Credit risk is the primary financial risk in the banking system. Identifying and assessing credit risk is essentially a first step in managing it effectively. In 1993, Bangladesh Bank as suggested by Financial Sector Reform Project (FSRP) first introduced and directed to use Credit Risk Grading system in the Banking Sector of Bangladesh under the caption “Lending Risk Analysis (LRA)”. The Banking sector since then has changed a lot as credit culture has been shifting towards a more professional and standardized Credit Risk Management approach.
Credit Risk Grading system is a dynamic process and various models are followed in different countries & different organizations for measuring credit risk. The risk grading system changes in line with business complexities. A more effective credit risk grading process needs to be introduced in the Banking Sector of Bangladesh to make the credit risk grading mechanism easier to implement.
Keeping the above objective in mind, the Lending Risk Analysis Manual (under FSRP) of Bangladesh Bank has been amended, developed and re-produced in the name of “Credit Risk Grading Manual”.
The Credit Risk Grading Manual has taken into consideration the necessary changes required in order to correctly assess the credit risk environment in the Banking industry. This manual has also been able to address the limitations prevailed in the Lending Risk Analysis Manual.
All Banks should adopt a credit risk grading system outlined in this manual. Risk grading is a key measurement of a Bank’s asset quality, and as such, it is essential that grading is a robust process.
Credit risk grading is an important tool for credit risk management as it helps the Banks & financial institutions to understand various dimensions of risk involved in different credit transactions. The aggregation of such grading across the borrowers, activities and the lines of business can provide better assessment of the quality of credit portfolio of a bank or a branch. 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 loan price, what should be the extent of exposure, what should be the appropriate credit facility, what are the various facilities, what are the various risk mitigation tools to put a cap on the risk level.
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 of credit risk grading, it becomes imperative for the banking system to carefully develop a credit risk grading model which meets the objective outlined above.
The Lending Risk Analysis (LRA) manual introduced in 1993 by the Bangladesh Bank has been in practice for mandatory use by the Banks & financial institutions for loan size of BDT 1.00 crore and above. However, the LRA manual suffers from a lot of subjectivity, sometimes creating confusion to the lending Bankers in terms of selection of credit proposals on the basis of risk exposure. Meanwhile, in 2003 end Bangladesh Bank provided guidelines for credit risk management of Banks wherein it recommended, interalia, the introduction of Risk Grade Score Card for risk assessment of credit proposals.
Since the two credit risk models are presently in vogue, the Governing Board of Bangladesh Institute of Bank Management (BIBM) under the chairmanship of the Governor, Bangladesh Bank decided that an integrated Credit Risk Grading Model be developed incorporating the significant features of the above mentioned models with a view to render a need based simplified and user friendly model for application by the Banks and financial institutions in processing credit decisions and evaluating the magnitude of risk involved therein.
Bangladesh Bank expects all commercial banks to have a well defined credit risk management system which delivers accurate and timely risk grading. This manual describes the elements of an effective internal process for grading credit risk. It also provides a comprehensive, but generic discussion of the objectives and general characteristics of effective credit risk grading system. In practice, a bank’s credit risk grading system should reflect the complexity of its lending activities and the overall level of risk involved.
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 individual obligor, credit portfolio of a unit, line of business, the branch or the Bank as a whole.
• As evident, the CRG outputs would be relevant for individual 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. These would largely constitute obligor level analysis.
• Risk grading would also be relevant for surveillance and monitoring, internal MIS and assessing the aggregate risk profile of a Bank. It is also relevant for portfolio level analysis.
NUMBER AND SHORT NAME OF GRADES USED IN THE CRG
• The proposed CRG scale 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/Watchlist MG/WL 4
Special Mention SM 5
Sub standard 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:
• Superior – (SUP) – 1
Credit facilities, which are fully secured i.e. fully cash covered.
Credit facilities fully covered by government guarantee.
Credit facilities fully covered by the guarantee of a top tier international Bank.
• Good – (GD) – 2
Strong repayment capacity of the borrower
The borrower has excellent liquidity and low leverage.
The company demonstrates consistently strong earnings and cash flow.
Borrower has well established, strong market share.
Very good management skill & expertise.
All security documentation should be in place.
Credit facilities fully covered by the guarantee of a top tier local Bank.
Aggregate Score of 85 or greater based on the Risk Grade Score Sheet
• Acceptable – (ACCPT) – 3
These borrowers are not as strong as GOOD Grade borrowers, but still demonstrate consistent earnings, cash flow and have a good track record.
