Internship Report of Sanjib Debnath (P)

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Prepared for Mr. Shakil Huda Professor
Prepared by Sanjib Debnath Roll: 02 MBA 42D
Institute of Business Administration University of Dhaka
July 8, 2010
July 8, 2010 Professor Shakil Huda Chairman Internship and Placement Program Institute of Business Administration University of Dhaka Dear Sir:
Here is the Internship Report I am required to submit to IBA as a part of the completion of MBA program. While doing the job with Dhaka Bank Limited, I was allowed to do internship in Dhaka Bank Limited at Karwan Bazar Branch. For doing so, I had to work in various sections of the said branch of Dhaka Bank Ltd, such as, Credit Department, Foreign Trade Department etc. When I was working in Credit Department, I came to know about Basel II and its implications in credit risk management. This subject interests me greatly and after consulting with my internship supervisor I have decided to choose my internship topic as Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited. In this report, I have also tried to portray a comparative picture of performance of functions of Karwan Bazar Branch with respect to the whole Dhaka Bank Limited. I hope that the information placed through this Report will provide you enough information about Basel II and its compliance in Dhaka Bank Ltd, one of the leading private commercial Bank in Bangladesh. Should you think the information flaws in explanation, I am always available to discuss the same with you to be abreast of the time. Yours sincerely
Sanjib Debnath Roll # 02 MBA, Batch-42D IBA, DU
Acknowledgement
It is the requirement of MBA conducted by the Institute of Business Administration, University of Dhaka to do Internship and to prepare an Internship Report. For doing my internship I have selected Dhaka Bank Limited where I joined as a Probationary Officer
I am very much grateful to my Supervisor Mr. Shakil Huda for giving me time to guide and rectify my errors. I am also grateful to the management of Dhaka Bank Limited for offering me to carry out my Internship Program as well as providing me the necessary information in order to finalize the Report.
I am especially indebted to my senior officials of Dhaka Bank Ltd of Karwan Bazar branch, such as, Mr. A. S. M. Abu Bokor Siddique, Ms. Salma Akter Seema as well as the Branch-inCharge Mr. Md. Mostaque Ahmed for kindly assisting me while doing the Report. I would like to also thank Mr. Imran Ahmed, Incharge of Basel II implementation Unit for providing me current status of implementation of Basel II in Dhaka Bank Limited.
I have prepared this Report with the help and guidance of our Course Coordinator and the senior officials of Dhaka Bank Ltd. to whom I am indebted to for the suggestions I have had from time to time despite their preoccupations.
Table of Contents
EXECUTIVE SUMMARY ................................................................................................................................ X 1.0 2.0 THE INTERNSHIP PROGRAM ................................................................................................................... 2 AN OVERVIEW OF THE ORGANIZATION: DHAKA BANK LIMITED ............................................................. 5
2.1 KEY FACTS ABOUT DHAKA BANK LIMITED............................................................................................................... 5 2.2 PRODUCTS AND SERVICES ................................................................................................................................... 7 2.2.1 Retail Banking ...................................................................................................................................... 7 2.2.2 Corporate Banking ............................................................................................................................... 8 2.2.3 Trade Finance ..................................................................................................................................... 10 2.2.4 SME .................................................................................................................................................... 13 2.2.5 Remittance ......................................................................................................................................... 13 2.3 SUPPORTING DEPARTMENTS ............................................................................................................................. 13 2.3.1 Centralized Processing Unit ................................................................................................................ 13 2.3.2 Human Resources (HR) ....................................................................................................................... 14 2.3.3 Information Technology Department ................................................................................................. 14 2.3.4 Finance & Accounts ............................................................................................................................ 15 2.3.4 Internal Control and Compliance (ICC) ............................................................................................... 16 2.4 FINANCIAL PERFORMANCE AND GROWTH OF DHAKA BANK LIMITED ......................................................................... 17 2.4.1 Assets ................................................................................................................................................. 17 2.4.2 Liabilities ............................................................................................................................................ 18 2.4.3 Income and Expense ........................................................................................................................... 19 2.4.4 Operating and Net Profit .................................................................................................................... 20 2.5 FUTURE PLAN ................................................................................................................................................. 21 3.0 INTRODUCTION .................................................................................................................................... 23
3.1 ISSUES AND PROBLEMS .................................................................................................................................. 25 3.2 ORIGIN OF THE REPORT ................................................................................................................................. 25 3.3 OBJECTIVE.................................................................................................................................................... 26 3.3.1 Broad Objective ................................................................................................................................. 26 3.3.2 Specific Objectives.............................................................................................................................. 26 3.4 RATIONALE .................................................................................................................................................. 27 3.5 SCOPE AND LIMITATIONS ............................................................................................................................... 27 3.6 METHODOLOGY ............................................................................................................................................ 27 3.7 REPORT PREVIEW ............................................................................................................................................ 28 4.0 LITERATURE REVIEW ............................................................................................................................. 30
5.0
RISK MANAGEMENT IN DHAKA BANK LIMITED ..................................................................................... 35
5.1 CORE RISKS IN BANK ........................................................................................................................................ 35 5.1.1 Asset Liability Management ............................................................................................................... 35 5.1.2 Foreign Exchange Risk ........................................................................................................................ 35 5.1.3 Internal Control and Compliance Risk ................................................................................................ 36 5.1.4 Money Laundering Risk ...................................................................................................................... 36 5.1.5 Credit Risk ........................................................................................................................................... 36 5.2 TYPES OF CREDIT PRODUCTS ............................................................................................................................. 36 5.2.1 Classification on the basis of time: ..................................................................................................... 36 5.2.2 Classification on characteristics of financing ..................................................................................... 37 5.2.3 Classification on Provision Base ......................................................................................................... 38 5.3 CREDIT RISK MANAGEMENT IN DHAKA BANK LIMITED............................................................................................ 39 5.3.1 Lending guidelines .............................................................................................................................. 40 5.3.2 Credit Assessment & Risk Grading...................................................................................................... 40 5.3.3 Approval Authority ............................................................................................................................. 45 5.3.4 Segregation of Duties ......................................................................................................................... 45 5.3.5 Internal Audit ..................................................................................................................................... 46 5.3.6 Credit Monitoring ............................................................................................................................... 46 5.4 CREDIT RISK MANAGEMENT AND BASEL ACCORDS ................................................................................................. 46 5.4.1 Basel I ................................................................................................................................................. 47 5.4.2 Criticism of Basel I .............................................................................................................................. 47 5.4.3 The Entrance of Basel II ...................................................................................................................... 48 6.0 BASEL II FRAMEWORK AND ITS IMPLEMENTATION IN BANGLADESH ................................................... 51
6.1 THE THREE PILLARS ......................................................................................................................................... 51 6.1.1 Pillar 1-Minimum Capital Requirements ............................................................................................ 52 6.1.2 Pillar 2-Supervisory Review Process ................................................................................................... 52 6.1.3 Pillar 3-Market Forces ........................................................................................................................ 52 6.2.1 Standardized Approach (SA) ............................................................................................................... 52 6.2.2 Internal Rating Based Approach (IRB) ................................................................................................ 53 6.3 ROLE OF ECIA IN STANDARDIZED APPROACH........................................................................................................ 56 6.4 CONSTITUENTS OF CAPITAL ............................................................................................................................... 57 6.5 CREDIT RISK MITIGATION ................................................................................................................................. 57 6.5.1 Application of Credit Risk Mitigation in Basel II ................................................................................. 58 6.5.2 Eligible Collaterals for CRM Purpose .................................................................................................. 59 6.6 BASEL II IN BANGLADESH .................................................................................................................................. 59 6.6.1 Action Plan ......................................................................................................................................... 60 6.6.2 Basel II implementation status in Dhaka Bank ................................................................................... 62
6.7 PROBLEMS FACING DURING IMPLEMENTATION ..................................................................................................... 63 7.0 CAPITAL REQUIREMENT FOR CREDIT RISK UNDER BASEL-II IN DBL ....................................................... 67
7.1 THE CONSTITUENT OF CAPITAL ........................................................................................................................... 67 7.1.1 Core capital (basic equity or Tier 1) .................................................................................................... 67 7.1.2 Supplementary Capital (Tier 2) ........................................................................................................... 68 7.1.3 Short-term subordinated debt covering market risk (Tier 3) .............................................................. 71 7.1.4 Deductions from capital ..................................................................................................................... 72 7.2 CREDIT RISK THE STANDARDIZED APPROACH: .................................................................................................... 72 7.2.1 Claims on sovereigns .......................................................................................................................... 72 7.2.2 Claims on non-central government public sector entities (PSEs) ....................................................... 73 7.2.3 Claims on multilateral development banks (MDBs) ........................................................................... 73 7.3.4 Claims on banks.................................................................................................................................. 74 7.3.5 Claims on securities firms ................................................................................................................... 75 7.3.6 Claims on corporate ........................................................................................................................... 75 7.3.7 Claims included in the regulatory retail portfolios ............................................................................. 75 7.3.8 Claims secured by residential property .............................................................................................. 76 7.3.9 Claims secured by commercial real estate ......................................................................................... 77 7.3.10 Past due loans .................................................................................................................................. 77 7.3.11 Off-balance sheet items: .................................................................................................................. 78 7.3.12 Credit risk mitigation ........................................................................................................................ 79 7.4 CAPITAL ADEQUACY RATIO ............................................................................................................................... 79 7.5 TREND ANALYSIS ............................................................................................................................................. 81 7.6 CAPITAL RAISING OPTION ................................................................................................................................. 82 7.6.1 Tier 1 Capital ...................................................................................................................................... 82 7.6.2 Tier II Capital ...................................................................................................................................... 83 8.0 9.0 IMPACT OF ADOPTION OF BASEL II IN DHAKA BANK LIMITED .............................................................. 85 RECOMMENDATION ............................................................................................................................. 88
REFERENCES................................................................................................................................................... 90 APPENDICES................................................................................................................................................... 92
List of Figures
Figure 1: Number of Branches over the Years .......................................................................... 7 Figure 2: Operating Profit per Employee................................................................................. 14 Figure 3: Investment over the Years ........................................................................................ 17 Figure 4: Advances over the Year ........................................................................................... 18 Figure 5: Loan Portfolio........................................................................................................... 18 Figure 6: Deposits of Dhaka Bank ........................................................................................... 19 Figure 7: Deposit Mix .............................................................................................................. 19 Figure 8: Operating Profit vs Net Profit .................................................................................. 20 Figure 9: The Basel II Framework ........................................................................................... 51 Figure 10: Total Eligible Capital ............................................................................................. 81 Figure 11: Risk Weighted Asset .............................................................................................. 81 Figure 12: Capital Adequacy Ratio (CAR) ............................................................................. 82
List of Tables
Table 1: Sectorwise Exposure .................................................................................................... 8 Table 2: Classification of credit based on Characteristics of financing................................... 38 Table 3: Criteria for Sub-Standard Loan ................................................................................. 38 Table 4: Criteria for Doubtful Loan ......................................................................................... 39 Table 5: Criteria for Bad and Loss ........................................................................................... 39 Table 6: CRG Scores Band ...................................................................................................... 44 Table 7: Constituents of Capital .............................................................................................. 57 Table 8: Basel II Implementation Action Plan ........................................................................ 60 Table 9: Core Capital calculation of Dhaka Bank Limited...................................................... 68 Table 10: Tier-2 Capital Calculation of Dhaka Bank Limited as on 31.03.2010 .................... 70 Table 11: Risk Weighted Asset for DBL ................................................................................. 80 Table 12: Minimum Capital Requirement under Risk Based Capital ..................................... 80
Executive Summary
At IBA, students are required to complete an Internship Program to fulfill all the requirement of the MBA degree. The writer joined Dhaka Bank Limited as a Probationary Officer in Karwan Bazar Branch. Dhaka Bank mainly deals with large corporate customers seeking large loan facilities. But for banks, loans are the largest and most obvious source of risk. Experience in recent years has shown that absence of proper management of such risk has resulted in significant losses or even crippling losses for a number of banking institutions. Effective credit risk management is therefore vital to ensure that a banking institutions credit activities are conducted in a prudent manner and the risk of potential bank failures reduced. So, appropriate policies, procedures and systems should be implemented at each financial institution for identifying, measuring, monitoring and controlling credit risk effectively.
DBL follows a centralized approach in extending its credit. Relationship Managers (RM) brings in new customers and prepares credit proposals for them. The proposal package is then sent to the Credit Risk Management (CRM) department analyzes the risk mitigating factors and sends the proposal with recommendation to the credit approving authority. Credit approving authority approves the proposal or denies it and sends the same to CRM again. DBL has a written credit policy manual. It fully complies with Bangladesh Bank Guidelines. DBL does not extend credit to a business, if it does not understand the business. The process of credit assessment is also guided by the central bank directives. A thorough credit and risk assessment is conducted prior to the granting of loans, and at least annually thereafter for all facilities. The loan structure is matched with the cash conversion cycle of the business and appropriate security is taken as collateral. In short, credits are not extended relying on just the borrowers or sponsoring units reputation in Dhaka Bank Limited.
Though all these steps are taken for managing credit risk, it is not enough. Due to the system, failure can occur. As Bank deals with the depositors money, it must have some safety precaution when giving loan. To prevent such failure international accords like Basel I, Basel II are formulated. Bangladesh Bank instructed all the Banks of Bangladesh to adopt Basel II from 2007. Though it has not been made fully activated yet and the simpler approach to measuring capital was taken by the Bangladesh Bank, still its a big challenge for all the
Banks. Regulatory authorities are therefore making efforts to design appropriate strategies that would enable the banking sector for smooth transition to Basel II.
'The New Accord' comprises of three pillars. Pillar I sets out the minimum capital requirements. Pillar II defines the process of supervisory review of a financial institution's risk management framework. Pillar III determines market discipline through improved disclosure. It is argued here that implementation of Pillar I is a more critical than the other two. It requires minimum bank capital against three kinds of risk: credit risk, operational risk and market risk. Since existing regulation requires banks to maintain capital against credit risk only, it is plausible to expect that additional capital requirement for two other risks will cause all banks to raise capital appreciably. RBI (2006) also argues that banks would need to raise additional capital to support expansion of their balance sheets. As a regulator, Bangladesh Bank is required to design policies that will facilitate smooth transition to Basel II.
Calculations of capital requirement suggest that Dhaka Bank Limited has adequate Capital Adequacy Ratio as it is over 8% in the last quarter. But, as per Bangladesh Bank Guideline, from July 2010 the ratio must be maintained over 9%, so DBL has to raise capital quickly to be compliant with the regulation. As, per the standardized approach of credit risk, every unrated client will be risk weighted by 150% of their loan amount, so it will be tougher for DBL as most of the clients are unrated. So, this is a very big challenge the Bank are trying to take in the next quarter of the year. Basel II has manifold implications, like it will prevent the small and unrated borrowers to take loan as Bank dont want to be charged, higher lending cost etc. In summary, it can be said that, upto now DBL is compliant with the capital requirements, but in the next quarter the capital requirements will not be enough. It has to increase capital by raising fund from public, issuing subordinated bonds or issuing right share. Already, DBL has decided to issue subordinated bond to fill the capital requirements for market risk. More of such efforts are needed.
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CHAPTER 1
THE INTERNSHIP PROGRAM
1.0 The Internship Program

