Implementation of Credit Risk Grading by the Banks in Bangladesh

INTRODUCTION

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.

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.

NUMBER AND SHORT NAME OF GRADES USED IN THE CRG

The proposed CRG scale for the banks consists of 8 categories with Short names and numbers

are provided as follows:

Grading	Short Name	Number
Superior	SUP	1
Good	GD	2
Acceptable	ACCPT	3
Marginal/watch list	MG/WL	4
Special Mention	SM	5
Substandard	SS	6
Doubtful	DF	7
Bad Loss	BL	8

CREDIT RISK GRADING DEFINITIONS

A clear definition of the different categories of Credit Risk Grading is given as follows:

Risk Rating	Grade	Definition
Superior – Low Risk	1	Facilities are fully secured by cash deposits Government bonds or a counter guarantee from a top tier international bank. All security documentation should be in place.
Good – Satisfactory Risk	2	The repayment capacity of the borrower is strong. The borrower should have excellent liquidity and low leverage. The company should demonstrate consistently strong earnings and cash flow. All security documentation should be in place. Aggregate Score of 95 or greater based on the Risk Grade Scorecard.
Acceptable – Fair Risk	3	Adequate financial condition though may not be able to sustain any major or continued setbacks. These borrowers are not as strong as Grade 2 borrowers, but should still demonstrate consistent earnings, cash flow and have a good track record An Aggregate Score of 75-94 based on the Risk Grade Scorecard.
Marginal – Watch list	4	Grade 4 assets warrant greater attention due to conditions affecting the borrower, the industry or the economic environment. These borrowers have an above average risk due to strained liquidity, higher than normal leverage, thin cash flow and/or inconsistent earnings. Aggregate Score of 65-74 based on the Risk Grade Scorecard.
Special Mention	5	Grade 5 assets have potential weaknesses that deserve management’s close attention. If left uncorrected, these weaknesses may result in a deterioration of the repayment prospects of the borrower An Aggregate Score of 55-64 based on the Risk Grade Scorecard.
Substandard	6	Financial condition is weak and capacity or inclination to repay is in doubt Loans should be downgraded to 6 if loan payments remain past due for 60-90 days Not yet considered non-performing as the correction of the deficiencies may result in an improved condition, and interest can still be taken into profits. An Aggregate Score of 45-54 based on the Risk Grade Scorecard.
Doubtful and Bad (non-performing)	7	Full repayment of principal and interest is unlikely and the possibility of loss is extremely high. However, due to specifically identifiable pending factors, such as litigation, liquidation procedures or capital injection, the asset is not yet classified as Loss. The adequacy of provisions must be reviewed at least quarterly on all non-performing loans, and the bank should pursue legal options to enforce security to obtain repayment or negotiate an appropriate loan rescheduling. In all cases, the requirements of Bangladesh Bank in CIB reporting, loan rescheduling and provisioning must be followed. An Aggregate Score of 35-44 based on the Risk Grade Scorecard
Loss (non-performing)	8	Assets graded 8 are long outstanding with no progress in obtaining repayment (in excess of 180 days past due) or in the late stages of wind up/liquidation. The prospect of recovery is poor and legal options have been pursued. The proceeds expected from the liquidation or realization of security may be awaited. The continuance of the loan as a bankable asset is not warranted An Aggregate Score of 35 or less based on the Risk Grade Scorecard

HOW TO COMPUTE CREDIT RISK GRADING OF A BANK

Step I: Identify all the Principal Risk Components (Quantitative & Qualitative)

Credit risk for counterparty may be broadly categories under Quantitative and Qualitative factors which arise from an aggregation of the following:

QUANTITATIVE FACTOR:

Capital Adequacy

Asset Quality

Earnings Quality

Liquidity and Capacity of External Fund Mobilization

Size of the Bank & Market Presence

QUALITATIVE FACTOR:

Management status

Regulatory Environment & Compliance

Risk Management

Sensitivity to Market Risk

Ownership (Share holding pattern) & Corporate Governance

Accounting Quality

Franchise Value

Step II: Allocate weightages to Principal Risk Components

According to the importance of risk profile, the following weights are proposed for corresponding principal risks components (Quantitative and Qualitative factors).

