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Credit Risk Management Practices in

Banks: An Appreciation
Md. Saidur Rahman

Abstract
The banks in Bangladesh have started undertaking a number of quantitat
ive and qualitative
measures to understand the risks involve in credit or chance of default which ma
y come from
the failure of counterparty or obligor (client) to fulfill his/her com
mitments as per agreed
terms and contractual agreement with the bank. Traditionally, a bank g
ives emphasis on
collateral in funding to the clients whereas in the concept of modern
banking a bank keenly
feels to measure the business risk over the security risk for ensuring
the timely repayment of
invested funds. Now-a-days a banker likes to adopt a number of sophis
ticated financial
techniques in credit appraisal process with a view to assessing the b
orrowers business as
well as financial position rigorously. The use of sophisticated techniq
ues for measuring the
financial, business and other risks is yet to be established in the banking oper
ations very fast
due to the advent of computer based technologies. In some cases, the
rate of adoption of
analyzing tools and techniques is highly remarkable in credit operation
. This attitude of the
bankers has been changed by introducing quality training and reinforcin
g sophisticated
financial as well as risk grading techniques. A strong database is th
e demand of the day for
the proper application of the much-demanded credit risk management guid
elines along with
effective risk grading system.
1. Introduction
Credit risk may be defined as the possibility that the potential client or c
ounterparty
will fail to meet its obligations in accordance with the agreed terms with the b
ank. It
also signifies the risk of making credit to a risky customer for a risky venture
which is
not likely to generate enough revenue to repay the money back to the
bank. Credit
risk is the largest and most obvious source of risk in banking and
it comes from a
banks credit portfolio. The credit portfolio of a bank usually consists
of money
market portfolio, capital market portfolio and general credit portfolio. Here a
bank is
highly exposed in the risks of capital market and general credit port
folio. In recent
times, the awareness among the bankers has grown regarding the need for managing

The author is Joint Director (Training) and Faculty Member, Islami Bank Train
ing and Research
Academy (IBTRA), Dhaka. The views expressed in this article are authors own.
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
38
perceived risks in credit related activities. One of the goals of credit risk ma
nagement
in banks is to maximize a banks risk-adjusted rate of return by maint
aining credit
risk exposure within the acceptable level. Hence, the credit risk asse
ssment and
grading system are being applied to evaluate, identify, measure and monitor the
level
or status of perceived risk associated with a credit proposal. A numb
er of financial
and non-financial factors or parameters are used by the banks for these purposes
. The
use of comprehensive credit risk assessment and grading techniques incr
easing very
rapidly in the banking sector in Bangladesh because of deterioration i
n the credit
standing of the clients, adoption of Basel accords, compliance of inte
rnational
accounting standards (IAS) & international financial reporting standards
(IFRS) and
the fast revolution of technologies that has made the bankers user fr
iendly in the
adoption of these techniques.
From the findings of different studies, it can be noted that at the
very outset the
banking sector in Bangladesh provided huge amount of soft debt facilit
ies to trade,
industry and farming activities for enhancing overall economic growth of the cou
ntry
and it was done as a part of social commitment of the nationalized sector. There
fore,
the bankers were more concerned to disburse credit to the clients and not
to control
the credit flow. At that time, bankers used to take credit decisions mostly on t
he basis
of 5Cs consists of character, capacity, capital, collateral, condition
and control for
safeguarding their credit and without requiring any information of much sophisti
cated
nature from the borrowers for using credit risk assessment for qualifying credit
. Even
in many cases bankers were reluctant to apply very sophisticated financial techn
iques
in credit decision making if they were satisfied with the security or collateral
supplied
by the borrowers. Thus the practice of sophisticated financial techniqu
es as well as
credit risk assessment system for evaluating borrowers creditworthiness w
ere more
or less absent in credit operations. But the bankers attitudes towards
applying indepth financial analysis in credit decision making have been changed -

particularly
after 1980s when they observed an alarming amount of default credit i
n their
portfolio. They started taking the whole financial scenario of the bus
iness of the
borrowers along with the security and collateral. They also started pr
acticing the
techniques of financial analysis to evaluate the financial statements submitted
by the
borrowers. But again the use of financial techniques was limited to t
he study of
income statement, balance sheet and cash flow statement only with the applicatio
n of
some traditional financial ratios like current ratio, gross profit marg
in, debt service
coverage ratio, debt-equity ratio, break-even point analysis, net present worth,
benefit
cost ratio, internal rate of return, etc.
All the bankers were seen quite enthusiastic in the early 1990s when
a broad based
Financial Sector Reforms Program (FSRP) was undertaken in the financial sector f
or
improving the efficiency of the banks. Under the said program, much emphasis wer
e
Credit Risk Management Practices in Banks: An Appreciation 39
given in the process of selecting a credit proposal, risk analysis, c
redit pricing,
classification and provisioning thereof. In 1993, Bangladesh Bank made
the first
regulatory move to introduce the best practices in this area through the introdu
ction of
the Lending Risk Analysis (LRA) manual for all credit exposures undert
aken by a
bank in excess of Tk.10 million. Bankers were asked to prepare Financ
ial Spread
Sheet (FSS) to cover financial trend analysis through comparative and common
-size
financial statements, cash and funds flow analysis, measuring credit sc
ores like Zscore and Y-score along with Lending Risk Analysis (LRA) for a particular
amount
of credit. Under LRA, more emphasis was given to measure the business risk of
the
clients. Henceforward, for the first time the bankers in Bangladesh st
arted using
formal risk analysis techniques for measuring risk level of a credit
proposal. The
concept of security in credit has been changed by adopting new techniques of
credit
analysis. The bankers started understanding that the collateral or custo
mers pledge
for credits is just one of the safety zones that a banker must keep fo
r giving overall
protection against the funds which is given to the customers and the liquidate v
alue of
the collateral or pledged goods must be equal or greater than the exposed risk v
alue of
credit sanctioned. But from a number of studies it is found that the legal syste
m in our
country sometimes makes it difficult for the bankers to repossess and

sell out the


collateral taken against the credit. So it is clear that the income
and cash flow from
business are to be the primary safety zones of a credit (Figure-1) a
nd these are
actually preferred sources of ensuring repayment of credit.
Figure -1: Safety Zones Surrounding the Funds Credited by a Bank

Source: Rose, Peter S. (1996), Banking Credit: Policies and Procedures,


Commercial Bank Management ,3
rd
edition, Boston: Irwin-McGraw-Hill Publishing.
Personal guarantees and pledges made by the

owners of a business firm or by cosigners to a credit.


Resources on the customers balance sheet

and collateral pledged.


Customers expected profits, income

or cash flow.
Principal amount of credit
plus interest owed the bank.
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
40
The most outer or remote safety zone of a credit is the guarantee from the borro
wers
or cosigners where they pledged their personal assets to back the credit taken f
rom the
bank. Before taking any personal guarantee, banker must have the idea about pers
onal

net-worth of the person (s) which may help in mitigating risk.


