Credit Risk Management Practices in

Banks: An Appreciation
Md. Saidur Rahman

Abstract
The banks in Bangladesh have started undertaking a number of quantitative and qualitative
measures to understand the risks involve in credit or chance of default which may come from
the failure of counterparty or obligor (client) to fulfill his/her commitments as per agreed
terms and contractual agreement with the bank. Traditionally, a bank gives emphasis on
collateral in funding to the clients whereas in the concept of modern banking a bank keenly
feels to measure the business risk over the security risk for ensuring the timely repayment of
invested funds. Now-a-days a banker likes to adopt a number of sophisticated financial
techniques in credit appraisal process with a view to assessing the borrowers business as
well as financial position rigorously. The use of sophisticated techniques for measuring the
financial, business and other risks is yet to be established in the banking operations very fast
due to the advent of computer based technologies. In some cases, the rate of adoption of
analyzing tools and techniques is highly remarkable in credit operation. This attitude of the
bankers has been changed by introducing quality training and reinforcing sophisticated
financial as well as risk grading techniques. A strong database is the demand of the day for
the proper application of the much-demanded credit risk management guidelines along with
effective risk grading system.

1. Introduction
Credit risk may be defined as the possibility that the potential client or counterparty
will fail to meet its obligations in accordance with the agreed terms with the bank. It
also signifies the risk of making credit to a risky customer for a risky venture which is
not likely to generate enough revenue to repay the money back to the bank. Credit
risk is the largest and most obvious source of risk in banking and it comes from a
banks credit portfolio. The credit portfolio of a bank usually consists of money
market portfolio, capital market portfolio and general credit portfolio. Here a bank is
highly exposed in the risks of capital market and general credit portfolio. In recent
times, the awareness among the bankers has grown regarding the need for managing

The author is Joint Director (Training) and Faculty Member, Islami Bank Training and Research
Academy (IBTRA), Dhaka. The views expressed in this article are authors own.

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

perceived risks in credit related activities. One of the goals of credit risk management
in banks is to maximize a banks risk-adjusted rate of return by maintaining credit
risk exposure within the acceptable level. Hence, the credit risk assessment and
grading system are being applied to evaluate, identify, measure and monitor the level
or status of perceived risk associated with a credit proposal. A number of financial
and non-financial factors or parameters are used by the banks for these purposes. The
use of comprehensive credit risk assessment and grading techniques increasing very
rapidly in the banking sector in Bangladesh because of deterioration in the credit
standing of the clients, adoption of Basel accords, compliance of international
accounting standards (IAS) & international financial reporting standards (IFRS) and
the fast revolution of technologies that has made the bankers user friendly in the
adoption of these techniques.
From the findings of different studies, it can be noted that at the very outset the
banking sector in Bangladesh provided huge amount of soft debt facilities to trade,
industry and farming activities for enhancing overall economic growth of the country
and it was done as a part of social commitment of the nationalized sector. Therefore,
the bankers were more concerned to disburse credit to the clients and not to control
the credit flow. At that time, bankers used to take credit decisions mostly on the basis
of 5Cs consists of character, capacity, capital, collateral, condition and control for
safeguarding their credit and without requiring any information of much sophisticated
nature from the borrowers for using credit risk assessment for qualifying credit. Even
in many cases bankers were reluctant to apply very sophisticated financial techniques
in credit decision making if they were satisfied with the security or collateral supplied
by the borrowers. Thus the practice of sophisticated financial techniques as well as
credit risk assessment system for evaluating borrowers creditworthiness were more
or less absent in credit operations. But the bankers attitudes towards applying indepth financial analysis in credit decision making have been changed - particularly
after 1980s when they observed an alarming amount of default credit in their
portfolio. They started taking the whole financial scenario of the business of the
borrowers along with the security and collateral. They also started practicing the
techniques of financial analysis to evaluate the financial statements submitted by the
borrowers. But again the use of financial techniques was limited to the study of
income statement, balance sheet and cash flow statement only with the application of
some traditional financial ratios like current ratio, gross profit margin, debt service
coverage ratio, debt-equity ratio, break-even point analysis, net present worth, benefit
cost ratio, internal rate of return, etc.
All the bankers were seen quite enthusiastic in the early 1990s when a broad based
Financial Sector Reforms Program (FSRP) was undertaken in the financial sector for
improving the efficiency of the banks. Under the said program, much emphasis were

Credit Risk Management Practices in Banks: An Appreciation

39

given in the process of selecting a credit proposal, risk analysis, credit pricing,
classification and provisioning thereof. In 1993, Bangladesh Bank made the first
regulatory move to introduce the best practices in this area through the introduction of
the Lending Risk Analysis (LRA) manual for all credit exposures undertaken by a
bank in excess of Tk.10 million. Bankers were asked to prepare Financial Spread
Sheet (FSS) to cover financial trend analysis through comparative and common-size
financial statements, cash and funds flow analysis, measuring credit scores like Zscore and Y-score along with Lending Risk Analysis (LRA) for a particular amount
of credit. Under LRA, more emphasis was given to measure the business risk of the
clients. Henceforward, for the first time the bankers in Bangladesh started using
formal risk analysis techniques for measuring risk level of a credit proposal. The
concept of security in credit has been changed by adopting new techniques of credit
analysis. The bankers started understanding that the collateral or customers pledge
for credits is just one of the safety zones that a banker must keep for giving overall
protection against the funds which is given to the customers and the liquidate value of
the collateral or pledged goods must be equal or greater than the exposed risk value of
credit sanctioned. But from a number of studies it is found that the legal system in our
country sometimes makes it difficult for the bankers to repossess and sell out the
collateral taken against the credit. So it is clear that the income and cash flow from
business are to be the primary safety zones of a credit (Figure-1) and these are
actually preferred sources of ensuring repayment of credit.
Figure -1: Safety Zones Surrounding the Funds Credited by a Bank

Personal guarantees and pledges made by the

Resources on the customers balance sheet
Customers expected profits, income
Principal amount of credit
plus interest owed the bank.

or cash flow.
and collateral pledged.

owners of a business firm or by cosigners to a credit.

Source: Rose, Peter S. (1996), Banking Credit: Policies and Procedures,
Commercial Bank Management ,3rd edition, Boston: Irwin-McGraw-Hill Publishing.

