Chapter Three

Credit Risk Management of

IDLC

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 3.1 WHAT IS RISK?

In general Risk can be define as the “ Probability or threat of a damage, injury, liability,
loss, or other negative occurrence, caused by external or internal vulnerabilities, and
which may be neutralized through pre-mediated action.”
But in Finance risk is defined concerning some special factors of market and other
externalities which can affect an individual or organization’s decision. In Finance risk is
defined as “Probability that an actual return on an investment will be lower than the
expected return.” Financial risk is divided into the following general categories: (1) Basis
risk: Changes in interest rates will cause interest-bearing liabilities (deposits) to re-price
at a rate higher than that of the interest-bearing assets (loans). (2) Capital risk: Losses
from un- recovered loans will affect the financial institution's capital base and may
necessitate floating of a new stock (share) issue.
Therefore to reduce this risk Banks, NBFIs, and other organizations take various types of
measures so that it can be reduced in a minimal affordable limit. In Banks and NBFIs the
core risk is credit risk. As Banks, NBFIs performs there major operations on providing
loan, lease (for NBFIs) therefore there is a chance of default at time of repayment. So to
reduce this default risk so that number of default payment does not increase and to
forecast this probability with appropriate tools Banks, NBFIs always work on managing
their Credit Risk. Several Guideline and standards are prepared so that Credit Risk for
individual banks and NBFIs can be reduced.

3.2 CREDIT RISK

Credit risk is the possibility that a borrower or counter party will fail to meet agreed
obligations. Globally, more than 50% of total risk elements in banks and FIs are Credit
Risk alone. Thus managing credit risk for efficient management of a FI has gradually
become the most crucial task. Credit risk may take the following forms:
 In direct lease/term finance: rentals/principal/and or interest amount may not be
repaid
 In issuance of guarantees: applicant may fail to build up fund for settling claim, if any;
 In documentary credits: applicant may fail to retire import documents and many others
 In factoring: the bills receivables against which payments were made, may fail to be paid

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 In treasury operations: the payment or series of payments due from the counter parties
under the respective contracts may not be forthcoming or ceases
 In securities trading businesses: funds/ securities settlement may not be effected
 In cross-border exposure: the availability and free transfer of foreign currency funds may
either cease or restrictions may be imposed by the sovereign
 Credit risk management encompasses identification, measurement, matching mitigations,
monitoring and control of the credit risk exposures to ensure that:
 The individuals who take or manage risks clearly understand it
 The organization’s Risk exposure is within the limits established by Board of Directors
with respect to sector, group and country’s prevailing situation
 Risk taking Decisions are in line with the business strategy and objectives set by BOD
 The expected payoffs compensate the risks taken
 Risk taking decisions are explicit and clear
 Sufficient capital as a buffer is available to take risk

3.3 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. It should provide for sound practices in:
1. Credit processing/appraisal;
2. Credit approval/sanction;
3. Credit documentation;
4. Credit administration;
5. Disbursement;
6. Monitoring and control of individual credits;
7. Monitoring the overall credit portfolio (stress testing)
8. Credit classification; and
9. Managing problem credits/recovery

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3.3.1 Credit processing
Credit processing is the stage where all required information on credit is gathered and
applications are screened. Credit application forms should be sufficiently detailed to
permit gathering of all information needed for credit assessment at the outset. In this
connection, NBFIs should have a checklist to ensure that all required information is, in
fact, collected.
NBFIs should set out pre-qualification screening criteria, which would act as a guide for
their officers to determine the types of credit that are acceptable. For instance, the criteria
may include rejecting applications from blacklisted customers. These criteria would help
institutions avoid processing and screening applications that would be later rejected.
Moreover, all credits should be for legitimate purposes and adequate processes should be

established to ensure that financial institutions are not used for fraudulent activities or
activities that are prohibited by law or are of such nature that if permitted would
contravene the provisions of law. Institutions must not expose themselves to reputational
risk associated with granting credit to customers of questionable repute and integrity.
The next stage to credit screening is credit appraisal where the financial institution
assesses the customer’s ability to meet his obligations. Institutions should establish well
designed credit appraisal criteria to ensure that facilities are granted only to creditworthy
customers who can make repayments from reasonably determinable sources of cash flow
on a timely basis.
Financial institutions usually require collateral or guarantees in support of a credit in
order to mitigate risk. It must be recognized that collateral and guarantees are merely
instruments of risk mitigation. They are, by no means, substitutes for a customer’s ability
to generate sufficient cash flows to honor his contractual repayment obligations.
Collateral and guarantees cannot obviate or minimize the need for a comprehensive
assessment of the customer’s ability to observe repayment schedule nor should they be
allowed to compensate for insufficient information from the customer.
Care should be taken that working capital financing is not based entirely on the existence
of collateral or guarantees. Such financing must be supported by a proper analysis of
projected levels of sales and cost of sales, prudential working capital ratio, past
experience of working capital financing, and contributions to such capital by the borrower
itself.

