Electronic copy available at: http://ssrn.com/abstract=1849144

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Credit Risk Management Practices –An Evaluation of Commercial Banks in Bangladesh

Abstract

This study first identifies the importance of Credit Risk Management for commercial banks

and then tries to find out the existing procedures for credit risk management that are

followed by the different commercial banks in Bangladesh. The future of banking will

undoubtedly rest on risk management dynamics. Only those banks that have efficient risk

management system will survive in the market in the long run. The effective management of

credit risk is a critical component of comprehensive risk management essential for long-

term success of a banking institution. From the study we found that the existing procedures

of credit management are not adequate to compete with the challenging financial and

economic environment. This paper is concluded with some guidelines that will help

commercial banks to sustain in the volatile market.

Key words: Credit, Risk Management, Tools of credit, Credit Risk Grading.

Electronic copy available at: http://ssrn.com/abstract=1849144

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Introduction

The word "Credit" is derived from the Latin word "credo" meaning, "I believe". Speaking

broadly, credit is finance made available by one party (lender, seller, or shareholder/owner)

to another (borrower, buyer, corporate or non-corporate firm) (Woelfel 1994). More

generally the term credit is used narrowly for debt finance. Credit is simply the opposite of

debt. Debt is the obligation to make future payments. Credit is the claim to receive these

payments. So, credit is referred to “The right to receive payment or an obligation to make

payment on demand or at some future time on account of the immediate transfer of goods

(securities)” (Johan and John 1994).

One of the two primary functions of a commercial bank is to extend credit to the deficit

economic unit that comprises borrowers of all types. Bank credit is a catalyst of economic

development. Without adequate finance, there can be no growth in the economy. Bank

lending is important for the economy in the sense that it can simultaneously finance all of

the sub-sectors of financial arena, which comprises agricultural, commercial and industrial

activities of a nation (Radhaswami and Vasudevan 2000). Therefore, a bank is supposed to

distribute its loan able fund among economic agent-in-deficit in a manner that it will

generate sufficient income for it and at the same time benefit the borrower to overcome

his/her deficit.

Risk is the potentiality that both the expected and unexpected events may have an adverse

impact on the bank’s capital or earnings. The expected loss is to be borne by the borrower

and hence is taken care by adequately pricing the products through risk premium and

reserves created out of the earnings. Whereas, the unexpected loss on account of individual

exposure and the whole portfolio is entirely is to be borne by the bank itself and hence is to

be taken care by the capital (Arunkumar and Kotreshwar 2005).

The future of banking will undoubtedly rest on risk management dynamics. Only those

banks that have efficient risk management system will survive in the market in the long run.

The effective management of credit risk is a critical component of comprehensive risk

management essential for long-term success of a banking institution (Caouette et al. 1998).

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Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business,

inherits. This has however, acquired a greater significance in the recent past for various

reasons. Foremost among them is the wind of economic liberalization that is blowing across

the globe (Chowdhury 2002). Bangladesh is no exception to this swing towards market

driven economy. Competition from within and outside the country has intensified. This has

resulted in multiplicity of risks both in number and volume resulting in volatile markets.

The credit risk in a bank’s loan portfolio consists of three components (Arunkumar and

Kotreshwar 2005):

(1) Transaction Risk: Transaction risk focuses on the volatility in credit quality and

earnings resulting from how the bank underwrites individual loan transactions. Transaction

risk has three dimensions: selection, underwriting and operations.

(2) Intrinsic Risk: It focuses on the risk inherent in certain lines of business and loans to

certain industries. Intrinsic risk addresses the susceptibility to historic, predictive, and

lending risk factors that characterize an industry or line of business.

(3) Concentration Risk: Concentration risk is the aggregation of transaction and intrinsic

risk within the portfolio and may result from loans to one borrower or one industry,

geographic area, or lines of business. Bank must define acceptable portfolio concentrations

for each of these aggregations.

