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(1.1) INDUSTRY PROFILE

Non-Banking Financial Companies (NBFCs) are fast emerging as an important

segment of the Indian Financial System. It is a heterogeneous group of institutions

(other than commercial and co-operative banks) performing financial intermediation

in a variety of ways, like accepting deposits, making loans and advances, leasing, hire

purchase etc. They raise funds from the public and then lend them to ultimate

spenders. They advance loans to the various wholesale and retail traders, small-scale

industries and self-employed persons. Thus, they have broadened and diversified the

range of products and services offered by the financial sector.

Gradually, they are being recognized as complementary to the banking sector due to

customer- oriented services, simplified procedures and attractive rates of return on

deposits, flexibility and timeliness in meeting the credit needs of the specified sectors.

The working and operation of NBFC are regulated by the Reserve Bank of India

within the Reserve Bank of India Act of 1934.

As per the RBI, a non-banking financial company is defined as:-

A financial institution which is a company.

A non-banking institution which is a company and which has as its principle

business the receiving of deposits, under any scheme of arrangement or in any

other manner or lending in any manner.

Such other non-banking institution or class of such institutions, as the bank

may, with the previous approval of the Central Government and by

notification in the Official Gazette specify.

THE TYPES OF NBFCs REGISTERED WITH THE RBI ARE:-

Equipment Leasing Company: - is any financial institution whose principle

business is that of leasing equipments or financing of such an activity.

Hire-Purchase Company: - is any financial intermediary whose principle

business relates to hire-purchase transaction or financing of such transactions.

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Loan Company: - means any financial institution whose principle business is

that of providing finance, whether by making loans or advances or otherwise

for any activity other than its own (excluding any equipment leasing or hire-

purchase finance activity).

Investment Company:-is any financial intermediary whose principle business

is that of buying and selling of securities.

Now these NBFCs have been re-classified into three categories:-

Asset Finance Companies: - These are financial institutions whose

principle business is of financing of physical assets such as

automobiles, tractors, construction equipments, material handling

equipments and other machines.

Investment Companies:- They are generally involved in the business

of shares, stocks, bonds, debentures issued by the government or local

authority that are marketable in nature.

Loan Companies: - They are loan giving companies which operate in

the business of providing loans. They can be housing loans, gold loans,

etc.

NBFCs are different from banks in the following ways:-

NBFCs cannot accept demand deposits (Demand Deposits are funds deposited

in an institution that are payable immediately on demand, e.g.-savings deposit,

current account, etc.)

A NBFC cannot issue cheques to their customers and is not a part of their

payment and settlement system.

Deposit Insurance facility of Deposit Insurance Credit Guarantee Corporation

is not available to NBFCs customers.

They cannot offer interest rates higher than the ceiling rates prescribed by the

RBI from time to time (Currently the ceiling rate is 12.5%)

They cannot offer gifts, incentives or any other additional benefit to its

depositors.

They should have minimum investment grade credit rating from the credit

rating agencies.

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Non-Banking Financial Companies (NBFCs) are fast emerging as an important

segment of the Indian Financial System. It is a heterogeneous group of institutions

(other than commercial and co-operative banks) performing financial intermediation

in a variety of ways, like accepting deposits, making loans and advances, leasing, hire

purchase etc. They raise funds from the public and then lend them to ultimate

spenders. They advance loans to the various wholesale and retail traders, small-scale

industries and self-employed persons. Thus, they have broadened and diversified the

range of products and services offered by the financial sector.

Gradually, they are being recognized as complementary to the banking sector due to

customer-oriented services, simplified procedures and attractive rates of return on

deposits, flexibility and timeliness in meeting the credit needs of the specified sectors.

The working and operation of NBFC are regulated by the Reserve Bank of India

within the Reserve Bank of India Act of 1934.

As per the RBI, a non-banking financial company is defined as:-

A financial institution which is a company.

A non-banking institution which is a company and which has as its principle

business the receiving of deposits, under any scheme of arrangement or in any

other manner or lending in any manner.

Such other non-banking institution or class of such institutions, as the bank

may, with the previous approval of the Central Government and by

notification in the Official Gazette specify.

(1.2) COMPANY OVERVIEW

Shriram Group is a financial servicesconglomerate founded on April 5, 1974 by R.

Thyagarajan, AVS Raja and T. Jayaraman. They have their headquarters in Chennai,

Tamil Nadu, India. The group had its beginning in chit funds business and later on

entered the lending business in a big way through Shriram Transport Finance

(Commercial Vehicle Finance) and Shriram City Union Finance (Consumer and

MSME Finance). R. Thyagarajan was awarded Padma Bhushan award in 2013 for

empowering financial inclusion in India.

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The journey of Shriram has seen them making several financial innovations while

standing at the very edge of Organized Finance. The Banks and other Financial

Institutions were guided by the Economists Vision, the small truck owner who

always fell on their blind side, was given a miss.

With a track record of almost 35 years, STFC is now among the leading organized

finance provider for the commercial vehicle segment with a focus to provide various

credit facilities to Small Road Transport Operators (SRTOs).

STFC, being a pioneer in pre-owned CV segment, has institutionalized its expertise in

loan origination, valuation and collection. Over the years, STFC has created an

ecosystem of empowerment by expanding its products and services to encompass

similar asset classes (pre-owned and new commercial and passenger vehicles, tractors,

3 wheelers, multi-utility vehicles, etc.) and ancillary services (Finance for working

capital, engine replacement, bill discounting, credit cards and tyre loans as holistic

financing support).

For employees at Shriram, credit-worthiness of the Small Truck Owner has always

been an article of faith. This faith has guided their journey from its pioneering days in

financing Small Truck Owners to the present day leadership. Today they are not only

the leader in Truck Finance; but are also India's largest Asset Based Non-Banking

Finance Company.

STFCs pan-India presence through its widespread network of branches has helped in

its overall growth over the years. As on March 2014,it has 654 branch offices and 629

rural centres and tie up with over 500 private financiers across the country. As on

March, 2014 STFCs employee strength was 18122, including more than 11,209

product executives and credit executives who are colloquially referred to as our field

force.

STFC has demonstrated consistent growth in its business and profitability. Today,

STFC has approximately 20-25% market-share in pre-owned commercial vehicles

and approximately 7-8% market share in new commercial vehicles with more than

9,50,000 customers.

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(1.2.1) PERFORMANCE OF STFC (in crores)

PARTICULARS 31.03.12 31.03.13 31.03.14

ASSET UNDER

MANAGEMENT

41922.41 52,000 56,520

MARKETSHARE

A)PRE

OWNED

B)NEW

TRUCKS

22-25%

6-7%

22-25%

6-7%

22-25%

6-7%

CREDITRATING Stable Stable High Safety

NET PROFIT 1257.45 1360.62 1264.21

DIVIDEND 62% 65 % 70 %

NET NPA 0.40% 0.77 % 0.83%

TOTAL NO OF

EMPLOYEES

15467 16178 18122

Table-1.1

Here we can see that Asset under management is increasing Asset Under management

is the value of documents on which company has hypothecation. As NBFCs are not

allowed to take deposit as a debt so it is the only assets with the company. So an

increasing trend shows that company is in a good state. Market share is remained

same. Credit Rating of the company is also improved which is again is good for the

company. But net profit is decreasing which is because finance charges are increasing.

Dividend given to per share to the share holder is increasing which will further boost

the shareholders faith and their investment motive. Though the NPA is still under the

percentage fixed by the RBI, but it is increasing which shows company should take a

corrective measure while providing loans. Increase in number of employees depict

that outreach of the company is increasing year by year.

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CREDIT RATING:-The credit rating enjoyed by the Company as on March 31,

2013 is as follows.

CREDIT RATING PROVIDED BY DIFFERENT CREDIT RATING

INSTITUTIONS

Credit Rating Agency Instruments Ratings

CARE Non-Convertible

Debentures

CARE AA+

CARE Subordinate Debt CARE AA+

CRISIL Fixed Deposit CRISIL AA+/Stable

CRISIL Subordinate Debt CRISIL AA/Stable

CRISIL Non-Convertible

Debentures-Public

CRISIL AA+/Stable

CRISIL Short-Term Debt CRISIL A1+

CRISIL Bank Loan Long Term and

Short Term

CRISIL AA+/Stable

ICRA Fixed Deposit MAA+ with Stable

outlook

Table-1.2

(1.2.2) WORK DONE BY STFC AT HEAD OFFICE LEVEL

INTERNAL AUDIT

When paid up capital > 5 crore then have to form audit committee. IDEA software is

used in STFC for data analysis for internal auditing. External auditing is done by CA

firms hired time to time. Main types of auditing done in STFC are-

Operational audit- covers only operational activities ex inquire about loans

documents, how customers are being sourced and how they are retained etc.