Borrowers have adequate liquidity, cash flow and earnings.
Credit in this grade would normally be secured by acceptable collateral (1st charge over inventory / receivables / equipment / property).
Acceptable parent/sister company guarantee
Aggregate Score of 75-84 based on the Risk Grade Score Sheet
• Marginal/Watchlist – (MG/WL) – 4
This grade warrants 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.
Weaker business credit & early warning signals of emerging business credit detected.
The borrower incurs a loss
Loan repayments routinely fall past due
Account conduct is poor, or other untoward factors are present.
Credit requires attention
Aggregate Score of 65-74 based on the Risk Grade Score Sheet
• Special Mention – (SM) – 5
This grade has 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.
Severe management problems exist.
Facilities should be downgraded to this grade if sustained deterioration in financial condition is noted (consecutive losses, negative net worth, excessive leverage),
An Aggregate Score of 55-64 based on the Risk Grade Score Sheet.
• Substandard – (SS) – 6
Financial condition is weak and capacity or inclination to repay is in doubt.
These weaknesses jeopardize the full settlement of loans.
Bangladesh Bank criteria for sub-standard credit shall apply.
An Aggregate Score of 45-54 based on the Risk Grade Score Sheet.
• Doubtful – (DF) – 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 Bad & Loss.
Bangladesh Bank criteria for doubtful credit shall apply.
An Aggregate Score of 35-44 based on the Risk Grade Score Sheet.
• Bad & Loss – (BL) – 8
Credit of this grade has long outstanding with no progress in obtaining repayment or on the verge of wind up/liquidation.
Prospect of recovery is poor and legal options have been pursued.
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.
This classification reflects that it is not practical or desirable to defer writing off this basically valueless asset even though partial recovery may be affected in the future. Bangladesh Bank guidelines for timely write off of bad loans must be adhered to. Legal procedures/suit initiated.
Bangladesh Bank criteria for bad & loss credit shall apply.
An Aggregate Score of less than 35 based on the Risk Grade Score Sheet.
REGULATORY DEFINITION ON GRADING OF CLASSIFIED ACCOUNTS
Irrespective of credit score obtained by a particular obligor, grading of the classified names should be in line with Bangladesh Bank guidelines on classified accounts, which is extracted from “PRUDENTIAL REGULATIONS FOR BANKS: SELECTED ISSUES” (updated till August 07, 2005) by Bangladesh Bank are presently as follows:
Basis for Loan Classification:
(A) Objective Criteria:
□ Any Continuous Loan if not repaid/renewed within the fixed expiry date for repayment will be treated as irregular just from the following day of the expiry date. This loan will be classified as Sub-standard if it is kept irregular for 6 months or beyond but less than 9 months, as `Doubtful’ if for 9 months or beyond but less than 12 months and as `Bad & Loss’ if for 12 months or beyond.
□ Any Demand Loan will be considered as Sub-standard if it remains unpaid for 6 months or beyond but not less then 9 months from the date of claim by the bank or from the date of forced creation of the loan; likewise the loan will be considered as ‘Doubtful’ and ‘Bad & Loss’ if remains unpaid for 9 months or beyond but less then 12 months and for 12 months and beyond respectively.
□ In case any instalment(s) or part of instalment(s) of a Fixed Term Loan is not repaid within the due date, the amount of unpaid instalment(s) will be termed as `defaulted instalment’.
In case of Fixed Term Loans, which are repayable within maximum 5 (five) years of time: –
If the amount of `defaulted instalment’ is equal to or more than the amount of instalment(s) due within 6 months, the entire loan will be classified as ‘Sub-standard’.
If the amount of ‘defaulted instalment’ is equal to or more than the amount of instalment(s) due within 12 months, the entire loan will be classified as ‘Doubtful’.
If the amount of ‘defaulted instalment’ is equal to or more than the amount of instalment(s) due within 18 months, the entire loan will be classified as ‘Bad & Loss’.
In case of Fixed Term Loans, which are repayable in more than 5 (five) years of time: –
□ If the amount of ‘defaulted instalment’ is equal to or more than the amount of instalment(s) due within 12 months, the entire loan will be classified as ‘Sub-standard.’
□ If the amount of ‘defaulted instalment’ is equal to or more than the amount of instalment(s) due within 18 months, the entire loan will be classified as ‘Doubtful’.
