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Credit Risk Management Practices in Banks: An Appreciation
Md. Saidur Rahman
Abstract The banks in Bangladesh have started undertaking a
number of 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
borrowers 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 banks
credit portfolio. The credit portfolio of a bank usually consists
of money market portfolio, capital market portfolio and general
credit portfolio. Here a bank is highly exposed in the risks of
capital market and general credit 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
authors own.
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Journal of Islamic Economics, Banking and Finance, Vol. 7, No.
3, Jul Sep 2011 38
perceived risks in credit related activities. One of the goals
of credit risk management in banks is to maximize a banks
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 in-depth 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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Credit Risk Management Practices in Banks: An Appreciation
39
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 Z-score
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 customers 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
Source: Rose, Peter S. (1996), Banking Credit: Policies and
Procedures, Commercial Bank Management ,3rd edition, Boston:
Irwin-McGraw-Hill Publishing.
Personal guarantees and pledges made by the
owners of a business firm or by cosigners to a credit.
Resources on the customers balance sheet
and collateral pledged.
Customers expected profits, income
or cash flow.
Principal amount of credit plus interest owed the bank.
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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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Credit Risk Management Practices in Banks: An Appreciation
41
3. Observations on Previous Practices The Financial Sector
Reform Program (FSRP) was introduced in the early nineties in
Bangladesh with a view to bringing about financial discipline by
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 borrowers 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 non-repayment 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 Security Risk
1.Industry Risk
1.1 Supplies Risk
1.2 Sales Risk
2.Company Risk
2.1 Company Position Risk
Performance Risk
Resilience Risk
2.2 Management Risk
Management Competence Risk
Management Integrity Risk
1. Security Control Risk
2. Security Cover Risk
Source: FSRP Bangladesh, Credit Risk Analysis, June 1993.
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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 side-by-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 individuals own judgment and biasness
are remained in assessing credit risk through LRA. Single Form for
assessing varieties of credits and ambiguities regarding some terms
and concepts incorporated in the LRA Manual makes it difficult to
use a proper credit risk assessment tool. Keeping these 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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Credit Risk Management Practices in Banks: An Appreciation
43
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
Credit Assessment &
Risk Grading Approval Authority Segregation of Duties Internal
Audit
Structure Key Responsibilities
Approval Process Credit
Administration Credit Monitoring Credit Recovery
Source: Bangladesh Bank (2003), Managing Core Risks in Banking:
Credit Risk Management, Dhaka: Bangladesh Bank, Head Office.
Bangladesh Bank, under its prudential regulatory guidelines,
advised all the banks and financial institutions in Bangladesh to
follow a robust and structured 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 banks 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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Credit Risk Management Practices in Banks: An Appreciation
45
ready to meet all the legitimate demands for credit facilities
at all the times by customizing their credit policy. While looking
into the matter of customizing credit policy, the changes in
economic outlook and the evolution of banks 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
clients 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 banks asset quality and it is a robust process.
Therefore borrowers 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 borrowers
business/industry risk the size of borrowers 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 Grade
Description Weighted Score
Key Indicators
1 Superior (SUP)
None -Facilities are fully cash secured, secured by
Government/international bank guarantee.
2 Good (GD) 85 + - Repayment capacity: Strong - Liquidity:
Excellent - Leverage: Low - Earnings & Cash Flow: Consistently
Strong - Track record/Account conduct: Unblemished
3 Acceptable (ACCPT)
75 - 84 - Repayment capacity: Adequate. - Liquidity: Adequate -
Earnings & Cash Flow: Adequate & Consistent.
- Track record/Account conduct: Good 4 Marginal
/Watch List (MG/WL)
65 - 74 - Repayment: Routinely fall past due - Liquidity:
Strained liquidity - Leverage: Higher than normal -Earnings &
Cash Flow: Thin, incurs loss and inconsistent. -Track
Record/Account conduct: Poor
5 Special Mention (SM)
55 - 64 -Repayment: Deteriorate repayment prospects -Net-worth:
Negative -Management: Severe problems -Leverage: Excessive
-Earnings & Cash Flow: Consecutive losses
6 Substandard (SS)
45 - 54 -Repayment: Capacity and inclination to repay is in
doubt. -Financial condition: Weak
7 Doubtful (DF)
35 - 44 -Repayment: Unlikely and possibility of credit loss is
extremely high
8 Bad & Loss (BL)
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Credit Risk Management Practices in Banks: An Appreciation
47
reputation etc. However, a borrower with special mentions,
sub-standard, doubtful and bad/loss rating at pre-sanction stage
will be treated as not-feasible. A borrower with superior, good and
acceptable rating at post-sanction stage is a performing one.
