ABSTRACT

Bank faces different types of risks in

their daily activities such as interest rate
risk, liquidity risk, operational risk,
market risk, credit risk etc. There are
different types of tools available to
mitigate these risk at a certain level. This
paper analyzes and discusses the tools
applied by commercial banks in
Bangladesh to minimize & mitigate the
risks of different types.

RISK MANAGEMENT B -516: Business Research Methodology

OF COMMERCIAL
BANKS IN
BANGLADESH
 Risk Management of Commercial Banks in Bangladesh

Prepared For:
Dr. Md. Rafiqul Islam
Professor
Department of Banking and Insurance
University of Dhaka

Prepared By:
Group-ABC
ID Group Member’s Name Remarks

19-034 Md. Abdul Jalil

19-050 Tanvir Hossain

19-096 Al Amin Biswas

19-108 Niyem Siddike

Group Leader: Al Amin Biswas

Email: alaminbanking@gmail.com

Department of Banking and Insurance

Faculty of Business Studies
University of Dhaka
13th November, 2017

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH i

 LETTER OF TRANSMITTAL
Date: 13-11-17
To
Dr. Md. Rafiqul Islam
Professor
Department of Banking and Insurance
University of Dhaka

Subject: Submission of report on ‘Risk Management of Commercial Banks in

Bangladesh’

Dear Sir,
This is our great pleasure to have the opportunity to submit the report on the ‘Risk
Management of Commercial Banks in Bangladesh’ as part of our course studies.

The report is prepared based on published reports, websites and other related
documents and the documents collected from library. Through our best sincerity we have
tried to present all the related issues in the report within several limitations. We sincerely
hope and believe that these findings will be able to meet the requirements of the course.
Once again, thank you for making our (B-516) Business Research class an enlightening
and enjoyable experience.

Therefore we would like to place this report for your kind judgment and valuable
suggestion.

Thanking you.
Sincerely yours

Al Amin Biswas
Roll: 19-096
On behalf of the group-ABC

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH ii

 ACKNOWLEDGEMENT

At first we are very grateful and thankful to the Almighty ALLAH (SWT).

For the completion of this report searching for websites, articles and related documents
were required. However, it was our instructor, Dr. Md. Rafiqul Islam who played the
important role by giving us an insight about the report. We express our profound
indebtedness and gratitude to him, for his valuable advice that helped immensely in
preparing this report.

We would also like to thank all the team members who worked so hard to the finishing of
the report with such devotion, target, energy and their participation. However, this report
was a combined effort. Therefore, all the credit of our accomplishment spreads to all the
helping hands.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH iii

 EXECUTIVE SUMMARY
This report is all about the risk management practices of commercial banks in
Bangladesh. Managing and minimizing the risks is one of the core challenges a
commercial faces in recent time. There are various types of risks a bank faces in
conducting their regular operation. These are Interest rate risk, Liquidity risk, credit risk,
operational risk, foreign exchange risk etc. Banks try to manage and minimize their risks
by adopting various risk management processes.

At the initial part of the report a brief introduction regarding risk management practices
of commercial banks in Bangladesh have been given. Among the core risks the banks face,
interest rate risk is one of them. Interest rate risk is arisen due to the adverse change in
market condition. Bank’s earnings, assets and liabilities in the financial statement are
mostly affected by the risk. Normally banks use two techniques to manage and minimize
their interest rate risk. These are Interest/rate sensitive gap management and Duration
gap analysis. In interest sensitive gap management interest sensitive assets and liabilities
are used and in duration gap analysis the effects of the duration mismatch between the
assets and liabilities on the net worth of the bank are shown.

Liquidity risk is another problem a bank always try to minimize through measuring the
liquidity position of the bank. Normally each and every commercial bank of Bangladesh
needs to maintain CRR, SLR according to the guideline of Bangladesh bank to ensure the
sufficient liquidity. It is the responsibility of Asset Liability Management Committee of a
bank to monitor and minimize the credit risk by analyzing the various ratios. These ratios
are advance to deposit (ADR) ratio, liquid assets to total deposit ratio, medium term
stable funding ratio etc. After analyzing the ratio it seems that the liquidity condition of
commercial banks is very satisfactory.

