Credit Risk Management In Banks

  Prepared by:Md. Shahidul Islam ID#1125069Mahmudur Rahman ID#1035080Md. Imran Rony ID#1110837Eftekhar Ahamed ID# 1035038

What is Credit Risk Management

• Credit risk management works by helping lenders cut back the chances of lending to someone who will never pay them back. It's performed by using a series of formulas based on a person's income, current debts, credit history and score. When all of this information is taken into consideration, it can help a bank determine if someone is a good credit risk or not.

Significance of CRM

• As unpleasant as it sounds, credit risk management is a necessary part of the financial world. In fact, it's so important, businesses need to review whether their current risk indicators are working. If not, it's time to change the calculations and figure out a new way to determine a creditworthy individual or business. That might include such things as personal interviewing and finding out the reason for the new credit request.

Historical Development CRM

Up to the late 1970s the credit risk assessment was analyzed using predominantly qualitative models. Qualitative models, also called expert systems, rely on FI’s experts to use their skills and insights to make a decision whether to grant credit or what the loan price should be.

The focal points of the analysis are borrower’s reputation, capital structure, volatility of earnings and collateral.

For today’s risk management qualitative models prove to be unsuitable. Assessing the risk of a single obligor takes a lot of experts’ time and it would be impractical to assess all banks credit transactions. Exceptions are made when the counterparty represent significantly large exposure, so that the expensive analysts time is justified in monetary terms.

For the above mentioned reasons, quantitative models are considered the better alternative to qualitative models due to their fast processing time and objective predictions.

Historical Development CRM

• Moreover, these models incorporate widely recognized modern financial theory and widely available financial data.

• The latest CRMs focus on predicting the distribution of credit losses through either Monte Carlo simulations or analytical methods.

• Additionally, besides default risk, the new breed CRMs also weigh in concentration risk, downgrade risk and spread risk in the overall assessment result.

• So we can day that, “The existence of the quantitative CRMs is predominantly the result of technological developments and improved financial data availability and regulations”

Components Of Credit Risk Grading

• Financial risk: The uncertainty of future incomes due to the company’s financing. Financial risk management refers to the practices used by corporate finance managers and accountants to limit and control uncertainty in the firm’s total portfolio. Two sets of financial ratio helps measure financial risk: 1. Balance sheet ratios 2. Earnings or cash flow available to pay fixed financial charges.

• Business/Industry risk: The risk related to the inability of the firm to hold its competitive position and maintain stability and growth in earnings. The uncertainty of income caused by the firm’s income. For each sector, a clear indication of the bank’s appetite for growth should be indicated (as an example, Textiles: Grow, Cement: Maintain, Construction: Shrink

Components Of Credit Risk Grading

• Management Risk: The risks associated with ineffective, destructive or underperforming management, which hurts shareholders and the company or fund being managed. Management risk is given below:1. Experience/relevant background 2. Track record of management in see through economic cycles 3. Succession 4. Reputation

• Security risk: Security risk mainly depends on the potential owners or other source. Future is always uncertain, can take any step to minimize uncertain situation to the potential owner. Some Security risks are given below:1.Perishability 2.Enforceability /Legal structure 3.Forced Sale Value (calculations of force sale value should be at least guided by Bangladesh Bank guidelines)

Components Of Credit Risk Grading

• Relationship risk: Relationship risk mainly based on supplier and customer relation to the entrepreneur. If the entrepreneur can make a good relation to the customer or supplier he or she also get the loan at a lower rate.

• Non-Financial Risk: Non-financial risk or sustainability risk is that which didn’t affect the credit directly but has an indirect impact on the overall risk management of the bank. Bangladesh Bank now define guidelines for the banks to follow the non-financial risks also. Sustainability risk actually contains 3 components.

1.Good Governance regulated by Security and Exchange Commission (SEC) 2.Corporate Social Responsibility (CSR) regulated by Bangladesh Bank (BB) 3.Environmental Responsibility (ER) regulated by Bangladesh Bank (BB)

Questionnaire

• As a requirement for completing this assignment of credit risk management in banks first we developed a questionnaire and collect information from two banks through the questionnaire. Our information collecting banks are1.Bank Alfalah Limited.2.The City Bank Limited.

Discussion on the questionnaire

• Question 1: In making lending decisions what type risk grading mechanism you are following right now?

