Impact of Basel II in credit risk management: Bangladesh perspective
Wednesday, 27 October 2010
Sk. Md. Lutful Kabir
Bangladesh Bank prescribes a standardised approach to managing the credit risk as per Basel II guidelines out of the three alternative approaches viz, Standardised Approach, Internal Rating Based Approach (IRB) and Advanced Internal Rating Based Approach (AIRB). Almost all the South Asian countries adopted the same approach, especially due to its simplicity as well as initial preparation towards the IRB approach. Although the system has some inherent limitations, globally it is recognised as the best cost effective approach among the bankers.
The standardised approach suggests use of recognised External Credit Assessment Institute (ECAI)/ Credit Rating Agencies in assessing the risk profile of the bank clients. A specified risk mapping is being formulated by the Bangladesh Bank to address the different risk grades of the recognised credit rating agencies having relation with Bangladesh Bank Risk Grade. And based on the risk grade for each exposure of the bank clients, capital requirement is being assessed by the banks against each of the rated exposures.
In reference to this, commercial banks are required to address at least the following objectives in adopting credit risk assessment approach under Basel II:
1. Assessment of the risk profile of each individual client and its exposure/loan availed
2. Identifying the capital requirement against each exposure amount
3. Assessment of the overall risk profile of the banking clients at gross portfolio level
4. Assessment of capital requirement after overall assessment of risk inherent in the gross credit portfolio
We think the fourth objective is the prime objective as well as ultimate target of the above three. But in most cases, banking sector is very much unaware of the above and concentrating only to meet the minimum capital requirement (MCR) either through issuing rights offer or through issuing of Tier II Bond. The above issue of shares or subordinated bond may support the capital requirement but identifying the risk of each client and subsequent assessment of capital requirement against that can not be achievable.
There is opinion that our regulator is yet to be successful in passing the message that Basel II is not only limited to assessment of minimum capital requirement; rather, it is a whole package of banking risk management having a co-relation between assessment of overall risk and capital requirement. In absence of this message, most of the commercial banks in the country are being satisfied only with the compliance of Minimum Capital Requirement (MCR), not thinking of rearranging of banking practices and behaviour in light of the Basel II principles.
About the capital adequacy of many commercial banks, just one message is reflected there… 'What is net capital requirement to meet the regulatory compulsion at present and in immediate future?' Where Basel II suggests maintenance of "Economic Capital or Adequate Capital" to secure the survival of a bank in the worst case scenario that will work as a buffer against heavy shocks; but our banking sector is more inclined to maintain the Regulatoy Capital where buffer is absent. Only due to this reason, importance is not placed on the risk assessment of each client's exposure. Rather, many commercial banks are quite satisfied with the risk assessment of a small number of selective clients those have good repayment track record to get the capital relief.
Basically, in maintaining the regulatoy capital, no reshuffle is required in the risk management practices or to identify the weaknessess at the gross portfolio level; but in assesing the econimic capital requirement, a reshuffle of risk management practices is required in the overall banking affairs to support the identification and measurement of risk of all credit exposures. Our regulator should place more imphasis on economic capital rather on regulatory capital, because economic capital must satisfy the regulatory requirement. Notable here, economic capital consists of the capital requirement for credit risk, operational risk and market risk having cushion against heavy shocks.
For effective implementation of the standardized approach, the role of the central bank is to formulate policy guideline for which Bangladesh Bank has already took necessary preparation. As per the guideline, already one year passed with parallel run basis along with Basel I principles and from 01, 2010, full implementation of Basel II continues. In response to the Bangladesh Bank requirement, the commercial banks are reporting
quarterly about its capital adequacy position as per format provided by the Bangladesh Bank. Our central bank perceives that after full implementation of Basel II, a good number of corporate clients will be under rating process than in the early of parallel implementation. However, it reveals that almost all the banks reported
the capital adequacy position with only 2.0% - 5.0% of their credit portfolio that have been rated and the balance 95%-98% fall in unrated credit portfolio although the unrated portfolio is addressing straight 125% risk weight. i.e. not getting any capital reduction benefit from the rating of its clients.
This is the major divergence of Basel II principles though a good number of the commercial banks are maintaining minimum capital requirement (MCR) even at 125% risk weight with its major portfolio being unrated. Many commercial banks including the foreign banks are yet to adopt any noticeable steps to rate any of its corporate clients. Study reveals that due to reduction of MCR to 8.0% up to June 30, 2010 and at 9.0% up to June 2011 from early requirement of 10% capital adequacy ratio (CAR) induces the commercial banks to adopt go slow policy.
