Chapter 2

Credit Risk
Management
• THE CREDIT PROCESS
• Credit analysis or credit assessment is the process of assessing risk
as measured by a borrower’s ability to repay the loan. Within the
credit analysis or assessment process, analysts also consider possible
recovery in the case of default and evaluate the support collateral and
other credit support tools that bear on the bank’s final decision to develop
a creditor relationship.
• Figure 5.1 shows the steps involved in the credit process.
• Identifying the Credit Opportunity
• In the credit process, the loan officer or relationship
manager initiates contact with the potential borrower. In
many banks, the chief function of the loan officer is marketing:
to seek out new business opportunities and present them for
evaluation.
• Credit Evaluation
• After a loan officer identifies an opportunity, the officer will
gather all required information from the borrower and present it
to the credit analyst. The credit analyst then analyzes the
creditworthiness of the potential borrower by evaluating the
proposed loan type and the potential risks (business risk,
financial risk, and structural risk) and then makes a
recommendation to proceed with the loan or not and, if so, on
what terms (e.g., amount to be lent, the interest rate for the
loan, use of collateral or other security, maturity, etc.).
The credit analyst collects and reviews information about
the potential borrower, including:
• Internal bank records and account performance
• Historical and current financial accounts (normally data
captured in spreadsheets)
• Management accounts and projections
• External ratings of the borrower as provided by independent
rating firms
• Company websites and brochures
• Group structure, ownership, and management information,
including information on the board of directors
• Credit Decision Making
• Often, routine credit decisions are made by the loan
officer in conjunction with the credit analyst or by a
committee. Loan officers are generally compensated by the
number of loans generated. This creates a potential conflict of
interest and, therefore, poses a risk when the loan officer makes
the loan decision.
• To guard against this problem, banks implement processes
that require all loans to be reviewed by an independent
senior manager or credit analyst.
• Decisions on larger and specialized loans are generally
made by senior bank officers or a committee of senior
bankers or, in some cases, by the bank’s board (the
bank’s board normally delegates various levels of lending/risk
powers to the credit committee and senior bank credit officers).
• Credit Disbursement
• Once the credit request has been approved, the loan agreement
is prepared for signature. The loan agreement is a legal
contract between the bank and the borrower and includes a
description of undertakings and understandings, such as
the principal, the stated interest rate and its calculation,
the schedule of payments and repayments, the use of
collateral, covenants, etc. Once the contract is signed, funds
are made available to the borrower.
• Credit Monitoring
• After the credit is underwritten and the funds have been
made available to the borrower, the bank continues
to monitor the financial performance of the
borrower.
• The contract usually has hard and soft covenants or
provisions. An example of a hard covenant is a
requirement that the borrower maintains certain key
financial ratios throughout the life of the loan.
• An example of a soft covenant is the requirement that
the borrower delivers its financial statements to the
lender in a timely manner.
• THE CREDIT ANALYSIS Figure 5.2 depicts a schematic
PROCESS of the Five Cs.
• Credit analysis is not an exact
science as there is no single
formula, ratio, or tool that will
determine if a company is an
acceptable credit risk or not.
Therefore, it is important to
follow some basic principles
and practices of good lending.
• The Five Cs of Credit
• The Five Cs of Credit provide
a basic framework for good
lending, which is particularly
relevant to small business
lending and to the SME sector.
• The Five Cs of Credit: No. 1—Character
• In analyzing character, the bank seeks to answer the following question: What is the reputation of
the company’s management in the industry and in the greater business community?
• The Five Cs of Credit:No.2—Capital
• When analyzing capital, the bank seeks to answer the following questions: How is the company
currently financed? What is its level of leverage, that is, the amount of money, or equity, that
owners have invested in the business relative to the company’s assets?
• The Five Cs of Credit:No.3—Conditions
• When analyzing conditions, the bank seeks to answer the following questions: What is the
economic situation in the country or countries in which a company operates, and what are the
economic conditions of the industry in which it operates?
• The Five Cs of Credit:No.4—Capacity
• When analyzing capacity, the bank seeks to answer the following questions: How much cash does
the company generate, and are the cash flows sustainable, repeatable, and predicable? The credit
analyst must evaluate the company’s ability to generate sufficient cash flows as well as
management’s ability to run its operations efficiently and effectively.
• The Five Cs of Credit:No.5—Collateral
• When analyzing collateral, the bank seeks to answer the following question: In the event the
borrower cannot honor its obligations, what assets does it have that the bank can lay claim to
satisfy the debt?
• The Credit Analysis Path
• The key to a successful credit analysis is to assess accurately the
creditworthiness of each prospect. To accomplish this, credit analysts
review the key business, financial, and structural risks. These three
areas form part of a focused analytical tool referred to as the credit
analysis path. The analysis steps are depicted in Figure 5.4.
• In the credit analysis path, the focus is to analyze the various risks
that may impact the borrower. The overall analysis encompasses
business (or macro) risks, financial (or micro) risks, and structural risks.
These risk areas overlap as the factors that impact these various
areas are closely related and mutually interdependent.
• The three areas of analysis are separated into several general layers, or
components, and are shown in Figure 5.5.
• The credit analysis path shows that the company’s decision-
making process will directly impact the risks the organization
takes, and that management’s decisions are influenced by the
industry’s macro- and microeconomic trends. The relationship
between business risks and structural risks is illustrated
in Figure 5.6.
• Business, or Macro, Risks
• The business, or macro, risks reflect both the bank’s and the
borrower’s respective environments.
• Analysis of the bank’s operating environment helps management
determine the appropriate loan allocation. Banks usually select loans
where the risk/return trade-off.
• Analysis of the borrower’s operating environment reflects a market risk
assessment. After reviewing the borrower’s overall market (i.e.,
macroeconomic drivers, competitive factors, etc.), the credit analyst is
able to determine the borrower’s challenges and opportunities. These
macro factors are trends that impact all industries, companies, and firms.
There are numerous macro factors; typically, they are likely to include
long-term trends:
• Level of economic activity (measured by changes in the global GDP)
• Global changes in inflation (the decline in the purchasing power of
money)
• Worldwide price of energy (the price of crude oil, an important
commodity that, when refined, powers machinery, etc.)
• Financial, or Micro, Risks
• The financial risk assessment reviews the company’s
management and especially how it handles the
company’s operating and financial environment.
• Credit analysts primarily focus on management strategies and
their ability to manage the business in conjunction with an in-
depth analysis of the company’s historical, current, and pro
forma financial statements. The overall assessment and results
are then compared to the company’s peers.
• Structural Risk
• The analysis of structural risk focuses on loan pricing
and mitigation. Covenants and collateral play considerable
roles in structural risk assessment.
• In this assessment, the credit analyst must understand the legal
structure of the borrower, the various subsidiaries, intra-
company transactions, and ownership and partnership linkages.
All are analyzed to better gauge the true financial and potential
economic exposure embedded in the proposed credit structure
(covenants and pricing are intended to mitigate potential
lapses).
• Credit risk
• Credit risk is the risk of loss resulting from an
obligor’s inability to meet its obligations. It refers
to the risk that a borrower defaults on any type of debt
by failing to make required payments.
• The potential loss from default includes lost principal
and interest and increased collection costs. The loss
may be partial when the lender is able to recover a
fraction of the amount due. Or, in a less extreme
situation, the credit quality of a counterpart may
deteriorate so that a loan becomes more and more
risky.
• CREDIT RISK COMPONENTS
• The factors that have an incidence on the potential loss from
credit risk are called “credit risk components”.
