CREDIT RISK MANAGEMENT

CREDIT RISK MANAGEMENTFINANCIAL RISK MANAGEMENT

SUBMITTED TO

AJAB KHAN BURKI

BILAL NASEER (GL)KHAWAR AZIZUSMAN AZIZMISBAH JAMILWAQAS KHALIDMAJJID IMTIAZ CLASS: MBA-6(A)DATE: 15-01-2015

TABLE OF CONTENTS

INTRODUCTION4GLOBAL SCENARIO4DOMESTIC SCENARIO6COMPANY PROFILE OF MEEZAN BANK6PROBLEM STATEMENT7OBJECTIVES7COLLECTION OF DATA7BASEL I8CREDIT RISK9CREDIT RISK MANAGEMENT PRACTICES IN MEEZAN BANK9POLICIES, STRATEGIES AND PROCESSES10STRATEGIES ADOPTED BY MEEZAN BANK FOR MANAGING THE RISK13CREDIT RISK MITIGATION13PROCESSES AND PRACTICES OF CREDIT RISK MANAGEMENT IN MEEZAN BANK15CREDIT RISK MITIGATION16FINDINGS16RECOMMENDATIONS17CONCLUSION17LEARNING OUTCOMES18BIBLIOGRAPHY18

EXECUTIVE SUMMARYThe dissertation project done is on the credit risk management practices followed by Meezan Bank. In the fast growing world, banks are facing many types of risks among which credit risk stands at the top of the list. Hence, the topic is credit risk management. One bank was chosen to understand the practices followed by them in depth which would apply to other banks in general. Meezan bank is one of the public sector banks and is supposed to be in line with SBP guidelines. This helped in understanding the credit risk management practices followed by the bank in a better way. The process of credit risk management is identification, measurement, monitoring and control. The bank follows these steps very clearly and has a sound credit risk management system installed. It has also installed software for risk rating which was provided by CRISIL which is in turn in lines with SBP guidelines. The banks net profit has seen a growth of 35% and the total business is up by 16%. The banks deposits are up by 13% and gross advances are up by 19%. The credit risk exposure is increased to 80064.90 as of Sep, 30 2011. The credit risk of the bank has decreased over the past five years. They have installed an integrated risk management system in line with BASEL II norms and SBP guidelines. They follow strict hedging policies to reduce credit risk of the bank. They take financial collaterals and guarantees to hedge their credit risk. Hence all the policies and strategies have led to a sound credit risk management system. The recommendations include up gradation to internal ratings based approach which is the next step of risk measurement. They have to improve their systems so as to adhere to BASEL III norms which might be implemented in near future. They need to include credit risk during yearly policy making.

INTRODUCTIONPakistani economy today is trying their level best for becoming a one of the world class economy. The Pakistani banking industry is making great advancement in terms of quality, quantity, expansion and diversification and is keeping up with the updated technology, ability; stability and thrust of a financial system, where the commercial banks play a very important role emphasize the need of a strong effective control system with extra concern for the risk involved in the business. The risk arises due to uncertainties, which in turn arise due to changes taking place in the economic, social and political environment and lack of non-availability of information concerning such changes. Risk means uncertainty/possibility of loss. In the financial arena, enterprise risks can be broadly categorized as credit risk, market risk, operational risk, strategic risk, funding risk, political and legal risk. Credit risk is the possibility that a borrower or counter party will fail to meet agreed obligations. Globally more than 50% of total risk elements in banks and financial institutions are credit risk alone. In banks, losses shoot from outright default due to inability or unwillingness of customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transactions. Thus managing credit risk for efficient management of a financial institution or bank has gradually become the most crucial task and this is the motivation for this research.

