Credit Risk Management Process
Credit risk management process should cover the entire credit cycle starting from the origination of the credit in a financial institution’s books to the point the credit is extinguished from the books (Morton Glantz, 2002).
Credit Risk Management: A Case Study on National Bank Ltd.
The credit risk management process followed in National Bank Ltd. can be categorized in the following specNational segments:
- Mission Statement of Punali Bank Limited
- Credit Policy Guidelines
- Credit Assessment
- Credit Risk Grading
- Credit Approval Process
- Credit Risk Management
- Credit Recovery
To provide credit facilities to customers of PBL with care and competence and institute PBL as the ideal credit service provider in the country in terms of wide range of credit products, competitive price, adherence to credit norms, exercising due diligence and effective management of risk assets.
Credit Policy Guidelines
The credit policy guidelines of National Bank Ltd. include the following:
Credit Portfolio mix
Products and services of PBL
Credit Principles in National Bank Ltd.
The credit division of National Bank Ltd. is guided by 10 specNational credit principles. They are as follows:
i) Evaluate borrower’s nature for reliability and keenness to pay.
ii) Evaluate borrower’s loan settlement capability.
iii) Develop action plans for the likelihood of non-payment.
iv) Extension of credit in satisfactorily controllable risk areas.
v) Guarantee self-directed participation of the credit officials in the credit extension process.
vi) Perform the credit process in an ethical manner.
vii) Be proactive in recognizing, administering and conveying credit risk
viii) PBL requirements must be followed in ensuring the credit exposures and operations.
ix) Try to achieve an acceptable equilibrium between risk and reward.
x) Construct and sustain a diversified credit portfolio.
i) Evaluate borrower’s nature for reliability and keenness to pay
A borrower’s capacity and commitment to repay a loan are two important factors to a bank. In this respect, the bank has to examine the customer’s records and background in his former credit / loan related dealings. The bank should not engage itself into any commitment where there is potential threat and in these cases the bank the bank should be prepared for some exit plans.
ii)Evaluate borrower’s loan settlement capability
The loan servicing capacity of the borrower is an essential factor that has to be assessed by the bank prior to the extension of any credit facilities. For this purpose, financial techniques and procedures can be used by the bank. The bank should examine the customer’s reason for borrowing, major modes of repayment, historical and projected financial information, industry and competitive position, managerial skills, information source and systems, borrower’s operational efficiency, cyclical fluctuations in operations, supply and distribution position.
iii)Develop action plans for the likelihood of non-payment
Any kind of loan carries the possibility of default and thus it is very important for the bank to assess the secondary and tertiary modes of repayment along with the primary source. For this purpose, the bank should consider the security value, value impairment conditions, should define and document the terms and conditions of loan and ensure effective assessment.
iv)Extension of credit in satisfactorily controllable risk areas
To avoid any potential adverse situation, the bank should engage itself only in those areas where it can effectively manage and handle the transaction risk as well as the entity or business risk. In this regard, the bank has the responsibility toward developing and maintaining a productive and efficient relationship with the borrower.
v) Guarantee self-directed participation of the credit officials in the credit extension process
The independent credit participation of the credit officials is desired since it can aid in achieving the benefits of synergy and accountability. The credit personnel should utilize his or her personal skill and ability in determining the credit worthiness of the borrower and should convey all positive and negative information in time of seeking credit approval.
vi)Perform the credit process in an ethical manner
Any kind of unethical and illegal behavior, speculation, conflict of interests is prohibited in PBL. Customer related information should be kept confidential.
vii)Be proactive in recognizing, administering and conveying credit risk
The bank has to be proactive in identifying the state of the borrower’s after disbursement performance. Regular monitoring of the accounts, prompt reporting of material deterioration, utilizing Early Warning System (EWS), adjusting of lending terms and conditions are also important factors to be conformed.
viii)PBL requirements must be followed in ensuring the credit exposures and operations
Bank’s guidelines, requirements and internal directives must be complied with. The Relationship Manager must exercise his or her judgment in unforeseen circumstances.
ix)Try to achieve an acceptable equilibrium between risk and reward
The bank should be compensated for the risk it takes. Therefore, an appropriate as well as competitive pricing strategy has to be followed. Credit exposure, loan period, security, credit structure etc. should be arranged in accordance with the bank’s policies and guidelines keeping the risk return priorities in view.
x)Construct and sustain a diversified credit portfolio
Undiversified investment can expose the bank to industry specNational risk. Therefore, PBL has to adhere to its policy about sectoral allocation of portfolio, maintain approved ceiling for single borrower, and accurately identify risk characteristics of each exposure.
