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

Early warning system helps arrest non-performing loans

Nironjan Roy from Toronto, Canada | November 09, 2018 00:00:00

Any rating in the world of technology is performed using a technologically developed module. The ICRRS (Internal Credit Risk Rating System) based on Bangladesh Bank (BB) guidelines should not be an exception to that. Since the central bank guidelines have discussed about risk rating modules, it is also believed to have been developed using computer technology. However, it is not clear whether this risk rating module will be integrated with banks' technology-based risk management procedure. If this module is not integrated with the banks' credit operation system, the desired result may not be achieved and there may remain scope for manipulation. Experience shows that banks develop completely separate system/software for running the modules, where risk rating can be assessed as many times as possible. Information can be manufactured and manoeuvred in the module time and again to get the desired score so that banks can approve loans. But that should not be the objective of introducing standard risk rating system. Therefore, ICRRS modules should be integrated with banks' credit operation system and all attempted risk rating scores (RRS) have to be recorded. When this risk rating is carried out, the score report will provide all the scores attempted. There should be a bar on the number of attempts to run risk rating module (RRM) on one particular customer. As for example, a bank may change necessary information and can run second rating if the first rating produces lesser score, say 77 out of 100 or D under letter-based grading. Similarly, the third attempt can be carried out if the second attempt does not produce satisfactory result. However, final rating score will depict all the attempted scores so that risk officers or adjudicating team can review all the attempted scores and investigate further, if felt necessary. The information will be stored in the bank's lending system and all these RRS will appear whenever information on the customer in question is obtained from the system. At the same time, there should have a bar on the maximum number of attempts - say maximum three times and the system will be designed in such a way that will automatically lock the concerned borrower's risk rating attempt after three attempts.

RRS, INTERPRETATION, LENDING CAP AND EWS: Risk rating itself will not bear any fruitful result if its due interpretation and implications are not conspicuously spelt out. Besides, RRS should be made easily understandable, free from any sort of ambiguity. The score, produced by ICRRS, clearly reveals what a risk management officer needs to know. Score may be denoted with either numbers or alphabets e.g., rating may scale from 20 to 99 or H to A where 99 or A will be interpreted as no risk at all, while 20 or H, on the other hand, may be interpreted as the worst risk. At the same time, maximum lending cap should be linked with the final RRS. The bank's credit policy will particularly mention the maximum amount of loan that may be approved at each risk level. Since maximum amount is very difficult to determine based on the RRS, a ratio or percentage in relation to the borrower's RRS may be applied to determine maximum loan amount. A hypothetical example may provide a picture on this issue. As for example, if RRS is found to be superior i.e., 99 or A, 100 per cent of the requirement calculated using different methodology can be financed or if RRS is found to be 85 or C, maximum 70 per cent of the requirement calculated can be financed. Whatever might be the ratio of score and maximum loan amount, it should be predetermined and kept in black and white so that no ambiguity arises at adjudicating level. This control mechanism will be monitored and performed by technologically developed system so that no human error or manipulation can take place.

This risk rating system plays a very important role in triggering early warning system (EWS) for the credit facility with deteriorating debt servicing trend. In modern banking, EWS is found to be playing a very significant role in arresting non-performing loans (NPLs). If EWS for each loan can be determined, careful measures can be taken prior to further deterioration and as such loans turning NPLs can be prevented. RRS can easily be used to identify loans with EWS, as a certain score, as for example, 67 in numerical score or F in letter-based score may be categorised as EWS risk rating score. As per the ongoing evaluation, if score against any loan account is found to be 67 or F, this loan will be placed under EWS and immediate measures, as recommended for handling this type of loan, should be initiated.

RRS AND MANAGING NPL: While announcing the introduction of ICRRS, BB has mentioned that this new RRM will help banks cut NPL. But how this RRS will help reduce NPL is not understandable to many. No doubt, ICRRS if designed properly and applied with due diligence will immensely help bankers procure quality assets i.e., loans and advances. Inferior loans and advances can easily be filtered out through effective application of ICRRS. It can, therefore, be said that application of this new risk rating system may prevent newly-impaired loans. However, this newly-developed ICRRS may not come to the help of reducing the volume of existing NPL, rather may adversely impact the overall loan portfolio. The way banking industry is running, the state of NPL remains without any proper remedy and there are enormous amount of NPL in disguise or sums about to turn into NPL in the banks' books. As soon as the newly-developed ICRRS is applied to all existing loan accounts, derived score on those NPL accounts in disguise will get drastically dropped and as such this type of loan will have to be declared as impaired loan. Therefore, there is the likely possibility of a sharp rise in the country's NPL if and when this newly-developed ICRRS is effectively and diligently applied in evaluation of banks' entire loan portfolio. BB should take the issue into their active consideration prior to asking the banks for full implementation. If situation warrants, initial application of this new risk rating technique may be kept limited to acquiring new assets, and evaluation of existing assets may be gradually brought under evaluation of the ICRRS, especially when appropriate measures towards treatment of NPL is finalised.

PERIODIC REVIEW OF RRS: Any risk rating measure is not a static step, rather an ongoing process. This is not a one time measure, but a continuous process under which loan accounts will be periodically evaluated through application of ICRRS with periodic intervals. At the time of acquiring new asset, this RRS will be derived and thereafter, risk scoring process will be carried out on that account with regular interval. Preferably after every quarter or half year end, this ICRRS should be applied to rate the loan portfolio. However, risk rating should be applied soon after release of a borrower's final and interim accounts. Therefore, the periodical timeframe will have to be specifically mentioned in BB's ICRRS guidelines.

In today's banking environment, BB has taken appropriate move by developing new guidelines and module of ICRRS for managing the commercial banks' quality assets i.e., loans and advances. It is hoped that the move, if effectively applied, will not only prevent impaired loans but also improve quality of the banks' assets. Apart from this, application of standard risk rating system will raise banks' image and acceptability in international banking arena.

Nironjan Roy is a banker.


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