Very recently the Focus Group on risk management has prepared an indu
stry best
practice guidelines titled Credit Risk Management Guidelines for the sche
duled
banks in Bangladesh under the leadership of Bangladesh Bank with a vi
ew to
managing risk exposure effectively. To shed light this purpose and imp
roving the
credit portfolio of the banks, the guidelines consists of some directi
onal policy
frameworks and procedural methods like credit policy, credit risk assessment and
risk
grading system, segregation of duties of approval authority, internal audit, pr
eferred
organizational structure and responsibilities, approval process, credit a
dministration,
credit monitoring and credit recovery. To supplement the policy frameworks anoth
er
manual on risk grading has also been prepared under the leadership of
Bangladesh
Bank. Risk Grading Manual mainly deals with the credit risk grading p
rocess by
considering the principal risk components associated with the clients,
early warning
signals (EWS), credit risk grading review, MIS on credit risk grading,
financial
spread sheet (FSS), etc. It is expected that these guidelines along w
ith the grading
system will improve the risk management culture, establish minimum stan
dards for
segregation of duties and responsibilities, and will assist in the on going impr
ovement
of the banking sector of Bangladesh.
2. Objectives, Scope and Methodology
The main objectives of this study is to make a thorough review of t
ools and
techniques of credit risk management practices in banks and financial in
stitutions in
Bangladesh as suggested by the relevant bodies and experts under the
leadership of
Bangladesh Bank and highlighting the key features in order to grow awareness of
the
users about credit risk management practices and its proper implementat
ion in the
credit decision making. Banks and financial institutions put their sign
ificant portion
of funds in the long-term financing along with other forms of advances to the pu
blic
and private sector programs. As a developing country a huge amount of credit flo
w is
very much needed both in public and private sector. But it is mentio
nable that the
credit operation involves risk of non-repayment from the counterparties or clien
ts. In
order to manage the risk exposure which may come from such activities
, the credit
risk management practices is one of the important aspects in bank management and
it

must be proper and in systematic manner.


This study is the result of
consulting the
existing literature and is basically theoretical in nature on the subj
ect. All the
discussions that have been included in this paper are the results of extensive s
tudy of
existing credit risk grading and risk management systems prevailing in
this sector
which were issued by the central bank and international bodies time to time.
Credit Risk Management Practices in Banks: An Appreciation 41
3. Observations on Previous Practices
The Financial Sector Reform Program (FSRP) was introduced in the early nineties
in
Bangladesh with a view to bringing about financial discipline by under
taking
appropriate reform measures in the financial sector. The program was undertaken
by
the Government of Bangladesh (GoB) with combined support of the World Bank and
USAID under the Structural Adjustment Program. The program mainly covered the
banking institutions in the financial sector and suggested several refo
rm measures.
Among the measures that FSRP recommended, the Lending Risk Analysis (L
RA)
constitutes as an important measure. LRA was prescribed for taking sou
nd credit
decision in consolidated form on the basis of analyzing risks involved in borro
wers
business and security. With a view to ensuring better credit risk management, th
e use
of LRA was made mandatory in case of sanctioning or renewing large c
redits until
the adoption of Credit Risk Grading (CRG) in 2003. At present LRA ha
s been
replaced by the CRG.
Lending Risk Analysis (LRA) was involved in assessing the likelihood o
f nonrepayment of credits (mainly credit risk) from the borrowers as per credit agree
ment
by analyzing some sort of risks associated with the borrowers business and securi
ty.
Business risk, the prime component of credit risk, was viewed from two a
ngles viz.
industry risk and company risk.
Table-1: Contents of Risk under LRA Manual
Business Risk Security Risk
1.Industry Risk
1.1 Supplies Risk
1.2 Sales Risk
2.Company Risk
2.1 Company Position Risk
Performance Risk
Resilience Risk
2.2 Management Risk
Management Competence Risk
Management Integrity Risk
1. Security Control Risk
2. Security Cover Risk
Source: FSRP Bangladesh, Credit Risk Analysis, June 1993.
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

42
Again, industry risk was consisted with two types of risks viz. supplies risk an
d sales
risk. On the other hand, company risk was consisted with four types
of risks like
performance risk and resilience risk under company position risk and m
anagement
competence risk and management integrity risk under management risk. Fi
nally,
security risk was broken down into two segments like security control
risk and
security cover risk. But in practice it limits the use in taking sound decision
making
due to some reasons. Saha et al. (2001) conducted a study titled LRA
Practices in
Credit Decision in Banks. The study mentioned that for the purpose of
processing
term credit proposal, LRA is being used as a supplementary tool by the
banks sideby-side traditional approach. LRA helps to magnify the use of traditional approa
ch of
credit analysis and there is no conflict between them no doubt. But
LRA is not yet
used as a monitoring or follow-up tool in credit operation. However,
banks are not
using the techniques of giving early warning signal on the basis of
changing risk
status under LRA. More emphasis was given here for the subjective ran
king. The
possibilities to reflect the individuals own judgment and biasness are
remained in
assessing credit risk through LRA. Single Form for assessing varieties of credits
and
ambiguities regarding some terms and concepts incorporated in the LRA
Manual
makes it difficult to use a proper credit risk assessment tool. Keeping these li
mitations
in mind, the Lending Risk Analysis Manual (under RSRP) of Bangladesh
Bank has
been amended, developed and re-produced in the name of Credit Risk Gra
ding
Manual (Bangladesh Bank: Credit Risk Grading Manual, November 2005). Und
er
the newly issued manual, the process of credit risk grading has been
made more
effective and easier to use in credit decision. It has also been prepared in lin
e with the
business complexities of banks and various processes and models followe
d by the
different countries and organizations in assessing credit risk.
Note that before adopting new practices under CRM Guidelines, the cred
it risk
management practices were confined to examine only the risk level for
the larger
amount term credits and no attempt used to take to risk grading syst
em for
unclassified accounts in subsequent stages.
4. Findings and Observations on Recent Risk Management Practices in
Banks

Bangladesh Bank issued its BRPD Circular No. 17 dated October 07, 200
3 advised
all the scheduled banks to put in place an effective risk management
system by
December, 2003 based on the certain guidelines furnished to them. It
appears from
the circular that the banking industry is completely different from other indust
ries in
terms of the diversity and complexities of the risks they are exposed
to. For
sustainable performance of the banks in view of the deregulation and
globalization,
Credit Risk Management Practices in Banks: An Appreciation 43
the banks must be capable of managing their risks. Credit Risk Manage
ment
Guidelines involves in assessing and managing credit risks associated w
ith the
selection process of a potential borrower, credit structuring (amount,
duration,
purpose, repayment, and support), approval process of credit, credit do
cumentation
(security and disbursement), credit administration, credit monitoring and
recovery
functions of a bank or financial institution. At the selection stage, credit ris
k grading
is essential to keep the credit risk exposure at a tolerable level.
Table-2: Contents of CRM Guidelines
Policy Framework Organization Procedures
Credit Guidelines
Credit Assessment &
Risk Grading
Approval Authority
Segregation of Duties
Internal Audit
Structure
Key Responsibilities
Approval Process
Credit
Administration
Credit Monitoring
Credit Recovery
Source: Bangladesh Bank (2003), Managing Core Risks in Banking: Credit
Risk
Management, Dhaka: Bangladesh Bank, Head Office.
Bangladesh Bank, under its prudential regulatory guidelines, advised all
the banks
and financial institutions in Bangladesh to follow a robust and structured frame
work
for risk management. In order to help them in building such type of
effective risk
management system, it formed some Focus Groups comprising the representati
ves
from
Bangladesh Bank, SCBs, PCBs and FCBs to study the global indust
ry best
practices in banking and to recommend a suitable framework of the risk management
system. The present guidelines on core risks management are the outcom
e of such
types of exercise. The Focus Groups have identified some risk areas w

