CRG Manual

IMPLEMENTATION OF CREDIT RISK GRADING MANUAL. REF: BRPD CIRCULAR NO. 07 DATED 09.07.2007.

Preamble

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.

INTRODUCTION

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.

DEFINITIONOFCREDIT 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
  • A Credit Risk Grading deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit
  • Credit Risk Grading is the basic module for developing a Credit Risk Management

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
  • As evident, the CRG outputs would be relevant for individual credit selection, wherein either a borrower or a particular exposure/facility is 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 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:
GRADI NG 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

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:

  • Financial Risk
  • Business/Industry Risk
  • Management Risk
  • Security Risk
  • Relationship Risk

Each of the above mentioned key risk areas require to be evaluated and aggregated to arrive at an overall risk grading measure.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. Evaluation of Relationship Risk:

These risk areas cover evaluation of limits utilization, account performance, conditions/covenants compliance by the borrower and deposit relationship.

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According to the importance of risk profile, the following weightages are proposed for corresponding principal risks.

Principal Risk Com ponent s:                      W eight :

ƒ Financial Risk 50%
ƒ Business/Industry Risk 18%
ƒ Management Risk 12%
ƒ Security Risk 10%
ƒ Relationship Risk 10%

 

 

Step I I I          Establish the Key Parameters

Principal Risk Com ponent s:                        Key Param et ers:

 

ƒ

ƒ

Financial Risk Business/Industry Risk Leverage, Liquidity, Profitability & Coverage ratio. Size of Business, Age of Business, Business Outlook,
    Industry Growth, Competition & Barriers to Business
ƒ

ƒ

ƒ

Management Risk

Security Risk Relationship Risk

Experience, Succession & Team Work.

Security Coverage, Collateral Coverage and Support. Account Conduct ,Utilization of Limit, Compliance of covenants/conditions & Personal Deposit.

 

 

Step I V           Assign weightages to each of the key parameters.

Principal Risk Com ponent s:                        Key Param et ers:                  W eight :

 

ƒ Financial Risk     50%
    Þ Leverage 15%
    Þ Liquidity 15%
    Þ Profitability 15%
    Þ Coverage 5%
ƒ Business/ I ndustry Risk     18%
    Þ Size of Business 5%
    Þ Age of Business 3%
    Þ Business Outlook 3%
    Þ Industry growth 3%
    Þ Market Competition 2%
    Þ Entry/Exit Barriers 2%
ƒ Management Risk     12%
    Þ Experience 5%
    Þ Succession 4%
    Þ Team Work 3%
ƒ Security Risk     10%
    Þ Security coverage 4%
    Þ Collateral coverage 4%
    Þ Support 2%
ƒ Relationship Risk     10%
    Þ Account conduct 5%
    Þ Utilization of limit 2%
    Þ Compliance of covenants  
      /condition 2%
    Þ Personal deposit 1%

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