Internship Report of Sanjib Debnath (P)

Compliance of Basel II in Credit Risk Management of

Dhaka Bank Limited

Compliance of Basel II in Credit Risk Management of

Dhaka Bank Limited

Prepared for

Mr. Shakil Huda

Professor

Prepared by

Sanjib Debnath

Roll: 02

MBA 42D

Institute of Business Administration

University of Dhaka

July 8, 2010

July 8, 2010

Professor Shakil HudaChairmanInternship and Placement ProgramInstitute of Business AdministrationUniversity of Dhaka

Dear Sir:

Here is the Internship Report I am required to submit to IBA as a part of the completion of MBA program.

While doing the job with Dhaka Bank Limited, I was allowed to do internship in Dhaka Bank Limited at Karwan Bazar Branch. For doing so, I had to work in various sections of the said branch of Dhaka Bank Ltd, such as, Credit Department, Foreign Trade Department etc.

When I was working in Credit Department, I came to know about Basel II and its implications in credit risk management. This subject interests me greatly and after consulting with my internship supervisor I have decided to choose my internship topic as “Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited”.

In this report, I have also tried to portray a comparative picture of performance of functions of Karwan Bazar Branch with respect to the whole Dhaka Bank Limited.

I hope that the information placed through this Report will provide you enough information about Basel II and its compliance in Dhaka Bank Ltd, one of the leading private commercial Bank in Bangladesh. Should you think the information flaws in explanation, I am always available to discuss the same with you to be abreast of the time.

Yours sincerely

Sanjib Debnath

Roll # 02

MBA, Batch-42D

IBA, DU

Acknowledgement

It is the requirement of MBA conducted by the Institute of Business Administration,

University of Dhaka to do Internship and to prepare an Internship Report. For doing my

internship I have selected Dhaka Bank Limited where I joined as a Probationary Officer

I am very much grateful to my Supervisor Mr. Shakil Huda for giving me time to guide and

rectify my errors. I am also grateful to the management of Dhaka Bank Limited for offering

me to carry out my Internship Program as well as providing me the necessary information in

order to finalize the Report.

I am especially indebted to my senior officials of Dhaka Bank Ltd of Karwan Bazar branch,

such as, Mr. A. S. M. Abu Bokor Siddique, Ms. Salma Akter Seema as well as the Branch-in-

Charge Mr. Md. Mostaque Ahmed for kindly assisting me while doing the Report. I would

like to also thank Mr. Imran Ahmed, Incharge of Basel II implementation Unit for providing

me current status of implementation of Basel II in Dhaka Bank Limited.

I have prepared this Report with the help and guidance of our Course Coordinator and the

senior officials of Dhaka Bank Ltd. to whom I am indebted to for the suggestions I have had

from time to time despite their preoccupations.

Table of Contents

EXECUTIVE SUMMARY............................................................................................................................... X

1.0 THE INTERNSHIP PROGRAM................................................................................................................. 2

2.0 AN OVERVIEW OF THE ORGANIZATION: DHAKA BANK LIMITED............................................................5

2.1 KEY FACTS ABOUT DHAKA BANK LIMITED.............................................................................................................5

2.2 PRODUCTS AND SERVICES..................................................................................................................................7

2.2.1 Retail Banking.....................................................................................................................................7

2.2.2 Corporate Banking..............................................................................................................................8

2.2.3 Trade Finance....................................................................................................................................10

2.2.4 SME...................................................................................................................................................13

2.2.5 Remittance........................................................................................................................................13

2.3 SUPPORTING DEPARTMENTS............................................................................................................................13

2.3.1 Centralized Processing Unit...............................................................................................................13

2.3.2 Human Resources (HR)......................................................................................................................14

2.3.3 Information Technology Department................................................................................................14

2.3.4 Finance & Accounts...........................................................................................................................15

2.3.4 Internal Control and Compliance (ICC)..............................................................................................16

2.4 FINANCIAL PERFORMANCE AND GROWTH OF DHAKA BANK LIMITED.......................................................................17

2.4.1 Assets................................................................................................................................................17

2.4.2 Liabilities...........................................................................................................................................18

2.4.3 Income and Expense..........................................................................................................................19

2.4.4 Operating and Net Profit...................................................................................................................20

2.5 FUTURE PLAN...............................................................................................................................................21

3.0 INTRODUCTION.................................................................................................................................. 23

3.1 ISSUES AND PROBLEMS................................................................................................................................25

3.2 ORIGIN OF THE REPORT...............................................................................................................................25

3.3 OBJECTIVE..................................................................................................................................................26

3.3.1 Broad Objective................................................................................................................................26

3.3.2 Specific Objectives............................................................................................................................26

3.4 RATIONALE.................................................................................................................................................27

3.5 SCOPE AND LIMITATIONS.............................................................................................................................27

3.6 METHODOLOGY...........................................................................................................................................27

3.7 REPORT PREVIEW..........................................................................................................................................28

4.0 LITERATURE REVIEW.......................................................................................................................... 30

5.0 RISK MANAGEMENT IN DHAKA BANK LIMITED...................................................................................35

5.1 CORE RISKS IN BANK......................................................................................................................................35

5.1.1 Asset Liability Management..............................................................................................................35

5.1.2 Foreign Exchange Risk.......................................................................................................................35

5.1.3 Internal Control and Compliance Risk................................................................................................36

5.1.4 Money Laundering Risk.....................................................................................................................36

5.1.5 Credit Risk.........................................................................................................................................36

5.2 TYPES OF CREDIT PRODUCTS............................................................................................................................36

5.2.1 Classification on the basis of time:....................................................................................................36

5.2.2 Classification on characteristics of financing.....................................................................................37

5.2.3 Classification on Provision Base.........................................................................................................38

5.3 CREDIT RISK MANAGEMENT IN DHAKA BANK LIMITED..........................................................................................39

5.3.1 Lending guidelines.............................................................................................................................40

5.3.2 Credit Assessment & Risk Grading.....................................................................................................40

5.3.3 Approval Authority............................................................................................................................45

5.3.4 Segregation of Duties........................................................................................................................45

5.3.5 Internal Audit....................................................................................................................................46

5.3.6 Credit Monitoring..............................................................................................................................46

5.4 CREDIT RISK MANAGEMENT AND BASEL ACCORDS...............................................................................................46

5.4.1 Basel I................................................................................................................................................47

5.4.2 Criticism of Basel I.............................................................................................................................47

5.4.3 The Entrance of Basel II.....................................................................................................................48

6.0 BASEL II FRAMEWORK AND ITS IMPLEMENTATION IN BANGLADESH..................................................51

6.1 THE THREE PILLARS........................................................................................................................................51

6.1.1 Pillar 1-Minimum Capital Requirements............................................................................................52

6.1.2 Pillar 2-Supervisory Review Process...................................................................................................52

6.1.3 Pillar 3-Market Forces.......................................................................................................................52

6.2.1 Standardized Approach (SA)..............................................................................................................52

6.2.2 Internal Rating Based Approach (IRB)...............................................................................................53

6.3 ROLE OF ECIA IN STANDARDIZED APPROACH......................................................................................................56

6.4 CONSTITUENTS OF CAPITAL.............................................................................................................................57

6.5 CREDIT RISK MITIGATION................................................................................................................................57

6.5.1 Application of Credit Risk Mitigation in Basel II.................................................................................58

6.5.2 Eligible Collaterals for CRM Purpose.................................................................................................59

6.6 BASEL II IN BANGLADESH................................................................................................................................59

6.6.1 Action Plan........................................................................................................................................60

6.6.2 Basel II implementation status in Dhaka Bank..................................................................................62

6.7 PROBLEMS FACING DURING IMPLEMENTATION...................................................................................................63

7.0 CAPITAL REQUIREMENT FOR CREDIT RISK UNDER BASEL-II IN DBL......................................................67

7.1 THE CONSTITUENT OF CAPITAL.........................................................................................................................67

7.1.1 Core capital (basic equity or Tier 1)...................................................................................................67

7.1.2 Supplementary Capital (Tier 2)..........................................................................................................68

7.1.3 Short-term subordinated debt covering market risk (Tier 3).............................................................71

7.1.4 Deductions from capital....................................................................................................................72

7.2 CREDIT RISK – THE STANDARDIZED APPROACH:..................................................................................................72

7.2.1 Claims on sovereigns.........................................................................................................................72

7.2.2 Claims on non-central government public sector entities (PSEs).......................................................73

7.2.3 Claims on multilateral development banks (MDBs)...........................................................................73

7.3.4 Claims on banks................................................................................................................................74

7.3.5 Claims on securities firms..................................................................................................................75

7.3.6 Claims on corporate..........................................................................................................................75

7.3.7 Claims included in the regulatory retail portfolios.............................................................................75

7.3.8 Claims secured by residential property..............................................................................................76

7.3.9 Claims secured by commercial real estate.........................................................................................77

7.3.10 Past due loans.................................................................................................................................77

7.3.11 Off-balance sheet items:.................................................................................................................78

7.3.12 Credit risk mitigation.......................................................................................................................79

7.4 CAPITAL ADEQUACY RATIO..............................................................................................................................79

7.5 TREND ANALYSIS...........................................................................................................................................81

7.6 CAPITAL RAISING OPTION...............................................................................................................................82

7.6.1 Tier 1 Capital.....................................................................................................................................82

7.6.2 Tier II Capital.....................................................................................................................................83

8.0 IMPACT OF ADOPTION OF BASEL II IN DHAKA BANK LIMITED.............................................................85

9.0 RECOMMENDATION.......................................................................................................................... 88

REFERENCES............................................................................................................................................... 90

APPENDICES............................................................................................................................................... 92

List of Figures

Figure 1: Number of Branches over the Years...........................................................................7

Figure 2: Operating Profit per Employee.................................................................................14

Figure 3: Investment over the Years........................................................................................17

Figure 4: Advances over the Year............................................................................................18

Figure 5: Loan Portfolio...........................................................................................................18

Figure 6: Deposits of Dhaka Bank...........................................................................................19

Figure 7: Deposit Mix..............................................................................................................19

Figure 8: Operating Profit vs Net Profit...................................................................................20

Figure 9: The Basel II Framework...........................................................................................51

Figure 10: Total Eligible Capital..............................................................................................81

Figure 11: Risk Weighted Asset..............................................................................................81

Figure 12: Capital Adequacy Ratio (CAR).............................................................................82

List of Tables

Table 1: Sectorwise Exposure....................................................................................................8

Table 2: Classification of credit based on Characteristics of financing...................................38

Table 3: Criteria for Sub-Standard Loan..................................................................................38

Table 4: Criteria for Doubtful Loan.........................................................................................39

Table 5: Criteria for Bad and Loss...........................................................................................39

Table 6: CRG Scores Band......................................................................................................44

Table 7: Constituents of Capital...............................................................................................57

Table 8: Basel II Implementation Action Plan.........................................................................60

Table 9: Core Capital calculation of Dhaka Bank Limited......................................................68

Table 10: Tier-2 Capital Calculation of Dhaka Bank Limited as on 31.03.2010....................70

Table 11: Risk Weighted Asset for DBL.................................................................................80

Table 12: Minimum Capital Requirement under Risk Based Capital......................................80

Executive Summary

At IBA, students are required to complete an Internship Program to fulfill all the requirement

of the MBA degree. The writer joined Dhaka Bank Limited as a Probationary Officer in

Karwan Bazar Branch. Dhaka Bank mainly deals with large corporate customers seeking

large loan facilities. But for banks, loans are the largest and most obvious source of risk.

Experience in recent years has shown that absence of proper management of such risk has

resulted in significant losses or even crippling losses for a number of banking institutions.

Effective credit risk management is therefore vital to ensure that a banking institution’s credit

activities are conducted in a prudent manner and the risk of potential bank failures reduced.

So, appropriate policies, procedures and systems should be implemented at each financial

institution for identifying, measuring, monitoring and controlling credit risk effectively.

DBL follows a centralized approach in extending its credit. Relationship Managers (RM)

brings in new customers and prepares credit proposals for them. The proposal package is then

sent to the Credit Risk Management (CRM) department analyzes the risk mitigating factors

and sends the proposal with recommendation to the credit approving authority. Credit

approving authority approves the proposal or denies it and sends the same to CRM again.

DBL has a written credit policy manual. It fully complies with Bangladesh Bank Guidelines.

DBL does not extend credit to a business, if it does not understand the business. The process

of credit assessment is also guided by the central bank directives. A thorough credit and risk

assessment is conducted prior to the granting of loans, and at least annually thereafter for all

facilities. The loan structure is matched with the cash conversion cycle of the business and

appropriate security is taken as collateral. In short, credits are not extended relying on just the

borrower’s or sponsoring units’ reputation in Dhaka Bank Limited.

Though all these steps are taken for managing credit risk, it is not enough. Due to the system,

failure can occur. As Bank deals with the depositors’ money, it must have some safety

precaution when giving loan. To prevent such failure international accords like Basel I, Basel

II are formulated. Bangladesh Bank instructed all the Banks of Bangladesh to adopt Basel II

from 2007. Though it has not been made fully activated yet and the simpler approach to

measuring capital was taken by the Bangladesh Bank, still it’s a big challenge for all the

x

Banks. Regulatory authorities are therefore making efforts to design appropriate strategies

that would enable the banking sector for smooth transition to Basel II.

'The New Accord' comprises of three pillars. Pillar I sets out the minimum capital

requirements. Pillar II defines the process of supervisory review of a financial institution's

risk management framework. Pillar III determines market discipline through improved

disclosure. It is argued here that implementation of Pillar I is a more critical than the other

two. It requires minimum bank capital against three kinds of risk: credit risk, operational risk

and market risk. Since existing regulation requires banks to maintain capital against credit

risk only, it is plausible to expect that additional capital requirement for two other risks will

cause all banks to raise capital appreciably. RBI (2006) also argues that banks would need to

raise additional capital to support expansion of their balance sheets. As a regulator,

Bangladesh Bank is required to design policies that will facilitate smooth transition to Basel

II.

Calculations of capital requirement suggest that Dhaka Bank Limited has adequate Capital

Adequacy Ratio as it is over 8% in the last quarter. But, as per Bangladesh Bank Guideline,

from July 2010 the ratio must be maintained over 9%, so DBL has to raise capital quickly to

be compliant with the regulation. As, per the standardized approach of credit risk, every

unrated client will be risk weighted by 150% of their loan amount, so it will be tougher for

DBL as most of the clients are unrated. So, this is a very big challenge the Bank are trying to

take in the next quarter of the year. Basel II has manifold implications, like it will prevent the

small and unrated borrowers to take loan as Bank don’t want to be charged, higher lending

cost etc. In summary, it can be said that, upto now DBL is compliant with the capital

requirements, but in the next quarter the capital requirements will not be enough. It has to

increase capital by raising fund from public, issuing subordinated bonds or issuing right

share. Already, DBL has decided to issue subordinated bond to fill the capital requirements

for market risk. More of such efforts are needed.

xi

CHAPTER 1THE INTERNSHIP PROGRAM

Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited

1.0 The Internship Program

At IBA, students are required to complete an Internship Program to fulfill all the requirement

of the MBA degree. The primary goal of internship is to provide an on-the-job exposure to

students and an opportunity for relating theoretical concepts to real-life situations. The

program includes twelve weeks of organizational attachment and four weeks for report

writing. Students are required to prepare and submit an internship report in that period. This

report has been prepared to comply with that requirement.

The writer joined Dhaka Bank Limited as a Probationary Officer on 1st February, 2010. As

the job is a full time one, the writer has opportunity to do the internship while doing his job.

Officially, the internship program was started on March 1, 2010 and ended on May 23, 2010.

After joining the writer was placed in the Karwan Bazar Branch of the said Bank. The branch

is one of the best performing branches of DBL. The branch has wide range of services. As the

Branch is an authorized dealer, it can do foreign trade business. As in the probation period,

one is required do some work at every department to have ideas about total banking

transactions. The writer was first placed at the General Banking Division, then Foreign Trade

Department and lastly at Credit Department. In this period, the writer tried to have some

ideas about different operations of a branch of a commercial bank. Following are some of the

tasks the writer used to perform during the internship period:

CIB Report:

As part of loan assessment, DBL checks a borrower’s credit status, if any, with other

financial institutions. For that, DBL fetches Credit Information Bureau (CIB) report from the

central bank. The writer used to take the undertakings from the customers and send the

inquiry to head office for further processing.

Credit Risk Grading:

Credit Risk Grading is very important tool for evaluating a customer. Corporate customers,

wishing to take any kind of credit facility, have to submit their last three years financials.

From that the writer had the opportunity to prepare CRG spreadsheet, which shows different

ratios, and CRG score sheet, which gives a score by taking all the quantitative and qualitative

data in consideration. Moreover, Different borrowers prepare financial statements differently,

i.e. the format varies from customer to customer. Formats may also vary for a same borrower

P a g e | 2


from one year to another. To avoid this kind of problems, Eastern Bank Limited has its own

format and an MIS for that. The MIS upon correct restatement of the balance sheet and the

income statement automatically generates ratio statement, cash flow statement.

Visiting the collateral/security to be mortgaged

Usually when a corporate customer wants to take loan, it has to provide collateral/security

such as land, building, stocks, vehicles etc. It is required that Bank officers would go to the

place in person to see the status and estimate the value of the property. The writer had the

opportunity to go in property visit. After visit, the writer also prepared the visit report of the

visited property.

Sending Letters:

Sending letters to the customer is one of the responsibilities of the writer. Whenever a

loan/limit expires or runs excess over the limits, sending letters is the first thing to do. The

writer took the responsibility of monitoring borrowers’ account performance sends all sorts of

letters to borrowers. The writer did prepare past due letters for the unit.