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Financial institutions must have a policy for valuing collateral, taking into account the
requirements of the Bangladesh Bank guidelines dealing with the matter. Such a policy
shall, among other things, provide for acceptability of various forms of collateral, their
periodic valuation, process for ensuring their continuing legal enforceability and
realization value.
In the case of loan syndication, a participating financial institution should have a policy to
ensure that it does not place undue reliance on the credit risk analysis carried out by the
lead underwriter. The institution must carry out its own due diligence, including credit
risk analysis, and an assessment of the terms and conditions of the syndication.
The appraisal criteria will of necessity vary between corporate credit applicants and
personal credit customers. Corporate credit applicants must provide audited financial
statements in support of their applications. As a general rule, the appraisal criteria will
focus on:
 Amount and purpose of facilities and sources of repayment;
 Integrity and reputation of the applicant as well as his legal capacity to assume the
credit obligation;
 Risk profile of the borrower and the sensitivity of the applicable industry sector to
economic fluctuations;
 Performance of the borrower in any credit previously granted by the financial
institution, and other institutions, in which case a credit report should be sought from
them;
 The borrower’s capacity to repay based on his business plan, if relevant, and projected
cash flows using different scenarios;
 Cumulative exposure of the borrower to different institutions;
 Physical inspection of the borrower’s business premises as well as the facility that is
the subject of the proposed financing;
 Borrower’s business expertise;
 Adequacy and enforceability of collateral or guarantees, taking into account the
existence of any previous charges of other institutions on the collateral;
 Current and forecast operating environment of the borrower;
 Background information on shareholders, directors and beneficial owners for
corporate customers; and
 Management capacity of corporate customers.

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3.3.2 Credit Approval:

A financial institution must have some written guidelines on the credit approval process
and the approval authorities of individuals or committees as well as the basis of those
decisions. Approval authorities should be sanctioned by the board of directors. Approval
authorities will cover new credit approvals, renewals of existing credits, and changes in
terms and conditions of previously approved credits, particularly credit restructuring, all
of which should be fully documented and recorded. Prudent credit practice requires that
persons empowered with the credit approval authority should not also have the customer
relationship responsibility.
Approval authorities of individuals should be commensurate to their positions within
management ranks as well as their expertise. Depending on the nature and size of credit,
it would be prudent to require approval of two officers on a credit application, in
accordance with the Board’s policy. The approval process should be based on a system of
checks and balances. Some approval authorities will be reserved for the credit committee
in view of the size and complexity of the credit transaction.

3.3.3 Credit Documentation:

Documentation is an essential part of the credit process and is required for each phase of
the credit cycle, including credit application, credit analysis, credit approval, credit
monitoring, and collateral valuation, and impairment recognition, foreclosure of impaired
loan and realization of security. The format of credit files must be standardized and files
neatly maintained with an appropriate system of cross-indexing to facilitate review and
follow-up.

Documentation establishes the relationship between the financial institution and the
borrower and forms the basis for any legal action in a court of law. Institutions must
ensure that contractual agreements with their borrowers are vetted by their legal advisers.
Credit applications must be documented regardless of their approval or rejection.
For security reasons, financial institutions need to consider keeping the copies of critical
documents (i.e., those of legal value, facility letters, and signed loan agreements) in credit
files while retaining the originals in more secure custody. Credit files should also be
stored in fire-proof cabinets and should not be removed from the institution's premises.
Financial institutions must ensure that their credit portfolio is properly administered, that

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is, loan agreements are duly prepared, renewal notices are sent systematically and credit
files are regularly updated.

3.3.4 Credit Administration:

An institution may allocate its credit administration function to a separate department or
to designated individuals in credit operations, depending on the size and complexity of its
credit portfolio.
A financial institution’s credit administration function should, as a minimum, ensure that:
 Credit files are neatly organized, cross-indexed, and their removal from the premises
is not permitted;
 The borrower has registered the required insurance policy in favour of the bank and is
regularly paying the premiums;
 The borrower is making timely repayments of lease rents in respect of charged
leasehold properties;
 Credit facilities are disbursed only after all the contractual terms and conditions have
been met and all the required documents have been received;
 Collateral value is regularly monitored;
 The borrower is making timely repayments on interest, principal and any agreed to
fees and commissions;
 Information provided to management is both accurate and timely;
 Funds disbursed under the credit agreement are, in fact, used for the purpose for which
they were granted;
 “Back office” operations are properly controlled;
 The established policies and procedures as well as relevant laws and regulations are
complied with; and
 On-site inspection visits of the borrower’s business are regularly conducted and
assessments documented.