Borrower who is beginning to demonstrate above average risk i.e.
marginal/watch list or special mention at post-sanction stage will
require bankers attention because it has become as early alert
(warning) account. Rest of the ratings of a borrower at the
post-sanction stage exhibit as non-performing or classified
status.
Table-4: Decision Matrix of CRG Pre-Sanction Stage Grading
Status Post-Sanction
Stage Superior
Good
(1) F
easible
Acceptable
(1)
Perfo
rming
(2) Conditional/ Exceptionally Acceptable
Marginal/Watchlist
Special Mention
(2) Early Warning Account
Sub-standard
Doubtful
(3) N
ot -F
easible
Bad/Loss
(3)
No
n-
Perfo
rming
4.5 Use of Classification and Provisioning Rules in determining
Credit Risk Grading Out of the eight categories of risk exposures
mentioned under the guidelines, four risk exposures or grading are
determined as per the prevailing loan classification and
provisioning rules of the central bank. Therefore, central banks
rules for credit classification shall be applied irrespective of
risk rating under CRG sheet in case of risk exposures like special
mention, sub-standard, doubtful and bad & loss.
4.6 More Emphasis has been given on the Financial Risk of the
Borrowers under the New Guidelines
Five major risk components are considered to quantify the risk
status of a potential client before funding like financial risk
(50%), business/industry risk (18%),
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management risk (12%), security risk (10%) and relationship risk
(10%). It is to be mentioned that according to the importance of
risk profile, the highest weightage (i.e. 50% out of 100%) has been
assigned against the financial risk and the rest weightages are
assigned for the rest principal risk components.
4.7 Introduction of Credit Assessment System Besides credit risk
grading, a thorough credit assessment should also be done before
sanctioning any credit facility in line with the credit risk
management guidelines. The task of credit assessment will cover
analysis of borrower, its guarantors, suppliers, buyers, etc. To
supplement such assessment all banks must have well equipped Know
Your Customer (KYC) form. Credit assessment starts with some
summaries results from the credit application of the borrower like
the amount and types of credit facility proposed, purpose of the
credit, its structure, security arrangement, etc. In addition, some
risk areas viz. borrower analysis, industry analysis,
supplier/buyer analysis, historical financial analysis, projected
financial analysis where term facilities require more than one year
tenor, account conduct, adherence to credit guidelines, mitigating
factors, security and name credit are to be addressed here.
4.8 Segregation of Major Credit Functions With a view to
improving the knowledge levels and expertise in various functional
areas of credit, to impose controls over the disbursement of
authorized credit facilities and to obtain an objective and
independent judgment of credit proposal it is advised to segregate
the credit functions into Credit Approval, Relationship
Management/Marketing and Credit Administration. Moreover, it is
advised to make separate approval function from the marketing
function.
4.9 Suggestions for Delegating Approval Authority to Individual
Executive not to Committees To ensure the accountability in the
approval process, the authority to approve or sanction facilities
must be delegated to the senior credit executive not to the
committees based on his/her knowledge and experiences. Approving
authorities should have at least 5 years experience working in
corporate/commercial banking as a relationship manager or account
executive, training and experience in financial statement analysis,
financial reporting and full disclosure, cash flow, projections,
trade cycle, risk analysis, credit structuring and documentation, a
thorough working knowledge of accounting, local industry and market
dynamics, etc.
4.10 Suggestions for using Computer Based Forms and Templates
Credit risk management is a comprehensive and robust process. It
calls for various sorts of analysis, preservation of results of the
analysis and communicating the same
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Credit Risk Management Practices in Banks: An Appreciation
49
among the parties involved with the process. It has been advised
that banks should create and use some computer based forms and
templates to perform the credit risk related activities to ensure
the accuracy and easy access of information.
4.11 Preferred Organizational Structure Like all businesses,
banks have a hierarchy of command and a division of responsibility
in different functional areas. Credit activity is one of them and
it is also a subject of large dimension. Therefore, within the
credit function the banks need to establish organizational
structure and it must be in place to ensure the objectivity and
accountability in credit risk management. As per the proposed
organizational structure of CRM guidelines, below the position of
MD or CEO there should be the Head of CRM and the Head of
Corporate/Commercial Banking. Other direct reports say, internal
audit may also belong to the position of MD/CEO. The credit
administration, credit approval and credit monitoring/recovery
function may come under the Head of CRM. On the other hand,
relationship management/marketing and business development may come
under the Head of Corporate/Commercial Banking.
4.12 Introduction of Internal Audit System Credit audit is an
important yardstick to measure how well a credit policy and
guidelines, operating procedures, central banks directives and
credit practices are being followed. The independent internal audit
should seek at a minimum whether the credit amount is within the
bankers approval authority, whether the security is valid and
sufficient, whether the documentation is complete and accurate,
whether review has done on a timely basis, whether credits are
being graded on a timely basis, whether the credit administration
is in overall compliance with the credit operation, and so
forth.
