How to Maintain Credit Risk Management

Credit Risk Management

Risk in inherent in all aspects of a commercial operation, however for banks and financial institutions, credit risk is an essential factor that needs to be managed. Credit risk is the possibility that a borrower or counter party will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the bank’s dealings with or lending to corporate, individuals, and other banks or financial institution.

Credit risk management needs to be a strong process that enables banks to proactively manage loan portfolios in order to minimize losses and earn an acceptable level of return for shareholders. Central to this is a comprehensive IT system, which should have the ability to capture all key customer data, risk management and transaction information including trade. Given the fast changing, dynamic global economy and the increasing pressure of globalization, consolidation and disintermediation, it is essential that we have a robust credit risk management policies and procedures that are sensitive and responsive to these changes. It is pertinent to mention here that we are already in the process of implementing state of the art IT system for integrated performance.

Guide lines of Credit Policy

The guidelines contain outline general principles that are designed to govern the implementation of more detail procedures and risk grading system within individual banks.

Lending Guidelines:

All Banks have an established “Credit Policies” that clearly outline the business development priorities and the terms and conditions that should be adhered to in order for loans to be approved.  AB Bank Ltd has such type of guideline through which it manages the credit operation. This lending guideline is updated regularly in response to Bangladesh bank’s guidelines to reflect changes in the economic outlook and the evolution of the bank’s loan portfolio, and distributed to all lending/marketing officers. The lending Guidelines are approved by the Managing Director/CEO and 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 of deviation from the Lending Guidelines is explicitly identified in credit applications and justification for approval provided.

The lending guidelines provided the key functions for relationship managers to formulate their recommendation for approval incorporating the following:

•   Industry and Business Segment Focus

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

•  Types  of Loan Facilities

Indication of the type of loan that are permitted, such as working capital, Trade Finance , term loan, etc.

•  Single Borrower / Group Limits/ Syndication

Details of the bank’s Single Borrower/Group limits are include as per Bangladesh Bank guidelines. ABBL establish more conservative criteria in this regard.

•  Lending Caps

The bank establishes a specific industry sector exposure cap to avoid over concentration in any one-industry sector.

• Discourage Business Types

ABBL outline industries or lending activities that are discouraged. As a minimum, the following is 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
• Talking an Equity Stake in Borrowers
• Lending to Holding Companies
• Bridge Loans relying on equity/ debt issuance as a source of repaymen

Loan Facility Parameters

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

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

Cross Border Risk

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

-Synonymous with cross political and sovereign risk.

-Third world debt crisis

For example, export documents negotiated for countries like Nigeria

Credit Assessment and Risk Grading

Credit Assessment

A through credit and risk assessment 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 responsible to ensure the accuracy of the entire credit application submitted for approval. RMs must be familiar with the bank’s Lending Guideline sand conduct due diligence on new borrowers, principals and guarantors.

It is essential that RMs know their ckustome5rs and conduct due diligence on new borrowers, principals, and guarantors to ensure such parties are in fact who they represent themselves to be.

Credit Application summaries the result of the RMs assessment and includes, as a minimum, the following details:

• Amount and type of loans proposed.
• Purpose of loans.
• Loan Structure (Tenor, Covenants, Repayment Schedule, Interest)
• Security Arrangement.

In addition, the following risk areas are being addressed by the bank:

