Credit Risk Management Practices in Banks - Islami Bank Training ...

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Source: Rose, Peter S. (1996), “Banking Credit: Policies and Procedures,”. Commercial Bank Management ,3rd edition, Boston: Irwin-McGraw-Hill Publishing.
Credit Risk Management Practices in Banks: An Appreciation Md. Saidur Rahman∗

Abstract The banks in Bangladesh have started undertaking a number of quantitative and qualitative measures to understand the risks involve in credit or chance of default which may come from the failure of counterparty or obligor (client) to fulfill his/her commitments as per agreed terms and contractual agreement with the bank. Traditionally, a bank gives emphasis on collateral in funding to the clients whereas in the concept of modern banking a bank keenly feels to measure the business risk over the security risk for ensuring the timely repayment of invested funds. Now-a-days a banker likes to adopt a number of sophisticated financial techniques in credit appraisal process with a view to assessing the borrower’s business as well as financial position rigorously. The use of sophisticated techniques for measuring the financial, business and other risks is yet to be established in the banking operations very fast due to the advent of computer based technologies. In some cases, the rate of adoption of analyzing tools and techniques is highly remarkable in credit operation. This attitude of the bankers has been changed by introducing quality training and reinforcing sophisticated financial as well as risk grading techniques. A strong database is the demand of the day for the proper application of the much-demanded credit risk management guidelines along with effective risk grading system.

1. Introduction Credit risk may be defined as the possibility that the potential client or counterparty will fail to meet its obligations in accordance with the agreed terms with the bank. It also signifies the risk of making credit to a risky customer for a risky venture which is not likely to generate enough revenue to repay the money back to the bank. Credit risk is the largest and most obvious source of risk in banking and it comes from a bank’s credit portfolio. The credit portfolio of a bank usually consists of money market portfolio, capital market portfolio and general credit portfolio. Here a bank is highly exposed in the risks of capital market and general credit portfolio. In recent times, the awareness among the bankers has grown regarding the need for managing



The author is Joint Director (Training) and Faculty Member, Islami Bank Training and Research Academy (IBTRA), Dhaka. The views expressed in this article are author’s own.

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perceived risks in credit related activities. One of the goals of credit risk management in banks is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within the acceptable level. Hence, the credit risk assessment and grading system are being applied to evaluate, identify, measure and monitor the level or status of perceived risk associated with a credit proposal. A number of financial and non-financial factors or parameters are used by the banks for these purposes. The use of comprehensive credit risk assessment and grading techniques increasing very rapidly in the banking sector in Bangladesh because of deterioration in the credit standing of the clients, adoption of Basel accords, compliance of international accounting standards (IAS) & international financial reporting standards (IFRS) and the fast revolution of technologies that has made the bankers user friendly in the adoption of these techniques. From the findings of different studies, it can be noted that at the very outset the banking sector in Bangladesh provided huge amount of soft debt facilities to trade, industry and farming activities for enhancing overall economic growth of the country and it was done as a part of social commitment of the nationalized sector. Therefore, the bankers were more concerned to disburse credit to the clients and not to control the credit flow. At that time, bankers used to take credit decisions mostly on the basis of 5Cs consists of character, capacity, capital, collateral, condition and control for safeguarding their credit and without requiring any information of much sophisticated nature from the borrowers for using credit risk assessment for qualifying credit. Even in many cases bankers were reluctant to apply very sophisticated financial techniques in credit decision making if they were satisfied with the security or collateral supplied by the borrowers. Thus the practice of sophisticated financial techniques as well as credit risk assessment system for evaluating borrowers’ creditworthiness were more or less absent in credit operations. But the bankers’ attitudes towards applying indepth financial analysis in credit decision making have been changed - particularly after 1980s when they observed an alarming amount of default credit in their portfolio. They started taking the whole financial scenario of the business of the borrowers along with the security and collateral. They also started practicing the techniques of financial analysis to evaluate the financial statements submitted by the borrowers. But again the use of financial techniques was limited to the study of income statement, balance sheet and cash flow statement only with the application of some traditional financial ratios like current ratio, gross profit margin, debt service coverage ratio, debt-equity ratio, break-even point analysis, net present worth, benefit cost ratio, internal rate of return, etc. All the bankers were seen quite enthusiastic in the early 1990s when a broad based Financial Sector Reforms Program (FSRP) was undertaken in the financial sector for improving the efficiency of the banks. Under the said program, much emphasis were