The corner stone of credit risk management is the establishment of a framework that

defines corporate priorities, loan approval process, and credit risk rating system, risk-

adjusted pricing system, loan-review mechanism and comprehensive reporting system

(David 1997). The two distinct dimensions of credit risk management can readily be

identified as preventive measures and curative measures. Preventive measures include risk

assessment, risk measurement and risk pricing, early warning system to pick early signals

of future defaults and better credit portfolio diversification. The curative measures, on the

other hand, aim at minimizing post-sanction loan losses through such steps as

securitization, derivative trading, risk sharing, legal enforcement etc. It is widely believed

that an ounce of prevention is worth a pound of cure (Das, S.C. et al. 2005).

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Objectives of the Study:

The present study attempts to achieve the following objectives:

1. Evaluating the credit risk management practices of commercial banks in

Bangladesh.

2. Suggesting a broad outline of measures for improving credit risk management

practices of Bangladeshi commercial banks.

3. Profiling and analysis of concentration risk in commercial banks.

4. Reviewing the New Basel Capital Accord norms and their likely impact on credit

risk management practices of Bangladeshi commercial banks.

5. Examining the role of Risk Based Supervision in strengthening credit risk

management practices of commercials banks in Bangladesh.

6. To review the techniques used by the bank to make it lucrative.

7. Find out the challenges associated with this business and overcome this.

8. To get an overall idea of Credit Risk Management practices in Bangladesh.

Significance of the study

Importance of credit is realized from both macro and micro aspects of economy. At Macro

level credit influences and is influenced by quantity of money, level of economic activity,

imports and net foreign assets. At micro level credit influences behaviour of economic

sector (industry, agriculture) and behaviour of economic agents (business, financial

institutions, households). It is, therefore, imperative that the banks have adequate systems

for credit assessment of individual projects and evaluating risk associated therewith as well

as the industry as a whole. Generally, Banks in Bangladesh evaluate a proposal through the

traditional tools of project financing, computing maximum permissible limits, assessing

management capabilities and prescribing a ceiling for an industry exposure. As banks move

in to a new high powered world of financial operations and trading with new risks, the need

is felt for more sophisticated and versatile instruments for risk assessment, monitoring and

controlling risk exposures. It is, therefore, time that banks managements equip themselves

fully to grapple with the demands of creating tools and systems capable of assessing,

monitoring and controlling risk exposures in a more scientific manner. In this study we try

to find out how the commercial banks in Bangladesh evaluate their risk and what they

should do.

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Tools for Credit Management

Effective credit management is must for a bank to sustain its profitability and growth. The

lending banker needs some tools or instrument by means of which he can manage his/her

credit portfolio in a fruitful way. Some of these tools that are regarded indispensable for the

management of different credit portfolio are furnished below.

I.Security:

It ensures recovery of loans and advances. Though now-a-days greater emphasis is put on

the purpose of the loan rather than securities, nevertheless the securities play an extremely

important role to take a decision. The types of securities offered vary from place to place.

However securities can be classified into two categories on the basis of their nature. a)

Primary security: means the security offered by the borrower himself as cover for the

loan. It refers to the asset, which has been bought with the help of the bank .b) Collateral

security: means all other additional security other than the primary securities such as land /

Building etc. are considered as collateral securities which may be offered / deposited by the

borrower or , by any other third party.

II. Margin:

Margin is a cushion against any possible shortage. It is a portion of borrower's

contribution. The fixation of margin depends on the nature and type of security and the

financial stability of the customer and also keeping in view the restrictions imposed by the

Bangladesh Bank (Head Office from time to time). In case of goods reasonable margin

should be retained for covering any shortage due to shrinkage, fluctuation of rate, fall in

prices and charging of bank interest.

III. Creation of Charge:

While advancing money, banker must secure his position. Not only that he should insist on

good security but the method of charging it should be legal and perfect. The securities may

be charged by any of the following ways (Das, S.C. et al. 2005 ): Lien, Pledge,

Hypothecation, Mortgage, Charge, Actionable claims, Assignment, Set-off.

� A lien is the right of a person in the possession of goods, to retain them until debts

due to him have been satisfied.

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� A pledge is the bailment of goods as security for payment of a debt or performance

of a promise.

� Hypothecation is defined as a charge against property for an amount of debt where

neither ownership nor possession is passed to the creditor. It means creating some

claim in goods or related documents without transferring their possession to the

lender.

