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Abstract
This study first identifies the importance of Credit Risk Management for commercial banks
and then tries to find out the existing procedures for credit risk management that are
followed by the different commercial banks in Bangladesh. The future of banking will
undoubtedly rest on risk management dynamics. Only those banks that have efficient risk
management system will survive in the market in the long run. The effective management of
credit risk is a critical component of comprehensive risk management essential for longterm success of a banking institution. From the study we found that the existing procedures
of credit management are not adequate to compete with the challenging financial and
economic environment. This paper is concluded with some guidelines that will help
commercial banks to sustain in the volatile market.
Key words: Credit, Risk Management, Tools of credit, Credit Risk Grading.
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Electronic copy available at: http://ssrn.com/abstract=1849144
Introduction
The word "Credit" is derived from the Latin word "credo" meaning, "I believe". Speaking
broadly, credit is finance made available by one party (lender, seller, or shareholder/owner)
to another (borrower, buyer, corporate or non-corporate firm) (Woelfel 1994).
More
generally the term credit is used narrowly for debt finance. Credit is simply the opposite of
debt. Debt is the obligation to make future payments. Credit is the claim to receive these
payments. So, credit is referred to The right to receive payment or an obligation to make
payment on demand or at some future time on account of the immediate transfer of goods
(securities) (Johan and John 1994).
One of the two primary functions of a commercial bank is to extend credit to the deficit
economic unit that comprises borrowers of all types. Bank credit is a catalyst of economic
development. Without adequate finance, there can be no growth in the economy. Bank
lending is important for the economy in the sense that it can simultaneously finance all of
the sub-sectors of financial arena, which comprises agricultural, commercial and industrial
activities of a nation (Radhaswami and Vasudevan 2000). Therefore, a bank is supposed to
distribute its loan able fund among economic agent-in-deficit in a manner that it will
generate sufficient income for it and at the same time benefit the borrower to overcome
his/her deficit.
Risk is the potentiality that both the expected and unexpected events may have an adverse
impact on the banks capital or earnings. The expected loss is to be borne by the borrower
and hence is taken care by adequately pricing the products through risk premium and
reserves created out of the earnings. Whereas, the unexpected loss on account of individual
exposure and the whole portfolio is entirely is to be borne by the bank itself and hence is to
be taken care by the capital (Arunkumar and Kotreshwar 2005).
The future of banking will undoubtedly rest on risk management dynamics. Only those
banks that have efficient risk management system will survive in the market in the long run.
The effective management of credit risk is a critical component of comprehensive risk
management essential for long-term success of a banking institution (Caouette et al. 1998).
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Electronic copy available at: http://ssrn.com/abstract=1849144
Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business,
inherits. This has however, acquired a greater significance in the recent past for various
reasons. Foremost among them is the wind of economic liberalization that is blowing across
the globe (Chowdhury 2002). Bangladesh is no exception to this swing towards market
driven economy. Competition from within and outside the country has intensified. This has
resulted in multiplicity of risks both in number and volume resulting in volatile markets.
The credit risk in a banks loan portfolio consists of three components (Arunkumar and
Kotreshwar 2005):
(1) Transaction Risk: Transaction risk focuses on the volatility in credit quality and
earnings resulting from how the bank underwrites individual loan transactions. Transaction
risk has three dimensions: selection, underwriting and operations.
(2) Intrinsic Risk: It focuses on the risk inherent in certain lines of business and loans to
certain industries. Intrinsic risk addresses the susceptibility to historic, predictive, and
lending risk factors that characterize an industry or line of business.
(3) Concentration Risk: Concentration risk is the aggregation of transaction and intrinsic
risk within the portfolio and may result from loans to one borrower or one industry,
geographic area, or lines of business. Bank must define acceptable portfolio concentrations
for each of these aggregations.
The corner stone of credit risk management is the establishment of a framework that
defines corporate priorities, loan approval process, and credit risk rating system, riskadjusted pricing system, loan-review mechanism and comprehensive reporting system
(David 1997). The two distinct dimensions of credit risk management can readily be
identified as preventive measures and curative measures. Preventive measures include risk
assessment, risk measurement and risk pricing, early warning system to pick early signals
of future defaults and better credit portfolio diversification. The curative measures, on the
other hand, aim at minimizing post-sanction loan losses through such steps as
securitization, derivative trading, risk sharing, legal enforcement etc. It is widely believed
that an ounce of prevention is worth a pound of cure (Das, S.C. et al. 2005).