Credit portfolio mix
- Trade finance———————————— xx %
- Industry- Short term working capital ——– xx %
- Retail and SME ——————————— xx %
- Project- Finance medium and long term —– xx %
- Others ——————————————— xx %
Products offered by PBL
Table: 1: Products offered by PBL
|100% cash covered|
|12 months period|
|Overdraft (OD)||General purpose|
|12 months period|
|Time loan||Against security or collateral|
|To finance inventory / receivables|
|Term loan||Against fixed assets|
|Over 12 months|
|Maximum 7 years|
|Packing Credit||Against export LC and export order|
|Payment against document (PAD)||Against sight LC|
|Loan against trust receipt (LATR)||Against import LC|
|Cash credit (Hypo)||To finance inventory|
|Local documentary bill purchased (LDBP)||To purchase discount against local usence LC|
|Foreign documentary bill purchased (FDBP)||To purchase discounted export document|
|45 / 180 days|
|Sight LC||For imports|
|Back to back LC & Acceptance||For import of raw materials and accessories for subsequent export|
|Maximum 180 days|
|Letter of Guarantee||For contractual Obligations|
|Spec National period|
Source: PBL credit policy
Before extension of loans, a comprehensive credit risk appraisal is done and annual reviews are made. A credit memorandum (CM) is prepared by the Relationship Manager (RM) which includes the findings of such assessment. The RM used to be the owner of the customer relationship and he / she is held responsible for complying with all the policies and guidelines of Bangladesh bank, bank laws, PBL policies and guidelines etc.
At the time inception of a relationship, the relationship manager tries to gather more and more information about the client. He / she sometimes visit the business premises to get an idea about the financial and operational condition of the prospective client. The market reputation, competitive position etc. are also duly assessed. Branch manager along with the relationship manager is also connected in this process. These initial visits or enquiries are referred to as ‘calls’.
Based on the findings of such calls, RM and the branch manager send a call report to the Head of Marketing, Head of Credit and Managing Director for initial review.
The call report contains some basic information about the client such as:
a) Client’s background
c) Market share
e) Credit exposure
f) Existing banking relationships
g) Credit requirements
h) Pricing of the proposed credit facility
Credit Memorandum (CM)
If the Head Office conveys positive sign for a call report, then only the branch RM goes for preparing a CM. The preparation of CM includes the in-depth analysis of credit risk factors, critical assessment of the client in the light of credit policy guidelines of the bank. Then it is sent to the Head of Marketing to enclose the necessary recommendations and to commence the credit approval process. The CM has to be accompanied with all the required legal documents and the financial information of the prospective client.
The CM generally contains the followings:
a) A spec National control number and base number for each client.
b) The credit risk grading score.
c) The authorization for the approval process.
d) The description of the proposed facility.
e) Rationale behind the loan extension.
f) Financial information of the client mainly the income statements for the past years, earnings forecasts in normal and adverse conditions.
g) Forecasted earnings from the relationship to be established.
h) Lending agreement.
i) Compliance of the policies and guidelines of Bangladesh Bank and PBL.
Most of the times CM also contains the followings:
Table : Credit Memorandum enclosure
|a) Facility Plan||Credit product and credit lines|
|Mode of repayment|
|b) Security Schedule||Primary and collateral security|
|Valuation by professional surveyor|
|Valuation by the expert credit officers|
|c) Security Assistance||Personal or corporate or third party guarantee along with the detail information about the guarantor|
|Personal financial statement|
|d) Payment||Terms and conditions for disbursement|
|Vetting of documents, security valuation, mortgage execution, deposition of fees|
|e) Lending Covenants||Financial covenants|
|f) Risks and Mitigants||Business risk|
|g) Visit and Inspection||Inspection report by RM, credit officer and project engineer|
|Stock inspection report|
|h) Repayment||Repayment source|
|Repayment agenda or schedule|
Source: NATIONAL credit policy
The CM also contains the assessment of the following areas
a) Borrower analysis
The majority shareholders, management team and group or affiliate companies are assessed. Any issues regarding lack of management depth, complicated ownership structures or intergroup transactions are addressed, and risks mitigated.
b) Industry Analysis
The key risk factors of the borrower’s industry are assessed. Any issues regarding the borrower’s position in the industry, overall industry concerns or competitive forces are addressed and the strengths and weaknesses of the borrower relative to its competition are identified.
c) Supplier/Buyer Analysis
Any customer or supplier concentration is addressed, as these could have a sign Nationalant impact on the future viability of the borrower.