Credit risk is the most significant risk a bank needs to handle very carefully. To handle
the credit risks banks normally use both qualitative and quantitative approach. In
Bangladesh qualitative approaches are mostly used by the commercial banks for
determining the possibility of credit risk or default risk. In qualitative approach banks
conduct 5 Cs analysis for evaluating the borrower. Although quantitative approach is not

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH iv

popular in Bangladesh, it has a significant usage for determining the probability of default
risk. In quantitative approach various, models and techniques are used and among them
the Altman Z-score is much more popular. By using the Altman Z-score for identifying the
possibility of bankruptcy for the commercial banks of Bangladesh it seems that the
financial condition of the commercial banks is very healthy and sound.

Another important risk is the operational risk which is arisen from inadequate or failed
internal processes, people and systems, or from external events. There are some
fundamental principles of operational risk management that the commercial banks of
Bangladesh need to follow to minimize the operational risk. Besides banks use qualitative
and quantitative approach discussed in the report to manage and minimize the
operational risk. Basic indicator approach is the most common approach used by the all
the commercial banks in Bangladesh. After using the basic indicator approach it seems
that the operational risk is mostly influenced by the size of the banks.

At the later part of the report findings and recommendations has been described. By
completing the report some important issues about the risk management practices by the
commercial banks in Bangladesh have been realized and these issues have been
described in findings part. After analyzing various approaches and models of risk
management of commercial banks it seems that the risk management practice is very
satisfactory. However there are some suggestions for the banks to improve further and
maintain the present condition. These suggestions have been described in the
recommendations part.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH v

 BRIEF CONTENTS
No. Content Names Page No.

01 Letter of Transmittal II

02 Acknowledgement III

03 Executive Summary IV,V

04 Table of Contents VI

05 List of Figures and Tables VII, VIII

06 Chapter 1: Introduction 1-8

07 Chapter 2: Interest Rate Risk Management 9-16

08 Chapter 3: Liquidity Risk Management 17-24

09 Chapter 4: Credit Risk Management 25-33

10 Chapter 5: Operational Risk Management 34-40

11 Chapter 6: Conclusion 41-44

12 Bibliography 45-46

13 Appendices 47-66

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH vi

 LIST OF FIGURES
Figure No. Figure Name Page No.

2.1 Types of Interest /Profit Rate Risk 10

2.2 Refinancing Risk 11

2.3 Reinvestment Risk 11

2.4 Interest Sensitive Gap 13

2.5 Relative IS Gap 14

2.6 Interest Sensitivity Ratio 14

3.1 Liquidity Ratio 19

3.2 10-Years Liquidity Ratio Trend 19

3.3 Variations in Liquidity Ratio 19

3.4 Advance to Deposit Ratio 20

3.5 10-Years Trend of ADR 21

3.6 3-Months Net Liquidity Gap 22

3.7 Standard Deviations in Net Liquidity Gap 22

3.8 Net Stable Funding Ratio 23

3.9 Liquidity Coverage Ratio 23

3.10 2-Years Liquidity Coverage Ratio 24

3.11 2-Years Net Stable Funding Ratio 24

4.1 Trend of Z Score 32

5.1 Gross Income for the Selected Banks 39

5.2 Capital Requirement for the Selected Banks 39

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH vii

 LIST OF TABLES
Table No. Table Name Page No.

4.1 Z Score of Commercial Banks (2007-2016) 31

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH viii

 Chapter 1
Introduction

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 1

1.1 Research Aims & Objectives

The main aim of this research is to find out the practices of risk management by
commercial banks in Bangladesh. The specific objectives is outlined below.