Sending Request to Central Processing Centre:

Central Processing Centre is the centralized processing centre for processing various request

of the branches related to posting and documentation of credit and foreign trade operation.

All request sent by the branches such as disbursing a loan, adjustment of loan etc. have a

required format. The writer sent some request for disbursement of loans in this internship

period.

Filing:

The customer support unit is tasked with filing account and security related documents

properly so that those can be found out when required. As an intern of this unit, the writer did

a lot of filing for the unit. The filing was helpful in that it oriented the writer with many legal

documents related to security or collateral, documents from the Registrar of Joint Stock

Companies and Firms, sanction letter, charge documents, CIB undertaking, stock reports,

insurers’ documents, debit-credit advice, credit memorandum, board approvals, etc.

In summary, it can be said that the outcome of the internship period is very satisfactory. The

writer engaged in the day-to-day banking activities and hence had a clear idea about various

banking operation. Also, within this brief period, the writer met many people and had a good

idea how to serve the customers.

P a g e | 3

CHAPTER 2AN OVERVIEW OF THE ORGANIZATION: DHAKA BANK LIMITED


2.0 An Overview of the Organization: Dhaka Bank Limited

Bangladesh economy has been experiencing a rapid growth since the '90s. Industrial and

agricultural development, international trade, inflow of expatriate Bangladeshi workers'

remittance, local and foreign investments in construction, communication, power, food

processing and service enterprises ushered in an era of economic activities. Urbanization and

lifestyle changes concurrent with the economic development created a demand for banking

products and services to support the new initiatives as well as to channelize consumer

investments in a profitable manner. A group of highly acclaimed businessmen of the country

grouped together to responded to this need and established Dhaka Bank Limited in the year

1995.

2.1 Key Facts about Dhaka Bank Limited

The banks that were given license during the mid 90s are called the 2nd Generation Private

Commercial Banks. Dhaka Bank Limited (DBL) is one of them that incorporated as a public

limited company under the Companies Act in 1994 and is governed by Banking Companies

Act, 1991. The Bank started its commercial operation on July 05, 1995. Since its

incorporation, DBL has proved itself as a true development partner of the Government in

developing the national economy by providing efficient banking services to different sectors

of the economy. Some important facts about Dhaka Bank Limited are given below:

Date of Incorporation : April 06, 1995.

Registered Office : Biman Bhaban, 100 Motijheel C/A, Dhaka

First Branch : Local Office, Adamjee Court, Motijheel, Dhaka

Enlisted as Public Limited Co. : 1998

Capital Structure at Formation

Authorized Capital : BDT 100 Crore

Paid up capital : BDT 10 Crore

Capital Structure as on June, 2010

Authorized Capital : BDT 600 Crore

Paid up capital : BDT 266 Crore

P a g e | 5


Mission

To be the premier financial institution in the country providing high quality products and

services backed by latest technology and a team of highly motivated personnel to deliver

Excellence in Banking.

Vision

At Dhaka Bank we draw our inspiration from the distant stars. Our team is committed to

assure a standard that makes every banking transaction a pleasurable experience. Our

endeavor is to offer you the razor sharp sparkle through accuracy, reliability, timely delivery,

cutting edge technology, tailored solutions for business needs, global reach in trade and

commerce and high yield on your investments.

Our people, products and processes are aligned to meet the demand of our discerning

customer. Our goal is to achieve a distinction like the luminaries in the skies. Our prime

objective is to deliver a quality that demonstrates a true reflection of our vision - Excellence

in Banking.

Values

Customer Focus

Integrity

Teamwork

Respect for the individual

Quality

Responsible Citizenship

Strategic Objectives

To conduct transparent and high quality business operation based on market mecha-

nism within the legal and social framework spelt in our mission and reflected in our

vision.

To provide the customers efficient, innovative and high quality products with excel-

lent delivery system.

To generate profit with qualitative business as a sustainable ever growing organiza-

tion and enhance fair retuns to our shareholders.

P a g e | 6


Committed to our community as a corporate citizen and contributing towards the

progress of the nation.

Branches

As on June 2010 the Bank serves it’s customers through 52 (Fifty-two) branches and 20

ATM booths spread all over the country. It also has six CMS unit, eight business centers.

Figure 1: Number of Branches over the Years

Source: Annual Report 2009, Dhaka Bank Ltd.

2.2 Products and Services

Dhaka Bank Limited has a wide range of products and services in its assortment. These value

based products are very much contemporary and standardized. All the products are very well

thought-out and addressed to the very basic financial needs of the individuals and

organizations. Its main products and services are described briefly next:

2.2.1 Retail Banking

DBL is a leading bank in the countries consumer banking arena. Emphasis on customer

service, product innovation, asset quality and brand building are the cornerstones of the

Retail Banking strategy. The major products and services of Retail Banking include:

Liability Products

Savings Bundled Product

Deposit Pension Scheme

Special Deposit Scheme

Deposit Double Scheme

P a g e | 7


Gift Cheque

Asset Products

Home Loan

Personal Loan

Vacation Loan

Car Loan

Any Purpose Loan

Services

Internet Banking

SMS Banking

Locker

ATM Card & VISA Credit Card

2.2.2 Corporate Banking

Providing a tailored solution is the essence of Corporate Banking services of DBL. Dhaka

Bank recognizes that Corporate Customers' needs vary from one to another and a customized

solution is critical for the success of their business. Dhaka Bank offers a full range of tailored

advisory, financing and operational services to its corporate client groups combining trade,

treasury, investment and transactional banking activities in one package. At the moment

Dhaka Bank’s exposure (as of December 31, 2009) under Corporate Banking Business is

distributed in the following sectors:

Table 1: Sectorwise Exposure

Sl. Sector DBL’s Exposure

(BDT in Crore)

1 Agricultural 30

2 Chemical 130

3 Electronics & Automobile 9

4 Energy & Power 58

5 Engineering & Metal including Ship Breaking 394

6 Food & Allied 350

7 Housing & Construction 692

8 Pharmaceuticals 56

P a g e | 8


9 Service 158

10 Textile & Garment 973

11 Transport & Communication 191

11 Others 2,249

Total 5,291

Source: Annual Report, 2009

Following are some of the corporate products offered by DBL:

Securitization of Assets

A powerful and effective means of generating funds for a certain category of institutions,

Securitization of Assets is still in its infancy in The need however for such a service is great

and there is a lot of support from multilateral financial institutions, such as the World Bank

and the Asian Development Bank, for such activities to be developed further in this country.

Dhaka Bank intends to take up this challenge and play a significant role in ensuring that

Securitization of Assets becomes a normal part of the range of financial instruments available

for organizations who can count on a steady, but piecemeal, flow of revenue and want to

translate this stream into cash resources with which to carry out further lending activities to

new customers.

Finance & Advisory Services

Given the needs of its large and varied base of corporate clients Dhaka Bank will be

positioning itself to provide investment banking advisory services. These could cover a whole

spectrum of activities such as Guidance on means of raising finance from the local Stock

markets, Mergers and Acquisitions, Valuations, Reconstructions of Distressed companies and

other expert knowledge based advice. By this means Dhaka Bank hopes to play the role of

strategic counselor to blue-chip Bangladesh companies and then move from the level of

advice to possible implementation of solutions to complex financing problems that may arise

from time to time. This would be an extra service that would complement the normal

financing activities that Dhaka Bank already offers to corporate business houses.

Syndication of Funds

There has been a surge in the number of syndication deals closed in the last few years. 2004

was an exceptionally good year for syndicated deals for the local commercial banks also for

the foreign banks. The total number of syndications in 2004 exceeded 10 totaling over Tk. 10

P a g e | 9


billion. This rise in the number of syndications can be primarily attributed to the prudential

lending guidelines of the Bangladesh Bank. A commercial bank may provide funded facilities

up to a maximum of 25% of its equity. Due to this reason, projects with sizeable costs need to

approach more than one bank for their debt requirements and therefore the demand for

syndications exist. Credit risk diversification has led many international companies to

introduce credit derivatives that are actively being traded.

Project Finance

Project financing is an innovative and timely financing technique that has been used to fund

large-scale corporate projects. It includes understanding the rationale for project financing,

preparing the financial plan, assessing the risks, designing the financing mix, and raising the

funds.

Project finance is different from traditional forms of finance because the financier principally

looks to the assets and revenue of the project in order to secure and service the loan. Project

financing relies primarily on the project's cash flow for repayment, with the project's assets,

rights, and interests held as secondary security or collateral. Dhaka Bank offers a full range of

services to the entrepreneurs implementing a project including structuring mode of financing,

mitigation of different risks and providing advisory service for successful implementation of

the project.

Working Capita l Finance

Dhaka Bank caters to the working capital needs of the client taking into account the current

asset requirement of the client.

Dhaka bank extends different types of working capital facility like Cash Credit (CC),

Overdraft (OD) facility, Short Term Loan (STL), Bank Guarantee, etc. to facilitate the

business operation of the client.

2.2.3 Trade Finance

Dhaka Bank Limited (DBL) started it trade operations in 1995 and all the trade activities

were carried out by DBL’s 15 (fifteen) Authorized Dealer (AD) Branches. In the year 2009,

DBL established the Central Processing Center (CPC) at BGMEA Bhaban, Karwanbazar,

Dhaka and Agrabad, Chittagong. Since then the CPC does the processing of all the trade

activities of DBL by using state of the art technology and well groomed team. The trade

P a g e | 10


activities of 40 branches are routed through the Dhaka Hub and that of the rest 12 branches

are routed through the Chittagong Hub.

Central processing center of DBL is well equipped with highly talented and experienced team

who has very good knowledge in foreign trade and technology. Strong MIS, network

coverage and real time technology help us to satisfy customer needs just in time maintaining

Quality of Work Life (QWL). All sorts of statement are generated centrally to comply with the

compliance issue of internal and external authorities. Various kind of trade finance facility is

stated next:

2.2.3.1 Import Finance

DBL undertakes Import Finance in the form of both pre-import and post-import finance.

These two categories of import finances include:

Letter of Credit

This is a pre-import finance, which is made in the form of commitment on behalf of the client

to pay an agreed sum of money to the beneficiary of the Letter of Credit upon fulfillment of

terms & conditions of the Credit.

Performance Bonds & Other Gua rantees

DBL offers excellent solution to meet all performance bonds & guarantees required by its

valued clients.

Loan against Trust Receipt (LTR)

In this category of finance, possession of the goods remains with the borrower and the

borrower executes ‘Letter of Trust Receipt’ in acknowledgement of debt and its repayment

along with interest within agreed period of time.

2.2.3.2 Export Finance

Like import trade, DBL advances in export trade at both pre-shipment and post-shipment

shipment stages. The pre-shipment facilities are usually required to finance the costs to

execute export orders, such as: procuring & processing of raw materials, packaging and

transportation, payment of various fees and charges including insurance premium etc. The

facilities under both the categories are:

P a g e | 11


Export Letter of Credit Advising

Dhaka Bank provides prompt advising of export letter of credit from a wide international

network.

Back to Back LC

BB L/C is a type of pre shipment finance by way of opening L/C in favor of a local or foreign

supplier for purchase of raw materials or the finished merchandise, as the case may be, to

execute export order.

Export Bills for Collection

Export Bills for Collection are documents which are presented to the bank by the

seller/exporter to collect payment from the buyer through the buyer’s bank.

Packing Credit

To execute export orders under L/C or firm contract the bank awards packing credit facility

to meet client’s working capital requirement.

FDBP

Foreign Documentary Bill Purchased (FDBP) is a post shipment finance allowed to the

customer through the purchase/negotiation of foreign documentary bills adjustable from the

relevant export proceeds.

IDBP

Inland Documentary Bills Purchased (IDBP) facility is accommodated both for export and

local trade.

EDF

Export Development Fund (EDF) at Bangladesh Bank is intended to facilitate access to

financing in foreign exchange for input procurements by manufacturer-exporters. Authorized

Dealer (AD) banks can borrow US Dollar funds from the EDF against their foreign currency

loans to manufacturer-exporters for input procurement.

P a g e | 12


2.2.4 SME

Small and Medium Enterprises (SMEs) are the ‘engines of growth’ in almost all the emerging

economies of the globe. It has been playing a pivotal role in job creation and overall

economic development in Bangladesh. Banking to the SMEs can be termed as banking to the

‘unbanked’, as many is yet to receive bank finances to ensure greater business development.

DBL is planning to add 6 to 7 SME branch or service centers across the country by the end of

2010. DBL signed a new refinancing deal on ‘Solar Energy’, Solar panel assembling plant

and ETP with Bangladesh Bank.

2.2.5 Remittance

DBL is continuously pursuing for improvement of its Remittance operation for smooth

mobilization of fund from the NRB’s. For this, DBL is increasing its distribution channel. It

has already started payment of remittance through two renowned NGO of Bangladesh-PAGE

and PADAKHEP MANOBIK UNNOYON KENDRO, which added 250 distribution centers.

It is also a member of EL-DORADO which is a 9-bank Elite Network for remittance

distribution facility. It has already introduced Mobile remittance disbursement partnering

with Banglalink.

2.3 Supporting Departments

To ensure smooth running of the above departments Dhaka Bank has supporting/back end

departments. These departments are not directly involved with the profit making or business

of the company, but they are very critical for day to day banking operations. Some of the

departments are mentioned next:

2.3.1 Centralized Processing Unit

To provide the customer the best possible and world class service Dhaka Bank Limited has

centralized its Trade service and Credit Operations. This important initiative is aligned with

the CRM guideline of Bangladesh Bank. The centralization of these functions lead to better

control and monitoring and minimizing the risks, and helps in segregation of duties and

responsibilities as well as reduces different type of irregularities. It also heps inn maintaining

P a g e | 13


uniform process and policy, rational and optimum utilization of manpower and taking full

advantage of bank’s existing cutting edge technology platform.

2.3.2 Human Resources (HR)

Dhaka Bank Ltd has been investing generously in human resources since its inception. DBL

HR is working as a business partner for both of its internal and external customers to help

them achieve better business results. It is directly involved with the people and therefore

committed to ensure staff motivation, learning and development, retention, reward and

recognition to drive better business results.

Creating a progressive and possessive

environment for the people to work at DBL

is the undeviating objective of HR. At

DBL, employee performance is directly

aligned with business results. Employees

feel appreciated and valued for their hard

work and dedications manifested in

measurable performances. Dhaka Bank

Limited is widely recognized for its

holistic work environment, corporate culture and best practices that attract and help retain top

talent of the industry. During 2009, operating profit per employee was BDT 3.04 million

which was on an increasing curve.

2.3.3 Information Technology Department

It is increasingly recognized that to be successful in business, banks need to have an effective

technology platform. The bank gives right attention to its overall technology service

management by not only acquiring technology but also investing in training and continuous

refinement of processes. The bank is open to accept industries’ good practices. DBL use the

i-flex Flexcube for its core banking purposes. The system has enhanced customer service

capabilities, further improved cost per transaction and managed risks better with latest control

tools.

Technology innovation is one of the most effective ways to achieve cost savings by

automating manual processes. More importantly, management of technology enables new

P a g e | 14

2005 2006 2007 2008 20090.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Ope

ratin

g Pr

ofit P

er E

mpl

oyee

(in

mill

ion

Tk.)

Figure 2: Operating Profit per Employee


revenue opportunities by providing better and timely information about internal processes

and client data.

2.3.4 Finance & Accounts

This division has four units, viz. Financial Operations & Control, Financial Analyses &

Reporting, Financial Planning & Projects and Reconciliation & GL Control.

Financial Operations & Control:

This unit is assigned with management of day to day payables, fixed assets, corporate tax,

employee retirement benefit plans, etc. Except payroll, FOC processes almost all sorts of

payables of the bank.

Financial Analyses & Reporting:

Major responsibilities of this unit include various central bank reporting, due diligence report

for various partner organizations (e.g. IFC, ADB), preparation of quarterly and half-yearly

financial statements including Annual Report on fixed periodic intervals. Other reports

include Capital Adequacy Reports, CAMELS report, etc. As a reporting unit, it has to handle

various central bank audits and provide explanations to queries from internal and external

group related to financial statements and reports.

Financial Planning & Projects:

Major responsibilities include preparing monthly financials of the bank (Business and

Financial Performance) for MANCOM and yearly business unit wise budget of the bank,

budget variance/review forecast, etc. It has also shown excellence in process

improvement/reengineering by developing in-house software applications, queries and

reports.

Reconciliation & GL Control:

To enhance integrity of financial information, this unit drives various reconciliation

initiatives regularly. A comprehensive GL Control Policy is in process that will help the bank

to ensure integrity of recording transactions and thereby integrity of financial statements.

Besides, the team monitors risk sensitive GLs such as suspense, inter-branch, inter-system,

etc. regularly to ensure internal control.

P a g e | 15


2.3.4 Internal Control and Compliance (ICC)

DBL has established a sophisticated organizational structure to establish and maintain a

strong control culture by implementing and strengthening policy guidelines of internal

controls. Internal Control is an integral part of the daily activity of a bank, which on its own

merit identifies the risks associated with the process and adopts a measure to mitigate the

same.

The main objectives of the Internal Control and Compliance Department are as follows:

Efficiency and effectiveness of activities (performance objectives).

Reliability, completeness and timelines of financial and management information (in-

formation objectives).

Compliance with applicable laws and regulations (compliance objectives).

Structure of ICC:

The head of Internal Control and Compliance Department [ICCD] have a reporting line with

the Managing Director and the Audit Committee of the board. The department has three

separate units:

1. Monitoring Unit

2. Compliance Unit and

3. Internal Audit & Inspection Unit

The Monitoring unit is responsible to monitor the operational performance of various

branches and departments. It collects relevant data and analyzes those to assess the risk of

individual units. In case it finds major deviation, it recommends to the Internal Control Head

for sending audit and inspection team for thorough review. The Compliance unit is entrusted

to ensure that bank complies with all regulatory requirements while conducting its business.