GLOBAL SCENARIO The period 2007-2012 underwent financial crisis, also known as the Global Financial Crisis (GFC), or the Great Recession, is considered by many economists to be the worst financial crisis since the great depression of the 1930s. This resulted in the collapse of large financial institutions, the bailout of banks by national Governments, and downturns in stock markets around the world. Even the housing market suffered, resulting in evictions, foreclosures and prolonged unemployment contributing to the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a significant decline in the economic activity, leading to a severe 2008-2012 global recessions.The bursting of the U.S. housing bubble, which peaked in 2007, caused the values of securities tied to U.S. real estate pricing to plummet, damaging financial institutions globally. The financial crisis was triggered by a complex interplay of valuation and liquidity problems in the United States banking system in 2008. Securities in stock markets suffered large losses during the 2008 and early 2009. Economies worldwide slowed down during this period, as credit tightened and international trade declined. This financial crisis ended by around late 2008 and mid-2009. The current European sovereign debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to re-finance their Government debt without the assistance of third parties. From late 2009, fears of a sovereign debt crisis developed among investors as a result of the rising Government debt levels around the world together with a wave of downgrading of Government debt in some European states. Concerns intensified in early 2010 and thereafter, leading Europes finance ministers on 9 May 2010 approved a rescue package worth 750 billion to ensure financial stability across Europe creating the European financial stability facility (EFSF). In October 2011 and February 2012, the Euro zone leaders agreed on more measures designed to prevent the collapse of member economies. M & AS (MERGER AND ACQUISITION) ON THE RISE The banking and capital market is readily transforming itself with increased competition and globalization. Investment banking has bounced back because merger and acquisition (M&A) has gathered momentum. Hedge fund activity and increase of M&A activity are the main characteristics of globalized banking. M&As are usually horizontal in banking sector as it is the same business. Ex: The Bank of Tokyo-Mitsubishi UFJ, which became the worlds largest bank, by merging with Mitsubishi Tokyo Financial Group Inc. and UFJ holdings Inc. It created the bank of Tokyo-Mitsubishi, worlds largest financial group by assets at around $1.6 trillion, leaving behind; the U.S. based Citigroup Inc.s $1.55 trillion.

FUNDS CONTINUE TO FLOW TO EMERGING COUNTRIES Emerging market continues to bring in more funds in the banking sector. Lending to emerging markets rose. More and more funds continue to flow in the emerging markets like Latin American countries. Hedge fund activity has also increased over time. DOMESTIC SCENARIO Pakistani banking industry has evolved over a long period of time. Despite the recent growth of private banks, the sector is dominated by Government-controlled banks that hold nearly three-fourths of total banks assets. The global financial crises have not much affected the Pakistani banks significantly one, two banks affected due to the crisis. Internet, wireless technology and global straight-through processing have created a paradigm shift in the banking industry. The growing market is attracting more and more banks into the Pakistani territories. In Pakistan, the most significant achievement of the financial sector reforms is the improvement in the financial health of commercial banks in terms of capital adequacy, profitability and asset quality as well as greater attention to risk management. Later on, after adopting the policy of deregulation, it opened the new opportunities for the banks to increase revenues by diversifying into investment banking, insurance, credit cards, depository services, mortgage financing, securitization, etc. As now banks benchmark themselves against global standards, they have increased the disclosures and transparency in bank balance sheets, the banks also started focusing more on corporate governance.

COMPANY PROFILE OF MEEZAN BANKINTRODUCTION Meezan Bank Ltd has grown to become the largest Islamic bank in the country. The bank claims to be the Pakistan premier Islamic bank determined to set higher standards of achievements. The bank comes in to existence by the order promulgated by governor general and standard functioning from Nov 20, 1997.Meezan Bank is the major business partner our government of Pakistan with special emphasis on fostering Pakistan economic growth through aggressive and balanced lending policies, technologically oriented products and services offered through its large network of 203 branches. Meezan Bank is a commercial bank which receives deposits from the people who have it spare and invests it with those who are in need of them. It has got the license of commercial banking from the State Bank of Pakistan and is registered under the legislation of Banking Companies Ordinance 1962. It has dedicated itself to do business of banking according to Islamic rules and regulations and is supervised by a Shariah Board who keeps an eye on the operations of the bank and ensures that the same must be in accordance with the teachings of Islam and there must be no element of Riba in it.

PROBLEM STATEMENT To analyze the credit risk management practices of Meezan Bank and suggest ways to Improve them.

OBJECTIVES To study the credit risk faced by Meezan Bank. To analyze the process of credit risk management and the practices followed in Meezan Bank. To analyze methods used by Meezan Bank to mitigate their risks. To suggest ways to improve the credit risk management system in Meezan Bank.

COLLECTION OF DATAThe data is collected from both secondary and primary data. The secondary data is derived from SBP website and various other related websites and books. The secondary data comprises of understanding credit risk management as a subject and its parameters. These parameters comprise of the various guidelines framed by SBP for all banks for better credit risk management. Primary data is collected through conducting the interview from Khurrum Rashid from Meezan Bank as a Regional Credit Manager.

