internship report of sanjib debnath (p)
TRANSCRIPT
Compliance of Basel II in Credit Risk Management of
Dhaka Bank Limited
Compliance of Basel II in Credit Risk Management of
Dhaka Bank Limited
Prepared for
Mr. Shakil Huda
Professor
Prepared by
Sanjib Debnath
Roll: 02
MBA 42D
Institute of Business Administration
University of Dhaka
July 8, 2010
July 8, 2010
Professor Shakil HudaChairmanInternship and Placement ProgramInstitute of Business AdministrationUniversity of Dhaka
Dear Sir:
Here is the Internship Report I am required to submit to IBA as a part of the completion of MBA program.
While doing the job with Dhaka Bank Limited, I was allowed to do internship in Dhaka Bank Limited at Karwan Bazar Branch. For doing so, I had to work in various sections of the said branch of Dhaka Bank Ltd, such as, Credit Department, Foreign Trade Department etc.
When I was working in Credit Department, I came to know about Basel II and its implications in credit risk management. This subject interests me greatly and after consulting with my internship supervisor I have decided to choose my internship topic as “Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited”.
In this report, I have also tried to portray a comparative picture of performance of functions of Karwan Bazar Branch with respect to the whole Dhaka Bank Limited.
I hope that the information placed through this Report will provide you enough information about Basel II and its compliance in Dhaka Bank Ltd, one of the leading private commercial Bank in Bangladesh. Should you think the information flaws in explanation, I am always available to discuss the same with you to be abreast of the time.
Yours sincerely
Sanjib Debnath
Roll # 02
MBA, Batch-42D
IBA, DU
Acknowledgement
It is the requirement of MBA conducted by the Institute of Business Administration,
University of Dhaka to do Internship and to prepare an Internship Report. For doing my
internship I have selected Dhaka Bank Limited where I joined as a Probationary Officer
I am very much grateful to my Supervisor Mr. Shakil Huda for giving me time to guide and
rectify my errors. I am also grateful to the management of Dhaka Bank Limited for offering
me to carry out my Internship Program as well as providing me the necessary information in
order to finalize the Report.
I am especially indebted to my senior officials of Dhaka Bank Ltd of Karwan Bazar branch,
such as, Mr. A. S. M. Abu Bokor Siddique, Ms. Salma Akter Seema as well as the Branch-in-
Charge Mr. Md. Mostaque Ahmed for kindly assisting me while doing the Report. I would
like to also thank Mr. Imran Ahmed, Incharge of Basel II implementation Unit for providing
me current status of implementation of Basel II in Dhaka Bank Limited.
I have prepared this Report with the help and guidance of our Course Coordinator and the
senior officials of Dhaka Bank Ltd. to whom I am indebted to for the suggestions I have had
from time to time despite their preoccupations.
Table of Contents
EXECUTIVE SUMMARY............................................................................................................................... X
1.0 THE INTERNSHIP PROGRAM................................................................................................................. 2
2.0 AN OVERVIEW OF THE ORGANIZATION: DHAKA BANK LIMITED............................................................5
2.1 KEY FACTS ABOUT DHAKA BANK LIMITED.............................................................................................................5
2.2 PRODUCTS AND SERVICES..................................................................................................................................7
2.2.1 Retail Banking.....................................................................................................................................7
2.2.2 Corporate Banking..............................................................................................................................8
2.2.3 Trade Finance....................................................................................................................................10
2.2.4 SME...................................................................................................................................................13
2.2.5 Remittance........................................................................................................................................13
2.3 SUPPORTING DEPARTMENTS............................................................................................................................13
2.3.1 Centralized Processing Unit...............................................................................................................13
2.3.2 Human Resources (HR)......................................................................................................................14
2.3.3 Information Technology Department................................................................................................14
2.3.4 Finance & Accounts...........................................................................................................................15
2.3.4 Internal Control and Compliance (ICC)..............................................................................................16
2.4 FINANCIAL PERFORMANCE AND GROWTH OF DHAKA BANK LIMITED.......................................................................17
2.4.1 Assets................................................................................................................................................17
2.4.2 Liabilities...........................................................................................................................................18
2.4.3 Income and Expense..........................................................................................................................19
2.4.4 Operating and Net Profit...................................................................................................................20
2.5 FUTURE PLAN...............................................................................................................................................21
3.0 INTRODUCTION.................................................................................................................................. 23
3.1 ISSUES AND PROBLEMS................................................................................................................................25
3.2 ORIGIN OF THE REPORT...............................................................................................................................25
3.3 OBJECTIVE..................................................................................................................................................26
3.3.1 Broad Objective................................................................................................................................26
3.3.2 Specific Objectives............................................................................................................................26
3.4 RATIONALE.................................................................................................................................................27
3.5 SCOPE AND LIMITATIONS.............................................................................................................................27
3.6 METHODOLOGY...........................................................................................................................................27
3.7 REPORT PREVIEW..........................................................................................................................................28
4.0 LITERATURE REVIEW.......................................................................................................................... 30
5.0 RISK MANAGEMENT IN DHAKA BANK LIMITED...................................................................................35
5.1 CORE RISKS IN BANK......................................................................................................................................35
5.1.1 Asset Liability Management..............................................................................................................35
5.1.2 Foreign Exchange Risk.......................................................................................................................35
5.1.3 Internal Control and Compliance Risk................................................................................................36
5.1.4 Money Laundering Risk.....................................................................................................................36
5.1.5 Credit Risk.........................................................................................................................................36
5.2 TYPES OF CREDIT PRODUCTS............................................................................................................................36
5.2.1 Classification on the basis of time:....................................................................................................36
5.2.2 Classification on characteristics of financing.....................................................................................37
5.2.3 Classification on Provision Base.........................................................................................................38
5.3 CREDIT RISK MANAGEMENT IN DHAKA BANK LIMITED..........................................................................................39
5.3.1 Lending guidelines.............................................................................................................................40
5.3.2 Credit Assessment & Risk Grading.....................................................................................................40
5.3.3 Approval Authority............................................................................................................................45
5.3.4 Segregation of Duties........................................................................................................................45
5.3.5 Internal Audit....................................................................................................................................46
5.3.6 Credit Monitoring..............................................................................................................................46
5.4 CREDIT RISK MANAGEMENT AND BASEL ACCORDS...............................................................................................46
5.4.1 Basel I................................................................................................................................................47
5.4.2 Criticism of Basel I.............................................................................................................................47
5.4.3 The Entrance of Basel II.....................................................................................................................48
6.0 BASEL II FRAMEWORK AND ITS IMPLEMENTATION IN BANGLADESH..................................................51
6.1 THE THREE PILLARS........................................................................................................................................51
6.1.1 Pillar 1-Minimum Capital Requirements............................................................................................52
6.1.2 Pillar 2-Supervisory Review Process...................................................................................................52
6.1.3 Pillar 3-Market Forces.......................................................................................................................52
6.2.1 Standardized Approach (SA)..............................................................................................................52
6.2.2 Internal Rating Based Approach (IRB)...............................................................................................53
6.3 ROLE OF ECIA IN STANDARDIZED APPROACH......................................................................................................56
6.4 CONSTITUENTS OF CAPITAL.............................................................................................................................57
6.5 CREDIT RISK MITIGATION................................................................................................................................57
6.5.1 Application of Credit Risk Mitigation in Basel II.................................................................................58
6.5.2 Eligible Collaterals for CRM Purpose.................................................................................................59
6.6 BASEL II IN BANGLADESH................................................................................................................................59
6.6.1 Action Plan........................................................................................................................................60
6.6.2 Basel II implementation status in Dhaka Bank..................................................................................62
6.7 PROBLEMS FACING DURING IMPLEMENTATION...................................................................................................63
7.0 CAPITAL REQUIREMENT FOR CREDIT RISK UNDER BASEL-II IN DBL......................................................67
7.1 THE CONSTITUENT OF CAPITAL.........................................................................................................................67
7.1.1 Core capital (basic equity or Tier 1)...................................................................................................67
7.1.2 Supplementary Capital (Tier 2)..........................................................................................................68
7.1.3 Short-term subordinated debt covering market risk (Tier 3).............................................................71
7.1.4 Deductions from capital....................................................................................................................72
7.2 CREDIT RISK – THE STANDARDIZED APPROACH:..................................................................................................72
7.2.1 Claims on sovereigns.........................................................................................................................72
7.2.2 Claims on non-central government public sector entities (PSEs).......................................................73
7.2.3 Claims on multilateral development banks (MDBs)...........................................................................73
7.3.4 Claims on banks................................................................................................................................74
7.3.5 Claims on securities firms..................................................................................................................75
7.3.6 Claims on corporate..........................................................................................................................75
7.3.7 Claims included in the regulatory retail portfolios.............................................................................75
7.3.8 Claims secured by residential property..............................................................................................76
7.3.9 Claims secured by commercial real estate.........................................................................................77
7.3.10 Past due loans.................................................................................................................................77
7.3.11 Off-balance sheet items:.................................................................................................................78
7.3.12 Credit risk mitigation.......................................................................................................................79
7.4 CAPITAL ADEQUACY RATIO..............................................................................................................................79
7.5 TREND ANALYSIS...........................................................................................................................................81
7.6 CAPITAL RAISING OPTION...............................................................................................................................82
7.6.1 Tier 1 Capital.....................................................................................................................................82
7.6.2 Tier II Capital.....................................................................................................................................83
8.0 IMPACT OF ADOPTION OF BASEL II IN DHAKA BANK LIMITED.............................................................85
9.0 RECOMMENDATION.......................................................................................................................... 88
REFERENCES............................................................................................................................................... 90
APPENDICES............................................................................................................................................... 92
List of Figures
Figure 1: Number of Branches over the Years...........................................................................7
Figure 2: Operating Profit per Employee.................................................................................14
Figure 3: Investment over the Years........................................................................................17
Figure 4: Advances over the Year............................................................................................18
Figure 5: Loan Portfolio...........................................................................................................18
Figure 6: Deposits of Dhaka Bank...........................................................................................19
Figure 7: Deposit Mix..............................................................................................................19
Figure 8: Operating Profit vs Net Profit...................................................................................20
Figure 9: The Basel II Framework...........................................................................................51
Figure 10: Total Eligible Capital..............................................................................................81
Figure 11: Risk Weighted Asset..............................................................................................81
Figure 12: Capital Adequacy Ratio (CAR).............................................................................82
List of Tables
Table 1: Sectorwise Exposure....................................................................................................8
Table 2: Classification of credit based on Characteristics of financing...................................38
Table 3: Criteria for Sub-Standard Loan..................................................................................38
Table 4: Criteria for Doubtful Loan.........................................................................................39
Table 5: Criteria for Bad and Loss...........................................................................................39
Table 6: CRG Scores Band......................................................................................................44
Table 7: Constituents of Capital...............................................................................................57
Table 8: Basel II Implementation Action Plan.........................................................................60
Table 9: Core Capital calculation of Dhaka Bank Limited......................................................68
Table 10: Tier-2 Capital Calculation of Dhaka Bank Limited as on 31.03.2010....................70
Table 11: Risk Weighted Asset for DBL.................................................................................80
Table 12: Minimum Capital Requirement under Risk Based Capital......................................80
Executive Summary
At IBA, students are required to complete an Internship Program to fulfill all the requirement
of the MBA degree. The writer joined Dhaka Bank Limited as a Probationary Officer in
Karwan Bazar Branch. Dhaka Bank mainly deals with large corporate customers seeking
large loan facilities. But for banks, loans are the largest and most obvious source of risk.
Experience in recent years has shown that absence of proper management of such risk has
resulted in significant losses or even crippling losses for a number of banking institutions.
Effective credit risk management is therefore vital to ensure that a banking institution’s credit
activities are conducted in a prudent manner and the risk of potential bank failures reduced.
So, appropriate policies, procedures and systems should be implemented at each financial
institution for identifying, measuring, monitoring and controlling credit risk effectively.
DBL follows a centralized approach in extending its credit. Relationship Managers (RM)
brings in new customers and prepares credit proposals for them. The proposal package is then
sent to the Credit Risk Management (CRM) department analyzes the risk mitigating factors
and sends the proposal with recommendation to the credit approving authority. Credit
approving authority approves the proposal or denies it and sends the same to CRM again.
DBL has a written credit policy manual. It fully complies with Bangladesh Bank Guidelines.
DBL does not extend credit to a business, if it does not understand the business. The process
of credit assessment is also guided by the central bank directives. A thorough credit and risk
assessment is conducted prior to the granting of loans, and at least annually thereafter for all
facilities. The loan structure is matched with the cash conversion cycle of the business and
appropriate security is taken as collateral. In short, credits are not extended relying on just the
borrower’s or sponsoring units’ reputation in Dhaka Bank Limited.
Though all these steps are taken for managing credit risk, it is not enough. Due to the system,
failure can occur. As Bank deals with the depositors’ money, it must have some safety
precaution when giving loan. To prevent such failure international accords like Basel I, Basel
II are formulated. Bangladesh Bank instructed all the Banks of Bangladesh to adopt Basel II
from 2007. Though it has not been made fully activated yet and the simpler approach to
measuring capital was taken by the Bangladesh Bank, still it’s a big challenge for all the
x
Banks. Regulatory authorities are therefore making efforts to design appropriate strategies
that would enable the banking sector for smooth transition to Basel II.
'The New Accord' comprises of three pillars. Pillar I sets out the minimum capital
requirements. Pillar II defines the process of supervisory review of a financial institution's
risk management framework. Pillar III determines market discipline through improved
disclosure. It is argued here that implementation of Pillar I is a more critical than the other
two. It requires minimum bank capital against three kinds of risk: credit risk, operational risk
and market risk. Since existing regulation requires banks to maintain capital against credit
risk only, it is plausible to expect that additional capital requirement for two other risks will
cause all banks to raise capital appreciably. RBI (2006) also argues that banks would need to
raise additional capital to support expansion of their balance sheets. As a regulator,
Bangladesh Bank is required to design policies that will facilitate smooth transition to Basel
II.
Calculations of capital requirement suggest that Dhaka Bank Limited has adequate Capital
Adequacy Ratio as it is over 8% in the last quarter. But, as per Bangladesh Bank Guideline,
from July 2010 the ratio must be maintained over 9%, so DBL has to raise capital quickly to
be compliant with the regulation. As, per the standardized approach of credit risk, every
unrated client will be risk weighted by 150% of their loan amount, so it will be tougher for
DBL as most of the clients are unrated. So, this is a very big challenge the Bank are trying to
take in the next quarter of the year. Basel II has manifold implications, like it will prevent the
small and unrated borrowers to take loan as Bank don’t want to be charged, higher lending
cost etc. In summary, it can be said that, upto now DBL is compliant with the capital
requirements, but in the next quarter the capital requirements will not be enough. It has to
increase capital by raising fund from public, issuing subordinated bonds or issuing right
share. Already, DBL has decided to issue subordinated bond to fill the capital requirements
for market risk. More of such efforts are needed.
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CHAPTER 1THE INTERNSHIP PROGRAM
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
1.0 The Internship Program
At IBA, students are required to complete an Internship Program to fulfill all the requirement
of the MBA degree. The primary goal of internship is to provide an on-the-job exposure to
students and an opportunity for relating theoretical concepts to real-life situations. The
program includes twelve weeks of organizational attachment and four weeks for report
writing. Students are required to prepare and submit an internship report in that period. This
report has been prepared to comply with that requirement.
The writer joined Dhaka Bank Limited as a Probationary Officer on 1st February, 2010. As
the job is a full time one, the writer has opportunity to do the internship while doing his job.
Officially, the internship program was started on March 1, 2010 and ended on May 23, 2010.
After joining the writer was placed in the Karwan Bazar Branch of the said Bank. The branch
is one of the best performing branches of DBL. The branch has wide range of services. As the
Branch is an authorized dealer, it can do foreign trade business. As in the probation period,
one is required do some work at every department to have ideas about total banking
transactions. The writer was first placed at the General Banking Division, then Foreign Trade
Department and lastly at Credit Department. In this period, the writer tried to have some
ideas about different operations of a branch of a commercial bank. Following are some of the
tasks the writer used to perform during the internship period:
CIB Report:
As part of loan assessment, DBL checks a borrower’s credit status, if any, with other
financial institutions. For that, DBL fetches Credit Information Bureau (CIB) report from the
central bank. The writer used to take the undertakings from the customers and send the
inquiry to head office for further processing.
Credit Risk Grading:
Credit Risk Grading is very important tool for evaluating a customer. Corporate customers,
wishing to take any kind of credit facility, have to submit their last three years financials.
From that the writer had the opportunity to prepare CRG spreadsheet, which shows different
ratios, and CRG score sheet, which gives a score by taking all the quantitative and qualitative
data in consideration. Moreover, Different borrowers prepare financial statements differently,
i.e. the format varies from customer to customer. Formats may also vary for a same borrower
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
from one year to another. To avoid this kind of problems, Eastern Bank Limited has its own
format and an MIS for that. The MIS upon correct restatement of the balance sheet and the
income statement automatically generates ratio statement, cash flow statement.
Visiting the collateral/security to be mortgaged
Usually when a corporate customer wants to take loan, it has to provide collateral/security
such as land, building, stocks, vehicles etc. It is required that Bank officers would go to the
place in person to see the status and estimate the value of the property. The writer had the
opportunity to go in property visit. After visit, the writer also prepared the visit report of the
visited property.
