Credit Risk Grading and Limit Setting at Eastern Bank Limited

The main objective of this report is to analysis Credit Risk Grading and Limit Setting at Eastern Bank Limited. General objectives of this reports are to familiarize with practical job environment, have an exposure on the financial institutions such as banking environment of Bangladesh and gain experience on different functions of banking business in Bangladesh. Here also examine the Financial practice in Banking Business and examine the Credit Policies and practices at EBL. Finally this report make swot analysis Credit Risk Grading and Limit Setting at Eastern Bank Limited.

OBJECTIVES OF THE STUDY

• To familiarize with practical job environment
• To have an exposure on the financial institutions such as banking environment of Bangladesh
• To gain experience on different functions of banking business in Bangladesh
• To examine the Financial practice in Banking Business
• To examine the Credit Policies and practices at EBL
• To acquire in–depth knowledge over EBL’s International Division’s work flow and their inter division dependencies where my knowledge of finance will be practiced
• To gather the actual knowledge about the HR operations in the organizations

INTRODUCTION

The emergence of Eastern Bank Limited in the private sector is an important event in the banking industry of Bangladesh. Eastern Bank Limited started its business as a public limited company on August 08, 1992 with the primary objectives to carry on all kinds of banking business in and outside of Bangladesh and also with a view to safeguard the interest of the depositors of erstwhile BCCI [Bank of Credit and Commerce International (Overseas)] under the Reconstruction Scheme, 1992, framed by Bangladesh Bank.

In 1991, when BCCI had collapsed internationally, the operation of this bank had been closed in Bangladesh. After a long discussion with the BCCI employees and taking into consideration the depositors’ interest, Bangladesh Bank then gave the permission to form a bank named Eastern Bank Limited which would take over all the assets, cash and liabilities of erstwhile BCCI in Bangladesh, with effect from August 16, 1992. So, it can be said the EBL is a successor of BCCI.

EBL started its business as a scheduled bank with only four branches, which included Principal Branch, Dhaka; Motijheel Branch, Dhaka; Agrabad Branch, Chittagong and Khulna Branch. EBL started its business with motto to grow as a leader in the banking arena of Bangladesh through better counseling and efficient service to clients. EBL resumed its operational activities initially with an authorized capital of Tk. 1000 million, divided into 10 million shares of Tk. 100 each and paid up capital of Tk. 310 million. The initial shareholders were the NCBs, various govt. agencies, and some of the depositors who had agreed to accept shares in the new bank in lieu of their deposits. The first Board of Directors of EBL constituted under govt. supervision, consisted of 7 directors from various business and professions. Eastern Bank Limited was under government control until the end of 2000 and therefore, there were lots of deficiencies in the Bank’s management. In 2001, the board of directors brought in new professional management from various foreign banks who have been trying to modernize the bank ever since.

OBJECTIVES OF EASTERN BANK LIMITED

Maximization of profit along with the benefits of employees is the main objective of the bank. In addition, the other objectives are:

• To be one of the leading banks of Bangladesh in terms of ROE and ROE
• To be the market leader in high quality banking products and services
• Achieve excellence in customer service through providing the most modern and advanced state-art technological in the different spheres of banking
• Cater to a broader and differentiated segment of retail and wholesale customers.
• To grow its credit extension service to the commercials as well industrial sector;
• To increase its diversification of loan portfolio and geographical coverage
• To curd present operating expenses further so as to increase earning before tax
• To reduce the burden of non performing assets

HISTORICAL REVIEW AND DIFFERENT MILESTONES OF EBL

In the year of 1992 EBL started their banking operation in the country. Within these 15 years EBL became one of the successful banks in Bangladesh. They are able to gain this huge success because of their employee’s honesty, integration and hard work.

EBL dreams to be the bank of choice of the general public which includes both the consumer and the corporate clients. It has adopted the tag line “simple math”, the philosophy of Easy Banking while celebrating the 10^th anniversary in 2002, EBL’s logo was changed to reflect the restricting and the transformations it is going through; the colors of the new logo signify the vibrant green of mother earth, a blue sky full of possibilities and a yellow rising sun of hope.  In order to achieve superior growth and financial performance for its shareholders, EBL is radically transforming the way it dies business .The bank has already restructured from the traditional geographic matrix (branch based banking) to business unit matrix. The bank is also centralizing most of the business functions in the head office to ensure greater control and efficiency.

FINANCIAL PERFORMANCE INDICATORS

CURRENT BANKING SCENARIO OF BD AND EBL’S POSITION IN THE MARKET

From the beginning of the year 2004, the entire banking industry in Bangladesh started facing stiff competition to procure business, under the changed circumstances of the policy of BB to lower the rates of interest in lending and to go for syndication against large loan portfolios with the objective to ensure better operation and control of all functions of the bank. Despite such situation the year was a remarkable on for EBL when the bank finally completed the introduction of a state-of-the art IT technology platform of Flex Cube, a world class banking software. All of bank’s 25 braches were connected to this IT platform giving an enviable opportunity to all the EBL customers to obtain the most coveted services that no other bank could offer them yet.

To cope with the status quo, Eastern Bank Limited welcomed these developments and restructured the bank to meet the challenges in future. The branches of the bank are now termed as the “Sales & Services Center” which are solely concentrated providing service to the corporate and consumer clients and maintain relationship with them. 2006, last year was another year of continued success of EBL across all the business units. The Bank has made an Operating Profit growth of 28.6% to BDT 1,358 million during the year but suffered a decline of Profit after Tax by 6.1% to BDT 513 million mainly due to increased general provisioning requirement by BB and disallowance of specific provision in tax computation. Therefore EPS dropped to BDT 61.98 in 2006 against BDT 66.00.