hich are
associated with the banking operations like credit risk, asset-liability
management
risk, foreign exchange risk, internal control and compliance risk, mone
y laundering
risk and ICT risk. These risks are referred to collectively core risks
in banking. The
credit risk is one of the major core risks faced by the banks. It
is the possibility of
potential losses that may arise from the failure of counter party or obligor (cl
ient) to
meet its contractual agreement with the bank. Again, the failure may come from
the
declining in financial condition, adverse situation in the industry or
unfavorable
condition of the business, trouble in management, weak support due to
inferior
quality of security, lack of ready succession and bad relationship with the bank
of the
counterparty.
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
44
The main feature of these guidelines is the flexibility in practice.
Bangladesh Bank
has made the guidelines flexible for the banks in the sense that the respecti
ve banks
can design their own risk management system depending on their size and complexi
ty
of business. Central bank, however, trained a good number of officers
of the
scheduled banks who in turn may help their respective banks in buildi
ng up the
capacity to adopt the risk management system. Other features of credit
risk
management guidelines have been discussed below:
4.1 Centralization of Major Credit Related Activities
All the banks should have comprehensive credit risk management policies
and
procedures to ensure earnings at acceptable level and minimize losses
in their
portfolio. The policies will provide directional guidelines to perform
credit related
activities properly and efficiently. Credit policy, credit assessment an
d risk grading
system, approval procedures, internal auditing system are the major are
as of credit
risk management policy. Procedural guidelines consist of some set rules of activ
ities
to conduct specific credit function effectively. Credit approval process
, credit
administration, credit monitoring, and credit recovery are the part of
procedural
guidelines. These policies and procedures should be approved and strictly enforc
ed by
the managing director or chief executive officer and the board of directors. It
is noted
that any credit activity which does not comply with the policy guideli
nes will require
approval from head of credit or managing director or chief executive officer and
board

of directors. Security documents should be centralized at the head off


ice or regional
office besides the copy of the same preserving in safe custody at branch level.
4.2 Establishing Own Credit Policy
For the purpose of performing credit activities in desired manner, each bank nee
ds to
establish own credit policy in accordance with their business philosophy. The ba
nks
credit philosophy its general goals and objectives including the mission and vis
ion
of the banks are reflected in its credit policy. Thus industry and bus
iness segment
focus, types of credit facilities, single client or group limits, credit caps, d
iscouraged
business types, credit facility parameters, system of approval etc. sha
ll be
incorporated in the credit policy in black and white with a view to providing ov
erall
framework of credit activities. However it should cover, at a minimum,
what
constitutes proper credit support, risk based pricing and documentation
of credit
for safety.
4.3 Customization of Credit Policy Based on Changing Circumstances
Now in a deregulated environment, banks are no longer considered as passive take
rs.
Therefore after the introduction of prudential credit policy, the banks
must stand
Credit Risk Management Practices in Banks: An Appreciation 45
ready to meet all the legitimate demands for credit facilities at all
the times by
customizing their credit policy. While looking into the matter of cust
omizing credit
policy, the changes in economic outlook and the evolution of banks credit portfo
lio
should be taken into account. The credit policy can also be modified
and tuned to
match the changing credit related rules and regulations of the country
and all the
modifications and changes must be approved by the managing director or
chief
executive officer and board of directors.
4.4 Introduction of Credit Risk Grading (CRG) System in Credit Operations
The risks associated with the borrower or counter-party need to be ca
refully and
critically analyzed before funding to the clients business. To quantify
the risk
exposure, it should be graded as per credit risk score sheet by the individual b
anks in
line with the guidelines of CRG Manual. Risk grading is a key measur
ement of a
banks asset quality and it is a robust process. Therefore borrowers risk grade sho
uld
be clearly stated on the credit application form for using credit dec
ision making
process. In CRG Manual, five risk components viz. financial risk, industry/busi
ness
risk, management risk, security risk and relationship risk have been identified

which
are responsible of failing to meet the obligations by the borrowers.
These risk
components are rated based on the some basic parameters. Note that there are twe
nty
parameters under the five risk components to reflect the risk exposure. Financia
l risk
comes from the financial distress of the counterparty. It includes ide
ntification of
extent of leverage through debt-equity ratio, liquidity of the borrower through
current
ratio, profitability performance through operating profit margin and coverage th
rough
debt-service coverage ratio. Business/Industry risk arises due to advers
e change in
business or industry situation. In order to assess the borrowers business/industr
y risk
the size of borrowers business in terms of annual sales volume, age o
f business,
industry growth, market competition and entry & exit barriers are to
be assessed.
Management risk is conducted in assessing the competence and risk taking propens
ity
of the management. It covers the parameters like experience, second lin
e/succession
plan and team work of the management. Security risk is assessed by a
nalyzing the
primary security, collateral security and support. Relationship risk is consider
ed under
CRG by assessing the account conduct, utilization of limit, compliance of covena
nts
and balance of personal deposits. There is a wide range of risk expo
sure or grading
system in the present practices where superior is the top position and bad & los
s is the
worst position. In between superior and bad & loss there are six typ
es of risk
exposures say, good, acceptable, marginal/watch list, special mention, s
ubstandard
and doubtful (Table-3).
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
46
Table-3: A Typical Risk Grading (Credit Rating) System under CRG Manual
Gra
de
Description Weighted
Score
Key Indicators
1 Superior
(SUP)
None -Facilities are fully cash secured, secured by
Government/international bank guarantee.
2 Good (GD) 85 + - Repayment capacity: Strong
- Liquidity: Excellent
- Leverage: Low
- Earnings & Cash Flow: Consistently Strong
- Track record/Account conduct: Unblemished
3 Acceptable
(ACCPT)
75 - 84 - Repayment capacity: Adequate.