Sending Letters:
Sending letters to the customer is one of the responsibilities of the writer. Whenever a
loan/limit expires or runs excess over the limits, sending letters is the first thing to do. The
writer took the responsibility of monitoring borrowers’ account performance sends all sorts of
letters to borrowers. The writer did prepare past due letters for the unit.
Sending Request to Central Processing Centre:
Central Processing Centre is the centralized processing centre for processing various request
of the branches related to posting and documentation of credit and foreign trade operation.
All request sent by the branches such as disbursing a loan, adjustment of loan etc. have a
required format. The writer sent some request for disbursement of loans in this internship
period.
Filing:
The customer support unit is tasked with filing account and security related documents
properly so that those can be found out when required. As an intern of this unit, the writer did
a lot of filing for the unit. The filing was helpful in that it oriented the writer with many legal
documents related to security or collateral, documents from the Registrar of Joint Stock
Companies and Firms, sanction letter, charge documents, CIB undertaking, stock reports,
insurers’ documents, debit-credit advice, credit memorandum, board approvals, etc.
In summary, it can be said that the outcome of the internship period is very satisfactory. The
writer engaged in the day-to-day banking activities and hence had a clear idea about various
banking operation. Also, within this brief period, the writer met many people and had a good
idea how to serve the customers.
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CHAPTER 2AN OVERVIEW OF THE ORGANIZATION: DHAKA BANK LIMITED
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
2.0 An Overview of the Organization: Dhaka Bank Limited
Bangladesh economy has been experiencing a rapid growth since the '90s. Industrial and
agricultural development, international trade, inflow of expatriate Bangladeshi workers'
remittance, local and foreign investments in construction, communication, power, food
processing and service enterprises ushered in an era of economic activities. Urbanization and
lifestyle changes concurrent with the economic development created a demand for banking
products and services to support the new initiatives as well as to channelize consumer
investments in a profitable manner. A group of highly acclaimed businessmen of the country
grouped together to responded to this need and established Dhaka Bank Limited in the year
1995.
2.1 Key Facts about Dhaka Bank Limited
The banks that were given license during the mid 90s are called the 2nd Generation Private
Commercial Banks. Dhaka Bank Limited (DBL) is one of them that incorporated as a public
limited company under the Companies Act in 1994 and is governed by Banking Companies
Act, 1991. The Bank started its commercial operation on July 05, 1995. Since its
incorporation, DBL has proved itself as a true development partner of the Government in
developing the national economy by providing efficient banking services to different sectors
of the economy. Some important facts about Dhaka Bank Limited are given below:
Date of Incorporation : April 06, 1995.
Registered Office : Biman Bhaban, 100 Motijheel C/A, Dhaka
First Branch : Local Office, Adamjee Court, Motijheel, Dhaka
Enlisted as Public Limited Co. : 1998
Capital Structure at Formation
Authorized Capital : BDT 100 Crore
Paid up capital : BDT 10 Crore
Capital Structure as on June, 2010
Authorized Capital : BDT 600 Crore
Paid up capital : BDT 266 Crore
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Mission
To be the premier financial institution in the country providing high quality products and
services backed by latest technology and a team of highly motivated personnel to deliver
Excellence in Banking.
Vision
At Dhaka Bank we draw our inspiration from the distant stars. Our team is committed to
assure a standard that makes every banking transaction a pleasurable experience. Our
endeavor is to offer you the razor sharp sparkle through accuracy, reliability, timely delivery,
cutting edge technology, tailored solutions for business needs, global reach in trade and
commerce and high yield on your investments.
Our people, products and processes are aligned to meet the demand of our discerning
customer. Our goal is to achieve a distinction like the luminaries in the skies. Our prime
objective is to deliver a quality that demonstrates a true reflection of our vision - Excellence
in Banking.
Values
Customer Focus
Integrity
Teamwork
Respect for the individual
Quality
Responsible Citizenship
Strategic Objectives
To conduct transparent and high quality business operation based on market mecha-
nism within the legal and social framework spelt in our mission and reflected in our
vision.
To provide the customers efficient, innovative and high quality products with excel-
lent delivery system.
To generate profit with qualitative business as a sustainable ever growing organiza-
tion and enhance fair retuns to our shareholders.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Committed to our community as a corporate citizen and contributing towards the
progress of the nation.
Branches
As on June 2010 the Bank serves it’s customers through 52 (Fifty-two) branches and 20
ATM booths spread all over the country. It also has six CMS unit, eight business centers.
Figure 1: Number of Branches over the Years
Source: Annual Report 2009, Dhaka Bank Ltd.
2.2 Products and Services
Dhaka Bank Limited has a wide range of products and services in its assortment. These value
based products are very much contemporary and standardized. All the products are very well
thought-out and addressed to the very basic financial needs of the individuals and
organizations. Its main products and services are described briefly next:
2.2.1 Retail Banking
DBL is a leading bank in the countries consumer banking arena. Emphasis on customer
service, product innovation, asset quality and brand building are the cornerstones of the
Retail Banking strategy. The major products and services of Retail Banking include:
Liability Products
Savings Bundled Product
Deposit Pension Scheme
Special Deposit Scheme
Deposit Double Scheme
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Gift Cheque
Asset Products
Home Loan
Personal Loan
Vacation Loan
Car Loan
Any Purpose Loan
Services
Internet Banking
SMS Banking
Locker
ATM Card & VISA Credit Card
2.2.2 Corporate Banking
Providing a tailored solution is the essence of Corporate Banking services of DBL. Dhaka
Bank recognizes that Corporate Customers' needs vary from one to another and a customized
solution is critical for the success of their business. Dhaka Bank offers a full range of tailored
advisory, financing and operational services to its corporate client groups combining trade,
treasury, investment and transactional banking activities in one package. At the moment
Dhaka Bank’s exposure (as of December 31, 2009) under Corporate Banking Business is
distributed in the following sectors:
Table 1: Sectorwise Exposure
Sl. Sector DBL’s Exposure
(BDT in Crore)
1 Agricultural 30
2 Chemical 130
3 Electronics & Automobile 9
4 Energy & Power 58
5 Engineering & Metal including Ship Breaking 394
6 Food & Allied 350
7 Housing & Construction 692
8 Pharmaceuticals 56
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
9 Service 158
10 Textile & Garment 973
11 Transport & Communication 191
11 Others 2,249
Total 5,291
Source: Annual Report, 2009
Following are some of the corporate products offered by DBL:
Securitization of Assets
A powerful and effective means of generating funds for a certain category of institutions,
Securitization of Assets is still in its infancy in The need however for such a service is great
and there is a lot of support from multilateral financial institutions, such as the World Bank
and the Asian Development Bank, for such activities to be developed further in this country.
Dhaka Bank intends to take up this challenge and play a significant role in ensuring that
Securitization of Assets becomes a normal part of the range of financial instruments available
for organizations who can count on a steady, but piecemeal, flow of revenue and want to
translate this stream into cash resources with which to carry out further lending activities to
new customers.
Finance & Advisory Services
Given the needs of its large and varied base of corporate clients Dhaka Bank will be
positioning itself to provide investment banking advisory services. These could cover a whole
spectrum of activities such as Guidance on means of raising finance from the local Stock
markets, Mergers and Acquisitions, Valuations, Reconstructions of Distressed companies and
other expert knowledge based advice. By this means Dhaka Bank hopes to play the role of
strategic counselor to blue-chip Bangladesh companies and then move from the level of
advice to possible implementation of solutions to complex financing problems that may arise
from time to time. This would be an extra service that would complement the normal
financing activities that Dhaka Bank already offers to corporate business houses.
Syndication of Funds
There has been a surge in the number of syndication deals closed in the last few years. 2004
was an exceptionally good year for syndicated deals for the local commercial banks also for
the foreign banks. The total number of syndications in 2004 exceeded 10 totaling over Tk. 10
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
billion. This rise in the number of syndications can be primarily attributed to the prudential
lending guidelines of the Bangladesh Bank. A commercial bank may provide funded facilities
up to a maximum of 25% of its equity. Due to this reason, projects with sizeable costs need to
approach more than one bank for their debt requirements and therefore the demand for
syndications exist. Credit risk diversification has led many international companies to
introduce credit derivatives that are actively being traded.
Project Finance
Project financing is an innovative and timely financing technique that has been used to fund
large-scale corporate projects. It includes understanding the rationale for project financing,
preparing the financial plan, assessing the risks, designing the financing mix, and raising the
funds.
Project finance is different from traditional forms of finance because the financier principally
looks to the assets and revenue of the project in order to secure and service the loan. Project
financing relies primarily on the project's cash flow for repayment, with the project's assets,
rights, and interests held as secondary security or collateral. Dhaka Bank offers a full range of
services to the entrepreneurs implementing a project including structuring mode of financing,
mitigation of different risks and providing advisory service for successful implementation of
the project.
Working Capita l Finance
Dhaka Bank caters to the working capital needs of the client taking into account the current
asset requirement of the client.
Dhaka bank extends different types of working capital facility like Cash Credit (CC),
Overdraft (OD) facility, Short Term Loan (STL), Bank Guarantee, etc. to facilitate the
business operation of the client.
2.2.3 Trade Finance
Dhaka Bank Limited (DBL) started it trade operations in 1995 and all the trade activities
were carried out by DBL’s 15 (fifteen) Authorized Dealer (AD) Branches. In the year 2009,
DBL established the Central Processing Center (CPC) at BGMEA Bhaban, Karwanbazar,
Dhaka and Agrabad, Chittagong. Since then the CPC does the processing of all the trade
activities of DBL by using state of the art technology and well groomed team. The trade
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
activities of 40 branches are routed through the Dhaka Hub and that of the rest 12 branches
are routed through the Chittagong Hub.
Central processing center of DBL is well equipped with highly talented and experienced team
who has very good knowledge in foreign trade and technology. Strong MIS, network
coverage and real time technology help us to satisfy customer needs just in time maintaining
Quality of Work Life (QWL). All sorts of statement are generated centrally to comply with the
compliance issue of internal and external authorities. Various kind of trade finance facility is
stated next:
2.2.3.1 Import Finance
DBL undertakes Import Finance in the form of both pre-import and post-import finance.
These two categories of import finances include:
Letter of Credit
This is a pre-import finance, which is made in the form of commitment on behalf of the client
to pay an agreed sum of money to the beneficiary of the Letter of Credit upon fulfillment of
terms & conditions of the Credit.
Performance Bonds & Other Gua rantees
DBL offers excellent solution to meet all performance bonds & guarantees required by its
valued clients.
Loan against Trust Receipt (LTR)
In this category of finance, possession of the goods remains with the borrower and the
borrower executes ‘Letter of Trust Receipt’ in acknowledgement of debt and its repayment
along with interest within agreed period of time.
2.2.3.2 Export Finance
Like import trade, DBL advances in export trade at both pre-shipment and post-shipment
shipment stages. The pre-shipment facilities are usually required to finance the costs to
execute export orders, such as: procuring & processing of raw materials, packaging and
transportation, payment of various fees and charges including insurance premium etc. The
facilities under both the categories are:
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Export Letter of Credit Advising
Dhaka Bank provides prompt advising of export letter of credit from a wide international
network.
Back to Back LC
BB L/C is a type of pre shipment finance by way of opening L/C in favor of a local or foreign
supplier for purchase of raw materials or the finished merchandise, as the case may be, to
execute export order.
Export Bills for Collection
Export Bills for Collection are documents which are presented to the bank by the
seller/exporter to collect payment from the buyer through the buyer’s bank.
Packing Credit
To execute export orders under L/C or firm contract the bank awards packing credit facility
to meet client’s working capital requirement.
FDBP
Foreign Documentary Bill Purchased (FDBP) is a post shipment finance allowed to the
customer through the purchase/negotiation of foreign documentary bills adjustable from the
relevant export proceeds.
IDBP
Inland Documentary Bills Purchased (IDBP) facility is accommodated both for export and
local trade.
EDF
Export Development Fund (EDF) at Bangladesh Bank is intended to facilitate access to
financing in foreign exchange for input procurements by manufacturer-exporters. Authorized
Dealer (AD) banks can borrow US Dollar funds from the EDF against their foreign currency
loans to manufacturer-exporters for input procurement.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
2.2.4 SME
Small and Medium Enterprises (SMEs) are the ‘engines of growth’ in almost all the emerging
economies of the globe. It has been playing a pivotal role in job creation and overall
economic development in Bangladesh. Banking to the SMEs can be termed as banking to the
‘unbanked’, as many is yet to receive bank finances to ensure greater business development.
DBL is planning to add 6 to 7 SME branch or service centers across the country by the end of
2010. DBL signed a new refinancing deal on ‘Solar Energy’, Solar panel assembling plant
and ETP with Bangladesh Bank.
2.2.5 Remittance
DBL is continuously pursuing for improvement of its Remittance operation for smooth
mobilization of fund from the NRB’s. For this, DBL is increasing its distribution channel. It
has already started payment of remittance through two renowned NGO of Bangladesh-PAGE
and PADAKHEP MANOBIK UNNOYON KENDRO, which added 250 distribution centers.
It is also a member of EL-DORADO which is a 9-bank Elite Network for remittance
distribution facility. It has already introduced Mobile remittance disbursement partnering
with Banglalink.
2.3 Supporting Departments
To ensure smooth running of the above departments Dhaka Bank has supporting/back end
departments. These departments are not directly involved with the profit making or business
of the company, but they are very critical for day to day banking operations. Some of the
departments are mentioned next:
2.3.1 Centralized Processing Unit
To provide the customer the best possible and world class service Dhaka Bank Limited has
centralized its Trade service and Credit Operations. This important initiative is aligned with
the CRM guideline of Bangladesh Bank. The centralization of these functions lead to better
control and monitoring and minimizing the risks, and helps in segregation of duties and
responsibilities as well as reduces different type of irregularities. It also heps inn maintaining
P a g e | 13
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
uniform process and policy, rational and optimum utilization of manpower and taking full
advantage of bank’s existing cutting edge technology platform.
2.3.2 Human Resources (HR)
Dhaka Bank Ltd has been investing generously in human resources since its inception. DBL
HR is working as a business partner for both of its internal and external customers to help
them achieve better business results. It is directly involved with the people and therefore
committed to ensure staff motivation, learning and development, retention, reward and
recognition to drive better business results.
Creating a progressive and possessive
environment for the people to work at DBL
is the undeviating objective of HR. At
DBL, employee performance is directly
aligned with business results. Employees
feel appreciated and valued for their hard
work and dedications manifested in
measurable performances. Dhaka Bank
Limited is widely recognized for its
holistic work environment, corporate culture and best practices that attract and help retain top
talent of the industry. During 2009, operating profit per employee was BDT 3.04 million
which was on an increasing curve.
2.3.3 Information Technology Department
It is increasingly recognized that to be successful in business, banks need to have an effective
technology platform. The bank gives right attention to its overall technology service
management by not only acquiring technology but also investing in training and continuous
refinement of processes. The bank is open to accept industries’ good practices. DBL use the
i-flex Flexcube for its core banking purposes. The system has enhanced customer service
capabilities, further improved cost per transaction and managed risks better with latest control
tools.
Technology innovation is one of the most effective ways to achieve cost savings by
automating manual processes. More importantly, management of technology enables new
P a g e | 14
2005 2006 2007 2008 20090.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
Ope
ratin
g Pr
ofit P
er E
mpl
oyee
(in
mill
ion
Tk.)
Figure 2: Operating Profit per Employee
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
revenue opportunities by providing better and timely information about internal processes
and client data.
2.3.4 Finance & Accounts
This division has four units, viz. Financial Operations & Control, Financial Analyses &
Reporting, Financial Planning & Projects and Reconciliation & GL Control.
Financial Operations & Control:
This unit is assigned with management of day to day payables, fixed assets, corporate tax,
employee retirement benefit plans, etc. Except payroll, FOC processes almost all sorts of
payables of the bank.
Financial Analyses & Reporting:
Major responsibilities of this unit include various central bank reporting, due diligence report
for various partner organizations (e.g. IFC, ADB), preparation of quarterly and half-yearly
financial statements including Annual Report on fixed periodic intervals. Other reports
include Capital Adequacy Reports, CAMELS report, etc. As a reporting unit, it has to handle
various central bank audits and provide explanations to queries from internal and external
group related to financial statements and reports.
Financial Planning & Projects:
Major responsibilities include preparing monthly financials of the bank (Business and
Financial Performance) for MANCOM and yearly business unit wise budget of the bank,
budget variance/review forecast, etc. It has also shown excellence in process
improvement/reengineering by developing in-house software applications, queries and
reports.
Reconciliation & GL Control:
To enhance integrity of financial information, this unit drives various reconciliation
initiatives regularly. A comprehensive GL Control Policy is in process that will help the bank
to ensure integrity of recording transactions and thereby integrity of financial statements.
Besides, the team monitors risk sensitive GLs such as suspense, inter-branch, inter-system,
etc. regularly to ensure internal control.
P a g e | 15
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
2.3.4 Internal Control and Compliance (ICC)
DBL has established a sophisticated organizational structure to establish and maintain a
strong control culture by implementing and strengthening policy guidelines of internal
controls. Internal Control is an integral part of the daily activity of a bank, which on its own
merit identifies the risks associated with the process and adopts a measure to mitigate the
same.