 To find out the interest rate risk management status

 To find out the liquidity risk management status
 To find out the credit risk management status
 To find out the operational risk management status

1.2 Research Questions

To analyze and to achieve the research objectives, some research questions are
formed stated below.
 Who manage the risk management in a commercial banks?
 What procedures are taken to mitigate each kinds of risks?
 Are the procedures or tools quantitative or qualitative in nature?
 What quantitative tools banks uses for each kinds of risks?
 How commercial banks implement Basel III in liquidity risk management?

1.3 Research Methodology

This research is done by taking 10 years data from 2007 to 2016. 10 Banks are
selected as a sample and all the banks are private commercial banks. The research is
mainly done on data from annual report published by each banks. Different ratios are
calculated from the raw data taken from annual report. The data sources are following:
 Annual report of selected banks from 2007 to 2016
 Bangladesh Bank annual report from 2007-2016
 Bangladesh Bank Financial Stability Report 2016

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 2

1.3.1 Interest Rate Risk Management
To see the effects of the interest rate changes on the bank’s net income, the banks
should calculate the rate sensitive assets and the liabilities. The bank now calculates the
gap between them. In case of duration technique, the bank should calculate the duration
of the assets and liabilities. To do all these, there are some formulas which has been used
in the report;
 Interest Sensitive Gap = Interest Sensitive Assets – Interest Sensitive Liabilities
 Relative IS Gap = IS Gap / Size of the Financial Institutions (Total Assets)
 Interest Sensitivity Ratio = ISA / ISL
∑Expected Cash Flow ×Period t / (1+YTM)t
 Duration =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑃𝑟𝑖𝑐𝑒
The results found using the above formula have been shown through using various
graphs, tables, charts and other smart arts.

1.3.2 Liquidity Risk Management

To determine, forecast and monitor liquidity risk, commercial banks uses many
liquidity ratio indicators. In this paper, Liquidity ratio, Advance to deposit ratio, Net
liquidity gap, Liquidity coverage ratio, and Net stable funding ratio have been used as
liquidity management tools. The results of these ratios are then analyzed through graph
and charts. The average and linear average is used to determine the trend for last 10
years. The standard deviations (SD) as a measurement of variance are also calculated.
The ratios with their numerator and denominator are listed below.

 Liquidity Ratio = Liquid Assets1 / Total Assets

 Advanced to Deposit Ratio (ADR) = Total Credit / Total Deposit

 3-Months Net Liquidity GAP (as a percentage of Total Assets) = (Assets up to 3

months maturity – Liabilities up to 3 months maturity)/Total Assets

1Liquid Assets = Cash in hand (including balance with Bangladesh Bank) + Balance with Balance with
other banks and financial institutions + Money at call and short notice.
RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 3
  Liquidity Coverage Ratio (LCR) = (Stock of high quality liquid assets/ Net cash
outflows over a 30 day time period) ≥ 100%

 Net Stable Funding Ratio (NSFR) = (Available stable funding/ required stable
funding) >100%

LCR should be at least 100% and NSFR must be greater than 100% as per Basel III
requirements.

1.3.3 Credit Risk Management

Altman Z-Score can be used for the bankruptcy of manufacturing industry, financial
industry and other industry. Different variables are used for different industry. In this
report the model is used for determining the bankruptcy of financial industry.

According to the model, Z = 6.56*X1 + 3.26*X2 + 6.2*x3 + 1.05*X4

Where,

X1 = Working Capital / Total Assets. This measures liquid assets as financial firm in
trouble will usually experience shrinking liquidity.

X2 = Retained Earnings / Total Assets. This indicates the cumulative profitability of the
financial firm, as shrinking profitability is a warning sign.

X3 = Earnings before Interest and Taxes / Total Assets. This ratio shows how productive
a bank or financial firm in generating earnings, relative to its size.

X4 = Market Value of Equity / Total Liabilities. This offers a quick test of how far the
company's assets can decline before the firm becomes technically insolvent (i.e. its
liabilities exceed its assets).

If Z > 2.60, the financial condition of particular institution or industry is healthy.