It maintains liaison with the regulators at all levels and notifies the other units regarding

regulatory changes. The Audit team performs periodic and special audit. This unit prepares a

risk-based audit plan, normally on an annual basis. These plans are approved by the bank's

senior management and by the audit committee. This risk based approach of audit assists the

organization by identifying and evaluating significant exposures to risk and contributing to

the improvement of risk management and control systems.

P a g e | 16


2.4 Financial Performance and Growth of Dhaka Bank Limited

Dhaka Bank Limited is high performing private commercial bank, which further consolidated

its position in the market in terms of quality services to the customers and value addition for

the shareholders. The Bank made healthy progress in all areas of business in 2009.

2.4.1 Assets

As of 31 December 2009, total asset of the Bank stood at Tk.77.77 billion, an increase of 9%

as against 2008. The increase in asset was mainly driven by significant growth of customer

deposits. The growth of deposits was used for funding in loans and advances and holding of

securities for SLR (Statutory Liquid Reserves).

Cash & Balances with Bangladesh Bank and its Agent:

The cash & balances with Bangladesh Bank and its agent registered 33% growth as of 31

December 2009. The growth of deposits increased the balances with Bangladesh Bank and its

agent for maintaining the Cash Reserve Requirement (CRR), which was maintained

adequately.

Balances with Other Banks and Financial Institution:

The Balances with other banks and financial institutions increased by 9% which was mainly

due to transfer of fund to current accounts of different banks for covering the payments

against Inward Foreign Remittances to beneficiaries.

Investment

The Bank’s investment during the year 2009

were mostly in long term Government

Securities which stood at Tk. 8,660 million as

against Tk. 7,239 million making a growth of

20% over the last year. The Government

Treasury Bonds purchased at higher rate of

interest to cover the increased SLR arising from

the growth of deposit liabilities.

P a g e | 17

Figure 3: Investment over the Years


Loans and Advances

The Bank implemented the system of

credit risk assessment and lending

procedures by stricter separation of

responsibilities between risk

assessment, lending decisions and

monitoring functions to improve the

quality and soundness of loan portfolio.

The Bank recorded a 6% growth in

advances with a total loans and

advances portfolio of Tk. 52,910

million at the end of December 2009 compared to Tk. 49,698 million at the end of December

2008.

As of 31 December 2009, 94.43% of

the total bank’s loan portfolio was

regular while only 5.57% of the total

portfolio was non-performing as

compared to 3.84% of 2008. The

volume of nonperforming loans stood

at Tk. 2,946 million in 2009 from Tk.

1,908 million in 2008.

2.4.2 Liabilities

Total liabilities of the Bank stood at Tk. 72,802 million as of 31 December, 2009 registering

a growth of 8% over the last year. This has happened for increase of deposits from customers

mainly and settlement of import payments against deferred and cash letter of credits.

Borrowings from Banks, Financial Institutions and Agents:

Treasury Division resorted to borrowing from money market. The Bank registered a negative

growth of 3% in borrowings from Banks, Financial Institutions and Agents as against last

year positions. The main reason of this negative growth was DBL’s borrowing from call

money market was significantly reduced.

P a g e | 18

2005 2006 2007 2008 20090

10000

20000

30000

40000

50000

60000

23372

3403939372

4969852910

Advances

Taka

in M

illio

nFigure 4: Advances over the Year

Regular Loan94%

Non-performing Loan6%

Loan Classification

Figure 5: Loan Portfolio


Deposits:

The deposit base of the Bank

continued to registered a steady

growth and stood at Tk.60,918

million excluding call as of 31

December 2009 compared to Tk.

56,986 million of the previous year

registered a 7% growth. The growth

was supporte by branch network and

high standard products an service

along with competitive interest

rate provided to customers. The customer group of the Bank was individual, corporation,

NBFI, Government Bodies, NGO, Autonomous Bodies etc.

The cost free and low cost

deposits comprised of 28%

of the deposits. Fixed

deposits remained the main

component of deposits

contributing about 70% of

the total deposits. Average

Cost of Deposits was 8.68%

in 2009 as against 9.0% in

2008. Deposit mix of the

Bank as of 31 December

2009 is given in the Figure 7.

2.4.3 Income and Expense

Interest income has been increased by 4% from Tk. 7,171 million in 2008 to Tk. 7,466 in

2009. The growth of advance caused this growth of interest income. Average yield on

advance was 14.32% during 2009. Income from investments increased by 38% mainly due to

the income from five and ten years Government Bonds at higher rate of interest which was

maintained for SLR purposes.

P a g e | 19

2005 2006 2007 2008 20090

10000200003000040000500006000070000

28439

4155448731

56986 60918

Deposits

TAka

in M

illio

nFigure 6: Deposits of Dhaka Bank

Current and Others9%

Savings10%

STD5%

FDR68%

DPS/MDS4%

Bills4%

Deposit Mix

Figure 7: Deposit Mix


The Net Interest Margin (NIM), which is derived by net interest income divided by average

assets, were 4.56% in 2009 as compared to 4.60% in 2008. The decrease of Net Interest

Margin was mainly because of increase of earning assets but lower rate of return from

advance which results the lower spread. Net Interest Income increased by 14% FROM Tk.

2,622 million in 2008 to Tk.2,980 million mainly due to increase of interest income form

both advances and investments.

Expenses

Interest expense increased by 4% in 2009, this rise is mainly attributable to the overall

increase in Deposit base of the bank. Salary and allowances increased by Tk. 68 million from

2008 mainly due to recruitment of new Employees. Other overhead expenses increased only

by Tk. 3 million as compared to 2008. Earning base in assests of the Bank remains

unchanged in 2009, which was 88% in 2008. The ratio indicates efficient utilization of

resources to earn revenues.

2.4.4 Operating and Net Profit

Dhaka Bank Limited registered an operating profit of Tk.2,810 million in 2009 compared to

Tk. 2,533 million in 2008 making a growth of 11%.The net profit for the bank as of 31

December 2009 stood at Tk. 959 million compared to previous years Tk. 839 million making

growth of 14%. Earning per share (EPS) was Tk. 45.09 in 2009. A comparative figure of

operating profit versus net profit is given below for last five years.

P a g e | 20

2005 2006 2007 2008 20090

500

1000

1500

2000

2500

3000

Operating Profit vs Net Profit

Operating ProfitNet Profit after Tax

Taka

in M

illio

n

Figure 8: Operating Profit vs Net Profit


2.5 Future Plan

Dhaka Bank is going to celebrate its 15-year anniversary on 5th July. In this 15 years of

journey, Dhaka Bank present itself as a modern and innovative Bank. The workforce is a

brilliant one and the work environment is very congenial. Though it has a strong brand image

among the corporate clients, retail division of the bank is not that strong as corporate

division. One of the problems in retail banking is dearth of ATM booths. To improve this

situation, Dhaka Bank plans to have own ATM network. Furthermore, it signed a deal with

OMNIBUS and Dutch-Bangla Bank Limited to have withdrawal facility for the clients of

Dhaka Bank in those networks. Dhaka Bank is planning to modernize its IT infrastructure to

provide the branch network a happy time when serving the customers.

P a g e | 21

CHAPTER 3INTRODUCTION


3.0 Introduction

Until the late 1970s, banks were highly regulated and protected entities with hardly any com-

petition among them. Collapse of the Bretton Woods agreement put them in a new environ-

ment of increased competition, leading to gradual erosion of capital that started to alarm the

regulators. Dealing with the problem on international level seemed to be the only possible

way of finding a proper solution without increasing competitive differences between banks

from individual countries.

Hence, a special committee was set up under the auspices of the Bank for International Settle-

ments (BIS) in Basel. The Committee, initially known as the Cooke Committee and later re-

named the Basel Committee on Banking Supervision (BCBS), formed a proposal in which it

suggested that a common framework for calculating the capital adequacy of banks should be

formed. This document, known as the 1988 Basel Capital Accord, became a huge success af-

ter its adoption – it not only managed to level the playing field, but it also brought national

practices on capital adequacy of banks in line. In 1988, the Basel Committee published a set

of minimal capital requirements for banks, known as the 1988 Basel Accord. These were en-

forced by law in the G-10 countries in 1992, with Japanese banks permitted an extended tran-

sition period.

The 1988 Basel Accord focused primarily on credit risk. Bank assets were classified into five

risk buckets i.e. grouped under five categories according to credit risk carrying risk weights

of zero, ten, twenty, fifty and one hundred per cent. Assets were to be classified into one of

these risk buckets based on the parameters of counter-party (sovereign, banks, public sector

enterprises or others), collateral (e.g. mortgages of residential property) and maturity. Gener-

ally, government debt was categorized at zero percent, bank debt at twenty per cent, and other

debt at one hundred per cent. Off-Balance Sheet (OBS) exposures such as performance guar-

antees and letters of credit were brought into the calculation of risk weighted assets using the

mechanism of variable credit conversion factor. Banks were required to hold capital equal to

8% of the risk-weighted value of assets.

Since 1988, this framework has been progressively introduced not only in member countries

but also in almost all other countries having active international banks. Close on the heel of

the 1996 amendment to the Basel I Accord, In June 1999 BCBS issued a consultative paper

P a g e | 23


on New Capital Adequacy Framework to replace the 1988 Accord. The new capital frame-

work consists of three pillars: minimum capital requirements, which seek to refine the stan-

dardized rules set forth in the 1988 Accord; supervisory review of an institution's internal as-

sessment process and capital adequacy; and effective use of disclosure to strengthen market

discipline as a complement to supervisory efforts.

The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad

brush structure) for measuring credit risk which created some problems for credit risk man-

agement. For example, all corporations carry the same risk weight of 100 per cent. It also

gave rise to a significant gap between the regulatory measurement of the risk of a given trans-

action and its actual economic risk. The most troubling side effect of the gap between regula-

tory and actual economic risk has been the distortion of financial decision-making, including

large amounts of regulatory arbitrage, or investments made on the basis of regulatory con-

straints rather than genuine economic opportunities. The strict rule based approach of the

1988 accord has also been criticized for its `one size fits all’ prescription. In addition, it

lacked proper recognition of credit risk mitigants such as credit derivatives, securitization,

and collaterals. The recent cases of frauds, acts of terrorism, hacking, have brought into focus

the operational risk that the banks and financial institutions are exposed to.

Basel II is claimed by BCBS to be an improved capital adequacy framework intended to fos-

ter a strong emphasis on risk management not only on credit risk management and to encour-

age ongoing improvements in banks’ risk assessment capabilities. It also seeks to provide a

`level playing field’ for international competition and attempts to ensure that its implementa-

tion maintains the aggregate regulatory capital requirements as obtaining under the current

accord. The new framework deliberately includes incentives for using more advanced and so-

phisticated approaches for risk measurement and attempts to align the regulatory capital with

internal risk measurements of banks subject to supervisory review and market disclosure.

Bangladesh Bank issued Basel II Road Map in 2007 in a BPRD Circular Implementation of

Basel II in Bangladesh started from January 2009. According to the initial plan, Basel II im-

plementation followed the specific approaches as initial steps with the parallel calculations

starting from January 2009:

Standardized Approach for calculating Risk Weighted Assets (RWA)

P a g e | 24


Standardized Rule Based Approach against Market Risk and

Basic Indicator Approach for Operational Risk

Dhaka Bank Limited, a second-generation private commercial bank also followed the imple-

mentation plan as specified by the Bangladesh Bank. In the first pillar of Basel II accord,

identification and mitigation of credit risk is the forerunner. So, this report tries to unveil the

current status of Basel II implementation in Credit Risk Management in Dhaka Bank Limited

and the impact of it in banking operations.

3.1 Issues and Problems

Credit risk continues to remain the largest source of risk for banking institutions in

Bangladesh. This is due to the fact that a banking institution’s loan portfolio is typically the

largest asset and the major source of revenue. Effective credit risk management is therefore

vital to ensure that a banking institution’s credit activities are conducted in a prudent manner

and the risk of potential bank failures reduced. Basel accords mainly focused on credit risk

mitigation as it provides a sophisticated framework that insulates the banks from potential risk

of failure arising from credit risk. According to Basel II framework, if any bank gives loan to a

risky customer, it has to retain more capital. As raising capital is not very easy, so banks are

passing through a hard time to comply with the Basel II framework, especially maintaining the

Capital Adequacy Ratio (CAR). Basel II has manifold impact in the banking industry like

shifting of choice to good rated companies, which shrinks the opportunity for taking loan to

the poor rated customer. The report focuses on the compliance status and the changes in

capital requirement for credit risk in Dhaka Bank Limited. It also gives some light on impact

of adoption of Basel II in Dhaka Bank Limited.

3.2 Origin of the Report

This report has been prepared as part of the internship program which is a part of MBA

degree requirement. The topic was chosen in consultation with the faculty advisor Mr. Shakil

Huda, Professor, IBA and the internship supervisor Mr. A.S.M. Abu Bokor Siddique,

Incharge, Credit Department, Karwan Bazar Branch, Dhaka Bank Limited.

P a g e | 25


3.3 Objective

Credit Risk Management is the most critical part of any bank operation. Many banks failed in

the past due to poor credit risk management. Though there are many tools for mitigating and

managing the credit risk, no tool is foolproof and globally received. Due to competition,

Banks often forced to take some unwanted risk by giving credit facility to poor rated clients,

which creates chances for failure of Banks. Basel II, an internationally accepted standard,

covers credit risk comprehensively. Dhaka Bank Limited started implementation of Basel II

by following the roadmap formulated by Bangladesh Bank. The objective of this report is to

see the implementation progress and compliance status of Basel II in credit risk management

DBL.

3.3.1 Broad Objective

The broad objective of the report is to see the status of compliance of Basel II in credit Risk

Management of Dhaka Bank Limited.

3.3.2 Specific Objectives

The specific objectives of the report are:

To study the framework of Basel II accord and the differences of it with the previous

capital accords.

To identify and measure different types of risks and their management thereof

To know the measures and tools of credit risk management and the impact of Basel II

adoption on it

To know about different approaches for capital calculation for different risks as

specified by Bangladesh Bank

To find out the minimum capital requirement for credit risk

To know about Risk weighted Asset and calculate the same for Dhaka Bank Limited.

To identify different issues and challenges in implementation of Basel II in Dhaka

Bank Limited.

P a g e | 26


3.4 Rationale

Primarily, this report fulfills the term paper requirement of internship. Secondly, it gives

concrete knowledge on the Credit Risk Management in the era of Basel II. Experiences that

will be gathered will surely help in the future when more complex approach will be taken to

calculate capital.

3.5 Scope and Limitations

Credit Risk Management and Basel II both are very vast topic to describe. For, concentrating

on the key things, the report focuses mainly on credit risk and capital requirement for credit

risk in Dhaka Bank. The other risks such as operational risk and market risk have been

described very briefly. Credit risk, market risk and operational risk are part of Pillar 1 of

Basel II accord. For being very specific on the subject matter, other two pillars of Basel II

have not been discussed in this report.

Basel II is relatively a new phenomenon in the Banking industry and only few people are

knowledgeable about this. So, getting information from the bank officers was not very easy.

As the minimum capital requirement has to be reported to Bangladesh Bank quarterly, the

latest data could not be obtained. Comparison among the Banks about the subject matter

could be interesting, but due to unavailability of data it cannot be done.

3.6 Methodology

The report involves both quantitative and qualitative analyses. Qualitative analysis covers

mainly the impact of Basel II implementation in credit activities of Dhaka Bank. On the other

hand, Quantitative analysis involves the calculation of core capital, risk weighted asset and

capital adequacy ratio and compliance of this with the specifications of Bangladesh Bank.

This analyses lead to some recommendation for the management to fully comply with the

Basel II accord within the given time frame.

Sources of Data

Information needed in this report was collected from both primary and secondary sources.

Primary Sources:

Informal interviews of executives, officers of Dhaka Bank Limited

P a g e | 27


Secondary Sources:

Study of old files

Circulars of Bangladesh Bank

Different journals and publications on Basel II.

Annual reports

Credit Risk Management Manual of Dhaka Bank Limited

Journals and Publications on Credit Management

3.7 Report Preview

The report has been prepared following the above methodologies and the objectives in mind.

The report starts with a review of literature in chapter – 4. Chapter – 5 gives an overview on

risk management in DBL. Then the next chapter discusses about the Basel II framework and

its relation with credit risk management. Chapter 7 discusses about Basel II implementation

and its progress in DBL. Calculation of various ratio and the analyses is done in Chapter 8. In

Chapter 9 impact of implementation of Basel II in credit risk management has been

discussed. Finally the report ended with some recommendations.

P a g e | 28

CHAPTER 4LITARTURE REVIEW


4.0 Literature Review

According to the existing theories, the main validation for capital regulations of banks is

often given in terms of “moral hazard” problem. The problem states that in the presence of

visibly available fund, bank managers may not do enough to reduce risk. Instead they will opt

for risky projects that are accompanied by higher return, which, if not stopped in time, may

compromise banks’ solvency in the long run. Therefore, the theoretical reason for capital

adequacy regulations is to counteract the risk-shifting incentives.

This topic has given birth to several strands of theoretical literature. A first strand uses the

portfolio approach of Pyle (1971) and Hart and Jaffee (1974), where banks are treated as

utility maximizing units. In a mean-variance analysis that allows banks’ portfolio choice to be

compared with and without a capital regulation, Koehn and Santomero (1980) showed that

the introduction of higher leverage ratios will lead banks to shift their portfolio to riskier

assets. As a solution to such a situation, Kim and Santomero (1988) suggested that this

problem can be overcome if the regulators use correct measures of risk in the computation of

the solvency ratio. Subsequently, Rochet (1992) extended the work of Koehn and Santomero

and found that effectiveness of capital regulations depended on whether the banks were

value-maximizing or utility-maximizing. In the former case, capital regulations could not

prevent risk-taking actions by banks. In the latter case, capital regulations could only be

effective if the weights used in the computations of the ratio are equal to the systematic risk

of the assets. A further theoretical ground argued that banks choose portfolios with maximal

risk and minimum diversification.