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given in the process of selecting a credit proposal, risk analysis, credit pricing, classification and provisioning thereof. In 1993, Bangladesh Bank made the first regulatory move to introduce the best practices in this area through the introduction of the Lending Risk Analysis (LRA) manual for all credit exposures undertaken by a bank in excess of Tk.10 million. Bankers were asked to prepare Financial Spread Sheet (FSS) to cover financial trend analysis through comparative and common-size financial statements, cash and funds flow analysis, measuring credit scores like Zscore and Y-score along with Lending Risk Analysis (LRA) for a particular amount of credit. Under LRA, more emphasis was given to measure the business risk of the clients. Henceforward, for the first time the bankers in Bangladesh started using formal risk analysis techniques for measuring risk level of a credit proposal. The concept of security in credit has been changed by adopting new techniques of credit analysis. The bankers started understanding that the collateral or customer’s pledge for credits is just one of the safety zones that a banker must keep for giving overall protection against the funds which is given to the customers and the liquidate value of the collateral or pledged goods must be equal or greater than the exposed risk value of credit sanctioned. But from a number of studies it is found that the legal system in our country sometimes makes it difficult for the bankers to repossess and sell out the collateral taken against the credit. So it is clear that the income and cash flow from business are to be the primary safety zones of a credit (Figure-1) and these are actually preferred sources of ensuring repayment of credit. Figure -1: Safety Zones Surrounding the Funds Credited by a Bank

Personal guarantees and pledges made by the Resources on the customer’s balance sheet Customer’s expected profits, income Principal amount of credit plus interest owed the bank.

or cash flow. and collateral pledged.

owners of a business firm or by cosigners to a credit. Source: Rose, Peter S. (1996), “Banking Credit: Policies and Procedures,” Commercial Bank Management ,3rd edition, Boston: Irwin-McGraw-Hill Publishing.

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The most outer or remote safety zone of a credit is the guarantee from the borrowers or cosigners where they pledged their personal assets to back the credit taken from the bank. Before taking any personal guarantee, banker must have the idea about personal net-worth of the person (s) which may help in mitigating risk. Very recently the Focus Group on risk management has prepared an industry best practice guidelines titled ‘Credit Risk Management Guidelines’ for the scheduled banks in Bangladesh under the leadership of Bangladesh Bank with a view to managing risk exposure effectively. To shed light this purpose and improving the credit portfolio of the banks, the guidelines consists of some directional policy frameworks and procedural methods like credit policy, credit risk assessment and risk grading system, segregation of duties of approval authority, internal audit, preferred organizational structure and responsibilities, approval process, credit administration, credit monitoring and credit recovery. To supplement the policy frameworks another manual on risk grading has also been prepared under the leadership of Bangladesh Bank. Risk Grading Manual mainly deals with the credit risk grading process by considering the principal risk components associated with the clients, early warning signals (EWS), credit risk grading review, MIS on credit risk grading, financial spread sheet (FSS), etc. It is expected that these guidelines along with the grading system will improve the risk management culture, establish minimum standards for segregation of duties and responsibilities, and will assist in the on going improvement of the banking sector of Bangladesh.

2. Objectives, Scope and Methodology The main objectives of this study is to make a thorough review of tools and techniques of credit risk management practices in banks and financial institutions in Bangladesh as suggested by the relevant bodies and experts under the leadership of Bangladesh Bank and highlighting the key features in order to grow awareness of the users about credit risk management practices and its proper implementation in the credit decision making. Banks and financial institutions put their significant portion of funds in the long-term financing along with other forms of advances to the public and private sector programs. As a developing country a huge amount of credit flow is very much needed both in public and private sector. But it is mentionable that the credit operation involves risk of non-repayment from the counterparties or clients. In order to manage the risk exposure which may come from such activities, the credit risk management practices is one of the important aspects in bank management and it must be proper and in systematic manner. This study is the result of consulting the existing literature and is basically theoretical in nature on the subject. All the discussions that have been included in this paper are the results of extensive study of existing credit risk grading and risk management systems prevailing in this sector which were issued by the central bank and international bodies time to time.