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

The most outer or remote safety zone of a credit is the guarantee from the borrowers
or cosigners where they pledged their personal assets to back the credit taken from the
bank. Before taking any personal guarantee, banker must have the idea about personal
net-worth of the person (s) which may help in mitigating risk.
Very recently the Focus Group on risk management has prepared an industry best
practice guidelines titled Credit Risk Management Guidelines for the scheduled
banks in Bangladesh under the leadership of Bangladesh Bank with a view to
managing risk exposure effectively. To shed light this purpose and improving the
credit portfolio of the banks, the guidelines consists of some directional policy
frameworks and procedural methods like credit policy, credit risk assessment and risk
grading system, segregation of duties of approval authority, internal audit, preferred
organizational structure and responsibilities, approval process, credit administration,
credit monitoring and credit recovery. To supplement the policy frameworks another
manual on risk grading has also been prepared under the leadership of Bangladesh
Bank. Risk Grading Manual mainly deals with the credit risk grading process by
considering the principal risk components associated with the clients, early warning
signals (EWS), credit risk grading review, MIS on credit risk grading, financial
spread sheet (FSS), etc. It is expected that these guidelines along with the grading
system will improve the risk management culture, establish minimum standards for
segregation of duties and responsibilities, and will assist in the on going improvement
of the banking sector of Bangladesh.

2. Objectives, Scope and Methodology

The main objectives of this study is to make a thorough review of tools and
techniques of credit risk management practices in banks and financial institutions in
Bangladesh as suggested by the relevant bodies and experts under the leadership of
Bangladesh Bank and highlighting the key features in order to grow awareness of the
users about credit risk management practices and its proper implementation in the
credit decision making. Banks and financial institutions put their significant portion
of funds in the long-term financing along with other forms of advances to the public
and private sector programs. As a developing country a huge amount of credit flow is
very much needed both in public and private sector. But it is mentionable that the
credit operation involves risk of non-repayment from the counterparties or clients. In
order to manage the risk exposure which may come from such activities, the credit
risk management practices is one of the important aspects in bank management and it
must be proper and in systematic manner. This study is the result of consulting the
existing literature and is basically theoretical in nature on the subject. All the
discussions that have been included in this paper are the results of extensive study of
existing credit risk grading and risk management systems prevailing in this sector
which were issued by the central bank and international bodies time to time.

Credit Risk Management Practices in Banks: An Appreciation

41

3. Observations on Previous Practices

The Financial Sector Reform Program (FSRP) was introduced in the early nineties in
Bangladesh with a view to bringing about financial discipline by undertaking
appropriate reform measures in the financial sector. The program was undertaken by
the Government of Bangladesh (GoB) with combined support of the World Bank and
USAID under the Structural Adjustment Program. The program mainly covered the
banking institutions in the financial sector and suggested several reform measures.
Among the measures that FSRP recommended, the Lending Risk Analysis (LRA)
constitutes as an important measure. LRA was prescribed for taking sound credit
decision in consolidated form on the basis of analyzing risks involved in borrowers
business and security. With a view to ensuring better credit risk management, the use
of LRA was made mandatory in case of sanctioning or renewing large credits until
the adoption of Credit Risk Grading (CRG) in 2003. At present LRA has been
replaced by the CRG.
Lending Risk Analysis (LRA) was involved in assessing the likelihood of nonrepayment of credits (mainly credit risk) from the borrowers as per credit agreement
by analyzing some sort of risks associated with the borrowers business and security.
Business risk, the prime component of credit risk, was viewed from two angles viz.
industry risk and company risk.
Table-1: Contents of Risk under LRA Manual
Business Risk
1.Industry Risk
1.1 Supplies Risk

Security Risk
1. Security Control Risk
2. Security Cover Risk

1.2 Sales Risk

2.Company Risk
2.1 Company Position Risk

Performance Risk

Resilience Risk

2.2 Management Risk

Management Competence Risk

Management Integrity Risk

Source: FSRP Bangladesh, Credit Risk Analysis, June 1993.

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

Again, industry risk was consisted with two types of risks viz. supplies risk and sales
risk. On the other hand, company risk was consisted with four types of risks like
performance risk and resilience risk under company position risk and management
competence risk and management integrity risk under management risk. Finally,
security risk was broken down into two segments like security control risk and
security cover risk. But in practice it limits the use in taking sound decision making
due to some reasons. Saha et al. (2001) conducted a study titled LRA Practices in
Credit Decision in Banks. The study mentioned that for the purpose of processing
term credit proposal, LRA is being used as a supplementary tool by the banks sideby-side traditional approach. LRA helps to magnify the use of traditional approach of
credit analysis and there is no conflict between them no doubt. But LRA is not yet
used as a monitoring or follow-up tool in credit operation. However, banks are not
using the techniques of giving early warning signal on the basis of changing risk
status under LRA. More emphasis was given here for the subjective ranking. The
possibilities to reflect the individuals own judgment and biasness are remained in
assessing credit risk through LRA. Single Form for assessing varieties of credits and
ambiguities regarding some terms and concepts incorporated in the LRA Manual
makes it difficult to use a proper credit risk assessment tool. Keeping these limitations
in mind, the Lending Risk Analysis Manual (under RSRP) of Bangladesh Bank has
been amended, developed and re-produced in the name of Credit Risk Grading
Manual (Bangladesh Bank: Credit Risk Grading Manual, November 2005). Under
the newly issued manual, the process of credit risk grading has been made more
effective and easier to use in credit decision. It has also been prepared in line with the
business complexities of banks and various processes and models followed by the
different countries and organizations in assessing credit risk.
Note that before adopting new practices under CRM Guidelines, the credit risk
management practices were confined to examine only the risk level for the larger
amount term credits and no attempt used to take to risk grading system for
unclassified accounts in subsequent stages.

4. Findings and Observations on Recent Risk Management Practices in

Banks
Bangladesh Bank issued its BRPD Circular No. 17 dated October 07, 2003 advised
all the scheduled banks to put in place an effective risk management system by
December, 2003 based on the certain guidelines furnished to them. It appears from
the circular that the banking industry is completely different from other industries in
terms of the diversity and complexities of the risks they are exposed to. For
sustainable performance of the banks in view of the deregulation and globalization,

Credit Risk Management Practices in Banks: An Appreciation

43

the banks must be capable of managing their risks. Credit Risk Management
Guidelines involves in assessing and managing credit risks associated with the
selection process of a potential borrower, credit structuring (amount, duration,
purpose, repayment, and support), approval process of credit, credit documentation
(security and disbursement), credit administration, credit monitoring and recovery
functions of a bank or financial institution. At the selection stage, credit risk grading
is essential to keep the credit risk exposure at a tolerable level.
Table-2: Contents of CRM Guidelines
Policy Framework