If Z < 1.10, the financial condition of particular institution or industry is unhealthy

If Z is between 1.10 and 2.60 the financial condition of particular institution or industry
is in grey zone indicating that the particular institution or industry is indifferent and
within near future there is a possibility of being bankrupt.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 4

1.3.4 Operational Risk Management
To calculate the capital requirement for operational risk, we use the Basic Indicator
approach as per the Basel committee.

Banking corporations using the Basic Indicator Approach must hold capital for
operational risk equal to the average over the previous three years of a fixed percentage
(denoted α) of positive annual gross income. Figures for any year in which annual gross
income is negative or zero should be excluded from both the numerator and denominator
when calculating the average. The charges may be expressed as follows:

KBIA= [∑ (GI1…n×α)] /N
Where,
KBIA = capital charge under the Basic Indicator Approach;
GI = annual gross income, where positive, over the previous three years;
N = number of the previous three years for which gross income is positive;
α = 15%, as determined by the Basel Committee, connecting between the requisite level
of capital and Indicator GI.

1.4 Literature Review

Interest rate risk is the risk that the earnings of a bank will be affected due to mismatch
of the rate sensitive assets and liabilities and also for the mismatch in the duration of the
assets and liabilities (Saunders & Cornett, 2013). According to Saunders & Cornett (2013)
there are two types of interest rate risks. These are the following;

 Refinancing Risk: The risk that the cost of reborrowing funds will increase above
the return being earned on the assets.
 Reinvestment Risk: The risk that the return from reinvesting funds will be lower
than the cost of collecting those funds.

Interest rate risk should be handled efficiently to get the maximum from it. There are two
models by which the interest rate risk could be managed (Rose & Hudgins, 2013). One is
Interest Sensitive Gap Model and the other one is Duration Gap Management.

Interest Sensitive Gap Management shows the effect of the interest rate changes on the
net interest margin of the bank due to mismatch between the rate sensitive assets and

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 5

the liabilities. Duration Gap Management shows the effect on the net worth of the bank
due to mismatch in the duration between the assets and liabilities (Rose & Hudgins,
2013).

There are some limitations of the interest sensitive gap analysis. The interest sensitive
gap management technique of interest risk management does not consider the effects of
the interest rate changes on the assets and liabilities in the balance sheet. Different
interest rates attached to the short term liabilities change faster compare to the interest
rates attached to long term assets. In practical, the duration of the assets and liabilities
can be equaled.

An asset can be said as liquid asset if it can be converted into cash within reasonable short
time and no or lower costs (Hudgins, 2013). Liquidity risk is the opposite of being liquid.
Liquidity risk can be defined as the risk of being unable to fund the portfolio of bank’s
assets at lower costs and with appropriate maturity and the risk of being unable to sell
the bank’s assets within short time and at reasonable prices (Ali, 2013; Greuning & Iqbal,
2008). Liquidity risk can be materialized into two ways according to IMF Global Financial
Stability Report (GSFR) 2011.

 Market Liquidity Risk: The risk of being unable to sell the assets in short notice
without incurring loss.
 Funding Liquidity Risk: The risk of being unable to rise funds in short notice at
reasonable cost (Ali, 2013).

Liquidity risk exists due to several reasons like high short term spread between deposits
and loan ratios, high off-balance sheet exposure, asset-liability duration mismatch and
lower investment in risk free government assets (Rahman & Banna, 2015). Islam &
Chowdhury (2009) compared the liquidity situation between an Islamic bank and a
conventional bank in Bangladesh and found that the Islamic bank had positive liquidity
gap on an average while the conventional bank had the opposite while in the long run
both the firm experienced positive liquidity gap.

Profitability ratios like EPS, P/E ratio, ROA, and ROE have a greater impact on liquidity
(Islam & Chowdhury, 2009). However, a study among six banks in Bangladesh revealed
that only ROA was affecting the liquidity risk in the case of conventional banks. The other
factors considered in the study were bank’s size, net working capital, ROE, capital

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 6

adequacy ratio which had either insignificant or negative relationship with liquidity risk
measured by cash to total assets (Rahman & Banna, 2015).

