Smart option for banks to manage credit risks

The failure of a bank or the case of a bank experiencing a crisis usually has negative impacts on other banks in the economy through informational conflagration or an increased cost of borrowings. The impacts are likely to be higher when other banks are close to failure as well. We should consider the fundamental value of a bank's assets into which it has invested its fund to generate income to satisfy both depositors and shareholders by paying interest and dividend respectively. The fundamental value is the expected sale value of its portfolio at a discount. If a particular bank's portfolio is too correlated to the average portfolio of the banking system, the discount rate will be higher. Higher value of discount is the signal that the bank is at the higher end of risky zone to survive.
Banking system in Bangladesh is not efficient enough in terms of diversification of portfolio and the entire industry is maintaining average portfolio since the product line of all banks is almost similar that might be one of the main reasons for escalating value of C. Most of the banks' investment portfolio consists of substantial portion of a) credit (highly correlated asset) and b) investment (security and equity). Banks have to consider both liquidity and efficient frontier while developing their portfolio. Efficient frontier is a concept of modern portfolio theory (MPT) that represents the trade-off between risk and expected return faced by an investor when forming his portfolio.
Average Advance Deposit (AD) ratio and Capital to Risk Weighted Asset Ratio (CRAR) are around 70 per cent and 10.50 per cent respectively in our banking system. Most banks have 20-30 per cent of their exposure against which no collateral is taken. This is due to accepting large loan proposals from big corporate companies. It is notable that banks hardly can make their large loan customers happy by keeping sufficient collateral as they are treated as cash cows for both interest and fee- based income. Bank management wants to ensure profitability first and then security. Day by day, banks are losing their negotiating capacity due to tough competition in the market.
Around 100 large corporate companies encompass the large loan portfolio of majority of the banks and they are still taking advantage without providing sufficient collateral. But today's Top-20 defaulters of each bank were in its Top-20 borrower list once upon a time and today's Top-20 borrowers may shift into tomorrow's Top-20 defaulters partially. About 30-50 per cent of Non-Performing Loan (NPL) portfolio of most banks belongs to their Top-20 defaulters which are not backed by sufficient security. This is largely responsible for increasing cost of banks and fading their balance sheets. This scenario is pushing the banking industry into threat that may consequently push the whole economy into risks.
Collateralised Debt Obligation (CDO) may help the banking industry and the economy a lot to overcome the traditional scenario and ensure strengthening balance sheets of banks. CDO is a type of structured asset-backed security (ABS), originally developed for the corporate debt markets. Over time, CDO is developed to encompass the mortgage and mortgage-backed security (MBS) markets. Like other private brand securities backed by assets, CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. The CDO is 'sliced' into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority.
According to this model, Top 100 or more large corporate houses will be identified by the regulators or bankers' forum like the Association of Bankers Bangladesh (ABB) and a bank will be selected to be called as agent bank for particular corporate house considering the size and health of the corporate body and the bank will arrange finance for them. Let us assume, ABC Bank has been selected as XYZ company's agent bank. ABC Bank will then assess both the security value and the requirement of total funded and non-funded credit line of XYZ Co. For example, the company has collateral of Tk.12.0 billion but it requires credit line of Tk. 20.0 billion (Tk.15.0 billion funded and Tk.5.0 billion non-funded). After taking all of XYZ's assets as security, ABC will issue CDO on behalf of XYZ for Tk.15.0 billion with 80 per cent surety, i.e. in the worst case, ABC will pay off 80 per cent of the bond value to its holders. Participants--both banking and non-banking financial institutions (FIs)--will make investment on the bond considering the coupon rate (r) and credit rating i.e. probability to defaults in short and long term. Coupon rate may be fixed (r) or floating (r = b + p) i.e. adding premium (p) with benchmark of 5 or 10-year Treasury bond rate (b). ABC will also charge management fees (f) for the fund at a certain rate to monitor its investment to minimize the probability to default. In the total process f is the income for agent bank while r is the income of participant investors.
ABC will also issue bond of Tk.5.0 billion on behalf of XYZ having call option to the issuer to facilitate XYZ's non-funded facilities at lower rate. The bond will be issued to bank as security to provide non-funded facilities i.e. letter of credit, bank guarantee etc. by participant investors. XYZ will redeem the bond while the transaction will be settled down. Pricing model and features of the CDO may vary from corporate to corporate and bank to bank. Not only banks, financial institutions may also participate in the model to create investment opportunity in a well-structured financial instrument.
CDO will enable banks to determine how much it will take exposure on a particular corporate body and diversify its concentration on subordinate risk. Moreover, it will cut the monitoring cost of banks as bondholders need not to monitor the performance of the corporate rather agent bank will do it for them. CDO may become more attractive if it can be listed in the stock exchange for trading due to its liquidity feature. Participant banks will have to maintain lower capital as it will be treated as investment instrument and subject to market risk instead of credit risk. Better credit discipline will be ensured and it will definitely lead to healthy balance sheet as it will help enhance quality of asset by plunging non-performing loan substantially. Subsequently, lower provision has to be maintained which will boost up the net profit of banking industry. Furthermore, large projects may be undertaken in the country by introducing CDO, as many financial institutions at home and abroad may participate in the investment. Finally, CDO may open new horizon in the financial system of the country that will also take part in capacity building of the financial institutions.
The writers are currently associated with Risk Management Division and Branch banking of Mercantile Bank Ltd. Views shared are those of the authors and do not necessarily reflect the official position of the bank they are associated with.
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