4.13 Credit Monitoring, Review and Early Alert Process Credit
monitoring helps to ensure that the banks funds are being used to
make profitable credits with a minimum risk exposure. It includes
periodic reviews, ratings and audits to provide an early indication
of the financial health of a borrower. The frequencies of the
review of the CRG of the client shall be regulated by the risk
exposure at the inception of credit and subsequent updated grading.
Lower grading requires more frequency of review. Annual review is
to be done in case of superior, good and acceptable risk grading,
half yearly review is to be done in case of marginal/watch list
risk grading and quarterly review is to be done in case of special
mention, sub-standard, doubtful and bad & loss grading. 4.14
Credit Recovery It is suggested that every bank should have a
separate Recovery Unit for conducting effective and efficient
credit recovery functions. This unit will take specific action
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plan/ recovery strategy for the accounts with sustained
deterioration based on the recommendations of CRM, pursue all sorts
of options to maximize recovery, ensure adequate and timely credit
loss provisioning and regular review of sub-standard and worse
accounts.
4.15 Non-performing Assets (NPA) Management The Recovery Unit is
also responsible for managing NPA of a bank. For this all NPAs
should be assigned to an Account Manager within the Recovery Unit,
who will coordinate and administer the action plan/recovery of
account. There should be a Classified Credit Review Form to know
the status of the action plan/recovery plan, adequacy of provisions
etc. on regular basis.
4.16 MIS on Risk Exposure To maintain the MIS reports of credit
risk grading, banks may develop some forms for the purpose of
reporting various risk grading say superior, good, acceptable,
marginal/watch list, special mention, sub-standard, doubtful and
bad/loss. Bank-wise consolidated report, branch and risk grade wise
report and grade wise borrower list may be developed.
4.17 Separate Guidelines for Assessing Risk Exposure of Small
Enterprise and Consumer Financing Like other credit facilities, the
Small Enterprise and Consumer Financing facilities must be a
subject to the banks risk management process. Small enterprise
means an entity, ideally not a public limited company, does not
employ more than 60 persons (if it is manufacturing concern) and 20
persons (if it is trading concern) and 30 persons (if it is service
concern) and also a service concern with total assets at cost
excluding land and building from Tk. 50,000 to Tk. 30 lac and a
trading concern with total assets at cost excluding land and
building from Tk. 50,000 to Tk. 50 lac and a manufacturing concern
with total assets at cost excluding land and building from Tk.
50,000 to Tk. 1 crore (Bangladesh Bank, 2004). At the time of
granting facility under various modes of small enterprise and
consumer financing banks shall follow the prudential guidelines
issued by the central bank.
4.18 Application of Financial Spread Sheet For the purpose of
reporting the financial strengths and weakness of the clients in a
precise but comprehensive manner it is advised to use the financial
spread sheet (FSS) in credit decision making under Credit Risk
Management practices. The newly adopted financial spread sheet
facilitates trend analysis with the help of common-size financial
statements covering audited as well as company prepared balance
sheets and income statements, financial ratio analysis and cash
flow analysis. The cash flow statement has been adopted in such a
way that anyone can easily identify the
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Credit Risk Management Practices in Banks: An Appreciation
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Earnings before Interest, Taxes, Depreciation and Amortization
(EBITDA) cash flow which is very much essential to know to
determine the Debt Service Coverage (DSC) of a borrower. However,
cash flow before and after capital expenditure, total change in
working capital during the year and its impact on cash flow,
financing need or surplus and financing support from the outsides
of the business can also be found from this Cash Flow Statement.
FSS contains thirty financial ratios with a view to assessing the
growth of key financial indicators, profitability, debt service
coverage, activity, liquidity and leverage position of the business
of a borrower.
5. Basel Principles and Credit Risk Management The Basel
Committee provides some guidelines in order to encourage the
banking sector globally to promote sound practices for managing
credit risk. The sound practices set out under the Basel guidelines
specially address the following areas:
(a) establishing an appropriate credit risk environment; (b)
operating under a sound credit granting process; (c) maintaining an
appropriate credit administration, measurement and
monitoring process; and (d) ensuring adequate controls over
credit risk. Although specific credit risk
management practices may differ among banks depending upon the
nature and complexity of their credit activities, a comprehensive
credit risk management program will address these four areas. These
practices should also be applied in conjunction with sound
practices related to the assessment of asset quality, the adequacy
of provisions and reserves, and the disclosure of credit risk.