Concurrent audit - this type of audit is done throughout the year. Very common in

banks.

Surprised audit- As the name suggests itself these audits are done without informing

the concerned branch. Main aim is to know the real condition of the bank on the spot.

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Because many times concerned branch is tried to manipulate the data related to audit

so that they can get good rank in auditing.

Stock audit- In this type of auditing closing and opining stock is evaluated. This is

related to inventory management.

After doing internal audit risk is basically measured. Risk is categorized in 6 types

depending upon the amount get defaulted at branch level.

Insignificant risk- no cash mismatch only entry is done wrongly.

Major risk- when default of 51 lakh-1 crore

Minor risk- up to 10 lakh

Moderate risk- 11-50 lakh

Catastrophic risk- of more than 1 crore.

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(1.2.3) BRANCH STRUCTURE

Fig-1.1

ABREVIATIONS:-

BTL-Branch Team Leader

CRE-Customer Relationship Executive

CSE-Customer Service Executive

PE-Product Executive

WORKING OF STFC AT BRANCH LEVEL

Process of lending in brief

Two URLs are available in STFC. UNO and WEST REPORT. Lending process is

divided into three stages stage I, stage II, stage III.

STAGE I- In this stage two main functions are vehicle deduping and and customer

deduping. Firstly we do vehicle deduping. We go to UNO and give their unique

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numbers related to vehicle like its chessis number, engine number, registration

number etc. It is done to know whether vehicle is already financed from the company

or not. If after filling any number UNO generates data related to it that means vehicle

is already being financed by the company and so loan will not be processed if all

things related to previous loan are cleared but if all EMI and ODCs are clear it is

being preceded. After it we go for customer deduping also called deduping. In it again

we give unique numbers related to the customer likes customer ID, customer name

etc. Through it we searched about customer whether he/she is already taken loan from

company or not and also searched is he/she acts as a guarantor. If customer is old then

we check his track record that is as a guarantor or as a borrower what was his

repayment tendency. That is we checked his credit worthiness. If customer is new

then company generate new customer ID. After that check all details related to the

vehicle and using oracle try to decide the amount of loan should be given on the

vehicle.

STAGE II - This stage is related to the documentation. Verify whether documents

like tax invoice, RC, quotation, receipt of margin money, particular and insurance etc

is available or not. Then company do Telly Verification to cross check the borrower.

STAGE III -Here we fixed EMI. That is amount of EMI and also scheme through

which EMI Is provided. Fes decides which type and pattern should be applied so that

IRR will be maintained and customer should also be comfortable in repaying it.

INSURANCE

IRDA (INSRANCE REGULATORY DEPATMENT AND AUTHORITY) is in India

to look over insurance cases. Two types of insurance are available in India First Party

Insurance and Second Party Insurance. According to Motor Vehicle ACT 1988 Third

party insurance is mandatory. It is also called incomprehensive insurance. It insured

the third party only thats why called so. Borrower or the owner of the vehicle is

considered as the first party, insurance company is considered as the second party and

the anything that adversely get affected by any type accident by this vehicle is

considered as the third party. In first party insurance both the owner and the thing

which is hitted by the vehicle are insured. That is why it is also called comprehensive

insurance policy. If we talk about STFC here comprehensive policy is mandatory for

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the vehicle but in some cases Third party insurance is also taken like (i) if customer

wants to do settlement (ii) if financing amount is of less than 1 lac. Before giving

insurance we check following things-:

(i) Vehicle number is right or not

(ii) Name of the owner on the RC.

(iii) HPN is on the insurance or not

(iv) Also match chessis and engine number from the RC.

(v) Check validity of the policy.

DEPOSITS

As we know STFC is a deposit taking non banking financial company.

Deposit taking NBFC like our company has to be rated by rating agencies

such as CRISIL, CAMEL, CARE, FRIPL, FITCH, Standard & Poor, Moodys

etc. This rating has to be done every year.

The best rated NBFC can get a maximum rating of AAA in respect of

deposits.

Even AAA rating NBFCs can accept deposit only to the maximum extent of 4

times of their Net Owned Funds. If the grading comes down like AA or A, the

quantum of accepting public deposit will also get reduced to 3 times, 2 times

respectively of NOF.

Out of the deposit amount, 15% must be invested in government approved

securities (such as RBI Bond, IDBI Bond, ICICI Bond, Central & State

Government Bonds etc).

The minimum period of deposit is 1 year and the maximum period is 5 years.

(1.2.4) SERVICES PROVIDED BY STFC

a. LENDING

MAIN PRODUCTS: -Shriram has divided its vehicle segments on the basis

of certain criteria and conditions in five segments. They are as follows:

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Segments of STFC

Fig-1.2:

Let us now develop a brief understanding into each of this segment:-

Small Commercial Vehicles (SCV):- As per RTO this vertical comprises of

vehicles with a Gross Vehicle Weight of less than 3.5 tonnes but as per

Shriram this vertical comprises of all vehicles upto 4 wheelers.

EXAMPLE: - Bajaj Delivery Van, Maruti Omni Cargo (used only for

transporting goods), Tata Ace.

Light Commercial Vehicles (LCV):-As per RTO this vertical comprises of

vehicles having Gross Vehicle Weight of greater than 3.5 tonnes and less than

7.5 tonnes but if Shriram is taken into consideration this vertical consists of all

6 wheelers.

EXAMPLE:-Tata SFC 407, Swaraj Mazda Premium Truck, Ashok Leyland

Cargo.

Heavy Goods Vehicle and Construction Vehicle:- As per RTO this segment

consists of vehicles and machinery used for construction with a Gross Vehicle

Weight of greater than 16 tonnes and if we take Shriram into picture then this

segment consists of all vehicles above 6 wheelers and all machinery.

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EXAMPLE: - Tata Turbo Truck, Ashok Leyland 3116, Ashok Leyland 2216,

JCB 3DX.

Farm Vehicles and Farm Equipments: -This segment consists of tractors

and farm equipments, like, harvesters, all tractor variants.

EXAMPLE:-Mahindra Tractors, Punjab Tractors, L&T all tractor variants,

Escorts harvester.

Passenger Vehicles: -This vertical comprises of vehicles used for transporting

passengers, that is, from 3 wheelers upto buses, like, Swaraj Bus, School bus.

EXAMPLE: - Atul Passenger Auto, Eicher School Bus, Mahindra Maxi Cab,

Swaraj School Bus.

Hence, all vehicles that come for financing under Shriram Transport Finance

Company ltd are classified under these segments. Thus, providing loans on

Commercial vehicles is considered to be the main product of Shriram Transport

Finance Company Ltd.

OTHER PRODUCTS:-They are also known as Working Capital loans. They

are value added services provided by STFC to its existing customers.

Eligibility Criteria for Working Capital loans.

Existing customers

Completed Six month of agreement period.

Out of 6 instalments 4 must have been paid.

The various kinds of Working Capital Loans are mentioned below:-

a) TYRE LOAN:

Based on the Dealer quote, STFC at its discretion extend the loan. ( with or

without margin money)

Loan amount from Rs. 4000 to Rs. 80,000

Repayment period- 4 months to 12 months

Documentations charges as per norms.

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b) POWER LOAN:- Purpose of loan:

For vehicle repairs

For fuel requirements, Driver/Cleaner wages, tollgate expenses.

Loan amount 75% of the estimated requirements.

c) ENGINE EXCHANGE LOAN:-

TATA Motors is offering reconditioned engines in exchange of used

engines.

75% of estimated requirement.

Documentation Charges: Rs. 250/-

Service Charges: 2 % of the loan amount or Rs. 1000/- whichever is

higher

d) PERSONAL LOAN:-To fulfil the personal needs of Borrower like

Medical expenses

Educational expenses for children

SLIC premium payment

Vehicle- premium payment

Maximum loan amount up to one lakh.

e) JEWEL LOAN-(Gold Loan) - Also known as asset backed personal

loan.

Only for STFC customers.

Gold Jewels only. (Gold coins, Bars, Biscuits not allowed)

Loan cannot be against jewel with very low gold weight e.g. - gross weight

of 200 grams and net pure weight of 20 grams only. Any collateral item

which has iron or copper as major weight contributing should not be

funded.

