IMaCS 2010Printed 11-May-11
Page 1For Classroom discussion only
Agenda for Day 5
Presentation of Cases by Participants
Lunch Break
IMaCS’ Recommendations to Banks
Session on current regulations in Bangladesh
Discussions on Issues Raised
IMaCS 2010Printed 11-May-11
Page 2For Classroom discussion only
Regulatory framework: Banks
• Tk. 200 croreMinimum Capital
• 10%• 5% Core Capital
Capital adequacy ratio
• Not more than % of capital in a bank may be acquiredwithout the approval of the Bangladesh Bank.Ownership
• Up to xx%Foreign ownership
• 365 days (in case of asset financing) , 180 days (incase of loans and other exposures)Provisioning
• YesAvailability of deposit insurance facility for
depositors
IMaCS 2010Printed 11-May-11
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Categories of Loans
Categories of Loans
Continuous Loan
Demand Loan
Fixed Term Loan
Short-term
Agricultural and Micro
Credit
If any uncertainty or
doubt arises in respect
of recovery of any
Continuous Loan,
Demand Loan or Fixed
Term Loan, the same
will have to be
classified on the basis
of qualitative judgment
be it classifiable or not
on the basis of
objective criteria
If any uncertainty or
doubt arises in respect
of recovery of any
Continuous Loan,
Demand Loan or Fixed
Term Loan, the same
will have to be
classified on the basis
of qualitative judgment
be it classifiable or not
on the basis of
objective criteria
IMaCS 2010Printed 11-May-11
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Loan Classification
• If not repaid/renewed within the fixed expiry date for repayment will be treated as past due/overdue from the following day of the expiry date
Past due/overdue
• A Continuous Loan/Demand loan/Term Loan which will remainoverdue for a period of 90 days or more, will be put into the "SpecialMention Account(SMA)"
Special Mention Account
• Sub-standard if it remains past due/overdue for 6 months or beyond but less than 9 months.Sub-standard
• `Doubtful' if for 9 months or beyond but less than 12 monthsDoubtful
• Bad-Debt' if for 12months or beyondBad-Debt
IMaCS 2010Printed 11-May-11
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Provisioning Norms …1
Classified Continuous, Demand and Fixed Term Loans
Sub-standard 20%
Doubtful 50%
Bad/Loss 100%
Provision in respect of Short-term Agricultural and Micro-Credits is to be maintained at the following rates
All credits except 'Bad/Loss'(i.e. 'Doubtful', 'Sub-standard', irregular and regular credit accounts)
5%
'Bad/Loss' 100%
IMaCS 2010Printed 11-May-11
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Provisioning Norms…2
Banks will be required to maintain General Provision
All unclassified loans (other than loans under ConsumerFinancing and Special Mention Account
1%
Unclassified amount for Consumer Financing whereas it has tobe maintained @ 2% on the unclassified amount for (i) Housing Finance and (ii) Loans for Professionals to set up business under Consumer Financing Scheme.
5%
Outstanding amount of loans kept in the 'Special MentionAccount' (SMA) after netting off the amount of Interest Suspense.