Each bank should develop a credit risk strategy or plan that
establishes the objectives guiding the banks credit-granting
activities and adopt the necessary policies and procedures for
conducting such activities. The credit risk strategy, as well as
significant credit risk policies, should be approved and
periodically reviewed by the board of directors. The board needs to
recognize that the strategy and policies must cover the many
activities of the bank in which there is a significant credit risk
exposure. The credit risk strategy should include a statement of
the banks willingness to grant credit based on type (for example,
commercial, consumer, real estate), economic sector, geographical
location, currency, and maturity and anticipated profitability.
This would include the identification of target markets and the
overall characteristics that the bank would want to achieve in its
credit portfolio (including levels of diversification and
concentration tolerances). A banks board of directors should
approve the banks strategy for selecting risks and maximizing
profits. The board should periodically review the financial results
of the bank and,
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based on these results, determine if changes need to be made to
the strategy. The credit risk strategy should be effectively
communicated throughout the organization. All relevant personnel
should clearly understand the banks approach to granting credit and
should be held accountable for complying with established policies
and procedures. Credit policies establish the framework for credit
and guide the credit-granting activities of a bank. Credit policies
should address such topics as target markets, portfolio mix,
pricing, the structure of limits, approval authorities, etc. The
policies should be designed and implemented within the context of
internal and external factors such as the banks market position,
business area, staff capabilities and technology. Policies and
procedures that are properly developed and implemented capable the
banks to: (i) maintain sound credit-granting standards; (ii)
monitor and control credit risk; (iii) properly evaluate new
business opportunities; and (iv) identify and administer problem
credit. Establishing sound, well-defined credit-granting criteria
is essential to approving credit in a safe and sound manner. The
criteria should set out who is eligible for credit and for how
much, what types of credit are available, and under what terms and
conditions the credit should be granted. Banks must receive
sufficient information to enable a comprehensive assessment of the
true risk profile of the borrower or counter party. According to
the Basel guidelines, at a minimum the following factors to be
considered and documented in approving credits:
the purpose of the credit and source of repayment;
the integrity and reputation of the client/borrower or counter
party;
the current risk profile (including the nature and aggregate
amount of risks) of the borrower or counter party and its
sensitivity;
The borrowers repayment history and current capacity to repay,
based on historical financial trends and cash flow projections;
A forward-looking analysis of the capacity to repay based on
various scenarios;
The legal capacity of the borrower or counter party to assume
the liability;
The borrowers business expertise and the status of the borrowers
economic sector and its position within that sector;
The proposed terms and conditions of the credit, including
covenants designed to limit changes in the future risk profile of
the borrower; and
Where applicable, the adequacy and enforceability of collateral
or guarantees, etc.
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Credit Risk Management Practices in Banks: An Appreciation
53
Once the credit-granting criterion has been established, it is
essential for the bank to ensure that the information it receives
is sufficient to make proper credit-granting decisions. This
information will also serve as the basis for rating the credit
under the banks internal rating system.
Banks should have in place a system for ongoing administration
of their various credit risk bearing portfolios. Credit
administration is a critical element in maintaining the safety and
soundness of a bank. Once a credit is granted, it is the
responsibility of the business function, often in conjunction with
a credit administration team, to ensure that the credit is properly
maintained. This includes (i) keeping the credit file up to date;
(ii) obtaining current financial information; and (iii) sending out
renewal notices and preparing various documents such as credit
agreements, etc. Given the wide range of responsibilities of the
credit administration function, its organizational structure varies
with the size and sophistication of the bank. In developing credit
administration area, bank should ensure:
The efficiency and effectiveness of credit administration
operations, including monitoring, documentation, contractual
requirements, legal covenants, collateral, etc.;
The accuracy and timeliness of information provided to
management information system;
The adequacy of controls overall back office procedures; and
Compliance with prescribed management policies and procedures as
well as applicable laws and regulations.
Banks must have in place a system for monitoring the condition
of individual credit. An effective credit monitoring system will
include measures to: (i) ensure that the bank understands the
current financial condition of the borrower or counter party; (ii)
ensure that all credits are in compliance with existing covenants;
(iii) follow the approved credit lines; (iv) ensure that projected
cash flows on major credits meet debt servicing requirements; (v)
ensure that, where applicable, collateral provides adequate
coverage relative to the obligators current condition; and (vi)
identify and classify potential problem credit on a timely basis.
An important tool in monitoring the quality of individual credits,
as well as the total portfolio, is the use of an internal risk
rating system. A well-structured internal risk rating system is a
good means of differentiating the degree of credit risk in the
different credit exposure of a bank and facilitates early
identification of problem credit. This will also allow more
accurate determination of the overall characteristics of the credit
portfolio, concentrations, problem credits, and the adequacy of
credit loss provisions.