Valuation of gold based on Branch Gold Appraisers Report

Market value of gold- as per UNO (Net pure wet*UNO gold rate)

Disbursal Mode-Total payment will go first to the customer account

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1. Minimum 55% of loan Amount OR entire loan amount to be deposited in the

parent loan account. (Cash inflow through Cheque of the loan amount

deposited to the account of customer.)

2. Maximum 45 % of loan amount disbursed for personal needs

3. Interest rate- Same as parent loan agreement.

4. Only EMI scheme

Tenure:

EMI- up to 36 months or expiry of Parent loan whichever is earlier.

Approval Authority- Branch Manager.

Processing Fee- Min Appraiser Fee.

KYC Documents- Not required.

Release of Gold Pledged- The collateral to be released on repayment of the

entire loan amount or 50% of the Loan Amount with BM/CM approval.

f) CREDIT CARD:-

Co- Branded Credit card ( SHRIRAM-AXIS)

Loan amount must be more than One Lac.

Age must be below 60 years.

Over- all credit limit- Rs. 15,000/-

Cash withdrawal limit- Rs. 5000/-

Interest charged @ 2.95 per month from the date of withdrawal &

compounded monthly.

Interest Free Period 20 to 50 days.

Billing Date is 13th to 12th of next month.

Validity of card is 3 years. However Card is to be surrendered, if the

loan is closed early.

Benefits.

Personal accident cover: Rs. 3,00,000/-

Lost card liability: Rs. 15,000/-

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g) CHALLAN DISCOUNTING:

It is a facility to get money in advance against money receivable in the

future.

Commission charges are 3% of the discounted amount of Challan.

Cash disbursal limit below Rs. 20,000.

b. DEPOSITS: - Apart from providing loans on new and pre-owned

commercial vehicles and other working capital loans, Shriram Transport

Finance Company also accepts deposits. The kinds of deposits and the

procedure of making deposits are as follows:-

Kinds of Deposits:-

i. Non-cumulative Deposits:-It is a deposit where the interest is being paid at

Monthly / Quarterly intervals. Fixed deposits are accepted in multiples of

Rs.1000/- subject to a minimum amount of Rs.10000/- per deposit account.

ii. Cumulative Deposits:-Cumulative Deposits are accepted in multiples of

Rs.1,000/- subject to a minimum amount of Rs.5,000/- per deposit account.

Application Procedure

For resident individuals, the list of documents required is:

Fresh application form

A/c payee cheque / Demand Draft / Pay order favouring Shriram Transport Finance

Company Ltd.

To comply with? Know your customer? Guidelines for NBFCs prescribed by the

Reserve Bank of India, first applicant should provide a copy of any one of the

following documents (which contains the photograph of the concerned first depositor)

for identification and proof of residential address.

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Passport

PAN card

Voter's Identity Card

Driving license

Bank passbook with photo

In case the address mentioned in the above document differs from the current address

mentioned in the application form then a copy of any one of the following documents

should be furnished as proof of residential address.

Telephone bill

Bank account statement

Letter from any recognized public authority

Electricity Bill

Ration Card

Letter from Employee

Interest Payment Modes:

Post Dated interest warrants sent direct to depositors

Direct to the depositor with bank details

Through RBI Electronic Clearance Service (ECS)

DD

THE CSR ACTIVITIES OF THE COMPANY INCLUDE:-

1. Providing education to the backward and weaker sections of the society.

2. Empowerment of Common Man and women

3. Providing Vocational Training for income generation and enhancing

employability of marginalized/ unprivileged people of the society.

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4. Undertaking projects for protection of environment such as tree plantation,

water conservation, etc.

5. Nutrition, Health care and Sanitation Programs.

(1.2.5) SWOT ANALYSIS OF STFC:-

STRENGTHS:-

The pioneer in commercial vehicle financing sector.

Knowledge-driven and relationship-based business model.

Pan-India presence with 539 branch offices.

A well-defined and scalable organization structure based on product, territory

and process knowledge.

Strong financial track record driven by fast growth in AUM with low Non-

Performing Asset.

Experienced and stable management team.

Strong relationship with public, private as well as foreign banks, institutions

and investors.

More than 9.5 lakhs customers all over India.

WEAKNESSES:-

The Companys business and its growth are directly linked to the GDP growth

of the country.

OPPORTUNITIES:-

Growth in the Commercial Vehicle market.

Strong demand for Construction Equipment.

Strong demand for Passenger Commercial Vehicles.

Strong demand for pre-owned tractors.

Loans for working capital requirement of Commercial Vehicle users.

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Partnerships with private financers will enable the company to enhance its

reach without significant investments in building infrastructure.

THREAT:-

Regulatory changes in the NBFC and ancillary sectors

(1.3) MANAGERIAL PROBLEM

Risk is the measure issue for any company, especially if we talked about Non-banking

financial companies it form an integral part of the Indian financial system. The history

of the NBFC Industry in India is a story of under-regulation followed by over-

regulation. Policy makers have swung from one extreme position to another in their

attempt to set controls and then restrain them so that they do not curb the growth of

the industry. Most of this NBFCs are operating with high risk of lending and more

often NBFCs lend credit to Small and Medium size enterprises, which are

categorized as high risk class of Assets. To assess such high risk assets we need to

have a comprehensive model. In STFC basically individual borrowers risk is

measured in qualitative basis.

(1.3.1) NEED OF THE STUDY

A Risk Assessment Model (RAM) is necessary to avoid the limitations associated

with a simplistic and broad classification of applicants into a "good" or "bad"

category. Ideally, credit and marketing functions should be separated. But, in the case

of Centurion Bank Limited, the marketing and credit functions are clubbed and are

performed by the marketing manager. If the manager detaches himself from the

organization, it will be difficult for the concern to carry on from there. The risk of

biased approach towards customers also poses a great threat. So, by systematizing the

whole process, we are not only evening out the process but also removing the element

of bias and subjectivity. The bank currently uses an evaluation sheet giving equal

weights to all parameters under consideration. Different parameters deserve different

degrees of importance. These raise the need for development of a Risk assessment

model to complement the evaluation sheet. The development of such a framework

will standardize the judgment in the credit selection procedures. The RAM will

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deploy a number as a primary summary indicator of risks associated with a credit

exposure. Risk management encompasses identification, measurement, monitoring

and control of the credit risk exposures. Such a rating framework is the basic module

for developing a risk management system.

(1.3.2) KEY OUTPUT OF RAM

I. Defining the pricing bands-- The grade on the rating scale is expected to

define the pricing and related terms and conditions for the accepted credit

exposures. It is possible to define broad pricing bands and directly link the

band with the grade on the rating scale. Higher the risk, higher could be the

price charged.

II. Limits on exposure-- The amount sanctioned would depend on the credit-

score on the RAM. These limits could be linked to specific parameters like, a

certain percentage of the total debt required by the borrower. This would help

in a larger dispersion of risk amongst lenders and limit risk concentration in

moderate credit-quality projects.

III. Tenure of loans-- The rating scale could also be used for deciding on the

tenure of the proposed assistance. A longer term could be offered to safe

customers.

IV. Monitoring the exposures-- Banks may also use the rating scale to keep a

close track of deteriorating credit quality and decide on the remedial

measures. For instance, the frequency of surveillance on category 4 exposures

could be kept at quarterly intervals, while those on category 2 loans could be

half-yearly.

Macaulay (1988) conducted a survey in the United States and found credit risk

management is best practice in bank and above 90% of the bank in country have

adopted the best practice. Inadequate credit policies are still the main source of

serious problem in the banking industry as result effective credit risk management has

gained an increased focus in recent years. The main role of an effective credit risk

management policy must be to maximize a banks risk adjusted rate of return by

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maintaining credit exposure within acceptable limits. Moreover, banks need to

manage credit risk in the entire portfolio as well as the risk in individual credits

transactions.

So I tried to applied IRCSIT approved model on samples of Bhiwani Branch so that I

can proposed it as a new model for STFC which will add value to it. This Risk

Assessment Model for NBFCs is based on both qualitative and quantitative aspects

of the client.

Quantitative aspect: Quantitative aspect refers to managing the credit risk by using

the quantitative tools and techniques such as ratio analysis, and reaching a concrete

number for every loan which would indicate the magnitude of risk and expected

returns, on a case by case basis.