In studying the issue, a few unique opinions also came forward from the market participants, viz.
1. Risk mapping by the Bangladesh Bank with the equivalent rating of the ECAIs is not motivating towards client rating at gross portfolio level
2. Why will commercial banks be interested to rate its corporate clients by the ECAIs if they meet the MCR under Basel II with their existing capital base?
3. When issue of subordinated debt or right share may support to comply the MCR within a short, motivating bank clients to rate by the ECAIs can prudently be avoided
4. Commercial banks are not interested to force their corporate clients to rate by the ECAIs due to negative response from the bank clients in most cases; as they are not interested to be disclosed to the public
5. Corporate clients are required to pay to the ECAIs for the rating service as additional overhead cost on yearly basis, although the service is basically required from bank's point of view. Many market practitioners also views that ECAIs charge comparatively higher fee than the Auditors.
We will try to supplement the above major observations with necessary footings and findings, so that both regulator and the market participants come to a joint decision to address the issues in the long term national interest.
About Risk Mapping: Risk mapping of the Bangladesh Bank (BB) requires more prudential approach to induce the corporate clients to improve their credit quality i.e. loan repayment capacity to address the lower risk weight that is the ultimate objective of Basel II. It reveals from the recent mapping that about seven rating grades (i.e. from 'AA-' to 'BBB-' as per CRISL scale) address the same risk weight i.e. 100%. It does not match with the definition and inner meanings of a rating grade. Even, Basel II document does not mention absorption of more than three rating grade to address same risk weight. The following format describes the mapping as per the Bangladesh Bank (BB) format and also our proposal towards the risk weight:
The above table reflects that, theoretically a "BBB-" rated corporate clients need about at least six/seven years of continuous improvement to reach at higher rating grade that address corresponding lower risk weight i.e. to address at 50% risk weight from 100% risk weight. This is very de-motivating factor to any corporate house to be rated by any of the ECAIs. Because, even after noticeable improvement in the credibility and fundamentals of a corporate that support for higher credit rating, but risk weight may remain same and also no possibility to decline in near term. Hence, we are am here to suggest 75% risk weight for BB rating grade 3 and 100% risk weight for BB Rating Grade 4. I think, it will motivate the corporate clients to improve their position within short period that is ultimate objectives of Basel II.
Besides, we are also suggesting to put 'AA-' in the same Bangladesh Bank Rating Grade 2 that includes AA and AA+. Because, BB rating grade 2 includes all the rating scales from 'AA-' to 'BBB-' for corporate and even the same BB rating grade 2 includes both non-investment grade (i.e. BB) with the high investment grade 'AA-' to address same risk weight for bank/financial institutions. This is completely a misrepresentation of the risk level for different level of credit rating.
Because, definition of AA- (means high safety) and A (means adequate safety) or BBB (means moderate safety) does not support to fall in the same risk category. Even, AA-, AA, and AA+, the three rating grades fall in the same cohort (i.e. group), just are positioning at lower, mid and upper tier respectively of a same cohort or group. So, if "AA-"is separated from the above group and put it in the lower rating group, it does not support the principle of rating scale formation. Even, we think it will also be a good motivating factor for the good clients those are fallen or may fall if the 'AA-' rating category. Study reveals that a good number of exposures have fallen in the AA- rating category that represents about 55 bank loan exposures out of 495 rated exposures by CRISL in the last nine months of introducing Bank Loan Ratings (blr). A summary of the distributions of CRISL-rated bank loan exposures are presented below to have a good understanding about the effect on sample basis:
The writer is Assistant Vice President & Head of Corporate Ratings of Credit Rating Information & Services Limited (CRISL). He may be contacted at kabir@crislbd.com. The views expressed in this write-up are of the writer's own and not necessarily of the organisation he serves
Bangladesh Bank prescribes a standardised approach to managing the credit risk as per Basel II guidelines out of the three alternative approaches viz, Standardised Approach, Internal Rating Based Approach (IRB) and Advanced Internal Rating Based Approach (AIRB). Almost all the South Asian countries adopted the same approach, especially due to its simplicity as well as initial preparation towards the IRB approach. Although the system has some inherent limitations, globally it is recognised as the best cost effective approach among the bankers.
The standardised approach suggests use of recognised External Credit Assessment Institute (ECAI)/ Credit Rating Agencies in assessing the risk profile of the bank clients. A specified risk mapping is being formulated by the Bangladesh Bank to address the different risk grades of the recognised credit rating agencies having relation with Bangladesh Bank Risk Grade. And based on the risk grade for each exposure of the bank clients, capital requirement is being assessed by the banks against each of the rated exposures.