Corporate Banking remains the major bread earner with largest volume of loan portfolio and fees income. Adding 3 more branches at strategic locations, Consumer Banking supplied the major part of funding assets of corporate and SME, one of the potential business segments. EBL Treasury has passed a superb year 2006 by achieving an extraordinary growth of FX income by 130% to the tune of BDT 434 million by exploiting market volatility. Investment income also grew by 47.48% due to govts increased borrowing at higher rates.

CREDIT RISK MANAGEMENT [PORTFOLIO DIVERSIFICATION]

Comprehensive risk management is a core competence of EBL. EBL take a prudent and conservative approach to risk that is fully aligned with their long-term strategy. The risk framework combines centralized policy setting with board oversight supported by risk execution and monitoring. It provides management with the ability to oversee the bank’s large and highly diversified portfolio effectively and efficiently.

EBL’s risk management systems are designed to identify and analyze risks management processes by establishing a credit risk management policy, credit underwriting standards, and credit risk rating methodology. It also established a Credit Risk Management Division, which is independent from relationship management units to ensure proper controls on its lending.

CSR OF THE EASTERN BANK LIMITED

In this 21st century, the social responsibility of an organization is unavoidable. The societal marketing concept holds that the organization should determine the needs wants, and interests of target markets. It should then deliver superior value to customers in a way that maintains or improves the consumer’s and the society’s well-being. In this concept the marketers will maximize the consumers’ value in the long run rater than short run to maximize their profit.

The bank realizes the importance of contributing to the public, community, and society as a whole as well as participating in environmental protection and conservation for a sustainable future. EBL ensures that the customer already having production facility that is susceptible to damage environment has due environmental clearance certificate from the concerned ministry while granting or renewing credit facility. Every year EBL contribute their in various types of social activities, are; awarding the talent student through “talent hunt”, monetary contribution in the disable fund, contribute increasing public awareness about the social ills and the most recently EBL contributed BDT 320 million in the Chief Advisors fund for the flood affected people.  No one in society can avoid the due responsibilities, EBL’s position is positive in this regard and they wish to find a suitable segment to work with in future to meet the corporate social responsibility.

CONCLUSION

Since banks deal with customer’s hard earned cash and finances business, it is natural financial organization largely depends on the service quality, promotional activity, personnel effort and distribution. EBL is the first local private bank in Bangladesh which has implanted the strategy of Centralization. The ultimate goal of following this strategy is to maximizing the profit and also reduces the amount of bad debts and in most reduces the internal conflicts. EBL has diversified its assets and remittance, loan portfolio and now EBL is focusing on establishing a leading small and medium enterprise as well as adding value added consumer banking products to satisfy its customers better as it lunched Simple Credit Card with the fullest possibilities of modern credit card. It has restructured its business process to meet the challenges of rapidly evolving technology based banking services, in the awake of growing competition in the financial service industry and changes in the customer needs. For EBL, hope is shining on the horizon; it is no far that EBL will be the number one private commercial bank in Bangladesh.

Credit Risk Grading & Limit Setting at Eastern Bank Limited

Credit Risk Grading Manual of Bangladesh Bank was circulated by Bangladesh Bank vide BRPD Circular No. 18 dated December 11, 2006 on Implementation of Credit Risk Grading Manual which is primarily in use for assessing the credit risk grading before a bank lend to its borrowing clients. Since the nature of business as well as leverage level of Banks and Non Banking Financial Institutions is different from that of other borrowing clients, the need for a separate Credit Risk Grading Manual has been felt. Keeping this in mind and with a view to properly risk rate a Bank in order to set up counter party limits for providing credit products extended by one bank to another Bank this Credit Risk Grading Manual for the Bank has been produced. The Credit Risk Grading Manual developed for a Bank shall be an effective tool to help a Bank to take a sound decision in analyzing credit risk on another bank and to set up a credit limit for money market and other business operations. This Credit Risk Grading Manual has taken into consideration the important aspects required in order to correctly assess the operation of a Banking Financial Institution and will ensure a very objective approach to credit risk grading and is easier to implement. All Banks should adopt this credit risk grading system outlined in this manual for assessing the credit risk in case they need to take exposure on another bank.

At the pre-sanction stage, credit grading helps the sanctioning authority to decide whether to lend or not to lend, what should be the pricing for a particular exposure, what the extent should be of exposure, what should be the appropriate credit facility and the various risk mitigation tools. At the post-sanction stage, the bank can decide about the depth of the review or renewal, frequency of review, periodicity of the grading, and other precautions to be taken. Having considered the significance and necessity of credit risk grading for a Bank, it becomes imperative to develop a credit risk grading model which meets the objective outlined above. This manual describes in detail the process required to spread and analyze the financial statement of a bank, identify the critical risk elements, mitigate these risk and provide appropriate weightage and marking to the risk element and thereby arrive at a systematic risk grading for an effective credit decision.

DEFINITION OF CREDIT RISK GRADING (CRG)

The Credit Risk Grading (CRG) is a collective definition based on the pre-specified scale and reflects the underlying credit-risk for a given exposure. A Credit Risk Grading deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit exposure. Credit Risk Grading is the basic module for developing a Credit Risk Management system.

FUNCTIONS OF CREDIT RISK GRADING

Well-managed credit risk grading systems promote bank safety and soundness by facilitating informed decision-making. Grading systems measure credit risk and differentiate individual credits and groups of credits by the risk they pose. This allows bank management and examiners to monitor changes and trends in risk levels. The process also allows bank management to manage risk to optimize returns.

USE OF CREDIT RISK GRADING

• The Credit Risk Grading matrix allows application of uniform standards to credits to ensure a common standardized approach to assess the quality of an individual obligor and the credit portfolio as a whole.
• As evident, the CRG outputs would be relevant for credit selection, wherein either a borrower or a particular exposure/facility is rated. The other decisions would be related to pricing (credit spread) and specific features of the credit facility.
• Risk grading would also be relevant for surveillance and monitoring, internal MIS and assessing the aggregate risk profile. It is also relevant for portfolio level analysis.