Importance of credit is realized from both macro and micro aspects of economy. At Macro
level credit influences and is influenced by quantity of money, level of economic activity,
imports and net foreign assets. At micro level credit influences behaviour of economic
sector (industry, agriculture) and behaviour of economic agents (business, financial
institutions, households). It is, therefore, imperative that the banks have adequate systems
for credit assessment of individual projects and evaluating risk associated therewith as well
as the industry as a whole. Generally, Banks in Bangladesh evaluate a proposal through the
traditional tools of project financing, computing maximum permissible limits, assessing
management capabilities and prescribing a ceiling for an industry exposure. As banks move
in to a new high powered world of financial operations and trading with new risks, the need
is felt for more sophisticated and versatile instruments for risk assessment, monitoring and
controlling risk exposures. It is, therefore, time that banks managements equip themselves
fully to grapple with the demands of creating tools and systems capable of assessing,
monitoring and controlling risk exposures in a more scientific manner. In this study we try
to find out how the commercial banks in Bangladesh evaluate their risk and what they
should do.
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Effective credit management is must for a bank to sustain its profitability and growth. The
lending banker needs some tools or instrument by means of which he can manage his/her
credit portfolio in a fruitful way. Some of these tools that are regarded indispensable for the
management of different credit portfolio are furnished below.
I.Security:
It ensures recovery of loans and advances. Though now-a-days greater emphasis is put on
the purpose of the loan rather than securities, nevertheless the securities play an extremely
important role to take a decision. The types of securities offered vary from place to place.
However securities can be classified into two categories on the basis of their nature. a)
Primary security: means the security offered by the borrower himself as cover for the
loan. It refers to the asset, which has been bought with the help of the bank .b) Collateral
security: means all other additional security other than the primary securities such as land /
Building etc. are considered as collateral securities which may be offered / deposited by the
borrower or , by any other third party.
II. Margin:
Margin is a cushion against any possible shortage.
It is a portion of borrower's
contribution. The fixation of margin depends on the nature and type of security and the
financial stability of the customer and also keeping in view the restrictions imposed by the
Bangladesh Bank (Head Office from time to time). In case of goods reasonable margin
should be retained for covering any shortage due to shrinkage, fluctuation of rate, fall in
prices and charging of bank interest.
III.Creation of Charge:
While advancing money, banker must secure his position. Not only that he should insist on
good security but the method of charging it should be legal and perfect. The securities may
be charged by any of the following ways (Das, S.C. et al. 2005 ): Lien, Pledge,
Hypothecation, Mortgage,
A lien is the right of a person in the possession of goods, to retain them until debts
due to him have been satisfied.
Range
Over I crore
Period
Monthly
Quarterly
VI.Credit Disbursement:
Having completely and accurately prepare the necessary loan documents, the loan officer
ready to disburse the loan to the borrowers loan account. After disbursement, the loan
needs to be monitored to ensure whether the terms and conditions of the loan fulfilled by
both bank and client or not.
A. Character. The loan officer must be convinced that the customer has a well-defined
purpose for requesting bank credit and a serious intention to repay. If the officer is not sure
exactly why the customer is requesting a loan, this purpose must be clarified to the banks
satisfaction. Responsibility, truthfulness, serious purpose, and serious intention to repay all
monies owed make up what a loan officer calls character.
B. Capacity. The loan officer must be sure that the customer requesting credit has the
authority to request a loan and the legal standing to sign a binding loan agreement. This
customer characteristic is known as the capacity to borrow money.
C. Cash. This key feature of any loan application centers on the question: Does the
borrower have the ability to generate enough cash, in the form of cash flow, to repay the
loan? In general, borrowing customers have only three sources to draw upon to repay their
loans: (a) cash flows generated from sales or income, (b) the sale or liquidation of assets,
(c) funds raised by issuing debt or equity securities. Any of these sources may provide
sufficient cash to repay a bank loan.
D. Collateral. In assessing the collateral aspect of a loan request, the loan officer must ask,
does the borrower possess adequate net worth or own enough quality assets to provide
adequate support for the loan? The loan officer is particularly sensitive to such features as
the age, condition, and degree of specialization of the borrowers assets.
E. Conditions. The loan officer and credit analyst must be aware of recent trends in the
borrowers line of work or industry and how changing economic conditions might affect the
loan.
F. Control. The last factor in assessing a borrowers creditworthy status is control which
centers on such questions as whether changes in law and regulation could adversely affect
the borrower and whether the loan request meets the banks and the regulatory authorities
standards for loan quality.
II.Can the Loan Agreement Be Properly Structured and Documented?