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3. Observations on Previous Practices The Financial Sector Reform Program (FSRP) was introduced in the early nineties in Bangladesh with a view to bringing about financial discipline by undertaking appropriate reform measures in the financial sector. The program was undertaken by the Government of Bangladesh (GoB) with combined support of the World Bank and USAID under the ‘Structural Adjustment Program’. The program mainly covered the banking institutions in the financial sector and suggested several reform measures. Among the measures that FSRP recommended, the Lending Risk Analysis (LRA) constitutes as an important measure. LRA was prescribed for taking sound credit decision in consolidated form on the basis of analyzing risks involved in borrower’s business and security. With a view to ensuring better credit risk management, the use of LRA was made mandatory in case of sanctioning or renewing large credits until the adoption of Credit Risk Grading (CRG) in 2003. At present LRA has been replaced by the CRG. Lending Risk Analysis (LRA) was involved in assessing the likelihood of nonrepayment of credits (mainly credit risk) from the borrowers as per credit agreement by analyzing some sort of risks associated with the borrowers’ business and security. Business risk, the prime component of credit risk, was viewed from two angles viz. industry risk and company risk. Table-1: Contents of Risk under LRA Manual Business Risk 1.Industry Risk 1.1 Supplies Risk

Security Risk 1. Security Control Risk 2. Security Cover Risk

1.2 Sales Risk 2.Company Risk 2.1 Company Position Risk 

Performance Risk



Resilience Risk

2.2 Management Risk 

Management Competence Risk



Management Integrity Risk

Source: FSRP Bangladesh, Credit Risk Analysis, June 1993.

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

4. Findings and Observations on Recent Risk Management Practices in Banks Bangladesh Bank issued its BRPD Circular No. 17 dated October 07, 2003 advised all the scheduled banks to put in place an effective risk management system by December, 2003 based on the certain guidelines furnished to them. It appears from the circular that the banking industry is completely different from other industries in terms of the diversity and complexities of the risks they are exposed to. For sustainable performance of the banks in view of the deregulation and globalization,

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the banks must be capable of managing their risks. Credit Risk Management Guidelines involves in assessing and managing credit risks associated with the selection process of a potential borrower, credit structuring (amount, duration, purpose, repayment, and support), approval process of credit, credit documentation (security and disbursement), credit administration, credit monitoring and recovery functions of a bank or financial institution. At the selection stage, credit risk grading is essential to keep the credit risk exposure at a tolerable level. Table-2: Contents of CRM Guidelines Policy Framework

Organization

Procedures



Credit Guidelines



Structure



Approval Process



Credit Assessment & Risk Grading



Key Responsibilities



Credit Administration



Approval Authority



Credit Monitoring



Segregation of Duties



Credit Recovery



Internal Audit

Source: Bangladesh Bank (2003), Managing Core Risks in Banking: Credit Risk Management, Dhaka: Bangladesh Bank, Head Office. Bangladesh Bank, under its prudential regulatory guidelines, advised all the banks and financial institutions in Bangladesh to follow a robust and structured framework for risk management. In order to help them in building such type of effective risk management system, it formed some ‘Focus Groups’ comprising the representatives from Bangladesh Bank, SCBs, PCBs and FCBs to study the global ‘industry best practices’ in banking and to recommend a suitable framework of the risk management system. The present guidelines on core risks management are the outcome of such types of exercise. The Focus Groups have identified some risk areas which are associated with the banking operations like credit risk, asset-liability management risk, foreign exchange risk, internal control and compliance risk, money laundering risk and ICT risk. These risks are referred to collectively core risks in banking. The credit risk is one of the major core risks faced by the banks. It is the possibility of potential losses that may arise from the failure of counter party or obligor (client) to meet its contractual agreement with the bank. Again, the failure may come from the declining in financial condition, adverse situation in the industry or unfavorable condition of the business, trouble in management, weak support due to inferior quality of security, lack of ready succession and bad relationship with the bank of the counterparty.