POLICY GUIDELINES

This section details fundamental Credit Risk Management policies that are recommended for adoption by all banks in Bangladesh. The guidelines contained herein outline general principles that are designed to govern the implementation of more detailed lending procedures and risk grading systems within individual banks.

• LENDING GUIDELINES

Eastern Bank Limited has established Credit Policies (“Lending Guidelines”) that 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.  The Lending Guidelines are being updated at least annually to reflect changes in the economic outlook and the evolution of the bank’s loan portfolio, and is distributed to all lending/marketing officers. The Lending Guidelines is approved by the Managing Director/CEO & Board of Directors of the bank based on the endorsement of the bank’s Head of Credit Risk Management and the Head of Corporate/Commercial Banking. Any departure or deviation from the Lending Guidelines is explicitly identified in credit applications and a justification for approval provided.  Approval of loans that do not comply with Lending Guidelines is restricted to the bank’s Head of Credit or Managing Director/CEO & Board of Directors.

The Lending Guidelines should provide the key foundations for account officers/relationship managers (RM) to formulate their recommendations for approval, and should include the following:

• INDUSTRY AND BUSINESS SEGMENT FOCUS

The Lending Guidelines is a clear identification to the business/industry sectors that should constitute the majority of the bank’s loan portfolio.  For each sector, a clear indication of the bank’s appetite for growth should be indicated (as an example, Textiles: Grow, Cement: Maintain, Construction: Shrink).  This will provide necessary direction to the bank’s marketing staff.

• TYPES OF LOAN FACILITIES

The type of loans that are permitted should be clearly indicated, such as Working Capital, Trade Finance, Term Loan, etc.

• SINGLE BORROWER/GROUP LIMITS/SYNDICATION

Details of the bank’s single Borrower/Group limits should be included as per Bangladesh Bank guidelines. Eastern Bank Limited may wish to establish more conservative criteria in this regard, provides brief description of financing under syndicated arrangement.

• LENDING CAPS

Banks should establish a specific industry sector exposure cap to avoid over concentration in any one industry sector.

• DISCOURAGED BUSINESS TYPES

Eastern Bank Limited has outlined industries or lending activities that are discouraged.  As a minimum, the following should be discouraged:

• Military Equipment/Weapons Finance.
• Highly Leveraged Transactions.
• Finance of Speculative Investments.
• Logging, Mineral Extraction/Mining, or other activity that is ethically or environmentally sensitive.
• Lending to companies listed on CIB black list or known defaulters.
• Counterparties in countries subject to UN sanctions.
• Share lending.
• Taking an Equity Stake in Borrowers.
• Lending to Holding Companies.
• Bridge Loans relying on equity/debt issuance as a source of repayment.

• LOAN FACILITY PARAMETERS

Facility parameters (e.g., maximum size, maximum tenor, and covenant and security requirements) should be clearly stated.   As a minimum, the following parameters should be adopted:

• Banks should not grant facilities where the bank’s security position is inferior to that of any other financial institution.
• Assets pledged as security should be properly insured.
• Valuations of property taken as security should be performed prior to loans being granted. A recognized 3rd party professional valuation firm should be appointed to conduct valuations.

• CROSS BORDER RISK

Eastern Bank Limited has identified risk associated with cross border lending. Borrowers of a particular country may be unable or unwilling to fulfill principle and/or interest obligations. Distinguished from ordinary credit risk because the difficulty arises from a political event, such as suspension of external payments

• Synonymous with political & sovereign risk
• Third world debt crisis

CREDIT ASSESSMENT & RISK GRADING

• CREDIT ASSESSMENT

A thorough credit and risk assessment should be conducted prior to the granting of loans, and at least annually thereafter for all facilities.  The results of this assessment should be presented in a Credit Application that originates from the relationship manager/account officer (“RM”), and is approved by Credit Risk Management (CRM).  The RM should be the owner of the customer relationship, and must be held responsible to ensure the accuracy of the entire credit application submitted for approval. RMs must be familiar with the bank’s Lending Guidelines and should conduct due diligence on new borrowers, principals, and guarantors.

It is essential that RMs know their customers and conduct due diligence on new borrowers, principals, and guarantors to ensure such parties are in fact who they represent themselves to be.  All banks should have established Know Your Customer (KYC) and Money Laundering guidelines which should be adhered to at all times.

Credit Applications should summaries the results of the RMs risk assessment and include, as a minimum, 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 should be addressed:

• Borrower Analysis. The majority shareholders, management team and group or affiliate companies should be assessed.  Any issues regarding lack of management depth, complicated ownership structures or inter-group transactions should be addressed, and risks mitigated.
• Industry Analysis. The key risk factors of the borrower’s industry should be assessed.  Any issues regarding the borrower’s position in the industry, overall industry concerns or competitive forces should be addressed and the strengths and weaknesses of the borrower relative to its competition should be identified.
• Supplier/Buyer Analysis. Any customer or supplier concentration should be addressed, as these could have a significant impact on the future viability of the borrower.
• Historical Financial Analysis. An analysis of a minimum of 3 years historical financial statements of the borrower should be presented.  Where reliance is placed on a corporate guarantor, guarantor financial statements should also be analyzed.  The analysis should address the quality and sustainability of earnings, cash flow and the strength of the borrower’s balance sheet.  Specifically, cash flow, leverage and profitability must be analyzed.
• Projected Financial Performance. Where term facilities (tenor > 1 year) are being proposed, a projection of the borrower’s future financial performance should be provided, indicating an analysis of the sufficiency of cash flow to service debt repayments.  Loans should not be granted if projected cash flow is insufficient to repay debts.
• Account Conduct. For existing borrowers, the historic performance in meeting repayment obligations (trade payments, cheques, interest and principal payments, etc) should be assessed.
• Adherence to Lending Guidelines. Credit Applications should clearly state 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 should approve Credit Applications that do not adhere to the bank’s Lending Guidelines.
• Mitigating Factors. Mitigating factors for risks identified in the credit assessment should be 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.
• Loan Structure. The amounts and tenors of financing proposed should be 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.
• Security. A current valuation of collateral should be obtained and the quality and priority of security being proposed should be assessed.  Loans should not be granted based solely on security. Adequacy and the extent of the insurance coverage should be assessed.
• Name Lending. Credit proposals should not be unduly influenced by an over reliance 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 should be discouraged and treated with great caution.  Rather, credit proposals and the granting of loans should be based on sound fundamentals, supported by a thorough financial and risk analysis.