• They are:
 Default event
Default probability and default event
Exposure and Exposure Risk
Recovery Risk and Loss Given Default
Credit Risk Mitigation: Collateral
Credit Risk Mitigation: Third Party Guarantee
• Default Event
• Default risk is the risk that borrowers fail to comply with their
contractual payment obligations. Various events potentially qualify
as default:
Delaying payments temporarily or indefinitely;
Restructuring of debt obligations due to a deterioration of the credit standing
of the borrower;
Bankruptcies.
• Restructuring of debt is very close to default if it results from the inability of
the borrower to face payment obligations unless its debt structure changes.
Defaults are not permanent if they are corrected within a short period of time
as the borrower resolves cash deficiencies.
• The definition of default relies on rules.
• Rating agencies consider that default occurs from the very first day of
defaulting by a single dollar on a payment obligation.
• For regulators, a default is the absence of a payment due extending over at
least 90 days. If payment occurs before the end of the period, the default is a
transitory delinquency.
• Default Probability and Default Event
• A probability of default measures the likelihood of a borrower’s
default.
• With a stable credit state, the chances of defaulting increase
with the horizon as the credit state and the Default
Probability (DP) changes as the credit standing migrates.
Basel requires the usage of annual DPs.
• DPs, given credit state, depend on prevailing economic
conditions. The chances of default increase when the current
conditions deteriorate.
• Estimating DPs is a challenging task.
• With large volumes of clients, statistics allows counting the
default events and deriving their frequencies over various
periods. This is the method used in retail banking by banks and
by rating agencies for all rated firms of various rating classes.
• In other cases, statistics are not significant. In general, there is
a variety of methodologies and data sources, which banks may
use for mapping DPs to internal grades. The three broad
approaches include the usage of data based on a bank’s own
default experience, the mapping of internal defaults to external
data and the usage of default models.
• Exposure and Exposure Risk
• Exposure is the size of the amount at risk with an obligor. Exposure
risk refers to the randomness of the size. The exposure at default
(EAD) is an estimate of the potential size under default, which is generally
unknown at the current date.
• The contractual exposure for loans derives from the repayment
schedule. For a term loan with a contractual amortization schedule, this
schedule is known. However, the effective amortization schedule differs from
the contractual schedule, for example in the case of prepayment of mortgages.
In other instances, the related cash flows are stochastic. Interest payments are
driven by market indexes for floating-rate loans. Or the cash flows are driven
by the clients’ behavior for lines without maturities, such as credit card loans.
• For corporations, banking facilities include commitments of the bank
to provide funds at the initiative of a borrower. With committed lines of
credit, the lender has the obligation to lend up to a maximum amount up to a
contractual maturity. The drawn amount is the cash effectively borrowed. The
undrawn amount is the remaining fraction of the committed line of credit,
which is an off-balance sheet commitment. Both future amounts are unknown
and draws on the credit line are contingent upon the borrower’s willingness to
borrow.
• Recovery Risk and Loss Given Default (LGD)
• The LGD is the fraction of the exposure at risk that is
effectively lost under default, after workout efforts and
recoveries from guarantees. The recovery rate is the
percentage of exposure recovered after a default, and is the
complement to one of the LGDs expressed in percentage of
exposure. The LGD is a major driver of credit losses and the
capital charge for credit risk is proportional to the final losses
post default.
• Because of the uncertainty attached to LGD, Basel imposed
percentages under certain approaches. Senior claims on
corporates, sovereigns and banks not secured by recognized
collateral are assigned a 45% LGD and all subordinated claims
on corporates, sovereigns and banks are assigned a 75% LGD.
Own estimates of LGD by banks are allowed only in the
advanced approach. Otherwise, supervisory rules have to be
• Credit Risk Mitigation: obligation. Collateral includes
Collateral cash and securities, often bonds
• Pledging assets as collateral of good credit quality.
transforms the credit risk of• Because of the uncertainty with
exposure into an asset risk. respect to the liquidation value of
• The assets pledged are sold in the assets posted as collateral,
the event of default and the the recognized value of the
proceeds used as partial or full collateral is lower than its current
repayment. Good quality value. The difference is the
collateral is made of assets that haircut (Figure below). The
are easy to liquidate without haircut serves as a buffer against
incurring losses from reduced the fluctuations of values of
liquidity or from movements of securities posted as collateral
markets. When financial assets and against potential adverse
are pledged, the lender can price variations arising from the
liquidate the assets if the obligor liquidation.
defaults on its payment
• Another common practice is to impose a cap on the
amount of loan backed by collateralized assets, or,
equivalently, a floor of the value of collateral function of
the loan size. The loan-to-value ratio is frequently used in
mortgages, as the home is pledged to the lender. When the
collateral is made of financial securities, and a loan-to-value
ratio is imposed, the debt might become a function of the
collateral value (Figure below). For example, funds borrow to
buy securities and the amount of borrowing are capped to a
fraction of the value of collateral. If the market prices move
down, the funds have to increase the collateral by pledging new
assets or to reduce the debt.
• Credit Risk Mitigation: Third Party Guarantee
• When a third party provides a guarantee, the lender has a claim to
the guarantor for defaulted payments. Guarantees are binding
commitments to honor the debt payment obligation in the event of a default
of the direct lender, similar to an insurance given by the guarantor to the
lender.
• Third party guarantees mitigate the likelihood of default. As the
guarantor acts as a substitute to the lender in the event of default,
the risk can be seen as transferred to the guarantor as if it were the
direct borrower.
• Under this view, a guarantee has a value if and only if the credit standing of
the guarantor is better than that of the direct borrower.
• The actual effect of a guarantee on the likelihood of default is different. The
DP is neither that of the direct borrower nor that of the guarantor. A default
occurs only when both the borrower and the guarantor default and
the likelihood of default is the joint probability of default of both
entities.
• A joint DP is generally different, and lower than the DPs of the
• The credit risk management framework is the combination of
policies, processes, people, infrastructure, and authorities that ensures that
credit risks are assessed, accepted, and managed in line with credit risk
appetite.
• Indicators of high credit risk or poor credit risk management
• Just as credit risk can be estimated for an individual loan, so too can the bank as a whole be
said to have varying degrees of credit risk. Unlike measuring credit risk for a loan,
however, measuring credit risk of an entire institution is a complicated assessment, involving
many quantitative and qualitative factors, the most important of which are summarized below.
• Indicators of high credit risk (not an exhaustive list)
The level of loans is high relative to total assets and equity capital.
Loan growth rates significantly exceed national trends and the trends of similar banks.
Growth was not planned or exceeds planned levels, and stretches management and staff
expertise.
The bank is highly dependent on interest and fees from loans and advances.
Loan yields are high and reflect an imbalance between risk and return.
The bank has one or more large concentrations. Concentrations have exceeded internal limits.
Existing and/or new extensions of credit reflect liberal judgment and risk-selection standards.
Practices have resulted in a large number of exceptions to the credit policy.
The bank has a large volume and/or number of classified loans.
Even among standard and special mention account loans, the portfolios are skewed toward
lower internal ratings.
Classified loans are skewed toward the less favorable categories (doubtful and bad/loss).
Collateral requirements are liberal, or if conservative, there are substantial deviations from
requirements.
Collateral valuations are not always obtained, frequently unsupported, and/or reflect
inadequate protection.
Loan documentation exceptions are frequent, and exceptions are outstanding for long periods
of time.
The bank liberally reschedules and/or restructures loans in a manner that raises substantial
concern about the accuracy or transparency of reported problem loan numbers.
Quarterly loan losses, as a percentage of the total loan portfolio, are high and/or routinely
exceed established provisions.
• Indicators of poor credit risk management (not an exhaustive list)
Credit culture is absent or materially flawed.
Strategic and/or business plans encourage taking on liberal levels of risk.
Anxiety for income dominates planning activities.
The bank engages in new loan products or initiatives without conducting sufficient due
diligence testing.
Loan management and personnel may not possess sufficient expertise and/or experience.