Principal Risk Components: Weights

QUANTITATIVE FACTOR: 60%

Capital Adequacy 15%

Asset Quality 15%

Earnings Quality 15%

Liquidity and Capacity of External Fund Mobilization 10%

Size of the Bank & Market Presence 5%

QUALITATIVE FACTOR: 40%

Management 10%

Regulatory Environment & Compliance 10%

Risk Management 5%

Sensitivity to Market Risk 5%

Ownership (Share holding pattern) & Corporate Governance 5%

Accounting Quality 3%

Franchise Value 2%

Step III: Establish the Key Parameters

Once weightages are allocated to the Principal Risk Components (Quantitative and Qualitative Factors) the next task is to arrive at key parameters corresponding to the Principal Risk Components.

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 nonperforming loans

Sector from where the gross NPL are coming from

Nature of security/collateral and the frequency of valuation

Key Parameters for Earnings Quality

Level of earnings

Diversity of earnings

Return on Assets (ROA)

Return on Equity (ROE)

Average cost of fund,

Net Interest Income Margin (NIIM) trend is satisfactory

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

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

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

Key Parameters for Management:

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

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

Disclosure requirement for banks

Delegation of power at operating level

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

Step IV: Assign weightages to each of the key parameters

Once the above mentioned key risk parameters are evaluated, analyzed and reviewed properly the next step will be to further assign weightages against each key parameter depending on its strength and merits.

Step V: Input data to arrive at the score on the key parameters

After the risk identification & weightages assignment process (as mentioned above), the next steps will be to input actual score obtained by the Bank (under review process) against the key parameters in the score sheet to arrive at the total scores obtained.

Step VI: Arrive at the Credit Risk Grading based on total score obtained

The following is the proposed Credit Risk Grade matrix based on the total score obtained by an obligor (i.e. a Bank).

Risk Grading	Short Name	Score
Superior	SUP	ü 85 – 100 ü Credit facilities fully cash covered (100%) or near cash. ü Government guarantee ü International Bank guarantee
Good	GD	75 – 84
Acceptable	ACCPT	65 – 74
Marginal/watch list	MG/WL	55 – 64
Special Mention	SM	45 – 54
Substandard	SS	35 – 44
Doubtful	DF	25 – 34
Bad Loss	BL	< 25

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. 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

All Banks should adopt a credit risk grading system. The system should define 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.

A Practical Example

Calculating CRG of Individual Credit of National Bank Ltd.:

National Bank Ltd. provides many types of credit. For calculating CRG for specific loans and advances we need the following data:

Balance Sheet of that firm
Income Statement of that firm
Their leverage condition
Sales Information
Liquidity Information
Profitability Information
Their management Information
Management Experience
Age of Business
Industry Information

Calculating the Ratios for CRG:

By using the above information we need to calculate the following ratios:

Leverage Ratio:

Debt to Equity Ratio =

Liquidity Ratio:

Current Ratio =

Profitability Ratio:

Profit Margin Ratio =

Coverage Ratio:

Interest Coverage Ratio =

After calculating the required ratios we use it CRG scoring Sheet as following way:

At first we calculate the above ratios from the Balance sheet and Income Statement of the assessing company or the company who submit loan proposal to the National Bank Ltd. and then we use it the column of Actual Parameter. Here one of the National Bank’s clients’ Aftab Autos Ltd. CRG Scoring Sheet is given.