Organization

Procedures

Credit Guidelines

Structure

Approval Process

Credit Assessment &

Risk Grading

Key Responsibilities

Credit
Administration

Approval Authority

Credit Monitoring

Segregation of Duties

Credit Recovery

Internal Audit

Source: Bangladesh Bank (2003), Managing Core Risks in Banking: Credit Risk
Management, Dhaka: Bangladesh Bank, Head Office.
Bangladesh Bank, under its prudential regulatory guidelines, advised all the banks
and financial institutions in Bangladesh to follow a robust and structured framework
for risk management. In order to help them in building such type of effective risk
management system, it formed some Focus Groups comprising the representatives
from Bangladesh Bank, SCBs, PCBs and FCBs to study the global industry best
practices in banking and to recommend a suitable framework of the risk management
system. The present guidelines on core risks management are the outcome of such
types of exercise. The Focus Groups have identified some risk areas which are
associated with the banking operations like credit risk, asset-liability management
risk, foreign exchange risk, internal control and compliance risk, money laundering
risk and ICT risk. These risks are referred to collectively core risks in banking. The
credit risk is one of the major core risks faced by the banks. It is the possibility of
potential losses that may arise from the failure of counter party or obligor (client) to
meet its contractual agreement with the bank. Again, the failure may come from the
declining in financial condition, adverse situation in the industry or unfavorable
condition of the business, trouble in management, weak support due to inferior
quality of security, lack of ready succession and bad relationship with the bank of the
counterparty.

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The main feature of these guidelines is the flexibility in practice. Bangladesh Bank
has made the guidelines flexible for the banks in the sense that the respective banks
can design their own risk management system depending on their size and complexity
of business. Central bank, however, trained a good number of officers of the
scheduled banks who in turn may help their respective banks in building up the
capacity to adopt the risk management system. Other features of credit risk
management guidelines have been discussed below:
4.1 Centralization of Major Credit Related Activities
All the banks should have comprehensive credit risk management policies and
procedures to ensure earnings at acceptable level and minimize losses in their
portfolio. The policies will provide directional guidelines to perform credit related
activities properly and efficiently. Credit policy, credit assessment and risk grading
system, approval procedures, internal auditing system are the major areas of credit
risk management policy. Procedural guidelines consist of some set rules of activities
to conduct specific credit function effectively. Credit approval process, credit
administration, credit monitoring, and credit recovery are the part of procedural
guidelines. These policies and procedures should be approved and strictly enforced by
the managing director or chief executive officer and the board of directors. It is noted
that any credit activity which does not comply with the policy guidelines will require
approval from head of credit or managing director or chief executive officer and board
of directors. Security documents should be centralized at the head office or regional
office besides the copy of the same preserving in safe custody at branch level.
4.2 Establishing Own Credit Policy
For the purpose of performing credit activities in desired manner, each bank needs to
establish own credit policy in accordance with their business philosophy. The banks
credit philosophy its general goals and objectives including the mission and vision
of the banks are reflected in its credit policy. Thus industry and business segment
focus, types of credit facilities, single client or group limits, credit caps, discouraged
business types, credit facility parameters, system of approval etc. shall be
incorporated in the credit policy in black and white with a view to providing overall
framework of credit activities. However it should cover, at a minimum, what
constitutes proper credit support, risk based pricing and documentation of credit
for safety.
4.3 Customization of Credit Policy Based on Changing Circumstances
Now in a deregulated environment, banks are no longer considered as passive takers.
Therefore after the introduction of prudential credit policy, the banks must stand

Credit Risk Management Practices in Banks: An Appreciation

45

ready to meet all the legitimate demands for credit facilities at all the times by
customizing their credit policy. While looking into the matter of customizing credit
policy, the changes in economic outlook and the evolution of banks credit portfolio
should be taken into account. The credit policy can also be modified and tuned to
match the changing credit related rules and regulations of the country and all the
modifications and changes must be approved by the managing director or chief
executive officer and board of directors.
4.4 Introduction of Credit Risk Grading (CRG) System in Credit Operations
The risks associated with the borrower or counter-party need to be carefully and
critically analyzed before funding to the clients business. To quantify the risk
exposure, it should be graded as per credit risk score sheet by the individual banks in
line with the guidelines of CRG Manual. Risk grading is a key measurement of a
banks asset quality and it is a robust process. Therefore borrowers risk grade should
be clearly stated on the credit application form for using credit decision making
process. In CRG Manual, five risk components viz. financial risk, industry/business
risk, management risk, security risk and relationship risk have been identified which
are responsible of failing to meet the obligations by the borrowers. These risk
components are rated based on the some basic parameters. Note that there are twenty
parameters under the five risk components to reflect the risk exposure. Financial risk
comes from the financial distress of the counterparty. It includes identification of
extent of leverage through debt-equity ratio, liquidity of the borrower through current
ratio, profitability performance through operating profit margin and coverage through
debt-service coverage ratio. Business/Industry risk arises due to adverse change in
business or industry situation. In order to assess the borrowers business/industry risk
the size of borrowers business in terms of annual sales volume, age of business,
industry growth, market competition and entry & exit barriers are to be assessed.
Management risk is conducted in assessing the competence and risk taking propensity
of the management. It covers the parameters like experience, second line/succession
plan and team work of the management. Security risk is assessed by analyzing the
primary security, collateral security and support. Relationship risk is considered under
CRG by assessing the account conduct, utilization of limit, compliance of covenants
and balance of personal deposits. There is a wide range of risk exposure or grading
system in the present practices where superior is the top position and bad & loss is the
worst position. In between superior and bad & loss there are six types of risk
exposures say, good, acceptable, marginal/watch list, special mention, substandard
and doubtful (Table-3).

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

Table-3: A Typical Risk Grading (Credit Rating) System under CRG Manual
Gra Description Weighted
Key Indicators
de
Score
1
Superior
None
-Facilities are fully cash secured, secured by
(SUP)
Government/international bank guarantee.
2
Good (GD)
85 +
- Repayment capacity: Strong
- Liquidity: Excellent
- Leverage: Low
- Earnings & Cash Flow: Consistently Strong
- Track record/Account conduct: Unblemished
3
Acceptable
75 - 84
- Repayment capacity: Adequate.
(ACCPT)
- Liquidity: Adequate
- Earnings & Cash Flow: Adequate &
Consistent.
- Track record/Account conduct: Good
4
Marginal
65 - 74
- Repayment: Routinely fall past due
/Watch List
- Liquidity: Strained liquidity
(MG/WL)
- Leverage: Higher than normal
-Earnings & Cash Flow: Thin, incurs loss and
inconsistent.
-Track Record/Account conduct: Poor
5
Special
55 - 64
-Repayment: Deteriorate repayment prospects
Mention
-Net-worth: Negative
(SM)
-Management: Severe problems
-Leverage: Excessive
-Earnings & Cash Flow: Consecutive losses
6
Substandard
45 - 54
-Repayment: Capacity and inclination to repay
(SS)
is in doubt.
-Financial condition: Weak
7
Doubtful
35 - 44
-Repayment: Unlikely and possibility of credit
(DF)
loss is extremely high
8
Bad & Loss
<35
-Repayment: Long outstanding, the prospect of
(BL)
recovery is poor, legal action have been
pursued etc.
Source: Bangladesh Bank (2005), Credit Risk Grading Manual, Dhaka: Bangladesh
Bank, Head Office.
The uses of CRG in credit decision making is shown in the Table-4. From the matrix
presented in the Table-4 it is found that after conducting CRG at pre sanction stage
based on clients information, a banker can select three risk categories viz. superior,
good and acceptable as feasible and marginal may be treated as exceptionally
acceptable subject to the quality of security may be offered by the client, his