� Mortgages are advances against immovable property. A mortgage is the transfer

of an interest in specific immovable property for the purpose of securing the

payment of money or advances by way of loan, an existing or future debt or the

performance of an engagement that may give rise to a pecuniary liability.

� Where immovable property of one person is, by act of parties or operation of law

made security for the payment of money to another and the transaction does not

amount to a mortgage, the later person is said to have a charge on the property, and

all the provisions which apply to a simple mortgage, shall so far as may be, apply to

such charge.

� An actionable claim means a claim to a) Any unsecured debt or, b) Any beneficial

interest in movable property not in the possession of the claimant.

� An assignment means transfer of right, property or debt (existing or future or to

make it over to another person).

� Set-off: It is, in effect, the combining of accounts between a debtor and a creditor

so as to arrive at the net balance payable to one or the other.

IV.Reporting to Credit Investigation Bureau (CIB) of Bangladesh Bank(BB):

Irrespective of outstanding amount, the Banks have to submit credit information of all of

then- accounts of loans and advances to the CIB of BB.

Category/ Classification of CIB Statements

Range Period

Over I crore Monthly

Over 10.00 lac but Under 1.00 Crore Quarterly

Under 10.00 lac but over 1.00 lac Quarterly

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V.Documentation: Documentation refers to the process involved in taking documents right

from drafting to the execution and ultimate recording in appropriate register. The

documentation does establish a legal relationship between the lending banker and the

borrower. The documents are of great importance to the banks as they assure the character

of primary evidence in any dispute between the parties to loans and advances.

VI.Credit Disbursement:

Having completely and accurately prepare the necessary loan documents, the loan officer

ready to disburse the loan to the borrower’s loan account. After disbursement, the loan

needs to be monitored to ensure whether the terms and conditions of the loan fulfilled by

both bank and client or not.

Techniques of Credit Analysis

The division of the bank responsible for analyzing and recommendations on the destiny of

most loan applications is the credit department. Experience has shown that this department

must satisfactorily answer three major questions regarding each loan application:

I. Is the borrower creditworthy?

II. Can the loan agreement be adequately protected and the customer has a high

probability of being able to service the loan without excessive strain?

III. Can the bank perfect its claim against the assets or earnings of the customer so that,

in the event of default, bank funds can be recovered rapidly at low cost and with

low risk?

I.Is the Borrower Creditworthy?

The question that must be dealt with before any other is whether or not the customer can

service the loan-that is, pay out the credit when due, with a comfortable margin for error.

This usually involves a detailed study of following six aspects:

A. Character. The loan officer must be convinced that the customer has a well-defined

purpose for requesting bank credit and a serious intention to repay. If the officer is not sure

exactly why the customer is requesting a loan, this purpose must be clarified to the bank’s

satisfaction. Responsibility, truthfulness, serious purpose, and serious intention to repay all

monies owed make up what a loan officer calls character.

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B. Capacity. The loan officer must be sure that the customer requesting credit has the

authority to request a loan and the legal standing to sign a binding loan agreement. This

customer characteristic is known as the capacity to borrow money.

C. Cash. This key feature of any loan application centers on the question: Does the

borrower have the ability to generate enough cash, in the form of cash flow, to repay the

loan? In general, borrowing customers have only three sources to draw upon to repay their

loans: (a) cash flows generated from sales or income, (b) the sale or liquidation of assets,

(c) funds raised by issuing debt or equity securities. Any of these sources may provide

sufficient cash to repay a bank loan.

D. Collateral. In assessing the collateral aspect of a loan request, the loan officer must ask,

does the borrower possess adequate net worth or own enough quality assets to provide

adequate support for the loan? The loan officer is particularly sensitive to such features as

the age, condition, and degree of specialization of the borrower’s assets.

E. Conditions. The loan officer and credit analyst must be aware of recent trends in the

borrower’s line of work or industry and how changing economic conditions might affect the

loan.

F. Control. The last factor in assessing a borrower’s creditworthy status is control which

centers on such questions as whether changes in law and regulation could adversely affect

the borrower and whether the loan request meets the bank’s and the regulatory authorities’

standards for loan quality.