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Banks must ensure that the credit-granting function is being
properly managed and that credit exposures are within levels
consistent with prudential standards and internal limits. The
establishment and enforcement of internal controls, operating
limits and other practices will help ensure that credit risk
exposures do not exceed levels acceptable to the individual bank.
Limit systems should ensure that granting of credit exceeding
certain predetermined levels receive prompt management attention.
An appropriate limit system would enable management to control
credit risk exposures, initiate discussion about opportunities and
risks, and monitor actual risk taking against predetermined credit
risk tolerances. Internal audits of the credit risk process should
be conducted on a periodic basis to determine that credit
activities are in compliance with the banks credit policies and
procedures.
6. Stress Testing A Sophisticated Approach for Managing Risks in
Banks & FIs Bangladesh Bank introduced a Guideline on Stress
Testing through Department of Offsite Supervision Circular No.01
dated 21 April, 2010 with effect from June, 2010. In this guideline
it is noted that the recent financial turmoil in the US financial
system has augmented the importance of establishing more developed
risks management regime in the financial industry. The financial
institutions around the world are increasingly employing stress
testing to determine the impact on the financial institutions under
set of exceptional but plausible assumptions through a series of
tests. IMF and Basel Committee on Banking Supervision have
suggested for conducting stress testing on the financial sector.
Bangladesh bank has already designed the stress testing framework
for the banks and financial institutions to proactively manage
risks in line with the international best practices. Initially,
stress testing begins with the simple sensitivity analysis and
scenario analysis considering only credit risk and market risk.
Eventually it is to be developed as a more comprehensive approach.
As a starting point the stress testing is limited to simple
sensitivity analysis approach with covering five different risk
factors viz. non-performing loans (investment), forced sale value
of collateral, interest rate risk, exchange rate risk and equity
price risk Moreover, the liquidity position of the institutions is
to be stressed separately. As per desire of the central bank, all
the banks and financial institutions operating in Bangladesh are to
carry out stress testing on quarterly basis i.e. on March 31, June
30, September 30 and December 31. The reporting format of stress
testing has been designed in line with the Basel II framework. At
institutional level, stress testing techniques provide a way to
quantify the reactions of changes in a number of risk factors on
the assets and liabilities portfolio of the institution. Effective
stress testing requires:
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Credit Risk Management Practices in Banks: An Appreciation
55
Defining the coverage and identifying the data required
Identifying, analyzing and proper recording of the assumptions used
for stress
testing Well organized management information system Setting up
some specific trigger points to meet the benchmark/standards
set
by central bank Calibrating the scenarios or shocks applied to
the data and interpreting the
results, etc. Ensuring a mechanism for an ongoing review of the
results of stress testing
7. Risk Management Practices in Islamic Banks in Bangladesh
Islamic banks are entities that perform financial intermediation
according to the rulings of Islamic Shariah. The unique nature of
products differentiates Islamic banks from conventional banks in
many aspects. Exclusion of interest, prohibition of making money
from money, implementation of profit and loss sharing system and
prohibition against excessive uncertainty are main sources of
differences associated with Islamic banks. The types and extend of
risks of Islamic banks also differ in great extend (Hasan and
Dicle, 2005).Today nearly four hundred (400) banks and financial
institutions are providing their banking services under Islamic
Shariah rulings in about one hundred thirty (130) countries of
Asia, Africa, Europe, America, Australia, Argentina, Germany,
Denmark, Luxembourg, Switzerland and United Kingdom. The banking
system of Pakistan and Iran is Islamised and that of Sudan has been
totally remodeled on the basis of Islamic Shariah. There has been a
rapid growth of Islamic banking industry and the estimated growth
rate not less than 15 per cent annually. The history of Islamic
banking began from the early days of Islam. The establishment of
Mit Ghamr Local Savings Bank (Islamic Shariah based bank) in the
Nile Delta of Egypt is considered one of the important events in
the history of Islamic banking. In 1963/1964, the first financial
year after commencement of banking business a total of 17,560
depositors put their many as deposit in this bank. Mit Ghamr is
considered as the milestone of modern Islamic banking system. The
achievements made by the Mit Ghamr Bank in Egypt and subsequently
the establishment of the Islamic Development Bank (IDB) in 1975,
the International Association of Islamic Banks (IAIB) in 1977
motivated the Scholars and Jurists throughout the Muslim world to
take steps for establishing Islamic banks in their own countries
with the support of regulatory authorities and Governments. The
Association provides technical assistance and expertise to Islamic
communities wishing to establish Islamic banks
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3, Jul Sep 2011 56
and assist in the development of such banks both at national and
international levels. Islamic Banking is a form of banking where
banking operations are conducted in consonance with the Islamic
principles. The philosophies and objectives of Islamic banking are
not similar to the conventional banking rather these are in line
with the principles highlighted in the Holy Quran and
Hadith/Sunnah. In view with the Islamic principles particularly
prohibition of interest, establishing honesty, justice and equity
in socio-economic arena it may be considered as a system of
financial intermediaries (FIs) that avoids receipt and payment of
interest (riba) in its operations and conducts its operations in a
way that it helps achieving the objectives of an Islamic economy.