d) Historical Financial Analysis
An analysis of a minimum of 3 years historical financial statements of the borrower is presented. Where reliance is placed on a corporate guarantor, guarantor financial statements are also analyzed. The analysis addresses the quality and sustainability of earnings, cash flow and the strength of the borrower’s balance sheet. SpecNationalally, cash flow, leverage and profitability are analyzed.
e) Projected Financial Performance
Where term facilities (tenor > 1 year) are being proposed, a projection of the borrower’s future financial performance is provided, indicating an analysis of the sufficiency of cash flow to service debt repayments. Loans are not granted if projected cash flow is insufficient to repay debts.
f) Account Conduct
For existing borrowers, the historic performances in meeting repayment NBLigations (trade payments, cheques, interest and principal payments, etc) are assessed.
g) Adherence to Lending Guidelines
Credit Applications 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 approve Credit Memorandum that does not adhere to the bank’s Lending Guidelines.
h) Mitigating Factors
Mitigating factors for risks identified in the credit assessment are identified. Possible risks include, but are not limited to: margin sustainability and/or volatility, high debt load (leverage/gearing), overstocking or debtor issues; rapid growth, acquisition or expansion; new business line/product expansion; management changes or succession issues; customer or supplier concentrations; and lack of transparency or industry issues.
i) Loan Structure
The amounts and tenors of financing proposed are justified based on the projected repayment ability and loan purpose. Excessive tenor or amount relative to business needs increases the risk of fund diversion and may adversely impact the borrower’s repayment ability.
A current valuation of collateral is obtained and the quality and priority of security being proposed are assessed. Loans are not granted based solely on security. Adequacy and the extent of the insurance coverage are also assessed. (PBL credit policy, 2005)
Credit Risk Grading
According to Bangladesh Bank guidelines, all Banks should adopt a credit risk grading system. Therefore, PBL has duly implemented a credit risk grading policy in its credit risk assessment program. The system defines the risk profile of borrower’s to ensure that account management, structure and pricing are commensurate with the risk involved. (Focus Group on Credit Risk Management, (2005), Credit Risk Management: Industry Best Practices, Managing Core Risks of Financial Institutions, Bangladesh Bank)
Risk grading is a key measurement of a Bank’s asset quality. All facilities are assigned a risk grade. Where deterioration in risk is noted, the Risk Grade assigned to a borrower and its facilities are immediately changed. Credit Memorandum includes a clear statement of the borrower’s risk grade.
Table : Credit risk grading
|Superior – Low Risk|
|Facilities are fully secured by cash deposits, government bonds or a counter guarantee from a top tier inter National Bank . All security documentation should be in place.|
|Good – Satisfactory Risk|
|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 and have an unblemished track record. All security documentation should be in place. Aggregate Score of 95 or greater based on the Risk Grade Scorecard.|
|Acceptable – Fair Risk|
|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. A borrower should not be graded better than 3 if realistic audited financial statements are not received. These assets would normally be secured by acceptable collateral (1st charge over stocks / debtors / equipment / property). Borrowers should have adequate liquidity, cash flow and earnings. An Aggregate Score of 75-94 based on the Risk Grade Scorecard.|
|Marginal – Watch list|
|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. Facilities should be downgraded to 4 if the borrower incurs a loss, loan payments routinely fall past due, account conduct is poor, or other untoward factors are present. An Aggregate Score of 65-74 based on the Risk Grade Scorecard.|
|Grade 5 assets have potential weaknesses that deserve management’s close attention. Facilities should be downgraded to 5 if sustained deterioration in financial condition is noted (consecutive losses, negative net worth, excessive leverage), if loan payments remain past due for 30-60 days, or if a sign Nationalant petition or claim is lodged against the borrower. Full repayment of facilities is still expected and interest can still be taken into profits. An Aggregate Score of 55-64 based on the Risk Grade Scorecard.|
|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, if the customer intends to create a lender group for debt restructuring purposes, the operation has ceased trading or any indication suggesting the winding up or closure of the borrower is discovered. An Aggregate Score of 45-54 based on the Risk Grade Scorecard.|
|Doubtful and Bad|
|Full repayment of principal and interest is unlikely and the possibility of loss is extremely high. However, due to specNationalally identifiable pending factors, such as litigation, liquidation procedures or capital injection, the asset is not yet classified as Loss. Assets should be downgraded to 7 if loan payments remain past due in excess of 90 days, and interest income should be taken into suspense (nonaccrual). Loan loss provisions must be raised against the estimated unrealizable amount of all facilities. 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|
|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, and the anticipated loss should have been provided for. Bangladesh Bank guidelines for timely write off of bad loans must be adhered to. An Aggregate Score of 35 or less based on the Risk Grade Scorecard|
Source: (Focus Group on Credit Risk Management, (2005), Credit Risk Management: Industry Best Practices, Managing Core Risks of Financial Institutions, Bangladesh Bank.