Responsibilities and accountabilities in the origination, administration, or problem loan
management processes are unclear.
The bank may not identify concentrated exposures, and/or identifies them but takes little or no
actions to limit, reduce, or mitigate risk.
Concentration limits, if any, are exceeded or raised frequently.
Compensation structure is skewed toward volume of loans originated, rather than quality.
There is little evidence of accountability for loan quality in the origination and/or
administration function.
Staffing levels throughout the origination and/or administration function are low.
Skills throughout the origination and/or administration function are low.
Credit policies are deficient in one or more ways and require significant improvement in one
or more areas. They may not be sufficiently clear or are too general to adequately communicate
portfolio objectives, risk tolerance, and loan judgment and risk selection standards.
The bank approves significant policy exceptions, but does not report them individually or in
the aggregate and/or does not analyze their effect on portfolio quality. Policy exceptions do not
receive appropriate approval.
Credit analysis is deficient. Analysis is superficial and key risks are overlooked.
Risk rating and problem loan review are deficient and require improvement. Problem loans
and advances are not identified accurately or in a timely manner; as a result, portfolio risk is
likely misstated.
The bank’s risk ratings (including the classification system) frequently deviate from BB’s risk
ratings or classifications.
The graduating of internal risk ratings in the standard and special mention categories is
insufficient to stratify risk for early warning or other purposes, such as loan pricing or capital
allocation.
Management information systems (MIS) have deficiencies requiring attention.
• Concentration risk
• Concentration risk arises when any bank invests its most or all of the assets
to single or few individuals or entities or sectors or instruments. Downturn
in concentrated activities and/or areas may cause huge losses to a bank relative
to its capital and can threaten the bank’s health or ability to maintain its core
operations. Banks need to pay attention to the following credit concentration
risk areas:
 Sector wise exposure,
 Division wise exposure (Geographic Concentration),
 Group wise exposure (Outstanding amount more than),
 Single borrower wise exposure (Outstanding amount more than),
 Top borrower wise exposure (Top 10-50 borrowers will be counted)
• Robust credit risk management policy as an answer to high credit risk/poor credit
risk management
• Banks always have a “credit policy,” but what is really needed is a high-quality “credit risk
management policy” (CRMP). The CRMP in its expanded form contains all of the
elements that a “credit policy” would contain, and goes beyond these. It must be updated
at least annually, with Board approval for these annual updates.
• i) Risk appetite statement (RAS)
• Risk appetite is the level and type of risk a bank is able and willing to assume in its exposures
and business activities, given its business objectives and obligations to stakeholders
(depositors, creditors, shareholders, borrowers, regulators).
• A robust CRMP starts with a well-crafted risk appetite statement (RAS). In this regard, The
Risk Appetite Statement shall be approved by board and embodied in risk policy and
delegated authorities.
• For credit risk specifically, the RAS should quantify the maximum expected loss the
bank is willing to endure across all credit products, including off-balance-sheet items
such as letters of credit and guarantees.
• Contents of the Risk Appetite Statement shall be, but are not limited to, the following
statements:
Industry-wise sectoral concentration
Product-wise funded loan concentration (composition of term loan, mid-term loan, demand
loan, continuous loan etc)
Product-wise non-funded loan concentration (composition of bank guarantee, acceptance,
etc.)
Area wise/geographical, currency wise and maturity wise credit concentration
Business segment-wise concentrations (corporate, MSMEs, Retail, Micro Credit, Card etc)
Client concentration based on external/internal credit rating.
Classification boundaries in terms of portfolio percentage, beyond which further growth may
be halted.
Maximum level of ‘high’ rated clients in terms of environmental and social due diligence.
• ii) Limits on loan type, borrower type, • *Scale-wise distribution of industry portfolio
rating grade, industry or economic sector • 1. Large Industries
• As stated above, it is an essential component • [Link],medium,cottage & micro industries
of credit risk management to establish limits
on concentrations across all possible • [Link] industries
dimensions of the credit portfolio. The first • C Trade & Commerce:
task in that effort is to establish a sensible
• a) Retail Trading
disaggregation of the portfolio, along the
following lines: • b)Wholesale Trading
• A Agriculture, Fishing, and Forestry • c)Export Financing
• B Industry • d)Import Financing
• Nature of Industry loan • e)Lease Finance
• a) Term loans • f) Others
• b) Working capital loans • (i) Secured by eligible securities
• (i) Secured by eligible securities • (ii) Secured by other than eligible securities
• (ii) Secured by other than eligible securities
• D Construction(commercial real estate, • c) Loans for the purchase of durable consumption
construction and land development loans): goods
• a) Residential Real estate • d) Credit card loans
• b) Commercial Real estate • e) Other personal loans
• c) Infrastructure development • G Loans to financial institutions
• d) Others • 1)Loans to NBFIs
• (i) Secured by eligible securities • 2) Loans to insurance companies
• (ii) Secured by other than eligible securities • 3) Loans to merchant banks and brokerage houses
• E Transport: • 4) Other, including loans to microfinance institutions
• a) Road Transport and NGOs

• b) Water Transport • H Miscellaneous

• c) Air Transport
• The above categorization, at its most disaggregated, contains
• F Consumer financing 37 separate categories.
• a) Loans for the purchase of flats or other single-
family dwellings
• b) Loans for the purchase of motorized personal
transport
• In addition, Category B in the above scheme, “Industrial Loans,” can be disaggregated in a
different way, focusing on the economic sectors rather than the type of enterprise and type of
loan. The following breakdown is preferred:
•  RMG
•  Textile
•  Food and allied industries
•  Pharmaceutical industries
•  Chemical, fertilizer, etc.
•  Cement and ceramic industries
•  Ship building industries
•  Ship breaking industries
•  Power and gas
•  Other manufacturing or extractive industries
•  Service industries
•  Others
• iii) Other necessary components of an adequate credit risk management
policy
• Every bank has to develop a credit policy (CP) as a part of an overall credit risk
management framework and get it approved by the Board. The CP should
clearly outline the bank's view of business development priorities and the
terms and conditions that should be applicable for credits to be approved.
The CP should be periodically updated, taking into account changing internal
and external circumstances.
• To make it effectual, CP should be communicated timely and implemented
by all levels of the bank through appropriate procedures. It should be
distributed to all lending authorities and credit officers. Significant
deviations from the CP must be communicated to the senior management or
Board and corrective measures should be taken.
• The CP should at least include:
• 1. Detailed and formalized credit evaluation/appraisal process;
• 2. Credit origination, administration and documentation procedures;
• 3. Formal credit approval process;
• 4. Approval procedure of credit extension beyond prescribed limits and other exceptions to
the CP;
• 5. Risk identification, measurement, monitoring and control;
• 6. Internal rating (risk grading) systems including definition of each risk grade and clear
demarcation for each risk grade in line with BB regulations and policies;
• 7. Risk acceptance criteria;
• a. Credit approval authority at various levels including authority for approving exceptions and
responsibilities of staffs involved in credit operations;
• 8. Roles and responsibilities of staffs involved in origination and management of credit;
• 9. Acceptable and unacceptable types of credit. These types can be on the basis of credit
facilities, type of collateral security, types of borrowers, or geographic sectors on which the
bank may focus;
• 10. Clear and specific policies for each of the various types of credits, including maximum loan-
to-value (LTV) ratios where applicable;
• 11. Concentration limits on single party or group of connected parties, particular industries or
economic sectors, geographic regions and specific products. Banks are allowed to set their own
stringent internal exposure limits, as long as they are at least as strict as prudential limits or
restrictions set by BB;
• 12. Pricing of credits, including whether loans will be granted on a fixed-rate or a floating rate
basis, and if floating, the frequency of rate changes and the reference rates that will be used for
rate changes;
• 13. Policies for the frequency and thoroughness of collateral verification and valuation;
• 14. Review and approval authority of allowances for probable losses and write-offs;
• 15. Guidelines on regular monitoring and reporting systems, including borrower follow-up and
mechanisms to ensure that loan proceeds are used for the stated purpose;
• 16. Guidelines on management of problem loans;
• 17. Policies on loan rescheduling and restructuring;
• 18. The process to ensure appropriate reporting and
• 19. Tolerance level of exceptions.