Before going to proceed futher about how the bank handle the credit risk first we will discuss the BASEL 1 and 2 what it says regarding handling of risk.

BASEL IBasel I primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero, ten, twenty, and fifty and up to one hundred percent. Banks with international presence are required to hold capital equal to 8% of the risk weighted assets. The creation of the credit default swap helped large banks hedge lending risk and allowed banks to lower their own risk. .BASEL IIBasel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices.

OBJECTIVE of Basel II Ensuring that capital allocation is more risk sensitive; Separating operational risk from credit risk, and quantifying both; Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic. Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. CREDIT RISK Credit risk is the possibility of loss from a credit transaction. In a banks portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Credit risk emanates from banks dealings with individuals, corporate, bank, financial institution or a sovereign. Credit risk includes the following: Credit growth in the organization and composition of the credit folio in terms of sectors, centers, and size of borrowing activities so as to assess the extent of credit concentration. Credit quality in terms of standard, sub-standard, doubtful and loss-making assets. Extent of the provisions made towards poor quality credits.

CREDIT RISK MANAGEMENT PRACTICES IN MEEZAN BANKCREDIT RISK:The bank has put in place a robust risk management architecture with due focus not only on capital optimization, but also on profit maximization, i.e. to do maximum business out of the available capital which in turn maximize profit or return on equity. Bank is benchmarking on globally accepted sound risk management system, conforming to BASEL II framework, enabling a more efficient equitable and prudent allocation of resources. In capital planning process, the bank reviews: Current capital requirement of the bank The targeted and sustainable capital in terms of business strategy and risk appetite. Capital need and capital optimization are monitored periodically by the Capital Planning Committee comprising Top Executives. Sensitivity analysis is conducted quarterly on the movement of Capital Adequacy Ratio, considering the projected growth in advances, investments in Subsidiaries/ Joint Ventures and the impact of Basel II framework etc. The Committee takes into consideration various options available for capital augmentation in tune with business growth and realignment of Capital structure duly undertaking the scenario analysis for capital optimization. The Banks policies maintain moderation in risk appetite and a healthy balance between risk and return in a prudent manner. The primary risk management goals are to maximize value for shareholders within acceptable parameters and to the requirements of regulatory authorities, depositors and other stakeholders. The guiding principles in risk management of the Bank comprise of Compliance with regulatory and legal requirements, achieving a balance between risk and return, ensuring independence of risk functions, and aligning risk management and business objectives. The Credit Risk Management process of the Bank is driven by a strong organizational culture and sound operating procedures, involving corporate values, attitudes, competencies, employment of business intelligence tools, internal control culture, effective internal reporting and contingency planning. The overall objectives of the Banks Credit Risk Management are to: Ensure credit growth, both qualitatively and quantitatively that would be sector ally balanced, diversified with optimum dispersal of risk. Ensure adherence to the regulatory prudential norms on exposures and portfolios. Adequately enable to price various risks in the credit exposure. Form part of an integrated system of risk management encompassing identification, Measurement, monitoring and control.

POLICIES, STRATEGIES AND PROCESSES The Board of directors and Risk management Committee of the Board gives directions, the Credit Risk management committee headed by Chairman and Managing Director ensures its implementation. The bank has defined policy guidelines for Credit Risk Management, Collateral Management and Credit Risk Mitigation (CRM), Ratings, etc. where the whole process and procedure to be adopted has been detailed. The bank has taken up implementation of Integrated Risk Management system through six solutions for Credit Risk Rating, Credit Risk, Market Risk, Operational Risk, and ALM & FTP to move towards advanced BASEL II norms. The Income recognition and Asset classification norms of Banks policy are in tune with SBP guidelines. Ninety days delinquency norm is followed to classify assets as performing & non-performing. The data is audited and adequate provisions for both performing and non-performing assets are made. For restructured assets additional provision is made and the bank also has a general floating provision. Definition of impaired assets (for accounting purposes): An asset becomes non-performing when it ceases to generate income for the bank when Interest and instalment of the loan remains overdue for a period of more than 90 days, in respect of term loan The account remains out of order for a period of more than 90 days, in respect of operative limits such as cash credit The bill remain overdue for a period of more than 90 days in cases of bills purchased/discounted The interest charged during any quarter, not fully serviced within 90 days from the end of the quarter The instalment of principal or interest thereon remains overdue for 2 crop seasons in the case of short duration crop loans and if instalment of principal or interest thereon remains overdue for one crop season in the case of long duration crop loans, as far as agricultural loans are concerned 90 days from the date of crystallization of non-fund based commitments expire The Bank has formulated a comprehensive Credit Risk management policy and constituted various committees.