RISK GRADING

Eastern Bank Limited has adopted a credit risk grading system.  The system has defined 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 a Bank’s asset quality, and as such, it is essential that grading is a robust process.  All facilities should be 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 should be clearly stated on Credit Applications. The more conservative risk grade (higher) should be applied if there is a difference between the personal judgment and the Risk Grade Scorecard results.  It is recognized that the banks may have more or less Risk Grades; however, monitoring standards and account management must be appropriate given the assigned Risk Grade.

PRINCIPAL RISK COMPONENTS

QUANTITATIVE FACTOR:

•  Capital Adequacy
• Asset Quality
•  Earnings Quality
•  Liquidity and Capacity of External Fund Mobilization
•  Size of the Bank & Market Presence

Key Parameters:

Key parameters corresponding to the Principal Risk Components of Quantitative Factors are detailed as follows.

Each of the key parameters mentioned below shall be evaluated, analyzed and reviewed in order to conclude on the credit risk grading of a banking company and which are as follows:

Key Parameters for Capital Adequacy

• Bank’s plan to raise equity to support its growth (Internal Capital Generation)
• Minimum Capital Adequacy Requirement (CAR) set by Bangladesh Bank
• Leverage ratio of the bank is satisfactory
• Dividend policy of the Bank

Key Parameters for Asset Quality

• Risk Management includes exhaustive pre-approval and post – approval activities.
• Portfolio Management System.
• Level of non performing loans.
• Amount of largest exposure to a single client/group, who are these and how many are nonperforming.
• Sector from where the gross NPL are coming from
• Are classified loans being followed regularly with clear action plan for recovery?
• Have Credit Risk Grading of clients are in place and effective.
• Portfolio Diversity (Industry wise breakdown of loans) & sectoral Concentration.
• Nature of security/collateral and the frequency of valuation.
• Quality of non-industrial lending.

Key Parameters for Earnings Quality

• Level of earnings
• Diversity of earnings
• Return on Assets (ROA)
• Return on Equity (ROE)
• Interest Rate Management, Interest rate policy (extent of change in lending and deposit rates and how this is likely to affect margins and profitability)
• Non funded business prospects and its contribution towards earnings
• Average cost of fund
• Average lending rate
• Average net spread
• Net Interest Income Margin (NIIM) trend is satisfactory
• Yield per taka staff cost

Key Parameters for Liquidity and Capacity of External Fund Mobilization

• Statutory Liquidity Reserve (SLR), Cash Reserve Requirement (CRR) and Loan Deposit Ratio compliance.
• Asset liability maturity structure.
• Bank’s liquidity ratio is satisfactory.
• Core asset funded by core liabilities.
• Impact on interest rate volatility on deposit and its trend.
• Ability to raise fund through stable sources in cost effective manner.
• Credibility of funding sources in distress situation.

Key Parameters for Size of the Bank & Market Presence

• Number of branch network and employees.
• Level of automation.
• Products and services offered are regularly reviewed.

PRINCIPAL RISK COMPONENTS:

QUALITATIVE FACTOR:

•  Management
•  Regulatory Environment & Compliance
•  Risk Management
•  Sensitivity to Market Risk
•  Ownership (Share holding pattern) & Corporate Governance
•  Accounting Quality
•  Franchise Value

Key Parameters:

Key parameters corresponding to the Principal Risk Components of Qualitative Factors are detailed as follows:

Each of the key parameters mentioned below shall be evaluated, analyzed and reviewed in order to conclude on the credit risk grading of a banking company and which are as follows.

Key Parameters for Management:

• Human resource based institutions
• Quality of Management (details of Senior Management, background of MD and other top executives)
• Experience and educational background of the senior, mid level and junior management
• Management Philosophy (Vision & Mission)
• Human resource development plans
• Quality of training being offered
• Management operating efficiency calculated on the basis of earning
• Emphasis placed on system & process based banking
• Staff turnover
• Emphasis to Information Technology and staff knowledge in this area

Key Parameters for Regulatory Environment & Compliance:

• Policy on loan classification and provisioning.
• Policy on large loans.
• Loan against Shares, Debentures etc.
• Disclosure requirement for banks.
• Delegation of power at operating level.
• Instructions for compliance of provisions of Money Laundering Prevention Act, 2002.
• Company has been operating satisfactorily in complying to the regulations of SEC and related bodies.
• Internal Control and Compliance mechanism.
• Status on Basel II compliance.

Key Parameters for Risk Management:

• Implementation of risk management in the areas of Credit Risk,
• Implementation of risk management in the areas of Operational Risk
• Implementation of risk management in the areas of and Market Risk

Key Parameters for Sensitivity to Market Risk

• Degree to which changes in interest rates can adversely affect company’s earnings.
• Degree to which changes in foreign exchange rates can adversely affect company’s earnings.
• Degree to which changes in commodity prices can adversely affect company’s business.