Credit Risk Management Practices in Banks: An Appreciation

47

reputation etc. However, a borrower with special mentions, sub-standard, doubtful

and bad/loss rating at pre-sanction stage will be treated as not-feasible. A borrower
with superior, good and acceptable rating at post-sanction stage is a performing one.
Borrower who is beginning to demonstrate above average risk i.e. marginal/watch list
or special mention at post-sanction stage will require bankers attention because it has
become as early alert (warning) account. Rest of the ratings of a borrower at the postsanction stage exhibit as non-performing or classified status.
Table-4: Decision Matrix of CRG
Pre-Sanction Stage
Grading Status

Marginal/Watchlist

Doubtful
Bad/Loss

(2) Early
Warning
Account
(3)
NonPerforming

(3) Not -Feasible

Special Mention
Sub-standard

(1)
Performing

(1) Feasible
(2) Conditional/ Exceptionally
Acceptable

Superior
Good
Acceptable

Post-Sanction
Stage

4.5 Use of Classification and Provisioning Rules in determining Credit Risk

Grading
Out of the eight categories of risk exposures mentioned under the guidelines, four risk
exposures or grading are determined as per the prevailing loan classification and
provisioning rules of the central bank. Therefore, central banks rules for credit
classification shall be applied irrespective of risk rating under CRG sheet in case of
risk exposures like special mention, sub-standard, doubtful and bad & loss.
4.6 More Emphasis has been given on the Financial Risk of the Borrowers under
the New Guidelines
Five major risk components are considered to quantify the risk status of a potential
client before funding like financial risk (50%), business/industry risk (18%),

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

management risk (12%), security risk (10%) and relationship risk (10%). It is to be
mentioned that according to the importance of risk profile, the highest weightage (i.e.
50% out of 100%) has been assigned against the financial risk and the rest weightages
are assigned for the rest principal risk components.
4.7 Introduction of Credit Assessment System
Besides credit risk grading, a thorough credit assessment should also be done before
sanctioning any credit facility in line with the credit risk management guidelines. The
task of credit assessment will cover analysis of borrower, its guarantors, suppliers,
buyers, etc. To supplement such assessment all banks must have well equipped
Know Your Customer (KYC) form. Credit assessment starts with some summaries
results from the credit application of the borrower like the amount and types of credit
facility proposed, purpose of the credit, its structure, security arrangement, etc. In
addition, some risk areas viz. borrower analysis, industry analysis, supplier/buyer
analysis, historical financial analysis, projected financial analysis where term
facilities require more than one year tenor, account conduct, adherence to credit
guidelines, mitigating factors, security and name credit are to be addressed here.
4.8 Segregation of Major Credit Functions
With a view to improving the knowledge levels and expertise in various functional
areas of credit, to impose controls over the disbursement of authorized credit facilities
and to obtain an objective and independent judgment of credit proposal it is advised
to segregate the credit functions into Credit Approval, Relationship
Management/Marketing and Credit Administration. Moreover, it is advised to make
separate approval function from the marketing function.
4.9 Suggestions for Delegating Approval Authority to Individual Executive not
to Committees
To ensure the accountability in the approval process, the authority to approve or
sanction facilities must be delegated to the senior credit executive not to the
committees based on his/her knowledge and experiences. Approving authorities
should have at least 5 years experience working in corporate/commercial banking as a
relationship manager or account executive, training and experience in financial
statement analysis, financial reporting and full disclosure, cash flow, projections,
trade cycle, risk analysis, credit structuring and documentation, a thorough working
knowledge of accounting, local industry and market dynamics, etc.
4.10 Suggestions for using Computer Based Forms and Templates
Credit risk management is a comprehensive and robust process. It calls for various
sorts of analysis, preservation of results of the analysis and communicating the same

Credit Risk Management Practices in Banks: An Appreciation

49

among the parties involved with the process. It has been advised that banks should
create and use some computer based forms and templates to perform the credit risk
related activities to ensure the accuracy and easy access of information.
4.11
Preferred Organizational Structure
Like all businesses, banks have a hierarchy of command and a division of
responsibility in different functional areas. Credit activity is one of them and it is also
a subject of large dimension. Therefore, within the credit function the banks need to
establish organizational structure and it must be in place to ensure the objectivity and
accountability in credit risk management. As per the proposed organizational
structure of CRM guidelines, below the position of MD or CEO there should be the
Head of CRM and the Head of Corporate/Commercial Banking. Other direct reports
say, internal audit may also belong to the position of MD/CEO. The credit
administration, credit approval and credit monitoring/recovery function may come
under the Head of CRM. On the other hand, relationship management/marketing and
business development may come under the Head of Corporate/Commercial Banking.
4.12 Introduction of Internal Audit System
Credit audit is an important yardstick to measure how well a credit policy and
guidelines, operating procedures, central banks directives and credit practices are
being followed. The independent internal audit should seek at a minimum whether the
credit amount is within the bankers approval authority, whether the security is valid
and sufficient, whether the documentation is complete and accurate, whether review
has done on a timely basis, whether credits are being graded on a timely basis,
whether the credit administration is in overall compliance with the credit operation,
and so forth.
4.13 Credit Monitoring, Review and Early Alert Process
Credit monitoring helps to ensure that the banks funds are being used to make
profitable credits with a minimum risk exposure. It includes periodic reviews, ratings
and audits to provide an early indication of the financial health of a borrower. The
frequencies of the review of the CRG of the client shall be regulated by the risk
exposure at the inception of credit and subsequent updated grading. Lower grading
requires more frequency of review. Annual review is to be done in case of superior,
good and acceptable risk grading, half yearly review is to be done in case of
marginal/watch list risk grading and quarterly review is to be done in case of special
mention, sub-standard, doubtful and bad & loss grading.
4.14 Credit Recovery
It is suggested that every bank should have a separate Recovery Unit for conducting
effective and efficient credit recovery functions. This unit will take specific action