A properly structured loan agreement must also protect the bank and those it representsprincipally its depositors and stockholders- by imposing certain restrictions (covenants) on
the borrowers activities then these activities could threaten the recovery of bank funds. The
process of recovering the banks funds- when and where the bank can take action to get its
funds returned-also must be carefully spelled out in a loan agreement.
The loan classification procedure for all types of loan is governed by the guidelines
contained in BCD Circular no 34 issued by Bangladesh Bank, in 1989 and subsequently
revised partially through BRPD Circular no 16, issued in 1999. After that there was
another BRPD Circular (No. 16 dated May 14, 2001) circulated that brings some changes in
case of continuous & demand loans.
i) General Principles:
(a) Inspection: The department of banking Inspection and the agricultural Credit
Inspection Department, Bangladesh Bank will inspect the classification, interest
suspense and provisioning carried out by the banks.
(c)
(d)
(b)
(c)
(d)
(e)
(f)
(b)
Demand loan: The loan which is payable after demand of bank. Moreover, if any
contingent on other liabilities that is turned into forced loan (not sanction as regular
loan earlier) is to be treated as demand loan. Ex. Forced LIM (loan against
imported merchandise), PAD (payment against document) etc.
(c)
Term loan: The loan, which is payable on specific repayment schedule and specific
period is to be treated as term loan.
(d)
Short-term agriculture and Micro credit: Short- term agriculture loan include the
short- term credit mentioned in the circular issued by Agriculture Credit Department
of Bangladesh Bank under annual credit program. Loan disbursed in agri-sector
repayable within 12 months will also be treated under this head. Short-term small
loan means loan up to Tk. 10000 and micro credit repayable within 12 months.
(3)Term Loan:
If any installment of a term loan is not repaid within as per repayment schedule the unpaid
amount will be treated as overdue installment.
If the advances remain irregular for 12 months the amount is treated as substandard.
(ii)
(iii)
the loan due to change the circumstances under which the loan was originally sanctioned,
i.e., on the basis of qualitative factors, this Judgment can be made regardless whether the
loan is overdue or not on the basis of objective criteria. This criterion includes but is not
limited to: more than a normal risks due to adverse financial condition (arising from loss of
a part of borrower's capital), poor financial performance of the borrowers (borrowers cash
low is insufficient to service debt requirements) or due to insufficiency of security (value of
security is less than the amount of loan outstanding) or other unfavorable factors.
Interest on classified loan (as sub-standard or doubtful) can be charged but cannot be
shown as interest income, interest on classified loan to be provided/shown as interest
suspense account.
(b)
(c)
If any classified loan or part of the loan is realized, then charged or uncharged interest
on that loan to be adjusted first. Principle amount will be adjusted after adjusted of
the above interests.
----- 20%
Provision to be made on the amount found by deducting the interest suspense A/C
and value of eligible securities from the outstanding balance of the classified loans.
provision at the rate of 1% to be maintained on the classified loan.
(c)
(ii)
I 00% market value of gold and gold ornament bailed to the bank.
(iii)
(iv)
(d)
(v)
(vi)
(ii)
Most bank loans to individuals arise from a direct request from a customer who
approaches a member of the banks staff and asks to fill up a loan application. Business
can requests, on the other hand, often arise from contacts the banks loan officers and
sales representatives make as they solicit new accounts from firms operating in the banks
market area. Sometimes loan officers will call on the same company for months before
the customer finally agrees to give the bank a try by filling up a loan application.
Once a customer decides to request a loan, an interview with a loan officer usually
follows right away, giving the customer the opportunity to explain his or her credit needs.
That interview is particularly important because it provides an opportunity for the banks
loan officer to assess the customers character and sincerity of purpose.
If a business or mortgage loan is applied for, a site visit is usually made by an officer of
the bank to assess the customers location and the condition of the property and to ask
clarifying questions. The loan officer may contact other creditors who have previously
loaned money to this customer to see what their experience has been.
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If all is favorable to this point, the customer is asked to submit several crucial documents
the bank needs in order to fully evaluate the loan request, including complete financial
statements and, in the case of a corporation, board of directors resolutions authorizing
the negotiation of a loan with the bank. Once all documents are on file, the credit analysis
division of the bank conducts a thorough financial analysis of them aimed at determining
whether the customer has sufficient cash flows and backup assets to repay the loan. The
credit analysis division then prepares a brief summary and recommendation, which goes
to the loan committee for approval.
If the loan committee approves the customers request, the loan officer or the credit
committee will usually check on the property or other assets to be pledged as collateral in
order to ensure that the bank has immediate access to the collateral or can acquire title to
the property involved if the loan agreement is defaulted. This is often referred to as
perfecting the banks claim to collateral. Once the loan officer and the banks loan
committee are satisfied that both the loan and the proposed collateral are sound, the note
and other documents that make up a loan agreement are prepared and are signed by all
parties to the agreement.
