Now we will introduce the credit market. The main type of banking activity consists in operations with loans and deposits. Credit here is interpreted here in the way of banking transaction in which the bank transfers money to another person, receiving in exchange the right to claim the return of these funds under certain conditions. Thus, a number of important characteristics is implied. Firstly, because of the issuance of a bank loan on the balance sheet of the bank there is a working asset, or in other words a bringing interest income asset. Secondly, when issuing a loan, the Bank always assumes a certain risk of non-repayment of funds, which is a credit risk. Thirdly, by issuing a loan, the bank creates liquidity in the economy, as it exchanges a super liquid asset (money) for a notoriously less liquid asset (the right to claim the return of these funds). Sometimes bank loans are classified as commodities because of the very low degree of differentiation of these products compared to non-commodities. Nevertheless, it is possible to credit on completely different terms. The intersection of these conditions forms many types of credit products.

The borrowers are very different in terms of creditworthiness, and may also have specific needs for borrowed funds. In total, there are four types of borrowers, ranking them by the volume of the credit market. Firstly, these are corporate borrowers. This category includes various legal entities, ranging from the largest international corporations to small and medium-sized businesses. Within the framework of corporate lending, there are two fundamentally different subtypes - revolving lending and project financing. In revolving credit, the bank provides money to support the company's current activities, for example, the bank provides it with current liquidity to smooth seasonal fluctuations in sales. Since the activity is well-established, it is possible to assess the risks of default, resting upon the financial statements in the assumption that they will not change radically on financing horizon. As a rule, the main drivers of risk are the size of the enterprise, measured either by turnover or the amount of assets, and the ratio of the company's profit to the amount of debt. In project financing, the bank issues money for the implementation of a completely new project. The risks here are significantly higher than in the previous case, as it is not yet known whether the project will be successful or not. The risk assessment has to be based on a thorough study of the business plan of the project, the borrower's experience in implementing similar projects in the past and other characteristics of this kind. The second type of borrowers are banks. As it was briefly mentioned before banks regularly lend to each other in the interbank market, as well as buy each other's debt securities in order to manage liquidity. The level of risk is traditionally quite low. The third type of borrowers are retail borrowers. This category includes consumers and individual entrepreneurs. The level of risk in this category is on average higher than in corporate lending. Also, the risk is quite different depending on the purpose for which the borrower requests a loan. Consumer lending aimed at increasing current consumption, for example, buying household appliances, gadgets, tourist vouchers and so on, is very high-risk. Targeted lending, for example, to buy an apartment or a car or to pay for education, is usually significantly less risky, often even less risky than certain types of corporate lending. Finally, the last type of borrowers are state and municipal authorities. Lending to the public sector is characterized by a low level of risk and, accordingly, low marginality. Lending can take completely different legal forms. Firstly, the bank can simply issue a loan by signing a contract. This trivial form is the most common in both corporate and retail lending. Secondly, the bank can place money in an account in another bank. It is important to note that any monetary loan is a loan for one side of the transaction and a deposit for the other side of the transaction. Placing money on deposits and accounts is a common form of interbank lending. Thirdly, the bank can buy a debt security. By purchasing bonds, promissory notes, savings certificates and other debt instruments, the bank acquires the right to claim funds from the issuer. Lending through the purchase of securities is one of the key forms of lending to the public sector, as well as to foreign borrowers.

The amount of credit can sometimes be a complex issue. There is a large class of credit products in which the loan amount is not known in advance to the parties to the transaction. These products include credit cards, credit lines and overdrafts that can be linked to both corporate and retail accounts. The idea of all these products is that the bank within the framework of the loan agreement establishes a certain maximum debt limit and a certain scheme under which the client can choose at what time and what share of this limit he can use. In credit cards such scheme consists in payments by credit card, in credit lines - in payments from credit lines through the IT system "bank - client", and in overdrafts - payments from current accounts or debit cards, when the balance on them becomes negative. Such products are called partially funded, as at the time of the conclusion of the relevant loan agreement and until the first use of funds there is no transfer of money from the balance sheet of the bank to the balance sheet of the client and no emergence of the corresponding right of claim. Since there is no transfer of money, then there is nothing to fund from the liabilities. Partially funded products can be an important source of liquidity and credit risk for the Bank, as within the established limit, the use of funds can occur at any time. Therefore, the limits for such products are subject to mandatory disclosure in the financial statements. They are reported in the balance sheet in the section "off-balance sheet contingent liabilities of a credit nature". Practice shows that if the borrower is experiencing financial difficulties, then he seeks to choose his credit limit to the maximum, so the share of utilization of limits among default borrowers is usually higher than among non-default borrowers. It is important to note that the bank earns interest income only from the share of the limit that is chosen by non-default borrowers, but the carried risk arises from the amount of the limit chosen by default borrowers.

The term of the loan is a very important characteristic, as it affects the value of the money issued and the level of the balance sheet risks accepted by the banks. At the same time, the loan term is not always known to the parties in advance. There are two types of loans terms that are not set in advance. The first is the placement of funds in current accounts and demand deposits with other banks. The second is partially funded products. At the same time, even if the loan term is set in the contract, there is still a risk of non-compliance due to the fact that the client may want to pay the loan in advance. Uncertainty about the timing of lending creates difficulties for the pricing of loans.