At IBA, students are required to complete an Internship Program to fulfill all the requirement of the MBA degree. The primary goal of internship is to provide an on-the-job exposure to students and an opportunity for relating theoretical concepts to real-life situations. The program includes twelve weeks of organizational attachment and four weeks for report writing. Students are required to prepare and submit an internship report in that period. This report has been prepared to comply with that requirement. The writer joined Dhaka Bank Limited as a Probationary Officer on 1st February, 2010. As the job is a full time one, the writer has opportunity to do the internship while doing his job. Officially, the internship program was started on March 1, 2010 and ended on May 23, 2010. After joining the writer was placed in the Karwan Bazar Branch of the said Bank. The branch is one of the best performing branches of DBL. The branch has wide range of services. As the Branch is an authorized dealer, it can do foreign trade business. As in the probation period, one is required do some work at every department to have ideas about total banking transactions. The writer was first placed at the General Banking Division, then Foreign Trade Department and lastly at Credit Department. In this period, the writer tried to have some ideas about different operations of a branch of a commercial bank. Following are some of the tasks the writer used to perform during the internship period:
CIB Report: As part of loan assessment, DBL checks a borrowers credit status, if any, with other financial institutions. For that, DBL fetches Credit Information Bureau (CIB) report from the central bank. The writer used to take the undertakings from the customers and send the inquiry to head office for further processing. Credit Risk Grading: Credit Risk Grading is very important tool for evaluating a customer. Corporate customers, wishing to take any kind of credit facility, have to submit their last three years financials. From that the writer had the opportunity to prepare CRG spreadsheet, which shows different ratios, and CRG score sheet, which gives a score by taking all the quantitative and qualitative data in consideration. Moreover, Different borrowers prepare financial statements differently, i.e. the format varies from customer to customer. Formats may also vary for a same borrower from one year to another. To avoid this kind of problems, Eastern Bank Limited has its own Page|2
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited format and an MIS for that. The MIS upon correct restatement of the balance sheet and the income statement automatically generates ratio statement, cash flow statement. Visiting the collateral/security to be mortgaged Usually when a corporate customer wants to take loan, it has to provide collateral/security such as land, building, stocks, vehicles etc. It is required that Bank officers would go to the place in person to see the status and estimate the value of the property. The writer had the opportunity to go in property visit. After visit, the writer also prepared the visit report of the visited property. Sending Letters: Sending letters to the customer is one of the responsibilities of the writer. Whenever a loan/limit expires or runs excess over the limits, sending letters is the first thing to do. The writer took the responsibility of monitoring borrowers account performance sends all sorts of letters to borrowers. The writer did prepare past due letters for the unit. Sending Request to Central Processing Centre: Central Processing Centre is the centralized processing centre for processing various request of the branches related to posting and documentation of credit and foreign trade operation. All request sent by the branches such as disbursing a loan, adjustment of loan etc. have a required format. The writer sent some request for disbursement of loans in this internship period. Filing: The customer support unit is tasked with filing account and security related documents properly so that those can be found out when required. As an intern of this unit, the writer did a lot of filing for the unit. The filing was helpful in that it oriented the writer with many legal documents related to security or collateral, documents from the Registrar of Joint Stock Companies and Firms, sanction letter, charge documents, CIB undertaking, stock reports, insurers documents, debit-credit advice, credit memorandum, board approvals, etc. In summary, it can be said that the outcome of the internship period is very satisfactory. The writer engaged in the day-to-day banking activities and hence had a clear idea about various banking operation. Also, within this brief period, the writer met many people and had a good idea how to serve the customers.
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CHAPTER 2
AN OVERVIEW OF THE ORGANIZATION: DHAKA BANK LIMITED
2.0 An Overview of the Organization: Dhaka Bank Limited

Bangladesh economy has been experiencing a rapid growth since the '90s. Industrial and agricultural development, international trade, inflow of expatriate Bangladeshi workers' remittance, local and foreign investments in construction, communication, power, food processing and service enterprises ushered in an era of economic activities. Urbanization and lifestyle changes concurrent with the economic development created a demand for banking products and services to support the new initiatives as well as to channelize consumer investments in a profitable manner. A group of highly acclaimed businessmen of the country grouped together to responded to this need and established Dhaka Bank Limited in the year 1995.
2.1 Key Facts about Dhaka Bank Limited

The banks that were given license during the mid 90s are called the 2nd Generation Private Commercial Banks. Dhaka Bank Limited (DBL) is one of them that incorporated as a public limited company under the Companies Act in 1994 and is governed by Banking Companies Act, 1991. The Bank started its commercial operation on July 05, 1995. Since its incorporation, DBL has proved itself as a true development partner of the Government in developing the national economy by providing efficient banking services to different sectors of the economy. Some important facts about Dhaka Bank Limited are given below: Date of Incorporation Registered Office First Branch Enlisted as Public Limited Co. Capital Structure at Formation Authorized Capital Paid up capital : BDT 100 Crore : BDT 10 Crore : April 06, 1995. : Biman Bhaban, 100 Motijheel C/A, Dhaka : Local Office, Adamjee Court, Motijheel, Dhaka : 1998
Capital Structure as on June, 2010 Authorized Capital Paid up capital : BDT 600 Crore : BDT 266 Crore
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Mission To be the premier financial institution in the country providing high quality products and services backed by latest technology and a team of highly motivated personnel to deliver Excellence in Banking. Vision At Dhaka Bank we draw our inspiration from the distant stars. Our team is committed to assure a standard that makes every banking transaction a pleasurable experience. Our endeavor is to offer you the razor sharp sparkle through accuracy, reliability, timely delivery, cutting edge technology, tailored solutions for business needs, global reach in trade and commerce and high yield on your investments. Our people, products and processes are aligned to meet the demand of our discerning customer. Our goal is to achieve a distinction like the luminaries in the skies. Our prime objective is to deliver a quality that demonstrates a true reflection of our vision - Excellence in Banking. Values Customer Focus Integrity Teamwork Respect for the individual Quality Responsible Citizenship Strategic Objectives To conduct transparent and high quality business operation based on market mechanism within the legal and social framework spelt in our mission and reflected in our vision. To provide the customers efficient, innovative and high quality products with excellent delivery system. To generate profit with qualitative business as a sustainable ever growing organization and enhance fair retuns to our shareholders. Committed to our community as a corporate citizen and contributing towards the progress of the nation. Page|6
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Branches As on June 2010 the Bank serves its customers through 52 (Fifty-two) branches and 20 ATM booths spread all over the country. It also has six CMS unit, eight business centers.
Figure 1: Number of Branches over the Years

Source: Annual Report 2009, Dhaka Bank Ltd.
2.2 Products and Services

Dhaka Bank Limited has a wide range of products and services in its assortment. These value based products are very much contemporary and standardized. All the products are very well thought-out and addressed to the very basic financial needs of the individuals and organizations. Its main products and services are described briefly next: 2.2.1 Retail Banking DBL is a leading bank in the countries consumer banking arena. Emphasis on customer service, product innovation, asset quality and brand building are the cornerstones of the Retail Banking strategy. The major products and services of Retail Banking include: Liability Products Savings Bundled Product Deposit Pension Scheme Special Deposit Scheme Deposit Double Scheme Gift Cheque Page|7
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Asset Products Home Loan Personal Loan Vacation Loan Car Loan Any Purpose Loan Services Internet Banking SMS Banking Locker ATM Card & VISA Credit Card 2.2.2 Corporate Banking Providing a tailored solution is the essence of Corporate Banking services of DBL. Dhaka Bank recognizes that Corporate Customers' needs vary from one to another and a customized solution is critical for the success of their business. Dhaka Bank offers a full range of tailored advisory, financing and operational services to its corporate client groups combining trade, treasury, investment and transactional banking activities in one package. At the moment Dhaka Banks exposure (as of December 31, 2009) under Corporate Banking Business is distributed in the following sectors:
Table 1: Sectorwise Exposure
Sl.
Sector
DBLs
Exposure
(BDT in Crore) 1 2 3 4 5 6 7 8 9 Agricultural Chemical Electronics & Automobile Energy & Power Engineering & Metal including Ship Breaking Food & Allied Housing & Construction Pharmaceuticals Service 30 130 9 58 394 350 692 56 158 Page|8
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 10 11 11 Total Textile & Garment Transport & Communication Others 973 191 2,249 5,291
Source: Annual Report, 2009
Following are some of the corporate products offered by DBL: Securitization of Assets A powerful and effective means of generating funds for a certain category of institutions, Securitization of Assets is still in its infancy in The need however for such a service is great and there is a lot of support from multilateral financial institutions, such as the World Bank and the Asian Development Bank, for such activities to be developed further in this country. Dhaka Bank intends to take up this challenge and play a significant role in ensuring that Securitization of Assets becomes a normal part of the range of financial instruments available for organizations who can count on a steady, but piecemeal, flow of revenue and want to translate this stream into cash resources with which to carry out further lending activities to new customers. Finance & Advisory Services Given the needs of its large and varied base of corporate clients Dhaka Bank will be positioning itself to provide investment banking advisory services. These could cover a whole spectrum of activities such as Guidance on means of raising finance from the local Stock markets, Mergers and Acquisitions, Valuations, Reconstructions of Distressed companies and other expert knowledge based advice. By this means Dhaka Bank hopes to play the role of strategic counselor to blue-chip Bangladesh companies and then move from the level of advice to possible implementation of solutions to complex financing problems that may arise from time to time. This would be an extra service that would complement the normal financing activities that Dhaka Bank already offers to corporate business houses. Syndication of Funds There has been a surge in the number of syndication deals closed in the last few years. 2004 was an exceptionally good year for syndicated deals for the local commercial banks also for the foreign banks. The total number of syndications in 2004 exceeded 10 totaling over Tk. 10 billion. This rise in the number of syndications can be primarily attributed to the prudential Page|9
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited lending guidelines of the Bangladesh Bank. A commercial bank may provide funded facilities up to a maximum of 25% of its equity. Due to this reason, projects with sizeable costs need to approach more than one bank for their debt requirements and therefore the demand for syndications exist. Credit risk diversification has led many international companies to introduce credit derivatives that are actively being traded. Project Finance Project financing is an innovative and timely financing technique that has been used to fund large-scale corporate projects. It includes understanding the rationale for project financing, preparing the financial plan, assessing the risks, designing the financing mix, and raising the funds. Project finance is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan. Project financing relies primarily on the project's cash flow for repayment, with the project's assets, rights, and interests held as secondary security or collateral. Dhaka Bank offers a full range of services to the entrepreneurs implementing a project including structuring mode of financing, mitigation of different risks and providing advisory service for successful implementation of the project. Working Capital Finance Dhaka Bank caters to the working capital needs of the client taking into account the current asset requirement of the client. Dhaka bank extends different types of working capital facility like Cash Credit (CC), Overdraft (OD) facility, Short Term Loan (STL), Bank Guarantee, etc. to facilitate the business operation of the client. 2.2.3 Trade Finance Dhaka Bank Limited (DBL) started it trade operations in 1995 and all the trade activities were carried out by DBLs 15 (fifteen) Authorized Dealer (AD) Branches. In the year 2009, DBL established the Central Processing Center (CPC) at BGMEA Bhaban, Karwanbazar, Dhaka and Agrabad, Chittagong. Since then the CPC does the processing of all the trade activities of DBL by using state of the art technology and well groomed team. The trade
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited activities of 40 branches are routed through the Dhaka Hub and that of the rest 12 branches are routed through the Chittagong Hub. Central processing center of DBL is well equipped with highly talented and experienced team who has very good knowledge in foreign trade and technology. Strong MIS, network coverage and real time technology help us to satisfy customer needs just in time maintaining Quality of Work Life (QWL). All sorts of statement are generated centrally to comply with the compliance issue of internal and external authorities. Various kind of trade finance facility is stated next: 2.2.3.1 Import Finance DBL undertakes Import Finance in the form of both pre-import and post-import finance. These two categories of import finances include: Letter of Credit This is a pre-import finance, which is made in the form of commitment on behalf of the client to pay an agreed sum of money to the beneficiary of the Letter of Credit upon fulfillment of terms & conditions of the Credit. Performance Bonds & Other Guarantees DBL offers excellent solution to meet all performance bonds & guarantees required by its valued clients. Loan against Trust Receipt (LTR) In this category of finance, possession of the goods remains with the borrower and the borrower executes Letter of Trust Receipt in acknowledgement of debt and its repayment along with interest within agreed period of time. 2.2.3.2 Export Finance Like import trade, DBL advances in export trade at both pre-shipment and post-shipment shipment stages. The pre-shipment facilities are usually required to finance the costs to execute export orders, such as: procuring & processing of raw materials, packaging and transportation, payment of various fees and charges including insurance premium etc. The facilities under both the categories are:
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Export Letter of Credit Advising Dhaka Bank provides prompt advising of export letter of credit from a wide international network. Back to Back LC BB L/C is a type of pre shipment finance by way of opening L/C in favor of a local or foreign supplier for purchase of raw materials or the finished merchandise, as the case may be, to execute export order. Export Bills for Collection Export Bills for Collection are documents which are presented to the bank by the seller/exporter to collect payment from the buyer through the buyers bank. Packing Credit To execute export orders under L/C or firm contract the bank awards packing credit facility to meet clients working capital requirement. FDBP Foreign Documentary Bill Purchased (FDBP) is a post shipment finance allowed to the customer through the purchase/negotiation of foreign documentary bills adjustable from the relevant export proceeds. IDBP Inland Documentary Bills Purchased (IDBP) facility is accommodated both for export and local trade. EDF Export Development Fund (EDF) at Bangladesh Bank is intended to facilitate access to financing in foreign exchange for input procurements by manufacturer-exporters. Authorized Dealer (AD) banks can borrow US Dollar funds from the EDF against their foreign currency loans to manufacturer-exporters for input procurement.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 2.2.4 SME Small and Medium Enterprises (SMEs) are the engines of growth in almost all the emerging economies of the globe. It has been playing a pivotal role in job creation and overall economic development in Bangladesh. Banking to the SMEs can be termed as banking to the unbanked, as many is yet to receive bank finances to ensure greater business development. DBL is planning to add 6 to 7 SME branch or service centers across the country by the end of 2010. DBL signed a new refinancing deal on Solar Energy, Solar panel assembling plant and ETP with Bangladesh Bank.
2.2.5 Remittance DBL is continuously pursuing for improvement of its Remittance operation for smooth mobilization of fund from the NRBs. For this, DBL is increasing its distribution channel. It has already started payment of remittance through two renowned NGO of Bangladesh-PAGE and PADAKHEP MANOBIK UNNOYON KENDRO, which added 250 distribution centers. It is also a member of EL-DORADO which is a 9-bank Elite Network for remittance distribution facility. It has already introduced Mobile remittance disbursement partnering with Banglalink.
2.3 Supporting Departments

To ensure smooth running of the above departments Dhaka Bank has supporting/back end departments. These departments are not directly involved with the profit making or business of the company, but they are very critical for day to day banking operations. Some of the departments are mentioned next: 2.3.1 Centralized Processing Unit To provide the customer the best possible and world class service Dhaka Bank Limited has centralized its Trade service and Credit Operations. This important initiative is aligned with the CRM guideline of Bangladesh Bank. The centralization of these functions lead to better control and monitoring and minimizing the risks, and helps in segregation of duties and responsibilities as well as reduces different type of irregularities. It also heps inn maintaining
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited uniform process and policy, rational and optimum utilization of manpower and taking full advantage of banks existing cutting edge technology platform. 2.3.2 Human Resources (HR) Dhaka Bank Ltd has been investing generously in human resources since its inception. DBL HR is working as a business partner for both of its internal and external customers to help them achieve better business results. It is directly involved with the people and therefore committed to ensure staff motivation, learning and development, retention, reward and recognition to drive better business results. Creating a progressive and possessive environment for the people to work at DBL is the
Operating Profit Per Employee (in million Tk.) 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 2005 2006 2007 2008 2009
undeviating objective of HR. At DBL, employee performance is directly
aligned with business results. Employees feel appreciated and valued for their hard work and dedications manifested in
Figure 2: Operating Profit per Employee
measurable performances. Dhaka Bank Limited is widely recognized for its holistic work environment, corporate culture and best practices that attract and help retain top talent of the industry. During 2009, operating profit per employee was BDT 3.04 million which was on an increasing curve. 2.3.3 Information Technology Department It is increasingly recognized that to be successful in business, banks need to have an effective technology platform. The bank gives right attention to its overall technology service management by not only acquiring technology but also investing in training and continuous refinement of processes. The bank is open to accept industries good practices. DBL use the i-flex Flexcube for its core banking purposes. The system has enhanced customer service capabilities, further improved cost per transaction and managed risks better with latest control tools.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Technology innovation is one of the most effective ways to achieve cost savings by automating manual processes. More importantly, management of technology enables new revenue opportunities by providing better and timely information about internal processes and client data. 2.3.4 Finance & Accounts This division has four units, viz. Financial Operations & Control, Financial Analyses & Reporting, Financial Planning & Projects and Reconciliation & GL Control. Financial Operations & Control: This unit is assigned with management of day to day payables, fixed assets, corporate tax, employee retirement benefit plans, etc. Except payroll, FOC processes almost all sorts of payables of the bank. Financial Analyses & Reporting: Major responsibilities of this unit include various central bank reporting, due diligence report for various partner organizations (e.g. IFC, ADB), preparation of quarterly and half-yearly financial statements including Annual Report on fixed periodic intervals. Other reports include Capital Adequacy Reports, CAMELS report, etc. As a reporting unit, it has to handle various central bank audits and provide explanations to queries from internal and external group related to financial statements and reports. Financial Planning & Projects: Major responsibilities include preparing monthly financials of the bank (Business and Financial Performance) for MANCOM and yearly business unit wise budget of the bank, budget variance/review forecast, etc. It has also shown excellence in process improvement/reengineering by developing in-house software applications, queries and reports. Reconciliation & GL Control: To enhance integrity of financial information, this unit drives various reconciliation initiatives regularly. A comprehensive GL Control Policy is in process that will help the bank to ensure integrity of recording transactions and thereby integrity of financial statements. Besides, the team monitors risk sensitive GLs such as suspense, inter-branch, inter-system, etc. regularly to ensure internal control. P a g e | 15
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 2.3.4 Internal Control and Compliance (ICC) DBL has established a sophisticated organizational structure to establish and maintain a strong control culture by implementing and strengthening policy guidelines of internal controls. Internal Control is an integral part of the daily activity of a bank, which on its own merit identifies the risks associated with the process and adopts a measure to mitigate the same. The main objectives of the Internal Control and Compliance Department are as follows: Efficiency and effectiveness of activities (performance objectives). Reliability, completeness and timelines of financial and management information (information objectives). Compliance with applicable laws and regulations (compliance objectives). Structure of ICC: The head of Internal Control and Compliance Department [ICCD] have a reporting line with the Managing Director and the Audit Committee of the board. The department has three separate units: 1. 2. 3. Monitoring Unit Compliance Unit and Internal Audit & Inspection Unit
The Monitoring unit is responsible to monitor the operational performance of various branches and departments. It collects relevant data and analyzes those to assess the risk of individual units. In case it finds major deviation, it recommends to the Internal Control Head for sending audit and inspection team for thorough review. The Compliance unit is entrusted to ensure that bank complies with all regulatory requirements while conducting its business. It maintains liaison with the regulators at all levels and notifies the other units regarding regulatory changes. The Audit team performs periodic and special audit. This unit prepares a risk-based audit plan, normally on an annual basis. These plans are approved by the bank's senior management and by the audit committee. This risk based approach of audit assists the organization by identifying and evaluating significant exposures to risk and contributing to the improvement of risk management and control systems.
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2.4 Financial Performance and Growth of Dhaka Bank Limited