II.Can the Loan Agreement Be Properly Structured and Documented?

A properly structured loan agreement must also protect the bank and those it represents-

principally its depositors and stockholders- by imposing certain restrictions (covenants) on

the borrower’s activities then these activities could threaten the recovery of bank funds. The

process of recovering the bank’s funds- when and where the bank can take action to get its

funds returned-also must be carefully spelled out in a loan agreement.

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III.Needs for Collateral

Most Borrowers at one time or another will be asked to pledge some of their assets or to

personally guarantee the repayment of their loans. Getting a pledge of certain borrower

assets as collateral behind a loan really serves two purposes for a lender. Firstly, If the

borrower cannot pay, the pledge of collateral gives the lender the right to seize and sell

those assets designated as loan collateral, using the proceeds of the sale to cover what the

borrower did not pay back. Secondly, collateralization of a loan gives the lender a

psychological advantage over the borrower.

Procedure of Loan Classification

The loan classification procedure for all types of loan is governed by the guidelines

contained in BCD Circular no 34 issued by Bangladesh Bank, in 1989 and subsequently

revised partially through BRPD Circular no 16, issued in 1999. After that there was

another BRPD Circular (No. 16 dated May 14, 2001) circulated that brings some changes in

case of continuous & demand loans.

i) General Principles:

(a) Inspection: The department of banking Inspection and the agricultural Credit

Inspection Department, Bangladesh Bank will inspect the classification, interest

suspense and provisioning carried out by the banks.

(c) Branch level action: Classification, interest suspense calculations and provisioning

calculations should be done so that the results are available at both the head quarters

and the branch level on a loan-by-loan basis.

(d) Importance: The implementation of these classification procedures is of the utmost

importance and all banks must comply with this Circular promptly as set out below.

ii) Types of classified loan (C.L .)

(a) C.L.-1: Summary of classified loan

(b) C.L.-2: Cash credit (SOD)

(c) C.L.-3: Demand loan

(d) C.L.-4: Term loan up to 5 years

(e) C.L.-5: Term loan above 5 years

(f) C.L.-6: Agri./Micro credit.

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iii) Categories of loans and advances of a bank:

a. Un-classified: The repayment of loan and advances are regular.

b. Special Mention Account: Early warning mechanism to look at accounts with

potential problems in focused manner.

c. Sub- standard: The repayment of loan and advances are irregular but has reasonable

prospect of improvement.

d. Doubtful debt: It is unlikely to be repaid but special collection efforts may result in

partial recovery.

e. Bad/loss: There is little chance of recovery of loans and advances.

iv) Types of loans to be classified:

(a) Continuous loan: The loan, which is transacted without specific repayment

schedule but there is expiry date and credit limit is called continuous loan. Ex. Cash

Credit (CC).

(b) Demand loan: The loan which is payable after demand of bank. Moreover, if any

contingent on other liabilities that is turned into forced loan (not sanction as regular

loan earlier) is to be treated as demand loan. Ex. Forced LIM (loan against

imported merchandise), PAD (payment against document) etc.

(c) Term loan: The loan, which is payable on specific repayment schedule and specific

period is to be treated as term loan.

(d) Short-term agriculture and Micro credit: Short- term agriculture loan include the

short- term credit mentioned in the circular issued by Agriculture Credit Department

of Bangladesh Bank under annual credit program. Loan disbursed in agri-sector

repayable within 12 months will also be treated under this head. Short-term small

loan means loan up to Tk. 10000 and micro credit repayable within 12 months.

v) Basis for loan Classification:

(a) Objective Criteria:

(1) Continuous Loan:

A continuous loan will be treated as irregular/overdue if the advance has not been renewed,

that is expiration date is passed. If the loans become irregular for 3 months or more but less

than 6 months, the loan will be treated as sub standard. If the loan becomes irregular for 6

months or more but less than 12 months, the loan will be treated as doubtful. If the loan

becomes irregular for 12 months or above, the loan will be treated as bad loan.

