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Bank's risk rating: Borrower and credit facility should be treated separately

Second of a three-part article titled 'BB's guidelines on ICRRS and managing banks' assets'

Nironjan Roy from Toronto, Canada | November 08, 2018 00:00:00

BB's guideline on ICRRS mentions that banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual borrower transaction. But this does not, however, make it clear that each borrower and its facility should be rated separately, instead it means rating bank's entire portfolio and individual borrower. So, the BB should provide more clarity on this issue, writes Nironjan Roy from Toronto, Canada in the second of his three-part article titled 'BB's guidelines on ICRRS and managing banks' assets'

While introducing newly-developed Internal Credit Risk Rating System (ICRRS), adoption of optional parameters and risk components should be left to commercial banks' (CB) preference. However, banks must have the liberty to include more parameters and risk components if they find appropriate to include. Further, giving weightage on each parameter and risk component is also important and selection criteria should not be fixed in central bank's guideline. Rather, it must be made flexible so that each bank can set its own criteria. As for example, parameters recommended in the central bank's guideline may include liquidity ratio, current ratio etc., but the degree of weightage to be given to each ratio should be kept open. Obviously, minimum benchmark score must be recommended. This writer during his banking career in Bangladesh was involved in implementing CRM (Credit Risk Management) guideline, under which a Risk Grading System (RGS) was developed.

From the perspective of financial ratio analysis, neither lower current ratio nor excessively higher current ratio is good for a company's overall performance. Lower ratio exposes the company's failure to meet short-term obligation, while higher ratio indicates the company's inefficiency in managing working capital. Even longstanding excessive accounts receivable may be represented by higher current ratio. Although the then guideline of central bank did not provide flexibility, CBs still gave maximum weightage to the current ratio between two to three. For doing so, they had to initially face tremendous objection from BB's (Bangladesh Bank) audit team who were, however, finally convinced. So, it is expected that the BB guideline will provide some flexibility for banks given the stringent compliance of broader risk parameters and risk components.

DATA AVAILABILITY AND INTRODUCING DATABANK: Successful application of ICRRS will depend on reliable source of information and availability of required information, which is a very challenging area in Bangladesh's banking industry. In Bangladesh, there are plenty of information around us, but there is scarcity of authentic and reliable information. The effective use of ICRRS cannot be ensured without required information from authentic sources. Previously-recommended LRA (Lending Risk Analysis) have miserably failed to produce its desired result due to many reasons. One of those was unavailability of reliable data. This writer, at the beginning of his banking career in Bangladesh, had to analyse and prepare LRA, which was found to be almost difficult and in many cases impossible due to lack of reliable data. In Bangladesh, banks and the financial industry have tremendously developed with high turnover and huge growth during the last two decades keeping pace with accelerated growth of our private and public sectors. But a reliable databank has not been established yet. Even banks and non-bank financial institutions (NBFIs) have not built their own database in order to support their analysis and investment decision. Without creation of internal and external databank, it would be a very difficult and challenging task to implement BB's new risk rating module. BB should actively look into this area and come up with suitable solution. In this connection, the regulator can invite and encourage the country's research firms and think-tanks to develop databank on economy, finance, commerce and all other relevant fields. Using computer technology, this kind of databank can easily be developed and maintained. This initiative could be a good revenue generating avenue for those research firms and think-tanks, as they will sell information from their databank to those who need it. The country's banks and NBFIs can be their good market. In order to ensure authenticity of those information, BB or other regulatory authority may consider licensing those firms who will maintain databank. At the same time, banks and NBFIs should start building their own database. Creating and maintaining internal and external databank should be made integral to BB's guidelines on introducing and implementing ICRRS in the financial sector.

SEPARATE RATINGS FOR BORROWER AND FACILITY: While applying ICRRS, borrower and credit facility should be treated separately and different ratings should be conducted in order to produce rating score from different perspectives. In Bangladesh, risk rating has been exclusively assigned with the borrower and the practice of separately rating the borrower is almost absent. Although the borrower and its credit facility are integrated, there is still a distinction between the two and as such should be looked into and evaluated from different angles. This is required because experience reveals that there is a situation where rating score for borrower's facility could be higher than that of the borrower itself or vice versa. So, if these two scores are not viewed separately, proper adjudication cannot be made at risk management level. The following example may provide more clarity on this issue: company 'A' has been running business with comparatively poor performance particularly in turnover, current asset management, and as such stands far below the industry average. This company's debt servicing record is found satisfactory without any adverse report and recently they felt the necessity of mobilising some term finance from the banks. In order to secure their proposed term finance, the company intends to offer cash collateral in the form of either FDR or standby LC from other banks, which will eventually mitigate cent per cent risk of the lending bank on new term finance. In this situation, the borrower may be rated as good or average from the score derived, but new proposed term finance against cash collateral may be rated with higher risk. This separate risk rating procedure for the borrower and facility presents clear picture on the overall situation leaving no scope of concealment. Therefore, the proposed guideline for ICRRS must recommend the banks to rate risk of the borrower and the facility separately. BB's guideline on ICRRS mentions that banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual borrower transaction. But this does not, however, make it clear that each borrower and its facility should be rated separately, instead it means rating bank's entire portfolio and individual borrower. So, BB should provide more clarity on this issue and make it very clear that individual borrower and its facility should be rated separately.

CORRELATION BETWEEN INTERNAL AND EXTERNAL RATING: So far, it is perceived from BB's guideline on ICSSR that they have mainly focused on banks' own grading of their borrowers. But there is no verification scope for the banks' risk rating score. To what extent the risk rating score derived from the banks' own module is authentic and acceptable depends on how this score is verified with neutral grading system. This cross-checking and verification can be made possible if internal risk rating and external risk rating can be applied simultaneously. External risk rating comes from reputed credit rating company. It is already known that many credit rating companies have already started operation in Bangladesh and are providing risk rating services to many corporate companies. The companies will have to be streamlined and their role has to be made popular. In order to ensure the authenticity of external rating, credit rating companies must be brought under stringent regulation. When both internal and external risk rating scores along with correlation and standard deviation of two scores will be taken into consideration, real picture on a borrower's overall performance can be ascertained. It is hoped that concerned department of BB will actively consider integrating the use of external risk rating with their newly-recommended ICRRS so as to make their initiative a success.

Nironjan Roy, CPA, CMA, is a banker. nironjankumar_roy@yahoo.com

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