The same type of study taking into account these variables in Pakistan found that capital
adequacy ratio (CAR) in conventional banks and ROA in Islamic banks had positive and
significant relationship with liquidity risk (Akhtar, et al., 2011). Two liquidity standards
are included in Basel III namely liquidity coverage ratio (LCR) and net stable funding ratio
(NSFR). It is suggested that LCR should be at least 100% while NSFR must be greater than
100% (Basel Committee on Banking Supervision, 2010).

Froot & Stein (1998) found that credit risk management through active loan purchase
and sales activities affects banks’ investment risky loan. Banks that purchase and sell loan
hold more risky loan as a percentage of balance sheet than other banks. Again these result
results are specially striking because banks that manage their credit risk (by buying and
selling loan) holds more risky loan them banks that merely sells loan (but do not buy
them) and merely buy loan (but don’t sell them).

Khan A.R (2008) has described that Credit risk is one of the most vital risks for any
commercial banks in Bangladesh. According to him credit arise form non-performance of
the borrowers. It may arise from either inability or unwillingness to perform in the pre-
commitment contracted manner. The real risk from credit is the deviation of portfolio
performance from its expected value. The credit risk of a particular bank also affects the
book value of the bank. The more a bank faces credit risk the more the possibility it will
go for insolvency.

Uncertainty surrounding a financial firm’s earnings or rate of return due to failures in

computer systems, management errors, employee misconduct, floods, and similar events.
(Hudglns, 2013). Technology and operational risks are closely related and in recent years
have caused great concern to FI manager’s regulators alike. Indeed, so significant has
operational risk become that the BIS stated that banks should be made to carry a capital
cushion against losses from this risk. (Anthony Saunders, 2015-2016)

Principles for the Sound Management of Operational Risk and the Role of Supervision –
incorporates the evolution of sound practice and details eleven principles of sound
operational risk management covering (1) governance, (2) risk management
environment and (3) the role of disclosure. (BIS, 2011)

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 7

1.5 Structure of the Report

After the introducing part of the report including literature review, the structure of the
report follows chapter namely different types of risks. The second chapter analyzes the
interest rate risk, management, and practices. Interest sensitive gap analysis are shown.
The third chapter discusses liquidity risk management techniques. Different liquidity risk
indicators are used for analyzing the liquidity risk management. The fourth chapter
analyzes the credit risk management by discussing in the light of Altman Z score model.

Chapter 5 discusses and analyses operational risk by using basic indicator approach. The
last chapter concludes the report by portraying the findings and suggesting some
recommendations for the each of the risks type.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 8

 Chapter 2
Interest Rate Risk Management

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 9

2.1 Introduction

Interest rate risk or Profit rate risk (term used in Islamic banks) is the risk that bank’s
earnings, assets and liabilities in the financial statement will be affected by the market
interest rate or profit rate due to mismatch in amount of the rate sensitive assets and
liabilities and also for maturity or duration mismatch between the assets and liabilities.
Interest rate or profit rate highly affects the income statement items i.e. net interest
margin or net profit margin and also the balance sheet items of a bank including the
market value of the assets and liabilities and thereby the net worth. The interest rate risk
may be of two types i.e. Refinancing risk and Reinvestment risk (Saunders & Cornett,
2013).