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(2) Demand Loan:

A demand loan will be treated as sub- standard, doubtful, bad loan for the period of 3

months or more but less than 6 months, 6 months or more but less than 12 months, 12

months or above respectively.

(3)Term Loan:

If any installment of a term loan is not repaid within as per repayment schedule the unpaid

amount will be treated as overdue installment.

Term Loan payable within 5years:

(i) If the amount of overdue installment stands equal or more than the amounts which is

repayable 6 months, the entire advances will be treated as sub-standard.

(ii) If the amount of overdue installment stands equal or more than the amounts which is

repayable 12 months, the entire advances will be treated as doubtful.

(iii) If the amount of overdue installment stands equal or more than the amounts which is

repayable 18 months, the entire advances will be treated as bad/loss.

Term Loan payable over 5years:

(i) If the amount of overdue installment stands equal or more than the amounts which is

repayable 12 months, the entire advances will be treated as bad/loss.

(ii) If the amount of overdue installment stands equal or more than the amounts which is

repayable 18 months, the entire advances will be treated as bad/loss.

(iii) If the amount of overdue installment stands equal or more than the amounts which is

repayable 24 months, the entire advances will be treated as bad/loss.

Short- term Agricultural Micro credit:

(i) If the advances remain irregular for 12 months the amount is treated as sub-

standard.

(ii) If the advances remain irregular for 36 months the amount is treated as

doubtful.

(iii) If the advances remain irregular for 60 months the amount is treated as

bad/loss.

(b) Qualitative Criteria:

The loan (continuous, demand, and term loan) should be classified by the lending bank

whenever the bank has sufficient reason to believe that the loaner may not be able to repay

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the loan due to change the circumstances under which the loan was originally sanctioned,

i.e., on the basis of qualitative factors, this Judgment can be made regardless whether the

loan is overdue or not on the basis of objective criteria. This criterion includes but is not

limited to: more than a normal risks due to adverse financial condition (arising from loss of

a part of borrower's capital), poor financial performance of the borrowers (borrowers cash

low is insufficient to service debt requirements) or due to insufficiency of security (value of

security is less than the amount of loan outstanding) or other unfavorable factors.

vi) Accounting Procedure for Calculation of Interest of Classified Loan:

(a) Interest on classified loan (as sub-standard or doubtful) can be charged but cannot be

shown as interest income, interest on classified loan to be provided/shown as interest

suspense account.

(b) Interest cannot be charged on loan, which is classified as bad/loss. If any suit is to be

filed for recovery of such loan, interest to be charged up to time of filling suit for

recovery the principle including interest. But such interest to be shown as interest

suspense account.

(c) If any classified loan or part of the loan is realized, then charged or uncharged interest

on that loan to be adjusted first. Principle amount will be adjusted after adjusted of

the above interests.

vii) Maintaining of Provisions:

(a) The bank will make provision against classified loan for current, demand, a term loan at

the rates as mentioned below:

( i) Un-Classified-----------1%

(ii) Sub-standard ----- 20%

(iii) Doubtful --------- 50%

(iv) Bad/Loss -------- 100%

(b) Provision to be made on the amount found by deducting the interest suspense A/C

and value of eligible securities from the outstanding balance of the classified loans.

provision at the rate of 1% to be maintained on the classified loan.

(c) List of eligible securities:

(i) 100% of deposits lien against loan.

(ii) I 00% market value of gold and gold ornament bailed to the bank.

(iii) 100% value of govt. bond or SP liened to the bank.

(iv) 100% of guarantee given by BB.

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(v) 50% market value of marketable goods under the control of bank.

(vi) Maximum 50% market value of land and building kept as mortgage.

(d) Rate of provision on short-term agricultural and micro credit shall be maintained as

below:

(i) For un-classified loan, sub-standard, and doubtful loan as 5%.

(ii) For bad loan as 100%.

viii) To Measures for Non-Repayment of Loan:

(i) Issue notice for adjustment.

(ii) To issue legal notice for filling suit.

(iii) To encash securities (in case of demand loan).

(iv) To issue legal notice for selling the hypothecated goods.

(v) To issue suit for foreclosure.

