Risk is an inherent element of banking operations and effective risk management is the key to success. Granting of any form of loans or credit is the most common type of banking activities and is thus a very common source of risks the banks are exposed to. Considering the gravity of credit risks in banks, it has become a critical component of their risk management framework. From the point of view of risk management, regulators and central banks have a common focus - possibility of a financial institution suffering unexpected losses and the impact this would have on the financial system. Guiding banks through prudential regulations and offering right risk environment are crucial because of the fact that risk-taking is the main source of economic return for banks and if they fail to perform in risk management, banks would have little ability to earn profits and their role in mobilising savings and facilitating investment would be affected. The global financial crisis and the credit crunch that followed put credit risk management to the regulatory attention and regulators are now expecting more transparency in credit operation, thorough knowledge of customers, and even greater regulatory compliance under Basel regulation. About the clients' perspective, effective credit risk management is to gain a complete understanding of a bank's overall credit risk by viewing risk at individual and customer levels. It means, to handle credit risk, banks need comprehensive visibility into consumer risk through adequate information. Alongside willingness to make repayment of loans by the borrower, managing credit risk is about sustainability of clients and business entities, collateral assets, and overall ability to repay. The above discussion points to the importance of looking into credit risk aspect from different perspectives and integrated fashion.
Considering the nature of the banks' exposure in Bangladesh, it is obvious that credit risk is at the centre. It is crucial for good performance of banks and it is the factor that exposes true vulnerabilities of banks in the country. In fact, in contrast to the situation in most developed countries, banks in most developing and low-income countries are mostly exposed to credit risks, not market risks. Especially some banks are heavily burdened with high percentages of non-performing loans (NPL). Thus, it matters greatly how well our banks are managing credit risks in their lending activities. The reasons for non-performing credits might always be seen from different perspectives and thus credit risks must be seen from the point of view of three major stakeholders: regulators, banks and borrowers. Effective handling of credit risks in banks requires an environment with desired incentives that ensure concerted effort from demand side, supply side and regulatory authority.
In a bank, credit risk management commonly targets appropriate credit risk governance: ensuring a sound credit granting procedure, maintaining a sound credit administration and monitoring process, exercising adequate internal controls over credit risk, keeping a continuous eye on external development and systemic factors and ensuring the required compliance of regulatory and supervisory authority. International regulations like Basel-II and III have brought notable changes in the incentive structure of credit risk management by banks both in developed and developing economies.
Supervisors should consider setting of prudential and large exposure limits that would apply to all banks, irrespective of quality of their credit risk management process including restricting bank exposures to single borrowers or groups. Supervisors are expected to conduct an independent evaluation of a bank's strategies, policies, procedures and practices related to granting of credit and ongoing management of the portfolio. In performing their assessments of a bank's performance, it is important to judge that banks meet the required principles and guidelines. Practically, it is critical to assess the effectiveness of systems and controls for identifying, measuring, monitoring and controlling the level of credit risk, and asset quality problems in a timely manner. It is important that supervisors evaluate the credit risk management system not only at the level of individual businesses or legal entities but also across the wide spectrum of activities and subsidiaries within the consolidated banking organisation.
Choice of sound borrowers is a key protection for credit risk management on the part of banks. In connection with handling credit risk management by banks, the key issues from the point of view of borrowers include having a sound business plan, efficient use of credit, systemic factors, product design and contingency plan. These are clearly connected with business potential of borrowers, use of bank credit for expected return, and capacity of borrowers to pay back the loans. Right product should be for the right borrowers that can ensure using a loan for purposes for which it is drawn. The product features must be suitable to business comfort for traders or borrowers. Contingency arrangement is a bulwark to save itself from any unfavourable macro environment on the part of the borrower and thus is the key for credit risk management on the part of the bank. A borrower can timely respond to the change in the macroeconomic environment in right manner. However, borrowers' honesty, literacy and understanding of business and credit issues are crucial in this connection. However, borrowers' behaviour is often guided by several incentive factors.
Incentive factors covering boards' interference in credit operation, enforcement of prudential guidelines and supervision, Basel capital regulation and liquidity standard, enforcement of credit recovery related regulations, and campaign by civil society and media are key determinants of overall credit risk environment in an economy. Boards' interference in loan-granting process results in non-performing loans and bank failures in many economies. Such corporate culture, inadequate supervision by the central bank and weak enforcement of relevant regulations are important determinants of the approaches of banks and borrowers and cause wide-scale adverse selection and moral hazards in the banking market. Enforcement of Basel frameworks is working as a positive incentive for banks. By using capital and liquidity the risk-taking behaviour of banks may be controlled not only by the regulator but also by banks themselves. Social pressure works for preventing undue behaviour of bad borrowers and help restrict wilful default in a society. In this connection, the role of civil society organisations and media could be crucial.
There might be several weaknesses of banks' operation in credit risk management in the country that are critical and required to be addressed immediately. However, probably these are relatively easy issues or areas that demand attention of the bankers and the central bank. Banks and other stakeholders cannot control some systemic issues but may consider in predicting and assessing prospective changes. However, it is really difficult to address some incentive factors like business uncertainty, legal enforcement and corporate culture in banks that have been at the root of loan default problems in many instances and these are also equally important to ensure right kind of environment for effective credit risk management in the country.
Dr. Shah Md Ahsan Habib is Professor and Director (Training), Bangladesh Institute of Bank Management (BIBM). firstname.lastname@example.org
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