- Liquidity: Adequate
- Earnings & Cash Flow: Adequate &
Consistent.
- Track record/Account conduct: Good
4 Marginal
/Watch List
(MG/WL)
65 - 74 - Repayment: Routinely fall past due
- Liquidity: Strained liquidity
- Leverage: Higher than normal
-Earnings & Cash Flow: Thin, incurs loss and
inconsistent.
-Track Record/Account conduct: Poor
5 Special
Mention
(SM)
55 - 64 -Repayment: Deteriorate repayment prospects
-Net-worth: Negative
-Management: Severe problems
-Leverage: Excessive
-Earnings & Cash Flow: Consecutive losses
6 Substandard
(SS)
45 - 54 -Repayment: Capacity and inclination to repay
is in doubt.
-Financial condition: Weak
7 Doubtful
(DF)
35 - 44 -Repayment: Unlikely and possibility of credit
loss is extremely high
8 Bad & Loss
(BL)
<35 -Repayment: Long outstanding, the prospect of
recovery is poor, legal action have been
pursued etc.
Source: Bangladesh Bank (2005), Credit Risk Grading Manual, Dhaka: Bangladesh
Bank, Head Office.
The uses of CRG in credit decision making is shown in the Table-4. From the matr
ix
presented in the Table-4 it is found that after conducting CRG at pr
e sanction stage
based on clients information, a banker can select three risk categorie
s viz. superior,
good and acceptable as feasible and marginal may be treated as except
ionally
acceptable subject to the quality of security may be offered by the
client, his
Credit Risk Management Practices in Banks: An Appreciation 47
reputation etc. However, a borrower with special mentions, sub-standard,
doubtful
and bad/loss rating at pre-sanction stage will be treated as not-feasi
ble. A borrower
with superior, good and acceptable rating at post-sanction stage is a performing
one.
Borrower who is beginning to demonstrate above average risk i.e. marginal/watch
list
or special mention at post-sanction stage will require bankers attention because
it has
become as early alert (warning) account. Rest of the ratings of a borrower at th
e post-

sanction stage exhibit as non-performing or classified status.


Table-4: Decision Matrix of CRG
Pre-Sanction Stage Grading Status Post-Sanction
Stage
Superior
Good
(
1
)
F
e
a
s
i
b
l
e
Acceptable
(
1
)
P
e
r
f
o
r
m
i
n
g
(2) Conditional/ Exceptionally
Acceptable
Marginal/Watchlist
Special Mention
(2) Early
Warning
Account
Sub-standard
Doubtful
(
3
)
N
o
t
F
e
a
s
i

b
l
e
Bad/Loss
(
3
)
N
o
n
P
e
r
f
o
r
m
i
n
g

4.5 Use of Classification and Provisioning Rules in determining Credit


Risk
Grading
Out of the eight categories of risk exposures mentioned under the guidelines, fo
ur risk
exposures or grading are determined as per the prevailing loan classif
ication and
provisioning rules of the central bank. Therefore, central banks rules
for credit
classification shall be applied irrespective of risk rating under CRG shee
t in case of
risk exposures like special mention, sub-standard, doubtful and bad & loss.
4.6 More Emphasis has been given on the Financial Risk of the Borrowers under
the New Guidelines
Five major risk components are considered to quantify the risk status
of a potential
client before funding like financial risk (50%), business/industry risk
(18%),
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
48
management risk (12%), security risk (10%) and relationship risk (10%).
It is to be
mentioned that according to the importance of risk profile, the highest weightag
e (i.e.
50% out of 100%) has been assigned against the financial risk and the rest weigh
tages
are assigned for the rest principal risk components.
4.7 Introduction of Credit Assessment System
Besides credit risk grading, a thorough credit assessment should also be done be
fore
sanctioning any credit facility in line with the credit risk management guidelin
es. The
task of credit assessment will cover analysis of borrower, its guarant
ors, suppliers,

buyers, etc. To supplement such assessment all banks must have well e
quipped
Know Your Customer (KYC) form. Credit assessment starts with some summaries
results from the credit application of the borrower like the amount and types of
credit
facility proposed, purpose of the credit, its structure, security arran
gement, etc. In
addition, some risk areas viz. borrower analysis, industry analysis, su
pplier/buyer
analysis, historical financial analysis, projected financial analysis whe
re term
facilities require more than one year tenor, account conduct, adherence
to credit
guidelines, mitigating factors, security and name credit are to be addressed her
e.
4.8 Segregation of Major Credit Functions
With a view to improving the knowledge levels and expertise in variou
s functional
areas of credit, to impose controls over the disbursement of authorized credit f
acilities
and to obtain an objective and independent judgment of credit proposal it is a
dvised
to segregate the credit functions into Credit Approval, Relationship
Management/Marketing and Credit Administration. Moreover, it is advised
to make
separate approval function from the marketing function.
4.9 Suggestions for Delegating Approval Authority to Individual Executiv
e not
to Committees
To ensure the accountability in the approval process, the authority to
approve or
sanction facilities must be delegated to the senior credit executive n
ot to the
committees based on his/her knowledge and experiences. Approving authori
ties
should have at least 5 years experience working in corporate/commercial banking
as a
relationship manager or account executive, training and experience in f
inancial
statement analysis, financial reporting and full disclosure, cash flow,
projections,
trade cycle, risk analysis, credit structuring and documentation, a tho
rough working
knowledge of accounting, local industry and market dynamics, etc.
4.10 Suggestions for using Computer Based Forms and Templates
Credit risk management is a comprehensive and robust process. It calls
for various
sorts of analysis, preservation of results of the analysis and communicating the
same
Credit Risk Management Practices in Banks: An Appreciation 49
among the parties involved with the process. It has been advised that
banks should
create and use some computer based forms and templates to perform the
credit risk
related activities to ensure the accuracy and easy access of information.
4.11 Preferred Organizational Structure
Like all businesses, banks have a hierarchy of command and a division
of
responsibility in different functional areas. Credit activity is one of them and
it is also

a subject of large dimension. Therefore, within the credit function the banks ne
ed to
establish organizational structure and it must be in place to ensure the objecti
vity and
accountability in credit risk management. As per the proposed organizat
ional
structure of CRM guidelines, below the position of MD or CEO there should be th
e
Head of CRM and the Head of Corporate/Commercial Banking. Other direct reports
say, internal audit may also belong to the position of MD/CEO. The c
redit
administration, credit approval and credit monitoring/recovery function m
ay come
under the Head of CRM. On the other hand, relationship management/marketing and
business development may come under the Head of Corporate/Commercial Banking.
4.12 Introduction of Internal Audit System
Credit audit is an important yardstick to measure how well a credit
policy and
guidelines, operating procedures, central banks directives and credit pra
ctices are
being followed. The independent internal audit should seek at a minimum whether
the
credit amount is within the bankers approval authority, whether the security is v
alid
and sufficient, whether the documentation is complete and accurate, whet
her review
has done on a timely basis, whether credits are being graded on a t
imely basis,
whether the credit administration is in overall compliance with the cr
edit operation,
and so forth.
4.13 Credit Monitoring, Review and Early Alert Process
Credit monitoring helps to ensure that the banks funds are being used
to make
profitable credits with a minimum risk exposure. It includes periodic reviews, r
atings
and audits to provide an early indication of the financial health of
a borrower. The
frequencies of the review of the CRG of the client shall be regulate
d by the risk
exposure at the inception of credit and subsequent updated grading. Lo
wer grading
requires more frequency of review. Annual review is to be done in case of sup
erior,
good and acceptable risk grading, half yearly review is to be done i
n case of
marginal/watch list risk grading and quarterly review is to be done in case of s
pecial
mention, sub-standard, doubtful and bad & loss grading.
4.14 Credit Recovery
It is suggested that every bank should have a separate Recovery Unit for conduc
ting
effective and efficient credit recovery functions. This unit will take
specific action
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
50
plan/ recovery strategy for the accounts with sustained deterioration b
ased on the
recommendations of CRM, pursue all sorts of options to maximize recovery,

