Which of the following forms may not result in credit risk?
1. Principal and/or interest amount may not be repaid in the case of direct lending.
2. In case of guarantees or a letter of credit, funds may not be forthcoming from the constituents upon crystallization of the liability.
3. Funds/Securities settlement may not be effected in the case of securities trading business.
4. Provide information for determining the adequacy of loan loss provision.
Choose the correct answer from the options given below:

Correct option is D

Credit Risk is the risk of financial loss due to a borrower failing to repay a loan or meet contractual obligations. Forms that result in credit risk generally involve situations where obligations related to funds, securities, or guarantees are not met. 

1. Principal and/or interest amount may not be repaid in the case of direct lending (Credit Risk - Incorrect): This represents the most common form of credit risk, where a borrower defaults on their repayment of principal or interest.

2. In case of guarantees or a letter of credit, funds may not be forthcoming from the constituents upon crystallization of the liability (Credit Risk - Incorrect): If the party backed by the guarantee or letter of credit fails to fulfill its obligation, the guarantor is exposed to credit risk.

3. Funds/Securities settlement may not be effected in the case of securities trading business (Credit Risk - Incorrect): This refers to counterparty risk in securities trading, where one party fails to deliver funds or securities as agreed, leading to a financial loss.

4. Provide information for determining the adequacy of loan loss provision (Not Credit Risk - Correct): This refers to an accounting or risk management function and does not directly result in credit risk. It involves analyzing credit exposures and ensuring sufficient provisioning but does not inherently create risk.

Information Booster:

• Key Components of Credit Risk:

  • Default Risk: Risk of borrower failing to meet payment obligations.
  • Counterparty Risk: Risk of failure by the counterparty in a trade or contract.
  • Settlement Risk: Risk during fund or security settlement when one party fails to deliver.

• Loan Loss Provision:

  • Represents funds set aside to cover potential loan losses.
  • Determining adequacy of these provisions is a risk management function, not a source of credit risk.

Example: A bank analyzes its portfolio and sets aside a loan loss provision for risky borrowers, ensuring financial stability even if defaults occur.

Additional Knowledge:

(1) Principal and/or interest amount may not be repaid in the case of direct lending:

• Direct lending exposes banks or creditors to credit risk if borrowers default on payments.
• Example: A customer fails to repay a personal loan or EMIs, creating a loss for the lender.

(2) In case of guarantees or a letter of credit, funds may not be forthcoming from the constituents upon crystallization of the liability:

• A guarantee or letter of credit represents a promise to pay if the primary obligor defaults. If the obligor fails to meet the obligation, the guarantor faces credit risk.

(3) Funds/Securities settlement may not be effected in the case of securities trading business:

• In securities trading, credit risk arises if one party fails to deliver funds or securities on time.
• Example: A counterparty in a stock trade fails to transfer shares after receiving payment.