Qualitative aspect: Qualitative aspect is taking a holistic view by a bank at its overall

portfolio, deciding the lending limits to a sector, setting up the broad policies and

procedures, and so on. Both quantitative and qualitative aspects need to be taken into

consideration while computing the risk levels. In the case of corporate clients, post-

mortem of the balance sheet is one of the main instruments. Ratio analysis helps us

determine whether the loans have to be extended. But, past performance is not an

ideal indicator of the future performance. This raises the necessity to consider other

qualitative parameters such as technological status, reputation, repayment track with

others and so on.

The Model basically contains 4 risks Liquidity Risk, Operational Risk, Credit

Risk, Market Risk.

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(1.4) LAY OUT OF THE REPORT

Report is divided into 5 chapters. Chapter-1 is already being described in previous

pages. Chapter -1 was basically introduction part that contains COMPANY

PROFIELE, MANAGERIAL PROBLEM, and its third and last section is LAY OUT

OF THE REPORT. This part describes what this projects contain and briefly why

particular part is relevant for the project.

Chapter -2 contains Review Of Literature. This part describes all works done in the

area of the project. My topic is TO PROPOSE IACSIT APPROVED RISK

ASSESSMENT MODEL FOR STFC. So my Literature Review firstly described

Risk. What other persons think about risk and how it is categorized. It also defines

Risk Assessment and describes all theories related to it. Second part of the chapter

describes all work done by the Indians in Risk Assessment Area. Third part of the

chapter describes all work done by the International Researcher in this area.

Chapter -3 contains Research Methodology. This part is further is divided into 6 main

parts- Research Design, Sample Size, Sampling Procedure, Sources of Data and Time

Frame.

Chapter -4 Analysis of Data is done in this chapter.

Chapter -5 Contains Conclusion and Recommendation.

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(2.1) DEFINITION OF RISK

When doing business, constantly decisions, where the outcomes cannot be foreseen

with certainty due to incomplete information, have to be made (Stroeder, 2008,

p.135). This uncertainty connected with every kind of business activity is risks.

Although this term is of central importance, there does not exist an overall definition

of the meaning of risk (Wesel, 2010, p.280).

As a first step for the definition, similar terms, which are often used exchangeable in

every days speech, need to be distinguished, namely: uncertainty, danger and risk.

Uncertainty is used when the outcomes of future events are uncertain and the different

states cannot be connected with probabilities of occurrence (Stroeder, 2008, p.136)

The term danger in general stands for unplanned and unpredictable outcomes having a

negative impact on something. Like those two terms, risk summarizes events that are

uncertain regarding their outcome. The difference is that in the case of risk, the

outcomes can be connected with a probability of occurrence (Stroeder, 2008, p.136).

Furthermore, risk can be split into two categories. On the one hand there are pure

risks or systematic risks, which cannot be influenced by the manager and are

independent of business decisions. On the other hand there are unsystematic risks,

which are the result of managerial decision-making and can either have a negative or

a positive outcome (Stroeder, 2008, p.140; Retzlaff, 2007, p.11).

However there are differences in the definitions of risk. First of all some include also

possible positive outcomes of a risk, also referred to as upside risks or chances. Other

only define the possible occurrence of negative outcomes, or downside risks, as risks

because they are more in the focus of the management (Dhanini et al., 2007, p.74).

The inclusion or exclusion of chances is not the only difference in the common

definitions. They range from (negative) deviations of planned outcomes, over danger

of making wrong decisions to danger of losses due to information lacks (e.g. Nassauer

& Pausenberger, 2000, p.264; Hermann, 1996, pp.7-11). When focusing on the

common features of the definitions, risk is the possibility of deviation from a planned

outcome or goal. This implies that all business is connected with risks resulting from

the fact that future states of the world and outcomes of decisions can only be

predicted. As business activities are uncertain regarding their outcome and this

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uncertainty implies risks to the profit of the firm, a company needs to manage its risk

exposure (Retzlaff, 2007, p.9).

(2.2) RISK CATEGORIES

In general risks can occur everywhere within the company or its business

environment. Operational risks, financial risks and organizational and management

risks are internal risks as they have their source within the firm (Henschel, 2008, p.8).

External risks occur in the business environment of the company and can be

economical, technological, political, legal or cultural changes (Scheve, 2005, p.26).

Economic risks apply to all companies, as they include the influence of

macroeconomic variables on the company, its input factors and demand for the

firms products (Triantis, 2000, p.558). As this category covers risks, which depend

on changes in financial markets, it is also often referred to as external financial or

market risks. The main risk factors in this category are changes in interest rates,

exchange rates and commodity prices (Triantis, 2000, p.559; Eckbo, 2008, p.542).

However financial risks can also occur independent of the development of

international markets. Also the way of financing, liquidity and equity consumption

due to losses can become risks to the company. All three risks are internal financial

business risks (Hermann, 1996, p.153).

(2.2.1) EXTERNAL FINANCIAL RISK

Financial risks

Financial risk management has received increased attention over the past years

(Glaum, 2000, p.373). The reason for this is that financial risks, though they are not a

core competency of non-financial firms, also influence their business operations to a

large extend (Triantis, 2000, p.559). Financial risks can be of different forms. On the

one hand there are external financial risks depending on changes on financial markets.

On the other hand there are internal financial risks, where the company itself is the

source of the risks (Eichhorn, 2004, p.43).

External financial risks are based on the risk factors of exchange and interest rates as

well as commodity prices (Schnborn, 2010, p.3).

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Exchange rate risk- Exchange risk occurs when a company is involved in

international business and the cash in or outflows are in a foreign exchange rate. As

this rate is not fixed and cannot be fully anticipated a possible change in a foreign

exchange rate leads to the risk of changes in the amount of a payable / receivable and

by that a change in the amount of money the company has to pay / will receive. This

risk is measured by the concept of transaction exposure (Glaum, 2000, p.375;

Armeanu & Blu, 2007, p.65). Furthermore economic exposure can be included in the

evaluation of exchange rate risk. This includes changes in the quantity of future sales

due to changes in the exchange rate and therefore relative competitiveness of the

company (Nassauer & Pausenberger, 2000, p.271). However, the prediction of this

sensitivity is difficult and hardly measurable and thus the company cannot manage

this risk actively. Most firms therefore concentrate on transaction exposure and by

that on the price change and not the quantity change caused by the exchange rate

volatility (Smithson, Smith & Wilford, 1995, p.6).

Interest rate risk- Interest rate risk is based on changes in interest rates and can be

observed in different forms. The first form refers to changes in interest rates in

connection with variable loans and short-term financing. A rise in the interest rate

leads to higher interest payments for the variable rate loan and more expensive

follow-up financing. This decreases the companys earnings and can in worst case it is

lead to financial distress. Second, the vice versa case refers to cash positions of the

company with a variable interest rate. A fall in this rate leads to a loss in earnings.

Thirdly, also fixed rate debt contracts can be a risk for the company. In times of

declining interest rates those contracts cause higher payments then a variable loan

would do and are disadvantageous for the company. However, these costs are

opportunity costs and not real costs to the company (Dhanini et al., 2007, p. 74).

Therefore it can be summarized that the more corporate debt and especially short-term

and variable rate debt a company has, the more vulnerable it is to changes in the

interest rate (Dhanini et al., 2007, p.71

Commodity price risk- A risk on the procurement market is the price volatility of

commodities. This can become a significant risk for the company if the commodities

are relatively important inputs with regard to price and/ or quantity (Stroeder, 2008,

p.219).

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(2.2.2) INTERNAL FINANCIAL RISK

Financing risk- Firm financing can become a risk for the company due to different

reasons. The choice between fixed rate and floating rate debt, the duration of the debt

and the overall amount of debt financing are possible sources of risks, which already

have been assessed in the paragraph about interest rate risk. The firm wants to be

flexible and at the same time lower the costs for financing (Brner, 2006, p.298).

The duration of loans is important in connection with the assets, which are financed

with the loan. Here, often a mismatch between the durations can be observed. Long-

term assets are then financed with short-term and adjustable rate loans, leading to a

shortfall in cash flows in times of rising interest rates. This fact again can lead to a

worse ranking of the company and worse conditions to get future loans. Furthermore

difficulties regarding follow-up financing over the rest of the lifetime of the asset can

occur. Vice versa long-term financing of short-term assets might lead to access

financing when the asset is no longer existent. This causes unnecessary interest

payments for the company (Vickery, 2006, p.447).

Finally, a high amount of debt financing can become a risk to the company. In case

the return decreases and is lower than the demanded interest rate, the company is not

able to pay the interest without making a loss in that year. This consumes part of the

equity and might lead to an even more dramatic situation in the next period

(Hermann, 1996, p.156).