To effectively manage credit risk, every bank formulated and implemented the credit risk
grading manual in the credit approval system as prescribed by the Bangladesh Bank. Each
client is assigned with a credit risk grading score to denote the credit rating of the party.
The Credit Risk Grading (CRG) is a collective definition based on the pre-specified scale
and reflects the underlying credit-risk for a given exposure. In 1993, Bangladesh Bank as
suggested by Financial Sector Reform Project (FSRP) first introduced and directed to use
Credit Risk Grading system in the Banking Sector of Bangladesh under the caption
Lending Risk Analysis (LRA). The CRG scale consists of 8 categories with Short names
and Numbers are provided as follows:
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Grading
Superior
SUP
Good
GD
Acceptable
ACCPT
Marginal/Watchlist
MG/WL
Special Mention
SM
Sub standard
SS
Doubtful
DF
BL
A clear definition of the different categories of Credit Risk Grading is given as follows:
Superior - (SUP) - 1
Credit facilities, which are fully secured i.e. fully cash covered, fully covered by
government guarantee, fully covered by the guarantee of a top tier international Bank.
Good - (GD) - 2
The borrower has strong repayment capacity, excellent liquidity, low leverage, well
established strong market share, good management skill & expertise. The company
demonstrates consistently strong earnings and cash flow. All security documentation should
be in place. Credit facilities fully covered by the guarantee of a top tier local Bank and
aggregate Score of 85 or greater based on the Risk Grade Score Sheet.
Acceptable - (ACCPT) - 3
These borrowers are not as strong as GOOD Grade borrowers, but still demonstrate
consistent earnings, cash flow and have a good track record. Borrowers have adequate
liquidity, cash flow and earnings, acceptable management and parent/sister company
guarantee. Credit in this grade would normally be secured by acceptable collateral (1st
charge over inventory / receivables / equipment / property) and aggregate Score of 75-84
based on the Risk Grade Score Sheet.
Marginal/Watch list - (MG/WL) - 4
This grade warrants greater attention due to conditions affecting the borrower, the industry
or the economic environment. These borrowers have an above average risk due to strained
liquidity, higher than normal leverage, thin cash flow and/or inconsistent earnings, weaker
business credit & early warning signals of emerging business credit detected. The borrower
incurs a loss, loan repayments routinely fall past due, account conduct is poor, or other
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untoward factors are present. This kind of credit requires attention and aggregate Score of
65-74 based on the Risk Grade Score Sheet.
Special Mention - (SM) - 5
This grade has potential weaknesses that deserve managements close attention. If left
uncorrected, these weaknesses may result in a deterioration of the repayment prospects of
the borrower. Severe management problems exist. Facilities should be downgraded to this
grade if sustained deterioration in financial condition is noted (consecutive losses, negative
net worth, excessive leverage). An Aggregate Score of 55-64 based on the Risk Grade
Score Sheet.
Substandard - (SS) - 6
Financial condition is weak and capacity or inclination to repay is in doubt. These
weaknesses jeopardize the full settlement of loans. An Aggregate Score of 45-54 based on
the Risk Grade Score Sheet.
Doubtful - (DF) - 7
Full repayment of principal and interest is unlikely and the possibility of loss is extremely
high. However, due to specifically identifiable pending factors, such as litigation,
liquidation procedures or capital injection, the asset is not yet classified as Bad & Loss. An
Aggregate Score of 35-44 based on the Risk Grade Score Sheet.
Bad & Loss - (BL) - 8
Credit of this grade has long outstanding with no progress in obtaining repayment or on the
verge of wind up/liquidation. Prospect of recovery is poor and legal options have been
pursued. Proceeds expected from the liquidation or realization of security may be awaited.
The continuance of the loan as a bankable asset is not warranted, and the anticipated loss
should have been provided for. This classification reflects that it is not practical or desirable
to defer writing off this basically valueless asset even though partial recovery may be
affected in the future. Bangladesh Bank guidelines for timely write off of bad loans must
be adhered to legal procedures/suit initiated. An Aggregate Score of less than 35 based on
the Risk Grade Score Sheet.
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Financial Risk
Business/Industry Risk
Management Risk
Security Risk
Relationship Risk
Step II
In step (ii) each of the above mentioned key risk areas require be evaluating and
aggregating to arrive at an overall risk grading measure. According to the importance of
risk profile, the following are the weightages for corresponding principal risks.