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plan/ recovery strategy for the accounts with sustained deterioration based on the
recommendations of CRM, pursue all sorts of options to maximize recovery, ensure
adequate and timely credit loss provisioning and regular review of sub-standard and
worse accounts.
4.15
Non-performing Assets (NPA) Management
The Recovery Unit is also responsible for managing NPA of a bank. For this all
NPAs should be assigned to an Account Manager within the Recovery Unit, who will
coordinate and administer the action plan/recovery of account. There should be a
Classified Credit Review Form to know the status of the action plan/recovery plan,
adequacy of provisions etc. on regular basis.
4.16
MIS on Risk Exposure
To maintain the MIS reports of credit risk grading, banks may develop some forms
for the purpose of reporting various risk grading say superior, good, acceptable,
marginal/watch list, special mention, sub-standard, doubtful and bad/loss. Bank-wise
consolidated report, branch and risk grade wise report and grade wise borrower list
may be developed.
4.17 Separate Guidelines for Assessing Risk Exposure of Small Enterprise and
Consumer Financing
Like other credit facilities, the Small Enterprise and Consumer Financing facilities
must be a subject to the banks risk management process. Small enterprise means an
entity, ideally not a public limited company, does not employ more than 60 persons
(if it is manufacturing concern) and 20 persons (if it is trading concern) and 30
persons (if it is service concern) and also a service concern with total assets at cost
excluding land and building from Tk. 50,000 to Tk. 30 lac and a trading concern with
total assets at cost excluding land and building from Tk. 50,000 to Tk. 50 lac and a
manufacturing concern with total assets at cost excluding land and building from Tk.
50,000 to Tk. 1 crore (Bangladesh Bank, 2004). At the time of granting facility under
various modes of small enterprise and consumer financing banks shall follow the
prudential guidelines issued by the central bank.
4.18 Application of Financial Spread Sheet
For the purpose of reporting the financial strengths and weakness of the clients in a
precise but comprehensive manner it is advised to use the financial spread sheet
(FSS) in credit decision making under Credit Risk Management practices. The newly
adopted financial spread sheet facilitates trend analysis with the help of common-size
financial statements covering audited as well as company prepared balance sheets and
income statements, financial ratio analysis and cash flow analysis. The cash flow
statement has been adopted in such a way that anyone can easily identify the

Credit Risk Management Practices in Banks: An Appreciation

51

Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) cash

flow which is very much essential to know to determine the Debt Service Coverage
(DSC) of a borrower. However, cash flow before and after capital expenditure, total
change in working capital during the year and its impact on cash flow, financing need
or surplus and financing support from the outsides of the business can also be found
from this Cash Flow Statement. FSS contains thirty financial ratios with a view to
assessing the growth of key financial indicators, profitability, debt service coverage,
activity, liquidity and leverage position of the business of a borrower.

5. Basel Principles and Credit Risk Management

The Basel Committee provides some guidelines in order to encourage the banking
sector globally to promote sound practices for managing credit risk. The sound
practices set out under the Basel guidelines specially address the following areas:
(a) establishing an appropriate credit risk environment;
(b) operating under a sound credit granting process;
(c) maintaining an appropriate credit administration, measurement and
monitoring process; and
(d) ensuring adequate controls over credit risk. Although specific credit risk
management practices may differ among banks depending upon the nature
and complexity of their credit activities, a comprehensive credit risk
management program will address these four areas. These practices should
also be applied in conjunction with sound practices related to the assessment
of asset quality, the adequacy of provisions and reserves, and the disclosure
of credit risk.
Each bank should develop a credit risk strategy or plan that establishes the objectives
guiding the banks credit-granting activities and adopt the necessary policies and
procedures for conducting such activities. The credit risk strategy, as well as
significant credit risk policies, should be approved and periodically reviewed by the
board of directors. The board needs to recognize that the strategy and policies must
cover the many activities of the bank in which there is a significant credit risk
exposure. The credit risk strategy should include a statement of the banks
willingness to grant credit based on type (for example, commercial, consumer, real
estate), economic sector, geographical location, currency, and maturity and
anticipated profitability. This would include the identification of target markets and
the overall characteristics that the bank would want to achieve in its credit portfolio
(including levels of diversification and concentration tolerances). A banks board of
directors should approve the banks strategy for selecting risks and maximizing
profits. The board should periodically review the financial results of the bank and,

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

based on these results, determine if changes need to be made to the strategy. The
credit risk strategy should be effectively communicated throughout the organization.
All relevant personnel should clearly understand the banks approach to granting
credit and should be held accountable for complying with established policies and
procedures. Credit policies establish the framework for credit and guide the creditgranting activities of a bank. Credit policies should address such topics as target
markets, portfolio mix, pricing, the structure of limits, approval authorities, etc. The
policies should be designed and implemented within the context of internal and
external factors such as the banks market position, business area, staff capabilities
and technology. Policies and procedures that are properly developed and
implemented capable the banks to: (i) maintain sound credit-granting standards; (ii)
monitor and control credit risk; (iii) properly evaluate new business opportunities;
and (iv) identify and administer problem credit.
Establishing sound, well-defined credit-granting criteria is essential to approving
credit in a safe and sound manner. The criteria should set out who is eligible for credit
and for how much, what types of credit are available, and under what terms and
conditions the credit should be granted. Banks must receive sufficient information to
enable a comprehensive assessment of the true risk profile of the borrower or counter
party. According to the Basel guidelines, at a minimum the following factors to be
considered and documented in approving credits:

the purpose of the credit and source of repayment;

the integrity and reputation of the client/borrower or counter party;

the current risk profile (including the nature and aggregate amount of risks)
of the borrower or counter party and its sensitivity;

The borrowers repayment history and current capacity to repay, based on

historical financial trends and cash flow projections;

A forward-looking analysis of the capacity to repay based on various

scenarios;

The legal capacity of the borrower or counter party to assume the liability;

The borrowers business expertise and the status of the borrowers economic
sector and its position within that sector;

The proposed terms and conditions of the credit, including covenants

designed to limit changes in the future risk profile of the borrower; and

Where applicable, the adequacy and enforceability of collateral or guarantees,

etc.