□ If the amount of ‘defaulted instalment ‘is equal to or more than the amount of instalment(s) due within 24 months, the entire loan will be classified as ‘Bad & Loss’.
Explanation: If any Fixed Term Loan is repayable at monthly instalment, the amount of instalment(s) due within 6 months will be equal to the amount of summation of 6 monthly instalments. Similarly, if repayable at quarterly instalment, the amount of instalment(s) due within 6 months will be equal to the amount of summation of 2 quarterly instalments.
(B) Qualitative Judgement:
If any uncertainty or doubt arises in respect of recovery of any Continuous Loan, Demand Loan or Fixed Term Loan, the same will have to be classified on the basis of qualitative judgement be it classifiable or not on the basis of objective criteria.
If any situational changes occur in the stipulations in terms of which the loan was extended or if the capital of the borrower is impaired due to adverse conditions or if the value of the securities decreases or if the recovery of the loan becomes uncertain due to any other unfavorable situation, the loan will have to be classified on the basis of qualitative judgement .
Besides, if any loan is illogically or repeatedly re-scheduled or the norms of re-scheduling are violated or instances of (propensity to) frequently exceeding the loan-limit are noticed or legal action is lodged for recovery of the loan or the loan is extended without the approval of the proper authority, it will have to be classified on the basis of qualitative judgement .
Despite the probability of any loan’s being affected due to the reasons stated above or for any other reasons, if there exists any hope for change of the existing condition by resorting to proper steps, the loan, on the basis of qualitative judgement, will be classified as ‘Sub-standard’. But even if after resorting to proper steps, there exists no certainty of total recovery of the loan, it will be classified as ‘Doubtful’ and even after exerting the all-out effort, there exists no chance of recovery, it will be classified as ‘ Bad & Loss’ on the basis of qualitative judgement.
The concerned bank will classify on the basis of qualitative judgement and can declassify the loans if qualitative improvement does occur.
But if any loan is classified by the Inspection Team of Bangladesh Bank, the same can be declassified with the approval of the Board of Directors of the bank. However, before placing such case to the Board, the CEO and concerned branch manager shall have to certify that the conditions for declassification have been fulfilled.
a) Any change in classification criteria provided by the Bangladesh Bank shall supersede this grading system for classified accounts.
b) An account may also be classified based on qualitative judgment in line with Bangladesh Bank guidelines.
c) A particular bank may have classification criteria stricter than Bangladesh Bank guidelines.
HOW TO COMPUTE CREDIT RISK GRADING
The following step-wise activities outline the detail process for arriving at credit risk grading.
Credit risk for counterparty arises from an aggregation of the following:
Each of the above mentioned key risk areas require to be evaluated and aggregated to arrive at an overall risk grading measure.
a) Evaluation of Financial Risk:
Risk that counterparties will fail to meet obligation due to financial distress. This typically entails analysis of financials i.e. analysis of leverage, liquidity, profitability & interest coverage ratios. To conclude, this capitalizes on the risk of high leverage, poor liquidity, low profitability & insufficient cash flow.
b) Evaluation of Business/Industry Risk:
Risk that adverse industry situation or unfavorable business condition will impact borrowers’ capacity to meet obligation. The evaluation of this category of risk looks at parameters such as business outlook, size of business, industry growth, market competition & barriers to entry/exit. To conclude, this capitalizes on the risk of failure due to low market share & poor industry growth.
c) Evaluation of Management Risk:
Risk that counterparties may default as a result of poor managerial ability including experience of the management, its succession plan and team work.
d) Evaluation of Security Risk:
Risk that the bank might be exposed due to poor quality or strength of the security in case of default. This may entail strength of security & collateral, location of collateral and support.
e) Evaluation of Relationship Risk:
These risk areas cover evaluation of limits utilization, account performance, conditions/covenants compliance by the borrower and deposit relationship.
According to the importance of risk profile, the following weightages are proposed for corresponding principal risks.
Principal Risk Components: Weight:
Financial Risk 50%
Business/Industry Risk 18%
Management Risk 12%
Security Risk 10%
Relationship Risk 10%
Principal Risk Components: Key Parameters:
Financial Risk Leverage, Liquidity, Profitability & Coverage ratio.
Business/Industry Risk Size of Business, Age of Business, Business Outlook, Industry Growth, Competition & Barriers to Business
Management Risk Experience, Succession & Team Work.
Security Risk Security Coverage, Collateral Coverage and Support.
