Strengthening bank's risk rating system

Bangladesh Bank (BB) has introduced guidelines on developing commercial banks' Internal Credit Risk Rating System (ICRRS) and thereby applying this mechanism in managing the latter's credit portfolio. Reports say the central bank has set July 01, 2019 as deadline for adopting the new risk rating system. However, the banks until then may apply the existing Risk Grading System (RGS) while trying the new one. Justifying the new system, BB said the ICRRS, when applied, will immensely help improve the banks' loans and advances. The regulator further said that this new risk rating system (RRS) would also help banks reduce NPLs (non-performing loans). Such an initiative, therefore, can be regarded as a praiseworthy move on the part of BB in bringing about qualitative change in the banks' management of assets i.e., loans and advances.

Modern banks are run on quantitative judgment based on technology, and scope of qualitative decision has been either eliminated or restricted to the lowest. Score-based decision is a very popular concept in banking system of the developed world and even in many developing countries. Banks and non-bank financial institutions (NBFIs) in developed world and in many developing countries effectively use RRS not only to acquire new assets, but also to maintain the standard of existing asset portfolio. Importance of risk rating system is that there is no scope or insignificant scope of qualitative judgment at the banks' adjudicating level. Risk Management Officer's bias and personal preference do not affect credit decision when risk rating system is used in decision making process. Therefore, RRS or asset scoring system is found to be a kind of mandatory functionality of most banks and NBFIs across the world. Although RGS is being used in our banking industry for long, this technique is found to have remained far behind modern approach. In this context, BB's initiative to introduce ICRRS will of course standardise banks' risk management approach.

RISK GRADING SYSTEM: Introducing RRS for managing banks' loan portfolio is not at all new in Bangladesh's banking industry. Grading of loans and advances of commercial banks (CBs) is being followed here for last four decades. Initially, when there were no quantifiable tools and techniques for evaluating borrowers, and bankers used to apply CAMEL (Capital, Asset, Management, Equity and Liability) rating theory. Under this theory, all important aspects of the potential borrower were meticulously analysed and scanned through-- an indirect form of banks' asset rating. At the beginning of 1980, Bangladesh's banking sector had undergone extensive reform programme. The much-discussed and very expensive FSRP (Financial Sector Reform Programme) was undertaken with a view to streamlining the whole banking and financial industry. One of the most important parts of this programme was the introduction of LRA (Lending Risk Analysis), which was in fact a scoring system of the loans and advances to be acquired by banks. The applicability of LRA was restricted to large loans and mostly corporate borrowers. Hence, the medium and small borrowers remained out of the grading system that was introduced for the first time in the country's banking history. Unfortunately, LRA could not bring the desired result for some obvious reasons and therefore it was discontinued. Needless to speak that to what extent FSRP produced successful result for the country's banking sector is definitely a questionable issue. Thereafter, during the period of 2002-2003, another new programme called CRM (Credit Risk Management) had been implemented in Bangladesh's banking sector and one of the important components of CRM was introduction of credit scoring system (CSS). Under this new programme, RGS was put in place to evaluate borrowers' credit worthiness and thenceforth RGS is the only RRS in the country's banking industry and is still being used by the banks. Although the RRS used in Bangladesh is commonly referred to as banks' asset rating, this is technically the rating of the borrower - not the bank's asset. It may, however, be noted that there remains fundamental difference between borrower rating and facility rating.

PARAMETERS OF RISK RATING MODULE: Success of any Risk Rating Module (RRM) depends on what parameters and the degree of parameters have been included in the module. Moreover, how subjective and objective parameters have been accommodated in the RRM also determines its effectiveness and outcome. In order to derive optimum result from the RRM, only objective parameters that are clearly quantifiable must be included and any subjective parameter that cannot be easily quantifiable must be excluded from the module. In the LRA, most of the parameters were subjective in nature where bankers' judgement used to play an important role. As a result, we have experienced that LRA, prepared by different credit officers/analysts, used to produce different scores that eventually left the adjudicating team in a great confusion. So, any standard RRM must not include any subjective parameter. We have to keep in mind that subject parameter, if included in the RRM, leaves the scope of manipulation and thus the objective of using RRM is impaired. At the same time, using a wide array of parameters and risk components are also equally important for developing standard and well-designed RRM. If fewer parameters and risk components are included in the RRM, a poor result will be derived. It is observed that the higher the number of parameters and risk components, the more accurate the result is.

The RGS introduced under CRM programme included very few parameters and risk components. Hence, the grading generated from RGS cannot reflect the overall performance of the borrower and the facility as well. While developing ICRRS guidelines, BB mentioned that some 20 sub-sectors under four key sectors were included in the new RRM that will be implemented from the middle of next year. But whether selection of these sectors and sub-sectors are good enough or not cannot be said now, as all those sectors are not known to us. However, BB should try to include as many relevant parameters and risk components as possible in the module. They should split the whole list of parameters and risk components into two groups, of which one must be mandatory while the other may be made optional for the banks depending on risk environment. All banks must include all mandatory parameters and risk components in developing their own RRM in line with BB's guidelines. Similarly, scope of cross-checking and correlation with other relevant factors must be included in the RRM. The borrower's current performance, historical performance and future growth prospect and standard deviation in between the trend analysis should be included in the RRM. Similarly, the borrower's position with its peer group and in perspective of the industry is also important. At the same time, weight must be given to what extent the borrower's performance matrix and growth prospect are in line with the country's economic outlook. These additional risk components should be taken into consideration while following BB's guidelines in implementing ICRRS.

 It could not be understood clearly from media reports whether BB's guidelines for introducing ICRRS is flatly applicable to all banks or there is any scope of adjustment for different banks. Guidelines, especially the parameters, risk components and its degree, should be made wide so that each bank can manoeuvre this feature in developing their own RRM. Needless to say that each individual bank's organisational structure is unique as capital base, management efficiency, strength and weakness are completely different from others. Besides, risk appetite of each bank is different too, as one bank may follow aggressive risk policy while another may pursue moderate or conservative risk policy. If bank's manoeuvring scope is not provided in the central bank's guidelines for ICRRS, the bank will not be able to achieve its objective by using such module. Of course, mandatory parameters and risk components must be adopted by all banks, but its degree and acceptability can rest on bank's own judgment.

Nironjan Roy, CPA, CMA, is a banker.

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