The structure of credit risk management in the bank is as under:

The bank has fine-tuned the Risk management policies and lending policy, to include Credit appraisal standard like benchmark/hurdle ratios on key financial indicators, internal ceilings, prudential norms, standards for loan collateral, portfolio management, credit concentration, loan review mechanism/credit audit, special review of high value borrowed accounts, risk concentration/monitoring and pricing based on risk ratings, and review based on risk ratings etc, besides covering exposure ceiling for sensitive sectors such as capital market, real estate, and commodity sector. A comprehensive recovery policy is also put in place and revised from time to time.

For exposure amounts after risk mitigation subject to the standardized approach, amount of a banks outstanding (rated and unrated) in the three major risk buckets as well as those that are deducted are shown below:

STRATEGIES ADOPTED BY MEEZAN BANK FOR MANAGING THE RISKThe bank has introduced some strategies for credit risk management such as: Lending policy is revised from time to time to include new aspects of risk management order to enhance the effectiveness of the loan review mechanism, the bank introduced onsite credit audit for exposures of Rs. 5 Crore and above and also modified its loan review mechanism for exposures below Rs. 5 Crore. 30-40% of the credit exposures are covered under the loan review mechanism/credit audit. Stress test on credit risk is carried out on an annual basis. A comprehensive risk scoring system is put in place for better credit decisions Separate risk scoring models for housing and other retail sectors has been evolved and put in place so as to ensure higher coverage of risk rating exercise which is presently around 90%. Migration analysis is carried out on half yearly basis in respect of exposures of Rs. 1 crore and above. Bank has introduced credit risk rating software from CRISIL which is BASEL II compliant for conducting risk rating of all retail and non-retail loans.

CREDIT RISK MITIGATION The general principles, like having a specific lien, requisite minimum margin stipulation, valuation, legal certainty, documentation, periodical inspection, easy liquidity etc. as enumerated in BASEL II final guidelines of SBP has been used for credit risk mitigation techniques. All the prescribed haircuts with adjustments for currency mismatch and maturity mismatch are done. The financial collaterals are netted out of the credit exposure before assigning the risk weights. The effect of credit risk mitigation system is not double counted. The financial collaterals taken include: Banks own term deposits Cash margin Life policies Gold benchmarked at 99.99 purityCREDIT RATING FRAMEWORK AT MEEZAN BANK INTRODUCTION Credit Rating Framework (CRF) is one of the risk measurement techniques the banks use to a great extent under risk management system. In line with the guidelines of SBP, the Bank has proposed to bring in all the borrowed accounts (Standard accounts) with limits of Rs.2 lakh and above under the purview of credit risk rating. However, the rating model that will be applied varies according to the type / extent of exposure to suit the borrowers activities. The Bank is utilizing their own internal Credit Rating Model for grading the borrowed accounts so far. The grades used in the internal credit risk grading system should represent without any ambiguity, the default risks associated with an exposure. Hence, SBP suggests that the Bank can initiate the risk grading activity on a relatively smaller scale initially and introduce new categories as the risk gradation improves

NEED FOR CREDIT RISK RATING The need for Credit Risk Rating has arisen due to the following: Banking face new risks and challenges. Competition results in the survival of the fittest. It is therefore necessary to identify these risks, measure them, monitor and control them. It provides a basis for Credit Risk Pricing i.e. fixation of rate of interest on lending to different borrowers based on their credit risk rating thereby balancing Risk & Reward for the Bank. The Basel Accord and consequent State Bank of Pakistan guidelines requires that the level of capital required to be maintained by the Bank will be in proportion to the risk of the loan in Bank's Books for measurement of which proper Credit Risk Rating system is necessary. The credit risk rating can be a Risk Management tool for prospecting fresh borrowers in addition to monitoring the weaker parameters and taking remedial action. CREDIT RISK MANAGEMENT FRAMEWORK AT MEEZAN BANK As per SBP guidelines on Integrated Risk Management of Banks, all exposures across the Bank have to be risk rated. In this regard,Bank appointed Consultants recommended the following in respect of Credit Risk Management Framework for the Bank.AUTHORITY FOR RATING The recommending Authority for the Credit Risk rating shall be the Manager (Credit), in respect of VLB/ELBs and the Manager in-charge, RO in respect of RO power accounts. Sanctioning authority will be assigned with the power for confirming the rating of an account. In respect of ELB/VLBs, the rating will be done at the branch level itself and the rating will be confirmed by the respective AGM/CM of the branch. In respect of RO power accounts, branches shall ensure to furnish all the required particulars to the concerned RO while submitting the credit report at the time of renewal (as per the Annexure). PROCESSES AND PRACTICES OF CREDIT RISK MANAGEMENT IN MEEZAN BANK The bank has understood the need for credit risk management as described by SBP. They have identified the types of risks and are disclosed in the BASEL II disclosures every quarter appropriately in the banks website. Credit risk faced by the bank is properly identified which includes the following:

