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:
CREDIT RISK GRADING DEFINITIONS
A clear definition of the different categories of Credit Risk Grading is given as follows:
|Superior – Low Risk|
|Good – Satisfactory Risk|
|Acceptable – Fair Risk|
|Marginal – Watch list|
|Doubtful and Bad|
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:
Liquidity and Capacity of External Fund Mobilization
Size of the Bank & Market Presence
Regulatory Environment & Compliance
Sensitivity to Market Risk
Ownership (Share holding pattern) & Corporate Governance
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%
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
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).
|ü 85 – 100|
ü Credit facilities fully cash covered (100%) or near cash.
ü Government guarantee
ü International Bank guarantee
75 – 84
65 – 74
55 – 64
45 – 54
35 – 44
25 – 34
Credit Assessment & Risk Grading
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.
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
|Borrower||Aftab Autos Ltd.|
|Lender Name||National Bank Ltd.||Aggregate Score:||87|
|Branch:||Mohammadpur Branch, Dhaka|
|Date of Financials||31-Dec-11|
|Completed by||Mr. X|
|Approved by||Credit Manager|
Fully cash secured, secured by government
|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%
|(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
|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. 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|
|Cause for Concern||0|
|4. Industry Growth||Strong (10%+)||3||Good (>5% – 10%)||2|
|Good (>5% – 10%)||2|
|No Growth (<1%)||0|
|5. Market Competition||Dominant Player||2||Moderately Competitive||1|
Total Score – Business/Industry Risk
|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|
|2. 2nd 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|
Total Score- Management Risk
|D. Security Risk10%|
|1.Security Coverage (Primary)|
Fully Pledged facilities/substantially cash covered / Reg. Mortgage. for HBL
Registered Hypothecation 1st Charge/1st ParipassuCharge
|Registered Hypothecation(1stCharge/1st Pari passu Charge)||3|
|2nd charge/Inferior charge||2|
|Simple hypothecation/Negative lien on assets||1|
|2.Collateral Coverage (Property Location)||Registered Mortgage on Municipal corporation/Prime Area property||4|
Registered Mortgage on Pourashava/Semi-Urban area property
|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
|4. Personal Deposits|
Personal accounts of the key business Sponsors/ Principals are maintained in the bank,
Personal accounts of the key business Sponsors/Principals are maintained in the bank,
Total Score- Relationship Risk
|Grand Total – All Risk||100||87|
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.
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.
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)