(vi) Finally to sue in money loan court or insolvency court which is suitable?

Steps in the Lending Process • Most bank loans to individuals arise from a direct request from a customer who

approaches a member of the bank’s staff and asks to fill up a loan application. Business

can requests, on the other hand, often arise from contacts the bank’s loan officers and

sales representatives make as they solicit new accounts from firms operating in the banks

market area. Sometimes loan officers will call on the same company for months before

the customer finally agrees to give the bank a try by filling up a loan application.

• Once a customer decides to request a loan, an interview with a loan officer usually

follows right away, giving the customer the opportunity to explain his or her credit needs.

That interview is particularly important because it provides an opportunity for the bank’s

loan officer to assess the customer’s character and sincerity of purpose.

• If a business or mortgage loan is applied for, a site visit is usually made by an officer of

the bank to assess the customer’s location and the condition of the property and to ask

clarifying questions. The loan officer may contact other creditors who have previously

loaned money to this customer to see what their experience has been.

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• If all is favorable to this point, the customer is asked to submit several crucial documents

the bank needs in order to fully evaluate the loan request, including complete financial

statements and, in the case of a corporation, board of directors’ resolutions authorizing

the negotiation of a loan with the bank. Once all documents are on file, the credit analysis

division of the bank conducts a thorough financial analysis of them aimed at determining

whether the customer has sufficient cash flows and backup assets to repay the loan. The

credit analysis division then prepares a brief summary and recommendation, which goes

to the loan committee for approval.

• If the loan committee approves the customer’s request, the loan officer or the credit

committee will usually check on the property or other assets to be pledged as collateral in

order to ensure that the bank has immediate access to the collateral or can acquire title to

the property involved if the loan agreement is defaulted. This is often referred to as

perfecting the bank’s claim to collateral. Once the loan officer and the bank’s loan

committee are satisfied that both the loan and the proposed collateral are sound, the note

and other documents that make up a loan agreement are prepared and are signed by all

parties to the agreement.

Evaluation of Credit Risk

To effectively manage credit risk, every bank formulated and implemented the credit risk

grading manual in the credit approval system as prescribed by the Bangladesh Bank. Each

client is assigned with a credit risk grading score to denote the credit rating of the party.

The Credit Risk Grading (CRG) is a collective definition based on the pre-specified scale

and reflects the underlying credit-risk for a given exposure. In 1993, Bangladesh Bank as

suggested by Financial Sector Reform Project (FSRP) first introduced and directed to use

Credit Risk Grading system in the Banking Sector of Bangladesh under the caption

“Lending Risk Analysis (LRA)”. The CRG scale consists of 8 categories with Short names

and Numbers are provided as follows:

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Grading Short Name Number

Superior SUP 1

Good GD 2

Acceptable ACCPT 3

Marginal/Watchlist MG/WL 4

Special Mention SM 5

Sub standard SS 6

Doubtful DF 7

Bad & Loss BL 8

A clear definition of the different categories of Credit Risk Grading is given as follows:

• Superior - (SUP) - 1

Credit facilities, which are fully secured i.e. fully cash covered, fully covered by

government guarantee, fully covered by the guarantee of a top tier international Bank.

• Good - (GD) - 2

The borrower has strong repayment capacity, excellent liquidity, low leverage, well

established strong market share, good management skill & expertise. The company

demonstrates consistently strong earnings and cash flow. All security documentation should

be in place. Credit facilities fully covered by the guarantee of a top tier local Bank and

aggregate Score of 85 or greater based on the Risk Grade Score Sheet.

• Acceptable - (ACCPT) - 3

These borrowers are not as strong as GOOD Grade borrowers, but still demonstrate

consistent earnings, cash flow and have a good track record. Borrowers have adequate

liquidity, cash flow and earnings, acceptable management and parent/sister company

guarantee. Credit in this grade would normally be secured by acceptable collateral (1st

charge over inventory / receivables / equipment / property) and aggregate Score of 75-84

based on the Risk Grade Score Sheet.