The General Secretariat of the OIC defined the Islamic bank as a
financial institution whose statutes, rules and procedures
expressly state its commitment to the principles of Islamic Shariah
and to the banning of the receipt and payment of interest on any of
its operation. The Islamic banking system in Bangladesh started
with the establishment of first private sector commercial bank
Islami Bank Bangladesh Limited (IBBL) in 1983. At present seven (7)
full-fledged Islamic banks and eleven (11) conventional banks with
their twenty-four (24) Islamic banking branches are providing
Islamic banking services. Internationally reputed banks like the
Hong Kong and Shanghai Banking Corporation (HSBC) Ltd., Citi Bank
N.A., Standard Chartered Bank and Commercial Bank of Ceylon
introduced Islamic products. The state owned commercial banks
(former NCBs) have opened their Islamic banking wings to provide
Shariah compliant services. A state owned bond called Bangladesh
Government Islamic Investment Bond (BGIIB) has been issued by the
central bank. The five Islamic insurance companies operating under
the private sector in this country as Islamic financial
institutions these are Islamic Insurance Bangladesh Limited,
Islamic Commercial Insurance Limited, Takaful Insurance Company
Limited, Far East Islamic Life Insurance Limited and Padma Islamic
Life Insurance Company Limited. In Bangladesh, the share of deposit
mobilization and investments of Islamic banking in total banking
industry are 16 per cent and 20 per cent respectively. Recently a
study was done by Ahmed (2010) to identify the potential for
Islamic finance and to examine its impact. This study shows the
trends of savings and investment of some selected Islamic and
conventional banks which are established in contemporary period in
Bangladesh. According to the findings of the study, during 2004 to
2008 the total savings of Islamic banks is higher than those of the
conventional banks (Table 1). Over the years the savings
mobilization gaps widened in favor of the Islamic banks. The
differential amounts of savings mobilization between Islamic and
conventional banks are BDT 45,036 million, BDT 49,897 million, BDT
56,821 million, BDT 89,109 million and BDT 113,180 million during
the period under study.
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Credit Risk Management Practices in Banks: An Appreciation
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Table 1: Savings Mobilization by Islamic and Conventional
Banks
Amount in Million BDT Savings of Islamic Banks
(A) Savings of Conventional
Banks (B) Year IBBL SIBL ARAFAH
Total (A) NBL IFIC CBL
Total (B)
Difference (A-B)
2004 87721 19704 10108 117533 29486 20774 22237 72497 45036 2005
107788 16863 11644 136295 33335 22505 30558 86398 49897 2006 132419
16171 16775 165365 40351 28621 39572 108544 56821 2007 166325 18176
23009 207510 47961 29900 40540 118401 89109 2008 200343 22688 31470
254501 60195 36092 45034 141321 113180
Source: Ahmed (2010). Note: IBBL = Islami Bank Bangladesh Ltd.,
SIBL=Social Islami Bank Ltd., ARAFAH= Al-Arafah Islami Bank Ltd.,
NBL= National Bank Ltd., IFIC= International Finance Investment and
Commerce Bank Ltd. and CBL=The City Bank Ltd.
The study also shows the investment trends of Islamic and
conventional banks to justify the potential of Islamic finance.
Table 2 shows the year-wise amount of investment of Islamic and
conventional banks under study.
Table 1: Investment of Islamic and Conventional Banks Amount in
Million BDT
Investment of Islamic Banks (A)
Investment of Conventional Banks (B) Year
IBBL SIBL Arafah
Total (A) NBL IFIC CBL
Total (B)
Difference (A-B)
2004 76826 12887 8150 97863 22972 21281 17028 61281 36582 2005
93644 15097 11474 120215 27020 21695 23326 72041 48174 2006 1113575
15313 17423 146311 32709 25490 30789 88988 57323 2007 144921 15869
19214 180004 36476 28361 26788 91625 88379 2008 191230 18725 29723
239678 49665 33018 34421 117104 122574
Source: Ibid.