Step III
Weight:
Financial Risk
50%
Business/Industry Risk
18%
Management Risk
12%
Security Risk
10%
Relationship Risk
10%
Key Parameters
Financial Risk
Business/Industry Risk
Management Risk
Security Risk
Relationship Risk
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Step IV
Weight
50%
Financial Risk
Leverage
15%
Liquidity
15%
Profitability
15%
Coverage
5%
18%
Business/Industry Risk
Size of Business
5%
Age of Business
3%
Business Outlook
3%
Industry growth
3%
Market Competition
2%
Entry/Exit Barriers
2%
12%
Management Risk
Experience
5%
Succession
4%
Team Work
3%
10%
Security Risk
Security coverage
4%
Collateral coverage
4%
Support
2%
10%
Relationship Risk
Account conduct
5%
Utilization of limit
2%
Compliance of covenants
2%
Personal deposit
1%
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Step VI
The following is the proposed Credit Risk Grade matrix based on the total score obtained
by an obligor.
Risk Grading
Number
1
Short Name
Superior
Good
SUP
Score
Government guarantee
GD
85+
Acceptable
ACCPT
75-84
Marginal/Watchlist
MG/WL
65-74
Special Mention
SM
55-64
Sub-standard
SS
45-54
Doubtful
DF
35-44
BL
<35
Credit Risk Grading for each borrower should be assigned at the inception of lending and
should be periodically updated. Frequencies of the review of the credit risk grading are
mentioned below;
Number
Risk Grading
1
2
3
4
5
6
7
8
Superior
Good
Acceptable
Marginal/Watchlist
Special Mention
Sub-standard
Doubtful
Bad & Loss
Short
SUP
GD
ACCPT
MG/WL
SM
SS
DF
BL
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Conclusion
Credit Risk Management in todays deregulated market is a big challenge. Increased market
volatility has brought with it the need for smart analysis and specialized applications in
managing credit risk. A well defined policy framework is needed to help the operating staff
identify the risk-event, assign a probability to each, quantify the likely loss, assess the
acceptability of the exposure, price the risk and monitor them right to the point where they
are paid off. To avoid being blindsided, banks must develop a competitive Early Warning
System (EWS) which combines strategic planning, competitive intelligence and
management action. EWS reveals how to change strategy to meet new realities, avoid
common practices like benchmarking and tell executives what they need to know not
what they want to hear.
The reputation of a bank is very important for corporate clients. A corporation seeks to
develop relationship with a reputable banking entity with a proven track record of high
quality service and demonstrated history of safety and sound practices. Therefore, it is
imperative to adopt the advanced Basel-II methodology for credit risk. The Basel
Committee has acknowledged that the current uniform capital standards (Basel I) are not
sensitive and suggested a Risk Based Capital approach (Basel II)that is essential for the
commercial banks in Bangladesh to prepare themselves to be competitive among the
worlds largest banks. It is only expected that they adopt the international best practices in
credit risk management. For this purpose some guidelines of credit are given below:
Credit guidelines:
It should contain terms and conditions that adhered to in order for loans to be approved.
It should be updated annually to reflect changes in economic outlook & evaluate the bank
loan portfolio.
It should be distributed to lending/marketing officer and approved by MD/CEO and head
of CRM.
It should endorse to banks Head of credit risk management and Head of
corporate/commercial banking.
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Facility parameters and the basis of setting those parameter should be stated clearly e.g.,
maximum size, maximum tenor, and covenant and security requirements
Banks should not grant facilities where the banks security position is inferior to that of
any other financial institutions
Properly insured the assets pledged as security
Valuation of tangible security should be performed prior to loans being granted. A
recognized 3rd party professional valuation should be appointed to conduct valuations.
Banks should be discoursed the following types of business:
Finance of speculative investments and highly leveraged transactions.
Logging, mineral extraction/mining, or other activity that is ethically or environmentally
sensitive
Lending to companies listed on CIB or known defaulters
Bridge loans relying on equity/debt issuance as a source of repayment.
Moreover, credit approval, credit administration and credit recovery functions should be
segregated in the bank. Credit approval authority should be delegated to the individual
executives. Proposal beyond their delegation is to be approved or declined by the Board of
Directors. However, in determining Single Borrower/ Large Loan limit, the instruction of
BB should be strictly followed. Internal audit should conduct on periodical interval to
ensure compliance of banks and regulatory policies. At last Banker should always
remember:
.A banks success lies in its ability to assume and aggregate risk
within tolerable and manageable limits.
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References
22
23
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Timolthy W.Koch, (1998), Bank Management, Library of Congress Cataloging-in
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