• Marginal/Watch list - (MG/WL) - 4

This grade warrants greater attention due to conditions affecting the borrower, the industry

or the economic environment. These borrowers have an above average risk due to strained

liquidity, higher than normal leverage, thin cash flow and/or inconsistent earnings, weaker

business credit & early warning signals of emerging business credit detected. The borrower

incurs a loss, loan repayments routinely fall past due, account conduct is poor, or other

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untoward factors are present. This kind of credit requires attention and aggregate Score of

65-74 based on the Risk Grade Score Sheet.

• Special Mention - (SM) - 5

This grade has potential weaknesses that deserve management’s close attention. If left

uncorrected, these weaknesses may result in a deterioration of the repayment prospects of

the borrower. Severe management problems exist. Facilities should be downgraded to this

grade if sustained deterioration in financial condition is noted (consecutive losses, negative

net worth, excessive leverage). An Aggregate Score of 55-64 based on the Risk Grade

Score Sheet.

• Substandard - (SS) - 6

Financial condition is weak and capacity or inclination to repay is in doubt. These

weaknesses jeopardize the full settlement of loans. An Aggregate Score of 45-54 based on

the Risk Grade Score Sheet.

• Doubtful - (DF) - 7

Full repayment of principal and interest is unlikely and the possibility of loss is extremely

high. However, due to specifically identifiable pending factors, such as litigation,

liquidation procedures or capital injection, the asset is not yet classified as Bad & Loss. An

Aggregate Score of 35-44 based on the Risk Grade Score Sheet.

• Bad & Loss - (BL) - 8

Credit of this grade has long outstanding with no progress in obtaining repayment or on the

verge of wind up/liquidation. Prospect of recovery is poor and legal options have been

pursued. Proceeds expected from the liquidation or realization of security may be awaited.

The continuance of the loan as a bankable asset is not warranted, and the anticipated loss

should have been provided for. This classification reflects that it is not practical or desirable

to defer writing off this basically valueless asset even though partial recovery may be

affected in the future. Bangladesh Bank guidelines for timely write off of bad loans must

be adhered to legal procedures/suit initiated. An Aggregate Score of less than 35 based on

the Risk Grade Score Sheet.

Computation Credit Risk Grading ():

Computation of credit risk is not a single task. It is the combination of some steps based on

market risk segment. According to Das, S.C. et al. (2005), following step-wise activities

outline the detail process for arriving at credit risk grading.

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Step I : Identify all the Principal Risk Components:

Credit risk for counterparty arises from an aggregation of the following:

� Financial Risk

� Business/Industry Risk

� Management Risk

� Security Risk

� Relationship Risk

Step II Allocate weightages to Principal Risk Components In step (ii) each of the above mentioned key risk areas require be evaluating and

aggregating to arrive at an overall risk grading measure. According to the importance of

risk profile, the following are the weightages for corresponding principal risks.

Principal Risk Components: Weight:

� Financial Risk 50%

� Business/Industry Risk 18%

� Management Risk 12%

� Security Risk 10%

� Relationship Risk 10%

Step III Establish the Key Parameters

Principal Risk Components Key Parameters

Financial Risk Leverage, Liquidity, Profitability & Coverage ratio

Business/Industry Risk Size of Business, Age of Business, Business Outlook, Industry

Growth, Competition & Barriers to Business

Management Risk Experience, Succession & Team Work.

Security Risk Security Coverage, Collateral Coverage and Support.

Relationship Risk Account Conduct ,Utilization of Limit, Compliance of

covenants/conditions & Personal Deposit

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Step IV Assign weightages to each of the key parameters

Principal Risk Components Key Parameters Weight

Financial Risk 50%

Leverage

Liquidity

Profitability

Coverage

15%

15%

15%

5%

Business/Industry Risk 18%

Size of Business

Age of Business

Business Outlook

Industry growth

Market Competition

Entry/Exit Barriers

5%

3%

3%

3%

2%

2%

Management Risk 12%

Experience

Succession

Team Work

5%

4%

3%

Security Risk 10%

Security coverage

Collateral coverage

Support

4%

4%

2%

Relationship Risk 10%

Account conduct

Utilization of limit

Compliance of covenants

Personal deposit

5%

2%

2%

1%

Step V Input data to arrive at the score on the key parameters.