In reference to this, commercial banks are required to address at least the following objectives in adopting credit risk assessment approach under Basel II:
1. Assessment of the risk profile of each individual client and its exposure/loan availed
2. Identifying the capital requirement against each exposure amount
3. Assessment of the overall risk profile of the banking clients at gross portfolio level
4. Assessment of capital requirement after overall assessment of risk inherent in the gross credit portfolio
We think the fourth objective is the prime objective as well as ultimate target of the above three. But in most cases, banking sector is very much unaware of the above and concentrating only to meet the minimum capital requirement (MCR) either through issuing rights offer or through issuing of Tier II Bond. The above issue of shares or subordinated bond may support the capital requirement but identifying the risk of each client and subsequent assessment of capital requirement against that can not be achievable.
There is opinion that our regulator is yet to be successful in passing the message that Basel II is not only limited to assessment of minimum capital requirement; rather, it is a whole package of banking risk management having a co-relation between assessment of overall risk and capital requirement. In absence of this message, most of the commercial banks in the country are being satisfied only with the compliance of Minimum Capital Requirement (MCR), not thinking of rearranging of banking practices and behaviour in light of the Basel II principles.
About the capital adequacy of many commercial banks, just one message is reflected there… 'What is net capital requirement to meet the regulatory compulsion at present and in immediate future?' Where Basel II suggests maintenance of "Economic Capital or Adequate Capital" to secure the survival of a bank in the worst case scenario that will work as a buffer against heavy shocks; but our banking sector is more inclined to maintain the Regulatoy Capital where buffer is absent. Only due to this reason, importance is not placed on the risk assessment of each client's exposure. Rather, many commercial banks are quite satisfied with the risk assessment of a small number of selective clients those have good repayment track record to get the capital relief.
Basically, in maintaining the regulatoy capital, no reshuffle is required in the risk management practices or to identify the weaknessess at the gross portfolio level; but in assesing the econimic capital requirement, a reshuffle of risk management practices is required in the overall banking affairs to support the identification and measurement of risk of all credit exposures. Our regulator should place more imphasis on economic capital rather on regulatory capital, because economic capital must satisfy the regulatory requirement. Notable here, economic capital consists of the capital requirement for credit risk, operational risk and market risk having cushion against heavy shocks.
For effective implementation of the standardized approach, the role of the central bank is to formulate policy guideline for which Bangladesh Bank has already took necessary preparation. As per the guideline, already one year passed with parallel run basis along with Basel I principles and from 01, 2010, full implementation of Basel II continues. In response to the Bangladesh Bank requirement, the commercial banks are reporting
quarterly about its capital adequacy position as per format provided by the Bangladesh Bank. Our central bank perceives that after full implementation of Basel II, a good number of corporate clients will be under rating process than in the early of parallel implementation. However, it reveals that almost all the banks reported
| BB RatingGrade | EquivalentRatingof S&Pand Fitch | EquivalentRating ofCRISL | RiskWeightAs perBB | Proposalto BB forRiskWeight |
| 1 | AAA, AA+,AA,AA- | AAA | 20% | 20% |
| 2 | A+,A,A- | AA+, AA | 50% | 50% |
| 3 | BBB+,BBB,BBB- | AA-, A+,A, A- | 100% | 75% |
| 4 | BB to B | BBB+,BBB,BBB- | 100% | |
| 5 | Below B | BB, B, CCC | 150% | 150% |
| 6 | CC, C, D | |||
| Unrated | 125% | 125% | ||
the capital adequacy position with only 2.0% - 5.0% of their credit portfolio that have been rated and the balance 95%-98% fall in unrated credit portfolio although the unrated portfolio is addressing straight 125% risk weight. i.e. not getting any capital reduction benefit from the rating of its clients.
This is the major divergence of Basel II principles though a good number of the commercial banks are maintaining minimum capital requirement (MCR) even at 125% risk weight with its major portfolio being unrated. Many commercial banks including the foreign banks are yet to adopt any noticeable steps to rate any of its corporate clients. Study reveals that due to reduction of MCR to 8.0% up to June 30, 2010 and at 9.0% up to June 2011 from early requirement of 10% capital adequacy ratio (CAR) induces the commercial banks to adopt go slow policy.
In studying the issue, a few unique opinions also came forward from the market participants, viz.