Dhaka Bank Limited is high performing private commercial bank, which further consolidated its position in the market in terms of quality services to the customers and value addition for the shareholders. The Bank made healthy progress in all areas of business in 2009. 2.4.1 Assets As of 31 December 2009, total asset of the Bank stood at Tk.77.77 billion, an increase of 9% as against 2008. The increase in asset was mainly driven by significant growth of customer deposits. The growth of deposits was used for funding in loans and advances and holding of securities for SLR (Statutory Liquid Reserves). Cash & Balances with Bangladesh Bank and its Agent: The cash & balances with Bangladesh Bank and its agent registered 33% growth as of 31 December 2009. The growth of deposits increased the balances with Bangladesh Bank and its agent for maintaining the Cash Reserve Requirement (CRR), which was maintained adequately. Balances with Other Banks and Financial Institution: The Balances with other banks and financial institutions increased by 9% which was mainly due to transfer of fund to current accounts of different banks for covering the payments against Inward Foreign Remittances to beneficiaries. Investment The Banks investment during the year 2009 were mostly in long term Government
Securities which stood at Tk. 8,660 million as against Tk. 7,239 million making a growth of 20% over the last year. The Government Treasury Bonds purchased at higher rate of interest to cover the increased SLR arising from the growth of deposit liabilities.
Figure 3: Investment over the Years
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Loans and Advances The Bank implemented the system of credit risk assessment and lending procedures by stricter separation of
Taka in Million 60000 50000 40000 30000 20000 10000 0 2005 2006 2007 2008 2009 23372 34039 39372
Advances
49698 52910
responsibilities
between
risk
assessment, lending decisions and monitoring functions to improve the quality and soundness of loan
portfolio. The Bank recorded a 6% growth in advances with a total loans
and advances portfolio of Tk. 52,910 Figure 4: Advances over the Year million at the end of December 2009 compared to Tk. 49,698 million at the end of December 2008. As of 31 December 2009, 94.43% of the total banks loan portfolio was regular while only 5.57% of the total portfolio was non-performing as compared to 3.84% of 2008. The volume of nonperforming loans
Regular Loan 94% Figure 5: Loan Portfolio
Nonperforming Loan 6%
Loan Classification
stood at Tk. 2,946 million in 2009 from Tk. 1,908 million in 2008.
2.4.2 Liabilities Total liabilities of the Bank stood at Tk. 72,802 million as of 31 December, 2009 registering a growth of 8% over the last year. This has happened for increase of deposits from customers mainly and settlement of import payments against deferred and cash letter of credits. Borrowings from Banks, Financial Institutions and Agents: Treasury Division resorted to borrowing from money market. The Bank registered a negative growth of 3% in borrowings from Banks, Financial Institutions and Agents as against last year positions. The main reason of this negative growth was DBLs borrowing from call money market was significantly reduced. P a g e | 18
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Deposits: The deposit base of the Bank continued to registered a steady growth and stood at Tk.60,918
TAka in Million 80000 60000 40000 20000 0 2005 2006 2007 2008 2009 28439 41554 48731
Deposits
56986 60918
million excluding call as of 31 December 2009 compared to Tk. 56,986 million of the previous year registered a 7% growth. The growth was supporte by branch network and high standard
products an service along with
Figure 6: Deposits of Dhaka Bank
competitive interest rate provided to customers. The customer group of the Bank was individual, corporation, NBFI, Government Bodies, NGO, Autonomous Bodies etc. The cost free and low
Bills 4% DPS/MDS 4%
Deposit Mix
Current and Others 9% Savings 10% STD 5%
cost deposits comprised of 28% of the deposits. Fixed deposits remained the main component of deposits contributing
FDR 68%
about 70% of the total deposits. Average Cost of Deposits was 8.68% in 2009 as against 9.0% in
Figure 7: Deposit Mix
2008. Deposit mix of the
Bank as of 31 December 2009 is given in the Figure 7. 2.4.3 Income and Expense Interest income has been increased by 4% from Tk. 7,171 million in 2008 to Tk. 7,466 in 2009. The growth of advance caused this growth of interest income. Average yield on advance was 14.32% during 2009. Income from investments increased by 38% mainly due to the income from five and ten years Government Bonds at higher rate of interest which was maintained for SLR purposes.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited The Net Interest Margin (NIM), which is derived by net interest income divided by average assets, were 4.56% in 2009 as compared to 4.60% in 2008. The decrease of Net Interest Margin was mainly because of increase of earning assets but lower rate of return from advance which results the lower spread. Net Interest Income increased by 14% FROM Tk. 2,622 million in 2008 to Tk.2,980 million mainly due to increase of interest income form both advances and investments. Expenses Interest expense increased by 4% in 2009, this rise is mainly attributable to the overall increase in Deposit base of the bank. Salary and allowances increased by Tk. 68 million from 2008 mainly due to recruitment of new Employees. Other overhead expenses increased only by Tk. 3 million as compared to 2008. Earning base in assests of the Bank remains unchanged in 2009, which was 88% in 2008. The ratio indicates efficient utilization of resources to earn revenues. 2.4.4 Operating and Net Profit Dhaka Bank Limited registered an operating profit of Tk.2,810 million in 2009 compared to Tk. 2,533 million in 2008 making a growth of 11%.The net profit for the bank as of 31
Operating Profit vs Net Profit

3000 2500 Taka in Million 2000 1500 1000 500 0 2005 2006 2007 2008 2009 Operating Profit Net Profit after Tax
Figure 8: Operating Profit vs Net Profit
December 2009 stood at Tk. 959 million compared to previous years Tk. 839 million making growth of 14%. Earning per share (EPS) was Tk. 45.09 in 2009. A comparative figure of operating profit versus net profit is given below for last five years.
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2.5 Future Plan

Dhaka Bank is going to celebrate its 15-year anniversary on 5th July. In this 15 years of journey, Dhaka Bank present itself as a modern and innovative Bank. The workforce is a brilliant one and the work environment is very congenial. Though it has a strong brand image among the corporate clients, retail division of the bank is not that strong as corporate division. One of the problems in retail banking is dearth of ATM booths. To improve this situation, Dhaka Bank plans to have own ATM network. Furthermore, it signed a deal with OMNIBUS and Dutch-Bangla Bank Limited to have withdrawal facility for the clients of Dhaka Bank in those networks. Dhaka Bank is planning to modernize its IT infrastructure to provide the branch network a happy time when serving the customers.
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CHAPTER 3
INTRODUCTION
3.0 Introduction
Until the late 1970s, banks were highly regulated and protected entities with hardly any competition among them. Collapse of the Bretton Woods agreement put them in a new environment of increased competition, leading to gradual erosion of capital that started to alarm the regulators. Dealing with the problem on international level seemed to be the only possible way of finding a proper solution without increasing competitive differences between banks from individual countries. Hence, a special committee was set up under the auspices of the Bank for International Settlements (BIS) in Basel. The Committee, initially known as the Cooke Committee and later renamed the Basel Committee on Banking Supervision (BCBS), formed a proposal in which it suggested that a common framework for calculating the capital adequacy of banks should be formed. This document, known as the 1988 Basel Capital Accord, became a huge success after its adoption it not only managed to level the playing field, but it also brought national practices on capital adequacy of banks in line. In 1988, the Basel Committee published a set of minimal capital requirements for banks, known as the 1988 Basel Accord. These were enforced by law in the G-10 countries in 1992, with Japanese banks permitted an extended transition period. The 1988 Basel Accord focused primarily on credit risk. Bank assets were classified into five risk buckets i.e. grouped under five categories according to credit risk carrying risk weights of zero, ten, twenty, fifty and one hundred per cent. Assets were to be classified into one of these risk buckets based on the parameters of counter-party (sovereign, banks, public sector enterprises or others), collateral (e.g. mortgages of residential property) and maturity. Generally, government debt was categorized at zero percent, bank debt at twenty per cent, and other debt at one hundred per cent. Off-Balance Sheet (OBS) exposures such as performance guarantees and letters of credit were brought into the calculation of risk weighted assets using the mechanism of variable credit conversion factor. Banks were required to hold capital equal to 8% of the risk-weighted value of assets. Since 1988, this framework has been progressively introduced not only in member countries but also in almost all other countries having active international banks. Close on the heel of the 1996 amendment to the Basel I Accord, In June 1999 BCBS issued a consultative paper on New Capital Adequacy Framework to replace the 1988 Accord. The new capital P a g e | 23
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited framework consists of three pillars: minimum capital requirements, which seek to refine the standardized rules set forth in the 1988 Accord; supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad brush structure) for measuring credit risk which created some problems for credit risk management. For example, all corporations carry the same risk weight of 100 per cent. It also gave rise to a significant gap between the regulatory measurement of the risk of a given transaction and its actual economic risk. The most troubling side effect of the gap between regulatory and actual economic risk has been the distortion of financial decision-making, including large amounts of regulatory arbitrage, or investments made on the basis of regulatory constraints rather than genuine economic opportunities. The strict rule based approach of the 1988 accord has also been criticized for its `one size fits all prescription. In addition, it lacked proper recognition of credit risk mitigants such as credit derivatives, securitization, and collaterals. The recent cases of frauds, acts of terrorism, hacking, have brought into focus the operational risk that the banks and financial institutions are exposed to. Basel II is claimed by BCBS to be an improved capital adequacy framework intended to foster a strong emphasis on risk management not only on credit risk management and to encourage ongoing improvements in banks risk assessment capabilities. It also seeks to provide a `level playing field for international competition and attempts to ensure that its implementation maintains the aggregate regulatory capital requirements as obtaining under the current accord. The new framework deliberately includes incentives for using more advanced and sophisticated approaches for risk measurement and attempts to align the regulatory capital with internal risk measurements of banks subject to supervisory review and market disclosure. Bangladesh Bank issued Basel II Road Map in 2007 in a BPRD Circular Implementation of Basel II in Bangladesh started from January 2009. According to the initial plan, Basel II implementation followed the specific approaches as initial steps with the parallel calculations starting from January 2009:
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Standardized Approach for calculating Risk Weighted Assets (RWA) Standardized Rule Based Approach against Market Risk and Basic Indicator Approach for Operational Risk
Dhaka Bank Limited, a second-generation private commercial bank also followed the implementation plan as specified by the Bangladesh Bank. In the first pillar of Basel II accord, identification and mitigation of credit risk is the forerunner. So, this report tries to unveil the current status of Basel II implementation in Credit Risk Management in Dhaka Bank Limited and the impact of it in banking operations.
3.1 Issues and Problems

Credit risk continues to remain the largest source of risk for banking institutions in Bangladesh. This is due to the fact that a banking institutions loan portfolio is typically the largest asset and the major source of revenue. Effective credit risk management is therefore vital to ensure that a banking institutions credit activities are conducted in a prudent manner and the risk of potential bank failures reduced. Basel accords mainly focused on credit risk mitigation as it provides a sophisticated framework that insulates the banks from potential risk of failure arising from credit risk. According to Basel II framework, if any bank gives loan to a risky customer, it has to retain more capital. As raising capital is not very easy, so banks are passing through a hard time to comply with the Basel II framework, especially maintaining the Capital Adequacy Ratio (CAR). Basel II has manifold impact in the banking industry like shifting of choice to good rated companies, which shrinks the opportunity for taking loan to the poor rated customer. The report focuses on the compliance status and the changes in capital requirement for credit risk in Dhaka Bank Limited. It also gives some light on impact of adoption of Basel II in Dhaka Bank Limited.
3.2 Origin of the Report

This report has been prepared as part of the internship program which is a part of MBA degree requirement. The topic was chosen in consultation with the faculty advisor Mr. Shakil Huda, Professor, IBA and the internship supervisor Mr. A.S.M. Abu Bokor Siddique, Incharge, Credit Department, Karwan Bazar Branch, Dhaka Bank Limited.
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3.3 Objective
Credit Risk Management is the most critical part of any bank operation. Many banks failed in the past due to poor credit risk management. Though there are many tools for mitigating and managing the credit risk, no tool is foolproof and globally received. Due to competition, Banks often forced to take some unwanted risk by giving credit facility to poor rated clients, which creates chances for failure of Banks. Basel II, an internationally accepted standard, covers credit risk comprehensively. Dhaka Bank Limited started implementation of Basel II by following the roadmap formulated by Bangladesh Bank. The objective of this report is to see the implementation progress and compliance status of Basel II in credit risk management DBL. 3.3.1 Broad Objective The broad objective of the report is to see the status of compliance of Basel II in credit Risk Management of Dhaka Bank Limited. 3.3.2 Specific Objectives The specific objectives of the report are: To study the framework of Basel II accord and the differences of it with the previous capital accords. To identify and measure different types of risks and their management thereof To know the measures and tools of credit risk management and the impact of Basel II adoption on it To know about different approaches for capital calculation for different risks as specified by Bangladesh Bank To find out the minimum capital requirement for credit risk To know about Risk weighted Asset and calculate the same for Dhaka Bank Limited. To identify different issues and challenges in implementation of Basel II in Dhaka Bank Limited.
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3.4 Rationale
Primarily, this report fulfills the term paper requirement of internship. Secondly, it gives concrete knowledge on the Credit Risk Management in the era of Basel II. Experiences that will be gathered will surely help in the future when more complex approach will be taken to calculate capital.
3.5 Scope and Limitations

Credit Risk Management and Basel II both are very vast topic to describe. For, concentrating on the key things, the report focuses mainly on credit risk and capital requirement for credit risk in Dhaka Bank. The other risks such as operational risk and market risk have been described very briefly. Credit risk, market risk and operational risk are part of Pillar 1 of Basel II accord. For being very specific on the subject matter, other two pillars of Basel II have not been discussed in this report. Basel II is relatively a new phenomenon in the Banking industry and only few people are knowledgeable about this. So, getting information from the bank officers was not very easy. As the minimum capital requirement has to be reported to Bangladesh Bank quarterly, the latest data could not be obtained. Comparison among the Banks about the subject matter could be interesting, but due to unavailability of data it cannot be done.
3.6 Methodology
The report involves both quantitative and qualitative analyses. Qualitative analysis covers mainly the impact of Basel II implementation in credit activities of Dhaka Bank. On the other hand, Quantitative analysis involves the calculation of core capital, risk weighted asset and capital adequacy ratio and compliance of this with the specifications of Bangladesh Bank. This analyses lead to some recommendation for the management to fully comply with the Basel II accord within the given time frame. Sources of Data Information needed in this report was collected from both primary and secondary sources. Primary Sources: Informal interviews of executives, officers of Dhaka Bank Limited
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Secondary Sources: Study of old files Circulars of Bangladesh Bank Different journals and publications on Basel II. Annual reports Credit Risk Management Manual of Dhaka Bank Limited Journals and Publications on Credit Management
3.7 Report Preview

The report has been prepared following the above methodologies and the objectives in mind. The report starts with a review of literature in chapter 4. Chapter 5 gives an overview on risk management in DBL. Then the next chapter discusses about the Basel II framework and its relation with credit risk management. Chapter 7 discusses about Basel II implementation and its progress in DBL. Calculation of various ratio and the analyses is done in Chapter 8. In Chapter 9 impact of implementation of Basel II in credit risk management has been discussed. Finally the report ended with some recommendations.
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CHAPTER 4
LITARTURE REVIEW
4.0 Literature Review