Key Parameters for Ownership (Share holding Pattern) & Corporate Governance:

• Ownership pattern & composition of Board (current shareholding with names of promoters)
• Conflict of interest issues in the operational management
• Personal policy and employee satisfaction
• Application of information technology in the system

Key Parameters for Accounting Quality:

• Policies for income recognition
• Provisioning and valuation of investment are examined
• Quality of Auditors

Key Parameters for Franchise Value

• Joint venture partner or Strategic Alliance.
• Management contract or Technical collaboration.
• Alliance/arrangement with World Bank/ADB/IFC/SEDF or awards/certification/recognition.

Financial Spread Sheet (FSS)

Before evaluation of the risk element of key parameters it is required to obtain Audited Financial Statement of a bank for at least 3 years period and should be spread in the Financial Spread Sheet which will help to properly analyze the financial trend of a particular bank on whom exposures are being taken.

A Financial Spread Sheet (FSS) has been developed which may be used for analyzing the credit risk elements of a banking company from financial point of view. The FSS is well designed and programmed software having two parts. Input and Output Sheets. The financial numbers of banks need to be inputted in the Input Sheets, which will then automatically generate the Output Sheets.

CREDIT RISK GRADING PROCESS

• Credit Risk Grading should be completed by a Bank for its counterparty bank for facilities extended to them.
• If any credit facilities are extended to a Bank against 100% cash covered or near cash covered securities or covered by Government Guarantee or Guarantee by a top tier International Bank then the Credit Risk Grading should be Superior – 1(SUP-1) and in that case the CRG score sheet is not required.
• Credit risk grading matrix would be useful in analyzing credit proposal, new or renewal for regular limits or specific transactions, if basic information on a borrowing client to determine the degree of each factor is a) readily available, b) current, c) dependable, and d) parameters/risk factors are assessed judiciously and objectively. The Relationship Manager as per data collection checklist should collect required information.
• Relationship manager should ensure to correctly fill up the Limit Utilization Form in order to arrive at a realistic earning status for the borrower.
• Key Risk Parameters are to be evaluated and weighted very carefully, on the basis of most up-to-date and reliable data and complete objectivity must be ensured to assign the correct grading.
• Credit risk grading exercise should be originated by Relationship Manager and should be an on-going and continuous process. Relationship Manager shall complete the Credit Risk Grading Score Sheet and shall arrive at a risk grading and document it which shall then be concurred by a Credit Officer.
• The credit officers then would pass the approved Credit Risk Grading Form to Credit Administration Department and Corporate Banking/Line of Business/Recovery Unit for updating their MIS/record.
• The appropriate approving authority through the same Credit Risk Grading Form shall approve any subsequent change/revision i.e. upgrade or downgrade in credit risk grade.

Early Warning Signals (EWS)

Early Warning Signals (EWS) indicate risks or potential weaknesses of an exposure requiring monitoring, supervision, or close attention by management.

If these weaknesses are left uncorrected, they may result in deterioration of the repayment prospects in the Bank’s assets at some future date with a likely prospect of being downgraded to classified assets. Early identification, prompt reporting and proactive management of Early Warning Accounts are prime credit responsibilities of all Relationship Managers and must be undertaken on a continuous basis.

Despite a prudent credit approval process, loans may still become troubled. Therefore, it is essential that early identification and prompt reporting of deteriorating credit signs be done to ensure swift action to protect the Bank’s interest. The symptoms of early warning signals as mentioned below are by no means exhaustive and hence, if there are other concerns, like breach of loan covenants or adverse market rumors that warrant additional caution. Irrespective of credit score obtained by any obligor (i.e. a Bank) as per the proposed risk grade score sheet, the grading of the account highlighted as Early Warning Signals (EWS) accounts shall have the following risk symptoms.

EXCEPTIONS TO CREDIT RISK GRADING

• Head of Credit Risk Management may also downgrade credit risk grading of a Bank in the normal course of inspection or during the periodic portfolio review. In such event, the Credit Risk Grading Form will then be filled up by Credit Risk Management Department and will be referred to Corporate Banking/Line of Business/Credit Administration Department/Recovery Unit for updating their MIS/records.
• Recommendation for upgrading of an account has to be well justified by the recommending officers. Essentially complete removal of the reasons for downgrade should be    the basis of any upgrading.
• In case an account is rated Marginal / Watchlist, Special Mention or unacceptable credit risk as per the risk grading score sheet, this may be substantiated and credit risk may be accepted if the exposure is additionally collateralized through cash collateral, good tangible collaterals or strong guarantees.

These are exceptions and should be exceptionally approved by the appropriate approving authority.

• Whenever required an independent assessment of the credit risk grading of an individual account may be conducted by the Head of Credit Risk Management or by the Internal Auditor documenting as to why the credit deteriorated and also pointing out the lapses.
• If a Bank has its own well established risk grading system to risk rate a Banking Company equivalent to the proposed credit risk grading or stricter, then they will have the option to continue with their own credit risk grading system.

CREDIT ADMINISTRATION

The Credit Administration function is critical in ensuring that proper documentation and approvals are in place prior to the disbursement of loan facilities.  For this reason, it is essential that the functions of Credit Administration be strictly segregated from Relationship Management/Marketing in order to avoid the possibility of controls being compromised or issues not being highlighted at the appropriate level.

Credit Administration procedures should be in place to ensure the following.

 DISBURSEMENT

• Security documents are prepared in accordance with approval terms and are legally enforceable. Standard loan facility documentation that has been reviewed by legal counsel should be used in all cases.  Exceptions should be referred to legal counsel for advice based on authorisation from an appropriate executive in CRM.
• Disbursements under loan facilities are only be made when all security documentation is in place. CIB report should reflect/include the name of all the lenders with facility, limit & outstanding. All formalities regarding large loans & loans to Directors should be guided by Bangladesh Bank circulars & related section of Banking Companies Act. All Credit Approval terms have been met.