The main objectives of the Internal Control and Compliance Department are as follows:
Efficiency and effectiveness of activities (performance objectives).
Reliability, completeness and timelines of financial and management information (in-
formation objectives).
Compliance with applicable laws and regulations (compliance objectives).
Structure of ICC:
The head of Internal Control and Compliance Department [ICCD] have a reporting line with
the Managing Director and the Audit Committee of the board. The department has three
separate units:
1. Monitoring Unit
2. Compliance Unit and
3. Internal Audit & Inspection Unit
The Monitoring unit is responsible to monitor the operational performance of various
branches and departments. It collects relevant data and analyzes those to assess the risk of
individual units. In case it finds major deviation, it recommends to the Internal Control Head
for sending audit and inspection team for thorough review. The Compliance unit is entrusted
to ensure that bank complies with all regulatory requirements while conducting its business.
It maintains liaison with the regulators at all levels and notifies the other units regarding
regulatory changes. The Audit team performs periodic and special audit. This unit prepares a
risk-based audit plan, normally on an annual basis. These plans are approved by the bank's
senior management and by the audit committee. This risk based approach of audit assists the
organization by identifying and evaluating significant exposures to risk and contributing to
the improvement of risk management and control systems.
P a g e | 16
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
2.4 Financial Performance and Growth of Dhaka Bank Limited
Dhaka Bank Limited is high performing private commercial bank, which further consolidated
its position in the market in terms of quality services to the customers and value addition for
the shareholders. The Bank made healthy progress in all areas of business in 2009.
2.4.1 Assets
As of 31 December 2009, total asset of the Bank stood at Tk.77.77 billion, an increase of 9%
as against 2008. The increase in asset was mainly driven by significant growth of customer
deposits. The growth of deposits was used for funding in loans and advances and holding of
securities for SLR (Statutory Liquid Reserves).
Cash & Balances with Bangladesh Bank and its Agent:
The cash & balances with Bangladesh Bank and its agent registered 33% growth as of 31
December 2009. The growth of deposits increased the balances with Bangladesh Bank and its
agent for maintaining the Cash Reserve Requirement (CRR), which was maintained
adequately.
Balances with Other Banks and Financial Institution:
The Balances with other banks and financial institutions increased by 9% which was mainly
due to transfer of fund to current accounts of different banks for covering the payments
against Inward Foreign Remittances to beneficiaries.
Investment
The Bank’s investment during the year 2009
were mostly in long term Government
Securities which stood at Tk. 8,660 million as
against Tk. 7,239 million making a growth of
20% over the last year. The Government
Treasury Bonds purchased at higher rate of
interest to cover the increased SLR arising from
the growth of deposit liabilities.
P a g e | 17
Figure 3: Investment over the Years
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Loans and Advances
The Bank implemented the system of
credit risk assessment and lending
procedures by stricter separation of
responsibilities between risk
assessment, lending decisions and
monitoring functions to improve the
quality and soundness of loan portfolio.
The Bank recorded a 6% growth in
advances with a total loans and
advances portfolio of Tk. 52,910
million at the end of December 2009 compared to Tk. 49,698 million at the end of December
2008.
As of 31 December 2009, 94.43% of
the total bank’s loan portfolio was
regular while only 5.57% of the total
portfolio was non-performing as
compared to 3.84% of 2008. The
volume of nonperforming loans stood
at Tk. 2,946 million in 2009 from Tk.
1,908 million in 2008.
2.4.2 Liabilities
Total liabilities of the Bank stood at Tk. 72,802 million as of 31 December, 2009 registering
a growth of 8% over the last year. This has happened for increase of deposits from customers
mainly and settlement of import payments against deferred and cash letter of credits.
Borrowings from Banks, Financial Institutions and Agents:
Treasury Division resorted to borrowing from money market. The Bank registered a negative
growth of 3% in borrowings from Banks, Financial Institutions and Agents as against last
year positions. The main reason of this negative growth was DBL’s borrowing from call
money market was significantly reduced.
P a g e | 18
2005 2006 2007 2008 20090
10000
20000
30000
40000
50000
60000
23372
3403939372
4969852910
Advances
Taka
in M
illio
nFigure 4: Advances over the Year
Regular Loan94%
Non-performing Loan6%
Loan Classification
Figure 5: Loan Portfolio
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Deposits:
The deposit base of the Bank
continued to registered a steady
growth and stood at Tk.60,918
million excluding call as of 31
December 2009 compared to Tk.
56,986 million of the previous year
registered a 7% growth. The growth
was supporte by branch network and
high standard products an service
along with competitive interest
rate provided to customers. The customer group of the Bank was individual, corporation,
NBFI, Government Bodies, NGO, Autonomous Bodies etc.
The cost free and low cost
deposits comprised of 28%
of the deposits. Fixed
deposits remained the main
component of deposits
contributing about 70% of
the total deposits. Average
Cost of Deposits was 8.68%
in 2009 as against 9.0% in
2008. Deposit mix of the
Bank as of 31 December
2009 is given in the Figure 7.
2.4.3 Income and Expense
Interest income has been increased by 4% from Tk. 7,171 million in 2008 to Tk. 7,466 in
2009. The growth of advance caused this growth of interest income. Average yield on
advance was 14.32% during 2009. Income from investments increased by 38% mainly due to
the income from five and ten years Government Bonds at higher rate of interest which was
maintained for SLR purposes.
P a g e | 19
2005 2006 2007 2008 20090
10000200003000040000500006000070000
28439
4155448731
56986 60918
Deposits
TAka
in M
illio
nFigure 6: Deposits of Dhaka Bank
Current and Others9%
Savings10%
STD5%
FDR68%
DPS/MDS4%
Bills4%
Deposit Mix
Figure 7: Deposit Mix
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
The Net Interest Margin (NIM), which is derived by net interest income divided by average
assets, were 4.56% in 2009 as compared to 4.60% in 2008. The decrease of Net Interest
Margin was mainly because of increase of earning assets but lower rate of return from
advance which results the lower spread. Net Interest Income increased by 14% FROM Tk.
2,622 million in 2008 to Tk.2,980 million mainly due to increase of interest income form
both advances and investments.
Expenses
Interest expense increased by 4% in 2009, this rise is mainly attributable to the overall
increase in Deposit base of the bank. Salary and allowances increased by Tk. 68 million from
2008 mainly due to recruitment of new Employees. Other overhead expenses increased only
by Tk. 3 million as compared to 2008. Earning base in assests of the Bank remains
unchanged in 2009, which was 88% in 2008. The ratio indicates efficient utilization of
resources to earn revenues.
2.4.4 Operating and Net Profit
Dhaka Bank Limited registered an operating profit of Tk.2,810 million in 2009 compared to
Tk. 2,533 million in 2008 making a growth of 11%.The net profit for the bank as of 31
December 2009 stood at Tk. 959 million compared to previous years Tk. 839 million making
growth of 14%. Earning per share (EPS) was Tk. 45.09 in 2009. A comparative figure of
operating profit versus net profit is given below for last five years.
P a g e | 20
2005 2006 2007 2008 20090
500
1000
1500
2000
2500
3000
Operating Profit vs Net Profit
Operating ProfitNet Profit after Tax
Taka
in M
illio
n
Figure 8: Operating Profit vs Net Profit
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
2.5 Future Plan
Dhaka Bank is going to celebrate its 15-year anniversary on 5th July. In this 15 years of
journey, Dhaka Bank present itself as a modern and innovative Bank. The workforce is a
brilliant one and the work environment is very congenial. Though it has a strong brand image
among the corporate clients, retail division of the bank is not that strong as corporate
division. One of the problems in retail banking is dearth of ATM booths. To improve this
situation, Dhaka Bank plans to have own ATM network. Furthermore, it signed a deal with
OMNIBUS and Dutch-Bangla Bank Limited to have withdrawal facility for the clients of
Dhaka Bank in those networks. Dhaka Bank is planning to modernize its IT infrastructure to
provide the branch network a happy time when serving the customers.
P a g e | 21
CHAPTER 3INTRODUCTION
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
3.0 Introduction
Until the late 1970s, banks were highly regulated and protected entities with hardly any com-
petition among them. Collapse of the Bretton Woods agreement put them in a new environ-
ment of increased competition, leading to gradual erosion of capital that started to alarm the
regulators. Dealing with the problem on international level seemed to be the only possible
way of finding a proper solution without increasing competitive differences between banks
from individual countries.
Hence, a special committee was set up under the auspices of the Bank for International Settle-
ments (BIS) in Basel. The Committee, initially known as the Cooke Committee and later re-
named the Basel Committee on Banking Supervision (BCBS), formed a proposal in which it
suggested that a common framework for calculating the capital adequacy of banks should be
formed. This document, known as the 1988 Basel Capital Accord, became a huge success af-
ter its adoption – it not only managed to level the playing field, but it also brought national
practices on capital adequacy of banks in line. In 1988, the Basel Committee published a set
of minimal capital requirements for banks, known as the 1988 Basel Accord. These were en-
forced by law in the G-10 countries in 1992, with Japanese banks permitted an extended tran-
sition period.
The 1988 Basel Accord focused primarily on credit risk. Bank assets were classified into five
risk buckets i.e. grouped under five categories according to credit risk carrying risk weights
of zero, ten, twenty, fifty and one hundred per cent. Assets were to be classified into one of
these risk buckets based on the parameters of counter-party (sovereign, banks, public sector
enterprises or others), collateral (e.g. mortgages of residential property) and maturity. Gener-
ally, government debt was categorized at zero percent, bank debt at twenty per cent, and other
debt at one hundred per cent. Off-Balance Sheet (OBS) exposures such as performance guar-
antees and letters of credit were brought into the calculation of risk weighted assets using the
mechanism of variable credit conversion factor. Banks were required to hold capital equal to
8% of the risk-weighted value of assets.
Since 1988, this framework has been progressively introduced not only in member countries
but also in almost all other countries having active international banks. Close on the heel of
the 1996 amendment to the Basel I Accord, In June 1999 BCBS issued a consultative paper
P a g e | 23
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
on New Capital Adequacy Framework to replace the 1988 Accord. The new capital frame-
work consists of three pillars: minimum capital requirements, which seek to refine the stan-
dardized rules set forth in the 1988 Accord; supervisory review of an institution's internal as-
sessment process and capital adequacy; and effective use of disclosure to strengthen market
discipline as a complement to supervisory efforts.
The 1988 Basel I Accord has very limited risk sensitivity and lacks risk differentiation (broad
brush structure) for measuring credit risk which created some problems for credit risk man-
agement. For example, all corporations carry the same risk weight of 100 per cent. It also
gave rise to a significant gap between the regulatory measurement of the risk of a given trans-
action and its actual economic risk. The most troubling side effect of the gap between regula-
tory and actual economic risk has been the distortion of financial decision-making, including
large amounts of regulatory arbitrage, or investments made on the basis of regulatory con-
straints rather than genuine economic opportunities. The strict rule based approach of the
1988 accord has also been criticized for its `one size fits all’ prescription. In addition, it
lacked proper recognition of credit risk mitigants such as credit derivatives, securitization,
and collaterals. The recent cases of frauds, acts of terrorism, hacking, have brought into focus
the operational risk that the banks and financial institutions are exposed to.
Basel II is claimed by BCBS to be an improved capital adequacy framework intended to fos-
ter a strong emphasis on risk management not only on credit risk management and to encour-
age ongoing improvements in banks’ risk assessment capabilities. It also seeks to provide a
`level playing field’ for international competition and attempts to ensure that its implementa-
tion maintains the aggregate regulatory capital requirements as obtaining under the current
accord. The new framework deliberately includes incentives for using more advanced and so-
phisticated approaches for risk measurement and attempts to align the regulatory capital with
internal risk measurements of banks subject to supervisory review and market disclosure.
Bangladesh Bank issued Basel II Road Map in 2007 in a BPRD Circular Implementation of
Basel II in Bangladesh started from January 2009. According to the initial plan, Basel II im-
plementation followed the specific approaches as initial steps with the parallel calculations
starting from January 2009:
Standardized Approach for calculating Risk Weighted Assets (RWA)
P a g e | 24
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Standardized Rule Based Approach against Market Risk and
Basic Indicator Approach for Operational Risk
Dhaka Bank Limited, a second-generation private commercial bank also followed the imple-
mentation plan as specified by the Bangladesh Bank. In the first pillar of Basel II accord,
identification and mitigation of credit risk is the forerunner. So, this report tries to unveil the
current status of Basel II implementation in Credit Risk Management in Dhaka Bank Limited
and the impact of it in banking operations.
3.1 Issues and Problems
Credit risk continues to remain the largest source of risk for banking institutions in
Bangladesh. This is due to the fact that a banking institution’s loan portfolio is typically the
largest asset and the major source of revenue. Effective credit risk management is therefore
vital to ensure that a banking institution’s credit activities are conducted in a prudent manner
and the risk of potential bank failures reduced. Basel accords mainly focused on credit risk
mitigation as it provides a sophisticated framework that insulates the banks from potential risk
of failure arising from credit risk. According to Basel II framework, if any bank gives loan to a
risky customer, it has to retain more capital. As raising capital is not very easy, so banks are
passing through a hard time to comply with the Basel II framework, especially maintaining the
Capital Adequacy Ratio (CAR). Basel II has manifold impact in the banking industry like
shifting of choice to good rated companies, which shrinks the opportunity for taking loan to
the poor rated customer. The report focuses on the compliance status and the changes in
capital requirement for credit risk in Dhaka Bank Limited. It also gives some light on impact
of adoption of Basel II in Dhaka Bank Limited.
3.2 Origin of the Report
This report has been prepared as part of the internship program which is a part of MBA
degree requirement. The topic was chosen in consultation with the faculty advisor Mr. Shakil
Huda, Professor, IBA and the internship supervisor Mr. A.S.M. Abu Bokor Siddique,
Incharge, Credit Department, Karwan Bazar Branch, Dhaka Bank Limited.
P a g e | 25
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
3.3 Objective
Credit Risk Management is the most critical part of any bank operation. Many banks failed in
the past due to poor credit risk management. Though there are many tools for mitigating and
managing the credit risk, no tool is foolproof and globally received. Due to competition,
Banks often forced to take some unwanted risk by giving credit facility to poor rated clients,
which creates chances for failure of Banks. Basel II, an internationally accepted standard,
covers credit risk comprehensively. Dhaka Bank Limited started implementation of Basel II
by following the roadmap formulated by Bangladesh Bank. The objective of this report is to
see the implementation progress and compliance status of Basel II in credit risk management
DBL.
3.3.1 Broad Objective
The broad objective of the report is to see the status of compliance of Basel II in credit Risk
Management of Dhaka Bank Limited.
3.3.2 Specific Objectives
The specific objectives of the report are:
To study the framework of Basel II accord and the differences of it with the previous
capital accords.
To identify and measure different types of risks and their management thereof
To know the measures and tools of credit risk management and the impact of Basel II
adoption on it
To know about different approaches for capital calculation for different risks as
specified by Bangladesh Bank
To find out the minimum capital requirement for credit risk
To know about Risk weighted Asset and calculate the same for Dhaka Bank Limited.
To identify different issues and challenges in implementation of Basel II in Dhaka
Bank Limited.
P a g e | 26
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
3.4 Rationale
Primarily, this report fulfills the term paper requirement of internship. Secondly, it gives
concrete knowledge on the Credit Risk Management in the era of Basel II. Experiences that
will be gathered will surely help in the future when more complex approach will be taken to
calculate capital.
3.5 Scope and Limitations
Credit Risk Management and Basel II both are very vast topic to describe. For, concentrating
on the key things, the report focuses mainly on credit risk and capital requirement for credit
risk in Dhaka Bank. The other risks such as operational risk and market risk have been
described very briefly. Credit risk, market risk and operational risk are part of Pillar 1 of
Basel II accord. For being very specific on the subject matter, other two pillars of Basel II
have not been discussed in this report.
Basel II is relatively a new phenomenon in the Banking industry and only few people are
knowledgeable about this. So, getting information from the bank officers was not very easy.
As the minimum capital requirement has to be reported to Bangladesh Bank quarterly, the
latest data could not be obtained. Comparison among the Banks about the subject matter
could be interesting, but due to unavailability of data it cannot be done.
3.6 Methodology
The report involves both quantitative and qualitative analyses. Qualitative analysis covers
mainly the impact of Basel II implementation in credit activities of Dhaka Bank. On the other
hand, Quantitative analysis involves the calculation of core capital, risk weighted asset and
capital adequacy ratio and compliance of this with the specifications of Bangladesh Bank.
This analyses lead to some recommendation for the management to fully comply with the
Basel II accord within the given time frame.
Sources of Data
Information needed in this report was collected from both primary and secondary sources.
Primary Sources:
Informal interviews of executives, officers of Dhaka Bank Limited
P a g e | 27
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Secondary Sources:
Study of old files
Circulars of Bangladesh Bank
Different journals and publications on Basel II.
Annual reports
Credit Risk Management Manual of Dhaka Bank Limited
Journals and Publications on Credit Management
3.7 Report Preview
The report has been prepared following the above methodologies and the objectives in mind.