If any facility is to be downgraded, the RM prepares The Early Alert Report (Appendix III) and it is duly forwarded to the higher authority for approval. After approval, the report is forwarded to Credit Administration, who is responsible to ensure the correct facility/borrower Risk Grades are updated on the system.
Credit Approval Process
Before commencing the credit approval process, a proper credit analysis is done through Credit Memorandum. No credit facility may be approved unless a satisfactory presentation package has been prepared. Prior to securing the requisite approval, the authority ensures due diligence that:
a) The Bank is in possession of all credit information required to properly evaluate the risk being undertaken.
b) A detailed credit analysis has been completed, to include a written analysis of the financial condition of the borrower.
c) The proposed extension of credit fully meets the standard of purpose, quality etc.
d) The Board of Investment Registration, permission for all regulatory bodies, clean CIB reports etc. are obtained.
In the approval process, the bank segregates its relationship management from the approving authority. All the facilities offered by the branch must be approved from the Herd of Credit Committee.
After the facility has been approved, the credit officers of the branch prepare a sanction advice which is addressed to the client. It is a kind of formal letter addressed to the client that provides information regarding the amount of the loan, its purpose, tenor, interest, security details, insurance coverage and other spec National and general conditions applicable to the client.
A sanction advice contains the following information:
a) Address of the client
c) Facility type
d) Review / repayment date
e) Security details
f) Insurance coverage
g) SpecNational conditions
h) General conditions
i) Other conditions and covenants
A sanction advice is accompanied with the necessary legal documents. These documents may include:
a) Demand promissory note
b) Letter of agreement
c) Letter of continuity
d) Letter of revival
e) Letter of disbursement
f) Letter of hypothecation with supplementary documents
g) Registered deed of mortgage
h) Letter of guarantee
i) Registered power of attorney etc.
Credit Risk Management
The credit risk management process of PBL has the function of consistent monitoring of the transactions within approved limits and recovering the bank’s dues in time. The key responsibilities of the credit risk management process are as follows:
a) Oversight of the bank’s credit policies, procedures and controls relating to all credit risks arising from corporate/commercial/institutional banking, personal banking, & treasury operations.
b) Oversight of the bank’s asset quality.
c) Directly manage all Substandard, Doubtful & Bad and Loss accounts to maximize recovery and ensure that appropriate and timely loan loss provisions have been made.
d) To approve (or decline), within delegated authority, Credit Applications recommended by RM. Where aggregate borrower exposure is in excess of approval limits, to provide recommendation to MD/CEO for approval.
e) To provide advice/assistance regarding all credit matters to line management/RMs.
f) To ensure that lending executives have adequate experience and/or training in order to carry out job duties effectively. (Focus Group on Credit Risk Management, (2005), Credit Risk Management: Industry Best Practices, Managing Core Risks of Financial Institutions, Bangladesh Bank)
The credit risk management process of PBL includes the following operations:
The main responsibilities performed by the loan administration department are as follows:
a) To ensure that all security documentation complies with the terms of approval and is enforceable.
b) To monitor insurance coverage to ensure appropriate coverage is in place over assets pledged as collateral, and is properly assigned to the bank.
c) To control loan disbursements only after all terms and conditions of approval have been met, and all security documentation is in place.
d) To maintain control over all security documentation.
e) To monitor borrower’s compliance with covenants and agreed terms and conditions, and general monitoring of account conduct/performance.
(Focus Group on Credit Risk Management, (2005), Credit Risk Management: Industry Best Practices, Managing Core Risks of Financial Institutions, Bangladesh Bank)
Credit administration department ensures the following in connection with documentation:
a) All approvals and documents are in place.
b) Documents are prepared in accordance with the approved terms and conditions and are legally enforceable
c) Vetting of required documents is done.
d) Protection of the bank’s security interest.
e) Any exception from the standard loan facility is duly authorized from the Head of Credit.
The loan administration department performs the following responsibilities in connection with the disbursement to ensure that:
a) All standard security and charge documents are in place.
b) Documentation check list has been prepared.
c) Credit administration department has duly authorized the disbursement.
d) Disbursement authorization form is documented as an evidence of document.
e) A proper back up of all the documents is maintained in the computer system.
f) Incomplete documentation has received temporary waiver from the authority.
g) Pricing of the facility is appropriate.
h) All disbursements / drawings are in the form of approved credit facility.
i) Excess over limit are allowed under pre-fact approval.
j) A clean updated CIB report is obtained before disbursement.
k) The lending cap of the bank is duly maintained. (PBL credit policy)
To minimize credit losses, monitoring procedures and systems are in place that provides an early indication of the deteriorating financial health of a borrower. Credit monitoring process at PBL tries to monitor the following:
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.