CUSTODIAL DUTIES

• Loan disbursements and the preparation and storage of security documents should be centralized in the regional credit centres.
• Appropriate insurance coverage is maintained (and renewed on a timely basis) on assets pledged as collateral.
• Security documentation is held under strict control, preferably in locked fireproof storage.

COMPLIANCE REQUIREMENTS

• All required Bangladesh Bank returns are submitted in the correct format in a timely manner.
• Bangladesh Bank circulars/regulations are maintained centrally, and advised to all relevant departments to ensure compliance.
• All third party service providers (valuers, lawyers, insurers, CPAs etc.) are approved and performance reviewed on an annual basis. Banks are referred to Bangladesh Bank circular outlining approved external audit firms that are acceptable.

CREDIT MONITORING

To minimize credit losses, monitoring procedures and systems should be in place that provides an early indication of the deteriorating financial health of a borrower.  At a minimum, systems should be in place to report the following exceptions to relevant executives in CRM and RM team:

• Past due principal or interest payments, past due trade bills, account excesses, and breach of loan covenants;
• Loan terms and conditions are monitored, financial statements are received on a regular basis, and any covenant breaches or exceptions are referred to CRM and the RM team for timely follow-up.
• Timely corrective action is taken to address findings of any internal, external or regulator inspection/audit.
• All borrower relationships/loan facilities are reviewed and approved through the submission of a Credit Application at least annually.

Computer systems must be able to produce the above information for central/head office as well as local review. Where automated systems are not available, a manual process should have the capability to produce accurate exception reports. Exceptions should be followed up on and corrective action taken in a timely manner before the account deteriorates further.  Refer to the Early Alert Process.

EARLY ALERT PROCESS

An Early Alert Account is one that has risks or potential weaknesses of a material nature requiring monitoring, supervision, or close attention by management.

If these weaknesses are left uncorrected, they may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date with a likely prospect of being downgraded to CG 5 or worse (Impaired status), within the next twelve months.

Early identification, prompt reporting and proactive management of Early Alert Accounts are prime credit responsibilities of all Relationship Managers and must be undertaken on a continuous basis. An Early Alert report should be completed by the RM and sent to the approving authority in CRM for any account that is showing signs of deterioration within seven days from the identification of weaknesses. The Risk Grade should be updated as soon as possible and no delay should be taken in referring problem accounts to the CRM department for assistance in recovery.

Despite a prudent credit approval process, loans may still become troubled.  Therefore, it is essential that early identification and prompt reporting of deteriorating credit signs be done to ensure swift action to protect the Bank’s interest. Moreover, regular contact with customers will enhance the likelihood of developing strategies mutually acceptable to both the customer and the Bank.  Representation from the Bank in such discussions should include the local legal adviser when appropriate. An account may be reclassified as a Regular Account from Early Alert Account status when the symptom, or symptoms, causing the Early Alert classification have been regularized or no longer exist. The concurrence of the CRM approval authority is required for conversion from Early Alert Account status to Regular Account status.

CREDIT RECOVERY

The Recovery Unit (RU) of CRM should directly manage accounts with sustained deterioration (a Risk Rating of Sub Standard (6) or worse).  Banks may wish to transfer EXIT accounts graded 4-5 to the RU for efficient exit based on recommendation of CRM and Corporate Banking.  Whenever an account is handed over from Relationship Management to RU, a Handover/Downgrade Checklist should be completed.

The RU’s primary functions are:

• Determine Account Action Plan/Recovery Strategy
• Pursue all options to maximize recovery, including placing customers into receivership or liquidation as appropriate.
• Ensure adequate and timely loan loss provisions are made based on actual and expected losses.
• Regular review of grade 6 or worse accounts.

The management of problem loans (NPLs) must be a dynamic process, and the associated strategy together with the adequacy of provisions must be regularly reviewed. A process should be established to share the lessons learned from the experience of credit losses in order to update the lending guidelines.

NPL ACCOUNT MANAGEMENT

All NPLs should be assigned to an Account Manager within the RU, who is responsible for coordinating and administering the action plan/recovery of the account, and should serve as the primary customer contact after the account is downgraded to substandard.  Whilst some assistance from Corporate Banking/Relationship Management may be sought, it is essential that the autonomy of the RU be maintained to ensure appropriate recovery strategies are implemented.

ACCOUNT TRANSFER PROCEDURES

Within 7 days of an account being downgraded to substandard), a Request for Action and a handover/downgrade checklist should be completed by the RM and forwarded to RU for acknowledgment.  The account should be assigned to an account manager within the RU, who should review all documentation, meet the customer, and prepare a Classified Loan Review Report within 15 days of the transfer.  The CLR should be approved by the Head of Credit, and copied to the Head of Corporate Banking and to the Branch/office where the loan was originally sanctioned.  This initial CLR should highlight any documentation issues, loan structuring weaknesses, proposed workout strategy, and should seek approval for any loan loss provisions that are necessary. Recovery Units should ensure that the following is carried out when an account is classified as Sub Standard or worse:

• Facilities are withdrawn or repayment is demanded as appropriate. Any drawings or advances should be restricted, and only approved after careful scrutiny and approval from appropriate executives within CRM.
• CIB reporting is updated according to Bangladesh Bank guidelines and the borrower’s Risk Grade is changed as appropriate.
• Loan loss provisions are taken based on Force Sale Value (FSV).
• Loans are only rescheduled in conjunction with the Large Loan Rescheduling guidelines of Bangladesh Bank. Any rescheduling should be based on projected future cash flows, and should be strictly monitored.
• Prompt legal action is taken if the borrower is uncooperative.