Relationship Risk Account Conduct ,Utilization of Limit, Compliance of
covenants/conditions & Personal Deposit.
Principal Risk Components: Key Parameters: Weight:
Financial Risk 50%
Business/Industry Risk 18%
Size of Business 5%
Age of Business 3%
Business Outlook 3%
Industry growth 3%
Market Competition 2%
Entry/Exit Barriers 2%
Management Risk 12%
Team Work 3%
Security Risk 10%
Security coverage 4%
Collateral coverage 4%
Relationship Risk 10%
Account conduct 5%
Utilization of limit 2%
Compliance of covenants
Personal deposit 1%
After the risk identification & weightage assignment process (as mentioned above), the next steps will be to input actual parameter in the score sheet to arrive at the scores corresponding to the actual parameters.
This manual also provides a well programmed MS Excel based credit risk scoring sheet to arrive at a total score on each borrower. The excel program requires inputting data accurately in particular cells for input and will automatically calculate the risk grade for a particular borrower based on the total score obtained. The following steps are to be followed while using the MS Excel program.
a) Open the MS XL file named, CRG_SCORE_SHEET
b) The entire XL sheet named, CRG is protected except the particular cells to input data.
c) Input data accurately in the cells which are BORDERED & are colored YELLOW.
d) Some input cells contain DROP DOWN LIST for some criteria corresponding to the Key Parameters. Click to the input cell and select the appropriate parameters from the DROP DOWN LIST as shown below.
e) All the cells provided for input must be filled in order to arrive at accurate risk grade.
f) We have also enclosed the MS Excel file named, CRG_Score_Sheet in CD ROM for use.
The following is the proposed Credit Risk Grade matrix based on the total score obtained by an obligor.
Number Risk Grading Short Name Score
1 Superior SUP 100% cash covered
International Bank guarantees
2 Good GD 85+
3 Acceptable ACCPT 75-84
4 Marginal/Watchlist MG/WL 65-74
5 Special Mention SM 55-64
6 Sub-standard SS 45-54
7 Doubtful DF 35-44
8 Bad & Loss BL <35
CREDIT RISK GRADING PROCESS
Credit Risk Grading should be completed by a Bank for all exposures (irrespective of amount) other than those covered under Consumer and Small Enterprises Financing Prudential Guidelines and also under The Short-Term Agricultural and Micro – Credit.
For Superior Risk Grading (SUP-1) the score sheet is not applicable. This will be guided by the criterion mentioned for superior grade account i.e. 100% cash covered, covered by government & bank guarantee.
Credit risk grading matrix would be useful in analyzing credit proposal, new or renewal for regular limits or specific transactions, if basic information on a borrowing client to determine the degree of each factor is a) readily available, b) current, c) dependable, and d) parameters/risk factors are assessed judiciously and objectively. The Relationship Manager as per Data Collection Checklist as shown in Appendix-A should collect required information.
Relationship manager should ensure to correctly fill up the Limit Utilization Form as shown in Appendix-B in order to arrive at a realistic earning status for the borrower.
Risk factors are to be evaluated and weighted very carefully, on the basis of most up-to-date and reliable data and complete objectivity must be ensured to assign the correct grading. Actual parameter should be inputted in the Credit Risk Grading Score Sheet as shown in Appendix–C.
Credit risk grading exercise should be originated by Relationship Manager and should be an on-going and continuous process. Relationship Manager shall complete the Credit Risk Grading Score Sheet and shall arrive at a risk grading in consultation with a Senior Relationship Manager and document it as per Credit Risk Grading Form as shown in Appendix-D, which shall then be concurred by the Credit Officer in consultation with a Senior Credit Officer.
All credit proposals whether new, renewal or specific facility should consist of a) Data Collection Checklist, b) Limit Utilization Form c) Credit Risk Grading Score Sheet, and d) Credit Risk Grading Form.
The credit officers then would pass the approved Credit Risk Grading Form to Credit Administration Department and Corporate Banking/Line of Business/Recovery Unit for updating their MIS/record.
The appropriate approving authority through the same Credit Risk Grading Form shall approve any subsequent change/revision i.e. upgrade or downgrade in credit risk grade.
EARLY WARNING SIGNALS (EWS)
Early Warning Signals (EWS) indicate risks or potential weaknesses of an exposure requiring monitoring, supervision, or close attention by management.
If these weaknesses are left uncorrected, they may result in deterioration of the repayment prospects in the Bank’s assets at some future date with a likely prospect of being downgraded to classified assets.