Solvency risk- The partly or whole consumption of equity is another financial risk of

a company when the company is not able to earn a profit for the year. However this is

the result of other risks, which influence the business. Reasons can be a decrease in

sales or an increase in costs for example the financing of the firm and high interest

rates, which lead to a deviation from the plan and a loss. The result is a partly or

whole consumption of equity in the period and loss of solvency (Hermann, 1996,

p.154).

Liquidity risk- As well as consumption of equity, liquidity risk is mainly the result

of other risks, which cause a deviation of the planned outcome and might lead to

lower cash inflows or higher cash outflows. Liquidity measures the ability of the firm

to cover its expenses and therefore it also shows whether the company is able to cope

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with some losses due to risk occurrence (Smithson, Smith & Wilford, 1995, p.121). A

lack of financial funds can cause problems in the ability of the firm to pay its bills on

time and by that lead to additional costs (Brner, 2006, p.298). On the one hand costs

occur for arrears fees. On the other hand the rating of the company can be lower and

therefore future financing leads to higher interest payments (Eichhorn, 2004, p.44).

Due to that the financing risk becomes more urgent and can lead to higher liquidity

and solvency risks.

As external and internal financial risks can have a huge impact on the company and

its business continuity, a management of these risks is essential also for non-financial

companies.

(2.3) RISK ASSESSMENT- a part of RISK MANAGMENT

The term management can be derived from the Latin word manus (= hand) and means

handling. In a business context management is the organisation, administration and

leadership of a company (Duden online, 2011). Risk management is therefore the

organisation, administration and leading of risks in the company.

The roots of risk management can be found in the insurance sector in the 1960s

(Form, 2005, p.109). The acquisition of insurance makes it possible to secure business

against systematic risks. Over time the understanding of risk management was

extended and now also includes the management of unsystematic risk (Stroeder, 2008,

p.142).

The inclusion of managing unsystematic risks is in contrast with the theory of

Modigliani and Miller. They proposed in their paper from 1958 that in a perfect

market financial decisions will not influence the firm value. According to them,

companies therefore do not need to manage their risks or hedge to protect against

possible losses caused by unsystematic risks (Dhanini et al., 2007, p. 73; Oosterhof,

2001, p.2). The market does not price such actions. The only thing that is priced is the

systematic risk of the companies (Miller & Modigliani, 1958, p.296). This is based on

the assumption that each investor modifies his portfolio according to his risk

preference by diversification. Therefore risk does not need to be managed by the

company (Berk, 2009, p.283). Nevertheless management uses risk management to

decrease the volatility in earnings (Dhanini et al., 2007, p. 73).

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This is because of market frictions that are absent in the Modigliani-Miller world,

which means that corporate risk management can only be relevant if markets are

imperfect. (Oosterhof, 2001, p.2)

In real business environment there are market imperfections, which are absent in the

Modigliani-Miller assumptions. Corporate risk management can therefore add

additional value to the shareholders although the financial theory of Modigliani Miller

says it is obsolete (Oosterhof, 2001, p.2). One aspect is that in reality not all investors

are likely to have the opportunity to diversify their portfolios. Moreover, under the

perfect market assumptions taxes and transaction costs are neglected. These factors

are however part of reality and might make risk management reasonable (Berk, 2009,

p.384). Furthermore there are costs related to defaulting, like direct costs of

bankruptcy or financial distress (Triantis, 2000, p.560). In the long run, which is the

perspective of the theory, gains and losses due to volatility might even out. However

this might be different in a short-term point of view, which is important to the

company. In the short run, losses might lead to financial distress and cause costs to

the company, which can be avoided by risk management (Dhanini et al., 2007, p.73).

Another aspect are indirect costs associated with difficulties of entering contracts

under high risk of defaulting, which can also be avoided or at least reduced (Triantis,

2000, p.560). The indirect costs of entering contracts refer to stakeholders of the

company that are neglected in the theory of Modigliani and Miller. Suppliers,

employees and banks, might suffer from the occurrence of a risk (Berk, 2009, p.384).

Due to that, stakeholders might demand a premium for entering a business

relationship with the company (Triantis, 2000, p.560). The premium paid to banks is

even more present, since Basel II is in force. The aim of the act is to increase the

stability in the banking sector. One way to achieve this is that banks are obliged to

have a risk sensitive amount of equity for each loan outstanding. The higher the risk

of the debtor the more equity is required from the banks to support the loan. Risky

loans cause higher costs to the bank. Therefore interest rates for loans include a risk

premium, which depends on the default risk of the borrower (Schnborn, 2010, p.13).

Although Basel II does not explicitly demand the implementation of a risk

management system, when rating a company the bank will check the existing

management instruments and also the risk assessment (Henschel, 2008, p.4). The

existence of a risk management can improve the rating of a company and increase the

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likelihood of access to new capital and decrease the interest rates for credit financing

(Jonen & Simgen-Weber, 2008, p.102).

Therefore risk management can be of value not only to the investors of a company but

also to its other stakeholders (Berk, 2009, p.384). Its overall aim is to secure

business continuity and support the achievement of the companys goals by

preventing dangerous situations in an efficient way (Hermann, 1996, p.38; Retzlaff,

2007, p.14). However, it is not the goal to offset each single risk the company is

confronted with, as risk is essential to business activity and risk elimination also

decreases chances (Liekweg & Weber, 2000, p.280).

(2.4) PROCESS OF RISK MANAGEMENT

The different tasks of risk management are structured in a process of chronological

phases (Form, 2005, p.121). Although different researchers define the phases

similarly, the definitions to be found in the literature differ in the way the tasks are

ordered into the phases. Furthermore the wording differs also, although the tasks to be

done in the process stay the same (Hermann, 1996, p.40).

First of all a company needs to understand the sources of risk it is exposed to, to be

able to manage those (Triantis, 2000, p.571). Therefore the process of risk

management starts with the identification of risks. This is followed by the analysis

and evaluation of risks (Form, 2005, p.122). After that, in the risk assessment, the

best ways to handle the identified risks and how this handling can be included into

daily business are evaluated (Triantis, 2000, p.571). The final step of the process is

the risk monitoring, which becomes part of the daily business until the process is

started again from the beginning (Form, 2005, p.122). Risk assessment According to

the risk willingness, measures to handle the risk will be chosen in the third phase

(Wesel, 2010, p.300; Hartman Schenkel, 2003, p.42). Those measures range from risk

avoidance or prevention, over risk reduction, to transfer of risks and finally

acceptance of the risk (Henschel, 2008, p.7).

(2.5) RISK ASSESSMENT

1. Introduction- Risk assessment is an analytic techniques that are used in different

situations, depending upon the characteristic of the hazard, the existing data, and

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requirements of decision makers as explained by Haimes (2001). Risk based decision

making is a process that organizes information about the possibility for one or more

unwanted outcomes to occur into a broad, orderly structure that helps decision makers

make more informed management choices as described by Macesker (2004).

Risk Assessment-

Risk assessment is used for estimating the likelihood and the outcome of risks to

human health, safety and the environment and for enlightening decisions about how to

deal with those risks. Risk assessments are tools that used for preparing a scientific

basis to reduce the risk. The tools were selected as recommended by API 14J risk

assessment method for hazard analysis because the wide applicability and success in

making decisions such as HAZOP, HAZID, FMEA, FTA, ETA, etc

2.5.1 FMEA (Failure Mode Effect and Analysis) FTA (Fault Tree

Analysis) Moss and Kurty (1983) calculate the reliability analysis of preliminary

design of Tension Leg Platform (TLP) using FMEA and FTA. All possible failures

and their impacts are identified and examined using FMEA. FTA is constructed based

on the cause/impact correlation identified in FMEA. The FTA systematically

describes all causes of undesired events leading to the failure mode. Geum et al

(2009) used FTA to describe the customers selection to proposed Service Tree

Analysis (STA) which of service tree construction, qualitative analysis and

quantitative analysis. The weakness of this method is the subjectivity.

2.5.2. HAZOP (Hazard and Operability) - HAZID (Hazard Identification)

Pitt (1994) applied Hazop in manufacturing for safety assessment by defining how

dangers can happen and considering their severity. Controlling the probability of

failure and severity of failure will help the safety measures cost effective. Stiff et al.

(2003) described the differences between spread mooring and turret mooring systems

using HAZID that come out into scenario categories. The quantitative risk assessment

is calculated using the structural reliability analysis between spread mooring and

turret mooring.