NON PERFORMING LOAN (NPL) MONITORING

On a quarterly basis, a Classified Loan Review (CLR) (Appendix 3.4.2B) should be prepared by the RU Account Manager to update the status of the action/recovery plan, review and assess the adequacy of provisions, and modify the bank’s strategy as appropriate.  The Head of Credit should approve the CLR for NPLs up to 15% of the banks capital, with MD/CEO approval needed for NPLs in excess of 15%.  The CLR’s for NPLs above 25% of capital should be approved by the MD/CEO, with a copy received by the Board.

NPL PROVISIONING AND WRITE OFF

The guidelines established by Bangladesh Bank for CIB reporting, provisioning and write off of bad and doubtful debts, and suspension of interest should be followed in all cases.  These requirements are the minimum, and Banks are encouraged to adopt more stringent provisioning/write off policies.  Regardless of the length of time a loan is past due, provisions should be raised against the actual and expected losses at the time they are estimated.  The approval to take provisions, write offs, or release of provisions/upgrade of an account should be restricted to the Head of Credit or MD/CEO based on recommendation from the Recovery Unit.  The Request for Action (RFA) or CLR reporting format should be used to recommend provisions, write-offs or release/upgrades. The RU Account Manager should determine the Force Sale Value (FSV) for accounts grade 6 or worse.  Force Sale Value is generally the amount that is expected to be realized through the liquidation of collateral held as security or through the available operating cash flows of the business, net of any realization costs.  Any shortfall of the Force Sale Value compared to total loan outstanding should be fully provided for once an account is downgraded to grade 7.  Where the customer in not cooperative, no value should be assigned to the operating cash flow in determining Force Sale Value.

Fore Sale Value and provisioning levels should be updated as and when new information is obtained, but as a minimum, on a quarterly basis in the CLR.

APPROVAL FOR COUNTER PARTY LIMITS

This part is Limits for Money Market, Foreign Exchange and other transactions with different counter party Banks and (ii) setting limits for Fixed Deposits and Overnight Investments with different Non Bank Financial Institutions (NBFIs).

MONEY MARKET OPERATIONS:

Banks operate in the money market mainly to fulfill the following objectives:

1. To maintain liquidity i.e. to meet up the obligations of the bank as and when they fall due.
2. To use excess fund to ensure highest possible return.
3. To borrow necessary funds at the lowest possible cost.
4. To maintain Advance/ Deposit (AD) ratio and
5. To maintain the regulatory requirement for liquidity (CRR & SLR).

AREAS WHERE COUNTER PARTY LIMITS ARE APPLICABLE:

i) Money Market Transactions.

ii) Foreign Exchange Transactions

iii) Others:

a) Local Documentary Bill Purchased (LBPD)

b) Exposure against other bank’s FDR etc.                                            

TYPE OF RISKS IN TRANSACTIONS:

• Credit Risk:

In the market one borrows and another lends or places funds. There is no credit risk when we borrow. However, on the lending side, there is always a risk that the borrower may be unable to repay the funds or unable to repay on due date.

• Interest Rate Risk:

The risk arises when the maturities of the placement and the borrowings are not matched. For example, when we lend funds for 3 months by borrowing at call, we are taking an interest rate risk as the call rates are uncertain and may rise thereby affecting the profitability of the said transaction.

(c) Liquidity Risk:

The liquidity risk appears when funds are placed for the period longer than the source of funds.

RISK MITIGANT:

• The Credit Risk is controlled primarily by establishing lines for placements with each counter party. It will limit the amount for each counter party. Thereby, the counter party limit ensures control of an unduly high percentage of the total money market portfolio.
• Liquidity and interest rate risks can be controlled by imposing limits on the net position and periodical MIS such as daily, weekly, monthly, and quarterly and so forth will contribute in these areas. Bangladesh Bank’s regulatory requirement of CRR & SLR also covers part of the liquidity risk.

PRACTICES IN EBL:

EBL is following Counter Party Bank Limit approved by the Board in its 374 Meeting dated July 10, 2007 (Board Memo No. 256/07 Dated July 9, 2007).

RATING METHODOLOGY

Counter-party limit is generally set after deriving its credit rating taking into account the quantitative and qualitative aspects of Bank and NBFIs. We have reviewed both quantitative and qualitative aspects taking the Credit Risk Grading Manual of Bangladesh Bank into consideration. EBL’s review methodology provided a score and rating for the counter party Banks and NBFIs. Bank wise exposure/ limits have been reviewed on the basis of assessment of financial performance, operating efficiency, management quality, past experience etc. Banks and NBFIs are rated and placed in range of 1-8 ratings, on the basis of their credit quality. These ratings are: (1) Superior; (2) Good; (3) Acceptable; (4) Marginal / Watch list (5) Special Mention (6) Sub standard (7) Doubtful and (8) Bad & Loss.

SPREAD SHEET

Financial data has been analyzed with Microsoft Excel Based spread sheet, in order to find out and evaluate financial performance. The spread sheet also incorporated Income Statement, Balance Sheet and Key Financial Ratios e.g. Growth Ratio, Liquidity Ratio, Asset Quality, Leverage, Profitability, Efficiency and information on Market Share, Balance Sheet Highlights etc. Based on these, scoring has been done as follows. Detailed of the spread sheet and score sheet is enclosed with the Memo in Appendix C (for Banks) & D (for NBFIs).

BANK LIMIT REVIEWING:

We have analyzed spreadsheet of 44 Banks (out of total 48 Banks) and rated them accordingly. We could not rate 4 banks [BSRS, RAKUB, BSB and ICB Islamic Bank (Oriental)] as their financials are not available. Counter party limits have been proposed for total 51banks, special judgments have been given for BSRS, Amex, Mashreq, Wachovia, Commerzbank, National Commercial Bank (NCB, KSA) and Dresdner Bank.