5%
IMaCS 2010Printed 11-May-11
Page 7For Classroom discussion only
Agenda for Day 5
Presentation of Cases by Participants
Lunch Break
IMaCS’ Recommendations to Banks
Session on current regulations in Bangladesh
Discussions on Issues Raised
IMaCS 2010Printed 11-May-11
Page 8For Classroom discussion only
Governance framework for Risk Management
Organization structure with well defined roles
and responsibilities
Formulation of policies, processes and formation of different committees
Monitor execution through periodic reviews done by these committees
Robust reporting and analysis infrastructure for
early warnings or monitoring trends
Review of existing policies, processes and
systems and modifications if required
IMaCS 2010Printed 11-May-11
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Risk Management Process and Tools
Pre Sanction
Appraisal
Assessment through rating models
Prudential exposure limits
Post Sanction Pre disbursement
Execution of all documents
Meeting pre disbursement conditions
Post disbursement
DP report and stock audits
Monitoring report
Branch Compliance Certificate
Loan Review Mechanism
Re-rating of large accounts annually
Default
Special Mention Accounts report
NPA reporting
Evaluate decoupling of origination and assessment /
credit rating
Evaluate possibility of setting up a centralized legal
cell
Sector wise, product wise rating migrations
Sector wise, product wise NPA and SMA rating
IMaCS 2010Printed 11-May-11
Page 10For Classroom discussion only
Policy for Internal Capital Adequacy Assessment Process : Objectives
periodical internal audit
� Enunciate Bank’s overall risk philosophy
� Define acceptable risk measurement methodologies including risk mitigation
mechanisms
� Ability to assess capital adequacy to ensure
� Compliance with Bangladesh Bank guidelines
� Adequate capital as buffer to ensure business stability simultaneously with rapid growth
� Provide better internal governance environment and facilitate proactive Capital
Budgeting
� Define organization structure and responsibilities for effective internal assessment
process including reporting mechanisms
� Ensure continued validity and relevance of risk assessment methodologies through
periodical internal audit
IMaCS 2010Printed 11-May-11
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ICAAP framework
Identification of all material risks
Measurement and reporting of all
the material risks
Capital cushion based on
understanding of implicit risks
Linking capital requirements to
the level of Risks
Strategy for ensuring capital
adequacy
Oversight process and
structure
� RMD, CRMC, ORMC & ALM Cell
� Based on materiality
� Measurement methodology aligned with RBI guidelines
� Scenarios sensitized to bank’s profile
� Required to manage unexpected scenarios
� Stress testing framework to provide a measure of capital cushion
�Additional Capital for normal growth
�Additional capital for increased risks
�Additional Capital for normal growth
�Additional capital for increased risks
�Reporting of risks assessed
� Reporting of CRAR
�Actions
IMaCS 2010Printed 11-May-11
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Capital Planning
Additional Capital
Requirement
Strategy to acquire riskier assets for
higher target profitability or entry
into new areas
Expected asset growth with the
same portfolio mix
Stress test results indicate a breach in
tolerance levels
Planned investments
Notional capital cushion for risks not mentioned in
Pillar I and could be based on the stress
test results
IMaCS 2010Printed 11-May-11
Page 13For Classroom discussion only
Importance of Risk Based Pricing
� Aligns the incentive for a bank to balance risk with return
� Pricing is a tool to maintain proactive provisioning
� Necessary for value creation and preservation
� Building block for credit risk management
IMaCS 2010Printed 11-May-11
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Pre-requisites for “Risk Pricing” credit - A Bank must have the capability to generate...
� Loss given default
� History of risk score of borrowers
� Variance in loss given default
Information on defaults associated with the risk score � Information on defaults associated with the risk score of borrowers
IMaCS 2010Printed 11-May-11
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Computing Risk Premia - Expected Loss
ExpectedLoss (EL)
ExposureatDefault(EAD)
Probability of Default (PD)
Borrower Risk Score
1
2
3
4
5
6
7
8
9
10
PD
.05%
-
-
-
10%
-
-
-
-
100%
Loss Given Default (LGD)
Collateral Type
1
2
3
4
5
6
7
8
9
10
LGD
5%
-
-
-
20%
-
-
-
-
75%
x x=
IMaCS 2010Printed 11-May-11
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Present status in many banks - How mis-pricing of risk is harmful.