Approaches Authors Applications Specific Areas FMEA FTA Moss et al (1983)

Offshore Reliability Analysis of TLP FTA Geum et all (2009) Industry Service

Process Selection HAZOP Pitt (1994) Manufacturing Safety Assessment HAZID

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Structural Reliability Analysis Stiff et at l (2003) Offshore Comparative Risk

Analysis of Mooring FETI-HAZOP-FTA Roy et al (2003) Material Quantitative Risk

Assessment in Production Facility

FTA ETA

Jacinto & Silva (2009) Offshore Ship Building Industry Dianous&Fievez (2005)

Industry Methodology for Risk Assessment Targoutzidis (2009) Safety

Methodological tool in the process of risk assessment HAZID - ETA Petruska et al

(2009) Offshore Mooring MODU Risk Assessments ETA Ghodrati et al (2007)

Mining Spare part selection HAZOP FTA ETA Deacon et al (2010) Offshore Risk

Analysis in Offshore Emergencies Cockshott (2005) Chemical Risk Management

Tool

2.5.3. FETI (Fire Explosion and Toxicity Index) HAZOP (Hazard and

Operability) FTA (Fault Tree Analysis) Roy et al (2003) studied the quantitative

risk assessment for storage and purification section of a titanium sponge production

facility using FETI, HAZOP and FTA. FETI and HAZOP were used to find the most

hazardous section in the entire plant which is Titanium tetra chlodride (TiCl4), FTA is

used as probabilistic analysis to describe the root cause of an events.

2.5.4. FTA (Fault Tree Analysis) and ETA (Event Tree Analysis)

known as Bow Tie Analysis- Dianous & Fievez (2005) built methodology for

risk assessment in industry using bow tie diagrams to identify the major accidents and

the barriers. To assess the number and the reliability of the safety functions risk graph

is used so that a good risk control can be reached. Jacinto & Silva (2009) applied the

bow tie method in large shipyard. Firstly, it was used to initial qualitative analysis and

secondly to calculate the semi quantitative assessment. The accident risk level and

acceptance criteria were carried out using scoring system. Targoutzidis (2009) applied

methodological tool in the process of risk assessment for incorporation of human

factors. FTA is used to define and assess pre condition and structures examination of

human factors. ETA stage only considered human error supplement which is subject

to risk taking or skill based behavior. Risk is developed from product of risk

perception and risk motivation that includes economic, social or other benefits.

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2.5.5. HAZID (Hazard Identification) ETA (Event Tree Analysis) Petruska

et al (2009) considered quantitative risk assessment approach to evaluate the risk of

moored MODU in deepwater facilities. Identifying and defining the potential mooring

failure and the consequences using HAZID which then used to develop the event trees

of each scenario. ETA evaluates all the possible failure sequence and identification of

their respective consequence. Ghodrati et al (2007) modified the ETA to calculate the

associated risks (i.e. risk of shortage of spare parts) in estimation of the required

number of spare parts due to not considering the characteristics of system operating

environment. The result shows visualisation of risk in graphics that can facilitate

correct decision making.

2.5.6. HAZOP (Hazard and Operability) FTA (Fault Tree Analysis)

ETA (Event Tree Analysis) Deacon et al (2010) evaluated the risk of human error

during offshore emergency musters with HAZOP and bow tie analysis. HAZOP is

used to record failure modes, potential consequence and safeguards. Bow tie model

allow analyzing the human factors consequence. This method can decrease the gap

between real and perceived risk in emergency preparedness if used appropriately.

Cockshott (2005) constructed methodology for a new hazardous chemical marine

terminal using probability bow ties and expanded with rapid risk ranking (RRR). The

bow tie and RRR combination is called probability bow tie (PBT).

(2.6) THEORIES ON RISK ASSESSMENT

The fundamental difficulty in risk assessment is determining the rate of occurrence

since statistical formation is not available on all kinds of past incidents. Furthermore,

evaluating the in- severity of the con- sequences (impact) is often quite difficult for

immaterial assets. Asset valuation is another question that needs to be addressed.

Thus, best educated opinions and available statistics are the primary sources of

information. Nevertheless, risk assessment should produce such information for the

management of the organization that the primary risks are easy to understand and that

the risk management decisions may be prioritized. Thus, there have been several

theories and attempts to quantify risks. The fundamental difficulty in risk assessment

is determining the rate of occurrence since statistical in- formation is not available on

all kinds of past incidents. Furthermore, evaluating the severity of the con- sequences

Page | 32

(impact) is often quite difficult for immaterial assets. Asset valuation is another

question that needs to be addressed. Thus, best educated opinions and available

statistics are the primary sources of information. Nevertheless, risk assessment should

produce such information for the management of the organization that the primary

risks are easy to understand and that the risk management decisions may be

prioritized. Thus, there have been several theories and attempts to quantify risks.

(2.6.1) VALUE-AT-RISK MODELS- Value-at-Risk models are the primary

means through which financial institutions measure the magnitude of their exposure

to market risk. These models are designed to estimate, for a given portfolio, the

maximum amount that a bank could lose over a specific time period with a given

probability (Jorion, 1997). This way, they provide a summary measure of the risk

exposure generated by the given portfolio. Management then decides whether it feels

comfortable with this level of exposure or not and acts accordingly. Value-at-Risk

models are extensively used for reporting and limiting risk, allocating capital, and

measuring performance (Brian, 1995). Calculation of VaR depends on the method

used. It essentially involves using historical data on market prices and rates, the

current portfolio positions, and models for pricing those positions. These inputs are

then combined in various ways depending on the method used, to derive an estimation

of a particular percentile of the loss distribution, typically the 99th percentile loss.

According to the Basle Committee Proposal (1995, 1996), the computation of VaR

should be based on a set of uniform quantitative inputs, namely a horizon of 10

trading days, or two calendar weeks, a 99% level of confidence, and an observation

period based on at least a year of historical data. Three methods are commonly used

for computing VaR. This section provides a brief account of these three methods.

(2.6.2) DELTA NORMAL APPROACH- Delta-normal approach is the

simplest method to implement. However, it has several drawbacks such as non-

stability of parameters used, and the assumptions of normal distributions for all risk

factors and linearity for all securities in the risk factors. This method consists of going

back in time and computing variances and correlations for all risk factors. Portfolio

risk is then computed by a combination of linear exposures to numerous factors and

by the forecast of the covariance matrix (Dunbar, 1998). For this method, positions

on risk factors, forecasts of volatility, and correlations for each risk factor are

Page | 33

required. Delta-normal approach is generally not appropriate to portfolios that hold

options or instruments with imbedded options such as mortgage-backed securities,

callable bonds, and many structured notes. This approach is relatively easier to

compute and compare. It is also easy to compute marginal contribution to VaR.. Risk

Metrics, a particular implementation of the delta-normal approach, assumes a

particular structure for the evolution of market prices and rates through time. It, then,

transforms all portfolio positions into their constituent cash flows and performs the

VaR computation on those (Dowd, 1998). This model was launched by JP Morgan in

1994 aiming at promoting the use of value-at- risk among the firm's clients. The

service comprised a technical document describing how to implement a VaR measure

and a covariance matrix for several hundred key factors updated daily on the Internet.

It is an entirely logical approach, particularly for portfolios without a lot of non-

liearity, and is known to be responsible for popularizing VaR.

(2.6.3) HISTORIC OR BACK-SIMULATION APPROACH- Historic

Approach is also a relatively simple method where distributions can be non-normal,

and securities can be non-linear. Historic approach involves keeping a historical

record of preceding price changes. It is essentially a simulation technique that

assumes that whatever the realizations of those changes in prices and rates were in the

earlier period is what they can be over the forecast horizon. It takes those actual

changes, applies them to the current set of rates, and then uses those to revalue the

portfolio. The outcome is a set of portfolio revaluations corresponding to the set of

possible realizations of rates. From that distribution, the 99th percentile loss is taken

as the VaR (Dowd, 1998). However, historic approach uses only one sample path,

which may not efficiently represent future distributions. For this approach,

specification of a stochastic process for each risk factor is required. Also required are

the positions on various securities, and valuation models for all assets in the portfolio.

This method involves going back in time, and applying current weights to a time-

series of historical asset returns. This return restructures the history of a hypothetical

portfolio using the current position. Obviously, if asset returns are all normally

distributed, the VaR obtained under the historical-simulation method should be the

same as that under the delta-normal method (Dowd, 1998). This approach is easy to

compute and to understand. It allows for non-normality and non-linearity. It can also

easily be adapted to scenario analysis. However it has several draw- backs such as

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unstable parameters and altering variances. In addition, the model may not work well

if based on small sample (Stulz, 2000).