According to the existing theories, the main validation for capital regulations of banks is often given in terms of moral hazard problem. The problem states that in the presence of visibly available fund, bank managers may not do enough to reduce risk. Instead they will opt for risky projects that are accompanied by higher return, which, if not stopped in time, may compromise banks solvency in the long run. Therefore, the theoretical reason for capital adequacy regulations is to counteract the risk-shifting incentives. This topic has given birth to several strands of theoretical literature. A first strand uses the portfolio approach of Pyle (1971) and Hart and Jaffee (1974), where banks are treated as utility maximizing units. In a mean-variance analysis that allows banks portfolio choice to be compared with and without a capital regulation, Koehn and Santomero (1980) showed that the introduction of higher leverage ratios will lead banks to shift their portfolio to riskier assets. As a solution to such a situation, Kim and Santomero (1988) suggested that this problem can be overcome if the regulators use correct measures of risk in the computation of the solvency ratio. Subsequently, Rochet (1992) extended the work of Koehn and Santomero and found that effectiveness of capital regulations depended on whether the banks were value-maximizing or utility-maximizing. In the former case, capital regulations could not prevent risk-taking actions by banks. In the latter case, capital regulations could only be effective if the weights used in the computations of the ratio are equal to the systematic risk of the assets. A further theoretical ground argued that banks choose portfolios with maximal risk and minimum diversification. The second strand of literature on the topic utilizes option models. Furlong and Keeley (1989) and Keeley (1990) developed several models under this framework and showed that higher capital requirements reduce the incentives for a value-maximizing bank to increase asset risk, which is opposite to the conclusions of the first generation studies discussed above. They criticized the utility maximizing framework, which comes to opposite conclusions, as inappropriate because it mischaracterizes the banks investment opportunity set by omitting the option value of deposit insurance and the possibility of bank failure. However, this evidence of the option model was weakened by the findings of Gennottee and Pyle (1991). They relaxed the assumption that banks invest in zero net present value assets and found that
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited there are now plausible situations in which an increase in capital requirements results in an increase of asset risk. Using a dynamic framework (multiple periods), as opposed to the static framework used in the studies above, Blum (1999) found that capital regulation may increase banks riskiness due to an intertemporal effect. Using a two-period model, he showed that banks find it too costly to raise additional equity to meet new capital requirements tomorrow or are unable to do so, they will increase risk today. He also pointed out that this second effect will reinforce the well-known risk-shifting incentives due to the reduction in profits. Subsequently, Marshal and Prescott (2000) showed that capital requirements directly reduce the probability of default and portfolio risk and suggested that optimal bank capital regulations could be made by incorporating state-contingent penalties based on banks performance. At the same time, Vlaar (2000) found that capital requirements acted as a burden for inefficient banks when assets of banks are assumed to be fixed. However, such regulations increased the profitability of efficient banks.In short, whether imposing harsher capital requirements leads banks to increase or decrease the risk structure of their asset portfolio is still a debated question and, at least for now, it seems, there is no simple answer to this question. Empirical work in the area concentrates on two aspects of capital regulations. First, to investigate whether banks fulfill the capital requirements by increasing capital or by altering the risk weighted assets; and second, to test if the enforcement of capital requirements can result in a contraction in banks supply of loans, a situation best described as a credit crunch. Many of these works use a simultaneous equations approach, which allows comparing the behavior of undercapitalized and adequately capitalized banks with respect to changes in risk and capital ratios. Shrieves and Dahl (1992) used several periods of cross-section data on commercial banks in the U.S. under the simultaneous equations framework. They found that the effectiveness of risk-based capital regulations depend on how well the regulations reflected the true risk exposure of banks. They also found that banks in the undercapitalized categories increased their capital target ratios more quickly than other banks with higher initial capital. But, if one is interested in the impact of capital regulations in a broad sense, then this is not a big problem.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited The study by Jacques and Negro (1997) deals exclusively with the consequences of the Basel Accord, as it concentrates on the years 1990-91. They find that capital regulation has a significant impact on risk and vice versa. Ediz, Michael, and Perraudin (1998) and Rime (2001) present some non-U.S. evidence regarding the relationship between capital ratios and credit risk. Ediz, Michael, and Perraudin (1998) employ confidential U.K. data including detailed information about the balance sheet and profit and loss account of all British banks during the 1989-1995 periods whereas Rime (2001) uses Swiss data for the period 19891996. Ediz, Michael, and Perraudin (1998) used a limited information technique different from the simultaneous equations framework. Their study used a period 1989-1995 sample and applied a random effects model. They found that capital regulations were effective in increasing the capital to meet the minimum standard. The study by Rime (2001) is interesting because it provides the application of the simultaneous equations model. His results indicate that Swiss banks react to capital regulations by increasing their capital, but this did not change banks risk-taking. Sheldon (1996) used an option-pricing framework to analyze the risk effects of capital adequacy on eleven G-10 countries. He found that the Basel Accord did not have a risk-increasing impact on banks portfolio. But this result is not easy to interpret as he did not control for regulatory and non-regulatory influences. Moreover, sample coverage of this study is not representative for the countries they represent. Van Roy (2003) studied the impact of capital requirements on risk taking by commercial banks of seven OECD countries within the framework of the simultaneous equations framework. He found that changes in capital and credit risk were negatively related over the period studied, which supported the argument that stringent capital requirements went hand in hand with greater financial stability in addition to imposing a higher capital buffer against unexpected credit risk losses. Proper credit risk management is critical for Banks existence in the market. Santomero, A. M. (1996) suggests that a bank must apply a consistent evaluation and rating scheme to all its investment opportunities in order for credit decisions to be made in a consistent manner and for the resultant aggregate reporting of credit risk exposure to be meaningful. To facilitate this, a substantial degree of standardization of process and documentation is required.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Treacy and Carey (2000) suggest that in designing a credit rating system, a bank should consider numerous factors, including cost, efficiency of information gathering, consistency of rating produced, staff incentives, nature of a banks business, and uses to be made of the internal risk ratings. A rating system with more rating categories is better than a system with just a few categories. However, an internal rating system with larger number of grades is costly to operate because of the extra work required to distinguish finer degrees of risk. Raghavan, R. S. (2003) suggests that the key ingredient of credit risk is the risk of default that is measured by the probability that default occurs during a given period. As there is a significant co-relation between credit ratings and default frequencies, any derivation of probability from such historical data can be relied upon. Despite the advances in science and technology that allow the development of expert system or statistical classification models, human judgment is still an important ingredient in the credit risk assessment process. According to Treacy and Carey (2000), the rating process almost always involves the exercise of human judgment because factors to be considered in assigning a rating and the weights given to each factor can differ significantly among borrowers. For large exposures, the benefits of such accuracy may outweigh the higher costs of the judgmental systems. Because of the high cost involved, in general, banks produce credit ratings for business and institutional loans only.
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CHAPTER 5
RISK MANAGEMENT IN DHAKA BANK LIMITED
5.0
Risk Management in Dhaka Bank Limited
Risk concerns the expected value of one or more results of one or more future events. Technically, the value of those results may be positive or negative. However, general usage tends focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost (downside risk) or failing to attain any benefit (upside risk). Risk management can be considered the identification, assessment, prioritization of risks followed by coordinated and economical application of resources to minimize, monitor and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities.
5.1 Core Risks in Bank

The core risks involved in any banking operation are briefly described below: 5.1.1 Asset Liability Management The Asset Liability Management is integral part of Bank Management. This risk is related to the balance sheet gaps, interest rate gaps that can lead to under performance. To manage this risk Dhaka Bank Limited has a committee name ALCO (Asset Liability Committee) which usually meet at least once a month to analysis, review and formulate strategy to manage the balance sheet. Main functions of this committee are identifying the balance sheet management issues like balance sheet gap, interest rate gap/profile, reviewing deposit-pricing strategy and liquidity contingency plan. 5.1.2 Foreign Exchange Risk Todays financial institutions engage in activities starting from import, export and remittance to complex derivatives involving basic foreign exchange and money market to complex structured products. All these require high degree of expertise that is difficult to achieve in the transaction originating departments and as such the expertise is housed in a separate department. In DBL, this task is done by Treasury Department. Treasury department watches over the flow of foreign exchange, it takes long/short position of foreign currency to mitigate the risk of depreciation of the hold currencies.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 5.1.3 Internal Control and Compliance Risk Internal control is the process, affected by a companys board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the effectiveness and of operations, the reliability of financial reporting and compliance with applicable laws, regulations, and internal policies. In DBL the responsibilities of internal control are to check the efficiency and effectiveness of activities, reliability, completeness and timeliness of financial and management information etc. 5.1.4 Money Laundering Risk Though money laundering risk is relatively a old phenomenon, it got the organized look after the enactment of Money Laundering Act, 2009. This law barred some activities as legal and if any bank is found to be involved in any kind of money laundering, the concerned official and the bank will be punished. As, money laundering is very common in Bangladesh, it poses a great risk for the banks. To mitigate this risk, DBL employed a strong KYC (Know Your Customer) policy, strong account monitoring policy etc. 5.1.5 Credit Risk This is the most important risk of all as it involves the key asset quality of any bank. Credit Risk is defined as the risk of losses associated with the possibility that borrower will fail to meet its obligations; in other words it is the risk that the borrower wont repay what is owed. Many banks have failed in the past because of poor management of credit risk. To understand credit risk, it is important to know about the credit facilities. The next section focuses on that.
5.2 Types of Credit Products

Credit may be classified with reference to elements of time, nature and provision base. 5.2.1 Classification on the basis of time: On the basis of elements of time, bank credit may be classified into three heads, viz. Continuous loans: These are the advances having no fixed repayment schedule but have a date at which it is renewable on satisfactory performance of the clients. Continuous loan mainly includes "Cash credit both hypothecation and pledge" and "Overdraft". P a g e | 36
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Demand loan: In opening letter of credit (L/C), the clients have to provide the full L/C amount in foreign exchange to the bank. To purchase this foreign exchange, bank extends demand loan to the clients at stipulated margin. No specific repayment date is fixed. However, as soon as the L/C documents arrive, the bank requests the clients to adjust their loan and to retire the L/C documents. Demand loans mainly include Payment against Documents, "Loan against imported merchandise (LIM)" and "Letter of Trust Receipt". Term loans: These are the advances made by the bank with a fixed repayment schedule. Terms loans mainly include "Consumer credit scheme", "Lease finance"," Hire purchase", and "Staff loan". The term loans are defined as follows: Short term loan: Up to 12 months. Medium term loan: More than 12 months & up to 36 months Long term loan: More than 36 months. 5.2.2 Classification on characteristics of financing On characteristics of financing, the credit facilities of Dhaka Bank can be divided into two categories, viz. Funded These products give the client the facility to use the money to fulfill its working capital need, to cover temporary shortage of fund, to buy consumer durables etc. The facilities taken by the client are reflected in the balance sheet of the bank as assets. Majority of the credit product of the bank are of this type. As this type represents the major portion of credit portfolio of a bank, risk of default, i.e. credit risk is very evident here. So, the credit risk management is basically managing funded facility of a bank. Non-Funded These products give a third party the assurance that bank will pay in the event of failure of repayment of its client. Generally it is used to import goods from abroad, to participate in different tender etc. As these facilities deal with guarantee and not money these are not reflected in the balance sheet, they are reflected in the off-balance sheet. These are called contingent liability also.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited The following table examples of some funded and non-funded products are given:
Table 2: Classification of credit based on Characteristics of financing
Funded Overdraft Loan Consumer Credit Loan against Trust Receipt Payment against Documents Cash Credit (Pledge and Hypothecation) Staff Loan Term Loan Packing Credit 5.2.3 Classification on Provision Base
Non-Funded Letter of Credit Bank Guarantee
Credit facilities of Bank can be divided into four categories based on provision base of the facilities, viz. Unclassified The loan account is performing satisfactorily in the terms of its installments and no overdue is occurred. In this type one special type of classification is there which is called special mention account. Generally, if an account is not repaying its due for three months continuously, it is called special mention account (SMA) and is reported to the central bank which prevents the other banks to give the client fresh loan. Sub-Standard This classification contains where irregularities have been occurred but such irregularities are temporarily in nature. To fall in this class the loan and advance has to fulfill the following factor given in Table 3. This kind of loan is monitored closely by the monitoring division to make the loan regular.
Table 3: Criteria for Sub-Standard Loan
Category of Credit S-T Agri & Micro Credit Continuous loan Demand Loan Time overdue (irregularities) 3 months & above but less than 6 months. Un-recovered for 3 months & above but less than 6 months from the date of the loan is claimed. Repayable within 5years: If the overdue installment equals or exceeds the amount repayable within6 months. Repayable more than 5years: If the overdue installment equals or exceeds the amount repayable within12 months.
Sub-standard
Fixed Term loan
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Doubtful This classification contains where doubt exists on the full recovery of the loan and advance along with a loss is anticipated but cannot be quantifiable at this stage. Moreover if the state of the loan accounts falls under the following criterion can be declared as doubtful loan and advance.
Table 4: Criteria for Doubtful Loan
Category of Credit S-T Agri & Micro Credit Continuous loan Demand Loan Time overdue (irregularities) 6 months & above but less than 12 months. Un-recovered for 6 months & above but less than 12 months from the date of the loan is claimed. Repayable within 5years: If the overdue installment equals or exceeds the amount repayable within 12 months. Repayable more than 5years: If the overdue installment equals or exceeds the amount repayable within 18 months.
Doubtful
Fixed Term loan
Bad and Loss A particular loan and advance fall in this class when it seems that this loan and advance is not collectable or worthless even after all the security has been exhausted. In the following table the criteria to be fulfilled to fall in this category are summarized:
Table 5: Criteria for Bad and Loss
Category of Credit S-T Agri & Micro Credit Continuous loan Demand Loan Time overdue (irregularities) Not recovered within more than 12 months. Un-recovered more than 12 months from the date of the loan is claimed. Repayable within 5years: If the overdue installment equals or exceeds the amount repayable within 18 months. Repayable more than 5years: If the overdue installment equals or exceeds the amount repayable within 24 months.
Bad and Loss
Fixed Term loan
5.3 Credit Risk Management in Dhaka Bank Limited