The report starts with a review of literature in chapter – 4. Chapter – 5 gives an overview on
risk management in DBL. Then the next chapter discusses about the Basel II framework and
its relation with credit risk management. Chapter 7 discusses about Basel II implementation
and its progress in DBL. Calculation of various ratio and the analyses is done in Chapter 8. In
Chapter 9 impact of implementation of Basel II in credit risk management has been
discussed. Finally the report ended with some recommendations.
P a g e | 28
CHAPTER 4LITARTURE REVIEW
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
4.0 Literature Review
According to the existing theories, the main validation for capital regulations of banks is
often given in terms of “moral hazard” problem. The problem states that in the presence of
visibly available fund, bank managers may not do enough to reduce risk. Instead they will opt
for risky projects that are accompanied by higher return, which, if not stopped in time, may
compromise banks’ solvency in the long run. Therefore, the theoretical reason for capital
adequacy regulations is to counteract the risk-shifting incentives.
This topic has given birth to several strands of theoretical literature. A first strand uses the
portfolio approach of Pyle (1971) and Hart and Jaffee (1974), where banks are treated as
utility maximizing units. In a mean-variance analysis that allows banks’ portfolio choice to be
compared with and without a capital regulation, Koehn and Santomero (1980) showed that
the introduction of higher leverage ratios will lead banks to shift their portfolio to riskier
assets. As a solution to such a situation, Kim and Santomero (1988) suggested that this
problem can be overcome if the regulators use correct measures of risk in the computation of
the solvency ratio. Subsequently, Rochet (1992) extended the work of Koehn and Santomero
and found that effectiveness of capital regulations depended on whether the banks were
value-maximizing or utility-maximizing. In the former case, capital regulations could not
prevent risk-taking actions by banks. In the latter case, capital regulations could only be
effective if the weights used in the computations of the ratio are equal to the systematic risk
of the assets. A further theoretical ground argued that banks choose portfolios with maximal
risk and minimum diversification.
The second strand of literature on the topic utilizes option models. Furlong and Keeley
(1989) and Keeley (1990) developed several models under this framework and showed that
higher capital requirements reduce the incentives for a value-maximizing bank to increase
asset risk, which is opposite to the conclusions of the first generation studies discussed above.
They criticized the utility maximizing framework, which comes to opposite conclusions, as
inappropriate because it mischaracterizes the bank’s investment opportunity set by omitting
the option value of deposit insurance and the possibility of bank failure. However, this
evidence of the option model was weakened by the findings of Gennottee and Pyle (1991).
They relaxed the assumption that banks invest in zero net present value assets and found that
P a g e | 30
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
there are now plausible situations in which an increase in capital requirements results in an
increase of asset risk.
Using a dynamic framework (multiple periods), as opposed to the static framework used in
the studies above, Blum (1999) found that capital regulation may increase banks’ riskiness
due to an intertemporal effect. Using a two-period model, he showed that banks find it too
costly to raise additional equity to meet new capital requirements tomorrow or are unable to
do so, they will increase risk today. He also pointed out that this second effect will reinforce
the well-known risk-shifting incentives due to the reduction in profits. Subsequently, Marshal
and Prescott (2000) showed that capital requirements directly reduce the probability of
default and portfolio risk and suggested that optimal bank capital regulations could be made
by incorporating state-contingent penalties based on banks’ performance. At the same time,
Vlaar (2000) found that capital requirements acted as a burden for inefficient banks when
assets of banks are assumed to be fixed.
However, such regulations increased the profitability of efficient banks.In short, whether
imposing harsher capital requirements leads banks to increase or decrease the risk structure of
their asset portfolio is still a debated question and, at least for now, it seems, there is no
simple answer to this question. Empirical work in the area concentrates on two aspects of
capital regulations. First, to investigate whether banks fulfill the capital requirements by
increasing capital or by altering the risk weighted assets; and second, to test if the
enforcement of capital requirements can result in a contraction in banks’ supply of loans, a
situation best described as a credit crunch. Many of these works use a simultaneous equations
approach, which allows comparing the behavior of undercapitalized and adequately
capitalized banks with respect to changes in risk and capital ratios.
Shrieves and Dahl (1992) used several periods of cross-section data on commercial banks in
the U.S. under the simultaneous equations framework. They found that the effectiveness of
risk-based capital regulations depend on how well the regulations reflected the true risk
exposure of banks. They also found that banks in the undercapitalized categories increased
their capital target ratios more quickly than other banks with higher initial capital. But, if one
is interested in the impact of capital regulations in a broad sense, then this is not a big
problem.
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The study by Jacques and Negro (1997) deals exclusively with the consequences of the Basel
Accord, as it concentrates on the years 1990-91. They find that capital regulation has a
significant impact on risk and vice versa. Ediz, Michael, and Perraudin (1998) and Rime
(2001) present some non-U.S. evidence regarding the relationship between capital ratios and
credit risk. Ediz, Michael, and Perraudin (1998) employ confidential U.K. data including
detailed information about the balance sheet and profit and loss account of all British banks
during the 1989-1995 periods whereas Rime (2001) uses Swiss data for the period 1989-
1996. Ediz, Michael, and Perraudin (1998) used a limited information technique different
from the simultaneous equations framework. Their study used a period 1989-1995 sample
and applied a random effects model. They found that capital regulations were effective in
increasing the capital to meet the minimum standard.
The study by Rime (2001) is interesting because it provides the application of the
simultaneous equations model. His results indicate that Swiss banks react to capital
regulations by increasing their capital, but this did not change banks’ risk-taking. Sheldon
(1996) used an option-pricing framework to analyze the risk effects of capital adequacy on
eleven G-10 countries. He found that the Basel Accord did not have a risk-increasing impact
on banks’ portfolio. But this result is not easy to interpret as he did not control for regulatory
and non-regulatory influences. Moreover, sample coverage of this study is not representative
for the countries they represent.
Van Roy (2003) studied the impact of capital requirements on risk taking by commercial
banks of seven OECD countries within the framework of the simultaneous equations
framework. He found that changes in capital and credit risk were negatively related over the
period studied, which supported the argument that stringent capital requirements went hand
in hand with greater financial stability in addition to imposing a higher capital buffer against
unexpected credit risk losses.
Proper credit risk management is critical for Bank’s existence in the market. Santomero, A.
M. (1996) suggests that a bank must apply a consistent evaluation and rating scheme to all its
investment opportunities in order for credit decisions to be made in a consistent manner and
for the resultant aggregate reporting of credit risk exposure to be meaningful. To facilitate
this, a substantial degree of standardization of process and documentation is required.
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Treacy and Carey (2000) suggest that in designing a credit rating system, a bank should
consider numerous factors, including cost, efficiency of information gathering, consistency of
rating produced, staff incentives, nature of a bank’s business, and uses to be made of the
internal risk ratings. A rating system with more rating categories is better than a system with
just a few categories. However, an internal rating system with larger number of grades is
costly to operate because of the extra work required to distinguish finer degrees of risk.
Raghavan, R. S. (2003) suggests that the key ingredient of credit risk is the risk of default that
is measured by the probability that default occurs during a given period. As there is a
significant co-relation between credit ratings and default frequencies, any derivation of
probability from such historical data can be relied upon. Despite the advances in science and
technology that allow the development of expert system or statistical classification models,
human judgment is still an important ingredient in the credit risk assessment process.
According to Treacy and Carey (2000), the rating process almost always involves the
exercise of human judgment because factors to be considered in assigning a rating and the
weights given to each factor can differ significantly among borrowers. For large exposures,
the benefits of such accuracy may outweigh the higher costs of the judgmental systems.
Because of the high cost involved, in general, banks produce credit ratings for business and
institutional loans only.
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CHAPTER 5RISK MANAGEMENT IN DHAKA BANK LIMITED
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
5.0 Risk Management in Dhaka Bank Limited
Risk concerns the expected value of one or more results of one or more future events.
Technically, the value of those results may be positive or negative. However, general usage
tends focus only on potential harm that may arise from a future event, which may accrue
either from incurring a cost (downside risk) or failing to attain any benefit (upside risk). Risk
management can be considered the identification, assessment, prioritization of risks followed
by coordinated and economical application of resources to minimize, monitor and control the
probability and/or impact of unfortunate events or to maximize the realization of
opportunities.
5.1 Core Risks in Bank
The core risks involved in any banking operation are briefly described below:
5.1.1 Asset Liability Management
The Asset Liability Management is integral part of Bank Management. This risk is related to
the balance sheet gaps, interest rate gaps that can lead to under performance. To manage this
risk Dhaka Bank Limited has a committee name ALCO (Asset Liability Committee) which
usually meet at least once a month to analysis, review and formulate strategy to manage the
balance sheet. Main functions of this committee are identifying the balance sheet
management issues like balance sheet gap, interest rate gap/profile, reviewing deposit-pricing
strategy and liquidity contingency plan.
5.1.2 Foreign Exchange Risk
Today’s financial institutions engage in activities starting from import, export and remittance
to complex derivatives involving basic foreign exchange and money market to complex
structured products. All these require high degree of expertise that is difficult to achieve in
the transaction originating departments and as such the expertise is housed in a separate
department. In DBL, this task is done by Treasury Department. Treasury department watches
over the flow of foreign exchange, it takes long/short position of foreign currency to mitigate
the risk of depreciation of the hold currencies.
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5.1.3 Internal Control and Compliance Risk
Internal control is the process, affected by a company’s board of directors, management and
other personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the effectiveness and of operations, the reliability of financial reporting and
compliance with applicable laws, regulations, and internal policies. In DBL the
responsibilities of internal control are to check the efficiency and effectiveness of activities,
reliability, completeness and timeliness of financial and management information etc.
5.1.4 Money Laundering Risk
Though money laundering risk is relatively a old phenomenon, it got the organized look after
the enactment of Money Laundering Act, 2009. This law barred some activities as legal and
if any bank is found to be involved in any kind of money laundering, the concerned official
and the bank will be punished. As, money laundering is very common in Bangladesh, it poses
a great risk for the banks. To mitigate this risk, DBL employed a strong KYC (Know Your
Customer) policy, strong account monitoring policy etc.
5.1.5 Credit Risk
This is the most important risk of all as it involves the key asset quality of any bank. Credit
Risk is defined as the risk of losses associated with the possibility that borrower will fail to
meet its obligations; in other words it is the risk that the borrower won’t repay what is owed.
Many banks have failed in the past because of poor management of credit risk. To understand
credit risk, it is important to know about the credit facilities. The next section focuses on that.
5.2 Types of Credit Products
Credit may be classified with reference to elements of time, nature and provision base.
5.2.1 Classification on the basis of time:
On the basis of elements of time, bank credit may be classified into three heads, viz.
Continuous loans:
These are the advances having no fixed repayment schedule but have a date at which it is
renewable on satisfactory performance of the clients. Continuous loan mainly includes "Cash
credit both hypothecation and pledge" and "Overdraft".
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Demand loan:
In opening letter of credit (L/C), the clients have to provide the full L/C amount in foreign
exchange to the bank. To purchase this foreign exchange, bank extends demand loan to the
clients at stipulated margin. No specific repayment date is fixed. However, as soon as the L/C
documents arrive, the bank requests the clients to adjust their loan and to retire the L/C
documents. Demand loans mainly include “Payment against Documents,” "Loan against
imported merchandise (LIM)" and "Letter of Trust Receipt".
Term loans:
These are the advances made by the bank with a fixed repayment schedule. Terms loans
mainly include "Consumer credit scheme", "Lease finance"," Hire purchase", and "Staff
loan". The term loans are defined as follows:
Short term loan: Up to 12 months.
Medium term loan: More than 12 months & up to 36 months
Long term loan: More than 36 months.
5.2.2 Classification on characteristics of financing
On characteristics of financing, the credit facilities of Dhaka Bank can be divided into two
categories, viz.
Funded
These products give the client the facility to use the money to fulfill its working capital need,
to cover temporary shortage of fund, to buy consumer durables etc. The facilities taken by the
client are reflected in the balance sheet of the bank as assets. Majority of the credit product of
the bank are of this type. As this type represents the major portion of credit portfolio of a
bank, risk of default, i.e. credit risk is very evident here. So, the credit risk management is
basically managing funded facility of a bank.
Non-Funded
These products give a third party the assurance that bank will pay in the event of failure of
repayment of its client. Generally it is used to import goods from abroad, to participate in
different tender etc. As these facilities deal with guarantee and not money these are not
reflected in the balance sheet, they are reflected in the off-balance sheet. These are called
contingent liability also.
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The following table examples of some funded and non-funded products are given:
Table 2: Classification of credit based on Characteristics of financing
Funded Non-FundedOverdraftLoanConsumer CreditLoan against Trust ReceiptPayment against DocumentsCash Credit (Pledge and Hypothecation)Staff LoanTerm LoanPacking Credit
Letter of CreditBank Guarantee
5.2.3 Classification on Provision Base
Credit facilities of Bank can be divided into four categories based on provision base of the
facilities, viz.
Unclassified
The loan account is performing satisfactorily in the terms of its installments and no overdue
is occurred. In this type one special type of classification is there which is called special
mention account. Generally, if an account is not repaying its due for three months
continuously, it is called special mention account (SMA) and is reported to the central bank
which prevents the other banks to give the client fresh loan.
Sub-Standard
This classification contains where irregularities have been occurred but such irregularities are
temporarily in nature. To fall in this class the loan and advance has to fulfill the following
factor given in Table 3. This kind of loan is monitored closely by the monitoring division to
make the loan regular.
Table 3: Criteria for Sub-Standard Loan
Category of Credit Time overdue (irregularities)
Sub-standardS-T Agri & Micro Credit 3 months & above but less than 6 months.
Continuous loan Un-recovered for 3 months & above but less
than 6 months from the date of the loan is claimed.Demand Loan
Fixed Term loan
Repayable within 5years: If the overdue installment
equals or exceeds the amount repayable
within6 months.
Repayable more than 5years: If the overdue
installment equals or exceeds the amount repayable
within12 months.
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Doubtful
This classification contains where doubt exists on the full recovery of the loan and advance
along with a loss is anticipated but cannot be quantifiable at this stage. Moreover if the state
of the loan accounts falls under the following criterion can be declared as doubtful loan and
advance.
Table 4: Criteria for Doubtful Loan
Category of Credit Time overdue (irregularities)
DoubtfulS-T Agri & Micro Credit 6 months & above but less than 12 months.
Continuous loan Un-recovered for 6 months & above but less
than 12 months from the date of the loan is claimed.Demand Loan
Fixed Term loan
Repayable within 5years: If the overdue installment
equals or exceeds the amount repayable
within 12 months.
Repayable more than 5years: If the overdue installment
equals or exceeds the amount repayable
within 18 months.
Bad and Loss
A particular loan and advance fall in this class when it seems that this loan and advance is not
collectable or worthless even after all the security has been exhausted. In the following table
the criteria to be fulfilled to fall in this category are summarized:
Table 5: Criteria for Bad and Loss
Category of Credit Time overdue (irregularities)
Bad and Loss
S-T Agri & Micro Credit Not recovered within more than 12 months.
Continuous loan Un-recovered more than 12 months from the date of the
loan is claimed.Demand Loan
Fixed Term loan
Repayable within 5years: If the overdue installment
equals or exceeds the amount repayable
within 18 months.
Repayable more than 5years: If the overdue installment
equals or exceeds the amount repayable
within 24 months.
5.3 Credit Risk Management in Dhaka Bank Limited
To manage credit risk, Bangladesh Bank prescribed a framework. The key elements of credit
risk management are:
Lending Guideline
Credit Assessment & Risk Grading
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Approval Authority
Segregation of Duties
Internal Audit
5.3.1 Lending guidelines
Lending guidelines clearly outline the senior management’s view of business development
priorities and the terms and conditions that should be adhered to in order for loans to be
approved. This should be updated at least annually to reflect changes in the economic outlook
and the evolution of the bank’s loan portfolio. It contains:
Industry & Business Segment Focus: The lending guidelines in DBL specifies some
particular industries like textile, knit garments, cement, power etc.
Types of Loan Facilities: The guideline also specifies different kinds of loan that are
permitted to be disbursed. As per DBL lending guidelines, there are mainly two kinds
of loan, funded and non-funded. Examples of funded are working capital loan, term
loan, etc. On the other hand, examples of non-funded facilities are LC, Bank Guaran-
tee etc.
Single Borrower/ Group Limits: A single borrower/group is permitted to get highest
15% of the capital as funded facility and highest 20% of the capital as non-funded fa-
cility.
Lending Caps: There is a specific industry sector exposure cap to avoid over concen-
tration in any one industry sector.
Discouraged Business Types: In the lending guidelines of DBL, lending to some in-
dustries is discouraged such as military weapon, highly leveraged transaction and fi-
nance of speculative investment.
Loan Facility Parameters: As per the lending guidelines, the parameters should be
adopted like, not granting facility when security position is inferior, proper valuation
of security, pledge of security etc.
Cross Border Risk: It is synonymous with political and sovereign risk. If any diffi-
culty arises from any political event, then a plan is there in place.
5.3.2 Credit Assessment & Risk Grading
Lending is risky because loan quality is affected by both internal and external factors.
External factors include changes in economy, national disasters like earthquake, flood and the
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regulation by the government. Internal factors affecting loan risk include management errors,
illegal manipulation by bank officials and weak or ineffective lending policies. The risk of
lending function is mainly controlled by Government regulations and Internal policies and
procedures.