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The main feature of these guidelines is the flexibility in practice. Bangladesh Bank has made the guidelines flexible for the banks in the sense that the respective banks can design their own risk management system depending on their size and complexity of business. Central bank, however, trained a good number of officers of the scheduled banks who in turn may help their respective banks in building up the capacity to adopt the risk management system. Other features of credit risk management guidelines have been discussed below: 4.1 Centralization of Major Credit Related Activities All the banks should have comprehensive credit risk management policies and procedures to ensure earnings at acceptable level and minimize losses in their portfolio. The policies will provide directional guidelines to perform credit related activities properly and efficiently. Credit policy, credit assessment and risk grading system, approval procedures, internal auditing system are the major areas of credit risk management policy. Procedural guidelines consist of some set rules of activities to conduct specific credit function effectively. Credit approval process, credit administration, credit monitoring, and credit recovery are the part of procedural guidelines. These policies and procedures should be approved and strictly enforced by the managing director or chief executive officer and the board of directors. It is noted that any credit activity which does not comply with the policy guidelines will require approval from head of credit or managing director or chief executive officer and board of directors. Security documents should be centralized at the head office or regional office besides the copy of the same preserving in safe custody at branch level. 4.2 Establishing Own Credit Policy For the purpose of performing credit activities in desired manner, each bank needs to establish own credit policy in accordance with their business philosophy. The bank’s credit philosophy – its general goals and objectives including the mission and vision of the banks – are reflected in its credit policy. Thus industry and business segment focus, types of credit facilities, single client or group limits, credit caps, discouraged business types, credit facility parameters, system of approval etc. shall be incorporated in the credit policy in black and white with a view to providing overall framework of credit activities. However it should cover, at a minimum, what constitutes proper credit support, risk based pricing and documentation of credit for safety. 4.3 Customization of Credit Policy Based on Changing Circumstances Now in a deregulated environment, banks are no longer considered as passive takers. Therefore after the introduction of prudential credit policy, the banks must stand

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ready to meet all the legitimate demands for credit facilities at all the times by customizing their credit policy. While looking into the matter of customizing credit policy, the changes in economic outlook and the evolution of bank’s credit portfolio should be taken into account. The credit policy can also be modified and tuned to match the changing credit related rules and regulations of the country and all the modifications and changes must be approved by the managing director or chief executive officer and board of directors. 4.4 Introduction of Credit Risk Grading (CRG) System in Credit Operations The risks associated with the borrower or counter-party need to be carefully and critically analyzed before funding to the client’s business. To quantify the risk exposure, it should be graded as per credit risk score sheet by the individual banks in line with the guidelines of CRG Manual. Risk grading is a key measurement of a bank’s asset quality and it is a robust process. Therefore borrower’s risk grade should be clearly stated on the credit application form for using credit decision making process. In CRG Manual, five risk components viz. financial risk, industry/business risk, management risk, security risk and relationship risk have been identified which are responsible of failing to meet the obligations by the borrowers. These risk components are rated based on the some basic parameters. Note that there are twenty parameters under the five risk components to reflect the risk exposure. Financial risk comes from the financial distress of the counterparty. It includes identification of extent of leverage through debt-equity ratio, liquidity of the borrower through current ratio, profitability performance through operating profit margin and coverage through debt-service coverage ratio. Business/Industry risk arises due to adverse change in business or industry situation. In order to assess the borrower’s business/industry risk the size of borrower’s business in terms of annual sales volume, age of business, industry growth, market competition and entry & exit barriers are to be assessed. Management risk is conducted in assessing the competence and risk taking propensity of the management. It covers the parameters like experience, second line/succession plan and team work of the management. Security risk is assessed by analyzing the primary security, collateral security and support. Relationship risk is considered under CRG by assessing the account conduct, utilization of limit, compliance of covenants and balance of personal deposits. There is a wide range of risk exposure or grading system in the present practices where superior is the top position and bad & loss is the worst position. In between superior and bad & loss there are six types of risk exposures say, good, acceptable, marginal/watch list, special mention, substandard and doubtful (Table-3).

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Table-3: A Typical Risk Grading (Credit Rating) System under CRG Manual Gra Description Weighted Key Indicators de Score 1 Superior None -Facilities are fully cash secured, secured by (SUP) Government/international bank guarantee. 2 Good (GD) 85 + - Repayment capacity: Strong - Liquidity: Excellent - Leverage: Low - Earnings & Cash Flow: Consistently Strong - Track record/Account conduct: Unblemished 3 Acceptable 75 - 84 - Repayment capacity: Adequate. (ACCPT) - Liquidity: Adequate - Earnings & Cash Flow: Adequate & Consistent. - Track record/Account conduct: Good 4 Marginal 65 - 74 - Repayment: Routinely fall past due /Watch List - Liquidity: Strained liquidity (MG/WL) - Leverage: Higher than normal -Earnings & Cash Flow: Thin, incurs loss and inconsistent. -Track Record/Account conduct: Poor 5 Special 55 - 64 -Repayment: Deteriorate repayment prospects Mention -Net-worth: Negative (SM) -Management: Severe problems -Leverage: Excessive -Earnings & Cash Flow: Consecutive losses 6 Substandard 45 - 54 -Repayment: Capacity and inclination to repay (SS) is in doubt. -Financial condition: Weak 7 Doubtful 35 - 44 -Repayment: Unlikely and possibility of credit (DF) loss is extremely high 8 Bad & Loss