To manage credit risk, Bangladesh Bank prescribed a framework. The key elements of credit risk management are: Lending Guideline Credit Assessment & Risk Grading Approval Authority P a g e | 39
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Segregation of Duties Internal Audit 5.3.1 Lending guidelines Lending guidelines clearly outline the senior managements view of business development priorities and the terms and conditions that should be adhered to in order for loans to be approved. This should be updated at least annually to reflect changes in the economic outlook and the evolution of the banks loan portfolio. It contains: Industry & Business Segment Focus: The lending guidelines in DBL specifies some particular industries like textile, knit garments, cement, power etc. Types of Loan Facilities: The guideline also specifies different kinds of loan that are permitted to be disbursed. As per DBL lending guidelines, there are mainly two kinds of loan, funded and non-funded. Examples of funded are working capital loan, term loan, etc. On the other hand, examples of non-funded facilities are LC, Bank Guarantee etc. Single Borrower/ Group Limits: A single borrower/group is permitted to get highest 15% of the capital as funded facility and highest 20% of the capital as non-funded facility. Lending Caps: There is a specific industry sector exposure cap to avoid over concentration in any one industry sector. Discouraged Business Types: In the lending guidelines of DBL, lending to some industries is discouraged such as military weapon, highly leveraged transaction and finance of speculative investment. Loan Facility Parameters: As per the lending guidelines, the parameters should be adopted like, not granting facility when security position is inferior, proper valuation of security, pledge of security etc. Cross Border Risk: It is synonymous with political and sovereign risk. If any difficulty arises from any political event, then a plan is there in place. 5.3.2 Credit Assessment & Risk Grading Lending is risky because loan quality is affected by both internal and external factors. External factors include changes in economy, national disasters like earthquake, flood and the regulation by the government. Internal factors affecting loan risk include management errors, P a g e | 40
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited illegal manipulation by bank officials and weak or ineffective lending policies. The risk of lending function is mainly controlled by Government regulations and Internal policies and procedures. The risk is also controlled by creating and following written policies and procedures for processing each credit request. At DBL, a thorough credit assessment and risk grading are done prior to loan approval for minimizing risks maintaining Bangladesh Bank Guidelines. 5.3.2.1 Credit Assessment A thorough credit and risk assessment is conducted prior to the granting of loans, and at least annually thereafter for all facilities. The results of this assessment are presented in a Credit Application that originates from the relationship manager/account officer (RM), and is approved by Credit Risk Management (CRM). The RM is the owner of the customer relationship, and is held responsible to ensure the accuracy of the entire credit application submitted for approval. The RMs are familiar with the banks Lending Guidelines and conduct due diligence on new borrowers, principals, and guarantor. It is essential to ensure such parties are in fact who they represent themselves to be. The bank has an established Know Your Customer (KYC) and Money Laundering guidelines. Credit Applications summarize the results of the RMs risk assessment and include the following details: Amount and type of loan(s) proposed Purpose of loans Loan Structure (Tenor, Covenants, Repayment Schedule, Interest) Security Arrangements In addition, the following risk areas are addressed: Borrower Analysis Borrower analysis is the most important step in providing loans to borrowers. Unethical attitudes, asymmetric information and manipulation of records by borrowers etc. create complication in credit finance and as a consequence banks become burdened with unusual amount of classified loans. So, the borrower must be of good character, should be reliable, responsible and resourceful, so that the return of loan is easier. For that, the following information is provided on the loan application:
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Borrower background or history including group information if the concern is part of a group. The location of the borrowers office & factory and factory details like land area, buildings, number of shifts per day, number of workers and officers, factory space and sources of power & capacity, alternate source of power, source of machinery, etc. If the borrower has applied for a loan for a new project, then initial cost of the project, its means of finance, its product mix & production capacity and its market Total export earnings of the group List of machinery for existing project Particulars of the Board of Directors, and declaration of the Relationship Manager regarding personal net worth Corporate objective or strategy Once a borrower requests for a loan, a DBL official interviews the customer and finds out the credit needs. This interview is important because it enables the bank to assess the borrowers character and sincerity of purpose. For a new project, it also collects information memorandum. For business or mortgage loan, the DBL makes a visit to the customers location and assesses the condition of the property. Industry Analysis The key risk factors of the borrowers industry are assessed. Any issues regarding the borrowers position in the industry, overall industry concerns or competitive forces are addressed and the strengths and weaknesses of the borrower relative to its competition are identified. Critical success factors of the industry are also stated. Supplier/Buyer Analysis Information regarding the borrowers suppliers and buyers are collected mainly who they are. Any customer or supplier concentration is addressed, as these have a significant impact on the future viability of the borrower. Any issues regarding the market vulnerability are also addressed. Historical Financial Analysis An analysis of a minimum of three years historical financial statements of the borrower is presented. Where reliance is placed on a corporate guarantor, the guarantors financial statements are also analyzed. The analysis addresses the quality and the sustainability of P a g e | 42
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited earnings, cash flow and the strength of the borrowers balance sheet. Specifically, cash flow, leverage and profitability are analyzed. Projected Financial Performance Where term facilities for more than one year are being proposed, a projection of the borrowers future financial performance is conducted, indicating an analysis of the sufficiency of cash flow to service debt repayments. Loans are not granted if projected cash flow is insufficient to repay debts. Account Conduct For existing borrowers, the historic performance in meeting repayment obligations like trade payments, checks, interest and principal payments, etc is assessed. Performance with other banks like import performance, export performance, account conduct and liability position is also noted. For a comprehensive picture, the latest Credit Information Bureau (CIB) report of the central bank is summarized in this module. Adherence to Lending Guidelines The Credit Application clearly states whether or not the proposed application is in compliance with the banks Lending Guidelines. The Banks Head of Credit or Managing Director/CEO approves Credit Applications that do not adhere to the banks Lending Guidelines. Mitigating Factors There might be some trigger points for the industry which poses serious risks. So, mitigating factors for those risks are identified. Possible risks include, but are not limited to: margin sustainability and/or volatility, high debt load (leverage/gearing), overstocking or debtor issues; rapid growth, acquisition or expansion; new business line/product expansion; management changes or succession issues; customer or supplier concentrations; and lack of transparency or industry issues. Detailed analysis of risks and their mitigating factors are also analyzed. Loan Structure The amounts and tenors of financing proposed are justified based on the projected repayment ability and loan purpose. Excessive tenor or amount relative to business needs increases the risk of fund diversion and may adversely impact the borrowers repayment ability.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Security A current valuation of collateral is obtained and the quality and priority of security being proposed are assessed. Loans are not granted based solely on security. Adequacy and the extent of the insurance coverage are assessed. Any protective covenants or conditions are also advised in this module. Name Lending Credit proposals do not unduly rely on the sponsoring principals reputation, reported independent means, or their perceived willingness to inject funds into various business enterprises in case of need. These situations are discouraged and treated with great caution. Rather, credit proposals and the granting of loans are based on sound fundamentals, supported by a tho8rough financial and risk analysis. 5.3.2.2 Risk Grading The bank has adopted a credit risk grading system. The system defines the risk profile of borrowers to ensure that account management, structure and pricing are commensurate with the risk involved. Risk grading is a key measurement of the Banks asset quality, and as such, it is essential that grading is a robust process. All facilities are assigned a risk grade. Where deterioration in risk is noted, the Risk Grade assigned to a borrower and its facilities should be immediately changed. Borrower Risk Grades are clearly stated on Credit Applications. In the CRG prescribed by the Bangladesh Bank a borrower was given scores according to the key financial ratios and management of the borrowing company. This process almost covers all the aspects of business operation related with extending credit facilities. After giving score to each point the total score is calculated. A risk rating system is there in place to rate the calculated total score. The risk rating system has eight scoring slabs. The more score any company gets the better the risk grading is. In brief the CRG rating system is given below:
Table 6: CRG Scores Band
Risk Rating Superior - Low risk Good - Satisfactory risk Acceptable - Fair Risk Marginal - Watch List Special Mention
Grade 1 2 3 4 5
Scores >95 >85 75-84 65-74 55-64 P a g e | 44
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Substandard Doubtful Bad and Loss 5.3.3 Approval Authority The authority to sanction/approve loans is clearly delegated to senior credit executives by the Managing Director/CEO & Board based on the executives knowledge and experience. The following guidelines are followed in the approval/sanctioning of loans: Credit approval authority must be delegated in writing from the MD/CEO & Board. Delegated approval authorities must be reviewed annually by MD/CEO/Board. The credit approval function should be separate from the marketing/relationship management (RM) function. The role of Credit Committee may be restricted to only review of proposals i.e. recommendations or review of banks loan portfolios. Approvals must be evidenced in writing, or by electronic signature. Approval records must be kept on file with the Credit Applications. All credit risks must be authorized by executives within the authority limit delegated to them by the MD/CEO. The pooling or combining of authority limits should not be permitted. Credit approval should be centralized within the CRM function. Regional credit centers may be established, however, all large loans must be approved by the Head of Credit and Risk Management or Managing Director/CEO/Board or delegated Head Office credit executive. The aggregate exposure to any borrower or borrowing group must be used to determine the approval authority required. Any credit proposal that does not comply with Lending Guidelines, regardless of amount, should be referred to Head Office for Approval 5.3.4 Segregation of Duties At DBL the following lending functions are segregated to comply with the Bangladesh Banks guidelines. Credit Approval/Risk Management Relationship Management/Marketing P a g e | 45 6 7 8 45-54 35-44 <35
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Credit Administration The purpose of the segregation is to improve the knowledge levels and expertise in each department, to impose controls over the disbursement of authorized loan facilities and obtain an objective and independent judgment of credit proposals. 5.3.5 Internal Audit DBL has an internal audit department which is responsible for auditing all departments. The audits are done generally in annual basis. It takes the Regulatory Compliance, Internal Procedures, Lending Guidelines and Bangladesh Bank Requirements in view. 5.3.6 Credit Monitoring At DBL a separate credit monitoring unit is working at HO level where the following is monitored and necessary follow up is done with branches: o Excess Over the Limits (EOL) o Past Due Principal or Interest o Breach of Loan Covenants Special emphasis is given on the loans with classification status, like special mention account, sub-standard, doubtful and bad and loss.
5.4 Credit Risk Management and Basel accords

Credit Risk Management is a comprehensive package for protecting the Banks from risk of failure as credit risk covers 90% of the total risk of any Bank. But, CRM does not appear to be the foolproof solution for credit risk. Numerous Banks have been bankrupted though there was a credit risk management system. As banks gives loan to the client from the depositors money, failure of bank harms the depositors directly. Though there is a credit management system is place in almost every bank of the world, there is no set standard for CRM. Credit facilities were given to customers with no ability to repay. Malpractice, fraud and other irregularities are also responsible for giving loan to defaulters. To solve this problem and to insulate the depositors from losses the concept of capital adequacy has been given birth to. Capital adequacy is defined as the minimum level of capital, which is required to protect a bank from portfolio losses. However, debate on the quantum of minimum level of capital seems to be never ending. Though different methods and approaches were adopted in P a g e | 46
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited different points in time, they were insufficient to capture new dimensions and magnitudes of risk emanated from the continuous innovations in the domestic and international business. Consequently the 1970s and 80s experienced many uncertainties and volatilities that caused serious banking problems. The approach that a banks capital should be linked to a fixed ratio of its time and demand liabilities went under strong criticism on the ground that banks major risk is derived from the riskiness of its assets. The Basel Committee, based on this idea, designed Capital Regulation in 1988, which is known as the Basel Accord I. 5.4.1 Basel I Basel I was an international accord to set minimum levels of capital for banks, building societies and other deposit taking institutions. It was designed to create a level playing field for lenders from different countries and to ensure that lenders were sufficiently well capitalized to protect depositors and the financial system. Two fundamental objectives of the Accord were (a) to strengthen the soundness and stability of the international banking system and (b) to obtain a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks. To that end, the accord requires that banks meet a minimum capital ratio that must be equal to at least 8 percent of total risk-weighted assets. Though at first only credit risk was incorporated, in 1996 market risk was also incorporated in this accord. Basel I implementation in Bangladesh started at 1996. But the implementation was only in the credit risk section. 5.4.2 Criticism of Basel I However, the Accord has been widely criticized for its failure to achieve the stated objectives. Since it introduced risk-based capital requirement, which was adopted by many developed and developing countries as well, it was expected that the Accord would help to strengthen financial system stability and reduce banking and financial crises. On the contrary, banking crises again occurred in 1990s even in some robust economies of East Asia. The Accord was also criticized for the inherent weaknesses in the model as detailed below.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Rodriguez (2002) and others argue that the use of arbitrary risk categories and arbitrary weights that bear no relation to default rates incorrectly assume that all assets within one category are equally risky. For example, a loan to a well-established company such as Beximco Pharma or Square Pharmaceuticals is considered as risky as a loan to a new company established by a new entrepreneur. Loans made to companies in the non-trading sector of the economy are considered as risky as loans made to companies in the trading sector, even though the latter are usually less risky than the former. The risk assessment methodology is flawed in the sense that it assumes a portfolios total risk is equal to the sum of the risks of the individual assets in the portfolio. No account is taken of portfolio management strategies, which can greatly reduce the overall risk of a portfolio, or of the size of a portfolio, which can greatly influence its total risk profile. The accord gives preferential treatment to government securities, which are considered riskfree. The sovereign debt defaults of Russia in the summer of 1998 and Argentina in early 2002 demonstrated that government debt is not a risk free investment. Other criticisms include that the accord sets capital standards only for credit risk (i.e., the risk of counterparty failure), but not for other types of risk such as operational risk and market risk. Consequently, capital requirement was not reflective of economic risk. It has not provided enough incentive for risk management, risk mitigation and innovation in risk management such as arbitrage opportunities through securitization. When the Accord was formalized, no consensus and consultation were taken from the representatives of the developing nations. Therefore, it is sometimes criticized as OECD Club-rule. McDonough (2000) argues that as banks have developed innovative techniques for managing and mitigating risk, credit risk now exists in more complicated, less conventional forms than is recognized by the 1988 Accord, thus rendering capital ratios, as presently calculated, less useful to banking supervisors. The financial world has changed dramatically over the past dozen years, to the point that the Accord efficacy has eroded considerably (McDonough, 2000). 5.4.3 The Entrance of Basel II The Basel Committee tried to address some of these criticisms over the years, modifying the Accord throughout the years from 1990s to 2004 and Basel Accord II (included representatives from G10 and non-G10 countries) is the result of such efforts. The primary P a g e | 48
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited objective of the New Accord is to make it more risk-sensitive so that financial institutions will be able to sustain even in periods of financial crisis. Consequently, the new proposal moves ahead of the one-size-fit-all approach. Another objective of the Accord is to continue to enhance competitive equality among the internationally active banks throughout the world. The Accord has provided many areas of national discretions, which require an extensive study to guide policy actions in appropriate directions. This study has made an attempt to analyze the prevailing status and conditions of the banking sector in line with Basel II requirements. In order to deepen and widen understanding in a specific area, this study has mainly concentrated on the compliance aspects of Pillar I. In fact, this study has further narrowed down its scope to focus on different approaches for the measurement of capital charge against credit risk. The next chapter will describe the Basel II framework.
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CHAPTER 6
FRAMEWORK OF BASEL 2 AND ITS IMPLEMENTATION IN BANGLADESH
6.0
Basel II Framework and its Implementation in Bangladesh
The Basel II has defined a structured framework comprising three pillars such as Pillar I, II and III. Pillar I sets out minimum capital requirements. Pillar II defines the process of supervisory review of a financial institutions risk management framework. Pillar III determines market discipline through improved disclosure. In this chapter, these three pillars are discussed as follows:
6.1 The Three Pillars

Basel II capital accord is known for its three mutually reinforcing pillars, which are minimum capital requirement, supervisory review process and market discipline. In figure 9, the approaches for calculation of capital for pillar 1 are stated. In this section, these three pillars and the approaches for calculation of capital will be discussed. Pillar 1 of Basel II is somehow present in the previous capital accord Basel I but Pillar 2 and Pillar 3 are novelty. In the Pillar 1 it has identified three risks whereas in the previous accord there were two risks. Operational Risk was introduced for the first time in Basel II.
Figure 9: The Basel II Framework
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 6.1.1 Pillar 1-Minimum Capital Requirements In Pillar I, three kinds of risk such as credit risk, market risk and operational risk are considered to determine the minimum capital requirement. The definition of eligible regulatory capital remains the same as outlined in the 1988 Accord i.e., the ratio of capital to risk-weighted asset remains unchanged at 8%. This pillar is a quantitative one. As this report is about the credit risk, the approaches to calculate the capital requirement will be discussed in brief. 6.1.2 Pillar 2-Supervisory Review Process Pillar II ensures that not only do banks have adequate capital to cover their risks, but also that they employ better risk management practices so as to minimize the risks. Supervisors will be expected to evaluate the board and management of banks, to look into strategic decisions and to evaluate portfolio diversification as well as the ability to react to future risks in a rapidly changing environment. In particular, issues of transparency, corporate governance and efficient markets can be considered as additional challenges in pillar II enforcement. 6.1.3 Pillar 3-Market Forces Banking operations are becoming complex and difficult for supervisors to monitor and control. In this context, Basel Committee has recognized the importance of market discipline and has suggested implementing it by asking banks to make adequate disclosures. The potential audiences of these disclosures are supervisors, bank's customers, rating agencies, depositors and investors. With frequent and material disclosures, outsiders can learn about the bank's risks. 6.2 Approaches for Calculation of Capital Requirements for Credit Risk Basel II has provided a choice between two broad methodologies to calculate minimum capital requirement for credit risk: (a) standardized approach and (b) internal rating-based approach. 6.2.1 Standardized Approach (SA) Under standardized approach, credit assessment will be conducted by external credit assessment institutions (ECAI) as eligible for capital purposes by the national supervisors. Risk-weight against each rating will be applied to individual credit exposure to arrive at riskP a g e | 52
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited weighted asset. Before allowing ECAIs such as the rating agencies, national supervisor will have to ensure that they fulfill the following standards set by Basel Committee (2004): The methodology for assigning credit assessments must be rigorous, systematic and subject to some form of validation based on historical experience. Before being recognized by supervisors, an assessment methodology for each market segment, including rigorous back testing, must have been established for at least one year and preferably three years. An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. The assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest. The individual assessments should be available to both domestic and foreign institutions with legitimate interests and at equal terms. In addition, the general methodology used by the ECAI should be publicly available. An ECAI should disclose the information on its assessment methodologies, including the definition of default, the time horizon and the meaning of each rating, the actual default rates experienced in each assessment category, and the transitions of the assessments i.e., the likelihood of AA ratings becoming A over time. An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments. In addition, supervisors will be responsible for assigning eligible ECAIs assessments to the risk weights available under the standardized risk weighting framework, i.e., deciding which assessment categories correspond to which risk weights. 6.2.2 Internal Rating Based Approach (IRB) In the IRB approach, the four risk parameters that need to be estimated are PD (i.e., probability of default of borrower in each risk grade over a one year time horizon), LGD (i.e., loss in the event of a default), EAD (i.e., exposure amount at the time of default) and Maturity (i.e., remaining effective maturity of the exposure at default). The Accord has provided two types of IRB approach: (a) Foundation IRB Approach and (b) Advanced IRB Approach. P a g e | 53
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 6.2.2.1 Foundation IRB Approach Under the Foundation IRB approach banks provide their own estimates of PD and rely on supervisory estimates for other risk components such as LGD, EAD and M. Under the advanced approach, banks provide more of their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting the minimum standards. For both the foundation and advanced approaches, banks must always use the risk-weight functions provided in the New Accord for the purpose of deriving capital requirements. Estimation of the parameters The critical issues that both supervisor and the banks will face in implementing IRB approach are: Historical data to estimate PD Historical loss database to estimate LGD Historical exposure data to estimate EAD Various types and characteristics of data are necessary to estimate each of these parameters. Some of them are discussed below from Artigass (2004) famous article A Review of Credit Registers and their Use for Basel II. Historical data to estimate PD In order to calculate each banks minimum capital requirements under Basel II, banks need to have ready access to an essential information set. As regards, PD estimation, the development of an overall borrower rating system requires default information. In addition, the development of an appropriate rating system would require information on certain loan characteristics that could be used, either directly or through transformation (data refinement), to construct variables that are sufficient for determining each borrowers credit quality or, in other words, its probability of default. Among other items, desirable information would be on guarantees, duration of borrowers existence in the system, default history of each borrower (number of times that they have defaulted previously, or proportion of defaults in terms of how long they have been in the system), history of an obligors rating migrations (upgrades or downgrades), number and type of banks with which obligors deal, past due debt without reaching default status (delinquency status), industry to which obligors belong, type of credit instrument and maturity date. Others P a g e | 54
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited financial variables such as leverage ratios, debt burden, efficiency, productivity and profitability in the case of firms, and employment status and indebtedness profile in the case of individuals, along with the stage of the business cycle of the economy, could form the core group of variables needed to estimate a rating system. As per Basel standard, estimation of PD needs to be based on 5 years historical data. Historical loss database to estimate LGD In the case of LGD, certain readily identified characteristics would be needed to estimate its determinants empirically via a regression model. Calculating LGD properly requires knowledge of type of collateral, percentage of collateral coverage, credit operations interest rate, age of operation (time elapsed since loan origination), industry; loan size, loan maturity date, the amount finally recovered, the time taken to recover it, all the costs incurred in the process (from legal costs to the opportunity cost of money), all possible intermediate recoveries and the discount rate to be applied. Since the Accord leaves open the option of making use of external data, LGD can be estimated using market data such as market prices of defaulted loans or bonds. The above information along with other qualitative variables furnished by the departments entrusted with recovery management could also be used for LGD validation. It can be noted that for validation of the LGD the required information structure basically depends on characteristics of the credit operations themselves whereas for PD validation the required data mostly refer to intrinsic characteristics of borrowers. Historical exposure data to estimate EAD Regarding EAD validation, information on drawn and un-drawn exposures, particularly in the period of time prior to a default event, is necessary. An analysis of how borrowers make use of their commitments (particularly the unknown part) over time would be a good first approximation for validating EAD. Other items such as the number of banks with which a borrower deals, past default history, size of the loan, industry and guarantees appear to be items, which, in principle, may seem to explain EAD. Moreover, an assessment based on qualitative elements could also be a reasonable validation solution. It is argued that data quality is an important factor that could affect the quality of risk measures generated by the model. Incomplete, imprecise and archaic data may rather increase the risk and the losses faced by banks.
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6.3 Role of ECIA in Standardized Approach