The risk is also controlled by creating and following written policies and procedures for
processing each credit request. At DBL, a thorough credit assessment and risk grading are
done prior to loan approval for minimizing risks maintaining Bangladesh Bank Guidelines.
5.3.2.1 Credit Assessment
A thorough credit and risk assessment is conducted prior to the granting of loans, and at least
annually thereafter for all facilities. The results of this assessment are presented in a Credit
Application that originates from the relationship manager/account officer (“RM”), and is
approved by Credit Risk Management (CRM). The RM is the owner of the customer
relationship, and is held responsible to ensure the accuracy of the entire credit application
submitted for approval. The RMs are familiar with the bank’s Lending Guidelines and
conduct due diligence on new borrowers, principals, and guarantor.
It is essential to ensure such parties are in fact who they represent themselves to be. The bank
has an established Know Your Customer (KYC) and Money Laundering guidelines. Credit
Applications summarize the results of the RMs risk assessment and include the following
details:
Amount and type of loan(s) proposed
Purpose of loans
Loan Structure (Tenor, Covenants, Repayment Schedule, Interest)
Security Arrangements
In addition, the following risk areas are addressed:
Borrower Analysis
Borrower analysis is the most important step in providing loans to borrowers. Unethical
attitudes, asymmetric information and manipulation of records by borrowers etc. create
complication in credit finance and as a consequence banks become burdened with unusual
amount of classified loans. So, the borrower must be of good character, should be reliable,
responsible and resourceful, so that the return of loan is easier. For that, the following
information is provided on the loan application:
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Borrower background or history including group information if the concern is part of
a group.
The location of the borrower’s office & factory and factory details like land area,
buildings, number of shifts per day, number of workers and officers, factory space and
sources of power & capacity, alternate source of power, source of machinery, etc.
If the borrower has applied for a loan for a new project, then initial cost of the project,
its means of finance, its product mix & production capacity and its market
Total export earnings of the group
List of machinery for existing project
Particulars of the Board of Directors, and declaration of the Relationship Manager re-
garding personal net worth
Corporate objective or strategy
Once a borrower requests for a loan, a DBL official interviews the customer and finds out the
credit needs. This interview is important because it enables the bank to assess the borrower’s
character and sincerity of purpose. For a new project, it also collects information
memorandum. For business or mortgage loan, the DBL makes a visit to the customer’s
location and assesses the condition of the property.
Industry Analysis
The key risk factors of the borrower’s industry are assessed. Any issues regarding the
borrower’s position in the industry, overall industry concerns or competitive forces are
addressed and the strengths and weaknesses of the borrower relative to its competition are
identified. Critical success factors of the industry are also stated.
Supplier/Buyer Analysis
Information regarding the borrower’s suppliers and buyers are collected mainly who they are.
Any customer or supplier concentration is addressed, as these have a significant impact on
the future viability of the borrower. Any issues regarding the market vulnerability are also
addressed.
Historical Financial Analysis
An analysis of a minimum of three years historical financial statements of the borrower is
presented. Where reliance is placed on a corporate guarantor, the guarantor’s financial
statements are also analyzed. The analysis addresses the quality and the sustainability of
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earnings, cash flow and the strength of the borrower’s balance sheet. Specifically, cash flow,
leverage and profitability are analyzed.
Projected Financial Performance
Where term facilities for more than one year are being proposed, a projection of the
borrower’s future financial performance is conducted, indicating an analysis of the
sufficiency of cash flow to service debt repayments. Loans are not granted if projected cash
flow is insufficient to repay debts.
Account Conduct
For existing borrowers, the historic performance in meeting repayment obligations like trade
payments, checks, interest and principal payments, etc is assessed. Performance with other
banks like import performance, export performance, account conduct and liability position is
also noted. For a comprehensive picture, the latest Credit Information Bureau (CIB) report of
the central bank is summarized in this module.
Adherence to Lending Guidelines
The Credit Application clearly states whether or not the proposed application is in
compliance with the bank’s Lending Guidelines. The Bank’s Head of Credit or Managing
Director/CEO approves Credit Applications that do not adhere to the bank’s Lending
Guidelines.
Mitigating Factors
There might be some trigger points for the industry which poses serious risks. So, mitigating
factors for those risks are identified. Possible risks include, but are not limited to: margin
sustainability and/or volatility, high debt load (leverage/gearing), overstocking or debtor
issues; rapid growth, acquisition or expansion; new business line/product expansion;
management changes or succession issues; customer or supplier concentrations; and lack of
transparency or industry issues. Detailed analysis of risks and their mitigating factors are also
analyzed.
Loan Structure
The amounts and tenors of financing proposed are justified based on the projected repayment
ability and loan purpose. Excessive tenor or amount relative to business needs increases the
risk of fund diversion and may adversely impact the borrower’s repayment ability.
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Security
A current valuation of collateral is obtained and the quality and priority of security being
proposed are assessed. Loans are not granted based solely on security. Adequacy and the
extent of the insurance coverage are assessed. Any protective covenants or conditions are also
advised in this module.
Name Lending
Credit proposals do not unduly rely on the sponsoring principal’s reputation, reported
independent means, or their perceived willingness to inject funds into various business
enterprises in case of need. These situations are discouraged and treated with great caution.
Rather, credit proposals and the granting of loans are based on sound fundamentals,
supported by a tho8rough financial and risk analysis.
5.3.2.2 Risk Grading
The bank has adopted a credit risk grading system. The system defines the risk profile of
borrower’s to ensure that account management, structure and pricing are commensurate with
the risk involved. Risk grading is a key measurement of the Bank’s asset quality, and as such,
it is essential that grading is a robust process. All facilities are assigned a risk grade. Where
deterioration in risk is noted, the Risk Grade assigned to a borrower and its facilities should
be immediately changed. Borrower Risk Grades are clearly stated on Credit Applications.
In the CRG prescribed by the Bangladesh Bank a borrower was given scores according to the
key financial ratios and management of the borrowing company. This process almost covers
all the aspects of business operation related with extending credit facilities. After giving score
to each point the total score is calculated. A risk rating system is there in place to rate the
calculated total score. The risk rating system has eight scoring slabs. The more score any
company gets the better the risk grading is. In brief the CRG rating system is given below:
Table 6: CRG Scores Band
Risk Rating Grade Scores
Superior - Low risk 1 >95
Good - Satisfactory risk 2 >85
Acceptable - Fair Risk 3 75-84
Marginal - Watch List 4 65-74
Special Mention 5 55-64
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Substandard 6 45-54
Doubtful 7 35-44
Bad and Loss 8 <35
5.3.3 Approval Authority
The authority to sanction/approve loans is clearly delegated to senior credit executives by the
Managing Director/CEO & Board based on the executive’s knowledge and experience. The
following guidelines are followed in the approval/sanctioning of loans:
Credit approval authority must be delegated in writing from the MD/CEO & Board.
Delegated approval authorities must be reviewed annually by MD/CEO/Board.
The credit approval function should be separate from the marketing/relationship man-
agement (RM) function.
The role of Credit Committee may be restricted to only review of proposals i.e. rec-
ommendations or review of bank’s loan portfolios.
Approvals must be evidenced in writing, or by electronic signature. Approval records
must be kept on file with the Credit Applications.
All credit risks must be authorized by executives within the authority limit delegated
to them by the MD/CEO. The “pooling” or combining of authority limits should not
be permitted.
Credit approval should be centralized within the CRM function. Regional credit cen-
ters may be established, however, all large loans must be approved by the Head of
Credit and Risk Management or Managing Director/CEO/Board or delegated Head
Office credit executive.
The aggregate exposure to any borrower or borrowing group must be used to deter-
mine the approval authority required.
Any credit proposal that does not comply with Lending Guidelines, regardless of
amount, should be referred to Head Office for Approval
5.3.4 Segregation of Duties
At DBL the following lending functions are segregated to comply with the Bangladesh Banks
guidelines.
Credit Approval/Risk Management
Relationship Management/Marketing
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Credit Administration
The purpose of the segregation is to improve the knowledge levels and expertise in each
department, to impose controls over the disbursement of authorized loan facilities and obtain
an objective and independent judgment of credit proposals.
5.3.5 Internal Audit
DBL has an internal audit department which is responsible for auditing all departments. The
audits are done generally in annual basis. It takes the Regulatory Compliance, Internal
Procedures, Lending Guidelines and Bangladesh Bank Requirements in view.
5.3.6 Credit Monitoring
At DBL a separate credit monitoring unit is working at HO level where the following is
monitored and necessary follow up is done with branches:
o Excess Over the Limits (EOL)
o Past Due Principal or Interest
o Breach of Loan Covenants
Special emphasis is given on the loans with classification status, like special mention
account, sub-standard, doubtful and bad and loss.
5.4 Credit Risk Management and Basel accords
Credit Risk Management is a comprehensive package for protecting the Banks from risk of
failure as credit risk covers 90% of the total risk of any Bank. But, CRM does not appear to
be the foolproof solution for credit risk. Numerous Banks have been bankrupted though there
was a credit risk management system. As banks gives loan to the client from the depositors’
money, failure of bank harms the depositors directly. Though there is a credit management
system is place in almost every bank of the world, there is no set standard for CRM. Credit
facilities were given to customers with no ability to repay. Malpractice, fraud and other
irregularities are also responsible for giving loan to defaulters. To solve this problem and to
insulate the depositors from losses the concept of capital adequacy has been given birth to.
Capital adequacy is defined as the minimum level of capital, which is required to protect a
bank from portfolio losses. However, debate on the quantum of minimum level of capital
seems to be never ending. Though different methods and approaches were adopted in
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different points in time, they were insufficient to capture new dimensions and magnitudes of
risk emanated from the continuous innovations in the domestic and international business.
Consequently the 1970s and 80s experienced many uncertainties and volatilities that caused
serious banking problems. The approach that a bank’s capital should be linked to a fixed ratio
of its time and demand liabilities went under strong criticism on the ground that bank’s major
risk is derived from the riskiness of its assets. The Basel Committee, based on this idea,
designed Capital Regulation in 1988, which is known as the Basel Accord I.
5.4.1 Basel I
Basel I was an international accord to set minimum levels of capital for banks, building
societies and other deposit taking institutions. It was designed to create a level playing field
for lenders from different countries and to ensure that lenders were sufficiently well
capitalized to protect depositors and the financial system.
Two fundamental objectives of the Accord were (a) to strengthen the soundness and stability
of the international banking system and (b) to obtain a high degree of consistency in its
application to banks in different countries with a view to diminishing an existing source of
competitive inequality among international banks. To that end, the accord requires that banks
meet a minimum capital ratio that must be equal to at least 8 percent of total risk-weighted
assets.
Though at first only credit risk was incorporated, in 1996 market risk was also incorporated
in this accord. Basel I implementation in Bangladesh started at 1996. But the implementation
was only in the credit risk section.
5.4.2 Criticism of Basel I
However, the Accord has been widely criticized for its failure to achieve the stated
objectives. Since it introduced risk-based capital requirement, which was adopted by many
developed and developing countries as well, it was expected that the Accord would help to
strengthen financial system stability and reduce banking and financial crises. On the contrary,
banking crises again occurred in 1990s even in some robust economies of East Asia. The
Accord was also criticized for the inherent weaknesses in the model as detailed below.
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Rodriguez (2002) and others argue that the use of arbitrary risk categories and arbitrary
weights that bear no relation to default rates incorrectly assume that all assets within one
category are equally risky. For example, a loan to a well-established company such as
Beximco Pharma or Square Pharmaceuticals is considered as risky as a loan to a new
company established by a new entrepreneur. Loans made to companies in the non-trading
sector of the economy are considered as risky as loans made to companies in the trading
sector, even though the latter are usually less risky than the former. The risk assessment
methodology is flawed in the sense that it assumes a portfolio’s total risk is equal to the sum
of the risks of the individual assets in the portfolio. No account is taken of portfolio
management strategies, which can greatly reduce the overall risk of a portfolio, or of the size
of a portfolio, which can greatly influence its total risk profile.
The accord gives preferential treatment to government securities, which are considered risk-
free. The sovereign debt defaults of Russia in the summer of 1998 and Argentina in early
2002 demonstrated that government debt is not a risk free investment. Other criticisms
include that the accord sets capital standards only for credit risk (i.e., the risk of counterparty
failure), but not for other types of risk such as operational risk and market risk. Consequently,
capital requirement was not reflective of economic risk. It has not provided enough incentive
for risk management, risk mitigation and innovation in risk management such as arbitrage
opportunities through securitization.
When the Accord was formalized, no consensus and consultation were taken from the
representatives of the developing nations. Therefore, it is sometimes criticized as OECD
Club-rule. McDonough (2000) argues that as banks have developed innovative techniques for
managing and mitigating risk, credit risk now exists in more complicated, less conventional
forms than is recognized by the 1988 Accord, thus rendering capital ratios, as presently
calculated, less useful to banking supervisors. The financial world has changed dramatically
over the past dozen years, to the point that the Accord efficacy has eroded considerably
(McDonough, 2000).
5.4.3 The Entrance of Basel II
The Basel Committee tried to address some of these criticisms over the years, modifying the
Accord throughout the years from 1990s to 2004 and Basel Accord II (included
representatives from G10 and non-G10 countries) is the result of such efforts. The primary
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objective of the New Accord is to make it more risk-sensitive so that financial institutions
will be able to sustain even in periods of financial crisis. Consequently, the new proposal
moves ahead of the “one-size-fit-all” approach. Another objective of the Accord is to
continue to enhance competitive equality among the internationally active banks throughout
the world.
The Accord has provided many areas of national discretions, which require an extensive
study to guide policy actions in appropriate directions. This study has made an attempt to
analyze the prevailing status and conditions of the banking sector in line with Basel II
requirements. In order to deepen and widen understanding in a specific area, this study has
mainly concentrated on the compliance aspects of Pillar I. In fact, this study has further
narrowed down its scope to focus on different approaches for the measurement of capital
charge against credit risk. The next chapter will describe the Basel II framework.
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CHAPTER 6FRAMEWORK OF BASEL 2 AND ITS IMPLEMENTATION IN BANGLADESH
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
6.0 Basel II Framework and its Implementation in Bangladesh
The Basel II has defined a structured framework comprising three pillars such as Pillar I, II
and III. Pillar I sets out minimum capital requirements. Pillar II defines the process of
supervisory review of a financial institution’s risk management framework. Pillar III
determines market discipline through improved disclosure. In this chapter, these three pillars
are discussed as follows:
6.1 The Three Pillars
Basel II capital accord is known for its three mutually reinforcing pillars, which are minimum
capital requirement, supervisory review process and market discipline. In figure 9, the
approaches for calculation of capital for pillar 1 are stated. In this section, these three pillars
and the approaches for calculation of capital will be discussed. Pillar 1 of Basel II is
somehow present in the previous capital accord Basel I but Pillar 2 and Pillar 3 are novelty.
In the Pillar 1 it has identified three risks whereas in the previous accord there were two risks.
Operational Risk was introduced for the first time in Basel II.
Figure 9: The Basel II Framework
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6.1.1 Pillar 1-Minimum Capital Requirements
In Pillar I, three kinds of risk such as credit risk, market risk and operational risk are
considered to determine the minimum capital requirement. The definition of eligible
regulatory capital remains the same as outlined in the 1988 Accord i.e., the ratio of capital to
risk-weighted asset remains unchanged at 8%. This pillar is a quantitative one. As this report
is about the credit risk, the approaches to calculate the capital requirement will be discussed
in brief.
6.1.2 Pillar 2-Supervisory Review Process
Pillar II ensures that not only do banks have adequate capital to cover their risks, but also that
they employ better risk management practices so as to minimize the risks. Supervisors will be
expected to evaluate the board and management of banks, to look into strategic decisions and
to evaluate portfolio diversification as well as the ability to react to future risks in a rapidly
changing environment. In particular, issues of transparency, corporate governance and
efficient markets can be considered as additional challenges in pillar II enforcement.
6.1.3 Pillar 3-Market Forces
Banking operations are becoming complex and difficult for supervisors to monitor and
control. In this context, Basel Committee has recognized the importance of market discipline
and has suggested implementing it by asking banks to make adequate disclosures. The
potential audiences of these disclosures are supervisors, bank's customers, rating agencies,
depositors and investors. With frequent and material disclosures, outsiders can learn about the
bank's risks.
6.2 Approaches for Calculation of Capital Requirements for Credit Risk
Basel II has provided a choice between two broad methodologies to calculate minimum
capital requirement for credit risk: (a) standardized approach and (b) internal rating-based
approach.
6.2.1 Standardized Approach (SA)
Under standardized approach, credit assessment will be conducted by external credit
assessment institutions (ECAI) as eligible for capital purposes by the national supervisors.
Risk-weight against each rating will be applied to individual credit exposure to arrive at risk-
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weighted asset. Before allowing ECAIs such as the rating agencies, national supervisor will
have to ensure that they fulfill the following standards set by Basel Committee (2004):
The methodology for assigning credit assessments must be rigorous, systematic and subject
to some form of validation based on historical experience. Before being recognized by
supervisors, an assessment methodology for each market segment, including rigorous back
testing, must have been established for at least one year and preferably three years.