ensure
adequate and timely credit loss provisioning and regular review of sub-stan
dard and
worse accounts.
4.15 Non-performing Assets (NPA) Management
The Recovery Unit is also responsible for managing NPA of a bank. Fo
r this all
NPAs should be assigned to an Account Manager within the Recovery Unit, who will
coordinate and administer the action plan/recovery of account. There sh
ould be a
Classified Credit Review Form to know the status of the action plan/r
ecovery plan,
adequacy of provisions etc. on regular basis.
4.16 MIS on Risk Exposure
To maintain the MIS reports of credit risk grading, banks may develop
some forms
for the purpose of reporting various risk grading say superior, good,
acceptable,
marginal/watch list, special mention, sub-standard, doubtful and bad/loss. Bankwise
consolidated report, branch and risk grade wise report and grade wise
borrower list
may be developed.
4.17 Separate Guidelines for Assessing Risk Exposure of Small Enterpris
e and
Consumer Financing
Like other credit facilities, the Small Enterprise and Consumer Financi
ng facilities
must be a subject to the banks risk management process. Small enterprise means an
entity, ideally not a public limited company, does not employ more than
60 persons
(if it is manufacturing concern) and 20 persons (if it is trading co
ncern) and 30
persons (if it is service concern) and also a service concern with t
otal assets at cost
excluding land and building from Tk. 50,000 to Tk. 30 lac and a trading concern
with
total assets at cost excluding land and building from Tk. 50,000 to
Tk. 50 lac and a
manufacturing concern with total assets at cost excluding land and building from
Tk.
50,000 to Tk. 1 crore (Bangladesh Bank, 2004). At the time of granting facility
under
various modes of small enterprise and consumer financing banks shall f
ollow the
prudential guidelines issued by the central bank.
4.18 Application of Financial Spread Sheet
For the purpose of reporting the financial strengths and weakness of the
clients in a
precise but comprehensive manner it is advised to use the financial s
pread sheet
(FSS) in credit decision making under Credit Risk Management practices. The newl
y
adopted financial spread sheet facilitates trend analysis with the help of commo
n-size
financial statements covering audited as well as company prepared balance sheets
and
income statements, financial ratio analysis and cash flow analysis. The

cash flow
statement has been adopted in such a way that anyone can easily iden
tify the
Credit Risk Management Practices in Banks: An Appreciation 51
Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) ca
sh
flow which is very much essential to know to determine the Debt Service
Coverage
(DSC) of a borrower. However, cash flow before and after capital expenditure, to
tal
change in working capital during the year and its impact on cash flow, financing
need
or surplus and financing support from the outsides of the business can also be
found
from this Cash Flow Statement. FSS contains thirty financial ratios wi
th a view to
assessing the growth of key financial indicators, profitability, debt service
coverage,
activity, liquidity and leverage position of the business of a borrower.
5. Basel Principles and Credit Risk Management
The Basel Committee provides some guidelines in order to encourage the
banking
sector globally to promote sound practices for managing credit risk. T
he sound
practices set out under the Basel guidelines specially address the following are
as:
(a) establishing an appropriate credit risk environment;
(b) operating under a sound credit granting process;
(c) maintaining an appropriate credit administration, measurement and
monitoring process; and
(d) ensuring adequate controls over credit risk. Although specific cred
it risk
management practices may differ among banks depending upon the nature
and complexity of their credit activities, a comprehensive credit risk
management program will address these four areas. These practices shoul
d
also be applied in conjunction with sound practices related to the assessment
of asset quality, the adequacy of provisions and reserves, and the disclosure
of credit risk.
Each bank should develop a credit risk strategy or plan that establishes the obj
ectives
guiding the banks credit-granting activities and adopt the necessary pol
icies and
procedures for conducting such activities. The credit risk strategy, as
well as
significant credit risk policies, should be approved and periodically revi
ewed by the
board of directors. The board needs to recognize that the strategy an
d policies must
cover the many activities of the bank in which there is a significan
t credit risk
exposure. The credit risk strategy should include a statement of the
banks
willingness to grant credit based on type (for example, commercial, co
nsumer, real
estate), economic sector, geographical location, currency, and maturity
and
anticipated profitability. This would include the identification of targ
et markets and

the overall characteristics that the bank would want to achieve in its
credit portfolio
(including levels of diversification and concentration tolerances). A banks
board of
directors should approve the banks strategy for selecting risks and max
imizing
profits. The board should periodically review the financial results of
the bank and,
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
52
based on these results, determine if changes need to be made to the
strategy. The
credit risk strategy should be effectively communicated throughout the organiz
ation.
All relevant personnel should clearly understand the banks approach to
granting
credit and should be held accountable for complying with established p
olicies and
procedures. Credit policies establish the framework for credit and guid
e the creditgranting activities of a bank. Credit policies should address such top
ics as target
markets, portfolio mix, pricing, the structure of limits, approval author
ities, etc. The
policies should be designed and implemented within the context of inte
rnal and
external factors such as the banks market position, business area, staf
f capabilities
and technology. Policies and procedures that are properly developed and
implemented capable the banks to: (i) maintain sound credit-granting st
andards; (ii)
monitor and control credit risk; (iii) properly evaluate new business
opportunities;
and (iv) identify and administer problem credit.
Establishing sound, well-defined credit-granting criteria is essential to
approving
credit in a safe and sound manner. The criteria should set out who is eligible f
or credit
and for how much, what types of credit are available, and under what
terms and
conditions the credit should be granted. Banks must receive sufficient informati
on to
enable a comprehensive assessment of the true risk profile of the borrower or co
unter
party. According to the Basel guidelines, at a minimum the following
factors to be
considered and documented in approving credits:
the purpose of the credit and source of repayment;
the integrity and reputation of the client/borrower or counter party;
the current risk profile (including the nature and aggregate amount
of risks)
of the borrower or counter party and its sensitivity;
The borrowers repayment history and current capacity to repay, based
on
historical financial trends and cash flow projections;
A forward-looking analysis of the capacity to repay based on various
scenarios;
The legal capacity of the borrower or counter party to assume the liability;