(2.6.4) MONTE-CARLO APPROACH- Monte Carlo approach is widely

regarded as the most sophisticated VaR method. It looks easy to code Monte Carlo

analyses. However, it takes hours or even days to run those analyses, and to speed up

analyses complicated techniques such as variance reduction need to be implemented

(Dowd, 1998). In theory, Monte Carlo method makes some assumptions about the

distribution of changes in market prices and rates. Then, it collects data to estimate the

parameters of the distribution, and uses those assumptions to give successive sets of

possible future realizations of changes in those rates. For each set, the portfolio is

revalued and, as in the historic method, outcomes are ranked and the appropriate VaR

is selected. Monte-Carlo method makes it easier to cope with extreme non-linearities

as it allows for non-linear securities. It can also easily be adjusted according to the

distribution of risk factors. However it is computationally burdensome which

constitutes a problem for routine use (Dunbar, 1998).

(2.7) LITERATURE REVIEW INTERNATIONAL

PERSPECTIVE

Crouhy, Gala, Marick(26) have summarised the core principles of Enterprise wide

Risk Management. As per the authors Risk Management culture should percolate

from the Board Level to the lowest level employee. Firms will be required to make

significant investment necessary to comply with the latest best practices in the new

generation of Risk Regulation and Management. Corporate Governance regulation

with the advent of Sarbanes-Oxley Act in US and several other legislations in various

countries also provide the framework for sound Risk Management structures.

Hitherto, Enterprise wide Risk Management existed only for name sake. Generally

firms did not institute a truly integrated set of Risk measures, methodologies or Risk

Management Architecture. The ensuing decades will usher in a new set of Risk

Management tools encompassing all the activities of a Corporation. The integrated

Risk Management infrastructure would cover areas like Corporate Compliance,

Corporate Governance, Capital Management etc. Areas like business risk, reputation

risk and strategic risk also will be incorporated in the overall Risk Architecture more

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formally. As always it will be the Banks and the Financial Services firms which will

lead the way in this evolutionary process. The compliance requirements of Basel II

and III accords will also oblige Banks and Financial institutions to put in place robust

Risk Management methodologies. The authors felt that it is generally felt that Risk

Management concerns largely with activities within the firm. However, during the

next decade Governments in different countries would desire to have innovatively

drawn Risk Management system for the whole country. The authors draw reference to

the suggestions of Nobel Laureate Robert Merton who suggested that a country with

exposure to a few concentrated industries should be obliged to diversify its excessive

exposures by arranging appropriate swaps with other countries with similar problems.

Risk Management offers many other potential macro applications to improve the

management of their social security measures etc. They draw references to the spread

of Risk Management Education worldwide.

Hannan and Hanweckfelt that the insolvency for Banks become true when current

losses exhaust capital completely. It also occurs when the return on assets (ROA) is

less than the negative capital-asset ratio. The probability of insolvency is explained in

terms of an equation p, 1/(2(Z2 ). The help of Z-statistics is commonly employed by

Academicians in computing probabilities. Daniele Nouy elaborates the Basel Core

Principles for effective Banking Supervision, its innovativeness, content and the

challenges of quality implementation. Core Principles are a set of supervisory

guidelines aimed at providing a general framework for effective Banking supervision

in all countries. They are innovative in the way that they were developed by a mixed

drafting group and they were comprehensive in coverage, providing a checklist of the

principal features of a well designed supervisory system. The core Principles specify

preconditions for effective banking supervision characteristics of an effective

supervisory body, need for credit risk management and elaborates on Principle 22

dealing with supervisory powers.

Jacques de Larosiere, former Managing Director of the International Monetary Fund

discusses the implications of the new Prudential Framework. He explains at length

how the new Regulatory code could have some dangerous side effects. The increased

capital requirements as decided by the Basel Committee on Banking Supervision in

September 2010 will affect the amount of own funds would affect the profitability of

the Banks. The consequences of such increased capital requirements would

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incentivise the Banks to transfer certain operations that are heavily taxed in terms of

capital requirements to shadow Banking to avoid the scope of regulation. The risks of

such a practice might affect the financial stability. While the Central Banking

authorities might contemplate registration and supervision of such shadow banking

entities like the hedge funds and other pools, such a course might be more

cumbersome than expected. The new regulation would result in the Banks to reduce

activities with rather poor margins. For example they may reduce exposure to small

and medium enterprises or increase credit costs or concentrate on more profitable but

higher risk activities. He is also critical of the proposal of Basel to introduce an

absolute leverage ratio that might push Banks to concentrate their assets in riskier

operations. The author feels that the banking model which favours financial stability

and economic growth might become the victim of the new prudential framework, and

force Banks to search for assets with maximum returns despite the attendant risks.

As per G. Dalai, D. Rutherberg, M. Sarnat and B. Z. Schreiber- Risk is intrinsic to

banking. However the management of risk has gained prominence in view of the

growing sophistication of banking operations, derivatives trading, securities

underwriting and corporate advisory business etc. Risks have also increased on

account of the on-line electronic banking, provision of bill presentation and payment

services etc. The major risks faced by financial institutions are of course credit risk,

interest rate risk, foreign exchange risk and liquidity risk. Credit risk management

requires that Banks develop loan assessment policies and administration of loan

portfolio, fixing prudential per borrower, per group limits etc. The tendency for

excessive dependence on collateral should also be looked into. The other weaknesses

in Credit Risk Management are inadequate risk pricing, absence of loan review

mechanism and post sanction surveillance. Interest rate risk arises due to changes in

interest rates significantly impacting the net interest income, mismatches between the

time when interest rates on asset and liability are reset etc. Management of interest

rate risk involves employing methods like Value-at-Risk (VaR), a standard approach

to assess potential loss that could crystallise on trading portfolio due to variations in

market interest rates and prices. Foreign Exchange risk is due to running open

positions. The risk of open positions of late has increased due to wide variations in

exchange risks. The Board of Directors should law down strict intra-day and

overnight positions to ensure that the Foreign Exchange risk is under control.

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Chief Risk Officer, Alden Toevs of Commonwealth Bank of Australia states that a

major failure of risk management highlighted by the global financial crisis was the

inability of financial institutions to view risk on a holistic basis. The global financial

crisis exposed, with chilling clarity, the dangers of thinking in silos, particularly

where risk management is concerned says the author. The malady is due to the Banks

focussing on individual risk exposures without taking into consideration the broader

picture. As per the author the root of the problem is the failure of the Banks to

consider risks on an enterprise-wide basis. The new relevance and urgency for

implementing the Enterprise Risk Management (ERM) is due to the regulatory

insistence with a number of proposals to ensure that institutions stay focussed on the

big picture. In a way the Three Pillar Approach frame work of the Basel II Accord is

an effort to full fill this requirement. The risk weighted approaches to Credit Risk on

the basis of the asset quality, allocation of capital to Operational Risk and Market

Risks nearly capture all the risks attendant to a Banks functioning.

(2.8) LITERATURE REVIEW: INDIAN PERSPECTIVE

Rekha, Arun kumar and Koteshwar feel that the Credit Risk is the oldest and biggest

risk that Banks, by virtue of their very nature of business inherit. The pre-dominance

of credit risk is the main component in the capital allocation. As per their estimate

credit risk takes the major part of the Risk Management apparatus accounting for over

70 per cent of all Risks. As per them the Market Risk and Operational Risk are

important, but more attention needs to be paid to the Credit RISK Management in

Banks.

S. K. Bagchi, observed that in the world of finance more specifically in Banking,

Credit Risk is the most predominant risk in Banking and occupies roughly 90-95 per

cent of risk segment. The remaining fraction is on account of Market Risk,

Operations Risk etc. He feels that so much of concern on operational risk is

misplaced. As per him, it may be just one to two per cent of Banks risk. For this

small fraction, instituting an elaborate mechanism may be unwarranted. A well laid

out Risk Management System should give its best attention to Credit Risk and Market

Risk. In instituting the Risk Management apparatus, Banks seem to be giving equal

priority to these three Risks viz., Credit Risk, Operational Risk and Market Risk. This

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may prove counter-productive. Securitization and Reconstruction of Financial Assets

Enactment of Security Interest Act, 2002.(SARFAESI ACT).