An ECAI should be independent and should not be subject to political or economic pressures
that may influence the rating. The assessment process should be as free as possible from any
constraints that could arise in situations where the composition of the board of directors or
the shareholder structure of the assessment institution may be seen as creating a conflict of
interest. The individual assessments should be available to both domestic and foreign
institutions with legitimate interests and at equal terms. In addition, the general methodology
used by the ECAI should be publicly available.
An ECAI should disclose the information on its assessment methodologies, including the
definition of default, the time horizon and the meaning of each rating, the actual default rates
experienced in each assessment category, and the transitions of the assessments i.e., the
likelihood of AA ratings becoming A over time. An ECAI should have sufficient resources to
carry out high quality credit assessments. These resources should allow for substantial
ongoing contact with senior and operational levels within the entities assessed in order to add
value to the credit assessments.
In addition, supervisors will be responsible for assigning eligible ECAIs’ assessments to the
risk weights available under the standardized risk weighting framework, i.e., deciding which
assessment categories correspond to which risk weights.
6.2.2 Internal Rating Based Approach (IRB)
In the IRB approach, the four risk parameters that need to be estimated are PD (i.e.,
probability of default of borrower in each risk grade over a one year time horizon), LGD (i.e.,
loss in the event of a default), EAD (i.e., exposure amount at the time of default) and
Maturity (i.e., remaining effective maturity of the exposure at default). The Accord has
provided two types of IRB approach: (a) Foundation IRB Approach and (b) Advanced IRB
Approach.
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6.2.2.1 Foundation IRB Approach
Under the Foundation IRB approach banks provide their own estimates of PD and rely on
supervisory estimates for other risk components such as LGD, EAD and M. Under the
advanced approach, banks provide more of their own estimates of PD, LGD and EAD, and
their own calculation of M, subject to meeting the minimum standards. For both the
foundation and advanced approaches, banks must always use the risk-weight functions
provided in the New Accord for the purpose of deriving capital requirements.
Estimation of the parameters
The critical issues that both supervisor and the banks will face in implementing IRB approach
are:
Historical data to estimate PD
Historical loss database to estimate LGD
Historical exposure data to estimate EAD
Various types and characteristics of data are necessary to estimate each of these parameters.
Some of them are discussed below from Artigas’s (2004) famous article ‘A Review of Credit
Registers and their Use for Basel II’.
Historical data to estimate PD
In order to calculate each bank’s minimum capital requirements under Basel II, banks need
to have ready access to an essential information set. As regards, PD estimation, the
development of an overall borrower rating system requires default information. In addition,
the development of an appropriate rating system would require information on certain loan
characteristics that could be used, either directly or through transformation (data refinement),
to construct variables that are sufficient for determining each borrower’s credit quality or, in
other words, its probability of default.
Among other items, desirable information would be on guarantees, duration of borrower’s
existence in the system, default history of each borrower (number of times that they have
defaulted previously, or proportion of defaults in terms of how long they have been in the
system), history of an obligor’s rating migrations (upgrades or downgrades), number and type
of banks with which obligors deal, past due debt without reaching default status (delinquency
status), industry to which obligors belong, type of credit instrument and maturity date. Others
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financial variables such as leverage ratios, debt burden, efficiency, productivity and
profitability in the case of firms, and employment status and indebtedness profile in the case
of individuals, along with the stage of the business cycle of the economy, could form the core
group of variables needed to estimate a rating system. As per Basel standard, estimation of
PD needs to be based on 5 years’ historical data.
Historical loss database to estimate LGD
In the case of LGD, certain readily identified characteristics would be needed to estimate its
determinants empirically via a regression model. Calculating LGD properly requires
knowledge of type of collateral, percentage of collateral coverage, credit operation’s interest
rate, age of operation (time elapsed since loan origination), industry; loan size, loan maturity
date, the amount finally recovered, the time taken to recover it, all the costs incurred in the
process (from legal costs to the opportunity cost of money), all possible intermediate
recoveries and the discount rate to be applied. Since the Accord leaves open the option of
making use of external data, LGD can be estimated using market data such as market prices
of defaulted loans or bonds. The above information along with other qualitative variables
furnished by the departments entrusted with recovery management could also be used for
LGD validation. It can be noted that for validation of the LGD the required information
structure basically depends on characteristics of the credit operations themselves whereas
for PD validation the required data mostly refer to intrinsic characteristics of borrowers.
Historical exposure data to estimate EAD
Regarding EAD validation, information on drawn and un-drawn exposures, particularly in the
period of time prior to a default event, is necessary. An analysis of how borrowers make use
of their commitments (particularly the unknown part) over time would be a good first
approximation for validating EAD. Other items such as the number of banks with which a
borrower deals, past default history, size of the loan, industry and guarantees appear to be
items, which, in principle, may seem to explain EAD. Moreover, an assessment based on
qualitative elements could also be a reasonable validation solution.
It is argued that data quality is an important factor that could affect the quality of risk
measures generated by the model. Incomplete, imprecise and archaic data may rather increase
the risk and the losses faced by banks.
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6.3 Role of ECIA in Standardized Approach
It is argued that in many countries, low rating penetration and a lack of domestic rating
agencies may pose a challenge for implementation of the standardized approach, particularly
in respect of corporate claims. This is not untrue for Bangladesh where the rating industry is
not advanced enough and the majority of the individual claims of bank loans remain unrated.
Currently two rating agencies, namely CRISL and CRAB, are operative in the financial
market. Since banks in Bangladesh are linked with tens of thousands of borrowers, the
capability of these two rating agencies in terms of credit assessment of those borrowers
within the regulatory timeframe may not be sufficient. Cost of credit assessment will be
substantially increased due to high regulatory demand for this service. This, in turn, will
increase lending price and affect banks’ profitability.
The Accord requires that the assessment process should be as free as possible from any
constraints that could arise in situations where the composition of the board of directors or
the shareholder structure of the assessment institution may be seen as creating a conflict of
interest. However, the existing Credit Companies Rules that was enacted in 1996 to regulate
the business of credit rating agencies has not considered this issue in line with Basel’s new
standard. It is understood that directors of the existing rating agencies are directors of the
scheduled banks as well as directors of other public and private companies. This type of
conflict of interest may cause for rating-biases and need to be addressed urgently through
legal changes before adopting the standardized approach.
High default culture in the financial market of Bangladesh indicates that existing weak
regulatory framework for rating agencies may influence borrowers’ behavior to obtain good
rating inappropriately. Therefore rating regulations need to be updated to address such
potential problems. Effects of It can be noted that credit risk modeling, back-testing and
forecasting require high level knowledge of probability statistics, financial econometrics and
times series analysis. It is yet to be ascertained whether the existing rating agencies have
sufficient qualified human resources who can perform those activities in a professionally
competent manner. Since rating greatly depends on long historical data, given that the
industry is of recent origin, it can be assumed that they may not have sufficient database to
validate their models.
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6.4 Constituents of Capital
Existing regulation requires all scheduled banks to maintain minimum paid up capital and
reserve fund of 8 percent risk-weighted asset. But from July 2010, Banks have to keep 9% of
their risk-weighted asset. Banks can maintain their capital in the following constituents listed
in Table 7.
Table 7: Constituents of Capital
Core Capital (Tier 1) Supplementary Capital (Tier II)
A. Paid-up Capital
B. Non-repayable Share premium account
C. Statutory Reserve
D. General Reserve
E. Retained Earnings
F. Minority Interest in Subsidiaries
G. Non-Cumulative Irredeemable Prefer-
ence Share
H. Dividend Equalization Account
A. General Provision (1-5 percent of
unclassified Loans)
B. Asset Revaluation Reserve
C. All other Preference Shares
D. Perpetual Subordinated Debt
E. Exchange Equalization Account
6.5 Credit Risk Mitigation
The credit, construed both as funded and non-funded commitments of banks, involves
probability of ‘loss’ in the event of non-fulfillment of corresponding financial obligations by
the borrower or guarantor. Therefore, traditionally the banks and FIs seek to be covered by
appropriate tangible and realizable securities or by third party guarantees to avert or at least
minimize the loss in the event of the default by borrower or guarantor.
A Credit Risk Mitigation tool, commonly referred to as ‘security’, is universally recognized
as a ‘protection’ for the lenders although the same is often christened as ‘collateral’ also. The
personal covenants supported by the execution of promissory notes/ agreements are then
treated as ‘primary‘cover in the limited scope of a security cover.
In Bangladeshi context, however, there is a subtle difference between primary and collateral
security. A primary security is one on which the drawing power/loan availment is allowed
while a collateral security, though not considered for such purposes, provides the same
degree of comfort/rights for the lenders for ultimate recovery of the dues. It is fairly common
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in credit market that lenders insist for collaterals (e.g. mortgage of personal landed
property/other assets of the counter party) for extending large volumes of credit. This is done
to ensure an additional cushion on the top of primary security reckoned for drawing
power/loan availment computation. But the credit ‘risk mitigation’ and security cover
(primary/collateral) may not be treated as the same if followed the prescriptions of Basel
Accord II.
In conventional sense, all kinds of assets are recognized as eligible collateral whereas in
Basel II only some specific items of assets are recognized as eligible collateral. Credit Risk
mitigation covers securities such as cash, gold, debt securities issued by sovereigns rated
category, etc.(Stocks in trade, book debts, fixed assets, etc. are not recognized as credit
mitigation items)
In conventional way, Third party guarantee (i.e other than personal repayment undertaking of
the borrower) even by the government of the country, high net worth individuals, is not
strictly treated as ‘security’ although such third party guarantee may be quite valuable for the
lender. But in Basel II, Third party guarantee is treated as a credit mitigation tool subject to
fulfilling certain operational conditions such as unconditional guarantee, explicit
documentation, etc.
Credit risk mitigation guidelines under Basel II provide that the lender will be required to
subdivide the exposures between third party guarantee and other recognized risk mitigation
items whereas in conventional way there is no regulatory guideline.
6.5.1 Application of Credit Risk Mitigation in Basel II
CRM is applicable both for funded and non-funded exposure. Only banking book exposures
(exposures held for regular bank business i.e. not applicable for trading, for sale, etc.) are
considered for CRM. In addition, where issue specific rating reflects CRM, no additional
supervisory recognition of CRM will be granted to avoid double counting effects. Collateral
as a CRM tool may be posted by a third party besides recognizing collateral of the counter
party (borrower). Collateral must be charged to the bank for the life of the exposure, it must
be ‘marked to market’ and revalued at least once in six months. Appropriate haircuts as may
be specified by the regulatory authorities of each country are to be considered in CRM tool.
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Financing banks must have clear and robust procedures for the timely liquidation of
collateral. Exposures covered by collateral would have risk weights as applicable for the
respective collateral subject to a minimum of 20 per cent (for cash, however, nil per cent).
Third party guarantees would be recognized for CRM, provided the guarantees meet the
relevant laid down conditions and the regulatory authorities are satisfied in this regard.
6.5.2 Eligible Collaterals for CRM Purpose
Basel II has viewed collaterals eligible for CRM from two perspectives:
1. Financial Collateral
2. Non–Financial collateral
It is apparent that financial collaterals imply cash or near cash collaterals such as fixed
deposit in a bank, highly rated marketable securities, etc. Any other approved collateral like
gold will be treated as nonfinancial collateral. Cash, Certificate of Deposit (fixed deposit,
short deposit, etc.) issued by the lending bank (hence by implication such deposits held with
the other banks even when lien is offered will not be treated as eligible). So, this has huge
implication in credit risk management in Dhaka Bank Limited. The effect of such rule will
push banks like DBL to not giving any loans against security of other bank.
6.6 Basel II in Bangladesh
On December 30, 2007 Bangladesh Bank issued BRPD Circular no. 14 to all scheduled banks
in Bangladesh which depicted the action plan regarding implementation of Basel-II as follow:
Basel II started its implementation from January 2009. In this regard a quantitative impact
study (QIS) to assess the preparedness for implementing Basel II as well as the bank’s view
on the optional approaches for calculating Minimum Capital Requirement (MCR) as stated in
Basel II was carried out in April-May 2007. Study & subsequent discussion with few related
banks reveal that bankers should be more acquainted with the New Capital Accord (Basel-II).
To address this challenge capacity building of concerned implementing & supervisory
officials should be given first priority in the Action Plan/Roadmap. Basel II may be
implemented with the following specific approaches as initial steps:
a) Standardized Approach for calculating Risk Weighted Amount (RWA) against Credit
Risk supported by External Credit Assessment Institutions (ECAIs)
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b) Standardized Rule Based Approach against Market Risk and
c) Basic Indicator Approach for Operational Risk.
6.6.1 Action Plan
Accordingly, Action Plan/ Roadmap for implementing Basel II in Bangladesh may be
proposed as stated below:
Table 8: Basel II Implementation Action Plan
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6.6.2 Basel II implementation status in Dhaka Bank
Dhaka Bank considers implementation of Risk Based Capital Adequacy for Banks is one of
its topmost priorities. Accordingly Dhaka Bank has established a Basel II Implementation
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Unit (BIU) in the 1st quarter of year 2007 for effective implementation of the capital accord
ensuring Board and Senior Management oversight. The BIU is exclusively assigned with the
task of reviewing the nature and level of risks relating to banking assets and planning for
adequate capital framework. The BIU members meet on regular basis, at least monthly to
monitor implementation status of Risk Based Capital Adequacy of Banks and also those
issues which directly affect capital requirement.
In a view to make the BIU more functional Dhaka Bank has formed Basel II coreTeam
headed by Deputy Managing Director (Business Banking). Dhaka Bank has been successful
to meet all the deadlines so far as prescribed by Bangladesh Bank with quality deliverables
like quarterly Minimum Capital Reporting, Position Paper etc. The Bank has nominated
Credit Rating Information and Services Ltd. (CRISL) and Credit Rating Agency of
Bangladesh (CRAB).
As per BB directive, Banks must maintain 8% CAR upto June 2010. From July 2010, they
have to maintain CAR of 9% and from July 2011 the CAR level will reach to 10%.
6.7 Problems Facing During Implementation
Though Basel II implementation is started in Bangladesh, there are some challenges and
problems in the way, some of them are present and some are potential. These are discussed
below:
One of the present problems is the Standardized Approach and External Credit Rating
organizations. Standardized approach makes use of external credit ratings for attaching risk
weights. One of the major problems is the availability of credit ratings in Bangladesh, though
it has two Credit Rating agencies (Credit Rating Information and Services Limited and Credit
Rating Agency of Bangladesh Ltd.), the penetration of credit ratings is not deep. The supply-
demand imbalance would make it even more difficult for smaller players to get ratings. High
prices are making credit more costly for them.
Though standardized approach is being followed for credit risk for the time being, after some
time all the banks have to switch to the Internal Rating Based Approach which is much
superior to the standardized one. But, it will be very difficult to implement IRB in
Bangladesh. A major problem of IRB implementation is data availability. In Bangladesh,
State-owned banks are still in the process of computerization. The extent of historical data
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required to formulate and then convincingly test. The IRB based approach being one of the
more stringent approaches is the more ideal of the two to strengthen the financial system. The
actual implementation of an IRB based model for credit risk mitigation would require
excellent information retrieval and assessment capabilities. A high-end IT Infrastructure with
Risk Management Software collating real-time information is needed. This preparedness is
not there in a majority of banks in Bangladesh. Hurrying into an IRB based approach could
cost banks dearly because of the involvement of high capital expenditure. Inaccurate IRB
models could defeat the very purpose of better risk mitigation.
The Basel II definition of a banking company is very broad and includes banking subsidiaries
such as insurance companies. In Bangladesh, there is no single regulator to govern the whole
‘bank’ as per Basel II. In Bangladesh, Securities Exchange Commission, Bangladesh Bank,
National Board of Revenue, Dhaka Stock Exchange and Ministry of Finance would regulate
different aspects of Basel II. The consolidated balance sheet of the bank has to conform to
Capital adequacy regulations. In Bangladesh, Regulatory capital norms do not apply to
Insurance companies. The Pillar II implementation is the more difficult portion of the three
pillars. Risk Audits in banks are still in their nascent stages in Bangladesh. The availability of
trained risk auditors is another problem. Basel II calls for a Risk Management structure in
banks with Risk Management committees for Credit, Market and operational Risk
formulating the Risk Management standards. While banks in Bangladesh are implementing
this, it has remained a ceremonial process without the training at the grass root level to see
every activity with the lens of risk.
Pillar 3 is not a very useful discipline device in countries with small private markets or few
incentives for creditors to monitor banks (e.g. due to presence of implicit public guarantees).
In addition, the Pillar 3 might be inapplicable in those countries whose systems are
dominated by foreign banks, since the latter will likely have entered by purchasing and
delisting the domestic institution. Since those banks are not obliged to publicly disclose
information for their operations in such jurisdictions (unless requested by the domestic
authorities), there is little market transparency or discipline.
Another big problem in the way of Basel II implementation is unavailability of required risk
data in easily accessible or comprehensive format. Historical loss data is required to calculate
the main IRB risk parameters; that data are frequently incomplete/ unavailable (i.e. not
required to be collected in the past) or prohibitively expensive to collect (i.e. not in electronic
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format). Particularly for the development of rating systems and LGD parameters, individual
banks may not have a meaningful loss dataset to enable them to build the required models
and back-test their performance. In such an environment, it is essential to tackle the root
causes of this problem (e.g. legal or cultural factors impeding loss data collection and
sharing) prior to proceeding with Basel II adoption.