CREDIT RISK GRADING SCORE SHEET

Reference No.:			Date:	18/02/2012
Borrower	Aftab Autos Ltd.
Lender Name	National Bank Ltd.	Aggregate Score:		87
Branch:	Mohammadpur Branch, Dhaka
Industry/Sector	Engineering	Risk Grading	Good
Date of Financials	31-Dec-11
Completed by	Mr. X
Approved by	Credit Manager
Number	Grading	Short	Score
1	Superior	SUP	Fully cash secured, secured by government
2	Good	GD	85+
3	Acceptable	ACCPT	75-84
4	Marginal/Watch list	MG/WL	65-74
5	Special Mention	SM	55-64
6	Substandard	SS	45-54
7	Doubtful	DF	35-44
8	Bad/Loss	BL	<35
Criteria Weight	Parameter	Score	Actual Parameter		Score Obtained
A. Financial Risk 50%
1. Leverage: (15%)	Less than 0.25×	15	0.32		14
Debt Equity Ratio (×) – Times	0.26× to 0.35 x	14
	0.36× to 0.50 x	13
	0.51× to 0.75 x	12
	0.76× to 1.25 x	11
	1.26× to 2.00 x	10
	2.01× to 2.50 x	8
	2.51× to 2.75 x	7
	More than 2.75×	0
2. Liquidity: (15%)	Greater than 2.74×	15	3.06		15
Current Assets to Current Liabilities	2.50× to 2.74 x	14
	2.00× to 2.49 x	13
	1.50× to 1.99 x	12
	1.10× to 1.49 x	11
	0.90× to 1.09 x	10
	0.80× to 0.89 x	8
	0.70× to 0.79 x	7
	Less than 0.70×	0
3. Profitability 🙁 15%)	Greater than 25%	15	19.55		13
(Net Profit/Sales) X 100	20% to 24%	14
	15% to 19%	13
	10% to 14%	12
	7% to 9%	10
	4% to 6%	9
	1% to 3%	7
	Less than 1%	0
4. Coverage: (5%)	More than 2.00×	5	22.51		5
Interest Coverage Ratio (×) – Times	More than 1.51× Less than 2.00×	4
	More than 1.25× Less than 1.50×	3
	More than 1.00× Less than 1.24×	2
	Less than 1.00×	0
Total Score- Financial Risk			50		47
B. Industry Risk 15%
1. Size of Business (in BDT crore)	> 60.00	5	94		5
Measured in Sales	30.00 – 59.99	4
	10.00 – 29.99	3
	5.00 – 9.99	2
.	2.50 – 4.99	1
	< 2.50	0
2. Age of Business	> 10 Years	3	11		3
	> 5 – 10 Years	2
	2 – 5 Years	1
	< 2 Years	0
3. Business Outlook	Favorable	3	Stable		2
	Stable	2
	Slightly Uncertain	1
	Cause for Concern	0
4. Industry Growth	Strong (10%+)	3	Good (>5% – 10%)		2
	Good (>5% – 10%)	2
	Moderate (1%-5%)	1
	No Growth (<1%)	0
5. Market Competition	Dominant Player	2	Moderately Competitive		1
	Moderately Competitive	1
	Highly Competitive	0
6.Entry/Exit Barriers	Difficult	2	Average		1
	Average	1
	Easy	0
Total Score – Business/Industry Risk		18			11
C. Management Risk 12%
1. Experience	More than 10 years in the related line of business	5	More than 10 years in the related line of business		5
	5–10 years in the related line of business	4
	1–5 years in the related line of business	3
	No experience	0
2. 2^nd Line/Succession	Ready Succession	4	Ready Succession		4
	Succession within 1-2 years	3
	Succession within 2-3 years	2
	Succession in question	0
3. Team Work	Very Good	3	Very Good		3
	Moderate	2
	Poor	1
	Regular Conflict	0
Total Score- Management Risk			12		12
D. Security Risk10%