• Role of the Board of Directors with regard to credit risk
management
• The board has a vital role in granting credit as well as managing the credit risk of the bank. It
is the overall responsibility of a bank’s board to approve credit risk strategies and
significant policies relating to credit risk and its management which should be based on
the overall business strategy.
• The responsibilities of the board with regard to credit risk management shall include the
following:
•  Ensure that appropriate policies, plans and procedures for credit risk management are in
place. Ensure that bank implements sound fundamental policies;
•  Define the bank’s overall risk appetite in relation to credit risk;
•  Ensure that top management as well as staff responsible for credit risk management possess
sound expertise and knowledge to accomplish the risk management function;
•  Ensure that bank’s significant credit risk exposure is maintained at prudent levels and
consistent with the available capital.
•  Review trends in portfolio quality and the adequacy of bank’s provision for
credit losses;
•  Ensure that internal audit reviews the credit operations to assess whether or
not the bank’s policies and procedures are adequate and properly implemented;
•  Review exposures to insiders and other related parties, including policies
related thereto;
•  Limit involvement in individual credit decisions to those powers specifically
reserved to the Board by the bank’s articles of association, by-laws, and credit
risk management policy.
•  Ratify exposures exceeding the level of the management authority delegated
to management and be aware of exposures; and
•  Outline the content and frequency of management reports to the board on
credit risk management.
• Role of Senior Management
• The responsibility of senior management is to transform strategic directions set by the board
in the shape of policies and procedures. Senior management has to ensure that the policies are
embedded in the culture of the bank. Senior management is responsible for implementing the
bank’s credit risk management strategies and policies and ensuring that procedures are put in
place to manage and control credit risk and the quality of credit portfolio in accordance with
these policies.
• The responsibilities of senior management with regard to credit risk management shall
include:
 Developing credit policies and credit administration procedures for board approval;
 Implementing credit risk management policies to ensure an effective credit risk management
process;
•  Ensuring the development and implementation of appropriate reporting
system;
•  Monitoring and controlling the nature and composition of the bank’s credit
portfolio;
•  Monitoring the quality of credit portfolio and ensuring that the portfolio is
thoroughly and conservatively valued and probable losses are adequately
provided for;
•  Establishing internal controls and setting clear lines of accountability and
authority; and
•  Building lines of communication for the timely dissemination of credit risk
management policies, procedures and other credit risk management information
to all the credit staffs.
• Role of the Credit Risk Management Committee
• Each bank, depending upon its size, should constitute a credit risk management committee
(CRMC), at least comprising of head of credit risk management Department and or credit
department, head of recovery, head of RMD and treasury. The head of credit
department/CRMD shall act as a member secretary of CRMC. This committee shall report to
Board’s risk committee and Board who shall be empowered to oversee credit risk taking
activities and overall credit risk management function.
• The CRMC should be mainly responsible for:
• a) Implementation of the credit risk policy/strategy approved by the board.
• b) Monitoring credit risk on a bank-wide basis and ensure compliance with limits approved
by the board.
• c) Makings recommendations to the board, for its approval, clear policies on standards for
presentation of credit proposals, financial covenants, rating standards and benchmarks.
• d) Deciding delegation of credit approving powers, prudential limits on large credit
exposures, standards for loan collateral, portfolio management, loan review mechanism, risk
concentrations, risk monitoring and evaluation, pricing of loans, provisioning,
regulatory/legal compliance, etc.
• Managing Credit Risk in the Origination Process
• The following steps should be followed in managing Credit Risk in the
Origination Process
• 1 Borrower evaluation
• 2 Risk-based loan pricing
• 3. Credit Committee
• 4 Approval authority
• 5. Appeal / Review Process
• 6 Disbursement
• 7. Credit Reporting
1. Borrower evaluation
• The first step in the management of credit risks happens when the borrower walks through the
door and goes through the application process. The bank must examine the credit history
(if any) and repayment capacity of the borrower to ensure probability of repayment
paving the way for bank to earn an adequate risk-adjusted rate of return on the loan, without
charging an excessive interest rate that may be unacceptable to the borrower.
• Assessing the credit worthiness of a client before extending credit to them is smart business
practice.
• Analysis of credit risk will be addressed in the credit proposal. Relationship Manager will
provide actual fact & figures in the credit proposal and will be held responsible for providing
any erroneous information therein. He/she will select the prospective borrower in terms of
credit worthiness alongside collateral value. In this way of borrower selection he will keep
KYC profile of the borrower in light of existing Anti-Money Laundering Prevention Act,
AML & combating the financing of terrorism (CFT) Policy of the bank. In this process,
loan approval authority will perform the act of risk approval authority. Relationship Manager
will measure risks and thereafter take necessary actions for approval from approval authority.
• The bank should focus on the following factors in evaluating borrower:
• A. Credit Assessment
• i) Analysis of specific borrower repayment capacity
• ii) Required loan documentation
• B. Risk Grading / Rating
• i) Internal credit risk rating system
• ii) The role of external credit assessment institutions (ECAIs)
• C. Environmental & Social Risk Management (ESRM)
• A. Credit Assessment
• There is no substitute for thorough and rigorous credit assessment when
attempting to determine a borrower’s creditworthiness. The balance sheet,
income statement, cash flow statement, and financial projections all provide
crucial information about the borrower’s creditworthiness and capacity to repay.
SWOT analysis is prescribed as a tool to assess the prospective borrower for
lending.
• i) Analysis of specific borrower repayment capacity
• In order to make good credit decisions, lenders must know how to analyze financial
statements submitted by loan applicants. Lenders are expected to follow sound risk
management practices in the context of commercial credit analysis activities.
• Five Key Components of Financial Analysis
• The lender should always use five key components of analysis. These are;
•  Income statement,
•  Balance sheet,
•  Net worth and fixed asset reconciliation,
•  Key ratios, and
•  Cash flow statement.
• ii) Required loan documentation
• “Documentation” should be viewed as a process of ensuring shield against risk of non-repayment of loan comprehensively in 03 (three)
dimensions:
• i) The Type of Borrower
• ii) The Type of Loan or credit facilities &
• iii) The Type of Security Arrangement
• General Documents: In general, required papers and documents to be obtained/maintained irrespective of type of borrower, loan and security
are:
• 1. Demand Promissory Note
• 2. Letter of Authority
• 3. Letter of Arrangement
• 4. Letter of Disbursement
• 5. Letter of Revival
• 6. Personal Net Worth statement
• 7. Copy of National ID
• 8. Credit Approach in Business Pad of the Borrower
• 9. Credit Application in prescribed format duly filled in
• 10. Photograph of the Borrower
• 11. Photograph of the business/inventory
• 12. Photograph of the mortgaged property
• 13. Up to date CIB Report
• 14. Credit report of the Borrower/Supplier etc.
• B. Risk Grading / Rating
• To assess the asset quality and heighten the standing quality to a typical
standard, it is likely to make sure a strong risk grading arrangement. To each &
every credit / lending there is a classification or standard in terms of risk.
• To ascertain the classification, bank needs to watch carefully the financial
standing of the borrowers. The key financial performance indicators on
profitability, equity, leverage and liquidity will have to be analyzed. While
making such analysis due consideration should be given to business /industry
risk, borrowers' position within the industry and external factors such as
economic condition, government policies and regulations.
• i) Internal credit risk rating system
• An internal credit risk rating system (ICRRS) should categorize all credits into various classes
on the basis of underlying credit quality. Banks should develop an internal credit risk rating
system in line with regulatory authority’s prescription for its credits in consistent with the
nature, size and complexity of the bank’s activities.
• The rating system must be endorsed by the board and should have at least the following
parameters:
•  covers a broad range of the bank’s credit exposure, including off-balance sheet exposures;
•  covers both performing and non-performing assets;
•  has several grades covering exposures, with the lowest rating accorded to those where
losses are expected;
•  has risk ratings for “performing” credits with several grades (including the grade
corresponding to “special mention”);
•  has regulatory classifications (standard, special mention, sub-standard, doubtful &
bad/loss) should be incorporated within the risk rating systems; and
•  has the credit risk rating system detailed in the credit policy and procedures developed for
the determination and periodic review of the credit grades.
• ii) Risk Rating by External Credit Assessment Institutions (ECAIs)
• The analysis of a potential borrower’s creditworthiness by an ECAI is useful and
assist the credit analysts in organizing thinking and forming an opinion about
the potential borrower in question.
• Bank may take clients’ ratings assessed by ECAIs registered by Bangladesh
Securities and Exchange Commission as well as recognized by Bangladesh
Bank prior to lending. However, bank will rely on its own assessments of the
creditworthiness of the borrowers as the primary determinants of its credit
decision.
• C. ENVIRONMENTAL & SOCIAL RISK MANAGEMENT (ESRM)
• The financial and economic development of Bangladesh is inseparably linked to
our vulnerability to environmental & social degradation. An increasing
awareness of these issues and their impact on financial institutions and business
enterprises has made the environmental & social risk management a critical
component of Credit Risk Management procedures.
• As an environmental stakeholder bank needs to protect its financings from
environmental & social risk through own initiative for green as well as sector
specific leading to efficient energy and water resources management, waste
reduction, recycled materials and above all environmental friendly sectors.
• 2. Risk-based loan pricing
• i) Building blocks of loan pricing
• Banks must price loans to cover all costs, including a certain number of basis points over
the life of the loan to account for each of the following:
•  Cost of funds- The rate at which the bank is able to attract funds of equivalent tenor to the
loan in question. In banks that apply funds transfer pricing, this rate is a wholesale rate,
usually the swap rate (fixed or floating, depending on whether the loan is fixed or floating) of
an equivalent tenor.
•  Expected loss- The number of basis points that corresponds to the expected loss on the
loan, which will be higher on loans with more credit risk and lower on loans with less credit
risk. Although banks do not make loans with the expectation of suffering any loss, this
amount is not zero for any loan, no matter how well collateralized or guaranteed.
•  Cost of allocated capital- The cost of allocated capital is the amount of capital the bank has
allocated to the loan as coverage for unexpected loss, multiplied by the target return on equity
for the bank as a whole, and expressed in terms of basis points.
•  Term cost of liquidity- The number of basis points that captures the cost arising from the fact that loans of
longer and longer tenor require stable funding of longer and longer tenor, which will be costly for the bank
above and beyond any interest-rate risk considerations (which will be captured in the swap rate).
•  Cost of liquid asset buffer- Banks rarely “maturity-match” a loan with a specific source of funding of
equivalent tenor. They rightly know that a mix of current accounts, savings accounts, and fixed deposits will
render a stable source of funds under most circumstances. However, in extremely adverse and rare
circumstances, a run on deposits may occur and the bank may be forced to sell assets quickly at low prices or
seek additional deposits or other funds at high rates. For this reason, a liquid asset buffer must be held for these
unexpected situations. Since these assets either earn no interest at all, or very little interest for the bank, there is
an opportunity cost for holding the assets that must be expressed in terms of basis points and included in the
determination of the loan rate.
•  Loan administration costs- For any loan, big or small, there are staff costs involved in origination and
monitoring. Some of these costs are up-front and some are ongoing, but they all must be expressed in terms of
basis points over the life of the loan.
•  Competitive margin- Finally, after all other costs have been included in the rate, the bank will add on a certain
number of basis points to earn a margin. This component is the only one that is fully at the discretion of the
bank, given its funding and expense structure. This margin may even be negative, if the bank desires to gain a
temporary competitive advantage. However, it should not be negative on any kind of loan product for an
extended period of time.
• ii) Determination of selected components of risk-based loan pricing
• Some of the various components like swap rate, wholesale rate, liquidity
premium, senior debts issued by banks may be difficult to estimate in practice.
However, banks are expected to exert every effort in estimating these necessary
components and documenting their assumptions and results.
• 3. Credit Committee
• Credit Committee is a group of executives/ officials at the Corporate Branch/
Regional Office/ Principal Office/ Head Office level formed for recommendation
after assessing the credit standing and ability to repay debt of prospective
borrowers. The Credit Committee identifies possible risks assumed by the Bank
for different types of transactions which are not within the capability of the
Assets and Liabilities Directorate. The Credit Committee has the authority to
make suitable recommendation for approval or decline of any proposed credit.
• Composition of the Committee
• The Credit Committee at Head Office/ Principal Offices/ Regional Offices/
Corporate Branches level will be consisted of the Executives/ officers with
number of members as required. Among the members, a chairman and a member
secretary should be assigned separately in persons. The formation of the
committee at Principal Offices/ Regional Offices/ Corporate Branches level does
not require prior approval.
4. Approval authority
• Delegation of Authority Policy is established to define the limits of authority
designated to specified positions of responsibility to establish the types and
maximum amount of credit that may be approved to individuals or groups. All
employees should be aware of the conduct that violates the guidelines set forth
because violation will always be considered outside the scope of their
employment. Violating the policy may significantly damage the bank’s
operation. In addition, individuals who violate these guidelines are under the
purview of appropriate disciplinary action by the bank.
• i) Basic approval authority principles
• The authority to sanction/approve loans must be clearly delegated to senior credit executives by the Board,
based on the executive’s knowledge and experience. Approval authority should be delegated to individual
executives and not to committees to ensure accountability in the approval process.
• The following guidelines should apply in the approval/sanctioning of loans:
•  Credit approval authority must be delegated in writing from the MD/CEO and Board (as appropriate),
acknowledged by recipients, and records of all delegation retained in the CRM.
•  Delegated approval authorities must be reviewed annually by the Board.
•  The credit approval function should be separate from the marketing/relationship management (RM) function.
Credit approval authority cannot be delegated to a person assigned with marketing functions.
•  The role of the Credit Committee may be restricted to only the review of proposals and making
recommendations within the context of the bank’s overall loan portfolios. They may also review the compliance
with regulatory requirements.
•  Approvals must be evidenced in writing, or by electronic signature. Approval records must be kept on file
with the Credit Applications.
•  All credit risks must be approved by executives within the authority limits delegated to them. The “pooling”
or combining of authority limits should not be permitted.
•  The credit approval process should be centralized as a core CRM function. Considering the
volume of operations, Regional Credit Centers may be necessary. However, all large loans
must be recommended by the Credit Committee and Managing Director and approved by the
Board.
•  The aggregate exposure to any borrower or borrowing group must be used to determine the
approval authority required.
•  Any credit proposal that does not comply with the Bank’s Lending Policy, regardless of
amount, should be referred to Board of Directors for approval
•  A definite process is to be adopted to review, approve and monitor cross border exposure
risks.
•  Any breaches of lending authority should be reported to MD/CEO and Head of Internal
Control. There should be consequences for such breaches, to deter future violations.
•  It is essential that executives assigned delegated with approving loans possess relevant
training and experience to carry out their responsibilities effectively.
• Expertise required for Approval
• It is essential that executives assigned delegated with approving loans possess relevant
training and experience to carry out their responsibilities effectively. As a minimum,
approving executives should have:
• - At least 5 years’ experience working in corporate/commercial banking as a relationship
manager or as a credit analyst or account executive.
• - Training and experience in financial statement, cash flow and risk analysis with a critical
eye.
• - A thorough working knowledge of the fundamentals of accounting, finance and risk
management.
• - A good understanding of the local industry/market dynamics.
• - Successful completion of an assessment test demonstrating adequate knowledge in areas
including introduction of accrual accounting, industry/business risk assessment, borrowing
causes, financial reporting and full disclosure, financial statement analysis, asset
conversion/trade cycle, cash flow analysis, projections, loan structure and documentation,
loan management, etc.
• ii) Approval authority for large or complex exposures
• The approval level for large loans and loans to be restructured must be escalated to the Board.
It is also best practice for any complex or unusually high-risk loan to be escalated to the
Board for approval.
• iii) Exceptions
• In certain, limited circumstances, exceptions may be granted to the approval authority policy
on a case-by-case basis. However, such exceptions should be rare, and the reason for the
exception should be stated in the loan file. A compilation of the exceptions should be
provided to the Audit Committee of the Board on a regular basis.
• Approval Process
• The authority to sanction/approve loans will be clearly delegated to senior executives by the
Board, based on the executives’ knowledge and experience. Approval authority is delegated to
individual executive and not to committees to ensure accountability in the approval process.
Bank’s credit granting / approval process is to establish accountability for decisions taken to
approve credits or changes in credit terms. Approval authorities are expected to be
commensurate with the expertise of the individuals involved.
• The role of Relationship / Marketing Manager must be dissimilar from that of delegated
executives. The credit approval/ sanction will be continued within existing framework of
approved guidelines.
• Getting the proposal ready, the same is to be forwarded to the higher level of approval
authority for approval in line with following manner (process flow):
• Sss
• 5 Appeal / Review Process
• If any credit proposal is declined on the basis of credit appraisal
indicator or other reasons what so ever, the same may be sent to the
same/higher authority for review with justification for consideration
of the same on the basis of merit.
6. Credit Disbursement
• The credit administration should ensure that the credit application has proper
approval before entering facility limits into computer systems. Disbursement
should be effected only after execution of charge documents and completion of
covenants and creating charge on primary securities and collaterals (an
indicative documentation checklist is given in Annexure 1). In case of
exceptions, necessary approval should be obtained from competent authorities.
In no case should any of the loan proceeds be disbursed before all necessary
approvals have been granted.
• 7. Credit Reporting
• Monthly report on fresh sanctioned, renewed, enhanced loan or declined
proposal should be brought to the kind notice of the Management or the Board
in the following month.
• Credit Risk Mitigation Strategies
Credit Risk Mitigation
• Collateral and guarantees etc. are to be taken as credit risks mitigation
strategies. However credit risk mitigation should not be treated as
substitute for proper loan underwriting and loan administration. They are
correctly viewed only as secondary sources of loan repayment, never primary
sources. Officials are to take caution against making the loans depending upon
collateral or guarantee. A loan is considered collateral-dependent when
repayment is expected to be provided solely by the seizure and sale of the
collateral, the continued operation of the collateral, or, sometimes, both together.
• Credit Risk Mitigation Policy
• For productive credit risk mitigation, bank is desired to observe the following policies before
going for lending:
 Securitizing the lending
 Insuring of insurable securities
 Creating registered mortgage of mortgageable securities
 Mentioning collateral arrangement in credit proposal, in details
 Making agreement between bank and the borrower
 Keeping track of which loans are collateralized by which types of collateral
 Maintaining a concentration list of collateral
 Controlling & matching by CAM&RD the value of cash collateral which are liened to the
bank against which borrowings are allowed as per approval
 Legal counseling for establishing the required legal documentation for a borrower’s legal
standing and for enforcing the bank’s interest
 Vetting the mortgaged documents by bank’s legal counsel
 Creating registered mortgage of property supported by registered irrevocable general power
of attorney to sell the property
 Keeping loan-to-value ratio low enough to absorb declines in the value of the collateral
 Taking collateral having favorable marketability and liquidity
 Getting collateral assessed by enlisted survey firms
 Conducting inspection to verify the existence and valuation of the collateral
 Evaluating the level of coverage being provided in relation to the credit-quality and legal
capacity of the guarantor, in case of third party guarantees
 Complying with the additional credit-enhancing steps regarding third party guarantees.
• Insurable Security
• While necessary, it is important to protect lending business to have insurance for
products /goods of primary security. Otherwise bank may pay heavily for it, if it
is lost or damaged. The Head of Branch / concerned official will prepare
substantial report on primary security at least on monthly basis after physical
verification of the same and keep record thereof.
• Insurable security should be insured in due course for the amount equivalent to
sanctioned limit plus 10%.
• Collateral Security
• Bank may ask the borrower to offer collateral for minimize the credit risks. By securitizing
the loan with collateral, the borrower is made sense that it is he who will feel pain more from
default of the loans. So collateral is important for bank as it reduces the risks.
• So, for effective credit risk mitigation, bank will keep sufficient collateral as a guard of its
lending business. The following scheme for categorizing loans by collateral type is
recommended:
• 1. Shares and securities
• 2. Commodities/export documents
• a. Export documents
• b. Commodities
• i. Export commodities
• ii. Import commodities
• iii. Other commodities pledged or hypothecated
• 3. Machinery/fixed assets (excluding land, building/flat)
• 4. Real estate
• a. Residential Real estate
• b. Commercial Real estate
• 5. Financial obligations
• 6. Guarantee of individuals (personal guarantee)
• 7. Guarantee of institutions (corporate guarantee)
• a. Guarantee of bank or NBFI
• b. Other corporate guarantee
• 8. Miscellaneous
• a. Hypothecation of crops
• b. Other
• 9. Unsecured loans
• Third-Party Guarantees
• The officials must understand that the credit risk on a loan is not eliminated
by the existence of a third-party guarantee. With regard to guarantees, bank
will evaluate the level of coverage being provided in relation to the credit-
quality and legal capacity of the guarantor. While taking any third party
guarantee following steps are to be taken:
• - Individual guarantor’s status is to be higher than or equal to the
borrower/ applicant which is to be supported by Personal Net-Worth Statement
of the guarantor having sufficient Net Worth to repay the loan liabilities.
• - The corporate guarantee must be supported by a Memorandum of
Association (MoA) and Articles of Association (AoA) of the company giving
the corporate guarantee. Additionally, the corporate guarantee is to be
approved in the board meeting of the corporate guarantor.
• - The guarantor company must be rated in any of the investment grade
categories by at least one ECAI.
• - The balance sheet of the third party giving a corporate guarantee is to be
analyzed. Networth, total assets, profitability, existing credit lines, and security
arrangements of the company giving the corporate guarantee are to be analyzed
to ensure that the company is not exposed to financial obligation beyond its
capability.
• - Reciprocal guarantee arrangements between two banks will be disregarded.
For example, if Bank A guarantees loans made by Bank B to certain client(s),
and Bank B guarantees loans made by Bank A to certain client(s), only the
difference between the two guaranteed amounts will be considered as a credit
enhancement for the purpose of determining the overall level of credit risk at the
bank whose borrowers benefitted from the higher amount.
• Managing Credit Risk in the Administration Process
1 Borrower Follow-up & Corrective Actions
2 Independent Internal Loan Review and Changes to the Credit Risk Rating
• 2.1 Loan Review vs. Loan Monitoring
• 2.2 Loan Review by Credit Division
• 2.3 Loan Review by Credit Administration, Monitoring & Recovery Division
3 Loan Monitoring
• 3.1 Early Warning System (EWS)/ Timely Identification of Problem Assets
• 3.2 Exercise of Early Warning System
4 Provisioning in Managing Credit Risk
• 1 Borrower Follow-up & Corrective Actions
• Borrower follow-up & corrective actions are crucial in identifying Early Indication of Deteriorating
Financial Health of the borrower. Conducting customer calls and site visits to obtain key data is a
critical and continuous process. For this reason it is important for the Head of Branch/ authorized
officials to be out in the field as often as possible because:
• - Problems are often evident here first.
• - Problems are often disguised in financial statements.
• - The loan proceeds may have been diverted to some other purpose.
Depending on the size of loan and risk rating of the customer the Head of Branch/ authorized
officials will have to conduct a customer call monthly. To do this the Head of Branch/ authorized
officials will:
• - Develop a call schedule plan.
• - Plan other necessary data gathering.
• - Determine the frequency of site visits by utilizing the loan classification. The less favorable the
classification, the more frequent the visits should be.
• In addition, authorized officials will watch carefully the financial standing of the borrowers. The key
financial performance indicators on profitability, equity, leverage and liquidity should be analyzed.
• 2 Independent Internal Loan Review and Changes to the Credit Risk Rating
• The independent, internal loan review is crucial for proper Credit Risk Management.
• 2.1 Loan Review vs. Loan Monitoring
• Loan Review is a strategic process which:
• - Is to be accomplished by an objective third party/ person (not the loan officer/ Relationship Officer).
• - Will include assessment and evaluation of individual loans, loan portfolio components
• - Assesses the loan portfolio as a whole
• - May make recommendations for achieving corporate strategic objectives through the loan portfolio.
• - Will include assessment of the loan management process, credit quality, and the results / profitability
of the loan portfolio.
• Loan Monitoring is a tactical process which:
• - Is to be accomplished by loan officer
• - Includes tracking of a borrower to watch loan deterioration, with the emphasis on loan repayment.
• 2.2 Loan Review by Credit Division
• At least, 10% of total loans & advances approved by the Principal Offices/ Regional Offices/
Corporate Branches should be reviewed /overseen by Credit Division, Head Office annually. Loan
Review personnel must be experienced in working with lending activities especially with collateral, in
identifying liquidation value and be known of what is involved in liquidations. They will find out their
observations and submit the reports before the senior management, with their recommendations.
• 2.3 Loan Review by Credit Administration, Monitoring & Recovery Division
• Credit Administration, Monitoring & Recovery division will set forth the necessary guidelines for a
well-organized and effective loan Review Process. It is the responsibility of loan review to provide an
objective third-party opinion so that realistic loan-to-collateral relationships can be maintained by the
bank. Loan Review process should be established for addressing following five specific issues/
contents while reviewing individual credits:
• a) Credit Quality
• b) Documentation
• c) Liquidation of Collateral
• d) Pricing and Funds Management Objectives
• e) Compliance with Loan Policy, Laws and Regulations
• 7.3 Loan Monitoring
• Loan Monitoring is a tactical process which is to be accomplished by loan
officer. Loan officer will follow-up the borrower and find out the loan
deterioration, if any, giving emphasis on loan repayment. Branches will adopt
necessary steps to monitor each & every loan account maintaining schedules.
They will make their monitoring function active by maintaining proper liaison
with respective Regional Offices/ Principal Offices/ CAM&RD. A computer
generated monitoring system is crucial & thereby imperative to have as a fruitful
monitoring technique.
• 3.1 Early Warning System (EWS)/ Timely Identification of Problem Assets
• The Early Warning System (EWS) is an important tool. The EWS allows the bank to
effectively and promptly identify customers with increasing Credit Risk. Bank will put in
place a process for the early warning of increasing Credit Risk for the timely identification of
problem assets.
• 3.2 Exercise of Early Warning System
• a. The loan accounts which require more attention, intensive follow-up and instruction to
operate from competent authority should be included in the early alert list.
• b. If the account trends to fall under classification likely within 01 (one) year, it is to be
brought to the kind notice of the higher authority. Relationship Manager will adopt corrective
actions for betterment of overall situations. Report should be submitted to Credit
Administration, Monitoring & Recovery Division within 07 (seven) days of identifying such
account.
• c. Credit Administration, Monitoring & Recovery Division will take necessary actions or
recovery measures against identified irregular loan accounts. They will make necessary
reports on substances of irregular accounts and upgrade the risk levels present there.
• d. Regular close conduct is to be maintained with the borrower to get the worsening accounts
regular.
• 7.4 Provisioning in Managing Credit Risk
• Provisions for loan losses (alternatively known as loan loss reserves, loan loss allowances,
valuation allowances, etc.) are more than just an accounting entry on the liability side of the
bank’s balance sheet. In the aggregate, the level of provisions must reflect the expected loss
on each loan. Normally three types of loan provisioning:
• i. General Provision
• ii. Specific provisions
• iii. Provision for Short-Term Agricultural and Micro-Credits.
• General Provision
• General provisions are applied to portions of the portfolio (currently, on unclassified loans
and loans in the Special Mention Account) on a portfolio basis, expecting that some of the
loans (without knowing which) will be downgraded in the future and require specific
provisions.
• Specific Provisions
• Specific Provisions are applied to individual classified loans as an estimation of
expected losses on these individual loans. These balance sheet provisions,
formed by debiting expense accounts on the profit and loss statement also
known as “provisions,” play an essential role in managing Credit Risk.
• Provisioning Procedure
• Loan loss provisions should be calculated & retained based on actual and
expected losses as per guidelines of Bangladesh Bank. Bank will always be on a
track of accommodation with changes set forth by Bangladesh Bank time to
time.
• Managing Credit Risk of Problem Assets
• Problem loans are an inevitable consequence of lending. Any time a loan is
funded, unforeseen events could arise and make it difficult for the borrower to
live up to the terms of the loan agreement.
• Problem loans often begin with loan officer errors–for example, inaccurately
assessing the character of the borrower, misinterpreting the figures on a spread
sheet, or simply not saying no to the loan request. These causes of problem loans
should and can be minimized.
• Management of Non-Performing Loan (NPL)
• The management of problem loans (NPLs) must be a dynamic process, and the
associated strategy together with the adequacy of provisions must be regularly
reviewed. It is crucial for the NPL Management to be effective & dynamic in
terms of actions. Accounts lying on CRG Grade level 5, 6, 7 & 8 are to be
treated as NPL accounts. Credit Administration, Monitoring & Recovery
Division together with other related divisions will ensure adequate and suitable
measures in line with existing rules & regulations set forth by Bangladesh Bank
or other concerned authorities, on the way to recovery of problem assets. If any
loan or part of it or accrued interest thereon to any person /organization of his/its
own or related concern remains “Overdue” for more than 6(six) months, the
borrower availing of such loan facility will be treated as defaulted borrower as
per section 5(GaGa) of the Banking Companies Act-1991.
• Once a potential problem loan has been identified, the bank needs to follow the steps
appended below:
- Determine account-wise action plan/ Recovery Strategy
- Interact with the borrower
- Re-schedule/ restructure the loan only in accordance with BB directives set forth from time to time
- Recover the problem loans via Exit Technique (Waiver of Interest)
- Other acceptable recovery measures
- Follow the rules of Artha Rin Adalat Ain 2003
• Branches/ Corporate Branches/ Regional Offices/ Principal Offices will take the
responsibilities to ensure recovery of respective problem loans under their controls. The
recovery function must be managed / controlled centrally by Credit Administration,
Monitoring & Recovery Division, Head Office as usual.
• Interaction with borrower
• Interaction with borrower may be maintained adopting following steps:
- Develop a preliminary plan before meeting with the borrower.
- Schedule a meeting with the borrower soon after learning about the problem loan. Discuss the
problem, explore available alternatives to solve the problem, and establish what actions are
acceptable and not acceptable.
• Loan Re-Scheduling
• Loan rescheduling means stretching out of time over a longer period for
payment of principal and /or interest. In certain rare situations, the borrower may
find itself in a period of temporary financial distress. Loan rescheduling may be
an appropriate way of handling the problem loan situation, but only if the bank
is fairly certain that the borrower is able to fulfill the rescheduled terms of the
contract. In no way bank should go for rescheduling if significant doubt is
evident about the borrower’s willingness or ability to repay over the long term.
• Loan Re-Structuring
• If the borrower’s financial distress is more permanent rather than temporary,
restructuring may be appropriate in order to maximize the present value of the
future cash flows that can reasonably be expected from the borrower.
• As with rescheduling, banks should not restructure any loan unless the bank is
fairly certain that the borrower can fulfill the restructured terms. In all cases,
restructuring must be conducted only in accordance with BB directives from
time to time, including the formation of necessary provisions. Additional
provisions to capture all expected losses from the restructuring activity must
also be established. MIS reports to the Board and senior management will have
to encompass the losses embedded in this process.
• DEFINITION OF CREDIT RISK GRADING (CRG)
• 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.
• A Credit Risk Grading deploys a number/ alphabet/ symbol as a
primary summary indicator of risks associated with a credit
exposure.
• Credit Risk Grading is the basic module for developing a Credit
Risk Management system.
• Credit risk grading is an important tool for credit risk
management as it helps the Financial Institutions to understand
various dimensions of risk involved in different credit
transactions.
• At the pre-sanction stage, credit grading helps the sanctioning
authority to decide whether to lend or not to lend, what should be the
lending price, what should be the extent of exposure, what should be the
appropriate credit facility, what are the various facilities, what are the
various risk mitigation tools to put a cap on the risk level.
• At the post-sanction stage, the FI can decide about the depth of the
review or renewal, frequency of review, periodicity of the grading, and
other precautions to be taken. Risk grading should be assigned at the
inception of lending, and updated at least annually. FIs should, however,
review grading as and when adverse events occur.
• FUNCTIONS OF CREDIT RISK GRADING
• Well-managed credit risk grading systems promote bank safety and
soundness by facilitating informed decision-making.
• Grading systems measure credit risk and differentiate individual credits
and groups of credits by the risk they pose. This allows bank management
and examiners to monitor changes and trends in risk levels. The process
also allows bank management to manage risk to optimize returns.
• Risk Grading for Corporate and SME
• The proposed CRG scale is applicable for both new and existing borrowers.
• It consists of 8 categories, of which categories 1 to 5 represent various
grades of acceptable credit risk and 6 to 8 represent unacceptable credit
risk. However, individual FI depending on their risk appetite may
implement more stringent policy.
• CREDIT RISK GRADING DEFINITIONS
• A clear definition of the different categories of Credit Risk Grading is given as follows:
• REGULATORY DEFINITION ON GRADING OF CLASSIFIED ACCOUNTS
• Irrespective of credit score obtained by a particular obligor, grading of the classified names should
be in line with Bangladesh Bank guidelines on classified accounts, which is extracted from
“PRUDENTIAL REGULATIONS FOR BANKS: SELECTED ISSUES” (updated till August 07, 2005) by
Bangladesh Bank are presently as follows:
• Basis for Loan Classification:
• (A) Objective Criteria:
• □ Any Continuous Loan if not repaid/renewed within the fixed expiry date for repayment will be
treated as irregular just from the following day of the expiry date. This loan will be classified as Sub-
standard if it is kept irregular for 6 months or beyond but less than 9 months, as `Doubtful' if for 9
months or beyond but less than 12 months and as `Bad & Loss' if for 12 months or beyond.
• □ Any Demand Loan will be considered as Sub-standard if it remains unpaid for 6 months or beyond
but not less then 9 months from the date of claim by the bank or from the date of forced creation of
the loan; likewise the loan will be considered as ‘Doubtful' and ‘Bad & Loss’ if remains unpaid for 9
months or beyond but less then 12 months and for 12 months and beyond respectively.
• □ In case any instalment(s) or part of instalment(s) of a Fixed Term Loan is not repaid within the
due date, the amount of unpaid instalment(s) will be termed as `defaulted instalment'.
• In case of Fixed Term Loans, which are repayable within maximum 5 (five) years of time:
-
• If the amount of `defaulted instalment' is equal to or more than the amount of instalment(s) due
within 6 months, the entire loan will be classified as ‘Sub-standard’.
• If the amount of 'defaulted instalment' is equal to or more than the amount of instalment(s) due
within 12 months, the entire loan will be classified as ‘Doubtful’.
• If the amount of 'defaulted instalment' is equal to or more than the amount of instalment(s) due
within 18 months, the entire loan will be classified as ‘Bad & Loss’.
• In case of Fixed Term Loans, which are repayable in more than 5 (five) years of time: -
• □ If the amount of ‘defaulted instalment' is equal to or more than the amount of instalment(s) due
within 12 months, the entire loan will be classified as 'Sub-standard.'
• □ If the amount of ‘defaulted instalment' is equal to or more than the amount of instalment(s) due
within 18 months, the entire loan will be classified as 'Doubtful'.
• □ If the amount of 'defaulted instalment 'is equal to or more than the amount of instalment(s) due
within 24 months, the entire loan will be classified as 'Bad & Loss'.
• (B) Qualitative Judgement:
• If any uncertainty or doubt arises in respect of recovery of any Continuous Loan, Demand Loan or
Fixed Term Loan, the same will have to be classified on the basis of qualitative judgement be it
classifiable or not on the basis of objective criteria.
• If any situational changes occur in the stipulations in terms of which the loan was extended or if the
capital of the borrower is impaired due to adverse conditions or if the value of the securities
decreases or if the recovery of the loan becomes uncertain due to any other unfavorable situation,
the loan will have to be classified on the basis of qualitative judgement .
• Besides, if any loan is illogically or repeatedly re-scheduled or the norms of re-scheduling are
violated or instances of (propensity to) frequently exceeding the loan-limit are noticed or legal
action is lodged for recovery of the loan or the loan is extended without the approval of the proper
authority, it will have to be classified on the basis of qualitative judgement .
• HOW TO COMPUTE CREDIT RISK GRADING
• The following step-wise activities outline the detail process for arriving at credit risk grading.
• 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
• Each of the above mentioned key risk areas require to be evaluated and aggregated to arrive at an
overall risk grading measure.
• a) Evaluation of Financial Risk:
• Risk that counterparties will fail to meet obligation due to financial distress. This typically entails
analysis of financials i.e. analysis of leverage, liquidity, profitability & interest coverage ratios. To
conclude, this capitalizes on the risk of high leverage, poor liquidity, low profitability & insufficient
cash flow.
• b) Evaluation of Business/Industry Risk:
• Risk that adverse industry situation or unfavorable business condition will impact borrowers’
capacity to meet obligation. The evaluation of this category of risk looks at parameters such as
business outlook, size of business, industry growth, market competition & barriers to entry/exit. To
• c) Evaluation of Management Risk:
• Risk that counterparties may default as a result of poor managerial ability
including experience of the management, its succession plan and team
work.
• d) Evaluation of Security Risk:
• Risk that the bank might be exposed due to poor quality or strength of the
security in case of default. This may entail strength of security & collateral,
location of collateral and support.
• e) Evaluation of Relationship Risk:
• These risk areas cover evaluation of limits utilization, account
performance, conditions/covenants compliance by the borrower and
deposit relationship.
• Step II Allocate weightages to Principal Risk Components
• 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.
Thank You