• Good credit risks subsidising the poor credit risk accounts
• Threat of disintermediation leaves banks with poor credit risk accounts
• Already beginning to happen in most markets
The cross-subsidy
Bank pricing
Good credits overpriced
Risk-basedpricing
“Bad risks” under-priced
Subsidy
AAA BBB
%
Risk
Interest rate
IMaCS 2010Printed 11-May-11
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Risk Based Pricing - An example
Cost of Funds 5.50%Cost of Funds 5.50%
Cost of Operation 1.00%Cost of Operation 1.00%
1
2
3
4
Risk Adjusted Pricing (1+2+3+4)
=
8.78 %
Return on Capital (I*V*VI) (Loan Size %) 1.28%Return on Capital (I*V*VI) (Loan Size %) 1.28%
Expected Loss (III*IV) 1.00%Expected Loss (III*IV) 1.00%
Risk Grading B+I Loan Size (Tk. Crore) 100II Tenor (Years) 5III Probability of Default 2%IV Loss Given Default 50%V Hurdle Rate on Equity (Share holder Expectation) 16%VI Capital as % of funded assets 8%VII Cost of Funds for 5 Yr Tenor (From FTP) 5.50%
Client: XYZ
IMaCS 2010Printed 11-May-11
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� Banks’ activities are increasingly arranged along business unit lines to improve
focus
� Shareholders demand optimum risk-adjusted return on their risk capital
� Bank Management is able to allocate scarce capital among business units based on their potential risk-adjusted performance
Performance Measurement
Performance Budgeting
Capital Allocation
Lending decision
RAROC is gaining popularity as it links investor aspirations to Management goals
IMaCS 2010Printed 11-May-11
Page 19For Classroom discussion only
5 steps to RAROC of a loan/ business line/ portfolio
STEP 1: Calculate Net Interest EarnedSTEP 1: Calculate Net Interest Earned
STEP 2: Calculate Expected Loss
STEP 3: Calculate the Risk-Adjusted Spread
STEP 4: Calculate the Risk Capital to be allocated for that activity
STEP 5: Calculate RAROC from inputs of Step 3 and 4
IMaCS 2010Printed 11-May-11
Page 20For Classroom discussion only
RAROC: Step 1 of 5
Net Interest earned = (Interest Rate –Interest Expenses) x Amount of Loan
1.Interest rate is market determined on which the banker has limited control
2.Interest expense depends on bank’s cost of funds and is given by ALM
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
IMaCS 2010Printed 11-May-11
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RAROC: Step 2 of 5
Expected Loss = Probability of Default x Loss Given Default x Amount of loan
1.Probability of Default can be derived from transition matrix
2. Loss given default is the proportion of
money lost after recoveries on a defaulted
account
-
STEP 5 Calculate RAROC from inputs of Step 3 and 4
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
IMaCS 2010Printed 11-May-11
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RAROC: Step 3 of 5
Risk Adjusted Spread *=
Net Interest Earned (Step 1)
Less: Expected Loss (Step 2)
Less: Administrative Expenses
Add: Non-interest income
This is similar to risk-based pricing , but RAROC goes a step further
* The spread is in absolute amount
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
IMaCS 2010Printed 11-May-11
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RAROC: Step 4 of 5
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
Capital Allocated *= Standard Risk Weight (of an asset) x Minimum Regulatory capital x Loan amount
*Capital allocated may be Regulatory Capital
IMaCS 2010Printed 11-May-11
Page 24For Classroom discussion only
RAROC: Step 5 of 5
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
STEP 1 Calculate Net Interest Earned
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
STEP 4 Calculate the Risk Capital to be allocated for that activity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
Risk-Adjusted Spread (Step 3)
Risk Capital (Step 4)
If the RAROC is higher than the “Hurdle
rate” a loan is acceptable in terms of
risk/return
RAROC =
IMaCS 2010Printed 11-May-11
Page 25For Classroom discussion only
Credit Risk framework under Basel II
Credit RiskAlign regulatory capital more closely with economic capital
Measurement
Standardised Method
IRB Method
Foundation
Advanced
Regulatory
Economic Capital
Supervisory Risk weights and Credit Risk Mitigation
IMaCS 2010Printed 11-May-11
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Ownership and policy review
� The policy would be reviewed regularly to incorporate
� Additional material risks as and when they arise and are measurable
� Changes in risk measurement methodology based on regulatory
directives or implementation of various tools
� Reporting by different functions and levels
� Risk Management Department would review and maintain the policy
IMaCS 2010Printed 11-May-11
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Recommendations for Systems supporting credit process
� Risk Management Solution to be used for capturing origination data
� Sanction process workflow to be automated based on defined rules
� Credit rating to be automated and centralized
� User profiles to avoid conflicts of interest and decouple rating from
origination
� Capture data for rejected loan application and make it available in a
centralized manner
� Collateral management can be done using Risk Management Solution
IMaCS 2010Printed 11-May-11
Page 28For Classroom discussion only
DISCUSSIONS
IMaCS 2010Printed 11-May-11
Page 29For Classroom discussion only
All the contents of the presentation are confidential and
should not be published, reproduced or circulated without the
written consent of IFC, Bangladesh Bank and IMaCS.