Govt. Of India has taken the initiative of making the legislation to help Banks to

provide better Risk Management for their asset portfolio. Risk Management of the

Loan book has been posing a challenge to the Banks and Financial Institutions which

are helpless in view of the protracted legal processes. The act enables Banks to

realise their dues without intervention of Courts and Tribunals. As a part of the Risk

Management strategies, Banks can set up Asset Management Companies (AMC) to

acquire Non Performing Assets of Banks and Financial agencies by paying the

consideration in the form of Debentures, Bonds etc. This relieves the Bank

transferring the asset to concentrate on their loan book to secure that the quality of the

portfolio does not deteriorate. The act contains severe penalties on the debtors. The

AMC is vested with the power of issuing notices to the Borrowers calling for

repayment within 60 days. If the borrower fails to meet the commitment, the AMC

can take possession of the secured assets and appoint any Agency to manage the

secured assets. Borrowers are given the option of appealing to the Debt Tribunal, but

only after paying 75% of the amount claimed by the AMC. There are strict provisions

of penalties for offences or default by the securitisation or reconstruction company.

In case of default in registration of transactions, the company officials would be fined

upto Rs.5,000/- per day. Similarly non-compliance of the RBI directions also attract

fine up to Rs.5 lakhs and additional fine of Rs.10,000/- per day. This has proved to be

a very effective Risk Management Tool in the hands of the Banks.

Dr. Atul Mehrotra, Dean, Vishwakarma Institute of Management emphasises the

need for promotion of Corporate Governance in Banks in these uncertain and risky

times. This paper discussed at length Corporate Governance related aspects in Banks

as also touches upon the principles for enhancing Corporate Governance in Banks as

suggested by BCBS. The author felt that despite the RBIs initiatives on the

recommendations of the Consultative Group of Directors of Banks/Financial

Institutions under the Chairmanship of Dr. A.S. Ganguly, member of the Board for

Financial Supervision, there is more ground to be covered before Indian Banks are in

a position to attain good Governance Standards.

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Mrudul Gokhaleelaborately dealt with the subject of capital adequacy in Banks. As

per her, Banks mostly give adequate focus for the credit risk aspect. There is a shift

from the qualitative risk assessment to the quantitative management of risk. In tune

with the regulatory insistence on capturing risks for the purpose of capital charge,

sophisticated risk models are being developed. These models help Banks to near

accurately quantify the potential losses arising from different risks viz., credit risk,

market risk and operations risk. This will enable the Regulator to ascertain whether

individual Bank has accurately compiled the risk profile of assets.

It was in April 1992 that the Reserve Bank of India introduced a risk asset ratio

system for all banks including foreign Banks in India as a capital adequacy measure.

As per this system, the balance sheet assets both funded and non-funded items and

other off-balance sheet exposures are assigned prescribed risk weighs. Banks were

required to maintain unimpaired minimum capital funds equivalent to the prescribed

ratio on the aggregate of the risk weighted assets. BCBS released the International

Convergence of Capital Measurement and Capital Standards: A Revised Framework

on June 26, 2004. The revised Framework consists of three-mutually reinforcing

Pillars, viz., minimum capital requirements, supervisory review of capital adequacy

and market discipline. The core of the Basel Accord is its risk sensitivity approach.

The Accord offers three distinct options for computing capital requirement for credit

risk and three other options for computing capital requirement for operational risk.

The options available for computing capital for credit risk are on the basis of

Standardised Approach, Foundation Internal Rating Based Approach and Advanced

Internal Rating Based approach. The options available for computing capital for

operational risk are Basic Indicator Approach, Standardized Approach and Advanced

Measure Approach.

The Core Principles for Effective Banking Supervision released by the BCBS in 1997

stated that the Banking supervisors must be satisfied that the Banks under their

jurisdiction have adequate policies and procedures for identifying, monitoring and

controlling country risk and transfer risk in the international lending and investment

activities and for maintaining reserves against such risks (Principle XI). The Reserve

Bank reviewed the position in India in the light of this and found that Country Risk

Management (CRM) was one area where there was an observed deficiency in the

India Banks. Hence the RBI has initiated steps to elicit the views of the Banks on the

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basis of the Draft Guidelines and issued final Guidelines in February 2003. These

guidelines were made applicable to countries where an Indian Bank has more than 2

per cent or more of its assets. The guidelines are fairly detailed in nature with policy

and procedures. The RBI wanted the Banks to follow a rigorous CRM policy and

implement the Know Your Customer (KYC) guidelines strictly in their International

activities. RBI further defined the scope of these guidelines to include both funded

and non-funded exposures from their domestic as well as foreign branches for the

purpose of identifying, measuring, monitoring and controlling country risks.

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CHAPTER- 3: RESEARCH METHODOLOGY

Research methodology is a way to systematically solve the research problem. The

research methodology using for find out the solution of the research problem is

analytical research methodology and some extend descriptive research methodology.

(3.1) OBJECTIVE OF THE STUDY

1) TO PROPOSE IACSIT APPROVED MODEL OF RISK ASSESSMENT FOR

STFC.

2) Secondary Objective Study of risk assessment models available in STFC deeply.

3) To study working of STFC.

(3.2) RESEARCH DESIGN

1) Nature of the Study- The study is descriptive identifying the parameters and

assigning the appropriate weights for them.

(3.3) SAMPLING DESIGN

Sampling frame- This represents the list from which the sample has been selected.

Samples are collected on random basis from the LCC of Bhiwani Branch. Two

category of sample is selected. Firstly sample from LGV segment is selected. Then

sample from passenger vehicle is being selected. Sample consists of borrowers of the

Bhiwani Branch who have taken loan from it.

Type of sample- The sampling technique used is random sampling method.

Sample size- 10 borrower of LGV segment is considered and 15 borrower of

Passenger vehicle is considered. Total sample size thus is of 28. For risk assessment

of individual borrower through STFC model all these sample is used. But only 4

samples is putted on IRCSIT approved model.

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(3.4) DATA COLLECTION

The type of data used in assigning appropriate weights aiding the development of the

model is primary. However, the various parameters were identified using secondary

data. The instrument used for the survey is sampling.

Sources Of Data :

(a) Primary data:

Primary data required for study will be collected through direct interaction with

financial executives of the establishment. Since a good rapport has been maintained

the management has assured timely guidance and assistance and availability of

relevant information through risk analysis tools and documents. I worked on UNO,

OMNI DOCS, west report etc and filled credit sheet which is the main source of data

for customer analysis part.

(b)Secondary data-

Secondary data will consist of annual reports, publications, audited financial

statement issued, day-to-day working files and budgets for different years. Which will

be obtain from their websites- stfc.co.in,

This data basically help in calculating ratios for ratio analysis part.

(c)Interview with key Personnel-

Data will also be collected by interviewing the key personnel of the firm. How the

balance between the risk and Profitability is maintained and how risk is diversified is

explained by them. Branch visit play a key role for it. There got opportunity to meet

with a number of product executives, branch manager, Branch team leader, and other

employee working there.

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(3.5) TOOLS USED FOR THE RESEARCH.

These are the most popular tools of risk assessment. They focus on measuring the risk

associated with the individual borrowers.

RATIO ANALYSIS

Debt Equity Ratio- The ratio brings out the extent to which the firm is dependent on

outsiders for its existence and indicates the proportion of the owners stake in the

business. A high ratio means that claims of creditors are greater than owners funds.

Excessive liabilities tend to cause insolvency. This is the most unfavorable situation

for a banker, as he may gain the position of just one among the many creditors of the

company.

Current Ratio - The current ratio is an index of the concerns financial stability since

it shows the extent of the working capital, which is the amount by which the current

assets exceed the current liabilities. A high current ratio indicates inadequate

employment of funds while a poor current ratio is a danger signal to the management.

It shows that business is trading beyond its resources. Current ratio of 2 is ideal.

Liquid Ratio - This ratio is also an indicator of the short-term solvency of a firm.

Ideal ratio is 1:1. A comparison of current ratio to liquid ratio indicates inventory

hold-ups. The higher the amount of liquid assets to current liabilities the greater the

assurance of current liabilities being paid off.

Interest Coverage Ratio- It tells the analysts the extent to which the firms current

earnings are able to meet current interest payments. When this ratio is high it shows

that the business would earn sufficient profits to pay the interest charges periodically.

A low interest coverage ratio may result in financial embarrassment.

Debt Service Coverage Ratio- The standard ratio is 1.5. However, if the ratio is

between 1 and 1.5, suitable spacing of the repayment period and thereby lowering the

annual repayment obligations, may raise the ratio and make the proposal financially

viable. A persistently low ratio indicates heavy repayment obligations, which the

business is at pains to meet.

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Net Profit trend - The final profit figure arrived at after charging all the expenses of

the firm against all its