The borrowers business expertise and the status of the borrowers economic
sector and its position within that sector;
The proposed terms and conditions of the credit, including covenants
designed to limit changes in the future risk profile of the borrower; and
Where applicable, the adequacy and enforceability of collateral or guarantees,
etc.
Credit Risk Management Practices in Banks: An Appreciation 53
Once the credit-granting criterion has been established, it is essential for the
bank to
ensure that the information it receives is sufficient to make proper
credit-granting
decisions. This information will also serve as the basis for rating the credit u
nder the
banks internal rating system.
Banks should have in place a system for ongoing administration of the
ir various
credit risk bearing portfolios. Credit administration is a critical ele
ment in
maintaining the safety and soundness of a bank. Once a credit is gra
nted, it is the
responsibility of the business function, often in conjunction with a c
redit
administration team, to ensure that the credit is properly maintained. This incl
udes (i)
keeping the credit file up to date; (ii) obtaining current financial information
; and (iii)
sending out renewal notices and preparing various documents such as cr
edit
agreements, etc. Given the wide range of responsibilities of the credit administ
ration
function, its organizational structure varies with the size and sophist
ication of the
bank. In developing credit administration area, bank should ensure:
The efficiency and effectiveness of credit administration operations,
including monitoring, documentation, contractual requirements, legal
covenants, collateral, etc.;
The accuracy and timeliness of information provided to management
information system;
The adequacy of controls overall back office procedures; and
Compliance with prescribed management policies and procedures as well as
applicable laws and regulations.
Banks must have in place a system for monitoring the condition of individual cre
dit.
An effective credit monitoring system will include measures to: (i) en
sure that the
bank understands the current financial condition of the borrower or counter part
y; (ii)
ensure that all credits are in compliance with existing covenants; (ii
i) follow the
approved credit lines; (iv) ensure that projected cash flows on major credits me
et debt
servicing requirements; (v) ensure that, where applicable, collateral provides a
dequate
coverage relative to the obligators current condition; and (vi) identify
and classify
potential problem credit on a timely basis. An important tool in monitoring the
quality
of individual credits, as well as the total portfolio, is the use of an internal

risk rating
system. A well-structured internal risk rating system is a good means
of
differentiating the degree of credit risk in the different credit exposure of a
bank and
facilitates early identification of problem credit. This will also allo
w more accurate
determination of the overall characteristics of the credit portfolio, c
oncentrations,
problem credits, and the adequacy of credit loss provisions.
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
54
Banks must ensure that the credit-granting function is being properly
managed and
that credit exposures are within levels consistent with prudential stan
dards and
internal limits. The establishment and enforcement of internal controls,
operating
limits and other practices will help ensure that credit risk exposures
do not exceed
levels acceptable to the individual bank. Limit systems should ensure that grant
ing of
credit exceeding certain predetermined levels receive prompt management
attention.
An appropriate limit system would enable management to control credit
risk
exposures, initiate discussion about opportunities and risks, and monito
r actual risk
taking against predetermined credit risk tolerances. Internal audits of
the credit risk
process should be conducted on a periodic basis to determine that credit activit
ies are
in compliance with the banks credit policies and procedures.
6. Stress Testing A Sophisticated Approach for Managing Risks in
Banks & FIs
Bangladesh Bank introduced a Guideline on Stress Testing through Depart
ment of
Offsite Supervision Circular No.01 dated 21 April, 2010 with effect from June, 2
010.
In this guideline it is noted that the recent financial turmoil in the US financ
ial system
has augmented the importance of establishing more developed risks manag
ement
regime in the financial industry. The financial institutions around the
world are
increasingly employing stress testing to determine the impact on the f
inancial
institutions under set of exceptional but plausible assumptions through
a series of
tests. IMF and Basel Committee on Banking Supervision have suggested f
or
conducting stress testing on the financial sector. Bangladesh bank has
already
designed the stress testing framework for the banks and financial instit
utions to
proactively manage risks in line with the international best practices. Initia
lly, stress
testing begins with the simple sensitivity analysis and scenario analys
is considering

only credit risk and market risk. Eventually it is to be developed a


s a more
comprehensive approach. As a starting point the stress testing is limi
ted to simple
sensitivity analysis approach with covering five different risk factors
viz. nonperforming loans (investment), forced sale value of collateral, interest
rate risk,
exchange rate risk and equity price risk Moreover, the liquidity posit
ion of the
institutions is to be stressed separately. As per desire of the central bank, al
l the banks
and financial institutions operating in Bangladesh are to carry out stress
testing on
quarterly basis i.e. on March 31, June 30, September 30 and December
31. The
reporting format of stress testing has been designed in line with the
Basel II
framework. At institutional level, stress testing techniques provide a way to qu
antify
the reactions of changes in a number of risk factors on the assets
and liabilities
portfolio of the institution. Effective stress testing requires:
Credit Risk Management Practices in Banks: An Appreciation 55
Defining the coverage and identifying the data required
Identifying, analyzing and proper recording of the assumptions used for stress
testing
Well organized management information system
Setting up some specific trigger points to meet the benchmark/standard
s set
by central bank
Calibrating the scenarios or shocks applied to the data and interpret
ing the
results, etc.
Ensuring a mechanism for an ongoing review of the results of stress testing
7. Risk Management Practices in Islamic Banks in Bangladesh
Islamic banks are entities that perform financial intermediation accordi
ng to the
rulings of Islamic Shariah. The unique nature of products differentiates
Islamic
banks from conventional banks in many aspects. Exclusion of interest, prohibitio
n of
making money from money, implementation of profit and loss sharing sys
tem and
prohibition against excessive uncertainty are main sources of difference
s associated
with Islamic banks. The types and extend of risks of Islamic banks also differ i
n great
extend (Hasan and Dicle, 2005).Today nearly four hundred (400) banks and financi
al
institutions are providing their banking services under Islamic Shariah
rulings in
about one hundred thirty (130) countries of Asia, Africa, Europe, America, Austr
alia,
Argentina, Germany, Denmark, Luxembourg, Switzerland and United Kingdom. The
banking system of Pakistan and Iran is Islamised and that of Sudan has
been totally
remodeled on the basis of Islamic Shariah. There has been a rapid growth of Islam
ic

banking industry and the estimated growth rate not less than 15 per
cent annually.
The history of Islamic banking began from the early days of Islam. The establish
ment
of Mit Ghamr Local Savings Bank (Islamic Shariah based bank) in the Nile Delta of
Egypt is considered one of the important events in the history of Islamic bankin
g. In
1963/1964, the first financial year after commencement of banking business a tot
al of
17,560 depositors put their many as deposit in this bank. Mit Ghamr is considere
d as
the milestone of modern Islamic banking system. The achievements made by the Mit
Ghamr Bank in Egypt and subsequently the establishment of the Islamic
Development Bank (IDB) in 1975, the International Association of Islami
c Banks
(IAIB) in 1977 motivated the Scholars and Jurists throughout the Musli
m world to
take steps for establishing Islamic banks in their own countries with
the support of
regulatory authorities and Governments. The Association provides technica
l
assistance and expertise to Islamic communities wishing to establish Is
lamic banks
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
56
and assist in the development of such banks both at national and international l
evels.
Islamic Banking is a form of banking where banking operations are con
ducted in
consonance with the Islamic principles. The philosophies and objectives
of Islamic
banking are not similar to the conventional banking rather these are in
line with the
principles highlighted in the Holy Quran and Hadith/Sunnah. In view wit
h the
Islamic principles particularly prohibition of interest, establishing honesty, j
ustice and
equity in socio-economic arena it may be considered as a system of f
inancial
intermediaries (FIs) that avoids receipt and payment of interest (riba) in its o
perations
and conducts its operations in a way that it helps achieving the obj
ectives of an
Islamic economy. The General Secretariat of the OIC defined the Islamic bank as a
financial institution whose statutes, rules and procedures expressly sta
te its
commitment to the principles of Islamic Shariah and to the banning of
the receipt
and payment of interest on any of its operation. The Islamic banking
system in
Bangladesh started with the establishment of first private sector comme
rcial bank
Islami Bank Bangladesh Limited (IBBL) in 1983. At present seven (7) f
ull-fledged
Islamic banks and eleven (11) conventional banks with their twenty-four (24) Isl
amic
banking branches are providing Islamic banking services. Internationally