It is observed that like savings mobilization gaps, the gaps of
investment making also widened in favor of Islamic banks. Though
the market penetration of Islamic banks in Bangladesh is
significant but still now there no separate risk management
guidelines for Islamic banks. Both the conventional and Islamic
banks are following the same guidelines which have been advised by
the central bank for managing their risks in operations. The
central bank through a circular dated November 09, 2009 introduced
a Guidelines for Islamic Banking with a view to bringing greater
transparency and accountability in Islamic banking. The Guideline
covers the main areas of Islamic banking liquidity, maintenance of
books of accounts, preparation of financial statements and related
issues. It is a supplementary to the existing banking laws.
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Islamic banking, also known as participatory banking, refers to
a system of banking or banking activity that is consistent with the
principles of Islamic Shariah and its practical application through
the development of Islamic economics. In order to fully comply with
the Islamic Shariah rules in banking transaction all the banks have
their own Shariah Council. Besides Bangladesh Bank has formed a
Central Shariah Council and related issues. In addition, they are
also advised to follow the accounting and auditing standards
prescribed by the Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI). There are seventy (70) standards
on accounting, auditing and governance along with the code of
ethics and Shariah Standards of AAOIFI. The Islamic banks have a
number of objectives to perform their activities say, abolition of
interest (riba) in banking operations, allowing Shariah permissible
products/sectors for financing, risk sharing and participatory
banking, working as catalyst of development, upholding Islamic
ethical standards etc.
7.1 Guiding Principles of Islamic Financial Services Board
(IFSB) for Managing Risks Islamic banking sector continues to grow
globally at a rapid pace. The Islamic Financial Services Board
IFSB) is even more optimistic in its outlook for the growth of the
global Islamic banking industry. It forecasts that total asset
value of Islamic banking industry will expand to US Dollar 2.8
trillion in 2015 compared to US Dollar 1.4 trillion in 2010. The
IFSB has developed guiding principles for Islamic banking industry.
The issuance of the Guiding Principles of risk management by the
Islamic Financial Services Board (IFSB) is a giant step for the
Institutions offering Islamic Financial Services (IIFS). The IIFSs
include the commercial banks, investment banks, finance houses and
other fund mobilizing institutions that offer services in
accordance with Islamic Shariah rules and principles. The Guiding
Principles of IFSB provides a set of guidelines of best practice
for establishing and implementing effective risk management in
IIFS. The main features of the Guiding Principles are:
It has been endorsed by the Shariah Advisory Committee, Islamic
Development Bank (IDB) and co-opted Shariah scholars representing
central banks and monetary agencies which are members of the
IFSB.
It has been designed to complement the current risk management
principles issued by the BCSB and other international standard
setting bodies.
It sets out fifteen principles of risk management that have
practical effect to managing risks. The IFSB will oversee these
matters.
It retains the existing applicable Shariah-compliant
international principles.
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Credit Risk Management Practices in Banks: An Appreciation
59
It outlines a set of principles applicable to managing major six
risk areas like credit risk, equity investment risk, market risk,
liquidity risk, rate of return risk and operational risk.
7.2 Compliance of Basel II Accord with the Islamic Banks Hassan
and Dicle (2005) have noted in a recent article that the Accounting
and Auditing Organization for Islamic Financial Institutions
(AAOIFI, 1999) suggests a formula for the capital adequacy ratio:
CAR = OC / (WOC+L+WPLS * 50%). Where, CAR is the capital adequacy
ratio, WOE+L is the average risk weight of assets financed with the
Islamic banks own capital and liabilities other than investment
accounts, WPLS is the average risk weight of investment accounts.
AAOIFI requires the CAR to be equal to 8 percent.
In Bangladesh, Basel-I accord was started in 1996. Initially in
accordance with Basel-I the Capital Adequacy Ratio (CAR) was 8% on
Risk Weighted Assets which was increased to 9% on 30.06.2003 and
10% on 31.12.2007. The revised accord i.e. Basel-II was introduced
in Bangladesh through a BRPD circular No.9 dated 31.12.2008. For
implementing the revised accord experimentally, the parallel run of
Basel-II was started from 01 January, 2009 for 1 year and full
operation was started from 01 January, 2010. All the banks are
advised to meet the regulatory capital BDT 400 crore or 9% of risk
weighted assets whichever higher by August, 2011. It is noted that
most of the Islamic banks have fulfilled the revised capital
requirements. The Basel Committee on Banking Supervision suggests
considering the credit risk, operational risk and market risk
determining the risk weighted assets through using various
approaches say standardized approach, internal rating based
approach, basic indicator approach, advanced measurement approach,
internal model approach etc. Note that Bangladesh Bank has advised
all the scheduled banks (both conventional and Islamic banks) to
follow standardized approach, basic indicator approach and the
standardized approach to measure credit risk, operational risk and
market risk respectively.