Rating of all the Banks with major ratios and corresponding proposed Limit are presented in Appendix-A based on the following matrix.

SETTING LIMIT FOR NBFIS:

We have analyzed spreadsheet of 16 NBFIs to set limit for them (where there are existing and potential business opportunities).  Rating of the NBFIs with major ratios and corresponding proposed Limit are presented in Appendix-B based on the following matrix.

Limit for NBFIs has been proposed on above percentage on Paid Up-Capital (not on total capital) as per conservative approach. Any exception to NBFIs limits to be pre-approved by Head of Credit Risk Management and Managing Director or his delegated personnel.

EXCEPTIONS:

Exception has been done while determining limit based on capital for mainly NCBs, DFIs and some Foreign Banks. Special Considerations and judgments for proposed limit for these banks are presented in Appendix-A1. Exception for one NBFI has been placed in Appendix-B1

LOAN EQUIVALENT RISK (LER)

Foreign Exchange risk is not as high as Money Market risk. On an average, as per international standard, Loan Equivalent Risk (LER) is 100% for Money Market transaction and for Foreign Exchange Transactions the LER is 10.00% (approx.). For the purpose of simplicity we have assumed a flat LER of 10% for Foreign Exchange Transaction and 100% for Money Market and others.

BANK LIMIT INTO THREE CATEGORIES

We are proposing Total counter party bank limit for Tk 5360 Crore into 03 categories; Money Market limit 45%, Foreign Exchange Limit 30% and other business line (LDBP & Loan against FDR) 25% taking into account both quantitative and qualitative aspects (detailed in Appendix-A & A1). Total Loan Equivalent Limit is Tk.3589 Crore.

NBFIs  LIMIT INTO TWO CATEGORIES

We are proposing Total counter party limit for NBFIs as Tk 229 Crore into 02 categories; Fixed Deposit limit 60%, Overnight Placement Limit 40% of total Limit (detailed in Appendix-B & B1).

SPECIAL CLAUSE

No EOL approval will be required for Bank as long as total Loan Equivalent Outstanding (10% for FX and 100% for MM & Others) on any specific bank is within its total Loan Equivalent Limit. No EOL approval will be required for NBFI as long as total outstanding of Fixed Deposit and Overnight is within the total limit for any single NBFI.

MODUS OPERANDI

The following aspects of Modus Operandi of Bank Limit approved by the Board, in its 374 Meeting dated July 10, 2007 (Board Memo No. 256/2007 Dated July 9, 2007) shall remain unchanged.

Same modus Operandi for NBFIs as well being placed for approval by the Board:

1. The approved Limits for Banks and NBFIs shall be forwarded to Treasury Support Unit (TSU), Service Delivery.
2. TSU will advice the Limits to Treasury Front Office by incorporating the Limits availed by Treasury Front Office.
3. TSU will prepare MIS and report to Senior Management and ALCO members on a monthly basis/ as and when required the limits and corresponding outstanding.
4. Any exceptions or waiver on the Limit to be approved by Managing Director.
5. Any changes in Modus Operandi to be approved by Managing Director.
6. Bangladesh Bank guidelines through Focus Group report- Managing Core Risk in Banking on Asset Liability Management and Foreign Exchange Risk Management to be adhered to.
7. EBL’s Treasury Manual approved by the Board in its 320 Meeting dated 5^th July 2005 to be strictly adhered to.

RECOMMENDATIONS

• The Risk Managements should be encouraged to build up their knowledge base about various industries, the opportunities and risks in the sectors, the well performers and the upcoming companies, industry standards etc. For example, RMs can be given incentives to attend various seminars, workshops, or training programs in these areas.
• CRGM must be strict to see that all the procedures of Loan Evaluation and Monitoring are followed before giving any new loans. It was observed that not all the steps of the present guideline are followed strictly by the RMs. For example, the RMs did not go on regular quarterly calls to the clients and also sometimes did not verify all the information provided by the clients. This gives rise to chances that the client’s actual position may not be understood on time and increases the risk of classification. So steps must be taken to ensure strict adherence to the loan evaluation and monitoring policy.
• The RMs should keep their eyes open about the position of the industries of their respective clients.  As soon as any new risk occurs in the industry or the industry shows signs of deterioration, they should analyze its impact on their respective clients and act accordingly.
• As soon as the client fails to make timely repayment, pressure should be created on him to make the payment urgently and no further credit should be allowed to him unless he pays back the previous dues (except for cases where new loans are needed to ensure past loan’s recovery). Also no unnecessary restructuring of repayment schedule should be allowed.
• Credit Rating must be given proper emphasis. Whenever a credit rating is lowered, the RMs must look into the account to see whether there is any chance of the client being classified eventually. The RM should also prepare an alternative exit plan from the account, just in case it is needed.
• Special Asset Management Department should immediately launch legal procedures against those accounts where negotiation has failed and there is no chance of repayment. They should try to recover as much of the loan as possible by disposing of the securities held against these loans.

CONCLUSION

Credit Risk Grading is an important tool for credit risk management as it helps a Bank to understand various dimensions of risk involved in different credit transactions. The credit risk grading system is vital to take decisions both at the pre-sanction stage as well as post sanction stage. At the pre-sanction stage, credit grading helps the sanctioning authority to decide whether to lend or not to lend, what should be the pricing for a particular exposure, what the extent should be of exposure, what should be the appropriate credit facility and the various risk mitigation tools. At the post-sanction stage, the bank can decide about the depth of the review or renewal, frequency of review, periodicity of the grading, and other precautions to be taken. Having considered the significance and necessity of credit risk grading for a Bank, it becomes imperative to develop a credit risk grading model which meets the objective outlined above.