Credit Risk Management Practices in Banks: An Appreciation

53

Once the credit-granting criterion has been established, it is essential for the bank to
ensure that the information it receives is sufficient to make proper credit-granting
decisions. This information will also serve as the basis for rating the credit under the
banks internal rating system.
Banks should have in place a system for ongoing administration of their various
credit risk bearing portfolios. Credit administration is a critical element in
maintaining the safety and soundness of a bank. Once a credit is granted, it is the
responsibility of the business function, often in conjunction with a credit
administration team, to ensure that the credit is properly maintained. This includes (i)
keeping the credit file up to date; (ii) obtaining current financial information; and (iii)
sending out renewal notices and preparing various documents such as credit
agreements, etc. Given the wide range of responsibilities of the credit administration
function, its organizational structure varies with the size and sophistication of the
bank. In developing credit administration area, bank should ensure:

The efficiency and effectiveness of credit administration operations,

including monitoring, documentation, contractual requirements, legal
covenants, collateral, etc.;

The accuracy and timeliness of information provided to management

information system;

The adequacy of controls overall back office procedures; and

Compliance with prescribed management policies and procedures as well as

applicable laws and regulations.

Banks must have in place a system for monitoring the condition of individual credit.
An effective credit monitoring system will include measures to: (i) ensure that the
bank understands the current financial condition of the borrower or counter party; (ii)
ensure that all credits are in compliance with existing covenants; (iii) follow the
approved credit lines; (iv) ensure that projected cash flows on major credits meet debt
servicing requirements; (v) ensure that, where applicable, collateral provides adequate
coverage relative to the obligators current condition; and (vi) identify and classify
potential problem credit on a timely basis. An important tool in monitoring the quality
of individual credits, as well as the total portfolio, is the use of an internal risk rating
system. A well-structured internal risk rating system is a good means of
differentiating the degree of credit risk in the different credit exposure of a bank and
facilitates early identification of problem credit. This will also allow more accurate
determination of the overall characteristics of the credit portfolio, concentrations,
problem credits, and the adequacy of credit loss provisions.

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

Banks must ensure that the credit-granting function is being properly managed and
that credit exposures are within levels consistent with prudential standards and
internal limits. The establishment and enforcement of internal controls, operating
limits and other practices will help ensure that credit risk exposures do not exceed
levels acceptable to the individual bank. Limit systems should ensure that granting of
credit exceeding certain predetermined levels receive prompt management attention.
An appropriate limit system would enable management to control credit risk
exposures, initiate discussion about opportunities and risks, and monitor actual risk
taking against predetermined credit risk tolerances. Internal audits of the credit risk
process should be conducted on a periodic basis to determine that credit activities are
in compliance with the banks credit policies and procedures.

6. Stress Testing A Sophisticated Approach for Managing Risks in

Banks & FIs
Bangladesh Bank introduced a Guideline on Stress Testing through Department of
Offsite Supervision Circular No.01 dated 21 April, 2010 with effect from June, 2010.
In this guideline it is noted that the recent financial turmoil in the US financial system
has augmented the importance of establishing more developed risks management
regime in the financial industry. The financial institutions around the world are
increasingly employing stress testing to determine the impact on the financial
institutions under set of exceptional but plausible assumptions through a series of
tests. IMF and Basel Committee on Banking Supervision have suggested for
conducting stress testing on the financial sector. Bangladesh bank has already
designed the stress testing framework for the banks and financial institutions to
proactively manage risks in line with the international best practices. Initially, stress
testing begins with the simple sensitivity analysis and scenario analysis considering
only credit risk and market risk. Eventually it is to be developed as a more
comprehensive approach. As a starting point the stress testing is limited to simple
sensitivity analysis approach with covering five different risk factors viz. nonperforming loans (investment), forced sale value of collateral, interest rate risk,
exchange rate risk and equity price risk Moreover, the liquidity position of the
institutions is to be stressed separately. As per desire of the central bank, all the banks
and financial institutions operating in Bangladesh are to carry out stress testing on
quarterly basis i.e. on March 31, June 30, September 30 and December 31. The
reporting format of stress testing has been designed in line with the Basel II
framework. At institutional level, stress testing techniques provide a way to quantify
the reactions of changes in a number of risk factors on the assets and liabilities
portfolio of the institution. Effective stress testing requires:

Credit Risk Management Practices in Banks: An Appreciation

55

Defining the coverage and identifying the data required

Identifying, analyzing and proper recording of the assumptions used for stress
testing

Well organized management information system

Setting up some specific trigger points to meet the benchmark/standards set

by central bank

Calibrating the scenarios or shocks applied to the data and interpreting the
results, etc.

Ensuring a mechanism for an ongoing review of the results of stress testing

7. Risk Management Practices in Islamic Banks in Bangladesh

Islamic banks are entities that perform financial intermediation according to the
rulings of Islamic Shariah. The unique nature of products differentiates Islamic
banks from conventional banks in many aspects. Exclusion of interest, prohibition of
making money from money, implementation of profit and loss sharing system and
prohibition against excessive uncertainty are main sources of differences associated
with Islamic banks. The types and extend of risks of Islamic banks also differ in great
extend (Hasan and Dicle, 2005).Today nearly four hundred (400) banks and financial
institutions are providing their banking services under Islamic Shariah rulings in
about one hundred thirty (130) countries of Asia, Africa, Europe, America, Australia,
Argentina, Germany, Denmark, Luxembourg, Switzerland and United Kingdom. The
banking system of Pakistan and Iran is Islamised and that of Sudan has been totally
remodeled on the basis of Islamic Shariah. There has been a rapid growth of Islamic
banking industry and the estimated growth rate not less than 15 per cent annually.
The history of Islamic banking began from the early days of Islam. The establishment
of Mit Ghamr Local Savings Bank (Islamic Shariah based bank) in the Nile Delta of
Egypt is considered one of the important events in the history of Islamic banking. In
1963/1964, the first financial year after commencement of banking business a total of
17,560 depositors put their many as deposit in this bank. Mit Ghamr is considered as
the milestone of modern Islamic banking system. The achievements made by the Mit
Ghamr Bank in Egypt and subsequently the establishment of the Islamic
Development Bank (IDB) in 1975, the International Association of Islamic Banks
(IAIB) in 1977 motivated the Scholars and Jurists throughout the Muslim world to
take steps for establishing Islamic banks in their own countries with the support of
regulatory authorities and Governments. The Association provides technical
assistance and expertise to Islamic communities wishing to establish Islamic banks