8. Concluding Remarks In every economy bankers are regarded as a
creator of socio-economic development as they collect funds from
the surplus units of the society and to channelise the same to the
deficit units (user groups) of the society with the objectives to
deploy the funds in economic activities for enhancing industrial
growth and employment. But to earn positive return or profit from
the credit activities is also the prime consideration for their
survival. Since banking business is a mechanism of channeling
depositors funds as advance from one unit to another unit of a
society and the derivative products of this mechanism are to earn
profit, generate employment etc. thats why bankers are to
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take a lot of precautions before disbursing the depositors money
as credit. Banks deal with the depositors money and the banking
philosophy is primarily based on trust and any inconsistency in the
case of disbursing credit may breach the trust and confidence of
the depositors and which may ultimately create the financial
distress in the economy. Thus, an efficient banker should always
think about the probability of non-repayment of credit (credit
risk) before disbursing it to the borrowers. In this context, the
use of sophisticated risk grading techniques shows paramount
importance for measuring the financial risk, business or industry
risk, management risk, security risk and relationship risk of the
borrowers so as to minimize the risk exposure of credit which may
come from default. The banks in Bangladesh should follow the
techniques for measuring risk by customizing these according to our
socio-economic circumstances and organizational set up. Each bank
may establish data bank for its own consumption at the time of
taking credit decision under the sophisticated credit screening
techniques. Besides the data bank, well accepted norms and industry
average may be developed based on the clients information in
sector-wise funding for better practicing financial analysis.
Uniform practices for preparing projected financial statements may
be established in the banks for the clients who will seek
facilities from the banks. Most of the banking problems have been
either explicitly or indirectly caused by weakness in credit risk
management. Several credit losses in the banking system usually
reflect simultaneous problem in several areas such as
concentration, credit processing, failure of due diligence and
inadequate monitoring. First, concentration would include
concentration of credits to single borrower or counterparty, a
group of connected counterparties, and sectors or industries.
Banking supervisors should have specific regulations limiting
concentrations to one client or set of related clients, and, in
fact, should also expect banks to set much lower concentrations
Banks are to explore techniques to identify concentrations based on
common risk factors. Second, many credit problems reveal basic
weaknesses in the credit granting and monitoring process. A
thorough credit assessment (or basic due diligence) needs for
financial information based on sound accounting standards and
timely macroeconomic and flow of funds data. When this information
is not available or reliable, banks may dispense with financial and
economic analysis and support credit decisions with subjective
information. The absence of testing and validation of new
techniques of credit decision making is another important problem.
Third, many banks that experienced asset quality problems due to
lack of effective credit review process. The purpose of credit
review is to provide appropriate checks and balances to ensure that
credits are made in accordance with bank policy and to provide an
independent judgment of asset quality. Fourth, a common and very
important problem in credit process is lack of monitoring client or
collateral value. In absence of monitoring process the bank will
fail to recognize early signs that asset quality will
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Credit Risk Management Practices in Banks: An Appreciation
61
deteriorate and will miss the opportunities to work with clients
to stem their financial deterioration and to protect the banks
position. In some cases, the failure to perform adequate due
diligence and financial analysis and to monitor the client can
result in a breakdown of control to detect credit related fraud.
So, an effective credit review department and independent
collateral appraisals are important protective measures. Fifth, due
to lack of sufficient account of business cycle effects in taking
credit decisions, the banks will fail to understand the income
prospects and assets value that may change for changing business
cycle. Effective stress testing which takes account of business or
product cycle effects is one approach to incorporating into credit
decisions a fuller understanding of a clients credit risk. Fifth,
the lack of applying risk sensitive pricing methodology in credit
decision making. Banks that lack a sound pricing methodology and
the discipline to follow consistently such a methodology will tend
to attract a disproportionate share of under-priced risks. These
banks will be increasingly disadvantaged relative to banks that
have superior pricing skills. Finally, Hassan and Dicle (2005) have
noted in their article that the unique products and procedures of
Islamic banks require specialized rating process. Such process
should include specialized models and rating systems designed in
accordance with Islamic banks and associated risks. Basel II
proposes internal ratings based (IRB) approach for banks to
differentiate their risk measurement systems
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Jamia Al Islamia), Kerala, held in Kerala, India, October 4-6.
Bangladesh Bank (2003), Managing Core Risks in Banking: Credit
Risk Management, Dhaka: Bangladesh Bank, Head Office.
______________ (2005), Credit Risk Grading Manual, Dhaka:
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______________(2004), Prudential Regulations for Small
Enterprises Financing, Dhaka: Bangladesh Bank, Head Office.
______________ (2010), Guidelines on Stress Testing, Dhaka:
Bangladesh Bank, Head Office.
FSRP Bangladesh (1993), Credit Risk Analysis Manual, Dhaka:
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Hassan, M. Kabir and Mehmet F. Dicle (2005), Basel II and
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