reputed
banks like the Hong Kong and Shanghai Banking Corporation (HSBC) Ltd.,
Citi
Bank N.A., Standard Chartered Bank and Commercial Bank of Ceylon intro
duced
Islamic products. The state owned commercial banks (former NCBs) have
opened
their Islamic banking wings to provide Shariah compliant services. A st
ate owned
bond called Bangladesh Government Islamic Investment Bond (BGIIB) has b
een
issued by the central bank. The five Islamic insurance companies operating under
the
private sector in this country as Islamic financial institutions these
are Islamic
Insurance Bangladesh Limited, Islamic Commercial Insurance Limited, Takaf
ul
Insurance Company Limited, Far East Islamic Life Insurance Limited and
Padma
Islamic Life Insurance Company Limited. In Bangladesh, the share of de
posit
mobilization and investments of Islamic banking in total banking industry are 16
per
cent and 20 per cent respectively. Recently a study was done by Ahme
d (2010) to
identify the potential for Islamic finance and to examine its impact. This study
shows
the trends of savings and investment of some selected Islamic and conventional b
anks
which are established in contemporary period in Bangladesh. According t
o the
findings of the study, during 2004 to 2008 the total savings of Islamic banks is
higher
than those of the conventional banks (Table 1). Over the years the s
avings
mobilization gaps widened in favor of the Islamic banks. The differential amount
s of
savings mobilization between Islamic and conventional banks are BDT 45,
036
million, BDT 49,897 million, BDT 56,821 million, BDT 89,109 million an
d BDT
113,180 million during the period under study.
Credit Risk Management Practices in Banks: An Appreciation 57
Table 1: Savings Mobilization by Islamic and Conventional Banks
Amount in Million BDT
Savings of Islamic Banks
(A)
Savings of Conventional
Banks (B) Year
IBBL SIBL ARAFAH
Total
(A)
NBL IFIC CBL
Total
(B)
Difference
(A-B)
2004 87721 19704 10108 117533 29486 20774 22237 72497 45036
2005 107788 16863 11644 136295 33335 22505 30558 86398 49897
2006 132419 16171 16775 165365 40351 28621 39572 108544 56821

2007 166325 18176 23009 207510 47961 29900 40540 118401 89109
2008 200343 22688 31470 254501 60195 36092 45034 141321 113180
Source: Ahmed (2010).
Note: IBBL = Islami Bank Bangladesh Ltd., SIBL=Social Islami Bank Ltd.
, ARAFAH= AlArafah Islami Bank Ltd., NBL= National Bank Ltd., IFIC= International Finance In
vestment
and Commerce Bank Ltd. and CBL=The City Bank Ltd.
The study also shows the investment trends of Islamic and conventional
banks to
justify the potential of Islamic finance. Table 2 shows the year-wise
amount of
investment of Islamic and conventional banks under study.
Table 1: Investment of Islamic and Conventional Banks
Amount in Million BDT
Investment of Islamic
Banks (A)
Investment of
Conventional Banks (B) Year
IBBL SIBL Arafah
Total
(A)
NBL IFIC CBL
Total
(B)
Difference
(A-B)
2004 76826 12887 8150 97863 22972 21281 17028 61281 36582
2005 93644 15097 11474 120215 27020 21695 23326 72041 48174
2006 1113575 15313 17423 146311 32709 25490 30789 88988 57323
2007 144921 15869 19214 180004 36476 28361 26788 91625 88379
2008 191230 18725 29723 239678 49665 33018 34421 117104 122574
Source: Ibid.
It is observed that like savings mobilization gaps, the gaps of investment makin
g also
widened in favor of Islamic banks. Though the market penetration of Islamic bank
s in
Bangladesh is significant but still now there no separate risk management guidel
ines
for Islamic banks. Both the conventional and Islamic banks are followi
ng the same
guidelines which have been advised by the central bank for managing t
heir risks in
operations. The central bank through a circular dated November 09, 2009 introduc
ed
a Guidelines for Islamic Banking with a view to bringing greater transparency an
d
accountability in Islamic banking. The Guideline covers the main areas
of Islamic
banking liquidity, maintenance of books of accounts, preparation of fi
nancial
statements and related issues. It is a supplementary to the existing banking law
s.
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
58
Islamic banking, also known as participatory banking, refers to a system
of banking
or banking activity that is consistent with the principles of Islamic
Shariah and its

practical application through the development of Islamic economics. In order to


fully
comply with the Islamic Shariah rules in banking transaction all the banks have t
heir
own Shariah Council. Besides Bangladesh Bank has formed a Central Sharia
h
Council and related issues. In addition, they are also advised to follow the acc
ounting
and auditing standards prescribed by the Accounting and Auditing Organi
zation for
Islamic Financial Institutions (AAOIFI). There are seventy (70) standard
s on
accounting, auditing and governance along with the code of ethics and
Shariah
Standards of AAOIFI. The Islamic banks have a number of objectives to
perform
their activities say, abolition of interest (riba) in banking operation
s, allowing
Shariah permissible products/sectors for financing, risk sharing and part
icipatory
banking, working as catalyst of development, upholding Islamic ethical standards
etc.
7.1 Guiding Principles of Islamic Financial Services Board (IFSB) for Managing
Risks
Islamic banking sector continues to grow globally at a rapid pace. Th
e Islamic
Financial Services Board IFSB) is even more optimistic in its outlook for the gr
owth
of the global Islamic banking industry. It forecasts that total asset
value of Islamic
banking industry will expand to US Dollar 2.8 trillion in 2015 compared to US Do
llar
1.4 trillion in 2010. The IFSB has developed guiding principles for I
slamic banking
industry. The issuance of the Guiding Principles of risk management by th
e Islamic
Financial Services Board (IFSB) is a giant step for the Institutions
offering Islamic
Financial Services (IIFS). The IIFSs include the commercial banks, investment ba
nks,
finance houses and other fund mobilizing institutions that offer services in acc
ordance
with Islamic Shariah rules and principles. The Guiding Principles of IFSB provide
s a
set of guidelines of best practice for establishing and implementing e
ffective risk
management in IIFS. The main features of the Guiding Principles are:
It has been endorsed by the Shariah Advisory Committee, Islamic
Development Bank (IDB) and co-opted Shariah scholars representing central
banks and monetary agencies which are members of the IFSB.
It has been designed to complement the current risk management princi
ples
issued by the BCSB and other international standard setting bodies.
It sets out fifteen principles of risk management that have practical effect t
o
managing risks. The IFSB will oversee these matters.
It retains the existing applicable Shariah-compliant international principles.
Credit Risk Management Practices in Banks: An Appreciation 59
It outlines a set of principles applicable to managing major six risk areas lik

