Credit risk management: Doing it diligently

A risk-focused examination process is there to direct the inspection process to the more risk-prone areas of both operations and business. Skills in risk-focused supervision are continually being developed by exposing examiners to relevant training. By adopting this approach, the banking industry and specifically the small banks are sensitised about the need to have formal and documented risk management frameworks. Risk management is defined as the process that a bank puts in place to control its financial exposures. The process of risk management comprises the fundamental steps of risk identification, risk analysis and assessment, risk audit monitoring, and risk treatment or control.

Financial institutions, especially banks, are exposed to a variety of risks. They include interest rate risk, foreign exchange risk, political risk, market risk, liquidity risk, operational risk and credit risk. In some instances, commercial banks and other financial institutions approve decisions that are not vetted, there are cases of loan defaults and non-performing loans, large-scale extension of credit and directed lending. The main sources of credit risk include limited institutional capacity, inappropriate credit policies, volatile interest rates, poor management, inappropriate laws, low capital and liquidity levels, directed lending, massive licensing of banks, poor loan underwriting, reckless lending, poor credit assessment, no non-executive directors, laxity in credit assessment, poor lending practices, government interference and inadequate supervision by the central bank. To minimise these risks, it is necessary for the financial system to have well-capitalised banks, ensure service to a wide range of customers, share information about borrowers, stabilise interest rates, reduce non-performing loans, increase bank deposits and increase the credit flow to the borrowers. Loan defaults and non-performing loans need to be reduced.

In Bangladesh, the total classified loans in the banking industry was Tk. 657.31 billion (65,731 crore) as of December 2016. It was more than 10 per cent of the total loans. But if we consider the written-off loans worth Tk. 1,100 billion (110,000 crore), the total classified loans stand at Tk. 1,757.31 billion (175,731 crore), which is 23.56 per cent of the industry's total loans. Some of the banks saw their classified loans inflate to more than 50 per cent of their total loans and advances. While some commercial banks faced difficulties over the years for a multitude of reasons, the major cause of serious financial problems continues to be directly related to credit standards for borrowers, poor portfolio risk management or lack of attention to changes in the economic circumstances and competitive climate. The credit decision should be based on a thorough evaluation of the risk conditions of any lending and the characteristics of the borrower.

Numerous approaches have been developed for incorporating risks into the decision-making process by lending organisations. They range from relatively simple methods, such as the use of subjective or informal approaches, to fairly complex ones such as the use of computerised simulation models. Banks need to gather adequate information about potential customers to be able to calibrate the credit risk exposure. The information gathered will guide the bank in assessing the probability of a borrower defaulting on the loan and price the credit accordingly. Much of this information is gathered during loan documentation. The bank should, however, go beyond information provided by the borrower and seek additional information from third parties like credit rating agencies and credit reference bureaus etc.

A firm's credit policy may be lenient or stringent. In the case of a lenient policy, the firm lends liberally even to those whose credit worthiness is questionable. This leads to a high amount of borrowing and high profits, subject to full collection of the debts. On the other hand, under the stringent credit policy, credit is restricted to carefully determined customers through a credit appraisal system. This minimises costs and losses from bad debts but might reduce revenue earnings from loans, profitability and cash flow. The lending policy should be in line with the overall bank strategy and the factors considered in designing a lending policy should include the existing credit policy, industry norms, general economic condition and the prevailing economic climate. The guiding principle in credit appraisal is to ensure that only those borrowers who require credit and are able to meet repayment obligations can access credit. On the other hand, credit should be made available according to repayment capability and intension based on current performance.

The level of non-performing loans given by banks had been witnessing an upward trend in Bangladesh since 2013. It was at a lower level of 6.10 per cent in 2011. But the trend of net interest income in the banking industry has been increasing over the last decade, although some of the state-owned banks made heavy losses, especially in 2013. In 2013 the net loss of all state-owned banks stood at Tk. 5.40 billion. On the other hand, profitability of private commercial banks and foreign commercial banks saw an upward trend in all respects. The amount of credit extended to customers was also relatively high. Profits, credit flow and the level of nonperforming loans are all interlinked. It is also assumed that if the non-performing loans see a downward trend, the profit rises sharply. So, commercial banks that are keen on making high profits should concentrate on the factors-a higher credit flow but a lower amount of non-performing loans. 

Email: [email protected]