It is argued that in many countries, low rating penetration and a lack of domestic rating agencies may pose a challenge for implementation of the standardized approach, particularly in respect of corporate claims. This is not untrue for Bangladesh where the rating industry is not advanced enough and the majority of the individual claims of bank loans remain unrated. Currently two rating agencies, namely CRISL and CRAB, are operative in the financial market. Since banks in Bangladesh are linked with tens of thousands of borrowers, the capability of these two rating agencies in terms of credit assessment of those borrowers within the regulatory timeframe may not be sufficient. Cost of credit assessment will be substantially increased due to high regulatory demand for this service. This, in turn, will increase lending price and affect banks profitability. The Accord requires that the assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest. However, the existing Credit Companies Rules that was enacted in 1996 to regulate the business of credit rating agencies has not considered this issue in line with Basels new standard. It is understood that directors of the existing rating agencies are directors of the scheduled banks as well as directors of other public and private companies. This type of conflict of interest may cause for rating-biases and need to be addressed urgently through legal changes before adopting the standardized approach. High default culture in the financial market of Bangladesh indicates that existing weak regulatory framework for rating agencies may influence borrowers behavior to obtain good rating inappropriately. Therefore rating regulations need to be updated to address such potential problems. Effects of It can be noted that credit risk modeling, back-testing and forecasting require high level knowledge of probability statistics, financial econometrics and times series analysis. It is yet to be ascertained whether the existing rating agencies have sufficient qualified human resources who can perform those activities in a professionally competent manner. Since rating greatly depends on long historical data, given that the industry is of recent origin, it can be assumed that they may not have sufficient database to validate their models.
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6.4 Constituents of Capital

Existing regulation requires all scheduled banks to maintain minimum paid up capital and reserve fund of 8 percent risk-weighted asset. But from July 2010, Banks have to keep 9% of their risk-weighted asset. Banks can maintain their capital in the following constituents listed in Table 7.
Table 7: Constituents of Capital
Core Capital (Tier 1) A. Paid-up Capital B. Non-repayable Share premium account C. Statutory Reserve D. General Reserve E. Retained Earnings F. Minority Interest in Subsidiaries G. Non-Cumulative Irredeemable Preference Share H. Dividend Equalization Account
Supplementary Capital (Tier II) A. General Provision (1-5 percent of unclassified Loans) B. Asset Revaluation Reserve C. All other Preference Shares D. Perpetual Subordinated Debt E. Exchange Equalization Account
6.5 Credit Risk Mitigation

The credit, construed both as funded and non-funded commitments of banks, involves probability of loss in the event of non-fulfillment of corresponding financial obligations by the borrower or guarantor. Therefore, traditionally the banks and FIs seek to be covered by appropriate tangible and realizable securities or by third party guarantees to avert or at least minimize the loss in the event of the default by borrower or guarantor. A Credit Risk Mitigation tool, commonly referred to as security, is universally recognized as a protection for the lenders although the same is often christened as collateral also. The personal covenants supported by the execution of promissory notes/ agreements are then treated as primarycover in the limited scope of a security cover. In Bangladeshi context, however, there is a subtle difference between primary and collateral security. A primary security is one on which the drawing power/loan availment is allowed while a collateral security, though not considered for such purposes, provides the same degree of comfort/rights for the lenders for ultimate recovery of the dues. It is fairly common in credit market that lenders insist for collaterals (e.g. mortgage of personal landed P a g e | 57
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited property/other assets of the counter party) for extending large volumes of credit. This is done to ensure an additional cushion on the top of primary security reckoned for drawing power/loan availment computation. But the credit risk mitigation and security cover (primary/collateral) may not be treated as the same if followed the prescriptions of Basel Accord II. In conventional sense, all kinds of assets are recognized as eligible collateral whereas in Basel II only some specific items of assets are recognized as eligible collateral. Credit Risk mitigation covers securities such as cash, gold, debt securities issued by sovereigns rated category, etc.(Stocks in trade, book debts, fixed assets, etc. are not recognized as credit mitigation items) In conventional way, Third party guarantee (i.e other than personal repayment undertaking of the borrower) even by the government of the country, high net worth individuals, is not strictly treated as security although such third party guarantee may be quite valuable for the lender. But in Basel II, Third party guarantee is treated as a credit mitigation tool subject to fulfilling certain operational conditions such as unconditional guarantee, explicit documentation, etc. Credit risk mitigation guidelines under Basel II provide that the lender will be required to subdivide the exposures between third party guarantee and other recognized risk mitigation items whereas in conventional way there is no regulatory guideline. 6.5.1 Application of Credit Risk Mitigation in Basel II CRM is applicable both for funded and non-funded exposure. Only banking book exposures (exposures held for regular bank business i.e. not applicable for trading, for sale, etc.) are considered for CRM. In addition, where issue specific rating reflects CRM, no additional supervisory recognition of CRM will be granted to avoid double counting effects. Collateral as a CRM tool may be posted by a third party besides recognizing collateral of the counter party (borrower). Collateral must be charged to the bank for the life of the exposure, it must be marked to market and revalued at least once in six months. Appropriate haircuts as may be specified by the regulatory authorities of each country are to be considered in CRM tool. Financing banks must have clear and robust procedures for the timely liquidation of collateral. Exposures covered by collateral would have risk weights as applicable for the P a g e | 58
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited respective collateral subject to a minimum of 20 per cent (for cash, however, nil per cent). Third party guarantees would be recognized for CRM, provided the guarantees meet the relevant laid down conditions and the regulatory authorities are satisfied in this regard. 6.5.2 Eligible Collaterals for CRM Purpose Basel II has viewed collaterals eligible for CRM from two perspectives: 1. Financial Collateral 2. NonFinancial collateral It is apparent that financial collaterals imply cash or near cash collaterals such as fixed deposit in a bank, highly rated marketable securities, etc. Any other approved collateral like gold will be treated as nonfinancial collateral. Cash, Certificate of Deposit (fixed deposit, short deposit, etc.) issued by the lending bank (hence by implication such deposits held with the other banks even when lien is offered will not be treated as eligible). So, this has huge implication in credit risk management in Dhaka Bank Limited. The effect of such rule will push banks like DBL to not giving any loans against security of other bank.
6.6 Basel II in Bangladesh

On December 30, 2007 Bangladesh Bank issued BRPD Circular no. 14 to all scheduled banks in Bangladesh which depicted the action plan regarding implementation of Basel-II as follow: Basel II started its implementation from January 2009. In this regard a quantitative impact study (QIS) to assess the preparedness for implementing Basel II as well as the banks view on the optional approaches for calculating Minimum Capital Requirement (MCR) as stated in Basel II was carried out in April-May 2007. Study & subsequent discussion with few related banks reveal that bankers should be more acquainted with the New Capital Accord (Basel-II). To address this challenge capacity building of concerned implementing & supervisory officials should be given first priority in the Action Plan/Roadmap. Basel II may be implemented with the following specific approaches as initial steps: a) Standardized Approach for calculating Risk Weighted Amount (RWA) against Credit Risk supported by External Credit Assessment Institutions (ECAIs) b) Standardized Rule Based Approach against Market Risk and c) Basic Indicator Approach for Operational Risk. P a g e | 59
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 6.6.1 Action Plan Accordingly, Action Plan/ Roadmap for implementing Basel II in Bangladesh may be proposed as stated below:
Table 8: Basel II Implementation Action Plan
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6.6.2 Basel II implementation status in Dhaka Bank Dhaka Bank considers implementation of Risk Based Capital Adequacy for Banks is one of its topmost priorities. Accordingly Dhaka Bank has established a Basel II Implementation P a g e | 62
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Unit (BIU) in the 1st quarter of year 2007 for effective implementation of the capital accord ensuring Board and Senior Management oversight. The BIU is exclusively assigned with the task of reviewing the nature and level of risks relating to banking assets and planning for adequate capital framework. The BIU members meet on regular basis, at least monthly to monitor implementation status of Risk Based Capital Adequacy of Banks and also those issues which directly affect capital requirement. In a view to make the BIU more functional Dhaka Bank has formed Basel II coreTeam headed by Deputy Managing Director (Business Banking). Dhaka Bank has been successful to meet all the deadlines so far as prescribed by Bangladesh Bank with quality deliverables like quarterly Minimum Capital Reporting, Position Paper etc. The Bank has nominated Credit Rating Information and Services Ltd. (CRISL) and Credit Rating Agency of Bangladesh (CRAB). As per BB directive, Banks must maintain 8% CAR upto June 2010. From July 2010, they have to maintain CAR of 9% and from July 2011 the CAR level will reach to 10%.
6.7 Problems Facing During Implementation

Though Basel II implementation is started in Bangladesh, there are some challenges and problems in the way, some of them are present and some are potential. These are discussed below: One of the present problems is the Standardized Approach and External Credit Rating organizations. Standardized approach makes use of external credit ratings for attaching risk weights. One of the major problems is the availability of credit ratings in Bangladesh, though it has two Credit Rating agencies (Credit Rating Information and Services Limited and Credit Rating Agency of Bangladesh Ltd.), the penetration of credit ratings is not deep. The supplydemand imbalance would make it even more difficult for smaller players to get ratings. High prices are making credit more costly for them. Though standardized approach is being followed for credit risk for the time being, after some time all the banks have to switch to the Internal Rating Based Approach which is much superior to the standardized one. But, it will be very difficult to implement IRB in Bangladesh. A major problem of IRB implementation is data availability. In Bangladesh, State-owned banks are still in the process of computerization. The extent of historical data P a g e | 63
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited required to formulate and then convincingly test. The IRB based approach being one of the more stringent approaches is the more ideal of the two to strengthen the financial system. The actual implementation of an IRB based model for credit risk mitigation would require excellent information retrieval and assessment capabilities. A high-end IT Infrastructure with Risk Management Software collating real-time information is needed. This preparedness is not there in a majority of banks in Bangladesh. Hurrying into an IRB based approach could cost banks dearly because of the involvement of high capital expenditure. Inaccurate IRB models could defeat the very purpose of better risk mitigation. The Basel II definition of a banking company is very broad and includes banking subsidiaries such as insurance companies. In Bangladesh, there is no single regulator to govern the whole bank as per Basel II. In Bangladesh, Securities Exchange Commission, Bangladesh Bank, National Board of Revenue, Dhaka Stock Exchange and Ministry of Finance would regulate different aspects of Basel II. The consolidated balance sheet of the bank has to conform to Capital adequacy regulations. In Bangladesh, Regulatory capital norms do not apply to Insurance companies. The Pillar II implementation is the more difficult portion of the three pillars. Risk Audits in banks are still in their nascent stages in Bangladesh. The availability of trained risk auditors is another problem. Basel II calls for a Risk Management structure in banks with Risk Management committees for Credit, Market and operational Risk formulating the Risk Management standards. While banks in Bangladesh are implementing this, it has remained a ceremonial process without the training at the grass root level to see every activity with the lens of risk. Pillar 3 is not a very useful discipline device in countries with small private markets or few incentives for creditors to monitor banks (e.g. due to presence of implicit public guarantees). In addition, the Pillar 3 might be inapplicable in those countries whose systems are dominated by foreign banks, since the latter will likely have entered by purchasing and delisting the domestic institution. Since those banks are not obliged to publicly disclose information for their operations in such jurisdictions (unless requested by the domestic authorities), there is little market transparency or discipline. Another big problem in the way of Basel II implementation is unavailability of required risk data in easily accessible or comprehensive format. Historical loss data is required to calculate the main IRB risk parameters; that data are frequently incomplete/ unavailable (i.e. not required to be collected in the past) or prohibitively expensive to collect (i.e. not in electronic P a g e | 64
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited format). Particularly for the development of rating systems and LGD parameters, individual banks may not have a meaningful loss dataset to enable them to build the required models and back-test their performance. In such an environment, it is essential to tackle the root causes of this problem (e.g. legal or cultural factors impeding loss data collection and sharing) prior to proceeding with Basel II adoption. These are some problems that need to be taken care of with the implementation of Basel II. Unless these problems are overcome, full implementation of Basel II would not be possible.
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CHAPTER 7
CAPITAL REQUIREMENT FOR CREDIT RISK UNDER BASEL II FOR DBL
7.0
Capital requirement for Credit Risk under Basel-II in DBL
The first pillar of Basel-II states about minimum capital requirement for three kinds of risk viz. credit risk, market risk and operational risk. In this report only capital requirement for credit risk has been covered thoroughly and it also gives the main calculation of capital for other two risks. In the following sections capital has been calculated according to the guideline provided by Bangladesh Bank. The capital ratio is calculated using the definition of regulatory capital and risk-weighted assets. Until, June 2010, the total capital ratio must be no lower than 8%, whereas from July 2010 the ratio must be no lower than 9%. Total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figures to the sum of risk-weighted assets for credit risk.
7.1 The constituent of capital

7.1.1 Core capital (basic equity or Tier 1) The Basel Committee considers that the key element of capital on which the main emphasis should be placed is equity capital and disclosed reserves. This key element of capital is the only element common to all countries' banking systems; it is wholly visible in the published accounts and is the basis on which most market judgments of capital adequacy are made; and it has a crucial bearing on profit margins and a bank's ability to compete. This emphasis on equity capital and disclosed reserves reflects the importance the Committee attaches to securing an appropriate quality, and the level, of the total capital resources maintained by major banks. Notwithstanding this emphasis, the member countries of the Committee also consider that there are a number of other important and legitimate constituents of a bank's capital base which may be included within the system of measurement. The Committee has therefore concluded that capital, for supervisory purposes, should be defined in two tiers in a way which will have the effect of requiring at least 50% of a bank's capital base to consist of a core element comprised of equity capital and published reserves from post-tax retained earnings (Tier 1). The other elements of capital (supplementary capital) will be admitted into Tier 2 limited to 100% of Tier 1. P a g e | 67