These are some problems that need to be taken care of with the implementation of Basel II.
Unless these problems are overcome, full implementation of Basel II would not be possible.
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CHAPTER 7CAPITAL REQUIREMENT FOR CREDIT RISK UNDER BASEL II FOR DBL
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.0 Capital requirement for Credit Risk under Basel-II in DBL
The first pillar of Basel-II states about minimum capital requirement for three kinds of risk
viz. credit risk, market risk and operational risk. In this report only capital requirement for
credit risk has been covered thoroughly and it also gives the main calculation of capital for
other two risks. In the following sections capital has been calculated according to the
guideline provided by Bangladesh Bank. The capital ratio is calculated using the definition of
regulatory capital and risk-weighted assets. Until, June 2010, the total capital ratio must be no
lower than 8%, whereas from July 2010 the ratio must be no lower than 9%.
Total risk-weighted assets are determined by multiplying the capital requirements for market
risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and
adding the resulting figures to the sum of risk-weighted assets for credit risk.
7.1 The constituent of capital
7.1.1 Core capital (basic equity or Tier 1)
The Basel Committee considers that the key element of capital on which the main emphasis
should be placed is equity capital and disclosed reserves. This key element of capital is the
only element common to all countries' banking systems; it is wholly visible in the published
accounts and is the basis on which most market judgments of capital adequacy are made; and
it has a crucial bearing on profit margins and a bank's ability to compete. This emphasis on
equity capital and disclosed reserves reflects the importance the Committee attaches to
securing an appropriate quality, and the level, of the total capital resources maintained by
major banks.
Notwithstanding this emphasis, the member countries of the Committee also consider that
there are a number of other important and legitimate constituents of a bank's capital base
which may be included within the system of measurement. The Committee has therefore
concluded that capital, for supervisory purposes, should be defined in two tiers in a way
which will have the effect of requiring at least 50% of a bank's capital base to consist of a
core element comprised of equity capital and published reserves from post-tax retained
earnings (Tier 1). The other elements of capital (supplementary capital) will be admitted into
Tier 2 limited to 100% of Tier 1.
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Table 9: Core Capital calculation of Dhaka Bank Limited
Tier 1 (Core Capital) of Dhaka Bank Ltd (as on 31.03.2010) BDT
(in crores)
1.1 Paid-up Capital 265.96
1.2 Non-repayable Share Premium Account -
1.3 Statutory Reserve 197.03
1.4 General Reserves 0.38
1.5 Retained Earnings 32.18
1.6 Minority Interest in Subsidiaries -
1.7 Non-cumulative irredeemable Preference Shares -
1.8 Dividend Equalisation Account -
1.9 Sub-Total (1.1 to 1.8) 495.55Deductions:
1.1 Book value of Goodwill -1.11 Shortfall in provisions required against classified assets irrespective of
any relaxation allowed.-
1.12 Deficit on account of revaluation of investments held in AFS category -1.13 Any increase in equity capital resulting from a securitization transaction -
1.15 Other deductions (50% of the amount as calculated on CAP 2) -
1.16 Sub-Total (1.10 to 1.15) -1.17 Total eligible Tier 1 capital (1.9-1.16) 495.55
7.1.2 Supplementary Capital (Tier 2)
Undisclosed reserves
Unpublished or hidden reserves may be constituted in various ways according to differing
legal and accounting regimes in member countries. Under this heading are included only
reserves which, though unpublished, have been passed through the profit and loss account
and which are accepted by the bank's supervisory authorities. They may be inherently of the
same intrinsic quality as published retained earnings, but, in the context of an internationally
agreed minimum standard, their lack of transparency, together with the fact that many
countries do not recognize undisclosed reserves, either as an accepted accounting concept or
as a legitimate element of capital, argue for excluding them from the core equity capital
element.
2. Revaluation reserves
Some countries, under their national regulatory or accounting arrangements, allow certain
assets to be revalued to reflect their current value, or something closer to their current value
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than historic cost, and the resultant revaluation reserves to be included in the capital base.
Such revaluations can arise in two ways:
(a) from a formal revaluation, carried through to the balance sheets of banks' own premises;
or
(b) from a notional addition to capital of hidden values which arise from the practice of
holding securities in the balance sheet valued at historic costs. Such reserves may be included
within supplementary capital provided that the assets are considered by the supervisory
authority to be prudently valued, fully reflecting the possibility of price fluctuations and
forced sale.
General provisions/general loan-loss reserves
General provisions or general loan-loss reserves are created against the possibility of losses
not yet identified. Where they do not reflect a known deterioration in the valuation of
particular assets, these reserves qualify for inclusion in Tier 2 capital. Where, however,
provisions or reserves have been created against identified losses or in respect of an identified
deterioration in the value of any asset or group of subsets of assets, they are not freely
available to meet unidentified losses which may subsequently arise elsewhere in the portfolio
and do not possess an essential characteristic of capital. Such provisions or reserves should
therefore not be included in the capital base.
The supervisory authorities represented on the Committee undertake to ensure that the
supervisory process takes due account of any identified deterioration in value. They will also
ensure that general provisions or general loan-loss reserves will only be included in capital if
they are not intended to deal with the deterioration of particular assets, whether individual or
grouped.
This would mean that all elements in general provisions or general loan-loss reserves
designed to protect a bank from identified deterioration in the quality of specific assets
(whether foreign or domestic) should be ineligible for inclusion in capital. In particular,
elements that reflect identified deterioration in assets subject to country risk, in real estate
lending and in other problem sectors would be excluded from capital.
General provisions/general loan-loss reserves that qualify for inclusion in Tier 2 under the
terms described above do so subject to a limit of 1.25 percentage points of weighted risk
assets to the extent a bank uses the Standardized Approach for credit risk.
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Hybrid debt capital instruments
In this category fall a number of capital instruments which combine certain characteristics of
equity and certain characteristics of debt. Each of these has particular features which can be
considered to affect its quality as capital. It has been agreed that, where these instruments
have close similarities to equity, in particular when they are able to support losses on an on-
going basis without triggering liquidation, they may be included in supplementary capital. In
addition to perpetual preference shares carrying a cumulative fixed charge, the following
instruments, for example, may qualify for inclusion: long-term preferred shares in Canada,
titres participatifs and titres subordonnés à durée indéterminée in France, Genussscheine in
Germany, perpetual debt instruments in the United Kingdom and mandatory convertible debt
instruments in the United States.
Subordinated term debt
The Committee is agreed that subordinated term debt instruments have significant
deficiencies as constituents of capital in view of their fixed maturity and inability to absorb
losses except in liquidation. These deficiencies justify an additional restriction on the amount
of such debt capital which is eligible for inclusion within the capital base. Consequently, it
has been concluded that subordinated term debt instruments with a minimum original term to
maturity of over five years may be included within the supplementary elements of capital, but
only to a maximum of 50% of the core capital element and subject to adequate amortization
arrangements.
Table 10: Tier-2 Capital Calculation of Dhaka Bank Limited as on 31.03.2010
Tier 2 Capital of Dhaka Bank Ltd (Taka in crores)2.1 General Provisions (Unclassified loans + off balance seet exposure) 84.132.2 Asset Revaluation Reserves up to 50% -2.3 All other preference shares -2.4 Up to 50% of Revaluation Reserves for securities 12.522.5 Perpetual subordinated debt up to max 30% -
2.6 Balance of Exchange Equalization A/C 0.122.7 Total tier 2 Capital (2.1 to 2.5) 96.77
Deductions:
2.8 Other deductions (50% of the amount as calculated on CAP 2) -
2.9 Total Deductions -
2.10 Total eligible Tier 2 Capital (2.6-2.8) 96.77
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.1.3 Short-term subordinated debt covering market risk (Tier 3)
The principal form of eligible capital to cover market risks consists of shareholders’ equity
and retained earnings (Tier 1 capital) and supplementary capital (Tier 2 capital) as defined
above. But banks may also, at the discretion of their national authority, employ a third tier of
capital (“Tier 3”), consisting of short-term subordinated debt as defined in below for the sole
purpose of meeting a proportion of the capital requirements for market risks, subject to the
following conditions:
Banks will be entitled to use Tier 3 capital solely to support market risks.
Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to sup-
port market risks.
Tier 2 capital may not exceed total Tier 1 capital, and long-term subordinated debt
may not exceed 50% of Tier 1 capital
The sum total of Tier 2 plus Tier 3 capital should not exceed total Tier 1.
However, the Committee has decided that any decision whether or not to apply such a rule
should be a matter for national discretion. Some member countries may keep the constraint,
except in cases where banking activities are proportionately very small. Additionally,
national authorities will have discretion to refuse the use of short-term subordinated debt for
individual banks or for their banking systems generally.
For short-term subordinated debt to be eligible as Tier 3 capital, it needs, if circumstances
demand, to be capable of becoming part of a bank’s permanent capital and thus be available
to absorb losses in the event of insolvency. It must, therefore, at a minimum:
be unsecured, subordinated and fully paid up
have an original maturity of at least two years
not be repayable before the agreed repayment date unless the supervisory authority
agrees
be subject to a lock-in clause which stipulates that neither interest nor principal may
be paid (even at maturity) if such payment means that the bank falls below or remains
below its minimum capital requirement.
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7.1.4 Deductions from capital
It has been concluded that the following deductions should be made from the capital base for
the purpose of calculating the risk-weighted capital ratio. The deductions will consist of:
(i) Goodwill, as a deduction from Tier 1 capital elements;
(ii) Increase in equity capital resulting from a securitization exposure, as a deduction from
Tier 1 capital elements;
(iii) Investments in subsidiaries engaged in banking and financial activities which are not
consolidated in national systems. The normal practice will be to consolidate subsidiaries for
the purpose of assessing the capital adequacy of banking groups.
The Committee carefully considered the possibility of requiring deduction of banks' holdings
of capital issued by other banks or deposit-taking institutions, whether in the form of equity
or of other capital instruments. The Committee is very conscious that such double-gearing (or
"double-leveraging") can have systemic dangers for the banking system by making it more
vulnerable to the rapid transmission of problems from one institution to another and some
members consider these dangers justify a policy of full deduction of such holdings.
7.2 Credit Risk – The Standardized Approach:
For credit risk management under Basel II the standardized approach is used in DBL as per
the directives of Bangladesh Bank. Though this approach is not very highly acclaimed among
the experts all over the world, it is simple and easy to implement. For developing countries
like Bangladesh, slow implementation of Internal Rating Based approach will be justified one
as there is lack of trained and knowledgeable person regarding this approach in Bangladesh.
7.2.1 Claims on sovereigns
Claims on sovereigns and their central banks will be risk weighted as follows:
Credit
Assessment
AAA to
AA-
A+ to A- BBB+ to
BBB-
BB+ to B- Below B- Unrated
Risk Weight 0% 20% 50% 100% 150% 100%
DBL has no claims on sovereigns so risk weighted asset in this category in zero.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.2.2 Claims on non-central government public sector entities (PSEs)
Claims on domestic PSEs will be risk-weighted at national discretion, according to either
option 1 or option 2 for claims on banks. When option 2 is selected, it is to be applied without
the use of the preferential treatment for short-term claims.
Subject to national discretion, claims on certain domestic PSEs may also be treated as claims
on the sovereigns in whose jurisdictions the PSEs are established.23 Where this discretion is
exercised, other national supervisors may allow their banks to risk weight claims on such
PSEs in the same manner. DBL also does not have any exposure on 31st march, 2010 in this
category.
7.2.3 Claims on multilateral development banks (MDBs)
The risk weights applied to claims on MDBs will generally be based on external credit
assessments as set out under option 2 for claims on banks but without the possibility of using
the preferential treatment for short-term claims. A 0% risk weight will be applied to claims
on highly rated MDBs that fulfill to the Committee’s satisfaction the criteria provided below.
The Committee will continue to evaluate eligibility on a case-by-case basis. The eligibility
criteria for MDBs risk weighted at 0% are:
very high quality long-term issuer ratings, i.e. a majority of an MDB’s external
assessments must be AAA;
shareholder structure is comprised of a significant proportion of sovereigns with long-
term issuer credit assessments of AA- or better, or the majority of the MDB’s fund-
raising are in the form of paid-in equity/capital and there is little or no leverage;
strong shareholder support demonstrated by the amount of paid-in capital contributed
by the shareholders; the amount of further capital the MDBs have the right to call, if
required, to repay their liabilities; and continued capital contributions and new
pledges from sovereign shareholders;
adequate level of capital and liquidity (a case-by-case approach is necessary in order
to assess whether each MDB’s capital and liquidity are adequate); and,
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
strict statutory lending requirements and conservative financial policies, which would
include among other conditions a structured approval process, internal
creditworthiness and risk concentration limits (per country, sector, and individual
exposure and credit category), large exposures approval by the board or a committee
of the board, fixed repayment schedules, effective monitoring of use of proceeds,
status review process, and rigorous assessment of risk and provisioning to loan loss
reserve.
7.3.4 Claims on banks
There are two options for claims on banks. National supervisors will apply one option to all
banks in their jurisdiction. No claim on an unrated bank may receive a risk weight lower than
that applied to claims on its sovereign of incorporation. Under the first option, all banks
incorporated in a given country will be assigned a risk weight one category less favorable
than that assigned to claims on the sovereign of that country. However, for claims on banks in
countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk weight
will be capped at 100%.
The second option bases the risk weighting on the external credit assessment of the bank
itself with claims on unrated banks being risk-weighted at 50%. Under this option, a
preferential risk weight that is one category more favorable may be applied to claims with an
original maturity of three months or less, subject to a floor of 20%. This treatment will be
available to both rated and unrated banks, but not to banks risk weighted at 150%.
DBL has chosen the first option and After calculation, RWA for claims on Banks & NBFI
stands at 309.66 crore whereas total exposure is 754.25 crore.
Credit assessment
of Sovereign
AAA to
AA-
A+ to
A-
BBB+
to
BBB-
BB+
to
B-
Below
B-
Unrated
Risk weight under 20% 50% 100% 100% 150% 100%
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.3.5 Claims on securities firms
Claims on securities firms may be treated as claims on banks provided these firms are subject
to supervisory and regulatory arrangements comparable to those under this Framework
(including, in particular, risk-based capital requirements). Otherwise such claims would
follow the rules for claims on corporate. DBL has no exposure in this category on last quarter
of the year.
7.3.6 Claims on corporate
The table provided below illustrates the risk weighting of rated corporate claims, including
claims on insurance companies. The standard risk weight for unrated claims on corporate will
be 100%. No claim on an unrated corporate may be given a risk weight preferential to that
assigned to its sovereign of incorporation.
Credit
assessment
AAA to
AA-
A+ to A- BBB+ to
BB-
Below
BB-
Unrated
Risk weight 20% 50% 100% 150% 125%
As most of the companies of Bangladesh are not rated, the risk weighted asset for exposure
on corporate loan will be much higher as the risk weight is more than 100%. If looked at the
calculation then the real picture will come out. DBL’s total exposure to corporate loan on
31.03.2010 stands at 3001.87 crore but as the most of the clients are unrated, RWA has gone
up to 3738.07 crore which is almost 25% higher. Since, DBL’s maximum loan exposure is in
this category, it is suffering heavily for unrated clients as it has to keep more capital
according to Basel II requirement.
7.3.7 Claims included in the regulatory retail portfolios
Claims that qualify under the criteria listed below may be considered as retail claims for
regulatory capital purposes and included in a regulatory retail portfolio. Exposures included
in such a portfolio may be risk-weighted at 75%, except as provided for past due loans.
To be included in the regulatory retail portfolio, claims must meet the following four criteria:
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Orientation criterion: The exposure is to an individual person or persons or to a small
business;
Product criterion: The exposure takes the form of any of the following: revolving
credits and lines of credit (including credit cards and overdrafts), personal term loans
and leases (e.g. installment loans, auto loans and leases, student and educational
loans, personal finance) and small business facilities and commitments. Securities
(such as bonds and equities), whether listed or not, are specifically excluded from this
category. Mortgage loans are excluded to the extent that they qualify for treatment as
claims secured by residential property.
Granularity criterion: The supervisor must be satisfied that the regulatory retail
portfolio is sufficiently diversified to a degree that reduces the risks in the portfolio,
warranting the 75% risk weight. One way of achieving this may be to set a numerical
limit that no aggregate exposure to one counterpart can exceed 0.2% of the overall
regulatory retail portfolio.
Low value of individual exposures: The maximum aggregated retail exposure to one
counterpart cannot exceed an absolute threshold of €1 million.
In this category, DBL has exposure of Tk. 687.57 crore and RWA is calculated as Tk. 515.68.
7.3.8 Claims secured by residential property
Lending fully secured by mortgages on residential property that is or will be occupied by the
borrower, or that is rented, will be risk weighted at 50%. In applying the 50% weight, the
supervisory authorities should satisfy themselves, according to their national arrangements
for the provision of housing finance, that this concessionary weight is applied restrictively for
residential purposes and in accordance with strict prudential criteria, such as the existence of
substantial margin of additional security over the amount of the loan based on strict valuation
rules. Supervisors should increase the standard risk weight where they judge the criteria are
not met. As on 31.03.2010, RWA for the above category stands at 44.97 crore whereas the
total exposure is 89.94 (Appendix).