Ans: a) Credit initiation and internal rating system (CIIRS) By Bank Alfalahb) FSS By City Bankc)Credit Risk Grading(CRG) By Both Banks

• Most of the time they use the credit risk grading (CRG) system for calculating the credit risk.

• Question 2: What type of risk you are considering in the credit risk grading?

Ans: Both the banks consider Financial, Business or industry risk, Management risk, Security Risk and relationship risk.

• The Alfalah bank also consider the Residual risk. The term ‘residual risk’ is mandatory in the risk management process according to ISO 27001. According to ISO 27001, residual risk is “the risk remaining after risk treatment”.

Discussion on the questionnaire

• Question 3: If you do, then how do you consider it?Ans: Bank Alfalah consider it qualitatively and the city bank consider it quantitatively.

• Question 4: Do you consider the ESG risk issues in loan processing?Ans: Both the bank do it almost always.

Environmental Issues : Bank Alfalah limited

Environmental Issues : City Bank limited

Environmental Issues : City Bank limited

Understanding & Recommendation

• From the above questionnaire we see that actually banks are interested in the proper paper works in terms of environmental issue. Like they are very much aware about the Environmental clearance certificate but they are not too much concern about the noise pollution measure, Provision for solid waste management. It proves that they are trying to keep their responsibilities in a theoretical way. It’s a contradictory theory of Banks in case of environmental issues.

• Both the banks are aware of the human safety like fire and explosive prevention and control measures.

• City bank is not too much aware about potential new regulations that have new impact on product or service acceptability.

Recommendation: • In case of risk management Banks should give more weight to the environmental

issue. And bank should emphasize on both proper paper work and proper inspection and monitoring.

Social Issue: Bank Alfalah limited

Social Issue : City Bank limited

Understanding & Recommendation

• Both the banks are not aware of workshop health, safety and working conditions. But it shouldn’t be. Because human resource is another intangible prime assets of an organization.

• Both banks looks for equal opportunity in employment and the use of forced or child labor. (We confirm that the bank Alfalah officer mistakenly choose the wrong option).

Recommendations:• As social issue bank should look after the handling of transfer and dismissal and

preparation for retirement of employees. Because if any conflict arises between the management and the employee, it will hampers the operations of the industry.

• The City Bank limited should monitor more on CSR like charitable donations and community relations

Governance Issue: Bank Alfalah Limited

Governance Issue: : City Bank limited

Understanding & Recommendation

• Bank Alfalah is too much aware about the good governance issues.

• The city bank is liberal in case of governance issue which they should not be.

• Question 6: Do you think the ESG factors bring new business opportunities?

• Ans: Yes for both banks.

• Question 7: if yes what are those opportunities• Ans: Both bank agreed on all the options.

• Question 8: Is there any other risk, in addition to ESG risk factors mentioned above, that should be considered in CRM?

• Ans: There is no other risk.

Additional Risk Factors That Might be Added

Additional risk factors that might be added

•Marketing Risk•Technical Risk•Residual Risk

Number and Short Name of Grades Used in the CRG

Grading In Short

Superior SUP

Good GD

Acceptable ACCPT

Marginal/ Watch list MG/WL

Special Mention SM

Substandard SS

Doubtful DF

Bad/Loss BL

Risk Rating Grade Definition

• Grade 1 - Superior (Low Risk)• Grade 2 - Good (Satisfactory Risk)• Grade 3 - Acceptable (Fair Risk)• Grade 4 - Marginal (Watch list)• Grade 5 - Special Mention• Grade 6 – Substandard• Grade 7 - Doubtful (non-performing)• Grade 8 – Bad and Loss (non-performing)

Credit Risk Grading Review

SL Grading In Short Review Frequency (at least)

1 Superior SUP Annually

2 Good GD Annually

3 Acceptable ACCPT Annually

4 Marginal/ Watch list MG/WL Half Yearly

5 Special Mention SM Quarterly

6 Substandard SS Quarterly

7 Doubtful DF Quarterly

8 Bad/Loss BL Quarterly

Proposed Credit Risk Grading System

SL Principle Risk Components Weight

1 Financial Risk 30%

2 Technical Risk 6%

3 Business/Industry Risk 10%

4 Marketing Risk 5%

5 Managerial, Relationship and Good Governance Risk

10%

6 Security Risk 10%

7 Environmental Risk 12%

8 CSR or Social Risk 5%

9 Residual Risk 12%