is always risk of adverse market movements and
no organization is in a position to absorb/ accept unlimited losses. This results in
organizations putting in place “stop loss limits”. As a result of this and considering the
company’s own financial strengths, the management determines loss limits for particular
positions and/ or for a portfolio of positions, where the dealer must close the position or
the portfolio and book the loss and stop incurring further losses. Stop loss limit can both
be dealer specific and specific to the treasury as a whole.
2.3.8 Mark-to-Market: -
This is a process through which the treasury back-office values all outstanding positions
at the current market rate to determine the current market value of these. This exercise
also provides the profitability of the outstanding contracts. The treasury back office
gathers the market rates from an independent source i.e. other than dealers of the same
organization which is required to avoid any conflict of interest. Treasury back-office to
take immediate actions (confirmation, settlement etc.), which is not the case for off
premises deals.

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2.3.9 Valuations: -
The process of revaluing all positions at a pre-specified interval is known as valuation.
Though this exercise, an organization determines that if they are to liquidate all the
positions at a given time, at what profit or loss they would be able to do so. This function
is carried out by the treasury back-office by gathering revaluation rates. Ideally, the
treasury back-office should gather such rates from sources other than from the dealers of
the same organization to avoid any conflict of interest. Dealers’ are required to have their
own P&L estimate which must be tallied with the ones provided by the treasury back-
office. Any unacceptable difference between these two must be reconciled to an
acceptable level.

Factors Of Risk:
Risk is inherent in all aspects of a commercial operation; however for Banks and
financial institutions, credit risk and foreign exchange risk are essential factors that need
to be managed. Before minimizing the risk a bank should know what are factors are
influencing their risks.
Factors Influencing Credit Risk:

Different factors influencing the credit of a bank like Mercantile Bank can be given as:
a. Default nature of borrower: -Risk of credit with the borrower differentiation.
Different types of borrower contain different sort of risk. Default nature of the
borrower influence the risk in a large extent.

b. Industry size and Structure: The key risk factors of the borrower’s industry should
be assessed. Different industry contain different sort of risk and this factors have
to consider before proceeding loan.

c. Financial position of the borrower: Financial position of the borrower also affect
in the credit risk. If a borrower has enough current and fixed assets to support the
loan then it is safe to precede loan to him than who don’t.

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d. Project of the Loan: - The project for which the loan is taking is also an important
factor in credit risk management. Future of the loan settlement depends on the
attractiveness of the project success. That is why in determining credit risk project
attractiveness must be evaluated.

e. Accounts conduct: - For existing borrowers, the historic performance in meeting

repayment obligations (trade payments, cheques, interest and principal payments,
etc) should be assessed.
f. Margin Sustainability or Volatility: - Margin of the project or the existing margin
of the business is stable or volatile is also important in determining risk of credit.
Obviously bank will not prefer a volatile project for their business.

g. High Debt Load: - Amount of debt currently the firm or the borrower has also a
considering factor in credit management. If the firm or the person has fewer
current assets than the loan amount proceed than it will be a risky decision to
precede loan.
h. Growth Rate: - acquisition or expansion rate: Growth, acquisition or good
expansion rate of the borrower business give a positive signal for the loan
settlement.
i. Loan Structure: - The amounts and tenors of financing proposed should be
justified based on the projected repayment ability and loan purpose. Excessive
tenor or amount relative to business needs increases the risk of fund diversion and
may adversely impact the borrower’s repayment ability.

j. Security: - A current valuation of collateral should be obtained and the quality and
priority of security being proposed should be assessed. Loans should not be
granted based solely on security. Adequacy and the extent of the insurance
coverage should be assessed.

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 k. Guarantors’ strength: - When there are strong guarantors or a strong guarantor
then the future of the loan more secure than a loan with weak guarantors or
guarantors. Thus guarantors’ strength is also influencing factor in determining
risk of credit.

These are the major factors that influencing the risk of credit management. On the basis
of these factors we studied the opinion of five factors can be summarized as:

Factors No. of Percentage of respondents

respondents Believe that factor influence
risk
Default nature of borrower 5 80 %
Industry size and Structure 5 80 %
Financial position of the borrower 5 100 %
Project of the Loan 5 100 %
Accounts conduct 5 20 %
Margin Sustainability or Volatility 5 60 %
High Debt Load 5 80 %
Growth Rate 5 20 %
Loan Structure 5 20 %
Security 5 80 %
Guarantors’ strength 5 60 %

Thus 100% officials surveyed believed that financial position of the borrower and Project
of the loan are main factor and other important factors are default nature of borrower,
industry size, high debt loan, security and guarantor’s strength. Maximum officials
believe that accounts conduct, loan structure are not important factors of risk of credit.

Factors Influencing Foreign Exchange Risk:

Major factors that influence the foreign exchange risk are: -

1. Exchange rate risk 2. Political risk. 3. Country risk

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Exchange rate risk refers the chance fluctuating the exchange rate of foreign currency
more frequently. Political risk arises from political unrest in national and international
territory. For politically unstable situation foreign direct investment reduce, export
reduces and country depend more on import. On the other hand country risk is the risk
that arises from doing business in a particular country. It affects most in MNC.
The risk of foreign exchange incur form the change of the equilibrium exchange rate and
the factors that affect the foreign exchange rate can be given as:-
a. Relative inflation rate: - Suppose that the supply of dollars increases relative to its
demand. This excess growth in the money supply will cause inflation in the United
States, which means that U.S price will begin to rise relative price of German goods and
services. German consumers are likely to buy fewer U.S. products and begin switching to
German substitutes, leading to a decrease shift in the euro supply curve to S/ as shown in
the following curve.
Dollar price of on euro mark

S/
S

D/
D

Quantity of euros

Similarly, higher price in the United States will lead American consumers to substitute
German imports for US products, resulting in an increase in the demand for euros as

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depicted by D / . In effects, both Germans and Americans are searching for the best deals
worldwide and will switch their purchases accordingly. Hence, a higher rate of inflation
in the United States then in Germany will simultaneously increase German exports to the
United States an d reduce U.S exports to the Germany.
b. Relative Interest Rates: -Interest rate differentials will also affect the equilibrium
exchange rate. A rise in U.S interest rate relative to German rates, all else being equal,
will cause investors in both nations to switch form euro to dollar-denominated securities
to take advantage of the higher dollar rates. The net result will be depreciation of the euro
in the absence of government intervention.
c. Relative Economic Growth Rates: - Similarly, a nation with strong economic growth
will attract investment capital seeking to acquire domestic assets, in turn, results in an
increased demand. For the domestic currency and a stronger currency, other things being
equal. Empirical evidence supports the hypothesis that economic growth should lead to a
stronger currency. Conversely, nations with poor growth prospects will see an exodus of
capital and weaker currencies.
d. Political and Economic Risk: - Other factors that can influence exchange rates
include political and economic risks. Investors prefer to hold lesser amounts of riskier
assets; thus, low risk currencies- those associated with more politically and economically
stable nations- are more highly valued than high currencies.
These are factors that affect equilibrium as well as foreign exchange risk. On the basis of
these factors we studied the opinion of five officials factors can be summarizing as:
Factors No. of Percentage of respondents
respondents Believe that factor influence
risk
Exchange rate risk 5 100 %
Industry size and Structure 5 80 %
Financial position of the borrower 5 20 %
Thus we can say that 100% respondent believe that Exchange rate risk influence foreign
exchange risk where 80 % and 20 % respondents believe that industry size and structure,
financial position of the borrower respectively affect the foreign exchange risk.

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