(Focus Group on Credit Risk Management, (2005), Credit Risk Management: Industry Best Practices, Managing Core Risks of Financial Institutions, Bangladesh Bank)
Credit monitoring activities in the branch performs the following responsibility:
a) Monitor transactions in accounts to ensure turnover and utilization of limits.
b) Thoroughly review all past dues, collateral short fall, covenant breach and other irregularities.
c) Rectify all audit objections and follow their suggestions.
d) Periodic client calls and review by branch head.
e) Formal periodic review of all relationships.
f) Factory visit / stock inspection and progress of work against work / implementation of projects are to be recorded and reviewed.
g) Borrower to be communicated about past dues, over due installments, expiry of insurance, guarantee, limits etc.
h) Early alert reports are prepared within 7 days of identNationalation of weakness in the business and financial weakness of the client and sent to Head Office Loan Administration.
(PBL credit policy)
Loan Review Committee
The IT system of PBL produces over due positions on 3 periods viz. 30 days, 60 days and 90 days and above. It also produces expired limits and excess over limits (EOLs). The loan MIS are duly distributed to branches, HOM, HOC, HOO, HOCA and MD. A designated loan admin officer follows up the position on a daily basis. Besides, the loan review committee of the bank formally follows up the overdue positions, expired limits and EOL with the branches on a monthly basis which is minuted for taking actions at the earliest, before the account further deteriorates.
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 identNationalation, 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 (Appendix III) is 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 identNationalation of weaknesses. The Risk Grade is updated as soon as possible.
Despite a prudent credit approval process, loans may still become troubled. Therefore, it is essential that early identNationalation and prompt reporting of deteriorating credit signs be done to ensure swift action to protect the Bank’s interest. (PBL credit policy)
The credit division performs the following recovery related functions:
a) Directly managing accounts with sustained deterioration (a risk rating of sub standard or worse)
b) Determining work out plan / Recovery strategy.
c) Pursuing all avenues to maximize recovery, including placing customers into receivership or liquidation as appropriate.
d) Ensuring adequate and timely loan loss provisions are made based on actual and expected losses.
e) Keeping top management appraised of grade 6 or worse accounts.
The findings of this study are summarized below:
a) The credit risk management process of National Bank Ltd. is quite commendable. Systematic and timely monitoring and appropriate documentation are tried to be maintained.
b) Customer satisfaction level is quite good. Informal conversation with some customers reveals that they approve the credit evaluation and management process of National Bank Ltd.
c) Filing procedure is not maintained in a definite and clear manner. It is difficult to locate the documents in a chronological and sequential manner. A definite practice, though mentioned in the credit policy is not always maintained by the credit officials.
d) The credit sanction and disbursement procedure is quite lengthy.
e) Networking system in National Bank Ltd. has to be improved. Network gets disconnected several times a day which causes delays in the overall process and other operations of the bank.
In the light of the above findings, following recommendations are proposed:
a) An uninterrupted network system has to be ensured. It will save the officials from much hassle and will save time.
b) The credit sanction procedure should be made quicker since competition is very hard in today’s business world. People do not want to wait for three to four weeks on an average to get a loan which is even protected by security.
c) Decision making process can be made more decentralized. Participative approach should be adopted to gain prompt and effective result.
d) Filing is a very important component of proper documentation. It has to be dealt with importance.
Credit risk management is becoming more and more important in today’s competitive business world. It is all the more important in the context of Bangladesh. The tools for improving management of consumer credit risk have advanced considerably in recent years. Therefore, as a responsible and reputed commercial bank, National Bank has instituted a contemporary credit risk management system. From the study, it is evident that the bank is quite sincere in their approach to managing the consumer credit risk though there are rooms for improvement. They have to be more cautious in the recovery sector and preferential treatments to some big clients should also be stopped. However, they follow an in-depth procedure in assessing the credit risk by using the credit risk grading techniques which provides them a solid ground in the time of any settlement.
From the discussion in this report, it has become clear that credit risk management is a complex and on going process and therefore financial institutions must take a serious approach in addressing these issues. They have to be up to date in complying with all the required procedures and must employ competent people who have the ability to deal with these complex matters. Utmost importance should be given to the improvement of the networking system which is essential for modern banking environment and obviously for efficient and effective credit risk management process.
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