Interest/Profit
Rate Risk

Refinancing Reinvestment
Risk Risk

Figure 2.1: Types of Interest/Profit Rate Risk

2.2 Refinancing Risk

The refinancing risk is the risk that the cost of re-borrowing funds will rise above the
returns being earned on the assets invested (Saunders & Cornett, 2013). The refinancing
risk arises when there is an increase in the market rate of return expected by the
investors. For example, a bank invests funds at a rate of 8% interest rate or profit rate for
two years but it has collected funds for one year only at the rate of 7%. Here the banks’
spread is 1%, which is the difference between the bank’s rate of return on the invested
funds and the cost of collecting those funds. Assume the cost of collecting funds increases
to 9% after one year and for this increment the banks’ cost of borrowing funds will
increase by 2% compare to before and the bank now will face a loss. It is known as re-
financing risk.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 10

 Figure 2.2: Refinancing Risk Developed by the Author

2.3 Reinvestment Risk

Reinvestment risk is the risk that the bank will reinvest funds at a lower rate of return
than the cost of borrowing those funds. Reinvestment risk arises when the market rate of
return is in the decreasing trend. For example, a bank invests funds at a rate of 8% for
one year but it has collected funds from investors for two years at 7%. Assume the profit
rate for reinvesting funds falls to 6% after one year which is below the banks’ cost of fund
of 7%. The bank now will face losses. It is known as reinvestment risk.

Figure 2.3: Reinvestment Risk Developed by the Author

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 11

2.4 Management of Interest/Profit Rate Risk

The interest rate or profit rate risk should be handled efficiently by the banks to get
the maximum from it. There are two popularly used models to minimize the interest or
profit rate risk of the banks. Almost all the banks in Bangladesh follow either one or both
the models. The models are the following;
 Interest/Rate Sensitive Gap Management
 Duration Gap Management

2.5 Interest/Rate Sensitive Gap Management

Interest/Rate Sensitive Gap Management generally shows the effect of the

interest/profit rate changes on the Net Interest Margin or Net Profit Margin which is the
result of the mismatch between the rate sensitive assets and rate sensitive liabilities. By
rate sensitive assets and liabilities, re-priceable assets and liabilities are indicated.
Repriceable assets and liabilities are those which are about to mature or which are
eligible to be renewed soon (Rose & Hudgins, 2013). Under this technique, the amount of
rate sensitive assets and the amount of the rate sensitive liabilities are determined first.
Then it is seen whether the bank is an assets sensitive or liabilities sensitive basing on
three ways of calculations. The three ways are shown below;
 Interest Sensitive Gap = Interest Sensitive Assets – Interest Sensitive Liabilities
 Relative IS Gap = IS Gap / Size of the Financial Institutions (Total Assets)
 Interest Sensitivity Ratio = ISA / ISL

2.6 Interest Sensitive Gap

Interest sensitive gap can be found by subtracting total rate sensitive liabilities from
total rate sensitive assets. The gap may be positive, negative or zero. A positive gap
indicates that the bank is asset sensitive and on this position, an increase in the interest
rate will lead to an increase in the net interest margin as interest income will increase
more compare to the interest expense and vice versa. A negative gap indicates that the
bank is liabilities sensitive and on this position, an increase in the interest rate will lead
to a decrease in the net interest margin as the interest expense will increase more
compare to the interest income and vice versa.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 12

 Figure 2.4: Interest Sensitive Gap
3.5E+10
2007
2008
2009

5E+09 2010
2011
2012
2013
-2.5E+10 2014
2015
2016

-5.5E+10

Figure 2.4 shows the interest sensitive gap for 10 years for all the commercial banks of
Bangladesh which have been taken as sample for the purpose of the study. In the year
2015 & 16, the interest sensitive gap for the SIBL and EXIM Bank is negative which
indicates liabilities sensitive interest sensitive gap. On this position if the interest rate
increases, the amount of interest expense increases more than that of interest income and
it leads to decrease in the Net Interest Income. Mercantile Bank also had negative interest
sensitive gap in the year 2013 &14. However, on an average all the banks have a positive
interest sensitive gap which indicates that if the interest rate increases in the coming
future, it will be good for them as the net interest income will increase. But if the interest
rate decreases, it will be harmful for the banks as the interest income will fall in a greater
portion than that of interest expense.