e
credit risk, equity investment risk, market risk, liquidity risk, rate
of return
risk and operational risk.
7.2 Compliance of Basel II Accord with the Islamic Banks
Hassan and Dicle (2005) have noted in a recent article that the Acco
unting and
Auditing Organization for Islamic Financial Institutions (AAOIFI, 1999)
suggests a
formula for the capital adequacy ratio: CAR = OC / (W
OC+L
+W
PLS * 50%
).
Where,
CAR is the capital adequacy ratio, W
OE+L
is the average risk weight of assets financed
with the Islamic banks own capital and liabilities other than investmen
t accounts,
W
PLS
is the average risk weight of investment accounts. AAOIFI requires the CAR to
be equal to 8 percent.
In Bangladesh, Basel-I accord was started in 1996. Initially in accordance with
BaselI the Capital Adequacy Ratio (CAR) was 8% on Risk Weighted Assets wh
ich was
increased to 9% on 30.06.2003 and 10% on 31.12.2007. The revised acco
rd i.e.
Basel-II was introduced in Bangladesh through a BRPD circular No.9 dat
ed
31.12.2008. For implementing the revised accord experimentally, the parall
el run of
Basel-II was started from 01 January, 2009 for 1 year and full operation was
started
from 01 January, 2010. All the banks are advised to meet the regulatory capital
BDT
400 crore or 9% of risk weighted assets whichever higher by August, 2011. It is
noted
that most of the Islamic banks have fulfilled the revised capital req
uirements. The
Basel Committee on Banking Supervision suggests considering the credit
risk,
operational risk and market risk determining the risk weighted assets
through using
various approaches say standardized approach, internal rating based appr
oach, basic
indicator approach, advanced measurement approach, internal model approac
h etc.
Note that Bangladesh Bank has advised all the scheduled banks (both c
onventional
and Islamic banks) to follow standardized approach, basic indicator approach and
the
standardized approach to measure credit risk, operational risk and mark
et risk
respectively.
8. Concluding Remarks
In every economy bankers are regarded as a creator of socio-economic developmen
t

as they collect funds from the surplus units of the society and to channelise th
e same
to the deficit units (user groups) of the society with the objectives to deploy
the funds
in economic activities for enhancing industrial growth and employment. Bu
t to earn
positive return or profit from the credit activities is also the prime
consideration for
their survival. Since banking business is a mechanism of channeling depositors fu
nds
as advance from one unit to another unit of a society and the derivative
products of
this mechanism are to earn profit, generate employment etc. thats why bankers are
to
Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011
60
take a lot of precautions before disbursing the depositors money as credit. Banks
deal
with the depositors money and the banking philosophy is primarily based on trust
and any inconsistency in the case of disbursing credit may breach the
trust and
confidence of the depositors and which may ultimately create the financial distr
ess in
the economy. Thus, an efficient banker should always think about the probabilit
y of
non-repayment of credit (credit risk) before disbursing it to the borr
owers. In this
context, the use of sophisticated risk grading techniques shows paramount import
ance
for measuring the financial risk, business or industry risk, management risk, se
curity
risk and relationship risk of the borrowers so as to minimize the ri
sk exposure of
credit which may come from default. The banks in Bangladesh should fo
llow the
techniques for measuring risk by customizing these according to our socio-econom
ic
circumstances and organizational set up. Each bank may establish data
bank for its
own consumption at the time of taking credit decision under the sophisticate
d credit
screening techniques. Besides the data bank, well accepted norms and i
ndustry
average may be developed based on the clients information in sector-wis
e funding
for better practicing financial analysis. Uniform practices for preparin
g projected
financial statements may be established in the banks for the clients
who will seek
facilities from the banks. Most of the banking problems have been either explici
tly or
indirectly caused by weakness in credit risk management. Several credit losses i
n the
banking system usually reflect simultaneous problem in several areas su
ch as
concentration, credit processing, failure of due diligence and inadequate monit
oring.
First, concentration would include concentration of credits to single b
orrower or
counterparty, a group of connected counterparties, and sectors or industries. Ba

nking
supervisors should have specific regulations limiting concentrations to
one client or
set of related clients, and, in fact, should also expect banks to se
t much lower
concentrations Banks are to explore techniques to identify concentration
s based on
common risk factors. Second, many credit problems reveal basic weakness
es in the
credit granting and monitoring process. A thorough credit assessment (o
r basic due
diligence) needs for financial information based on sound accounting st
andards and
timely macroeconomic and flow of funds data. When this information is not availa
ble
or reliable, banks may dispense with financial and economic analysis a
nd support
credit decisions with subjective information. The absence of testing and validat
ion of
new techniques of credit decision making is another important problem. Third, ma
ny
banks that experienced asset quality problems due to lack of effective
credit review
process. The purpose of credit review is to provide appropriate checks and balan
ces to
ensure that credits are made in accordance with bank policy and to p
rovide an
independent judgment of asset quality. Fourth, a common and very impor
tant
problem in credit process is lack of monitoring client or collateral value. In
absence
of monitoring process the bank will fail to recognize early signs that asset qua
lity will
Credit Risk Management Practices in Banks: An Appreciation 61
deteriorate and will miss the opportunities to work with clients to stem their f
inancial
deterioration and to protect the banks position. In some cases, the failure to pe
rform
adequate due diligence and financial analysis and to monitor the client can resu
lt in a
breakdown of control to detect credit related fraud. So, an effective
credit review
department and independent collateral appraisals are important protective
measures.
Fifth, due to lack of sufficient account of business cycle effects in
taking credit
decisions, the banks will fail to understand the income prospects and assets val
ue that
may change for changing business cycle. Effective stress testing which t
akes
account of business or product cycle effects is one approach to incor
porating into
credit decisions a fuller understanding of a clients credit risk. Fifth
, the lack of
applying risk sensitive pricing methodology in credit decision making.
Banks that
lack a sound pricing methodology and the discipline to follow consiste
ntly such a
methodology will tend to attract a disproportionate share of under-priced risks.
These

banks will be increasingly disadvantaged relative to banks that have superior pr


icing
skills.
Finally, Hassan and Dicle (2005) have noted in their article that th
e unique
products and procedures of Islamic banks require specialized rating pro
cess. Such
process should include specialized models and rating systems designed in accorda
nce
with Islamic banks and associated risks. Basel II proposes internal ra
tings based
(IRB) approach for banks to differentiate their risk measurement systems
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