After the risk identification & weightage assignment process the next steps will be to input

actual parameter in the score sheet to arrive at the scores corresponding to the actual

parameters.

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Step VI Arrive at the Credit Risk Grading based on total score obtained. The following is the proposed Credit Risk Grade matrix based on the total score obtained

by an obligor.

Number Risk Grading Short Name Score

1 Superior SUP � 100% cash covered

� Government guarantee

� International Bank guarantees

2 Good GD 85+

3 Acceptable ACCPT 75-84

4 Marginal/Watchlist MG/WL 65-74

5 Special Mention SM 55-64

6 Sub-standard SS 45-54

7 Doubtful DF 35-44

8 Bad & Loss BL <35

Credit Risk Grading for each borrower should be assigned at the inception of lending and

should be periodically updated. Frequencies of the review of the credit risk grading are

mentioned below;

Number Risk Grading Short Review frequency (at least)

1 Superior SUP Annually 2 Good GD Annually 3 Acceptable ACCPT Annually 4 Marginal/Watchlist MG/WL Half yearly 5 Special Mention SM Quarterly 6 Sub-standard SS Quarterly 7 Doubtful DF Quarterly 8 Bad & Loss BL Quarterly

20

Conclusion

Credit Risk Management in today’s deregulated market is a big challenge. Increased market

volatility has brought with it the need for smart analysis and specialized applications in

managing credit risk. A well defined policy framework is needed to help the operating staff

identify the risk-event, assign a probability to each, quantify the likely loss, assess the

acceptability of the exposure, price the risk and monitor them right to the point where they

are paid off. To avoid being blindsided, banks must develop a competitive Early Warning

System (EWS) which combines strategic planning, competitive intelligence and

management action. EWS reveals how to change strategy to meet new realities, avoid

common practices like benchmarking and tell executives what they need to know – not

what they want to hear.

The reputation of a bank is very important for corporate clients. A corporation seeks to

develop relationship with a reputable banking entity with a proven track record of high

quality service and demonstrated history of safety and sound practices. Therefore, it is

imperative to adopt the advanced Basel-II methodology for credit risk. The Basel

Committee has acknowledged that the current uniform capital standards (Basel I) are not

sensitive and suggested a Risk Based Capital approach (Basel II)that is essential for the

commercial banks in Bangladesh to prepare themselves to be competitive among the

world’s largest banks. It is only expected that they adopt the international best practices in

credit risk management. For this purpose some guidelines of credit are given below:

Credit guidelines:

• It should contain terms and conditions that adhered to in order for loans to be approved.

• It should be updated annually to reflect changes in economic outlook & evaluate the bank

loan portfolio.

• It should be distributed to lending/marketing officer and approved by MD/CEO and head

of CRM.

• It should endorse to bank’s Head of credit risk management and Head of

corporate/commercial banking.

Should consider the following factor:

21

• Facility parameters and the basis of setting those parameter should be stated clearly e.g.,

maximum size, maximum tenor, and covenant and security requirements

• Banks should not grant facilities where the banks security position is inferior to that of

any other financial institutions

• Properly insured the assets pledged as security

• Valuation of tangible security should be performed prior to loans being granted. A

recognized 3rd party professional valuation should be appointed to conduct valuations.

Banks should be discoursed the following types of business:

• Finance of speculative investments and highly leveraged transactions.

• Logging, mineral extraction/mining, or other activity that is ethically or environmentally

sensitive

• Lending to companies listed on CIB or known defaulters

• Bridge loans relying on equity/debt issuance as a source of repayment.

Moreover, credit approval, credit administration and credit recovery functions should be

segregated in the bank. Credit approval authority should be delegated to the individual

executives. Proposal beyond their delegation is to be approved or declined by the Board of

Directors. However, in determining Single Borrower/ Large Loan limit, the instruction of

BB should be strictly followed. Internal audit should conduct on periodical interval to

ensure compliance of banks and regulatory policies. At last Banker should always

remember:

“…….…………………A bank’s success lies in its ability to assume and aggregate risk

within tolerable and manageable limits”.

22

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