The second strand of literature on the topic utilizes option models. Furlong and Keeley

(1989) and Keeley (1990) developed several models under this framework and showed that

higher capital requirements reduce the incentives for a value-maximizing bank to increase

asset risk, which is opposite to the conclusions of the first generation studies discussed above.

They criticized the utility maximizing framework, which comes to opposite conclusions, as

inappropriate because it mischaracterizes the bank’s investment opportunity set by omitting

the option value of deposit insurance and the possibility of bank failure. However, this

evidence of the option model was weakened by the findings of Gennottee and Pyle (1991).

They relaxed the assumption that banks invest in zero net present value assets and found that

P a g e | 30


there are now plausible situations in which an increase in capital requirements results in an

increase of asset risk.

Using a dynamic framework (multiple periods), as opposed to the static framework used in

the studies above, Blum (1999) found that capital regulation may increase banks’ riskiness

due to an intertemporal effect. Using a two-period model, he showed that banks find it too

costly to raise additional equity to meet new capital requirements tomorrow or are unable to

do so, they will increase risk today. He also pointed out that this second effect will reinforce

the well-known risk-shifting incentives due to the reduction in profits. Subsequently, Marshal

and Prescott (2000) showed that capital requirements directly reduce the probability of

default and portfolio risk and suggested that optimal bank capital regulations could be made

by incorporating state-contingent penalties based on banks’ performance. At the same time,

Vlaar (2000) found that capital requirements acted as a burden for inefficient banks when

assets of banks are assumed to be fixed.

However, such regulations increased the profitability of efficient banks.In short, whether

imposing harsher capital requirements leads banks to increase or decrease the risk structure of

their asset portfolio is still a debated question and, at least for now, it seems, there is no

simple answer to this question. Empirical work in the area concentrates on two aspects of

capital regulations. First, to investigate whether banks fulfill the capital requirements by

increasing capital or by altering the risk weighted assets; and second, to test if the

enforcement of capital requirements can result in a contraction in banks’ supply of loans, a

situation best described as a credit crunch. Many of these works use a simultaneous equations

approach, which allows comparing the behavior of undercapitalized and adequately

capitalized banks with respect to changes in risk and capital ratios.

Shrieves and Dahl (1992) used several periods of cross-section data on commercial banks in

the U.S. under the simultaneous equations framework. They found that the effectiveness of

risk-based capital regulations depend on how well the regulations reflected the true risk

exposure of banks. They also found that banks in the undercapitalized categories increased

their capital target ratios more quickly than other banks with higher initial capital. But, if one

is interested in the impact of capital regulations in a broad sense, then this is not a big

problem.

P a g e | 31


The study by Jacques and Negro (1997) deals exclusively with the consequences of the Basel

Accord, as it concentrates on the years 1990-91. They find that capital regulation has a

significant impact on risk and vice versa. Ediz, Michael, and Perraudin (1998) and Rime

(2001) present some non-U.S. evidence regarding the relationship between capital ratios and

credit risk. Ediz, Michael, and Perraudin (1998) employ confidential U.K. data including

detailed information about the balance sheet and profit and loss account of all British banks

during the 1989-1995 periods whereas Rime (2001) uses Swiss data for the period 1989-

1996. Ediz, Michael, and Perraudin (1998) used a limited information technique different

from the simultaneous equations framework. Their study used a period 1989-1995 sample

and applied a random effects model. They found that capital regulations were effective in

increasing the capital to meet the minimum standard.

The study by Rime (2001) is interesting because it provides the application of the

simultaneous equations model. His results indicate that Swiss banks react to capital

regulations by increasing their capital, but this did not change banks’ risk-taking. Sheldon

(1996) used an option-pricing framework to analyze the risk effects of capital adequacy on

eleven G-10 countries. He found that the Basel Accord did not have a risk-increasing impact

on banks’ portfolio. But this result is not easy to interpret as he did not control for regulatory

and non-regulatory influences. Moreover, sample coverage of this study is not representative

for the countries they represent.

Van Roy (2003) studied the impact of capital requirements on risk taking by commercial

banks of seven OECD countries within the framework of the simultaneous equations

framework. He found that changes in capital and credit risk were negatively related over the

period studied, which supported the argument that stringent capital requirements went hand

in hand with greater financial stability in addition to imposing a higher capital buffer against

unexpected credit risk losses.

Proper credit risk management is critical for Bank’s existence in the market. Santomero, A.

M. (1996) suggests that a bank must apply a consistent evaluation and rating scheme to all its

investment opportunities in order for credit decisions to be made in a consistent manner and

for the resultant aggregate reporting of credit risk exposure to be meaningful. To facilitate

this, a substantial degree of standardization of process and documentation is required.

P a g e | 32


Treacy and Carey (2000) suggest that in designing a credit rating system, a bank should

consider numerous factors, including cost, efficiency of information gathering, consistency of

rating produced, staff incentives, nature of a bank’s business, and uses to be made of the

internal risk ratings. A rating system with more rating categories is better than a system with

just a few categories. However, an internal rating system with larger number of grades is

costly to operate because of the extra work required to distinguish finer degrees of risk.

Raghavan, R. S. (2003) suggests that the key ingredient of credit risk is the risk of default that

is measured by the probability that default occurs during a given period. As there is a

significant co-relation between credit ratings and default frequencies, any derivation of

probability from such historical data can be relied upon. Despite the advances in science and

technology that allow the development of expert system or statistical classification models,

human judgment is still an important ingredient in the credit risk assessment process.

According to Treacy and Carey (2000), the rating process almost always involves the

exercise of human judgment because factors to be considered in assigning a rating and the

weights given to each factor can differ significantly among borrowers. For large exposures,

the benefits of such accuracy may outweigh the higher costs of the judgmental systems.

Because of the high cost involved, in general, banks produce credit ratings for business and

institutional loans only.

P a g e | 33

CHAPTER 5RISK MANAGEMENT IN DHAKA BANK LIMITED


5.0 Risk Management in Dhaka Bank Limited

Risk concerns the expected value of one or more results of one or more future events.

Technically, the value of those results may be positive or negative. However, general usage

tends focus only on potential harm that may arise from a future event, which may accrue

either from incurring a cost (downside risk) or failing to attain any benefit (upside risk). Risk

management can be considered the identification, assessment, prioritization of risks followed

by coordinated and economical application of resources to minimize, monitor and control the

probability and/or impact of unfortunate events or to maximize the realization of

opportunities.

5.1 Core Risks in Bank

The core risks involved in any banking operation are briefly described below:

5.1.1 Asset Liability Management

The Asset Liability Management is integral part of Bank Management. This risk is related to

the balance sheet gaps, interest rate gaps that can lead to under performance. To manage this

risk Dhaka Bank Limited has a committee name ALCO (Asset Liability Committee) which

usually meet at least once a month to analysis, review and formulate strategy to manage the

balance sheet. Main functions of this committee are identifying the balance sheet

management issues like balance sheet gap, interest rate gap/profile, reviewing deposit-pricing

strategy and liquidity contingency plan.

5.1.2 Foreign Exchange Risk

Today’s financial institutions engage in activities starting from import, export and remittance

to complex derivatives involving basic foreign exchange and money market to complex

structured products. All these require high degree of expertise that is difficult to achieve in

the transaction originating departments and as such the expertise is housed in a separate

department. In DBL, this task is done by Treasury Department. Treasury department watches

over the flow of foreign exchange, it takes long/short position of foreign currency to mitigate

the risk of depreciation of the hold currencies.

P a g e | 35


5.1.3 Internal Control and Compliance Risk

Internal control is the process, affected by a company’s board of directors, management and

other personnel, designed to provide reasonable assurance regarding the achievement of

objectives in the effectiveness and of operations, the reliability of financial reporting and

compliance with applicable laws, regulations, and internal policies. In DBL the

responsibilities of internal control are to check the efficiency and effectiveness of activities,

reliability, completeness and timeliness of financial and management information etc.

5.1.4 Money Laundering Risk

Though money laundering risk is relatively a old phenomenon, it got the organized look after

the enactment of Money Laundering Act, 2009. This law barred some activities as legal and

if any bank is found to be involved in any kind of money laundering, the concerned official

and the bank will be punished. As, money laundering is very common in Bangladesh, it poses

a great risk for the banks. To mitigate this risk, DBL employed a strong KYC (Know Your

Customer) policy, strong account monitoring policy etc.

5.1.5 Credit Risk

This is the most important risk of all as it involves the key asset quality of any bank. Credit

Risk is defined as the risk of losses associated with the possibility that borrower will fail to

meet its obligations; in other words it is the risk that the borrower won’t repay what is owed.

Many banks have failed in the past because of poor management of credit risk. To understand

credit risk, it is important to know about the credit facilities. The next section focuses on that.

5.2 Types of Credit Products

Credit may be classified with reference to elements of time, nature and provision base.

5.2.1 Classification on the basis of time:

On the basis of elements of time, bank credit may be classified into three heads, viz.

Continuous loans:

These are the advances having no fixed repayment schedule but have a date at which it is

renewable on satisfactory performance of the clients. Continuous loan mainly includes "Cash

credit both hypothecation and pledge" and "Overdraft".

P a g e | 36


Demand loan:

In opening letter of credit (L/C), the clients have to provide the full L/C amount in foreign

exchange to the bank. To purchase this foreign exchange, bank extends demand loan to the

clients at stipulated margin. No specific repayment date is fixed. However, as soon as the L/C

documents arrive, the bank requests the clients to adjust their loan and to retire the L/C

documents. Demand loans mainly include “Payment against Documents,” "Loan against

imported merchandise (LIM)" and "Letter of Trust Receipt".

Term loans:

These are the advances made by the bank with a fixed repayment schedule. Terms loans

mainly include "Consumer credit scheme", "Lease finance"," Hire purchase", and "Staff

loan". The term loans are defined as follows:

Short term loan: Up to 12 months.

Medium term loan: More than 12 months & up to 36 months

Long term loan: More than 36 months.

5.2.2 Classification on characteristics of financing

On characteristics of financing, the credit facilities of Dhaka Bank can be divided into two

categories, viz.

Funded

These products give the client the facility to use the money to fulfill its working capital need,

to cover temporary shortage of fund, to buy consumer durables etc. The facilities taken by the

client are reflected in the balance sheet of the bank as assets. Majority of the credit product of

the bank are of this type. As this type represents the major portion of credit portfolio of a

bank, risk of default, i.e. credit risk is very evident here. So, the credit risk management is

basically managing funded facility of a bank.

Non-Funded

These products give a third party the assurance that bank will pay in the event of failure of

repayment of its client. Generally it is used to import goods from abroad, to participate in

different tender etc. As these facilities deal with guarantee and not money these are not

reflected in the balance sheet, they are reflected in the off-balance sheet. These are called

contingent liability also.

P a g e | 37


The following table examples of some funded and non-funded products are given:

Table 2: Classification of credit based on Characteristics of financing

Funded Non-FundedOverdraftLoanConsumer CreditLoan against Trust ReceiptPayment against DocumentsCash Credit (Pledge and Hypothecation)Staff LoanTerm LoanPacking Credit

Letter of CreditBank Guarantee

5.2.3 Classification on Provision Base

Credit facilities of Bank can be divided into four categories based on provision base of the

facilities, viz.

Unclassified

The loan account is performing satisfactorily in the terms of its installments and no overdue

is occurred. In this type one special type of classification is there which is called special

mention account. Generally, if an account is not repaying its due for three months

continuously, it is called special mention account (SMA) and is reported to the central bank

which prevents the other banks to give the client fresh loan.

Sub-Standard

This classification contains where irregularities have been occurred but such irregularities are

temporarily in nature. To fall in this class the loan and advance has to fulfill the following

factor given in Table 3. This kind of loan is monitored closely by the monitoring division to

make the loan regular.

Table 3: Criteria for Sub-Standard Loan

Category of Credit Time overdue (irregularities)

Sub-standardS-T Agri & Micro Credit 3 months & above but less than 6 months.

Continuous loan Un-recovered for 3 months & above but less

than 6 months from the date of the loan is claimed.Demand Loan

Fixed Term loan

Repayable within 5years: If the overdue installment

equals or exceeds the amount repayable

within6 months.

Repayable more than 5years: If the overdue

installment equals or exceeds the amount repayable

within12 months.

P a g e | 38


Doubtful

This classification contains where doubt exists on the full recovery of the loan and advance

along with a loss is anticipated but cannot be quantifiable at this stage. Moreover if the state

of the loan accounts falls under the following criterion can be declared as doubtful loan and

advance.

Table 4: Criteria for Doubtful Loan


DoubtfulS-T Agri & Micro Credit 6 months & above but less than 12 months.

Continuous loan Un-recovered for 6 months & above but less

than 12 months from the date of the loan is claimed.Demand Loan

Fixed Term loan



within 12 months.

Repayable more than 5years: If the overdue installment


within 18 months.

Bad and Loss

A particular loan and advance fall in this class when it seems that this loan and advance is not

collectable or worthless even after all the security has been exhausted. In the following table

the criteria to be fulfilled to fall in this category are summarized:

Table 5: Criteria for Bad and Loss


Bad and Loss

S-T Agri & Micro Credit Not recovered within more than 12 months.

Continuous loan Un-recovered more than 12 months from the date of the

loan is claimed.Demand Loan

Fixed Term loan



within 18 months.

Repayable more than 5years: If the overdue installment


within 24 months.

5.3 Credit Risk Management in Dhaka Bank Limited

To manage credit risk, Bangladesh Bank prescribed a framework. The key elements of credit

risk management are:

Lending Guideline

Credit Assessment & Risk Grading

P a g e | 39


Approval Authority

Segregation of Duties

Internal Audit

5.3.1 Lending guidelines

Lending guidelines clearly outline the senior management’s view of business development

priorities and the terms and conditions that should be adhered to in order for loans to be

approved. This should be updated at least annually to reflect changes in the economic outlook

and the evolution of the bank’s loan portfolio. It contains:

Industry & Business Segment Focus: The lending guidelines in DBL specifies some

particular industries like textile, knit garments, cement, power etc.

Types of Loan Facilities: The guideline also specifies different kinds of loan that are

permitted to be disbursed. As per DBL lending guidelines, there are mainly two kinds

of loan, funded and non-funded. Examples of funded are working capital loan, term

loan, etc. On the other hand, examples of non-funded facilities are LC, Bank Guaran-

tee etc.

Single Borrower/ Group Limits: A single borrower/group is permitted to get highest

15% of the capital as funded facility and highest 20% of the capital as non-funded fa-

cility.

Lending Caps: There is a specific industry sector exposure cap to avoid over concen-

tration in any one industry sector.

Discouraged Business Types: In the lending guidelines of DBL, lending to some in-

dustries is discouraged such as military weapon, highly leveraged transaction and fi-

nance of speculative investment.

Loan Facility Parameters: As per the lending guidelines, the parameters should be

adopted like, not granting facility when security position is inferior, proper valuation

of security, pledge of security etc.

Cross Border Risk: It is synonymous with political and sovereign risk. If any diffi-

culty arises from any political event, then a plan is there in place.

5.3.2 Credit Assessment & Risk Grading

Lending is risky because loan quality is affected by both internal and external factors.

External factors include changes in economy, national disasters like earthquake, flood and the

P a g e | 40


regulation by the government. Internal factors affecting loan risk include management errors,

illegal manipulation by bank officials and weak or ineffective lending policies. The risk of

lending function is mainly controlled by Government regulations and Internal policies and

procedures.

The risk is also controlled by creating and following written policies and procedures for

processing each credit request. At DBL, a thorough credit assessment and risk grading are

done prior to loan approval for minimizing risks maintaining Bangladesh Bank Guidelines.

5.3.2.1 Credit Assessment

A thorough credit and risk assessment is conducted prior to the granting of loans, and at least

annually thereafter for all facilities. The results of this assessment are presented in a Credit

Application that originates from the relationship manager/account officer (“RM”), and is

approved by Credit Risk Management (CRM). The RM is the owner of the customer

relationship, and is held responsible to ensure the accuracy of the entire credit application

submitted for approval. The RMs are familiar with the bank’s Lending Guidelines and

conduct due diligence on new borrowers, principals, and guarantor.

It is essential to ensure such parties are in fact who they represent themselves to be. The bank

has an established Know Your Customer (KYC) and Money Laundering guidelines. Credit

Applications summarize the results of the RMs risk assessment and include the following

details:

Amount and type of loan(s) proposed

Purpose of loans

Loan Structure (Tenor, Covenants, Repayment Schedule, Interest)

Security Arrangements

In addition, the following risk areas are addressed:

Borrower Analysis

Borrower analysis is the most important step in providing loans to borrowers. Unethical

attitudes, asymmetric information and manipulation of records by borrowers etc. create

complication in credit finance and as a consequence banks become burdened with unusual

amount of classified loans. So, the borrower must be of good character, should be reliable,

responsible and resourceful, so that the return of loan is easier. For that, the following

information is provided on the loan application:

P a g e | 41


Borrower background or history including group information if the concern is part of

a group.

The location of the borrower’s office & factory and factory details like land area,

buildings, number of shifts per day, number of workers and officers, factory space and

sources of power & capacity, alternate source of power, source of machinery, etc.