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.3.9 Claims secured by commercial real estate
In view of the experience in numerous countries that commercial property lending has been a
recurring cause of troubled assets in the banking industry over the past few decades, the
Committee holds to the view that mortgages on commercial real estate do not, in principle,
justify other than a 100% weighting of the loans secured. As on 31.03.2010, RWA for the
above category stands at 42.52 crores.
7.3.10 Past due loans
The unsecured portion of any loan (other than a qualifying residential mortgage loan) that is
past due for more than 90 days, net of specific provisions (including partial writeoffs), will be
risk-weighted as follows:
150% risk weight when specific provisions are less than 20% of the outstanding
amount of the loan. RWA for this category on 31.03.2010 is 395.78 crore whereas the
total exposure is Tk. 263.85 crores.
100% risk weight when specific provisions are no less than 20% of the outstanding
amount of the loan. RWA for this category on 31.03.2010 is 73.29 crore.
100% risk weight when specific provisions are no less than 50% of the outstanding
amount of the loan, but with supervisory discretion to reduce the risk weight to 50%.
As per Bangladesh Bank directive, the risk weight is now 50%. RWA for this
category on 31.03.2010 is 17.82 crore whereas the total exposure is Tk. 35.64 crores.
For the purpose of defining the secured portion of the past due loan, eligible collateral and
guarantees will be the same as for credit risk mitigation. Past due retail loans are to be
excluded from the overall regulatory retail portfolio when assessing the granularity criterion.
In the case of qualifying residential mortgage loans, when such loans are past due for more
than 90 days they will be risk weighted at 100%, net of specific provisions. If such loans are
past due but specific provisions are no less than 20% of their outstanding amount, the risk
weight applicable to the remainder of the loan can be reduced to 50% at national discretion.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.3.11 Off-balance sheet items:
Off-balance-sheet items under the standardized approach will be converted into credit
exposure equivalents through the use of credit conversion factors (CCF). Counterparty risk
weightings for OTC derivative transactions will not be subject to any specific ceiling.
Commitments with an original maturity up to one year and commitments with an original
maturity over one year will receive a CCF of 20% and 50%, respectively. However, any
commitments that are unconditionally cancelable at any time by the bank without prior
notice, or that effectively provide for automatic cancellation due to deterioration in a
borrower’s creditworthiness, will receive a 0% CCF.
Direct credit substitutes, e.g. general guarantees of indebtedness (including standby letters of
credit serving as financial guarantees for loans and securities) and acceptances (including
endorsements with the character of acceptances) will receive a CCF of 100%. Sale and
repurchase agreements and asset sales with recourse, where the credit risk remains with the
bank will receive a CCF of 100%.
A CCF of 100% will be applied to the lending of banks’ securities or the posting of securities
as collateral by banks, including instances where these arise out of repo-style transactions
(i.e. repurchase/reverse repurchase and securities lending/securities borrowing transactions).
Forward asset purchases, forward deposits and partly-paid shares and securities, which
represent commitments with certain drawdown will receive a CCF of 100%. Certain
transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and
standby letters of credit related to particular transactions) will receive a CCF of 50%. Note
issuance facilities (NIFs) and revolving underwriting facilities (RUFs) will receive a CCF of
50%. For short-term self-liquidating trade letters of credit arising from the movement of
goods (e.g. documentary credits collateralized by the underlying shipment) a 20% CCF will
be applied to both issuing and confirming banks.
Total RWA for off-balance sheet item on 31.03.2010 is 638.63 crores.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.3.12 Credit risk mitigation
Banks use a number of techniques to mitigate the credit risks to which they are exposed.
Exposure may be collateralized in whole or in part with cash or securities, or a loan exposure
may be guaranteed by a third party. Where these various techniques meet the operational
requirements below credit risk mitigation (CRM) may be recognized.
The framework set out is applicable to the banking book exposures under the simplified
standardized approach. No transaction in which CRM techniques are used should receive a
higher capital requirement than an otherwise identical transaction where such techniques are
not used. The effects of CRM will not be double counted. Therefore, no additional
supervisory recognition of CRM for regulatory capital purposes will be granted on claims for
which an issue-specific rating is used that already reflects that CRM. Principal-only ratings
will also not be allowed within the framework of CRM.
Although banks use CRM techniques to reduce their credit risk, these techniques give rise to
risks (residual risks) which may render the overall risk reduction less effective. Where these
risks are not adequately controlled, supervisors may impose additional capital charges or take
other supervisory actions.
While the use of CRM techniques reduces or transfers credit risk, it simultaneously may
increase other risks to the bank, such as legal, operational, liquidity and market risks.
Therefore, it is imperative that banks employ robust procedures and processes to control these
risks, including strategy; consideration of the underlying credit; valuation; policies and
procedures; systems; control of roll-off risks; and management of concentration risk arising
from the bank’s use of CRM techniques and its interaction with the bank’s overall credit risk
profile. On 31st March, 2010 RWA for claims under credit risk mitigation stood at Tk. 127.88
crore.
7.4 Capital Adequacy Ratio
Bangladesh Bank adopted the idea of Capital Adequecy Ration through BRPD Circular in
1996. It advised assessment of Capital Adequacy on the basis of Risk Weighted Assets.
Capital Adequacy Ratio =Tier I Capital+Tier 2 Capital
Risk Weighted Assets× 100
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Total RWA for Dhaka Bank on March 31, 2010 is summarized below in the table. As this
report focuses on the credit risk of Basel II framework, detailed calculation of market risk and
operational risk is not given here.
Table 11: Risk Weighted Asset for DBL
Risk Weighted Assets (RWA) for Tk. in crores
A. Credit Risk
On Balance Sheet 5743.856382.48
Off-Balance Sheet 638.63
B. Market Risk1 21.07 263.34
C. Operational Risk2 56.45 705.67
Total RWA 7351.49
In the following table, calculation of Minimum Capital Requirement is shown. From the
table, it is clear that, DBL has certainly met the requirement as it has over Tk. 4 crore of
surplus. CAR is just above 8% and Core capital to RWA is 6.74% which is quite good.
Table 12: Minimum Capital Requirement under Risk Based Capital
Particulars Tk. in crore
A. Eligible Capital
1. Tier 1 (Core Capital) 495.55
2. Tier 2 (Supplementary Capital) 96.77
3. Tier 3(eligible fo market risk only) -
4. Total Eligible Capital 592.32
B. Total Risk Weighted Asset (RWA) 7351.49
C. Capital Adequacy Ratio (CAR) 8.06%
D. Core Capital to RWA 6.74%
E. Minimum Capital Requirement (MCR) 588.12
1 RWA for Market Risk is calculated by multiplying the total exposure by 12.52 Same as above for operational risk
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
7.5 Trend Analysis
A trend analysis has been done on three important variable of credit risk management under
Basel II. The variables are total eligible capital, RWA and CAR. The trend analysis is done
on last four quarters, i.e. from June 2009 to March 2010.
From the following figure, the trend in total eligible capital can be seen. Total eligible capital
increased almost Tk. 82 crore in the last year.
Figure 10: Total Eligible Capital
This capital includes both Tier 1 and Tier 2. It can also be seen from the figure that total
eligible capital gives a nose dive in the 3rd quarter of the year 2009, whereas in all other
quarter it increased satisfactorily.
Risk weighted asset is also a
very important variable in
Basel II. In standardized
approach, it depends heavily
on the rating of ECAIs. As
DBL deals mainly with the
corporate clients and few
clients have done credit
rating of them, the risk
weighted asset is increasing
day by day as the loan
portfolio is growing. But,
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Figure 11: Risk Weighted Asset
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
this increase of RWA will create pressure on bank to increase the capital substantially and
which is not that easy. From the figure 11, it can be seen that, RWA increased very largely in
the last two quarter, so to maintain, adequate CAR, the bank has to increase its capital which
can be seen from figure 10.
In the last figure, the trend of CAR is shown. As per BB directives, Basel II has a parallel run
with Basel I in 2009
and capital adequacy
ratio requirement
was above 7% at that
time. But from, 2010
Basel II is in full
effect. So, the CAR
must be above 8%
which is kept by
DBL as seen from
the figure 12. In all
the quarter Capital
Adequacy Ratio was above 7% which is good compliance with the set norm. But the bank
will be in a big challenge when this ratio must be maintained over 9% from July 2010. Either
the bank has to enhance the capital or decrease the RWA to improve the CAR. The next
section will show some ways to enhance the capital.
7.6 Capital Raising Option
Bank can increase their tier 1 and tier 2 capital if needed to comply with the BB directive.
Some of the ways are shown below:
7.6.1 Tier 1 Capital
Banks can maintain their capital in 8 (eight) constituents of Tier I capital as specified before.
Four of them, namely, Statutory Reserve, General Reserve, Retained Earnings and Dividend
Equalization Account are greatly dependent on annual income of a bank. A certain percent-
age of income that is retained as per requirement of the Banking Companies Act (BCA) 1991
is named as Statutory Reserve. General Reserve is made to meet contingencies which are in-
determinate at the time of making such reserve. Retained earnings are defined as sharehold-
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Figure 12: Capital Adequacy Ratio (CAR)
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
ers' equities in a banking company resulting from earnings in excess of losses and declared
dividends. The purpose of Dividend Equalization Account is to create a fund in those years in
which profits are large, so as to enable the bank to pay dividend at normal rate when profits
are small. Thus a bank cannot enhance capital immediately in these items to meet any regula -
tory obligation.
A bank can raise capital and non-repayable premium account by issuing right share, bonus
share and IPOs. But a bank whose shares have already been floated in the stock market can
further expand capital base by issuing either bonus shares or right shares or both. Issue of
bonus share again depends on genuine annual profit of a bank. This process does not enhance
financial resources of a bank; rather it converts earnings into shares. Whether a bank can is-
sue share at premium depends on each share's existing net worth value which, among other,
also depends on its accumulated earnings.
The above analysis indicates that if regulation requires banks to raise Tier I capital substan-
tially, the immediate option available for listed banks is to issue right shares. For the state-
owned banks government will require to inject capital while branches of foreign banks will
require collecting funds from their parent office. In addition, banks can respond to regulator's
instruction by issuing non-cumulative irredeemable preference shares. But there is a lack of
regulatory guideline regarding issue of such instruments.
7.6.2 Tier II Capital
As mentioned earlier, Tier II capital comprises of General Provision, Asset Revaluation Re-
serve, Preference Shares, and Perpetual Subordinated Debt Account. Banks maintain general
provision out of their business earnings. So they cannot raise general provision immediately
in response to enhancement of regulatory capital. Similar argument can be applied for asset
revaluation reserve and exchange equalization account. Since Bangladesh is following free
floating exchange rate policy since May 2003, exchange equalization account has become in-
effective in reality. In these circumstances, the options available for banks to raise Tier II
capital are either to issue perpetual subordinated debt or to issue preference share or to issue
both. However, there are no regulatory guidelines for the issuance of such instruments.
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CHAPTER 8IMPACT OF ADOPTION OF BASEL II IN DHAKA BANK LIMITED
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
8.0 Impact of Adoption of Basel II in Dhaka Bank Limited
As Basel II implementation started in Bangladesh from 2010, the impacts of adoption are not
visible clearly yet. But, there will be some certain impacts. In the following those certain and
some potential impacts are discussed.
Improved Risk Management and Capital Adequacy
One aspect that the staunchest critics of Basel II agree to is the fact that it will tighten the risk
management process, improve capital adequacy and strengthen the banking system.
Impact on Customers
For DBL, Basel II is an internal management exercise that does not directly affect customers.
However, there has been a good deal of talk about Basel II leading to greater risk-based
pricing in loan markets, as it increases the difference in capital required between risky and
safer lending categories. This could lead to riskier types of debt, such as consumer finance,
costing more relative to safer categories such as loan to large corporate house. From 2010,
management of the Bank decided to give preference to the client rated by ECAI. It also will
extend its credit towards the good rated borrower. This scenario will bar the poor rated client
to avail any loan.
Shorter Term to maturity of lending
Both the Basel I and II accords have a preference for short-term lending. This is because of
the ease in exiting the investment in case the situation turns adverse. Also the interest rates on
short term will also tend to be lower further incentivising such borrowings. For this reason,
DBL is trying to attract shorter term borrowing to get the benefits. This shall impact both the
bank and ultimate borrowers because of the change in the interest rate term structure and the
need for Asset and Liability Management (ALM).
Impact on capital flows
Short Term lending will further increase the volatility of capital flows within Bangladesh,
from one bank to another. If any negative event occurs at any point of the flow, people will
get panicked. There would be a tendency to press the panic button at the smallest change in
the situation, further deteriorating it, leading to crisis.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
Higher Interest Costs
Implementation of Basel II will force banks like Dhaka Bank to charge
more interest to risky customer as it has to keep some capital for that
loan. On the other hand, there are few good customers in Bangladesh, so
every bank will want them as their customer. So, competition will increase
and interest rate will fall for the well rated borrower.
Competitive Advantage of Corporate Borrowers
Corporate Banking is the main operating business model of Dhaka Bank Limited. But, in
Basel II advantage has been given to corporate borrowers with good rating. As the good
clients number is limited, and competition is huge. Dhaka Bank may lose some of its
customers.
Impact on Companies
The Shortened term funding of banks will find its way to the balance sheets of companies
because of the need for matching maturities. This would impact output levels in corporate
and skew the capital structure in favor of short term borrowings and working capital finance.
The Liquidity position and the companies’ ability to globalize would be hampered by this
difficulty in raising long-term capital.
The Vicious Circle of Curtailment of Credit to Developing Countries
This is countrywide impact which will hit all the financial organization in Bangladesh.
Developing countries like Bangladesh usually has lower sovereign rating. The lower ratings
will reduce the availability of funds in the developing countries. This has the potential to
deteriorate the situation in these countries leading to further recession. The reduced market
access and high costs of funding will further impact the ratings of these countries leading to a
vicious circle with each aspect feeding the other in a downward spiral.
In brief, these are some of the impacts that are felt and will be felt in future as DBL and other
banks adopt Basel II.
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CHAPTER 9RECOMMENDATION
Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
9.0 Recommendation
Dhaka Bank Limited has taken all the steps to implement Basel II. But there is an apprehen-
sion of capital shortfall in MCR (Minimum Capital Requirement) in the next quarter as the
level of CAR is going up by 1%. So, DBL has to raise capital very quickly to remain compli -
ant as before. At the current level of risk weighted asset the Bank may need additional Tk.
150 crore of Tier 1 capital to meet up the shortfall. Moreover, from 2011 the CAR will be
10% which will almost require additional Tk. 350 crore of total eligible capital if the growth
of loan portfolio remains stable. As Basel II has direct impact on credit risk management, re-
maining compliant should be the first priority to operate business. Though Dhaka Bank Lim-
ited is taking necessary steps to stay ahead of the action plan of Bangladesh Bank, the follow-
ing recommendation can be useful.
1. To meet the capital shortfall in Tier 1 capital, DBL should issue right shares of Tk.
100 crore. The existing shareholders can purchase these shares in rights. It will help
DBL to maintain a good ratio of core capital to risk weighted asset ratio. Offering
right share will not harm the current shareholders, offering them the right share is a
reward for them. It will create a positive brand image of the Bank.
2. To meet the capital shortfall in Tier 2 capital, DBL can issue subordinated bond.
These bonds will be unsecured, non convertible and DBL can issue bonds upto Tk.
250 crore. Issuing subordinated bonds does not create any problems for the existing
shareholder. If DBL issues these two types of securities, the shortfall problem will not
remain when Basel II will run at full force.
3. DBL should look for comprehensive IT solution for Basel II. Bangladesh will go to
implement the foundation IRB approach in 2012 and this approach requires extensive
Management Information System.
4. Management should set up a unit, which will work under the supervision of BIU,
whose task will be to encourage the clients to be rated by ECAI. This unit will also
keep contact with the ECAIs to gather borrower information. This will help speed up
the process of rating..
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
5. The Bank should recalculate its lending rate on a periodic basis to cope with changing
lending scenario caused by Basel II.
6. The Bank should introduce Risk Based Pricing. For this, Credit officer must be skilled
enough to understand the procedure.
7. No new borrower should be given credit facility without being rated by ECAI.
8. As there are few good customers in the market, extra attention should be given to
them as intense competition is taking place.
9. The Bank should concentrate more on short term lending as it charges less capital ac-
cording to Basel II.
10. To be fully compliant with BASEL II requirements, the bank should develop histori-
cal databases on probability of default (PD) and loss given default (LGD). Such data-
bases will enable the bank to compute expected loss (EL) from any new credit ap-
proval.
11. For credit risk mitigation purpose, the collateral accepted by Basel II only, should be
taken as security.
12. When assessing collateral, the bank should be mindful that the value of the collateral
might be impaired by the same factors that have led to the diminished recoverability
of the credit.
13. An investigative review should be carried out on significant cases. The review should
enable the bank to understand better how problem credits and losses develop and
identify weaknesses in the banking institution’s existing credit-granting process and
monitoring process.
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Compliance of Basel II in Credit Risk Management of Dhaka Bank Limited
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APPENDICES