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

and assist in the development of such banks both at national and international levels.
Islamic Banking is a form of banking where banking operations are conducted in
consonance with the Islamic principles. The philosophies and objectives of Islamic
banking are not similar to the conventional banking rather these are in line with the
principles highlighted in the Holy Quran and Hadith/Sunnah. In view with the
Islamic principles particularly prohibition of interest, establishing honesty, justice and
equity in socio-economic arena it may be considered as a system of financial
intermediaries (FIs) that avoids receipt and payment of interest (riba) in its operations
and conducts its operations in a way that it helps achieving the objectives of an
Islamic economy. The General Secretariat of the OIC defined the Islamic bank as a
financial institution whose statutes, rules and procedures expressly state its
commitment to the principles of Islamic Shariah and to the banning of the receipt
and payment of interest on any of its operation. The Islamic banking system in
Bangladesh started with the establishment of first private sector commercial bank
Islami Bank Bangladesh Limited (IBBL) in 1983. At present seven (7) full-fledged
Islamic banks and eleven (11) conventional banks with their twenty-four (24) Islamic
banking branches are providing Islamic banking services. Internationally reputed
banks like the Hong Kong and Shanghai Banking Corporation (HSBC) Ltd., Citi
Bank N.A., Standard Chartered Bank and Commercial Bank of Ceylon introduced
Islamic products. The state owned commercial banks (former NCBs) have opened
their Islamic banking wings to provide Shariah compliant services. A state owned
bond called Bangladesh Government Islamic Investment Bond (BGIIB) has been
issued by the central bank. The five Islamic insurance companies operating under the
private sector in this country as Islamic financial institutions these are Islamic
Insurance Bangladesh Limited, Islamic Commercial Insurance Limited, Takaful
Insurance Company Limited, Far East Islamic Life Insurance Limited and Padma
Islamic Life Insurance Company Limited. In Bangladesh, the share of deposit
mobilization and investments of Islamic banking in total banking industry are 16 per
cent and 20 per cent respectively. Recently a study was done by Ahmed (2010) to
identify the potential for Islamic finance and to examine its impact. This study shows
the trends of savings and investment of some selected Islamic and conventional banks
which are established in contemporary period in Bangladesh. According to the
findings of the study, during 2004 to 2008 the total savings of Islamic banks is higher
than those of the conventional banks (Table 1). Over the years the savings
mobilization gaps widened in favor of the Islamic banks. The differential amounts of
savings mobilization between Islamic and conventional banks are BDT 45,036
million, BDT 49,897 million, BDT 56,821 million, BDT 89,109 million and BDT
113,180 million during the period under study.

Credit Risk Management Practices in Banks: An Appreciation

57

Table 1: Savings Mobilization by Islamic and Conventional Banks

Amount in Million BDT
Year
2004
2005
2006
2007
2008

Savings of Islamic Banks

(A)
IBBL SIBL ARAFAH
87721 19704
10108
107788 16863
11644
132419 16171
16775
166325 18176
23009
200343 22688
31470

Total
(A)
117533
136295
165365
207510
254501

Savings of Conventional
Total Difference
Banks (B)
(B)
(A-B)
NBL
IFIC
CBL
29486 20774 22237 72497
45036
33335 22505 30558 86398
49897
40351 28621 39572 108544
56821
47961 29900 40540 118401
89109
60195 36092 45034 141321 113180

Source: Ahmed (2010).

Note: IBBL = Islami Bank Bangladesh Ltd., SIBL=Social Islami Bank Ltd., ARAFAH= AlArafah Islami Bank Ltd., NBL= National Bank Ltd., IFIC= International Finance Investment
and Commerce Bank Ltd. and CBL=The City Bank Ltd.

The study also shows the investment trends of Islamic and conventional banks to
justify the potential of Islamic finance. Table 2 shows the year-wise amount of
investment of Islamic and conventional banks under study.
Table 1: Investment of Islamic and Conventional Banks
Amount in Million BDT

Year
2004
2005
2006
2007
2008

Investment of Islamic
Banks (A)
IBBL SIBL Arafah
76826 12887 8150
93644 15097 11474
1113575 15313 17423
144921 15869 19214
191230 18725 29723

Total
(A)
97863
120215
146311
180004
239678

Investment of
Total Difference
Conventional Banks (B)
(B)
(A-B)
NBL IFIC
CBL
22972 21281 17028
61281
36582
27020 21695 23326
72041
48174
32709 25490 30789
88988
57323
36476 28361 26788
91625
88379
49665 33018 34421 117104
122574

Source: Ibid.
It is observed that like savings mobilization gaps, the gaps of investment making also
widened in favor of Islamic banks. Though the market penetration of Islamic banks in
Bangladesh is significant but still now there no separate risk management guidelines
for Islamic banks. Both the conventional and Islamic banks are following the same
guidelines which have been advised by the central bank for managing their risks in
operations. The central bank through a circular dated November 09, 2009 introduced
a Guidelines for Islamic Banking with a view to bringing greater transparency and
accountability in Islamic banking. The Guideline covers the main areas of Islamic
banking liquidity, maintenance of books of accounts, preparation of financial
statements and related issues. It is a supplementary to the existing banking laws.

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

Islamic banking, also known as participatory banking, refers to a system of banking

or banking activity that is consistent with the principles of Islamic Shariah and its
practical application through the development of Islamic economics. In order to fully
comply with the Islamic Shariah rules in banking transaction all the banks have their
own Shariah Council. Besides Bangladesh Bank has formed a Central Shariah
Council and related issues. In addition, they are also advised to follow the accounting
and auditing standards prescribed by the Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI). There are seventy (70) standards on
accounting, auditing and governance along with the code of ethics and Shariah
Standards of AAOIFI. The Islamic banks have a number of objectives to perform
their activities say, abolition of interest (riba) in banking operations, allowing
Shariah permissible products/sectors for financing, risk sharing and participatory
banking, working as catalyst of development, upholding Islamic ethical standards etc.
7.1 Guiding Principles of Islamic Financial Services Board (IFSB) for Managing
Risks
Islamic banking sector continues to grow globally at a rapid pace. The Islamic
Financial Services Board IFSB) is even more optimistic in its outlook for the growth
of the global Islamic banking industry. It forecasts that total asset value of Islamic
banking industry will expand to US Dollar 2.8 trillion in 2015 compared to US Dollar
1.4 trillion in 2010. The IFSB has developed guiding principles for Islamic banking
industry. The issuance of the Guiding Principles of risk management by the Islamic
Financial Services Board (IFSB) is a giant step for the Institutions offering Islamic
Financial Services (IIFS). The IIFSs include the commercial banks, investment banks,
finance houses and other fund mobilizing institutions that offer services in accordance
with Islamic Shariah rules and principles. The Guiding Principles of IFSB provides a
set of guidelines of best practice for establishing and implementing effective risk
management in IIFS. The main features of the Guiding Principles are:

It has been endorsed by the Shariah Advisory Committee, Islamic

Development Bank (IDB) and co-opted Shariah scholars representing central
banks and monetary agencies which are members of the IFSB.

It has been designed to complement the current risk management principles

issued by the BCSB and other international standard setting bodies.

It sets out fifteen principles of risk management that have practical effect to
managing risks. The IFSB will oversee these matters.

It retains the existing applicable Shariah-compliant international principles.