If the borrower has applied for a loan for a new project, then initial cost of the project,

its means of finance, its product mix & production capacity and its market

Total export earnings of the group

List of machinery for existing project

Particulars of the Board of Directors, and declaration of the Relationship Manager re-

garding personal net worth

Corporate objective or strategy

Once a borrower requests for a loan, a DBL official interviews the customer and finds out the

credit needs. This interview is important because it enables the bank to assess the borrower’s

character and sincerity of purpose. For a new project, it also collects information

memorandum. For business or mortgage loan, the DBL makes a visit to the customer’s

location and assesses the condition of the property.

Industry Analysis

The key risk factors of the borrower’s industry are assessed. Any issues regarding the

borrower’s position in the industry, overall industry concerns or competitive forces are

addressed and the strengths and weaknesses of the borrower relative to its competition are

identified. Critical success factors of the industry are also stated.

Supplier/Buyer Analysis

Information regarding the borrower’s suppliers and buyers are collected mainly who they are.

Any customer or supplier concentration is addressed, as these have a significant impact on

the future viability of the borrower. Any issues regarding the market vulnerability are also

addressed.

Historical Financial Analysis

An analysis of a minimum of three years historical financial statements of the borrower is

presented. Where reliance is placed on a corporate guarantor, the guarantor’s financial

statements are also analyzed. The analysis addresses the quality and the sustainability of

P a g e | 42


earnings, cash flow and the strength of the borrower’s balance sheet. Specifically, cash flow,

leverage and profitability are analyzed.

Projected Financial Performance

Where term facilities for more than one year are being proposed, a projection of the

borrower’s future financial performance is conducted, indicating an analysis of the

sufficiency of cash flow to service debt repayments. Loans are not granted if projected cash

flow is insufficient to repay debts.

Account Conduct

For existing borrowers, the historic performance in meeting repayment obligations like trade

payments, checks, interest and principal payments, etc is assessed. Performance with other

banks like import performance, export performance, account conduct and liability position is

also noted. For a comprehensive picture, the latest Credit Information Bureau (CIB) report of

the central bank is summarized in this module.

Adherence to Lending Guidelines

The Credit Application clearly states whether or not the proposed application is in

compliance with the bank’s Lending Guidelines. The Bank’s Head of Credit or Managing

Director/CEO approves Credit Applications that do not adhere to the bank’s Lending

Guidelines.

Mitigating Factors

There might be some trigger points for the industry which poses serious risks. So, mitigating

factors for those risks are identified. Possible risks include, but are not limited to: margin

sustainability and/or volatility, high debt load (leverage/gearing), overstocking or debtor

issues; rapid growth, acquisition or expansion; new business line/product expansion;

management changes or succession issues; customer or supplier concentrations; and lack of

transparency or industry issues. Detailed analysis of risks and their mitigating factors are also

analyzed.

Loan Structure

The amounts and tenors of financing proposed are justified based on the projected repayment

ability and loan purpose. Excessive tenor or amount relative to business needs increases the

risk of fund diversion and may adversely impact the borrower’s repayment ability.

P a g e | 43


Security

A current valuation of collateral is obtained and the quality and priority of security being

proposed are assessed. Loans are not granted based solely on security. Adequacy and the

extent of the insurance coverage are assessed. Any protective covenants or conditions are also

advised in this module.

Name Lending

Credit proposals do not unduly rely on the sponsoring principal’s reputation, reported

independent means, or their perceived willingness to inject funds into various business

enterprises in case of need. These situations are discouraged and treated with great caution.

Rather, credit proposals and the granting of loans are based on sound fundamentals,

supported by a tho8rough financial and risk analysis.

5.3.2.2 Risk Grading

The bank has adopted a credit risk grading system. The system defines the risk profile of

borrower’s to ensure that account management, structure and pricing are commensurate with

the risk involved. Risk grading is a key measurement of the Bank’s asset quality, and as such,

it is essential that grading is a robust process. All facilities are assigned a risk grade. Where

deterioration in risk is noted, the Risk Grade assigned to a borrower and its facilities should

be immediately changed. Borrower Risk Grades are clearly stated on Credit Applications.

In the CRG prescribed by the Bangladesh Bank a borrower was given scores according to the

key financial ratios and management of the borrowing company. This process almost covers

all the aspects of business operation related with extending credit facilities. After giving score

to each point the total score is calculated. A risk rating system is there in place to rate the

calculated total score. The risk rating system has eight scoring slabs. The more score any

company gets the better the risk grading is. In brief the CRG rating system is given below:

Table 6: CRG Scores Band

Risk Rating Grade Scores

Superior - Low risk 1 >95

Good - Satisfactory risk 2 >85

Acceptable - Fair Risk 3 75-84

Marginal - Watch List 4 65-74

Special Mention 5 55-64

P a g e | 44


Substandard 6 45-54

Doubtful 7 35-44

Bad and Loss 8 <35

5.3.3 Approval Authority

The authority to sanction/approve loans is clearly delegated to senior credit executives by the

Managing Director/CEO & Board based on the executive’s knowledge and experience. The

following guidelines are followed in the approval/sanctioning of loans:

Credit approval authority must be delegated in writing from the MD/CEO & Board.

Delegated approval authorities must be reviewed annually by MD/CEO/Board.

The credit approval function should be separate from the marketing/relationship man-

agement (RM) function.

The role of Credit Committee may be restricted to only review of proposals i.e. rec-

ommendations or review of bank’s loan portfolios.

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 authorized by executives within the authority limit delegated

to them by the MD/CEO. The “pooling” or combining of authority limits should not

be permitted.

Credit approval should be centralized within the CRM function. Regional credit cen-

ters may be established, however, all large loans must be approved by the Head of

Credit and Risk Management or Managing Director/CEO/Board or delegated Head

Office credit executive.

The aggregate exposure to any borrower or borrowing group must be used to deter-

mine the approval authority required.

Any credit proposal that does not comply with Lending Guidelines, regardless of

amount, should be referred to Head Office for Approval

5.3.4 Segregation of Duties

At DBL the following lending functions are segregated to comply with the Bangladesh Banks

guidelines.

Credit Approval/Risk Management

Relationship Management/Marketing

P a g e | 45


Credit Administration

The purpose of the segregation is to improve the knowledge levels and expertise in each

department, to impose controls over the disbursement of authorized loan facilities and obtain

an objective and independent judgment of credit proposals.

5.3.5 Internal Audit

DBL has an internal audit department which is responsible for auditing all departments. The

audits are done generally in annual basis. It takes the Regulatory Compliance, Internal

Procedures, Lending Guidelines and Bangladesh Bank Requirements in view.

5.3.6 Credit Monitoring

At DBL a separate credit monitoring unit is working at HO level where the following is

monitored and necessary follow up is done with branches:

o Excess Over the Limits (EOL)

o Past Due Principal or Interest

o Breach of Loan Covenants

Special emphasis is given on the loans with classification status, like special mention

account, sub-standard, doubtful and bad and loss.

5.4 Credit Risk Management and Basel accords

Credit Risk Management is a comprehensive package for protecting the Banks from risk of

failure as credit risk covers 90% of the total risk of any Bank. But, CRM does not appear to

be the foolproof solution for credit risk. Numerous Banks have been bankrupted though there

was a credit risk management system. As banks gives loan to the client from the depositors’

money, failure of bank harms the depositors directly. Though there is a credit management

system is place in almost every bank of the world, there is no set standard for CRM. Credit

facilities were given to customers with no ability to repay. Malpractice, fraud and other

irregularities are also responsible for giving loan to defaulters. To solve this problem and to

insulate the depositors from losses the concept of capital adequacy has been given birth to.

Capital adequacy is defined as the minimum level of capital, which is required to protect a

bank from portfolio losses. However, debate on the quantum of minimum level of capital

seems to be never ending. Though different methods and approaches were adopted in

P a g e | 46


different points in time, they were insufficient to capture new dimensions and magnitudes of

risk emanated from the continuous innovations in the domestic and international business.

Consequently the 1970s and 80s experienced many uncertainties and volatilities that caused

serious banking problems. The approach that a bank’s capital should be linked to a fixed ratio

of its time and demand liabilities went under strong criticism on the ground that bank’s major

risk is derived from the riskiness of its assets. The Basel Committee, based on this idea,

designed Capital Regulation in 1988, which is known as the Basel Accord I.

5.4.1 Basel I

Basel I was an international accord to set minimum levels of capital for banks, building

societies and other deposit taking institutions. It was designed to create a level playing field

for lenders from different countries and to ensure that lenders were sufficiently well

capitalized to protect depositors and the financial system.

Two fundamental objectives of the Accord were (a) to strengthen the soundness and stability

of the international banking system and (b) to obtain a high degree of consistency in its

application to banks in different countries with a view to diminishing an existing source of

competitive inequality among international banks. To that end, the accord requires that banks

meet a minimum capital ratio that must be equal to at least 8 percent of total risk-weighted

assets.

Though at first only credit risk was incorporated, in 1996 market risk was also incorporated

in this accord. Basel I implementation in Bangladesh started at 1996. But the implementation

was only in the credit risk section.

5.4.2 Criticism of Basel I

However, the Accord has been widely criticized for its failure to achieve the stated

objectives. Since it introduced risk-based capital requirement, which was adopted by many

developed and developing countries as well, it was expected that the Accord would help to

strengthen financial system stability and reduce banking and financial crises. On the contrary,

banking crises again occurred in 1990s even in some robust economies of East Asia. The

Accord was also criticized for the inherent weaknesses in the model as detailed below.

P a g e | 47


Rodriguez (2002) and others argue that the use of arbitrary risk categories and arbitrary

weights that bear no relation to default rates incorrectly assume that all assets within one

category are equally risky. For example, a loan to a well-established company such as

Beximco Pharma or Square Pharmaceuticals is considered as risky as a loan to a new

company established by a new entrepreneur. Loans made to companies in the non-trading

sector of the economy are considered as risky as loans made to companies in the trading

sector, even though the latter are usually less risky than the former. The risk assessment

methodology is flawed in the sense that it assumes a portfolio’s total risk is equal to the sum

of the risks of the individual assets in the portfolio. No account is taken of portfolio

management strategies, which can greatly reduce the overall risk of a portfolio, or of the size

of a portfolio, which can greatly influence its total risk profile.

The accord gives preferential treatment to government securities, which are considered risk-

free. The sovereign debt defaults of Russia in the summer of 1998 and Argentina in early

2002 demonstrated that government debt is not a risk free investment. Other criticisms

include that the accord sets capital standards only for credit risk (i.e., the risk of counterparty

failure), but not for other types of risk such as operational risk and market risk. Consequently,

capital requirement was not reflective of economic risk. It has not provided enough incentive

for risk management, risk mitigation and innovation in risk management such as arbitrage

opportunities through securitization.

When the Accord was formalized, no consensus and consultation were taken from the

representatives of the developing nations. Therefore, it is sometimes criticized as OECD

Club-rule. McDonough (2000) argues that as banks have developed innovative techniques for

managing and mitigating risk, credit risk now exists in more complicated, less conventional

forms than is recognized by the 1988 Accord, thus rendering capital ratios, as presently

calculated, less useful to banking supervisors. The financial world has changed dramatically

over the past dozen years, to the point that the Accord efficacy has eroded considerably

(McDonough, 2000).

5.4.3 The Entrance of Basel II

The Basel Committee tried to address some of these criticisms over the years, modifying the

Accord throughout the years from 1990s to 2004 and Basel Accord II (included

representatives from G10 and non-G10 countries) is the result of such efforts. The primary

P a g e | 48


objective of the New Accord is to make it more risk-sensitive so that financial institutions

will be able to sustain even in periods of financial crisis. Consequently, the new proposal

moves ahead of the “one-size-fit-all” approach. Another objective of the Accord is to

continue to enhance competitive equality among the internationally active banks throughout

the world.

The Accord has provided many areas of national discretions, which require an extensive

study to guide policy actions in appropriate directions. This study has made an attempt to

analyze the prevailing status and conditions of the banking sector in line with Basel II

requirements. In order to deepen and widen understanding in a specific area, this study has

mainly concentrated on the compliance aspects of Pillar I. In fact, this study has further

narrowed down its scope to focus on different approaches for the measurement of capital

charge against credit risk. The next chapter will describe the Basel II framework.

P a g e | 49

CHAPTER 6FRAMEWORK OF BASEL 2 AND ITS IMPLEMENTATION IN BANGLADESH


6.0 Basel II Framework and its Implementation in Bangladesh

The Basel II has defined a structured framework comprising three pillars such as Pillar I, II

and III. Pillar I sets out minimum capital requirements. Pillar II defines the process of

supervisory review of a financial institution’s risk management framework. Pillar III

determines market discipline through improved disclosure. In this chapter, these three pillars

are discussed as follows:

6.1 The Three Pillars

Basel II capital accord is known for its three mutually reinforcing pillars, which are minimum

capital requirement, supervisory review process and market discipline. In figure 9, the

approaches for calculation of capital for pillar 1 are stated. In this section, these three pillars

and the approaches for calculation of capital will be discussed. Pillar 1 of Basel II is

somehow present in the previous capital accord Basel I but Pillar 2 and Pillar 3 are novelty.

In the Pillar 1 it has identified three risks whereas in the previous accord there were two risks.

Operational Risk was introduced for the first time in Basel II.

Figure 9: The Basel II Framework

P a g e | 51


6.1.1 Pillar 1-Minimum Capital Requirements

In Pillar I, three kinds of risk such as credit risk, market risk and operational risk are

considered to determine the minimum capital requirement. The definition of eligible

regulatory capital remains the same as outlined in the 1988 Accord i.e., the ratio of capital to

risk-weighted asset remains unchanged at 8%. This pillar is a quantitative one. As this report

is about the credit risk, the approaches to calculate the capital requirement will be discussed

in brief.

6.1.2 Pillar 2-Supervisory Review Process

Pillar II ensures that not only do banks have adequate capital to cover their risks, but also that

they employ better risk management practices so as to minimize the risks. Supervisors will be

expected to evaluate the board and management of banks, to look into strategic decisions and

to evaluate portfolio diversification as well as the ability to react to future risks in a rapidly

changing environment. In particular, issues of transparency, corporate governance and

efficient markets can be considered as additional challenges in pillar II enforcement.

6.1.3 Pillar 3-Market Forces

Banking operations are becoming complex and difficult for supervisors to monitor and

control. In this context, Basel Committee has recognized the importance of market discipline

and has suggested implementing it by asking banks to make adequate disclosures. The

potential audiences of these disclosures are supervisors, bank's customers, rating agencies,

depositors and investors. With frequent and material disclosures, outsiders can learn about the

bank's risks.

6.2 Approaches for Calculation of Capital Requirements for Credit Risk

Basel II has provided a choice between two broad methodologies to calculate minimum

capital requirement for credit risk: (a) standardized approach and (b) internal rating-based

approach.

6.2.1 Standardized Approach (SA)

Under standardized approach, credit assessment will be conducted by external credit

assessment institutions (ECAI) as eligible for capital purposes by the national supervisors.

Risk-weight against each rating will be applied to individual credit exposure to arrive at risk-

P a g e | 52


weighted asset. Before allowing ECAIs such as the rating agencies, national supervisor will

have to ensure that they fulfill the following standards set by Basel Committee (2004):

The methodology for assigning credit assessments must be rigorous, systematic and subject

to some form of validation based on historical experience. Before being recognized by

supervisors, an assessment methodology for each market segment, including rigorous back

testing, must have been established for at least one year and preferably three years.

An ECAI should be independent and should not be subject to political or economic pressures

that may influence the rating. The assessment process should be as free as possible from any

constraints that could arise in situations where the composition of the board of directors or

the shareholder structure of the assessment institution may be seen as creating a conflict of

interest. The individual assessments should be available to both domestic and foreign

institutions with legitimate interests and at equal terms. In addition, the general methodology

used by the ECAI should be publicly available.

An ECAI should disclose the information on its assessment methodologies, including the

definition of default, the time horizon and the meaning of each rating, the actual default rates

experienced in each assessment category, and the transitions of the assessments i.e., the

likelihood of AA ratings becoming A over time. An ECAI should have sufficient resources to

carry out high quality credit assessments. These resources should allow for substantial

ongoing contact with senior and operational levels within the entities assessed in order to add

value to the credit assessments.

In addition, supervisors will be responsible for assigning eligible ECAIs’ assessments to the

risk weights available under the standardized risk weighting framework, i.e., deciding which

assessment categories correspond to which risk weights.

6.2.2 Internal Rating Based Approach (IRB)

In the IRB approach, the four risk parameters that need to be estimated are PD (i.e.,

probability of default of borrower in each risk grade over a one year time horizon), LGD (i.e.,

loss in the event of a default), EAD (i.e., exposure amount at the time of default) and

Maturity (i.e., remaining effective maturity of the exposure at default). The Accord has

provided two types of IRB approach: (a) Foundation IRB Approach and (b) Advanced IRB

Approach.

P a g e | 53


6.2.2.1 Foundation IRB Approach

Under the Foundation IRB approach banks provide their own estimates of PD and rely on

supervisory estimates for other risk components such as LGD, EAD and M. Under the

advanced approach, banks provide more of their own estimates of PD, LGD and EAD, and

their own calculation of M, subject to meeting the minimum standards. For both the

foundation and advanced approaches, banks must always use the risk-weight functions

provided in the New Accord for the purpose of deriving capital requirements.

Estimation of the parameters

The critical issues that both supervisor and the banks will face in implementing IRB approach

are:

Historical data to estimate PD

Historical loss database to estimate LGD

Historical exposure data to estimate EAD

Various types and characteristics of data are necessary to estimate each of these parameters.

Some of them are discussed below from Artigas’s (2004) famous article ‘A Review of Credit

Registers and their Use for Basel II’.