• Borrower Analysis: The Majority shareholders, management team and group or affiliate companies are assessed. Any issues regarding lack of management depth, complicated k ownership structures or inter-group transactions are being addressed, and risks mitigated.
• Industry Analysis:  The key risk factors of the borrower’s industry need to be assessed. Any issues regarding the borrowers position in the industry, overall industry concerns or competitive forces is being addressed and the strengths and weakness of the borrower relative to its competition are identified.
• Supplier / Buyer Analysis:  Any customer or supplier concentration is being addressed, as these have significant impact on the future viability of the borrower.
• Historical Financial Analysis: An analysis of a minimum of 3 years historical financial statement of the borrower is presented. Where reliance is placed on a corporate guarantor, analysis of guarantor financial. The analysis addresses the quality and sustainability of earnings, cash flow and the strength of the borrower’s balance sheet. Specially, cash flow, leverage and profitability are being analyzed.
• Projected financial performance: Where term facilities (tenor>1year) are proposed, a projection of the borrower’s future financial performance need to be provided, indicating an analysis of the sufficiency of cash  flow to service debt repayments. Loan do not granted if projected cash flow is insufficient to repay debts.
• Account Conduct:  for existing borrowers, the historic performance in meeting repayment obligation (trade payments, cheques, interest and principal payments, etc) is being assessed.
• Adherence to lending Guidelines: Credit Application 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 approved credit Applications that do not adhere to the bank’s Lending Guidelines.
• Mitigating Factors:  Mitigating factors for risks identified in the credit assessment are being identified. Possible risks include, but are not limited to margin sustainability and/ or debtor issues; rapid growth, acquisition or expansion; issues; customer or supplier concentrations; and lack of transparency or industry issues.
• Loan Structure: the amounts and tenors of proposed financing are being justified based on he 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:  Obtaining a current valuation of collateral and the quality and priority being proposed need to be. Loans do not grant based solely on security. Adequacy and the extent of the insurance coverage are also assessed.
• Name Lending: Credit Proposals do 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 are discouraged and treated with great caution. Rather, credit proposals and the granting of loans are based on sound fundamentals, supported by a through financial and risk analysis.

Risk Grading

All Banks should adopt a risk grading system. ABBL adopt a system that define the risk profile of borrower’s to ensure 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 borrower and its facilities should be immediately changed. Borrower Risk Grades should be clearly stated on Credit Applications.

The following Risk Grade Matrix is provided as an example. If there is a difference between the personal judgment and the Risk grade Scorecard results, ABBL applied the more conservative risk grade (higher) however, monitoring standards and account management must be appropriate given the assigned Risk Grade:

The Early Alert Report completed by the bank in a timely manner by the RM and forward to CRM for approval to affect any downgrade. After approval the report forward to Credit Administration, Who is responsible to ensure the correct facility / borrower Risk Grades are updated on the system. The downgrading of an account done immediately when adverse information in noted, and do not postpone until the annual review process.

Approval of Authority

The authority to sanction/approve loans clearly delegated to senior credit executives by the managing Director/CEO and board based on the executive’s knowledge and experience. Approval authority delegated to individual executives and not the committee to ensure accountability in the approval process. The following guidelines are normally applied in the approval/ sanctioning of loans:

• Credit approval authority delegated in writing from the MD/ CEO and board (as appropriate), acknowledged by receipts, and records of all delegation retained in CRM.
• Delegated approval authorities reviewed annually by MD/CEO /Board.
• The credit approval function separated from the marketing / relationship management (RM) function.
• The role of credit committee may be restricted to only review of proposals recommendations or review of banks loan portfolios.
• Approvals must be evidence 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 combining of authority limits should not be permitted.
• Credit Approval should be centralized within the CRM function. Regional credit centers 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 executives.
• The aggregate exposure to any borrower or borrowing group must be used to determine 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.
• Head of Credit Risk Management approve and monitor any cross-border exposure risk.
• It is essential that executives charged with approving loans have relevant training and experience to carry out their responsibilities effectives. As a minimum, approving executives should have:

At least 5 years experience working in corporate/ commercial banking as a relationship manager or account executives.

Training and experience in financial statement, cash flow and risk analysis.

A thorough working knowledge of accounting.

A good understanding of the local industry / market dynamics.

Successfully completed and assessment test demonstrating adequate knowledge of the following areas:

• Introduction of accrual accounting.
• Industry / Business Risk Analysis.
• Borrowing Causes.
• Financial reporting and full disclosure.
• Financial statement Analysis
• The asses conversion/Trade Cycle
• Projection
• Loan Structure and Documentation
• Loan Management

A monthly summary of all new facilities approved, renewed, enhanced, and a list of proposals declined stating reasons thereof reported by CRM to the CEO/MD

Segregation of Duties

Banks aim to segregate the following lending functions:

• Credit approval / Risk Management
• Relationship Management / Marketing
• Credit Administration

The purpose of the segregation is to improve the knowledge levels expertise in each department, to impose controls over the disbursement levels and expertise in teach department, to impose controls over the disbursement of authorized loan facilities and obtain an objective and independent judgment of credit proposals.

Organizational structure is (credit Division)

The appropriate organizational structure is in place to support the segregation of the Marketing / Relationship Management function from Approval/ Risk Management/ Administration functions.