There are different loan repayment schemes. We will consider four of them that are most popular. The first repayment scheme is an annuity. This is when the repayments are made in equal installments that includes both the body for a long time and percentage. This scheme is the most common. Especially often it is used in retail lending. The second repayment scheme is a bullet. Here only interest income is extinguished until the end of the loan term, the body itself is long paid in full at the end of the term. This repayment scheme is used in coupon bonds but is also sometimes used in project financing. The third repayment scheme is a discount. This is when there are no interest payments, but the body of the debt exceeds the issued funds by a certain amount. This repayment scheme is used in non-coupon bonds, and it is also used in REPO transactions. The fourth repayment scheme is a credit vacation or grace period. This is when during a certain period, payments are either not made at all or only interest is paid, and at the end of this period, the annuity repayment of the remaining debt begins. Repayment schemes affect the risk level of the product. The greater the share of payments concentrated at the time of repayment of the loan the greater the potential losses are. Therefore, the least risky scheme is the scheme of annuity payments, and the most risky - the discount scheme.

Another important characteristic of loans is the presence or absence of collateral and other special conditions. Collateral can be any property right that passes to the lender in case of default of the borrower's obligations under the loan agreement. Historically, collateral was the first main instrument of credit risk management. Ideally it should reduce it to zero. In fact, if the loan is secured by a liquid asset, the value of which is equal to the amount of the loan, then in case of default, the bank can simply sell the asset and fully compensate its losses. In practice, mortgages are usually low-liquid, for example, it is a different kind of real estate. Thus, lending is in fact a tool to increase collateral liquidity for the borrower. In retail lending products with collateral are mortgages. As well as car loans, where the collateral is the purchased car. In corporate lending, almost all loans have any collateral. Typically, enterprises pledge such their fixed assets as production facilities, equipment, and land. Often, the objects of security are the stocks of goods produced by the borrower, for example, grown cereals in the case of lending to agricultural enterprises. In practice, usually there is a negative correlation between the presence of qualitative assurance and the probability of default. This is due to the fact that the availability of high-quality collateral dramatically increases the cost of default for the borrower. Therefore, he seeks to repay the debt in any way.

Additionally, another tool to reduce credit risk is a covenant. That is a special restriction on the action of borrowers, the violation of which may result in sanctions by the bank. The most typical covenants are penalties for late payments, often in the form of additional interest charges. There are also more specific covenants, usually established in corporate lending. For example, project financing usually requires the borrower to finance part of the project from its own funds. Another common type of covenants is a limit to the borrower's ability to get additional debt so that the profit-to-debt ratio would not be compromised.

It is important to understand that any bank borrowing is the reverse side of another bank loan. Therefore, to describe the characteristics of banks borrowings need to get to same points as to describe the characteristics of loans. An important difference is that for loans the key characteristic is the level of credit risk, but for borrowings the key characteristic is their stability. That is, the level of risk of early withdrawal of these deposits, which determines the liquidity risk. As in the case of loans, the same four categories of lenders can be described. However, in the first place in importance of funding for the banking system will be individuals. The lowest liquidity risk is inherent in loans from individuals, while loans from banks and corporate borrowers are less stable. There are three main forms of borrowings by banks. Firstly, it is raising funds to current accounts and deposits. This is the main source of funding. Their stability depends on many factors. The second type is reverse REPO (short-term borrowing from other banks and the Central Bank). The third type of borrowing is the issue and sale of debt securities. Raising funds through a bond issue is the most stable source of funding. Attracting through the issuance of savings certificates is essentially equivalent to attracting retail deposits. Current accounts and deposits allow not only early withdrawals, but also topping up during the deposit period, which can also create additional risks for banks. Now we move on to the term of raising the funds and the repayment schemes. Term deposits have a fixed contractual maturity but they may be affected by the possibility of early withdrawals. Current accounts do not have a fixed term. Bank loans almost always involve bullet repayment. Now we move to the pledges and covenants. Bank loans are unsecured loans. However, in the case of retail deposits, the deposit insurance system provides depositors with a refund guarantee. As for the covenants, for term deposits, as a rule there are penalties for early withdrawal (for example, in the form of zeroing the accumulated interest income), as well as restrictions on early replenishment, as a rule after a certain period from the opening of the deposit. As we can see, the main uncertainty exists about the timing and amounts of deposits placed on current accounts and deposits. The first behavioral characteristic is the effective maturity of deposits under normal conditions. That is, what is the average term of storage of money by the depositor in the bank at constant interest rates. Secondly, the effective dynamics of the value of deposits in normal conditions. That is, what are the average expected early withdrawals and deposits at constant interest rates. Thirdly, sensitivity to changes in interest rates. That is, how likely the deposit will be withdrawn ahead of schedule in the event of an increase in rates, or vice versa replenished in the event of a decrease in rates.

To clearly understand these points, banks analyze the historical dynamics of deposits and try to identify stable patterns, which are then used as an introduction to the pricing of deposits. It should be noted that in certain cases, the bank can attract borrowings with negative margins, if the stability of funding is more important to the bank. For example, to perform any regulatory metrics. Borrowing costs consist of operating and specific costs. With regard to transaction costs, the situation is similar to the transaction costs of loans, but the specific costs should be described in more detail. As we stated before, the liquidity risk plays the same role for bank borrowings as the credit risk for bank loans. Therefore, we can distinguish the following types of specific costs of borrowings: firstly, it is the cost of storage on the balance sheet of liquidity reserves. The need to store liquidity reserves may be related both to the need to reserve deposits and to the need to comply with regulatory liquidity standards. In general, the less stable a borrowing is the more liquidity reserves need to be held for it. The second component is insurance payments to the deposit insurance system. These costs apply only to retail deposits.

1.7 Commission business