Historical data to estimate PD

In order to calculate each bank’s minimum capital requirements under Basel II, banks need

to have ready access to an essential information set. As regards, PD estimation, the

development of an overall borrower rating system requires default information. In addition,

the development of an appropriate rating system would require information on certain loan

characteristics that could be used, either directly or through transformation (data refinement),

to construct variables that are sufficient for determining each borrower’s credit quality or, in

other words, its probability of default.

Among other items, desirable information would be on guarantees, duration of borrower’s

existence in the system, default history of each borrower (number of times that they have

defaulted previously, or proportion of defaults in terms of how long they have been in the

system), history of an obligor’s rating migrations (upgrades or downgrades), number and type

of banks with which obligors deal, past due debt without reaching default status (delinquency

status), industry to which obligors belong, type of credit instrument and maturity date. Others

P a g e | 54


financial variables such as leverage ratios, debt burden, efficiency, productivity and

profitability in the case of firms, and employment status and indebtedness profile in the case

of individuals, along with the stage of the business cycle of the economy, could form the core

group of variables needed to estimate a rating system. As per Basel standard, estimation of

PD needs to be based on 5 years’ historical data.

Historical loss database to estimate LGD

In the case of LGD, certain readily identified characteristics would be needed to estimate its

determinants empirically via a regression model. Calculating LGD properly requires

knowledge of type of collateral, percentage of collateral coverage, credit operation’s interest

rate, age of operation (time elapsed since loan origination), industry; loan size, loan maturity

date, the amount finally recovered, the time taken to recover it, all the costs incurred in the

process (from legal costs to the opportunity cost of money), all possible intermediate

recoveries and the discount rate to be applied. Since the Accord leaves open the option of

making use of external data, LGD can be estimated using market data such as market prices

of defaulted loans or bonds. The above information along with other qualitative variables

furnished by the departments entrusted with recovery management could also be used for

LGD validation. It can be noted that for validation of the LGD the required information

structure basically depends on characteristics of the credit operations themselves whereas

for PD validation the required data mostly refer to intrinsic characteristics of borrowers.

Historical exposure data to estimate EAD

Regarding EAD validation, information on drawn and un-drawn exposures, particularly in the

period of time prior to a default event, is necessary. An analysis of how borrowers make use

of their commitments (particularly the unknown part) over time would be a good first

approximation for validating EAD. Other items such as the number of banks with which a

borrower deals, past default history, size of the loan, industry and guarantees appear to be

items, which, in principle, may seem to explain EAD. Moreover, an assessment based on

qualitative elements could also be a reasonable validation solution.

It is argued that data quality is an important factor that could affect the quality of risk

measures generated by the model. Incomplete, imprecise and archaic data may rather increase

the risk and the losses faced by banks.

P a g e | 55


6.3 Role of ECIA in Standardized Approach

It is argued that in many countries, low rating penetration and a lack of domestic rating

agencies may pose a challenge for implementation of the standardized approach, particularly

in respect of corporate claims. This is not untrue for Bangladesh where the rating industry is

not advanced enough and the majority of the individual claims of bank loans remain unrated.

Currently two rating agencies, namely CRISL and CRAB, are operative in the financial

market. Since banks in Bangladesh are linked with tens of thousands of borrowers, the

capability of these two rating agencies in terms of credit assessment of those borrowers

within the regulatory timeframe may not be sufficient. Cost of credit assessment will be

substantially increased due to high regulatory demand for this service. This, in turn, will

increase lending price and affect banks’ profitability.

The Accord requires that the assessment process should be as free as possible from any

constraints that could arise in situations where the composition of the board of directors or

the shareholder structure of the assessment institution may be seen as creating a conflict of

interest. However, the existing Credit Companies Rules that was enacted in 1996 to regulate

the business of credit rating agencies has not considered this issue in line with Basel’s new

standard. It is understood that directors of the existing rating agencies are directors of the

scheduled banks as well as directors of other public and private companies. This type of

conflict of interest may cause for rating-biases and need to be addressed urgently through

legal changes before adopting the standardized approach.

High default culture in the financial market of Bangladesh indicates that existing weak

regulatory framework for rating agencies may influence borrowers’ behavior to obtain good

rating inappropriately. Therefore rating regulations need to be updated to address such

potential problems. Effects of It can be noted that credit risk modeling, back-testing and

forecasting require high level knowledge of probability statistics, financial econometrics and

times series analysis. It is yet to be ascertained whether the existing rating agencies have

sufficient qualified human resources who can perform those activities in a professionally

competent manner. Since rating greatly depends on long historical data, given that the

industry is of recent origin, it can be assumed that they may not have sufficient database to

validate their models.

P a g e | 56


6.4 Constituents of Capital

Existing regulation requires all scheduled banks to maintain minimum paid up capital and

reserve fund of 8 percent risk-weighted asset. But from July 2010, Banks have to keep 9% of

their risk-weighted asset. Banks can maintain their capital in the following constituents listed

in Table 7.

Table 7: Constituents of Capital

Core Capital (Tier 1) Supplementary Capital (Tier II)

A. Paid-up Capital

B. Non-repayable Share premium account

C. Statutory Reserve

D. General Reserve

E. Retained Earnings

F. Minority Interest in Subsidiaries

G. Non-Cumulative Irredeemable Prefer-

ence Share

H. Dividend Equalization Account

A. General Provision (1-5 percent of

unclassified Loans)

B. Asset Revaluation Reserve

C. All other Preference Shares

D. Perpetual Subordinated Debt

E. Exchange Equalization Account

6.5 Credit Risk Mitigation

The credit, construed both as funded and non-funded commitments of banks, involves

probability of ‘loss’ in the event of non-fulfillment of corresponding financial obligations by

the borrower or guarantor. Therefore, traditionally the banks and FIs seek to be covered by

appropriate tangible and realizable securities or by third party guarantees to avert or at least

minimize the loss in the event of the default by borrower or guarantor.

A Credit Risk Mitigation tool, commonly referred to as ‘security’, is universally recognized

as a ‘protection’ for the lenders although the same is often christened as ‘collateral’ also. The

personal covenants supported by the execution of promissory notes/ agreements are then

treated as ‘primary‘cover in the limited scope of a security cover.

In Bangladeshi context, however, there is a subtle difference between primary and collateral

security. A primary security is one on which the drawing power/loan availment is allowed

while a collateral security, though not considered for such purposes, provides the same

degree of comfort/rights for the lenders for ultimate recovery of the dues. It is fairly common

P a g e | 57


in credit market that lenders insist for collaterals (e.g. mortgage of personal landed

property/other assets of the counter party) for extending large volumes of credit. This is done

to ensure an additional cushion on the top of primary security reckoned for drawing

power/loan availment computation. But the credit ‘risk mitigation’ and security cover

(primary/collateral) may not be treated as the same if followed the prescriptions of Basel

Accord II.

In conventional sense, all kinds of assets are recognized as eligible collateral whereas in

Basel II only some specific items of assets are recognized as eligible collateral. Credit Risk

mitigation covers securities such as cash, gold, debt securities issued by sovereigns rated

category, etc.(Stocks in trade, book debts, fixed assets, etc. are not recognized as credit

mitigation items)

In conventional way, Third party guarantee (i.e other than personal repayment undertaking of

the borrower) even by the government of the country, high net worth individuals, is not

strictly treated as ‘security’ although such third party guarantee may be quite valuable for the

lender. But in Basel II, Third party guarantee is treated as a credit mitigation tool subject to

fulfilling certain operational conditions such as unconditional guarantee, explicit

documentation, etc.

Credit risk mitigation guidelines under Basel II provide that the lender will be required to

subdivide the exposures between third party guarantee and other recognized risk mitigation

items whereas in conventional way there is no regulatory guideline.

6.5.1 Application of Credit Risk Mitigation in Basel II

CRM is applicable both for funded and non-funded exposure. Only banking book exposures

(exposures held for regular bank business i.e. not applicable for trading, for sale, etc.) are

considered for CRM. In addition, where issue specific rating reflects CRM, no additional

supervisory recognition of CRM will be granted to avoid double counting effects. Collateral

as a CRM tool may be posted by a third party besides recognizing collateral of the counter

party (borrower). Collateral must be charged to the bank for the life of the exposure, it must

be ‘marked to market’ and revalued at least once in six months. Appropriate haircuts as may

be specified by the regulatory authorities of each country are to be considered in CRM tool.

P a g e | 58


Financing banks must have clear and robust procedures for the timely liquidation of

collateral. Exposures covered by collateral would have risk weights as applicable for the

respective collateral subject to a minimum of 20 per cent (for cash, however, nil per cent).

Third party guarantees would be recognized for CRM, provided the guarantees meet the

relevant laid down conditions and the regulatory authorities are satisfied in this regard.

6.5.2 Eligible Collaterals for CRM Purpose

Basel II has viewed collaterals eligible for CRM from two perspectives:

1. Financial Collateral

2. Non–Financial collateral

It is apparent that financial collaterals imply cash or near cash collaterals such as fixed

deposit in a bank, highly rated marketable securities, etc. Any other approved collateral like

gold will be treated as nonfinancial collateral. Cash, Certificate of Deposit (fixed deposit,

short deposit, etc.) issued by the lending bank (hence by implication such deposits held with

the other banks even when lien is offered will not be treated as eligible). So, this has huge

implication in credit risk management in Dhaka Bank Limited. The effect of such rule will

push banks like DBL to not giving any loans against security of other bank.

6.6 Basel II in Bangladesh

On December 30, 2007 Bangladesh Bank issued BRPD Circular no. 14 to all scheduled banks

in Bangladesh which depicted the action plan regarding implementation of Basel-II as follow:

Basel II started its implementation from January 2009. In this regard a quantitative impact

study (QIS) to assess the preparedness for implementing Basel II as well as the bank’s view

on the optional approaches for calculating Minimum Capital Requirement (MCR) as stated in

Basel II was carried out in April-May 2007. Study & subsequent discussion with few related

banks reveal that bankers should be more acquainted with the New Capital Accord (Basel-II).

To address this challenge capacity building of concerned implementing & supervisory

officials should be given first priority in the Action Plan/Roadmap. Basel II may be

implemented with the following specific approaches as initial steps:

a) Standardized Approach for calculating Risk Weighted Amount (RWA) against Credit

Risk supported by External Credit Assessment Institutions (ECAIs)

P a g e | 59


b) Standardized Rule Based Approach against Market Risk and

c) Basic Indicator Approach for Operational Risk.

6.6.1 Action Plan

Accordingly, Action Plan/ Roadmap for implementing Basel II in Bangladesh may be

proposed as stated below:

Table 8: Basel II Implementation Action Plan

P a g e | 60


P a g e | 61


6.6.2 Basel II implementation status in Dhaka Bank

Dhaka Bank considers implementation of Risk Based Capital Adequacy for Banks is one of

its topmost priorities. Accordingly Dhaka Bank has established a Basel II Implementation

P a g e | 62


Unit (BIU) in the 1st quarter of year 2007 for effective implementation of the capital accord

ensuring Board and Senior Management oversight. The BIU is exclusively assigned with the

task of reviewing the nature and level of risks relating to banking assets and planning for

adequate capital framework. The BIU members meet on regular basis, at least monthly to

monitor implementation status of Risk Based Capital Adequacy of Banks and also those

issues which directly affect capital requirement.

In a view to make the BIU more functional Dhaka Bank has formed Basel II coreTeam

headed by Deputy Managing Director (Business Banking). Dhaka Bank has been successful

to meet all the deadlines so far as prescribed by Bangladesh Bank with quality deliverables

like quarterly Minimum Capital Reporting, Position Paper etc. The Bank has nominated

Credit Rating Information and Services Ltd. (CRISL) and Credit Rating Agency of

Bangladesh (CRAB).

As per BB directive, Banks must maintain 8% CAR upto June 2010. From July 2010, they

have to maintain CAR of 9% and from July 2011 the CAR level will reach to 10%.

6.7 Problems Facing During Implementation

Though Basel II implementation is started in Bangladesh, there are some challenges and

problems in the way, some of them are present and some are potential. These are discussed

below:

One of the present problems is the Standardized Approach and External Credit Rating

organizations. Standardized approach makes use of external credit ratings for attaching risk

weights. One of the major problems is the availability of credit ratings in Bangladesh, though

it has two Credit Rating agencies (Credit Rating Information and Services Limited and Credit

Rating Agency of Bangladesh Ltd.), the penetration of credit ratings is not deep. The supply-

demand imbalance would make it even more difficult for smaller players to get ratings. High

prices are making credit more costly for them.

Though standardized approach is being followed for credit risk for the time being, after some

time all the banks have to switch to the Internal Rating Based Approach which is much

superior to the standardized one. But, it will be very difficult to implement IRB in

Bangladesh. A major problem of IRB implementation is data availability. In Bangladesh,

State-owned banks are still in the process of computerization. The extent of historical data

P a g e | 63


required to formulate and then convincingly test. The IRB based approach being one of the

more stringent approaches is the more ideal of the two to strengthen the financial system. The

actual implementation of an IRB based model for credit risk mitigation would require

excellent information retrieval and assessment capabilities. A high-end IT Infrastructure with

Risk Management Software collating real-time information is needed. This preparedness is

not there in a majority of banks in Bangladesh. Hurrying into an IRB based approach could

cost banks dearly because of the involvement of high capital expenditure. Inaccurate IRB

models could defeat the very purpose of better risk mitigation.

The Basel II definition of a banking company is very broad and includes banking subsidiaries

such as insurance companies. In Bangladesh, there is no single regulator to govern the whole

‘bank’ as per Basel II. In Bangladesh, Securities Exchange Commission, Bangladesh Bank,

National Board of Revenue, Dhaka Stock Exchange and Ministry of Finance would regulate

different aspects of Basel II. The consolidated balance sheet of the bank has to conform to

Capital adequacy regulations. In Bangladesh, Regulatory capital norms do not apply to

Insurance companies. The Pillar II implementation is the more difficult portion of the three

pillars. Risk Audits in banks are still in their nascent stages in Bangladesh. The availability of

trained risk auditors is another problem. Basel II calls for a Risk Management structure in

banks with Risk Management committees for Credit, Market and operational Risk

formulating the Risk Management standards. While banks in Bangladesh are implementing

this, it has remained a ceremonial process without the training at the grass root level to see

every activity with the lens of risk.

Pillar 3 is not a very useful discipline device in countries with small private markets or few

incentives for creditors to monitor banks (e.g. due to presence of implicit public guarantees).

In addition, the Pillar 3 might be inapplicable in those countries whose systems are

dominated by foreign banks, since the latter will likely have entered by purchasing and

delisting the domestic institution. Since those banks are not obliged to publicly disclose

information for their operations in such jurisdictions (unless requested by the domestic

authorities), there is little market transparency or discipline.

Another big problem in the way of Basel II implementation is unavailability of required risk

data in easily accessible or comprehensive format. Historical loss data is required to calculate

the main IRB risk parameters; that data are frequently incomplete/ unavailable (i.e. not

required to be collected in the past) or prohibitively expensive to collect (i.e. not in electronic

P a g e | 64


format). Particularly for the development of rating systems and LGD parameters, individual

banks may not have a meaningful loss dataset to enable them to build the required models

and back-test their performance. In such an environment, it is essential to tackle the root

causes of this problem (e.g. legal or cultural factors impeding loss data collection and

sharing) prior to proceeding with Basel II adoption.

These are some problems that need to be taken care of with the implementation of Basel II.

Unless these problems are overcome, full implementation of Basel II would not be possible.

P a g e | 65

CHAPTER 7CAPITAL REQUIREMENT FOR CREDIT RISK UNDER BASEL II FOR DBL


7.0 Capital requirement for Credit Risk under Basel-II in DBL

The first pillar of Basel-II states about minimum capital requirement for three kinds of risk

viz. credit risk, market risk and operational risk. In this report only capital requirement for

credit risk has been covered thoroughly and it also gives the main calculation of capital for

other two risks. In the following sections capital has been calculated according to the

guideline provided by Bangladesh Bank. The capital ratio is calculated using the definition of

regulatory capital and risk-weighted assets. Until, June 2010, the total capital ratio must be no

lower than 8%, whereas from July 2010 the ratio must be no lower than 9%.

Total risk-weighted assets are determined by multiplying the capital requirements for market

risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and

adding the resulting figures to the sum of risk-weighted assets for credit risk.

7.1 The constituent of capital

7.1.1 Core capital (basic equity or Tier 1)

The Basel Committee considers that the key element of capital on which the main emphasis

should be placed is equity capital and disclosed reserves. This key element of capital is the

only element common to all countries' banking systems; it is wholly visible in the published

accounts and is the basis on which most market judgments of capital adequacy are made; and

it has a crucial bearing on profit margins and a bank's ability to compete. This emphasis on

equity capital and disclosed reserves reflects the importance the Committee attaches to

securing an appropriate quality, and the level, of the total capital resources maintained by

major banks.

Notwithstanding this emphasis, the member countries of the Committee also consider that

there are a number of other important and legitimate constituents of a bank's capital base

which may be included within the system of measurement. The Committee has therefore

concluded that capital, for supervisory purposes, should be defined in two tiers in a way

which will have the effect of requiring at least 50% of a bank's capital base to consist of a

core element comprised of equity capital and published reserves from post-tax retained

earnings (Tier 1). The other elements of capital (supplementary capital) will be admitted into

Tier 2 limited to 100% of Tier 1.