1) The gross credit risk exposure has grown to Rs. 80064.90 crore as of 30.9.2011 which is a 29% increase from the previous year that is 30.9.2010. Credit quality has is standard due to their sound credit risk management system. 2) They have made sufficient provisions for NPAs, NPIs and depreciation. 3) Volume of off-balance sheet exposures for both financial collateral and guarantee covered credit portfolio together is Rs. 136281.33 crore as of 30.9.2011 as against Rs. 101320.2 crore as of 30.9.2010. The bank decides on how much risk to take based on their risk appetite. The banks risk management policy is fine tuned to include credit appraisal standard like benchmark/hurdle ratios on key financial indicators, internal ceilings, prudential norms, etc. besides covering exposure ceiling for sensitive sectors such as capital market, real estate and commodity sector.

CREDIT RISK MITIGATION Based on the policies strategies are developed by the bank to mitigate credit risk. Credit risk is mitigated by appropriate credit appraisal systems before lending and proper collateral or guarantees are taken to hedge the risk. Integrated risk management system is put in place for better management of credit risk and a risk rating software is installed which is developed by CRISIL in compliance with SBP guidelines. The risk management function is reviewed periodically usually every quarter. The rating system for term loans is annual. The risk weights of the banks products are shown in the figure below:

FINDINGS The bank has a documented credit risk management policy. The bank uses credit rating system to assess credit risk as a part of loan lending mechanism. They use standardized approach for credit risk measurement currently and are fine tuning to upgrade to advanced approaches as per SBP guidelines. They have implemented an integrated risk management system as per SBP guidelines (MIS). They mitigate credit risk exposure through diversification, collaterals and guarantees. The credit risk exposure of the bank has decreased considerably in the last five years indicating a sound risk management policy. The risk weights associated with the banks products are in line with SBP guidelines. They have regular trainings for their credit risk management teams on the policies and guidelines. They rely on ratings provided by CRISIL/CARE/ICRA as per SBP guidelines.

RECOMMENDATIONS

They can invest in securitization as securitization exposures are nil. They have to start preparing for BASEL III norms which might come into effect in the near future. They can further decrease their credit risk exposures with better credit risk management policies and advanced approaches as per SBP guidelines. Bank should include credit risk component in yearly forecast based on multiple market scenarios.

CONCLUSIONThe bank follows a sound credit risk management and credit risk mitigation policy which is proven by the decreasing credit risk exposure of the bank for the past five years. The bank has adhered to SBP guidelines and implemented BASEL II norms and an integrated risk management system and risk rating software. The credit risk policies and strategies of the bank have improved over years and the bank is in a better position. The study shows that compliance with BASEL II norms helps the banks to improve their profitability through better credit risk management systems.

LEARNING OUTCOMES Understanding of the risk management in banks. Understanding of the credit risk management practices of MEEZAN Bank. Understanding of the SBP guidelines in respect of risk management practices to be followed by the banks. Understanding of risk rating framework of banks and lending policies of the bank. Understanding of BASEL II norms and implications.

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BIBLIOGRAPHY http://ercim-news.ercim.eu/en78/special/improving-banks-credit-risk-management http://www.sas.com/news/preleases/risk-management-for-banking.html http://www.financialexpress.com/news/banks-need-to-review-credit-risk-mgmt-systems/464894/ http://www.amazon.com/Credit-Risk-Assessment-Borrowers-www.Meezan bank.pkNotes of FRM Given by Sir Ajab Khan Burki5