Credit Risk Management Practices in Banks: An Appreciation

59

It outlines a set of principles applicable to managing major six risk areas like
credit risk, equity investment risk, market risk, liquidity risk, rate of return
risk and operational risk.

7.2 Compliance of Basel II Accord with the Islamic Banks

Hassan and Dicle (2005) have noted in a recent article that the Accounting and
Auditing Organization for Islamic Financial Institutions (AAOIFI, 1999) suggests a
formula for the capital adequacy ratio: CAR = OC / (WOC+L+WPLS * 50%). Where,
CAR is the capital adequacy ratio, WOE+L is the average risk weight of assets financed
with the Islamic banks own capital and liabilities other than investment accounts,
WPLS is the average risk weight of investment accounts. AAOIFI requires the CAR to
be equal to 8 percent.
In Bangladesh, Basel-I accord was started in 1996. Initially in accordance with BaselI the Capital Adequacy Ratio (CAR) was 8% on Risk Weighted Assets which was
increased to 9% on 30.06.2003 and 10% on 31.12.2007. The revised accord i.e.
Basel-II was introduced in Bangladesh through a BRPD circular No.9 dated
31.12.2008. For implementing the revised accord experimentally, the parallel run of
Basel-II was started from 01 January, 2009 for 1 year and full operation was started
from 01 January, 2010. All the banks are advised to meet the regulatory capital BDT
400 crore or 9% of risk weighted assets whichever higher by August, 2011. It is noted
that most of the Islamic banks have fulfilled the revised capital requirements. The
Basel Committee on Banking Supervision suggests considering the credit risk,
operational risk and market risk determining the risk weighted assets through using
various approaches say standardized approach, internal rating based approach, basic
indicator approach, advanced measurement approach, internal model approach etc.
Note that Bangladesh Bank has advised all the scheduled banks (both conventional
and Islamic banks) to follow standardized approach, basic indicator approach and the
standardized approach to measure credit risk, operational risk and market risk
respectively.
8. Concluding Remarks
In every economy bankers are regarded as a creator of socio-economic development
as they collect funds from the surplus units of the society and to channelise the same
to the deficit units (user groups) of the society with the objectives to deploy the funds
in economic activities for enhancing industrial growth and employment. But to earn
positive return or profit from the credit activities is also the prime consideration for
their survival. Since banking business is a mechanism of channeling depositors funds
as advance from one unit to another unit of a society and the derivative products of
this mechanism are to earn profit, generate employment etc. thats why bankers are to

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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

take a lot of precautions before disbursing the depositors money as credit. Banks deal
with the depositors money and the banking philosophy is primarily based on trust
and any inconsistency in the case of disbursing credit may breach the trust and
confidence of the depositors and which may ultimately create the financial distress in
the economy. Thus, an efficient banker should always think about the probability of
non-repayment of credit (credit risk) before disbursing it to the borrowers. In this
context, the use of sophisticated risk grading techniques shows paramount importance
for measuring the financial risk, business or industry risk, management risk, security
risk and relationship risk of the borrowers so as to minimize the risk exposure of
credit which may come from default. The banks in Bangladesh should follow the
techniques for measuring risk by customizing these according to our socio-economic
circumstances and organizational set up. Each bank may establish data bank for its
own consumption at the time of taking credit decision under the sophisticated credit
screening techniques. Besides the data bank, well accepted norms and industry
average may be developed based on the clients information in sector-wise funding
for better practicing financial analysis. Uniform practices for preparing projected
financial statements may be established in the banks for the clients who will seek
facilities from the banks. Most of the banking problems have been either explicitly or
indirectly caused by weakness in credit risk management. Several credit losses in the
banking system usually reflect simultaneous problem in several areas such as
concentration, credit processing, failure of due diligence and inadequate monitoring.
First, concentration would include concentration of credits to single borrower or
counterparty, a group of connected counterparties, and sectors or industries. Banking
supervisors should have specific regulations limiting concentrations to one client or
set of related clients, and, in fact, should also expect banks to set much lower
concentrations Banks are to explore techniques to identify concentrations based on
common risk factors. Second, many credit problems reveal basic weaknesses in the
credit granting and monitoring process. A thorough credit assessment (or basic due
diligence) needs for financial information based on sound accounting standards and
timely macroeconomic and flow of funds data. When this information is not available
or reliable, banks may dispense with financial and economic analysis and support
credit decisions with subjective information. The absence of testing and validation of
new techniques of credit decision making is another important problem. Third, many
banks that experienced asset quality problems due to lack of effective credit review
process. The purpose of credit review is to provide appropriate checks and balances to
ensure that credits are made in accordance with bank policy and to provide an
independent judgment of asset quality. Fourth, a common and very important
problem in credit process is lack of monitoring client or collateral value. In absence
of monitoring process the bank will fail to recognize early signs that asset quality will

Credit Risk Management Practices in Banks: An Appreciation

61

deteriorate and will miss the opportunities to work with clients to stem their financial
deterioration and to protect the banks position. In some cases, the failure to perform
adequate due diligence and financial analysis and to monitor the client can result in a
breakdown of control to detect credit related fraud. So, an effective credit review
department and independent collateral appraisals are important protective measures.
Fifth, due to lack of sufficient account of business cycle effects in taking credit
decisions, the banks will fail to understand the income prospects and assets value that
may change for changing business cycle. Effective stress testing which takes
account of business or product cycle effects is one approach to incorporating into
credit decisions a fuller understanding of a clients credit risk. Fifth, the lack of
applying risk sensitive pricing methodology in credit decision making. Banks that
lack a sound pricing methodology and the discipline to follow consistently such a
methodology will tend to attract a disproportionate share of under-priced risks. These
banks will be increasingly disadvantaged relative to banks that have superior pricing
skills.
Finally, Hassan and Dicle (2005) have noted in their article that the unique
products and procedures of Islamic banks require specialized rating process. Such
process should include specialized models and rating systems designed in accordance
with Islamic banks and associated risks. Basel II proposes internal ratings based
(IRB) approach for banks to differentiate their risk measurement systems

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Bangladesh Bank (2003), Managing Core Risks in Banking: Credit Risk Management, Dhaka:
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______________ (2005), Credit Risk Grading Manual, Dhaka: Bangladesh Bank, Head
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______________(2004), Prudential Regulations for Small Enterprises Financing, Dhaka:
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______________ (2010), Guidelines on Stress Testing, Dhaka: Bangladesh Bank, Head
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FSRP Bangladesh (1993), Credit Risk Analysis Manual, Dhaka: Bangladesh Bank, Head
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Journal of Islamic Economics, Banking and Finance, Vol. 7, No. 3, Jul Sep 2011

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