P a g e | 67


Table 9: Core Capital calculation of Dhaka Bank Limited

Tier 1 (Core Capital) of Dhaka Bank Ltd (as on 31.03.2010) BDT

(in crores)

1.1 Paid-up Capital 265.96

1.2 Non-repayable Share Premium Account -

1.3 Statutory Reserve 197.03

1.4 General Reserves 0.38

1.5 Retained Earnings 32.18

1.6 Minority Interest in Subsidiaries -

1.7 Non-cumulative irredeemable Preference Shares -

1.8 Dividend Equalisation Account -

1.9 Sub-Total (1.1 to 1.8) 495.55Deductions:

1.1 Book value of Goodwill -1.11 Shortfall in provisions required against classified assets irrespective of

any relaxation allowed.-

1.12 Deficit on account of revaluation of investments held in AFS category -1.13 Any increase in equity capital resulting from a securitization transaction -

1.15 Other deductions (50% of the amount as calculated on CAP 2) -

1.16 Sub-Total (1.10 to 1.15) -1.17 Total eligible Tier 1 capital (1.9-1.16) 495.55

7.1.2 Supplementary Capital (Tier 2)

Undisclosed reserves

Unpublished or hidden reserves may be constituted in various ways according to differing

legal and accounting regimes in member countries. Under this heading are included only

reserves which, though unpublished, have been passed through the profit and loss account

and which are accepted by the bank's supervisory authorities. They may be inherently of the

same intrinsic quality as published retained earnings, but, in the context of an internationally

agreed minimum standard, their lack of transparency, together with the fact that many

countries do not recognize undisclosed reserves, either as an accepted accounting concept or

as a legitimate element of capital, argue for excluding them from the core equity capital

element.

2. Revaluation reserves

Some countries, under their national regulatory or accounting arrangements, allow certain

assets to be revalued to reflect their current value, or something closer to their current value

P a g e | 68


than historic cost, and the resultant revaluation reserves to be included in the capital base.

Such revaluations can arise in two ways:

(a) from a formal revaluation, carried through to the balance sheets of banks' own premises;

or

(b) from a notional addition to capital of hidden values which arise from the practice of

holding securities in the balance sheet valued at historic costs. Such reserves may be included

within supplementary capital provided that the assets are considered by the supervisory

authority to be prudently valued, fully reflecting the possibility of price fluctuations and

forced sale.

General provisions/general loan-loss reserves

General provisions or general loan-loss reserves are created against the possibility of losses

not yet identified. Where they do not reflect a known deterioration in the valuation of

particular assets, these reserves qualify for inclusion in Tier 2 capital. Where, however,

provisions or reserves have been created against identified losses or in respect of an identified

deterioration in the value of any asset or group of subsets of assets, they are not freely

available to meet unidentified losses which may subsequently arise elsewhere in the portfolio

and do not possess an essential characteristic of capital. Such provisions or reserves should

therefore not be included in the capital base.

The supervisory authorities represented on the Committee undertake to ensure that the

supervisory process takes due account of any identified deterioration in value. They will also

ensure that general provisions or general loan-loss reserves will only be included in capital if

they are not intended to deal with the deterioration of particular assets, whether individual or

grouped.

This would mean that all elements in general provisions or general loan-loss reserves

designed to protect a bank from identified deterioration in the quality of specific assets

(whether foreign or domestic) should be ineligible for inclusion in capital. In particular,

elements that reflect identified deterioration in assets subject to country risk, in real estate

lending and in other problem sectors would be excluded from capital.

General provisions/general loan-loss reserves that qualify for inclusion in Tier 2 under the

terms described above do so subject to a limit of 1.25 percentage points of weighted risk

assets to the extent a bank uses the Standardized Approach for credit risk.

P a g e | 69


Hybrid debt capital instruments

In this category fall a number of capital instruments which combine certain characteristics of

equity and certain characteristics of debt. Each of these has particular features which can be

considered to affect its quality as capital. It has been agreed that, where these instruments

have close similarities to equity, in particular when they are able to support losses on an on-

going basis without triggering liquidation, they may be included in supplementary capital. In

addition to perpetual preference shares carrying a cumulative fixed charge, the following

instruments, for example, may qualify for inclusion: long-term preferred shares in Canada,

titres participatifs and titres subordonnés à durée indéterminée in France, Genussscheine in

Germany, perpetual debt instruments in the United Kingdom and mandatory convertible debt

instruments in the United States.

Subordinated term debt

The Committee is agreed that subordinated term debt instruments have significant

deficiencies as constituents of capital in view of their fixed maturity and inability to absorb

losses except in liquidation. These deficiencies justify an additional restriction on the amount

of such debt capital which is eligible for inclusion within the capital base. Consequently, it

has been concluded that subordinated term debt instruments with a minimum original term to

maturity of over five years may be included within the supplementary elements of capital, but

only to a maximum of 50% of the core capital element and subject to adequate amortization

arrangements.

Table 10: Tier-2 Capital Calculation of Dhaka Bank Limited as on 31.03.2010

Tier 2 Capital of Dhaka Bank Ltd (Taka in crores)2.1 General Provisions (Unclassified loans + off balance seet exposure) 84.132.2 Asset Revaluation Reserves up to 50% -2.3 All other preference shares -2.4 Up to 50% of Revaluation Reserves for securities 12.522.5 Perpetual subordinated debt up to max 30% -

2.6 Balance of Exchange Equalization A/C 0.122.7 Total tier 2 Capital (2.1 to 2.5) 96.77

Deductions:

2.8 Other deductions (50% of the amount as calculated on CAP 2) -

2.9 Total Deductions -

2.10 Total eligible Tier 2 Capital (2.6-2.8) 96.77

P a g e | 70


7.1.3 Short-term subordinated debt covering market risk (Tier 3)

The principal form of eligible capital to cover market risks consists of shareholders’ equity

and retained earnings (Tier 1 capital) and supplementary capital (Tier 2 capital) as defined

above. But banks may also, at the discretion of their national authority, employ a third tier of

capital (“Tier 3”), consisting of short-term subordinated debt as defined in below for the sole

purpose of meeting a proportion of the capital requirements for market risks, subject to the

following conditions:

Banks will be entitled to use Tier 3 capital solely to support market risks.

Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to sup-

port market risks.

Tier 2 capital may not exceed total Tier 1 capital, and long-term subordinated debt

may not exceed 50% of Tier 1 capital

The sum total of Tier 2 plus Tier 3 capital should not exceed total Tier 1.

However, the Committee has decided that any decision whether or not to apply such a rule

should be a matter for national discretion. Some member countries may keep the constraint,

except in cases where banking activities are proportionately very small. Additionally,

national authorities will have discretion to refuse the use of short-term subordinated debt for

individual banks or for their banking systems generally.

For short-term subordinated debt to be eligible as Tier 3 capital, it needs, if circumstances

demand, to be capable of becoming part of a bank’s permanent capital and thus be available

to absorb losses in the event of insolvency. It must, therefore, at a minimum:

be unsecured, subordinated and fully paid up

have an original maturity of at least two years

not be repayable before the agreed repayment date unless the supervisory authority

agrees

be subject to a lock-in clause which stipulates that neither interest nor principal may

be paid (even at maturity) if such payment means that the bank falls below or remains

below its minimum capital requirement.

P a g e | 71


7.1.4 Deductions from capital

It has been concluded that the following deductions should be made from the capital base for

the purpose of calculating the risk-weighted capital ratio. The deductions will consist of:

(i) Goodwill, as a deduction from Tier 1 capital elements;

(ii) Increase in equity capital resulting from a securitization exposure, as a deduction from

Tier 1 capital elements;

(iii) Investments in subsidiaries engaged in banking and financial activities which are not

consolidated in national systems. The normal practice will be to consolidate subsidiaries for

the purpose of assessing the capital adequacy of banking groups.

The Committee carefully considered the possibility of requiring deduction of banks' holdings

of capital issued by other banks or deposit-taking institutions, whether in the form of equity

or of other capital instruments. The Committee is very conscious that such double-gearing (or

"double-leveraging") can have systemic dangers for the banking system by making it more

vulnerable to the rapid transmission of problems from one institution to another and some

members consider these dangers justify a policy of full deduction of such holdings.

7.2 Credit Risk – The Standardized Approach:

For credit risk management under Basel II the standardized approach is used in DBL as per

the directives of Bangladesh Bank. Though this approach is not very highly acclaimed among

the experts all over the world, it is simple and easy to implement. For developing countries

like Bangladesh, slow implementation of Internal Rating Based approach will be justified one

as there is lack of trained and knowledgeable person regarding this approach in Bangladesh.

7.2.1 Claims on sovereigns

Claims on sovereigns and their central banks will be risk weighted as follows:

Credit

Assessment

AAA to

AA-

A+ to A- BBB+ to

BBB-

BB+ to B- Below B- Unrated

Risk Weight 0% 20% 50% 100% 150% 100%

DBL has no claims on sovereigns so risk weighted asset in this category in zero.

P a g e | 72


7.2.2 Claims on non-central government public sector entities (PSEs)

Claims on domestic PSEs will be risk-weighted at national discretion, according to either

option 1 or option 2 for claims on banks. When option 2 is selected, it is to be applied without

the use of the preferential treatment for short-term claims.

Subject to national discretion, claims on certain domestic PSEs may also be treated as claims

on the sovereigns in whose jurisdictions the PSEs are established.23 Where this discretion is

exercised, other national supervisors may allow their banks to risk weight claims on such

PSEs in the same manner. DBL also does not have any exposure on 31st march, 2010 in this

category.

7.2.3 Claims on multilateral development banks (MDBs)

The risk weights applied to claims on MDBs will generally be based on external credit

assessments as set out under option 2 for claims on banks but without the possibility of using

the preferential treatment for short-term claims. A 0% risk weight will be applied to claims

on highly rated MDBs that fulfill to the Committee’s satisfaction the criteria provided below.

The Committee will continue to evaluate eligibility on a case-by-case basis. The eligibility

criteria for MDBs risk weighted at 0% are:

very high quality long-term issuer ratings, i.e. a majority of an MDB’s external

assessments must be AAA;

shareholder structure is comprised of a significant proportion of sovereigns with long-

term issuer credit assessments of AA- or better, or the majority of the MDB’s fund-

raising are in the form of paid-in equity/capital and there is little or no leverage;

strong shareholder support demonstrated by the amount of paid-in capital contributed

by the shareholders; the amount of further capital the MDBs have the right to call, if

required, to repay their liabilities; and continued capital contributions and new

pledges from sovereign shareholders;

adequate level of capital and liquidity (a case-by-case approach is necessary in order

to assess whether each MDB’s capital and liquidity are adequate); and,

P a g e | 73


strict statutory lending requirements and conservative financial policies, which would

include among other conditions a structured approval process, internal

creditworthiness and risk concentration limits (per country, sector, and individual

exposure and credit category), large exposures approval by the board or a committee

of the board, fixed repayment schedules, effective monitoring of use of proceeds,

status review process, and rigorous assessment of risk and provisioning to loan loss

reserve.

7.3.4 Claims on banks

There are two options for claims on banks. National supervisors will apply one option to all

banks in their jurisdiction. No claim on an unrated bank may receive a risk weight lower than

that applied to claims on its sovereign of incorporation. Under the first option, all banks

incorporated in a given country will be assigned a risk weight one category less favorable

than that assigned to claims on the sovereign of that country. However, for claims on banks in

countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk weight

will be capped at 100%.

The second option bases the risk weighting on the external credit assessment of the bank

itself with claims on unrated banks being risk-weighted at 50%. Under this option, a

preferential risk weight that is one category more favorable may be applied to claims with an

original maturity of three months or less, subject to a floor of 20%. This treatment will be

available to both rated and unrated banks, but not to banks risk weighted at 150%.

DBL has chosen the first option and After calculation, RWA for claims on Banks & NBFI

stands at 309.66 crore whereas total exposure is 754.25 crore.

Credit assessment

of Sovereign

AAA to

AA-

A+ to

A-

BBB+

to

BBB-

BB+

to

B-

Below

B-

Unrated

Risk weight under 20% 50% 100% 100% 150% 100%

P a g e | 74


7.3.5 Claims on securities firms

Claims on securities firms may be treated as claims on banks provided these firms are subject

to supervisory and regulatory arrangements comparable to those under this Framework

(including, in particular, risk-based capital requirements). Otherwise such claims would

follow the rules for claims on corporate. DBL has no exposure in this category on last quarter

of the year.

7.3.6 Claims on corporate

The table provided below illustrates the risk weighting of rated corporate claims, including

claims on insurance companies. The standard risk weight for unrated claims on corporate will

be 100%. No claim on an unrated corporate may be given a risk weight preferential to that

assigned to its sovereign of incorporation.

Credit

assessment

AAA to

AA-

A+ to A- BBB+ to

BB-

Below

BB-

Unrated

Risk weight 20% 50% 100% 150% 125%

As most of the companies of Bangladesh are not rated, the risk weighted asset for exposure

on corporate loan will be much higher as the risk weight is more than 100%. If looked at the

calculation then the real picture will come out. DBL’s total exposure to corporate loan on

31.03.2010 stands at 3001.87 crore but as the most of the clients are unrated, RWA has gone

up to 3738.07 crore which is almost 25% higher. Since, DBL’s maximum loan exposure is in

this category, it is suffering heavily for unrated clients as it has to keep more capital

according to Basel II requirement.

7.3.7 Claims included in the regulatory retail portfolios

Claims that qualify under the criteria listed below may be considered as retail claims for

regulatory capital purposes and included in a regulatory retail portfolio. Exposures included

in such a portfolio may be risk-weighted at 75%, except as provided for past due loans.

To be included in the regulatory retail portfolio, claims must meet the following four criteria:

P a g e | 75


Orientation criterion: The exposure is to an individual person or persons or to a small

business;

Product criterion: The exposure takes the form of any of the following: revolving

credits and lines of credit (including credit cards and overdrafts), personal term loans

and leases (e.g. installment loans, auto loans and leases, student and educational

loans, personal finance) and small business facilities and commitments. Securities

(such as bonds and equities), whether listed or not, are specifically excluded from this

category. Mortgage loans are excluded to the extent that they qualify for treatment as

claims secured by residential property.

Granularity criterion: The supervisor must be satisfied that the regulatory retail

portfolio is sufficiently diversified to a degree that reduces the risks in the portfolio,

warranting the 75% risk weight. One way of achieving this may be to set a numerical

limit that no aggregate exposure to one counterpart can exceed 0.2% of the overall

regulatory retail portfolio.

Low value of individual exposures: The maximum aggregated retail exposure to one

counterpart cannot exceed an absolute threshold of €1 million.

In this category, DBL has exposure of Tk. 687.57 crore and RWA is calculated as Tk. 515.68.

7.3.8 Claims secured by residential property

Lending fully secured by mortgages on residential property that is or will be occupied by the

borrower, or that is rented, will be risk weighted at 50%. In applying the 50% weight, the

supervisory authorities should satisfy themselves, according to their national arrangements

for the provision of housing finance, that this concessionary weight is applied restrictively for

residential purposes and in accordance with strict prudential criteria, such as the existence of

substantial margin of additional security over the amount of the loan based on strict valuation

rules. Supervisors should increase the standard risk weight where they judge the criteria are

not met. As on 31.03.2010, RWA for the above category stands at 44.97 crore whereas the

total exposure is 89.94 (Appendix).

P a g e | 76


7.3.9 Claims secured by commercial real estate

In view of the experience in numerous countries that commercial property lending has been a

recurring cause of troubled assets in the banking industry over the past few decades, the

Committee holds to the view that mortgages on commercial real estate do not, in principle,

justify other than a 100% weighting of the loans secured. As on 31.03.2010, RWA for the

above category stands at 42.52 crores.

7.3.10 Past due loans

The unsecured portion of any loan (other than a qualifying residential mortgage loan) that is

past due for more than 90 days, net of specific provisions (including partial writeoffs), will be

risk-weighted as follows:

150% risk weight when specific provisions are less than 20% of the outstanding

amount of the loan. RWA for this category on 31.03.2010 is 395.78 crore whereas the

total exposure is Tk. 263.85 crores.

100% risk weight when specific provisions are no less than 20% of the outstanding

amount of the loan. RWA for this category on 31.03.2010 is 73.29 crore.

100% risk weight when specific provisions are no less than 50% of the outstanding

amount of the loan, but with supervisory discretion to reduce the risk weight to 50%.

As per Bangladesh Bank directive, the risk weight is now 50%. RWA for this

category on 31.03.2010 is 17.82 crore whereas the total exposure is Tk. 35.64 crores.

For the purpose of defining the secured portion of the past due loan, eligible collateral and

guarantees will be the same as for credit risk mitigation. Past due retail loans are to be

excluded from the overall regulatory retail portfolio when assessing the granularity criterion.

In the case of qualifying residential mortgage loans, when such loans are past due for more

than 90 days they will be risk weighted at 100%, net of specific provisions. If such loans are

past due but specific provisions are no less than 20% of their outstanding amount, the risk

weight applicable to the remainder of the loan can be reduced to 50% at national discretion.

P a g e | 77


7.3.11 Off-balance sheet items:

Off-balance-sheet items under the standardized approach will be converted into credit

exposure equivalents through the use of credit conversion factors (CCF). Counterparty risk

weightings for OTC derivative transactions will not be subject to any specific ceiling.

Commitments with an original maturity up to one year and commitments with an original

maturity over one year will receive a CCF of 20% and 50%, respectively. However, any

commitments that are unconditionally cancelable at any time by the bank without prior

notice, or that effectively provide for automatic cancellation due to deterioration in a

borrower’s creditworthiness, will receive a 0% CCF.

Direct credit substitutes, e.g. general guarantees of indebtedness (including standby letters of

credit serving as financial guarantees for loans and securities) and acceptances (including

endorsements with the character of acceptances) will receive a CCF of 100%. Sale and

repurchase agreements and asset sales with recourse, where the credit risk remains with the

bank will receive a CCF of 100%.

A CCF of 100% will be applied to the lending of banks’ securities or the posting of securities

as collateral by banks, including instances where these arise out of repo-style transactions

(i.e. repurchase/reverse repurchase and securities lending/securities borrowing transactions).