Credit approval centralized within the CRM function. Regional credit centers are established, however, all application are approved by the Head of Credit and Risk Management or Managing Director/CEO/Board or delegated Head Office credit executive:

Key Responsibilities

Key responsibilities of the function are as follows:

Credit Risk Management (CRM)

• Over of the bank’s credit policies, procedures and controls relating to all credit risks arising from corporate/ commercial / institutional banking, personal banking and treasury operations.
• Oversight of the bank’s asset quality.
• Directly manager all substandard, doubtful and Bad and loss accounts to maximize recovery and ensure that appropriate and timely loan loss provision have been made.
• To approve (or decline), within delegate authority, credit Applications recommended by RM. Where aggregate borrower exposure is in excess of approval limits, to provide recommendation to MD/CEO for approval.
• To provide advice / assistance regarding all credit matters to line management /RM.
• To ensure that lending executives have adequate experience and / or training in order to carry out duties effectively.

Credit Administration

• To ensure that all security documents comply with the terms of approval and it is enforceable.
• To monitor insurance coverage to ensure appropriate coverage is in place over assets pledged as collateral, and is properly assigned to the bank.
• To control loan disbursements only after all terms and conditions of approval have been met and all security documents.
• To maintain control over all security documents.
• Monitoring the borrower’s compliance with covenants and agreed terms and conditions, and general monitoring of account conduct or performance.

Relationship management

• To act as the primary bank contacts with borrowers.
• To maintain thorough knowledge of borrowers business and industry through regular contact, factory / warehouse inspections etc. RM should proactively monitor the financial performance and account conduct of borrowers.
• To be responsible for the timely and accurate submission of Credit Applications for new proposal and annual reviews, taking into account the credit assessment requirements.
• To highlight any deterioration in borrower’s financial standing and amend the borrower’s risk Grade in a timely manner. Changes in risk Grades should be advised to and approved by CRM.
• To seek assistance / advice at the earliest from CRM regarding the structuring of facilities, potential deterioration in accounts or for any credit related issues.

Procedural Guidelines

The main procedures that are followed by ABBL to ensure compliance with the credit policies narrated as under heads”

Approval Process

The approval process reinforces the segregation of relationship Management / Marketing from the approving authority. The responsibility for preparing the credit application rest with the RM within the corporate / commercial banking department.  Credit Application recommended for approval by the RM team and forward to the approval team within CRM and approved by individual executives. Banks may wish to establish various threshold, above which, the recommendation of the Head of Corporate/Commercial banking is required prior to onward recommendation to CRM for approval team to handle routine approvals. Executives in head office CRM approve all large loans.

The recommending or approving executives take responsibility for and are held accountable for their recommendations or approval. Delegation of approval limits are such that all proposals where the facilities are up to 15% of the bank’s capital approved at the CRM level, facilities up to 25% of capital approved by CEO/MD, with proposals in excess of 25% of capital  to be approved by the EC/Board only after recommendation of CRM, Corporate banking an MD/CEO

1. Application forwarded to Zonal Office for approved/ decline
2. Advise the decision as per delegated authority (approved decline) to recommending branches. A monthly summary of ZCO approvals sent to HOC and HOCB to report the previous month approvals sanctioned at the Zonal offices. The HOC reviews 10% of ZOC approvals to ensure adherence to Lending Guidelines and Bank policies.
3. ZCO supports and forwarded to Head of Corporate banking (HOCB) or delegate for endorsement, and Head of Credit (HOC) for approval or onward recommendation.
4. HOC advise the decision as per delegated authority to ZCO.
5. HOC and HOCB support and forwarded on Managing Director.
6. Managing Director advises the decision as pr delegate authority to HOC and HOCB.
7. EC / Board advise the decision to HOC and HOCB.

Regardless of the delegated authority HOC to advice the decision (approval/decline) to marketing department through ZCO

Recommended Delegated Approval Authority Levels

HOC/ CRM Executives                              Up to 15% of capital

Managing Director / CEO                          Up to 25% of Capital

EC/Board                                                    All exceed 25% of Capital

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 use in all cases. Exceptions are referred to legal counsel for device based on authorization from an appropriate executive in CRM.

Disbursements under loan facilities are only be made when all security documentation is in place. CIB report reflect/ include the name of all the lenders with facility, limit and outstanding. All formalities regarding large loans and loans to Directors should be guided by Bangladesh Bank circulars and related section of Banking Companies Act.