1.Security Coverage (Primary)	Fully Pledged facilities/substantially cash covered / Reg. Mortgage. for HBL	4	Registered Hypothecation 1st Charge/1st ParipassuCharge		3
	Registered Hypothecation(1^stCharge/1st Pari passu Charge)	3
	2nd charge/Inferior charge	2
	Simple hypothecation/Negative lien on assets	1
	No security	0
2.Collateral Coverage (Property Location)	Registered Mortgage on Municipal corporation/Prime Area property	4	Registered Mortgage on Pourashava/Semi-Urban area property		3
	Registered Mortgage on Pourashava/Semi-Urban area property	3
	Equitable Mortgage or No property but Plant and Machinery as collateral	2
3. Support (Guarantee)	Personal Guarantee with high net worth or Strong Corporate Guarantee	2	Personal Guarantee with high net worth or Strong Corporate Guarantee		2
	Personal Guarantees or Corporate Guarantee with average financial strength	1
E. Relationship Risk 10%
1. Account Conduct	More than 3 years Accounts with faultless record	5	More than 3 years Accounts with faultless record		5
	Less than 3 years Accounts with faultless record	4
	Accounts having satisfactory dealings with some late payments.	2
2.Utilization of Limit(actual/projection	More than 60%	2	90.00%		2
	40% – 60%	1
	Less than 40%	0
3.Compliance of Covenants / Conditions	Full Compliance	2	Some Non-Compliance		1
	Some Non-Compliance	1
	No Compliance	0
4. Personal Deposits	Personal accounts of the key business Sponsors/ Principals are maintained in the bank,	1	Personal accounts of the key business Sponsors/Principals are maintained in the bank,		1
Total Score- Relationship Risk			10		9
Grand Total – All Risk			100		87

Recommendation

After analyzing the creditworthiness in numerical way it is found that the Aftab Autos Ltd. Score is 87 that is in the Good category. The rating is in the second category of credit rating of the CRG Model and which is recognized as Satisfactory Risk for the bank. That means-

The repayment capacity of the Aftab Autos Ltd. is strong.
Aftab Autos Ltd. has excellent liquidity and low leverage.
The company should demonstrate consistently strong earnings and cash flow.
Interest coverage ratio is excellent
Business/ industry outlook is stable.
Size of business is satisfactory
Management efficiency of borrower is excellent.
Collateral position is good.

So National Bank can provide loan to the Aftab Autos Ltd. and it will maximize the wealth of bank as the credit rating scores shows good position.

Conclusion

An appropriate, precise and flexible Credit Risk Assessment and Evaluation model or system is mandatory for creating and adopting a risk management culture in the organization for developing a sustainable credit risk management environment in the banking sector of Bangladesh. Credit risk generates not only from counter party but also from improper policies, procedures and systems within the organization. This paper focuses on the weakness of the existing risk evaluation system that entails assessing risk through counter party or single obligor wise risk analysis. The new proposed Credit Risk Assessment and Evaluation system describes a new lending system that specifically addresses the flaws, thus helping all parties to the process. Based on the proposed evaluation system, it is expected that the credit risk analysis policies should: always follow the detailed and formalized credit evaluation or appraisal process, provide risk identification, measurement, monitoring and control, define target markets, risk acceptance criteria, credit approval authority, credit maintenance procedures and guidelines for portfolio management, be communicated to branches or controlling offices and clearly spell out roles and responsibilities of units involved in origination and evaluation system of credit risk for any industrial project.

References

I. Lehaj-Ul-Hasan, “Principles, Policies and Guidelines for Sustainable Credit Risk Management in Bangladesh”, A thesis work submitted to the Department of Industrial and Production Engineering, Bangladesh University of Science and Technology (BUET), December, 2007.

II. Commercial Bank Financial Management, In the Financial Services Industry, Sixth Edition- JOSEPH F. Sinkey, JR.

III. CRG Guidelines of Bangladesh Bank (www.bangladesh-bank.org)

IV. www.fe-bd.com

V. www.investopedia.com

VI. www.wikipedia.com