Table 9: Core Capital calculation of Dhaka Bank Limited
Tier 1 (Core Capital) of Dhaka Bank Ltd (as on 31.03.2010) 1.1 Paid-up Capital 1.2 Non-repayable Share Premium Account 1.3 Statutory Reserve 1.4 General Reserves 1.5 Retained Earnings 1.6 Minority Interest in Subsidiaries 1.7 Non-cumulative irredeemable Preference Shares 1.8 Dividend Equalisation Account 1.9 Sub-Total (1.1 to 1.8) Deductions: 1.1 Book value of Goodwill 1.11 Shortfall in provisions required against classified assets irrespective of any relaxation allowed. 1.12 Deficit on account of revaluation of investments held in AFS category 1.13 Any increase in equity capital resulting from a securitization transaction 1.15 Other deductions (50% of the amount as calculated on CAP 2) 1.16 Sub-Total (1.10 to 1.15) 1.17 Total eligible Tier 1 capital (1.9-1.16) 7.1.2 Supplementary Capital (Tier 2) Undisclosed reserves
BDT (in crores)
265.96 197.03 0.38 32.18 495.55 495.55
Unpublished or hidden reserves may be constituted in various ways according to differing legal and accounting regimes in member countries. Under this heading are included only reserves which, though unpublished, have been passed through the profit and loss account and which are accepted by the bank's supervisory authorities. They may be inherently of the same intrinsic quality as published retained earnings, but, in the context of an internationally agreed minimum standard, their lack of transparency, together with the fact that many countries do not recognize undisclosed reserves, either as an accepted accounting concept or as a legitimate element of capital, argue for excluding them from the core equity capital element. 2. Revaluation reserves Some countries, under their national regulatory or accounting arrangements, allow certain assets to be revalued to reflect their current value, or something closer to their current value
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited than historic cost, and the resultant revaluation reserves to be included in the capital base. Such revaluations can arise in two ways: (a) from a formal revaluation, carried through to the balance sheets of banks' own premises; or (b) from a notional addition to capital of hidden values which arise from the practice of holding securities in the balance sheet valued at historic costs. Such reserves may be included within supplementary capital provided that the assets are considered by the supervisory authority to be prudently valued, fully reflecting the possibility of price fluctuations and forced sale. General provisions/general loan-loss reserves General provisions or general loan-loss reserves are created against the possibility of losses not yet identified. Where they do not reflect a known deterioration in the valuation of particular assets, these reserves qualify for inclusion in Tier 2 capital. Where, however, provisions or reserves have been created against identified losses or in respect of an identified deterioration in the value of any asset or group of subsets of assets, they are not freely available to meet unidentified losses which may subsequently arise elsewhere in the portfolio and do not possess an essential characteristic of capital. Such provisions or reserves should therefore not be included in the capital base. The supervisory authorities represented on the Committee undertake to ensure that the supervisory process takes due account of any identified deterioration in value. They will also ensure that general provisions or general loan-loss reserves will only be included in capital if they are not intended to deal with the deterioration of particular assets, whether individual or grouped. This would mean that all elements in general provisions or general loan-loss reserves designed to protect a bank from identified deterioration in the quality of specific assets (whether foreign or domestic) should be ineligible for inclusion in capital. In particular, elements that reflect identified deterioration in assets subject to country risk, in real estate lending and in other problem sectors would be excluded from capital. General provisions/general loan-loss reserves that qualify for inclusion in Tier 2 under the terms described above do so subject to a limit of 1.25 percentage points of weighted risk assets to the extent a bank uses the Standardized Approach for credit risk. P a g e | 69
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Hybrid debt capital instruments In this category fall a number of capital instruments which combine certain characteristics of equity and certain characteristics of debt. Each of these has particular features which can be considered to affect its quality as capital. It has been agreed that, where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in supplementary capital. In addition to perpetual preference shares carrying a cumulative fixed charge, the following instruments, for example, may qualify for inclusion: long-term preferred shares in Canada, titres participatifs and titres subordonns dure indtermine in France, Genussscheine in Germany, perpetual debt instruments in the United Kingdom and mandatory convertible debt instruments in the United States. Subordinated term debt The Committee is agreed that subordinated term debt instruments have significant deficiencies as constituents of capital in view of their fixed maturity and inability to absorb losses except in liquidation. These deficiencies justify an additional restriction on the amount of such debt capital which is eligible for inclusion within the capital base. Consequently, it has been concluded that subordinated term debt instruments with a minimum original term to maturity of over five years may be included within the supplementary elements of capital, but only to a maximum of 50% of the core capital element and subject to adequate amortization arrangements.
Table 10: Tier-2 Capital Calculation of Dhaka Bank Limited as on 31.03.2010
Tier 2 Capital of Dhaka Bank Ltd 2.1 General Provisions (Unclassified loans + off balance seet exposure) 2.2 Asset Revaluation Reserves up to 50% 2.3 All other preference shares 2.4 Up to 50% of Revaluation Reserves for securities 2.5 Perpetual subordinated debt up to max 30% 2.6 Balance of Exchange Equalization A/C 2.7 Total tier 2 Capital (2.1 to 2.5) Deductions:
2.8 2.9
(Taka in crores) 84.13 -
12.52 0.12 96.77
Other deductions (50% of the amount as calculated on CAP 2)
96.77
Total Deductions 2.10 Total eligible Tier 2 Capital (2.6-2.8)
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 7.1.3 Short-term subordinated debt covering market risk (Tier 3) The principal form of eligible capital to cover market risks consists of shareholders equity and retained earnings (Tier 1 capital) and supplementary capital (Tier 2 capital) as defined above. But banks may also, at the discretion of their national authority, employ a third tier of capital (Tier 3), consisting of short-term subordinated debt as defined in below for the sole purpose of meeting a proportion of the capital requirements for market risks, subject to the following conditions: Banks will be entitled to use Tier 3 capital solely to support market risks. Tier 3 capital will be limited to 250% of a banks Tier 1 capital that is required to support market risks. Tier 2 capital may not exceed total Tier 1 capital, and long-term subordinated debt may not exceed 50% of Tier 1 capital The sum total of Tier 2 plus Tier 3 capital should not exceed total Tier 1.
However, the Committee has decided that any decision whether or not to apply such a rule should be a matter for national discretion. Some member countries may keep the constraint, except in cases where banking activities are proportionately very small. Additionally, national authorities will have discretion to refuse the use of short-term subordinated debt for individual banks or for their banking systems generally. For short-term subordinated debt to be eligible as Tier 3 capital, it needs, if circumstances demand, to be capable of becoming part of a banks permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum: be unsecured, subordinated and fully paid up have an original maturity of at least two years not be repayable before the agreed repayment date unless the supervisory authority agrees be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 7.1.4 Deductions from capital It has been concluded that the following deductions should be made from the capital base for the purpose of calculating the risk-weighted capital ratio. The deductions will consist of: (i) Goodwill, as a deduction from Tier 1 capital elements; (ii) Increase in equity capital resulting from a securitization exposure, as a deduction from Tier 1 capital elements; (iii) Investments in subsidiaries engaged in banking and financial activities which are not consolidated in national systems. The normal practice will be to consolidate subsidiaries for the purpose of assessing the capital adequacy of banking groups. The Committee carefully considered the possibility of requiring deduction of banks' holdings of capital issued by other banks or deposit-taking institutions, whether in the form of equity or of other capital instruments. The Committee is very conscious that such double-gearing (or "double-leveraging") can have systemic dangers for the banking system by making it more vulnerable to the rapid transmission of problems from one institution to another and some members consider these dangers justify a policy of full deduction of such holdings.
7.2 Credit Risk The Standardized Approach:

For credit risk management under Basel II the standardized approach is used in DBL as per the directives of Bangladesh Bank. Though this approach is not very highly acclaimed among the experts all over the world, it is simple and easy to implement. For developing countries like Bangladesh, slow implementation of Internal Rating Based approach will be justified one as there is lack of trained and knowledgeable person regarding this approach in Bangladesh. 7.2.1 Claims on sovereigns Claims on sovereigns and their central banks will be risk weighted as follows: Credit Assessment Risk Weight AAA to AA0% 20% A+ to ABBB+ to BBB50% 100% 150% 100% BB+ to BBelow BUnrated
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited DBL has no claims on sovereigns so risk weighted asset in this category in zero. 7.2.2 Claims on non-central government public sector entities (PSEs) Claims on domestic PSEs will be risk-weighted at national discretion, according to either option 1 or option 2 for claims on banks. When option 2 is selected, it is to be applied without the use of the preferential treatment for short-term claims. Subject to national discretion, claims on certain domestic PSEs may also be treated as claims on the sovereigns in whose jurisdictions the PSEs are established.23 Where this discretion is exercised, other national supervisors may allow their banks to risk weight claims on such PSEs in the same manner. DBL also does not have any exposure on 31st march, 2010 in this category. 7.2.3 Claims on multilateral development banks (MDBs) The risk weights applied to claims on MDBs will generally be based on external credit assessments as set out under option 2 for claims on banks but without the possibility of using the preferential treatment for short-term claims. A 0% risk weight will be applied to claims on highly rated MDBs that fulfill to the Committees satisfaction the criteria provided below. The Committee will continue to evaluate eligibility on a case-by-case basis. The eligibility criteria for MDBs risk weighted at 0% are: very high quality long-term issuer ratings, i.e. a majority of an MDBs external assessments must be AAA; shareholder structure is comprised of a significant proportion of sovereigns with longterm issuer credit assessments of AA- or better, or the majority of the MDBs fundraising are in the form of paid-in equity/capital and there is little or no leverage; strong shareholder support demonstrated by the amount of paid-in capital contributed by the shareholders; the amount of further capital the MDBs have the right to call, if required, to repay their liabilities; and continued capital contributions and new pledges from sovereign shareholders; adequate level of capital and liquidity (a case-by-case approach is necessary in order to assess whether each MDBs capital and liquidity are adequate); and, P a g e | 73
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited strict statutory lending requirements and conservative financial policies, which would include among other conditions a structured approval process, internal
creditworthiness and risk concentration limits (per country, sector, and individual exposure and credit category), large exposures approval by the board or a committee of the board, fixed repayment schedules, effective monitoring of use of proceeds, status review process, and rigorous assessment of risk and provisioning to loan loss reserve. 7.3.4 Claims on banks There are two options for claims on banks. National supervisors will apply one option to all banks in their jurisdiction. No claim on an unrated bank may receive a risk weight lower than that applied to claims on its sovereign of incorporation. Under the first option, all banks incorporated in a given country will be assigned a risk weight one category less favorable than that assigned to claims on the sovereign of that country. However, for claims on banks in countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk weight will be capped at 100%. The second option bases the risk weighting on the external credit assessment of the bank itself with claims on unrated banks being risk-weighted at 50%. Under this option, a preferential risk weight that is one category more favorable may be applied to claims with an original maturity of three months or less, subject to a floor of 20%. This treatment will be available to both rated and unrated banks, but not to banks risk weighted at 150%. DBL has chosen the first option and After calculation, RWA for claims on Banks & NBFI stands at 309.66 crore whereas total exposure is 754.25 crore. Credit assessment of Sovereign AAA to AAA+ to BBB+ Ato BBBRisk weight under 20% 50% 100% BB+ to B100% 150% 100% Below BUnrated
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 7.3.5 Claims on securities firms Claims on securities firms may be treated as claims on banks provided these firms are subject to supervisory and regulatory arrangements comparable to those under this Framework (including, in particular, risk-based capital requirements). Otherwise such claims would follow the rules for claims on corporate. DBL has no exposure in this category on last quarter of the year. 7.3.6 Claims on corporate The table provided below illustrates the risk weighting of rated corporate claims, including claims on insurance companies. The standard risk weight for unrated claims on corporate will be 100%. No claim on an unrated corporate may be given a risk weight preferential to that assigned to its sovereign of incorporation. Credit assessment AARisk weight 20% 50% 100% AAA to A+ to ABBB+ BBBB150% 125% to Below Unrated
As most of the companies of Bangladesh are not rated, the risk weighted asset for exposure on corporate loan will be much higher as the risk weight is more than 100%. If looked at the calculation then the real picture will come out. DBLs total exposure to corporate loan on 31.03.2010 stands at 3001.87 crore but as the most of the clients are unrated, RWA has gone up to 3738.07 crore which is almost 25% higher. Since, DBLs maximum loan exposure is in this category, it is suffering heavily for unrated clients as it has to keep more capital according to Basel II requirement. 7.3.7 Claims included in the regulatory retail portfolios Claims that qualify under the criteria listed below may be considered as retail claims for regulatory capital purposes and included in a regulatory retail portfolio. Exposures included in such a portfolio may be risk-weighted at 75%, except as provided for past due loans. To be included in the regulatory retail portfolio, claims must meet the following four criteria:
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Orientation criterion: The exposure is to an individual person or persons or to a small business; Product criterion: The exposure takes the form of any of the following: revolving credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. installment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities and commitments. Securities (such as bonds and equities), whether listed or not, are specifically excluded from this category. Mortgage loans are excluded to the extent that they qualify for treatment as claims secured by residential property. Granularity criterion: The supervisor must be satisfied that the regulatory retail portfolio is sufficiently diversified to a degree that reduces the risks in the portfolio, warranting the 75% risk weight. One way of achieving this may be to set a numerical limit that no aggregate exposure to one counterpart can exceed 0.2% of the overall regulatory retail portfolio. Low value of individual exposures: The maximum aggregated retail exposure to one counterpart cannot exceed an absolute threshold of 1 million. In this category, DBL has exposure of Tk. 687.57 crore and RWA is calculated as Tk. 515.68. 7.3.8 Claims secured by residential property Lending fully secured by mortgages on residential property that is or will be occupied by the borrower, or that is rented, will be risk weighted at 50%. In applying the 50% weight, the supervisory authorities should satisfy themselves, according to their national arrangements for the provision of housing finance, that this concessionary weight is applied restrictively for residential purposes and in accordance with strict prudential criteria, such as the existence of substantial margin of additional security over the amount of the loan based on strict valuation rules. Supervisors should increase the standard risk weight where they judge the criteria are not met. As on 31.03.2010, RWA for the above category stands at 44.97 crore whereas the total exposure is 89.94 (Appendix).
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 7.3.9 Claims secured by commercial real estate In view of the experience in numerous countries that commercial property lending has been a recurring cause of troubled assets in the banking industry over the past few decades, the Committee holds to the view that mortgages on commercial real estate do not, in principle, justify other than a 100% weighting of the loans secured. As on 31.03.2010, RWA for the above category stands at 42.52 crores. 7.3.10 Past due loans The unsecured portion of any loan (other than a qualifying residential mortgage loan) that is past due for more than 90 days, net of specific provisions (including partial writeoffs), will be risk-weighted as follows: 150% risk weight when specific provisions are less than 20% of the outstanding amount of the loan. RWA for this category on 31.03.2010 is 395.78 crore whereas the total exposure is Tk. 263.85 crores. 100% risk weight when specific provisions are no less than 20% of the outstanding amount of the loan. RWA for this category on 31.03.2010 is 73.29 crore. 100% risk weight when specific provisions are no less than 50% of the outstanding amount of the loan, but with supervisory discretion to reduce the risk weight to 50%. As per Bangladesh Bank directive, the risk weight is now 50%. RWA for this category on 31.03.2010 is 17.82 crore whereas the total exposure is Tk. 35.64 crores. For the purpose of defining the secured portion of the past due loan, eligible collateral and guarantees will be the same as for credit risk mitigation. Past due retail loans are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion. In the case of qualifying residential mortgage loans, when such loans are past due for more than 90 days they will be risk weighted at 100%, net of specific provisions. If such loans are past due but specific provisions are no less than 20% of their outstanding amount, the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 7.3.11 Off-balance sheet items: Off-balance-sheet items under the standardized approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF). Counterparty risk weightings for OTC derivative transactions will not be subject to any specific ceiling. Commitments with an original maturity up to one year and commitments with an original maturity over one year will receive a CCF of 20% and 50%, respectively. However, any commitments that are unconditionally cancelable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrowers creditworthiness, will receive a 0% CCF. Direct credit substitutes, e.g. general guarantees of indebtedness (including standby letters of credit serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptances) will receive a CCF of 100%. Sale and repurchase agreements and asset sales with recourse, where the credit risk remains with the bank will receive a CCF of 100%. A CCF of 100% will be applied to the lending of banks securities or the posting of securities as collateral by banks, including instances where these arise out of repo-style transactions (i.e. repurchase/reverse repurchase and securities lending/securities borrowing transactions). Forward asset purchases, forward deposits and partly-paid shares and securities, which represent commitments with certain drawdown will receive a CCF of 100%. Certain transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions) will receive a CCF of 50%. Note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) will receive a CCF of 50%. For short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipment) a 20% CCF will be applied to both issuing and confirming banks. Total RWA for off-balance sheet item on 31.03.2010 is 638.63 crores.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 7.3.12 Credit risk mitigation Banks use a number of techniques to mitigate the credit risks to which they are exposed. Exposure may be collateralized in whole or in part with cash or securities, or a loan exposure may be guaranteed by a third party. Where these various techniques meet the operational requirements below credit risk mitigation (CRM) may be recognized. The framework set out is applicable to the banking book exposures under the simplified standardized approach. No transaction in which CRM techniques are used should receive a higher capital requirement than an otherwise identical transaction where such techniques are not used. The effects of CRM will not be double counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on claims for which an issue-specific rating is used that already reflects that CRM. Principal-only ratings will also not be allowed within the framework of CRM. Although banks use CRM techniques to reduce their credit risk, these techniques give rise to risks (residual risks) which may render the overall risk reduction less effective. Where these risks are not adequately controlled, supervisors may impose additional capital charges or take other supervisory actions. While the use of CRM techniques reduces or transfers credit risk, it simultaneously may increase other risks to the bank, such as legal, operational, liquidity and market risks. Therefore, it is imperative that banks employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the banks use of CRM techniques and its interaction with the banks overall credit risk profile. On 31st March, 2010 RWA for claims under credit risk mitigation stood at Tk. 127.88 crore.
7.4 Capital Adequacy Ratio