Early identification, prompt reporting and proactive management of Early Warning Accounts are prime credit responsibilities of all Relationship Managers and must be undertaken on a continuous basis.
Despite a prudent credit approval process, loans may still become troubled. Therefore, it is essential that early identification and prompt reporting of deteriorating credit signs be done to ensure swift action to protect the Bank’s interest. The symptoms of early warning signals as mentioned below are by no means exhaustive and hence, if there are other concerns, such as a breach of loan covenants or adverse market rumors that warrant additional caution, a Credit Risk Grading Form (Appendix-D) should be presented.
Irrespective of credit score obtained by any obligor as per the proposed risk grade score sheet, the grading of the account highlighted as Early Warning Signals (EWS) accounts shall have the following risk symptoms.
a) Marginal/Watchlist (MG/WL – 4): if –
Any loan is past due/overdue for 60 days and above.
Frequent drop in security value or shortfall in drawing power exists.
b) Special Mention (SM – 5): if –
Any loan is past due/overdue for 90 days and above
Major document deficiency prevails (such deficiencies include but not limited to; board resolution for borrowing not obtained, sanction letter not accepted by client, charges/hypothecation over assets favoring bank not filed with Registrar, Joint Stock Companies, mortgage not in place, guarantees not obtained, etc.)
A significant petition or claim is lodged against the borrower.
The Credit Risk Grading Form of accounts having Early Warning Signals should be completed by the Relationship Manager and sent to the approving authority in Credit Risk Management Department. The Credit Risk Grade should be updated as soon as possible and no delay should be there in referring Early Warning Signal accounts or any problem accounts to the Credit Risk Management Department for their early involvement and assistance in recovery.
EXCEPTIONS TO CREDIT RISK GRADING
Head of Credit Risk Management may also downgrade/classify an account in the normal course of inspection of a Branch or during the periodic portfolio review. In such event, the Credit Risk Grading Form will then be filled up by Credit Risk Management Department and will be referred to Corporate Banking/Line of Business/Credit Administration Department/Recovery Unit for updating their MIS/records.
Recommendation for upgrading of an account has to be well justified by the recommending officers. Essentially complete removal of the reasons for downgrade should be the basis of any upgrading.
In case an account is rated marginal, special mention or unacceptable credit risk as per the risk grading score sheet, this may be substantiated and credit risk may be accepted if the exposure is additionally collateralized through cash collateral, good tangible collaterals and strong guarantees. These are exceptions and should be exceptionally approved by the appropriate approving authority.
Whenever required an independent assessment of the credit risk grading of an individual account may be conducted by the Head of Credit Risk Management or by the Internal Auditor documenting as to why the credit deteriorated and also pointing out the lapses.
If a Bank has its own well established risk grading system equivalent to the proposed credit risk grading or stricter, then they will have the option to continue with their own risk grading system.
CREDIT RISK GRADING REVIEW
Credit Risk Grading for each borrower should be assigned at the inception of lending and should be periodically updated. Frequencies of the review of the credit risk grading are mentioned below;
Number Risk Grading Short Review frequency (at least)
1 Superior SUP Annually
2 Good GD Annually
3 Acceptable ACCPT Annually
4 Marginal/Watchlist MG/WL Half yearly
5 Special Mention SM Quarterly
6 Sub-standard SS Quarterly
7 Doubtful DF Quarterly
8 Bad & Loss BL Quarterly
MIS ON CREDIT RISK GRADING
Bank should have comprehensive MIS reports on credit risk grading to evaluate entire credit portfolio of the Bank. Format of such MIS reports on credit risk grading has been presented in Appendix – E.
Credit Risk Grading Report (Consolidated)
Credit Risk Grading Report (Branch Wise)
Credit Risk Grading Report (Branch & Risk Grade Wise)
Credit Risk Grading Report (Grade Wise Borrower List)
MIS reports as mentioned above should be prepared and circulated at least on a quarterly basis.
FINANCIAL SPREAD SHEET (FSS)
A Financial Spread Sheet (FSS) has been developed which may be used by the Banks while analyzing the credit risk elements of a credit proposal from financial point of view.
The FSS is well designed and programmed software having two parts. Input and Output Sheets. The financial numbers of borrowers need to be inputted in the Input Sheets which will then automatically generate the Output Sheets. The Financial Spread Sheet (FSS) is attached as Appendix – F.