Credit risk - a tryst with strategic prudence

Risk is inherent in all aspects of a commercial operation. For banks and financial institutions, credit risk outruns all other operational risks. Credit risk has been defined as the risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk is the possibility that a borrower will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the bank's dealings with or lending to corporates, individuals and other banks or financial institutions.
Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk. Credit risk, therefore, is an area that deserves to be judiciously managed.
Credit risk management, meanwhile, is the practice of mitigating those losses by understanding the adequacy of both a bank's capital and loan loss reserves at any given time - a process that has long been a challenge for financial institutions. Credit risk management, a key element in banking operations, needs to be a robust process that enables banks to proactively manage loan portfolios in order to minimise losses and earn an acceptable level of return for shareholders. Given the fast changing, dynamic global economy and the increasing pressure of globalisation, liberalisation, consolidation and disintermediation, it is essential that banks have robust credit risk management policies and procedures that are sensitive and responsive to these changes.
The banking sector of Bangladesh is in a state of compounding credit risk arising mainly out of indiscriminate and inept loan disbursement. Such mindless lending has plunged the country's banking sector into unforeseen capital deficit. In other words, banks are now way behind in terms of proportionate capital reserve in comparison to loans extended. According to the latest Bangladesh Bank report, combined capital deficit of 9 commercial Banks of the country now stands at almost Tk 120,000 millions. This was triggered by gross irregularities in the form of reckless and imprudent lending by these banks. BB report reveals that capital deficits of 9 commercial banks stood at Tk.119,337 millions at the end of July this year. Three months earlier, capital deficit of 8 banks was Tk.97,317 millions.
 A new addition to the list is a private sector bank, Premier Bank, which has a capital deficit of Tk.563 millions. Capital deficits of state owned commercial banks (SOCBs) like, Sonali Bank and Rupali Bank are Tk.15,113 millions and Tk.2168 millions respectively, while those of Bangladesh Krishi Bank, Basic Bank and Rajshahi Krishi Bank are Tk.59985 millions, Tk.16755 millions and Tk.6499 millions respectively. Of the private sector banks, Bangladesh Commerce Bank and ICB Islami Bank have capital deficits of Tk.400 millions and Tk.14158.5 millions respectively and that of National Bank of Pakistan, a foreign bank, amount to Tk.3696 millions. Banks are required to preserve capital at the rate of 10 per cent against risk-based assets. But BB report shows a shortfall of Tk.8481.8 millions. Whereas there was a capital surplus of Tk.23777.4 millions at the end of march 2014, which reversed into a deficit of Tk.8481.8 millions in a space of only three months. In Sonali Bank alone, capital deficit at the end of June 2014 was Tk.15113.1 millions, which was Tk.2784.3 millions at the end of March 2014, i.e., a stupendous increase of 443 per cent in only three months. In the same manner, capital deficit at Basic Bank is now Tk.6385.5 millions.
Talking to newsmen a senior officer of Bangladesh Bank spoke about lack of investment and piling of cash reserve in banks which has risen to Tk.12,00,000 millions and is lying idle causing loss to a number of banks. Major share of bank losses can, however, be attributed to gross irregularities committed by the banks themselves. Long term investments are not forthcoming due to uncertainties prevailing in the country and there is tremendous lack of governance in the banking sector. Many state-owned banks have been found to have disbursed loans without verifying the quality of investments prompted by reasons other than banking. These loans ultimately became a burden for the banks and eventually turned into risk-based resources and triggered negative effect on capital deficit. The foreign banks, however, present a different picture. Capital reserve of these banks at the time of the said BB report was Tk.86331.5 millions, although they were supposed to have tk.58359.7 millions in capital reserve, which means, they had capital reserve surplus of Tk.27971.8 millions. But the capital deficit of the state-owned banks at that time was Tk.75241.8 millions.
The global financial crisis - and the credit crunch that followed - put credit risk management into regulatory spotlight. As a result, regulators appeared on the centre stage and began to demand more transparency. They wanted to ensure that a bank has thorough knowledge of customers and their associated credit risk.
Same thing happened in Bangladesh. Last year, Bangladesh Bank undertook a project to review the global best practices in the banking sector and examine the possibility of introducing those in the banking industry of Bangladesh. Four 'Focus Groups' were formed with participation from nationalised commercial banks, private commercial banks & foreign banks with representatives from the Bangladesh Bank as team coordinators to look into the practices of the best performing banks both at home and abroad. These focus groups aimed at identifying and selecting five core risk areas and producing a document that would be a basic risk management model for each of the five 'core' risk areas of banking. The five core risk areas are:
a)     Credit Risks;
b)     Asset and Liability/Balance Sheet Risks;
c)     Foreign Exchange Risks;
d)     Internal Control and Compliance Risks; and
e)     Money Laundering Risks
Credit risk management, meanwhile, is the practice of mitigating those losses by understanding the adequacy of both a bank's capital and loan loss reserves at any given time - a process that has long been a challenge for financial institutions.
To comply with the more stringent regulatory requirements and absorb the higher capital costs for credit risk, many banks are overhauling their approaches to credit risk. But banks who view this as strictly a compliance exercise, are being short-sighted. Better credit risk management also presents an opportunity to greatly improve overall performance and secure a competitive advantage.
Banks borrow money by accepting funds deposited on current accounts, by accepting term deposits, and by issuing debt securities such as banknotes and bonds. Banks lend money by making advances to customers on current accounts, by making instalment loans, and by investing in marketable debt securities and other forms of money lending.
Banks can create new money when they make a loan. New loans throughout the banking system generate new deposits elsewhere in the system. The money supply is usually increased by the act of lending, and reduced when loans are repaid faster than new ones are generated. If all the banks increase their lending together, then they can expect new deposits to return to them and the amount of money in the economy will increase. Excessive or risky lending can cause borrowers to default which makes the banks more cautious, so there is less lending and therefore less money in the economy. Bangladesh has set a classic example in this direction.
While b+anks strive for an integrated understanding of their risk profiles, much information is often scattered among business units. Without a thorough risk assessment, banks have no way of knowing if capital reserves accurately reflect risks or if loan loss reserves adequately cover potential short-term credit losses. Vulnerable banks are targets for close scrutiny by regulators and investors, as well as debilitating losses.
The key to reducing loan losses - and ensuring that capital reserves appropriately reflect the risk profile - is to implement an integrated and quantitative credit risk solution. This solution should get banks up and running quickly with simple portfolio measures. It should also accommodate a path to more sophisticated credit risk management measures as needs evolve. The solution should include:
*    Better model management that spans the entire modelling life cycle
*    Real-time scoring and limits monitoring
*   Robust stress-testing capabilities
*   Data visualisation capabilities and business intelligence tools that pass important information into the hands of those who need them.
The writer is a TV personality and writes on economic issues. [email protected]