Appeal Process

Any declined credit may be re presented to the next higher authority for reassessment/ approval. However, there is no appeal process beyond the Managing Director.

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 reasons, 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 are being highlighted at the appropriate level.

Credit Administration procedures should ne in place to ensure the following:

Custodian Duties:

• Loan disbursement and the preparation and storage of security documents centralized in the regional credit centers.
• Appropriate insurance coverage is maintained (and renewed in timely basis) on assets pledge 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 (values, lawyers, insurers, CPA 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 system is to be in place that provides an early indication of the deteriorating financial health of a borrower. At a minimum, systems are 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 excess 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 received an approved through the submission of Credit Application at least annually.

Computer system 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 has the capability to produce accurate exception reports. Exceptions are followed up on and corrective action taken in a timely manner before the account deteriorates further.

Early alert process:

An Early Alert Account (Appendix-3) is one that has risks or potential weakness of a material nature requiring monitoring, supervision, or close attention by management.

If these are left uncorrected, they may result in deterioration of are repayment prospects for the asset or in the Bank’s credit position at some future date with a likely prospect of being downgraded to CG5 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 is completed by the RM and sent to the approving authority in CRM for any account that is showing assigns or deterioration within seven days from the identification of weakness. The Risk Grade updated as soon as possible and no delay 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. The symptoms of early alert are by no means exhaustive and hence, if there are other concerns, such as a breach of loan covenants or adverse market rumors that warrant additional caution, an Early Alert report raised.

Moreover, regular contacts 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 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) directly manages 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 in recommendation of CRM and Corporate Banking. Whenever an account is handed over from Relationship Management to RU, a Handover/Downgrade Checklist (Appendix no.3) is 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 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 is established to share the lessons learned from the experience of credit losses in order to update the lending guidelines.

Account Transfer Procedures

Within 7 days of an account being downgraded to substandard (grade6), a Request for Action and a hand over/ downgrade checklist is completed by the RM and forwarded to RU for acknowledgement. The account assigned to an account manager within the RU, who reviews all documentation, meet the customer, and prepare a classified Loan Review Report within 15 days of the transfer. The CLR 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 highlight any documentation issues, loan structuring weaknesses, proposed workout strategy, and seek approval for any loan loss provisions that are necessary.

Recovery Units 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 drawing or advances 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 is 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) prepared by the RU Account Manager to update the status of the action / recovery plan, review and assess the adequacy of provisions, and modifies the bank’s strategy as appropriate. The Head of Credit approved the CLR for NPLs up to15% of the banks capital, with MD/CEO approval needed for NPLs in excess of 15% the CLR’s for NPL above 25$ of capital approved by the MD/CEO, with a copy received by the board.

NPL Provisioning and Write off:

This guideline establishes by Bangladesh Bank for CIB reporting provisioning and writers of of bad and doubtful debts, and suspensions of interest are followed in all cases. These requirements are the minimum, and ABBL adopt more stringent provisioning / write off policies. Regardless of the length of time a loan is past due, provisioning raised against the actual and expected losses at the time they are estimated. The RU account Manager determines the Force Sale Value (FLS) 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 Loans outstanding fully provided for once an account is downgraded to grade 7.  Where the customer is not cooperative, no value assigned to the operating cash flow in determining Force Sale Value (FSV).

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

Following formula is to be applied in determining the required amount of provision:

1. Gross Outstanding                                                                              (XXX)
2.  Less : (a)  Cash margin held or fixed

Deposits/ sp under lien                                                     (XXX)

(b)    Interest in suspense Account                                            (XXX)

3.    Loan Value

(For which provision is to be created before considering

Estimated realized value of other security/collateral held)                          (XXX)

4.    Less:  estimated salvage value of security/ collateral held                     (XXX)

(See Note below)

Net Value                                                                                                    (XXX)

(Note: the amount of required provision may, in some circumstances, be reduced by an estimated realizable forced sale value of (i.e. salvage value) of any tangible collateral held (viz: mortgage of property, pledge goods/ or hypothecated goods repossessed by the bank, pledged readily marketable securities etc). Hence, in these situations, it will be advisable to evaluate such collateral, estimate the most realistic sale value under duress and net off the value against the outstanding before determining the Net Loan Value for provision purpose. Conservative approach is taken to arrive at provision requirement and Bangladesh Bank guideline properly followed).