Forward asset purchases, forward deposits and partly-paid shares and securities, which

represent commitments with certain drawdown will receive a CCF of 100%. Certain

transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and

standby letters of credit related to particular transactions) will receive a CCF of 50%. Note

issuance facilities (NIFs) and revolving underwriting facilities (RUFs) will receive a CCF of

50%. For short-term self-liquidating trade letters of credit arising from the movement of

goods (e.g. documentary credits collateralized by the underlying shipment) a 20% CCF will

be applied to both issuing and confirming banks.

Total RWA for off-balance sheet item on 31.03.2010 is 638.63 crores.

P a g e | 78


7.3.12 Credit risk mitigation

Banks use a number of techniques to mitigate the credit risks to which they are exposed.

Exposure may be collateralized in whole or in part with cash or securities, or a loan exposure

may be guaranteed by a third party. Where these various techniques meet the operational

requirements below credit risk mitigation (CRM) may be recognized.

The framework set out is applicable to the banking book exposures under the simplified

standardized approach. No transaction in which CRM techniques are used should receive a

higher capital requirement than an otherwise identical transaction where such techniques are

not used. The effects of CRM will not be double counted. Therefore, no additional

supervisory recognition of CRM for regulatory capital purposes will be granted on claims for

which an issue-specific rating is used that already reflects that CRM. Principal-only ratings

will also not be allowed within the framework of CRM.

Although banks use CRM techniques to reduce their credit risk, these techniques give rise to

risks (residual risks) which may render the overall risk reduction less effective. Where these

risks are not adequately controlled, supervisors may impose additional capital charges or take

other supervisory actions.

While the use of CRM techniques reduces or transfers credit risk, it simultaneously may

increase other risks to the bank, such as legal, operational, liquidity and market risks.

Therefore, it is imperative that banks employ robust procedures and processes to control these

risks, including strategy; consideration of the underlying credit; valuation; policies and

procedures; systems; control of roll-off risks; and management of concentration risk arising

from the bank’s use of CRM techniques and its interaction with the bank’s overall credit risk

profile. On 31st March, 2010 RWA for claims under credit risk mitigation stood at Tk. 127.88

crore.

7.4 Capital Adequacy Ratio

Bangladesh Bank adopted the idea of Capital Adequecy Ration through BRPD Circular in

1996. It advised assessment of Capital Adequacy on the basis of Risk Weighted Assets.

Capital Adequacy Ratio =Tier I Capital+Tier 2 Capital

Risk Weighted Assets× 100

P a g e | 79


Total RWA for Dhaka Bank on March 31, 2010 is summarized below in the table. As this

report focuses on the credit risk of Basel II framework, detailed calculation of market risk and

operational risk is not given here.

Table 11: Risk Weighted Asset for DBL

Risk Weighted Assets (RWA) for Tk. in crores

A. Credit Risk

On Balance Sheet 5743.856382.48

Off-Balance Sheet 638.63

B. Market Risk1 21.07 263.34

C. Operational Risk2 56.45 705.67

Total RWA 7351.49

In the following table, calculation of Minimum Capital Requirement is shown. From the

table, it is clear that, DBL has certainly met the requirement as it has over Tk. 4 crore of

surplus. CAR is just above 8% and Core capital to RWA is 6.74% which is quite good.

Table 12: Minimum Capital Requirement under Risk Based Capital

Particulars Tk. in crore

A. Eligible Capital

1. Tier 1 (Core Capital) 495.55

2. Tier 2 (Supplementary Capital) 96.77

3. Tier 3(eligible fo market risk only) -

4. Total Eligible Capital 592.32

B. Total Risk Weighted Asset (RWA) 7351.49

C. Capital Adequacy Ratio (CAR) 8.06%

D. Core Capital to RWA 6.74%

E. Minimum Capital Requirement (MCR) 588.12

1 RWA for Market Risk is calculated by multiplying the total exposure by 12.52 Same as above for operational risk

P a g e | 80


7.5 Trend Analysis

A trend analysis has been done on three important variable of credit risk management under

Basel II. The variables are total eligible capital, RWA and CAR. The trend analysis is done

on last four quarters, i.e. from June 2009 to March 2010.

From the following figure, the trend in total eligible capital can be seen. Total eligible capital

increased almost Tk. 82 crore in the last year.

Figure 10: Total Eligible Capital

This capital includes both Tier 1 and Tier 2. It can also be seen from the figure that total

eligible capital gives a nose dive in the 3rd quarter of the year 2009, whereas in all other

quarter it increased satisfactorily.

Risk weighted asset is also a

very important variable in

Basel II. In standardized

approach, it depends heavily

on the rating of ECAIs. As

DBL deals mainly with the

corporate clients and few

clients have done credit

rating of them, the risk

weighted asset is increasing

day by day as the loan

portfolio is growing. But,

P a g e | 81

Figure 11: Risk Weighted Asset


this increase of RWA will create pressure on bank to increase the capital substantially and

which is not that easy. From the figure 11, it can be seen that, RWA increased very largely in

the last two quarter, so to maintain, adequate CAR, the bank has to increase its capital which

can be seen from figure 10.

In the last figure, the trend of CAR is shown. As per BB directives, Basel II has a parallel run

with Basel I in 2009

and capital adequacy

ratio requirement

was above 7% at that

time. But from, 2010

Basel II is in full

effect. So, the CAR

must be above 8%

which is kept by

DBL as seen from

the figure 12. In all

the quarter Capital

Adequacy Ratio was above 7% which is good compliance with the set norm. But the bank

will be in a big challenge when this ratio must be maintained over 9% from July 2010. Either

the bank has to enhance the capital or decrease the RWA to improve the CAR. The next

section will show some ways to enhance the capital.

7.6 Capital Raising Option

Bank can increase their tier 1 and tier 2 capital if needed to comply with the BB directive.

Some of the ways are shown below:

7.6.1 Tier 1 Capital

Banks can maintain their capital in 8 (eight) constituents of Tier I capital as specified before.

Four of them, namely, Statutory Reserve, General Reserve, Retained Earnings and Dividend

Equalization Account are greatly dependent on annual income of a bank. A certain percent-

age of income that is retained as per requirement of the Banking Companies Act (BCA) 1991

is named as Statutory Reserve. General Reserve is made to meet contingencies which are in-

determinate at the time of making such reserve. Retained earnings are defined as sharehold-

P a g e | 82

Figure 12: Capital Adequacy Ratio (CAR)


ers' equities in a banking company resulting from earnings in excess of losses and declared

dividends. The purpose of Dividend Equalization Account is to create a fund in those years in

which profits are large, so as to enable the bank to pay dividend at normal rate when profits

are small. Thus a bank cannot enhance capital immediately in these items to meet any regula -

tory obligation.

A bank can raise capital and non-repayable premium account by issuing right share, bonus

share and IPOs. But a bank whose shares have already been floated in the stock market can

further expand capital base by issuing either bonus shares or right shares or both. Issue of

bonus share again depends on genuine annual profit of a bank. This process does not enhance

financial resources of a bank; rather it converts earnings into shares. Whether a bank can is-

sue share at premium depends on each share's existing net worth value which, among other,

also depends on its accumulated earnings.

The above analysis indicates that if regulation requires banks to raise Tier I capital substan-

tially, the immediate option available for listed banks is to issue right shares. For the state-

owned banks government will require to inject capital while branches of foreign banks will

require collecting funds from their parent office. In addition, banks can respond to regulator's

instruction by issuing non-cumulative irredeemable preference shares. But there is a lack of

regulatory guideline regarding issue of such instruments.

7.6.2 Tier II Capital

As mentioned earlier, Tier II capital comprises of General Provision, Asset Revaluation Re-

serve, Preference Shares, and Perpetual Subordinated Debt Account. Banks maintain general

provision out of their business earnings. So they cannot raise general provision immediately

in response to enhancement of regulatory capital. Similar argument can be applied for asset

revaluation reserve and exchange equalization account. Since Bangladesh is following free

floating exchange rate policy since May 2003, exchange equalization account has become in-

effective in reality. In these circumstances, the options available for banks to raise Tier II

capital are either to issue perpetual subordinated debt or to issue preference share or to issue

both. However, there are no regulatory guidelines for the issuance of such instruments.

P a g e | 83

CHAPTER 8IMPACT OF ADOPTION OF BASEL II IN DHAKA BANK LIMITED


8.0 Impact of Adoption of Basel II in Dhaka Bank Limited

As Basel II implementation started in Bangladesh from 2010, the impacts of adoption are not

visible clearly yet. But, there will be some certain impacts. In the following those certain and

some potential impacts are discussed.

Improved Risk Management and Capital Adequacy

One aspect that the staunchest critics of Basel II agree to is the fact that it will tighten the risk

management process, improve capital adequacy and strengthen the banking system.

Impact on Customers

For DBL, Basel II is an internal management exercise that does not directly affect customers.

However, there has been a good deal of talk about Basel II leading to greater risk-based

pricing in loan markets, as it increases the difference in capital required between risky and

safer lending categories. This could lead to riskier types of debt, such as consumer finance,

costing more relative to safer categories such as loan to large corporate house. From 2010,

management of the Bank decided to give preference to the client rated by ECAI. It also will

extend its credit towards the good rated borrower. This scenario will bar the poor rated client

to avail any loan.

Shorter Term to maturity of lending

Both the Basel I and II accords have a preference for short-term lending. This is because of

the ease in exiting the investment in case the situation turns adverse. Also the interest rates on

short term will also tend to be lower further incentivising such borrowings. For this reason,

DBL is trying to attract shorter term borrowing to get the benefits. This shall impact both the

bank and ultimate borrowers because of the change in the interest rate term structure and the

need for Asset and Liability Management (ALM).

Impact on capital flows

Short Term lending will further increase the volatility of capital flows within Bangladesh,

from one bank to another. If any negative event occurs at any point of the flow, people will

get panicked. There would be a tendency to press the panic button at the smallest change in

the situation, further deteriorating it, leading to crisis.

P a g e | 85


Higher Interest Costs

Implementation of Basel II will force banks like Dhaka Bank to charge

more interest to risky customer as it has to keep some capital for that

loan. On the other hand, there are few good customers in Bangladesh, so

every bank will want them as their customer. So, competition will increase

and interest rate will fall for the well rated borrower.

Competitive Advantage of Corporate Borrowers

Corporate Banking is the main operating business model of Dhaka Bank Limited. But, in

Basel II advantage has been given to corporate borrowers with good rating. As the good

clients number is limited, and competition is huge. Dhaka Bank may lose some of its

customers.

Impact on Companies

The Shortened term funding of banks will find its way to the balance sheets of companies

because of the need for matching maturities. This would impact output levels in corporate

and skew the capital structure in favor of short term borrowings and working capital finance.

The Liquidity position and the companies’ ability to globalize would be hampered by this

difficulty in raising long-term capital.

The Vicious Circle of Curtailment of Credit to Developing Countries

This is countrywide impact which will hit all the financial organization in Bangladesh.

Developing countries like Bangladesh usually has lower sovereign rating. The lower ratings

will reduce the availability of funds in the developing countries. This has the potential to

deteriorate the situation in these countries leading to further recession. The reduced market

access and high costs of funding will further impact the ratings of these countries leading to a

vicious circle with each aspect feeding the other in a downward spiral.

In brief, these are some of the impacts that are felt and will be felt in future as DBL and other

banks adopt Basel II.

P a g e | 86

CHAPTER 9RECOMMENDATION


9.0 Recommendation

Dhaka Bank Limited has taken all the steps to implement Basel II. But there is an apprehen-

sion of capital shortfall in MCR (Minimum Capital Requirement) in the next quarter as the

level of CAR is going up by 1%. So, DBL has to raise capital very quickly to remain compli -

ant as before. At the current level of risk weighted asset the Bank may need additional Tk.

150 crore of Tier 1 capital to meet up the shortfall. Moreover, from 2011 the CAR will be

10% which will almost require additional Tk. 350 crore of total eligible capital if the growth

of loan portfolio remains stable. As Basel II has direct impact on credit risk management, re-

maining compliant should be the first priority to operate business. Though Dhaka Bank Lim-

ited is taking necessary steps to stay ahead of the action plan of Bangladesh Bank, the follow-

ing recommendation can be useful.

1. To meet the capital shortfall in Tier 1 capital, DBL should issue right shares of Tk.

100 crore. The existing shareholders can purchase these shares in rights. It will help

DBL to maintain a good ratio of core capital to risk weighted asset ratio. Offering

right share will not harm the current shareholders, offering them the right share is a

reward for them. It will create a positive brand image of the Bank.

2. To meet the capital shortfall in Tier 2 capital, DBL can issue subordinated bond.

These bonds will be unsecured, non convertible and DBL can issue bonds upto Tk.

250 crore. Issuing subordinated bonds does not create any problems for the existing

shareholder. If DBL issues these two types of securities, the shortfall problem will not

remain when Basel II will run at full force.

3. DBL should look for comprehensive IT solution for Basel II. Bangladesh will go to

implement the foundation IRB approach in 2012 and this approach requires extensive

Management Information System.

4. Management should set up a unit, which will work under the supervision of BIU,

whose task will be to encourage the clients to be rated by ECAI. This unit will also

keep contact with the ECAIs to gather borrower information. This will help speed up

the process of rating..

P a g e | 88


5. The Bank should recalculate its lending rate on a periodic basis to cope with changing

lending scenario caused by Basel II.

6. The Bank should introduce Risk Based Pricing. For this, Credit officer must be skilled

enough to understand the procedure.

7. No new borrower should be given credit facility without being rated by ECAI.

8. As there are few good customers in the market, extra attention should be given to

them as intense competition is taking place.

9. The Bank should concentrate more on short term lending as it charges less capital ac-

cording to Basel II.

10. To be fully compliant with BASEL II requirements, the bank should develop histori-

cal databases on probability of default (PD) and loss given default (LGD). Such data-

bases will enable the bank to compute expected loss (EL) from any new credit ap-

proval.

11. For credit risk mitigation purpose, the collateral accepted by Basel II only, should be

taken as security.

12. When assessing collateral, the bank should be mindful that the value of the collateral

might be impaired by the same factors that have led to the diminished recoverability

of the credit.

13. An investigative review should be carried out on significant cases. The review should

enable the bank to understand better how problem credits and losses develop and

identify weaknesses in the banking institution’s existing credit-granting process and

monitoring process.

P a g e | 89


References

Aggarwal, R. & Jacques, K. (1998), "Assessing the impact of prompt corrective action on

bank capital and risk," Economic Policy Review, Federal Reserve Bank of New York, issue

October, pp. 23-32.

Bangladesh Bank (2007), “Basel II Road Map”, December 30, 2007.

Basel Committee on Banking Supervision (2000), “Principles for the Management of Credit

Risk.” Basel, pp. 1-15

Basel Committee on Banking Supervision (2006),“International Convergence of Capital

Measurement and Capital Standards’, A Revised Framework Comprehensive Version”,

Bank for International Settlements.

Blum, J. (1999), “Do Capital Adequacy Requirements Reduce Risks in Baking?”, Journal of

Banking and Finance, vol 23, pp. 755-71.

Ediz, T., Michael, I. M. and Perraudin, W. R. M. (1998), “Bank Capital Dynamics and

Regulatory Policy”, Bank of England mimeo.

Ferri, G. and Kang, T. S. (1999), “The Credit Channel at Work: Lessons from the Financial

Crisis in Korea”, Economic Notes, 28, No. 2, 195-221.

Furlong, F. T. and Keely, M. C. (1989), “Capital regulation and bank risk-taking: A note”,

Journal of Banking and Finance, 13, 883-891.

Gennote, G. and Pyle, D. (1991), “Capital Controls and Bank Risk,” Journal of Banking and

Finance, 15, 805-41.

Hart, O.D. and Jaffe, D.M. (1974), “On the application of portfolio theory to depository

financial intermediaries,” Review of Economic Studies, 41, 129-147.

Jacques, K.T. and Nigro, P. (1997), “Risk-Based Capital, Portfolio Risk, and Bank Capital: A

Simultaneous Equations Approach,” Journal of Economic and Business, 533-47.

Kim, D. and Santomero, A.M. (1988), “Risk in Banking and Capital Regulation,” Journal of

Finance, 43, 1219-33.

P a g e | 90


Koehn, M. and Santomero, A.M. (1980), “Regulation of Bank Capital and Portfolio Risk,”

Journal of Finance, 35, 1235-44.

Marshall, D.A. and Prescott, E.S. (2000), “Bank Capital Regulation with and Without State-

Contingent Penalties,” Federal Reserve Bank of Chicago Working Paper,10.

Rime, B. (2001), “Capital Requirements and Bank Behavior: Empirical Evidence for

Switzerland,” Journal of Banking and Finance, 25, 798-805.

Rochet, J.C. (1992), “Capital Requirements and the Behavior of Commercial Banks”,

European Economic Review, 36, 1137-78.

Sheldon, G. (1996), “Capital Adequacy Rules and the Risk-Seeking Behavior of Banks: A

Firm-Level Analysis”, Swiss Journal of Economics and Statistics, 132,709-734.

Shrieves, R. E. and Dhal, D. (1992),”The Relationship between Risk and Capital in

Commercial Banks,” Journal of Banking and Finance, 16, 439-57

Patric, V. R. (2003), “Impact of the 1988 Basel Accord on banks’ capital ratios and credit

risk taking: an international study”, European Center for Advanced Research in Economics

and Statistics, Universite Libre de Bruxelles, Working Paper.

Vlaar, P. J. (2000), “Capital Requirements and Competition in the Banking Industry,” Federal

Reserve Bank of Chicago, Working Paper, 18.

Ward, J. (2002), “The New Basel Accord and Developing Countries: Problems and

Alternatives”, Cambridge Endowment of Research Finance, Working Paper No. 4, 14.

P a g e | 91

APPENDICES