1. Risk mapping by the Bangladesh Bank with the equivalent rating of the ECAIs is not motivating towards client rating at gross portfolio level
2. Why will commercial banks be interested to rate its corporate clients by the ECAIs if they meet the MCR under Basel II with their existing capital base?
3. When issue of subordinated debt or right share may support to comply the MCR within a short, motivating bank clients to rate by the ECAIs can prudently be avoided
4. Commercial banks are not interested to force their corporate clients to rate by the ECAIs due to negative response from the bank clients in most cases; as they are not interested to be disclosed to the public
5. Corporate clients are required to pay to the ECAIs for the rating service as additional overhead cost on yearly basis, although the service is basically required from bank's point of view. Many market practitioners also views that ECAIs charge comparatively higher fee than the Auditors.
We will try to supplement the above major observations with necessary footings and findings, so that both regulator and the market participants come to a joint decision to address the issues in the long term national interest.
About Risk Mapping: Risk mapping of the Bangladesh Bank (BB) requires more prudential approach to induce the corporate clients to improve their credit quality i.e. loan repayment capacity to address the lower risk weight that is the ultimate objective of Basel II. It reveals from the recent mapping that about seven rating grades (i.e. from 'AA-' to 'BBB-' as per CRISL scale) address the same risk weight i.e. 100%. It does not match with the definition and inner meanings of a rating grade. Even, Basel II document does not mention absorption of more than three rating grade to address same risk weight. The following format describes the mapping as per the Bangladesh Bank (BB) format and also our proposal towards the risk weight:
The above table reflects that, theoretically a "BBB-" rated corporate clients need about at least six/seven years of continuous improvement to reach at higher rating grade that address corresponding lower risk weight i.e. to address at 50% risk weight from 100% risk weight. This is very de-motivating factor to any corporate house to be rated by any of the ECAIs. Because, even after noticeable improvement in the credibility and fundamentals of a corporate that support for higher credit rating, but risk weight may remain same and also no possibility to decline in near term. Hence, we are am here to suggest 75% risk weight for BB rating grade 3 and 100% risk weight for BB Rating Grade 4. I think, it will motivate the corporate clients to improve their position within short period that is ultimate objectives of Basel II.
| RatingCategory | RiskWeight | No. of Loan/ExposuresRated | ExposureAmount(Tk. Million) | DistributionOf Exposures |
| AAA | 20% | 05 | 761.54 | 1% |
| AA+ | 50% | 24% | ||
| AA | 121 | 40,782.55 | ||
| AA- | 100% | 55 | 1,4567.61 | 74% |
| A+ | 98 | 37,691.78 | ||
| A | 79 | 22,676.45 | ||
| A- | 59 | 14,901.02 | ||
| BBB+ | 33 | 10,853.20 | ||
| BBB | 36 | 11,512.51 | ||
| BBB- | 05 | 1,025.88 | ||
| BB | 150% | 2% | ||
| B | 02 | 7.22 | ||
| C | 02 | 354.18 | ||
| D | ||||
| Exposure Rated by CRISL | 495 | 155,133.94 | 100% | |
Besides, we are also suggesting to put 'AA-' in the same Bangladesh Bank Rating Grade 2 that includes AA and AA+. Because, BB rating grade 2 includes all the rating scales from 'AA-' to 'BBB-' for corporate and even the same BB rating grade 2 includes both non-investment grade (i.e. BB) with the high investment grade 'AA-' to address same risk weight for bank/financial institutions. This is completely a misrepresentation of the risk level for different level of credit rating.
Because, definition of AA- (means high safety) and A (means adequate safety) or BBB (means moderate safety) does not support to fall in the same risk category. Even, AA-, AA, and AA+, the three rating grades fall in the same cohort (i.e. group), just are positioning at lower, mid and upper tier respectively of a same cohort or group. So, if "AA-"is separated from the above group and put it in the lower rating group, it does not support the principle of rating scale formation. Even, we think it will also be a good motivating factor for the good clients those are fallen or may fall if the 'AA-' rating category. Study reveals that a good number of exposures have fallen in the AA- rating category that represents about 55 bank loan exposures out of 495 rated exposures by CRISL in the last nine months of introducing Bank Loan Ratings (blr). A summary of the distributions of CRISL-rated bank loan exposures are presented below to have a good understanding about the effect on sample basis:
The writer is Assistant Vice President & Head of Corporate Ratings of Credit Rating Information & Services Limited (CRISL). He may be contacted at kabir@crislbd.com. The views expressed in this write-up are of the writer's own and not necessarily of the organisation he serves