3.3.5 Credit Disbursement:

Once the credit is approved, the customer should be advised of the terms and conditions
of the credit by way of a letter of offer. The duplicate of this letter should be duly signed
and returned to the institution by the customer. The facility disbursement process should
start only upon receipt of this letter and should involve, inter alia, the completion of

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formalities regarding documentation, the registration of collateral, insurance cover in the
institution’s favor and the vetting of documents by a legal expert. Under no circumstances
shall funds be released prior to compliance with pre-disbursement conditions and
approval by the relevant authorities in the financial institution.
3.3.6 Monitoring and control of Individual credit:
To safeguard financial institutions against potential losses, problem facilities need to be
identified early. A proper credit monitoring system will provide the basis for taking
prompt corrective actions when warning signs point to deterioration in the financial health
of the borrower. Examples of such warning signs include unauthorized drawings, arrears
in capital and interest and deterioration in the borrower’s operating environment.
Financial institutions must have a system in place to formally review the status of the
credit and the financial health of the borrower at least once a year. More frequent reviews
(e.g. at least quarterly) should be carried out of large credits, problem credits or when the
operating environment of the customer is undergoing significant changes.
 Funds advanced are used only for the purpose stated in the customer’s credit
application;
 Financial condition of a borrower is regularly tracked and management advised in a
timely fashion;
 Borrowers are complying with contractual covenants;
 Collateral coverage is regularly assessed and related to the borrower’s financial
health;
 The institution’s internal risk ratings reflect the current condition of the customer;
 Contractual payment delinquencies are identified and emerging problem credits are
classified on a timely basis; and
 Problem credits are promptly directed to management for remedial actions.
 More specifically, the above monitoring will include a review of up-to-date
information on the borrower, encompassing:
 Opinions from other financial institutions with whom the customer deals;
 Findings of site visits;
 Audited financial statements and latest management accounts;
 Details of customers' business plans;
 Financial budgets and cash flow projections; and
 Any relevant board resolutions for corporate customers.

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3.3.7 Monitoring the overall credit portfolio
An important element of sound credit risk management is analyzing what could
potentially go wrong with individual credits and the overall credit portfolio if
conditions/environment in which borrowers operate change significantly. The results of
this analysis should then be factored into the assessment of the adequacy of provisioning
and capital of the institution. Such stress analysis can reveal previously undetected areas
of potential credit risk exposure that could arise in times of crisis.
Possible scenarios that financial institutions should consider in carrying out stress testing
include:
 Significant economic or industry sector downturns;
 Adverse market-risk events; and
 Unfavorable liquidity conditions.
Financial institutions should have industry profiles in respect of all industries where they
have significant exposures. Such profiles must be reviewed /updated every year.

3.3.8 Credit classification

Credit classification process grades individual credits in terms of the expected degree of
recoverability. Financial institutions must have in place the processes and controls to
implement the board approved policies, which will, in turn, be in accord with the
proposed guideline. This guideline may also be called as Credit Risk Grading (CRG), is a
collective 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.
Credit risk grading is an important tool for credit risk management as it helps the
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 FI.
The credit risk grading system is vital to take decisions both at the pre-sanction stage as
well as post-sanction stage. Two- types of factors play vital role in modeling the CRG,
they are,
1. Quantitative factors
2. Qualitative factors

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At the pre-sanction stage, credit grading helps the sanctioning authority to decide whether
to lend or not to lend, what should be the lending price, what should be the extent of
exposure, what should be the appropriate credit facility, what are the various facilities, on
the basis of the above factors.
At the post-sanction stage, the FI can decide about the depth of the review or renewal,
frequency of review, periodicity of the grading, and other precautions to be taken. Risk
grading should be assigned at the inception of lending, and updated at least annually.
A financial institution’s credit risk policy should clearly set out how problem credits are
to be managed. The positioning of this responsibility in the credit department of an
institution may depend on the size and complexity of credit operations. It may form part
of the credit monitoring section of the credit department or located as an independent
unit, called the credit workout unit, within the department. Often it is more prudent and
indeed preferable to segregate the workout activity from the area that originated the credit
in order to achieve a more detached review of problem credits. The workout unit will
follow all aspects of the problem credit, including rehabilitation of the borrower,
restructuring of credit, monitoring the value of applicable collateral, scrutiny of legal
documents, and dealing with receiver/manager until the recovery matters are finalized.

3.3.9 Managing problem credit

Financial institutions will put in place systems to ensure that management is kept advised
on a regular basis on all developments in the recovery process, may that emanate from the
credit workout unit or other parts of the credit department.
There should be clear evidence on file of the steps that have been taken by the financial
institution in pursuing its claims against a delinquent customer, including any legal steps
initiated to realize on the collateral. Where there is a delay in the liquidation of collateral
or other credit recovery processes, the rationale should be properly documented and
anticipated actions recorded, taking into account any revised plans submitted by the
borrower.
The accountability of individuals/committees who sanctioned the credit as well as those
who subsequently monitored the credit should be revisited and responsibilities ascribed.
Lessons learned from the post mortem should be duly recorded on file.

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