Bangladesh Bank adopted the idea of Capital Adequecy Ration through BRPD Circular in 1996. It advised assessment of Capital Adequacy on the basis of Risk Weighted Assets. Capital Adequacy Ratio =
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Total RWA for Dhaka Bank on March 31, 2010 is summarized below in the table. As this report focuses on the credit risk of Basel II framework, detailed calculation of market risk and operational risk is not given here.
Table 11: Risk Weighted Asset for DBL
Risk Weighted Assets (RWA) for A. Credit Risk B. C. On Balance Sheet Off-Balance Sheet 5743.85 638.63 21.07 56.45
Tk. in crores
6382.48 263.34 705.67 7351.49
Market Risk1 Operational Risk2
Total RWA
In the following table, calculation of Minimum Capital Requirement is shown. From the table, it is clear that, DBL has certainly met the requirement as it has over Tk. 4 crore of surplus. CAR is just above 8% and Core capital to RWA is 6.74% which is quite good.
Table 12: Minimum Capital Requirement under Risk Based Capital
Particulars A. Eligible Capital 1. Tier 1 (Core Capital) 2. Tier 2 (Supplementary Capital) 3. Tier 3(eligible fo market risk only) 4. Total Eligible Capital B. C. D. E. Total Risk Weighted Asset (RWA) Capital Adequacy Ratio (CAR) Core Capital to RWA Minimum Capital Requirement (MCR)
Tk. in crore
495.55 96.77 592.32 7351.49 8.06% 6.74% 588.12
1 2
RWA for Market Risk is calculated by multiplying the total exposure by 12.5 Same as above for operational risk
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7.5 Trend Analysis

A trend analysis has been done on three important variable of credit risk management under Basel II. The variables are total eligible capital, RWA and CAR. The trend analysis is done on last four quarters, i.e. from June 2009 to March 2010. From the following figure, the trend in total eligible capital can be seen. Total eligible capital increased almost Tk. 82 crore in the last year.
Figure 10: Total Eligible Capital
This capital includes both Tier 1 and Tier 2. It can also be seen from the figure that total eligible capital gives a nose dive in the 3rd quarter of the year 2009, whereas in all other quarter it increased satisfactorily. Risk weighted asset is also a very important variable in Basel II. In standardized approach, it depends heavily on the rating of ECAIs. As DBL deals mainly with the corporate clients and few clients have done credit
rating of them, the risk weighted asset is increasing day by day as the loan portfolio is growing. But, P a g e | 81
Figure 11: Risk Weighted Asset
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited this increase of RWA will create pressure on bank to increase the capital substantially and which is not that easy. From the figure 11, it can be seen that, RWA increased very largely in the last two quarter, so to maintain, adequate CAR, the bank has to increase its capital which can be seen from figure 10. In the last figure, the trend of CAR is
shown. As per BB directives, Basel II has a parallel run with Basel I in 2009 and capital adequacy ratio requirement
was above 7% at that time. But from, 2010 Basel II is in full effect. So, the CAR
Figure 12: Capital Adequacy Ratio (CAR)
must be above 8% which is kept by
DBL as seen from the figure 12. In all the quarter Capital Adequacy Ratio was above 7% which is good compliance with the set norm. But the bank will be in a big challenge when this ratio must be maintained over 9% from July 2010. Either the bank has to enhance the capital or decrease the RWA to improve the CAR. The next section will show some ways to enhance the capital.
7.6 Capital Raising Option

Bank can increase their tier 1 and tier 2 capital if needed to comply with the BB directive. Some of the ways are shown below: 7.6.1 Tier 1 Capital Banks can maintain their capital in 8 (eight) constituents of Tier I capital as specified before. Four of them, namely, Statutory Reserve, General Reserve, Retained Earnings and Dividend Equalization Account are greatly dependent on annual income of a bank. A certain percentage of income that is retained as per requirement of the Banking Companies Act P a g e | 82
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited (BCA) 1991 is named as Statutory Reserve. General Reserve is made to meet contingencies which are indeterminate at the time of making such reserve. Retained earnings are defined as shareholders' equities in a banking company resulting from earnings in excess of losses and declared dividends. The purpose of Dividend Equalization Account is to create a fund in those years in which profits are large, so as to enable the bank to pay dividend at normal rate when profits are small. Thus a bank cannot enhance capital immediately in these items to meet any regulatory obligation. A bank can raise capital and non-repayable premium account by issuing right share, bonus share and IPOs. But a bank whose shares have already been floated in the stock market can further expand capital base by issuing either bonus shares or right shares or both. Issue of bonus share again depends on genuine annual profit of a bank. This process does not enhance financial resources of a bank; rather it converts earnings into shares. Whether a bank can issue share at premium depends on each share's existing net worth value which, among other, also depends on its accumulated earnings. The above analysis indicates that if regulation requires banks to raise Tier I capital substantially, the immediate option available for listed banks is to issue right shares. For the state-owned banks government will require to inject capital while branches of foreign banks will require collecting funds from their parent office. In addition, banks can respond to regulator's instruction by issuing non-cumulative irredeemable preference shares. But there is a lack of regulatory guideline regarding issue of such instruments. 7.6.2 Tier II Capital As mentioned earlier, Tier II capital comprises of General Provision, Asset Revaluation Reserve, Preference Shares, and Perpetual Subordinated Debt Account. Banks maintain general provision out of their business earnings. So they cannot raise general provision immediately in response to enhancement of regulatory capital. Similar argument can be applied for asset revaluation reserve and exchange equalization account. Since Bangladesh is following free floating exchange rate policy since May 2003, exchange equalization account has become ineffective in reality. In these circumstances, the options available for banks to raise Tier II capital are either to issue perpetual subordinated debt or to issue preference share or to issue both. However, there are no regulatory guidelines for the issuance of such instruments. P a g e | 83
CHAPTER 8
IMPACT OF ADOPTION OF BASEL II IN DHAKA BANK LIMITED
8.0
Impact of Adoption of Basel II in Dhaka Bank Limited
As Basel II implementation started in Bangladesh from 2010, the impacts of adoption are not visible clearly yet. But, there will be some certain impacts. In the following those certain and some potential impacts are discussed. Improved Risk Management and Capital Adequacy One aspect that the staunchest critics of Basel II agree to is the fact that it will tighten the risk management process, improve capital adequacy and strengthen the banking system. Impact on Customers For DBL, Basel II is an internal management exercise that does not directly affect customers. However, there has been a good deal of talk about Basel II leading to greater risk-based pricing in loan markets, as it increases the difference in capital required between risky and safer lending categories. This could lead to riskier types of debt, such as consumer finance, costing more relative to safer categories such as loan to large corporate house. From 2010, management of the Bank decided to give preference to the client rated by ECAI. It also will extend its credit towards the good rated borrower. This scenario will bar the poor rated client to avail any loan. Shorter Term to maturity of lending Both the Basel I and II accords have a preference for short-term lending. This is because of the ease in exiting the investment in case the situation turns adverse. Also the interest rates on short term will also tend to be lower further incentivising such borrowings. For this reason, DBL is trying to attract shorter term borrowing to get the benefits. This shall impact both the bank and ultimate borrowers because of the change in the interest rate term structure and the need for Asset and Liability Management (ALM). Impact on capital flows Short Term lending will further increase the volatility of capital flows within Bangladesh, from one bank to another. If any negative event occurs at any point of the flow, people will get panicked. There would be a tendency to press the panic button at the smallest change in the situation, further deteriorating it, leading to crisis.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Higher Interest Costs Implementation of Basel II will force banks like Dhaka Bank to charge more interest to risky customer as it has to keep some capital for that loan. On the other hand, there are few good customers in Bangladesh, so every bank will want them as their customer. So, competition will increase and interest rate will fall for the well rated borrower. Competitive Advantage of Corporate Borrowers Corporate Banking is the main operating business model of Dhaka Bank Limited. But, in Basel II advantage has been given to corporate borrowers with good rating. As the good clients number is limited, and competition is huge. Dhaka Bank may lose some of its customers. Impact on Companies The Shortened term funding of banks will find its way to the balance sheets of companies because of the need for matching maturities. This would impact output levels in corporate and skew the capital structure in favor of short term borrowings and working capital finance. The Liquidity position and the companies ability to globalize would be hampered by this difficulty in raising long-term capital. The Vicious Circle of Curtailment of Credit to Developing Countries This is countrywide impact which will hit all the financial organization in Bangladesh. Developing countries like Bangladesh usually has lower sovereign rating. The lower ratings will reduce the availability of funds in the developing countries. This has the potential to deteriorate the situation in these countries leading to further recession. The reduced market access and high costs of funding will further impact the ratings of these countries leading to a vicious circle with each aspect feeding the other in a downward spiral. In brief, these are some of the impacts that are felt and will be felt in future as DBL and other banks adopt Basel II.
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CHAPTER 9
RECOMMENDATION
9.0
Recommendation
Dhaka Bank Limited has taken all the steps to implement Basel II. But there is an apprehension of capital shortfall in MCR (Minimum Capital Requirement) in the next quarter as the level of CAR is going up by 1%. So, DBL has to raise capital very quickly to remain compliant as before. At the current level of risk weighted asset the Bank may need additional Tk. 150 crore of Tier 1 capital to meet up the shortfall. Moreover, from 2011 the CAR will be 10% which will almost require additional Tk. 350 crore of total eligible capital if the growth of loan portfolio remains stable. As Basel II has direct impact on credit risk management, remaining compliant should be the first priority to operate business. Though Dhaka Bank Limited is taking necessary steps to stay ahead of the action plan of Bangladesh Bank, the following recommendation can be useful. 1. To meet the capital shortfall in Tier 1 capital, DBL should issue right shares of Tk. 100 crore. The existing shareholders can purchase these shares in rights. It will help DBL to maintain a good ratio of core capital to risk weighted asset ratio. Offering right share will not harm the current shareholders, offering them the right share is a reward for them. It will create a positive brand image of the Bank. 2. To meet the capital shortfall in Tier 2 capital, DBL can issue subordinated bond. These bonds will be unsecured, non convertible and DBL can issue bonds upto Tk. 250 crore. Issuing subordinated bonds does not create any problems for the existing shareholder. If DBL issues these two types of securities, the shortfall problem will not remain when Basel II will run at full force. 3. DBL should look for comprehensive IT solution for Basel II. Bangladesh will go to implement the foundation IRB approach in 2012 and this approach requires extensive Management Information System. 4. Management should set up a unit, which will work under the supervision of BIU, whose task will be to encourage the clients to be rated by ECAI. This unit will also keep contact with the ECAIs to gather borrower information. This will help speed up the process of rating..
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited 5. The Bank should recalculate its lending rate on a periodic basis to cope with changing lending scenario caused by Basel II. 6. The Bank should introduce Risk Based Pricing. For this, Credit officer must be skilled enough to understand the procedure. 7. No new borrower should be given credit facility without being rated by ECAI. 8. As there are few good customers in the market, extra attention should be given to them as intense competition is taking place. 9. The Bank should concentrate more on short term lending as it charges less capital according to Basel II. 10. To be fully compliant with BASEL II requirements, the bank should develop historical databases on probability of default (PD) and loss given default (LGD). Such databases will enable the bank to compute expected loss (EL) from any new credit approval. 11. For credit risk mitigation purpose, the collateral accepted by Basel II only, should be taken as security. 12. When assessing collateral, the bank should be mindful that the value of the collateral might be impaired by the same factors that have led to the diminished recoverability of the credit. 13. An investigative review should be carried out on significant cases. The review should enable the bank to understand better how problem credits and losses develop and identify weaknesses in the banking institutions existing credit-granting process and monitoring process.
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References
Aggarwal, R. & Jacques, K. (1998), "Assessing the impact of prompt corrective action on bank capital and risk," Economic Policy Review, Federal Reserve Bank of New York, issue October, pp. 23-32. Bangladesh Bank (2007), Basel II Road Map, December 30, 2007. Basel Committee on Banking Supervision (2000), Principles for the Management of Credit Risk. Basel, pp. 1-15 Basel Committee on Banking Supervision (2006),International Convergence of Capital Measurement and Capital Standards, A Revised Framework Comprehensive Version, Bank for International Settlements. Blum, J. (1999), Do Capital Adequacy Requirements Reduce Risks in Baking?, Journal of Banking and Finance, vol 23, pp. 755-71. Ediz, T., Michael, I. M. and Perraudin, W. R. M. (1998), Bank Capital Dynamics and Regulatory Policy, Bank of England mimeo. Ferri, G. and Kang, T. S. (1999), The Credit Channel at Work: Lessons from the Financial Crisis in Korea, Economic Notes, 28, No. 2, 195-221. Furlong, F. T. and Keely, M. C. (1989), Capital regulation and bank risk-taking: A note, Journal of Banking and Finance, 13, 883-891. Gennote, G. and Pyle, D. (1991), Capital Controls and Bank Risk, Journal of Banking and Finance, 15, 805-41. Hart, O.D. and Jaffe, D.M. (1974), On the application of portfolio theory to depository financial intermediaries, Review of Economic Studies, 41, 129-147. Jacques, K.T. and Nigro, P. (1997), Risk-Based Capital, Portfolio Risk, and Bank Capital: A Simultaneous Equations Approach, Journal of Economic and Business, 533-47. Kim, D. and Santomero, A.M. (1988), Risk in Banking and Capital Regulation, Journal of Finance, 43, 1219-33.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited Koehn, M. and Santomero, A.M. (1980), Regulation of Bank Capital and Portfolio Risk, Journal of Finance, 35, 1235-44. Marshall, D.A. and Prescott, E.S. (2000), Bank Capital Regulation with and Without StateContingent Penalties, Federal Reserve Bank of Chicago Working Paper,10. Rime, B. (2001), Capital Requirements and Bank Behavior: Empirical Evidence for Switzerland, Journal of Banking and Finance, 25, 798-805. Rochet, J.C. (1992), Capital Requirements and the Behavior of Commercial Banks, European Economic Review, 36, 1137-78. Sheldon, G. (1996), Capital Adequacy Rules and the Risk-Seeking Behavior of Banks: A Firm-Level Analysis, Swiss Journal of Economics and Statistics, 132,709-734. Shrieves, R. E. and Dhal, D. (1992),The Relationship between Risk and Capital in Commercial Banks, Journal of Banking and Finance, 16, 439-57 Patric, V. R. (2003), Impact of the 1988 Basel Accord on banks capital ratios and credit risk taking: an international study, European Center for Advanced Research in Economics and Statistics, Universite Libre de Bruxelles, Working Paper. Vlaar, P. J. (2000), Capital Requirements and Competition in the Banking Industry, Federal Reserve Bank of Chicago, Working Paper, 18. Ward, J. (2002), The New Basel Accord and Developing Countries: Problems and Alternatives, Cambridge Endowment of Research Finance, Working Paper No. 4, 14.
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APPENDICES

Internship Report of Sanjib Debnath (P)

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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

Prepared for Mr. Shakil Huda Professor

Prepared by Sanjib Debnath Roll: 02 MBA 42D

Institute of Business Administration University of Dhaka

Sanjib Debnath Roll # 02 MBA, Batch-42D IBA, DU

RISK MANAGEMENT IN DHAKA BANK LIMITED ..................................................................................... 35

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

1.0 The Internship Program

AN OVERVIEW OF THE ORGANIZATION: DHAKA BANK LIMITED

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

2.0 An Overview of the Organization: Dhaka Bank Limited

2.1 Key Facts about Dhaka Bank Limited

Figure 1: Number of Branches over the Years

2.2 Products and Services

2.3 Supporting Departments

undeviating objective of HR. At DBL, employee performance is directly

Figure 2: Operating Profit per Employee

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

2.4 Financial Performance and Growth of Dhaka Bank Limited

portfolio. The Bank recorded a 6% growth in advances with a total loans

products an service along with

Figure 6: Deposits of Dhaka Bank

Current and Others 9% Savings 10% STD 5%

Figure 7: Deposit Mix

2008. Deposit mix of the

Operating Profit vs Net Profit

Figure 8: Operating Profit vs Net Profit

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

2.5 Future Plan

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

3.1 Issues and Problems

3.2 Origin of the Report

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

3.5 Scope and Limitations

3.7 Report Preview

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

4.0 Literature Review

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

Risk Management in Dhaka Bank Limited

5.1 Core Risks in Bank

5.2 Types of Credit Products

Non-Funded Letter of Credit Bank Guarantee

Fixed Term loan

Fixed Term loan

Bad and Loss

Fixed Term loan

5.3 Credit Risk Management in Dhaka Bank Limited

Scores >95 >85 75-84 65-74 55-64 P a g e | 44

5.4 Credit Risk Management and Basel accords

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

Basel II Framework and its Implementation in Bangladesh

6.1 The Three Pillars

Figure 9: The Basel II Framework

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

6.3 Role of ECIA in Standardized Approach

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

6.4 Constituents of Capital

6.5 Credit Risk Mitigation

6.6 Basel II in Bangladesh

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited