Managing credit risk in the banking sector is one of the core challenges in the present context and it is treated as a major concern of all banks and financial institutions, regulatory bodies and the government. The banking sector of our country has been facing a number of challenges over the years and the most serious one is the high credit risk phenomenon. This, to some extent, may be related to induction of borrowers with below credit standards, a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of the borrowers, lack of structured approach for better risk management, improperly or incompletely executed documents, weak screening mechanism of early alert accounts, etc.
After accepting deposits from the depositors banks plan to deploy these funds in the economy mainly by using three portfolios, namely, money market portfolio, capital market portfolio and general loans and advance (or investment) portfolio. The highest amount of funds is deployed under general loans and advance portfolio through direct negotiation with the borrowers and it is the highest contributor of returns for the banks. However, it is also the obvious source of credit risk.
The term credit risk is most simply defined as the potential that a bank's borrower or counterparty will fail to meet its obligations in accordance with the agreed terms. Banks need to manage the credit risk inherent in the entire portfolio as well as in individual credit facility or transaction since the major percentage of assets of the banks is subject to this risk. The effective credit risk management, now-a-days, has become a critical component of bank management and an essential aspect for the sustainability of any banking organisation. Banks and financial institutions which are operating their business in Bangladesh are keen to identify, measure, monitor and control the credit risk as well as to determine and holding adequate capital against this risk.
Capital adequacy refers to the amount of capital which is adequate to compensate for the risks to be covered. The Basel Committee is encouraging the banking industry globally to promote sound practices for managing credit risks. In our country, a number of initiatives have been taken by the central bank, regulatory authorities and the government to manage credit risks in the banking sector and these have had a positive impact.
If we go few years back, we can allude to some significant and remarkable initiatives in this regard. In mid-1980s, the National Commission on Money, Banking and Credit was constituted for the financial sector in order to define the scopes and modalities of the early phase of reforms programme. In the early 1990s, the first intervention with the international donor agencies was initiated and Bangladesh started adopting the Financial Sector Reform Programme (FSRP) measures under overall economic stabilisation and structural adjustment programme. As a part of implementation of the recommendations of National Banking Commission Report as well as financial sector reforms programme lending risk analysis, loans classification and provisioning thereon, guidelines of recovery of loans, etc., were introduced. The Artha Rin Adalat Ain, 2003 (amended a number of times) was enacted in 1990 to create a positive impact on bank's loan portfolio management. It was also enacted with a view to enable better supervision on lending activities of banks to deal with problems of bad loans or loan default. In 1992, the Credit Information Bureau (CIB) was established with the objective of minimising the extent of default loans and advances by providing the participants with timely reports on credit information based on the enquiry or request about the loan application. Banks were advised to take into account the different degrees of credit risk and cover both the on and off balance sheet transactions to determine capital adequacy first time since 1997 (vide BRPD Circular No.1 dated January 08, 1996). In 2003, the core risks management guidelines were introduced by the central bank to manage the risks in the banking sector meticulously. The management of IT (information technology) risk and environmental risk is also addressed under the core risks guidelines. In 2005, Credit Risk Grading (CRG) was introduced to replace Lending Risk Analysis (LRA) which is applicable for all exposures, irrespective of amount, other than those covered under consumer credit, small enterprise financing, short-term agricultural and micro credit, etc. CRG is structured with five basic risk elements of the customers containing twenty evaluating parameters to determine risk grade of the customers. There are eight categories of risk grade. The guidelines on Supervisory Review and Evaluation Process (SREP) was introduced in 2010 for a bank's own-supervisory review of capital position to reveal whether a bank has prudent risk management system and also has sufficient capital to cover the risk profile. Besides these initiatives and the keen awareness of the banks, the exposure to credit risk continues to be the leading source of problems in banking sector. Therefore the sound handling of credit risk management practices should take care of the following aspects along with other measures:
* Creating an appropriate and well-equipped credit risk management environment where credit risk grading and scoring practices are to be conducted thoroughly and objectively with a high stringent score sheet or even financial model recommended by the central bank or even own developed tools. Possibility and propensity to failure of the borrower or counterparty are to be assessed based on time series data as well as projected data related to particular borrower and his/her industry where his/her business belongs to. However, to create a credit risk management environment in the banks, it is a precondition to have credit risk management strategy and significant credit risk policies with the approval of Board of Directors. The Board of Directors will review these periodically and make necessary amendments as per requirements of the economy and banking sector. The credit policy of the banks should reflect at least the tolerance limit of risk to be undertaken, segments and allocation of credit under different clusters of industry/sector, credit diversification strategy to avoid credit concentration, credit pricing in terms of risk exposure, risk mitigation factors, segments of duties and responsibilities of approving and sanctioning authorities, etc. The senior management of the banks will take the responsibility for implementing the credit risk strategy approved by the Board of Directors and applying procedures for identifying, measuring, monitoring and controlling credit risk rigorously. It is to be ensured that the risks of products and activities new to the banks are subject to adequate procedures and controls before being undertaken and approval in advance from the Board of Directors or its appropriate committee to be obtained.
* Maintaining a sound credit granting and approval process with well-defined and structured credit granting criteria is the vital aspect for sound credit risk management. These criteria may include KYC (Know Your Client) of the potential borrower, clear purpose and structure of credit, source of repayment, security coverage, insurance, etc. The bank officials with relevant academic background, knowledge and practical experiences in the relevant field like documentation, legal aspect, financial projection, cash flow analysis, market analysis, etc., may be deployed in credit granting and approving activities. A clearly established process is to be in place for approving new credit facilities as well as renewal, enhancement, extension of existing credits etc. All renewal and extension of credit should be done on the basis of proper justification and fundamental analysis. Credit cap for single borrower or group of connected concerns should be followed both on and off balance sheet facilities. For the sake of better management, the credit-granting function should be properly managed and the credit exposures shall be within the levels consistent with prudential standards.
At a minimum, the following factors may be considered and documented in approving credit: (i) the clearly stated purpose of the credit and source(s) of repayment; (ii) the integrity and reputation of the borrower; (iii) the current risk profile of the borrower and its sensitivity to economic and market deterioration; (iv) the borrower's repayment history and current capacity to repay, based on historical financial trends analysis and cash flow projections; (v) a forward-looking analysis of the capacity to repay to be conducted based on various scenarios; (vi) the legal status and capacity of the borrower to executive documents and meet the liability; (vii) borrower's expertise and the status of the borrower's economic sector and its position within that sector; (viii) the proposed terms and conditions of the credit including credit covenants in case of default; and (ix) the adequacy and enforceability of collateral or guarantees. Finally, we need to understand to whom we are granting credit. Therefore, prior to entering into any new credit relationship, we must be familiar with the borrower and be confident that we are dealing with an individual or organization of sound repute and creditworthiness.
* A separate Credit Administration Unit or Cell with specific responsibilities like thorough checking of documents before disbursement, monitoring of terms and conditions of the facility agreement and all sorts of compliance operating in all banks. However, the on-going administration of credit with due diligence and governance has to be ensured. We may develop and utilise internal risk rating systems in addition to central bank's guidelines for managing credit risks. The rating system should be customised in such a way that it will be consistent with the nature and size of the proposal.
" Ensuring adequate control over credit is another important aspect for sound management of credit risks. A system for perfection of documentation, valuation, monitoring, supervision, follow-up, early alert process based on operational and financial performance of the borrower, etc., is to be developed to ensure adequate control over the credit. The results of on-going review, monitoring, follow-up, etc., are to be communicated to the top management on regular basis. However, we should have internal controls and practices to ensure that the information of review, monitoring, follow-up, etc., are reported in timely manner to the appropriate level of management.
* Maintaining adequate MIS (Management Information System) and obtaining complete KYC regarding the borrower and his/her business is a crucial issue for managing credit risk effectively. Bankers should take into consideration the potential future changes in economic conditions while assessing credit proposals and maintaining MIS for the same. Moreover, credit risk exposures under stressful conditions of a particular borrower should be assessed and should be kept under MIS. It should be kept in mind that changes in the economy, regulations, competitions, technology and other developments may adversely affect client's business. Non-sophisticated 'five Cs' model (which includes character, capacity, condition, collateral and cash flow) may be applied to know-the-customer. A number of relevant financial ratios like current ratio, acid-test ratio, liquidity ratio, asset ratio, gross profit margin, net profit margin, ROI (Return on Investment), operation expenses ratio, inventory turnover ratio, accounts receivable turnover ratio, accounts payable turnover ratio, debt-equity ratio and debt service coverage ratio may be calculated and documented at the time of assessing the borrower's creditworthiness. Credit Risk Grading (CRG) is to be conducted based on realistic and audited data related to the borrower and his/her industry. All these results are to be kept and used as MIS for further decision making. A good MIS also includes an occasional check of public records and a daily perusal of newspapers, magazines and trade publications.
* It is invariably important to develop a system for monitoring the overall composition and quality of the credit portfolio for effective credit risk management. Traditionally, the bankers give more focus on oversight of individual credit and managing its risks. While this focus is important, no doubt, but the bankers also need to have a system for monitoring the overall composition and quality of the credit portfolio. Credit concentration risk affects the overall quality of credit portfolio of the banks. Concentration occurs when a bank's portfolio contains a high level of credits to (i) a single borrower; (ii) a group of connected concerns; (iii) a particular industry or economic sector; (iv) a particular geographic region; (v) a type of credit facility; or (vi) a type of security. Concentration also occurs in credits with the same maturity. A high concentration exposes the bank to adverse changes in the area in which the credits are concentrated. For avoiding or reducing concentration risk we may diversify trade area, geographic location or try to get access to economically diverse borrowers and may undertake more financial inclusion programmes under investment portfolio.
* Establishing a system for managing non-performing credit and workout situation is also an inevitable step for risk management. In designing the strategy for managing non-performing credit at least four aspects are to be considered. Firstly, proper screening of credit proposal which includes objectively conducting credit risk grading, obtaining CIB report, report from trade checking and connected parties, etc. Secondly, monitoring mechanism which includes practising early alert process, off-site supervision, etc. Thirdly, transparency which includes proper credit filing, documentation, loan classification and provisioning, etc. Fourthly, lender's recourse which includes using legal provisions under Artha Rin Adalat Ain, NI Act, Limitations Act, Bankruptcy Act etc., as well as non-legal measures.
CREDIT RARELY BECOMES PROBLEM-CREDIT OVERNIGHT: Although credit risk cannot always be avoided, a number of safe-guarding strategies can restrict their occurrences and minimise a bank's losses. Thus, managing credit risk effectively may enable the banks not only to avoid unexpected losses from the credit portfolio but also help them strengthen their sustainability, protect them from forced provisioning, securing them against capital erosion and declining profitability, etc. Thus the credit risk management guidelines, credit appraisal format, approval and disbursement process, valuation of collateral and security, early alert process, monitoring and follow-up process, due diligence process, documentation checklist, governance etc. should be well-structured and customised as per nature and size of the borrower. Rigorous training and motivational programmes for the employees, extended use of information technology in credit management process, establishing credit counseling unit/cell for the borrowers, arranging talk-show in the media between borrowers and bankers, etc., may help to manage credit risks.
It is said that credit rarely becomes problem-credit overnight. Usually, a gradual deterioration in credit quality occurs that is accompanied by numerous warnings/early alert signals. If these signals are detected in time, banks can take action to prevent the problem-credit from developing or can at least move to minimise bank's losses in the event of a difficulty. For example, a borrower's company manufacturing only T-Shirts has failed to invest enough in product research and development over the years. As a result, its product has become obsolete. The growing obsolescence of its product would likely to reflect on the company's financial statements as declining sales and a slowdown in inventory turnover. The company heads for bankruptcy with potential sizeable losses for the banks or creditors. Here, the obvious symptom of this problem is the decline in the company's financial commitment to product research and development. So the key to minimise the risks is to note the telltale symptoms when they occur, rather than waiting for a major breakdown in repayment. Early recognition of problems of a borrower gives the bank an opportunity to work with the borrower and take remedial action before a credit workout or loss becomes inevitable.
To detect a problem-credit at an early stage, we should at least (i) analyse the financial statements thoroughly and on a regular basis; (ii) keep lines of communication open with the borrower with frequent telephone calls, correspondence and site visits; (iii) stay alert to direct or indirect signs supplied by credit officers as well as third parties; (iv) look at the borrower's total account relationship with the bank, etc.