2.7 Relative Interest Sensitive Gap

Relative IS gap can be calculated by dividing the interest sensitive gap with the total
assets or size of the financial institution. If the ratio is a positive one, then the bank is an
asset sensitive one. But if the ration is a negative one, the bank is a liabilities sensitive
one. The following graph shows the relative interest sensitive gap for all the commercial
banks.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 13

 IBBL
Figure 2.5: Relative IS Gap
0.18 SIBL
SJIBL
0.12 AIBL
EXIM
0.06
EBL
0 MBL
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Brac
-0.06 DBBL
UCBL
-0.12
Average
-0.18

Figure 2.5 shows the relative IS gap for 10 years for all the commercial banks in
Bangladesh. It shows the same result which has shown by the interest sensitive gap
calculation technique in the previous stage.

2.8 Interest Sensitivity Ratio

Interest sensitivity ratio can be calculated by dividing the interest sensitive assets
with the interest sensitive liabilities. If the ratio becomes greater than 1, the bank is an
asset sensitive one. And if the ratio is less than 1, the bank is a liabilities sensitive one.
The interest sensitivity ratio for all the commercial banks is given below;

Figure 2.6: Interest Sensitivity Ratio

1.4

0.6
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

IBBL SIBL SJIBL AIBL EXIM EBL

MBL Brac DBBL UCBL Average

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 14

Figure 2.6 shows the interest sensitivity ratio for all the commercial banks in Bangladesh.
Here all the lines above 1 shows that they are asset sensitive and all the lines below 1
shows liabilities sensitive position of the bank.

2.9 Limitations of Interest Sensitive Gap Analysis

There are some limitations of the interest sensitive gap analysis. The interest sensitive
gap management technique of interest risk management does not consider the effects of
the interest rate changes on the assets and liabilities in the balance sheet.
Different interest rates attached to the short term liabilities change faster compare to
the interest rates attached to long term assets.

2.10 Duration Gap Analysis

Duration gap analysis is concerned about the duration of the assets and liabilities in a
balance sheet of a bank. Duration is the time period within which the original investment
could be recovered from an investment.
Duration gap management shows the effects of the duration mismatch between the
assets and liabilities on the net worth of the bank. The duration gap calculation needs to
find out maturity of each asset and liability and the interest rate associated with it thereby
calculating the duration using the following formula:

∑Expected Cash Flow ×Period t / (1+YTM)t

Duration =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑃𝑟𝑖𝑐𝑒

After calculating the duration of each asset, the weighted average duration gap is
calculated. To minimize the interest rate risk, the leverage adjusted duration should be
zero. This is called immunization.

There is not enough information given by the bank which is required in the duration
gap analysis. That’s why we have shown only the interest sensitive gap analysis here.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 15

2.11 Conclusion

Interest rate risk can be managed through two models i.e. Interest sensitive gap
analysis and duration gap analysis. Interest sensitive gap analysis measures the effect of
the interest rate changes on the net interest income whereby the duration gap analysis
shows the effect of the interest rate changes on the net worth of the bank. Interest
sensitive gap analysis works on the items of the income statement and duration gap
analysis works on the items of the balance sheet of a bank.

From the interest sensitive analysis it is found that almost all the banks in Bangladesh
are asset sensitive which indicates that if the interest rate increases, the bank’s net
interest margin will also be increased as the interest income from assets will be higher
than the interest expense on the liabilities and vice versa. There is a major limitation of
the interest sensitive gap analysis which is different interest rates attached to the short
term liabilities change faster compare to the interest rates attached to long term assets.
The duration gap on the other hand shows the effect of the interest rate changes on the
net worth of the bank when there is mismatch of duration between the assets and
liabilities.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 16

 Chapter 3
Liquidity Risk Management

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 17

3.1 Introduction

Liquidity risk is the risk of being illiquid. To avoid any liquidity stress, financial
institutions need to keep liquid assets. But liquid assets have inverse relationship with
profitability as cash or liquid assets earn nothing almost. So, Banks or financial
institutions have to maintain enough liquid assets but not excess liquid assets (Ali, 2013).

The Asset Liability Management Committee (ALCO) looks after the liquidity risk and
liquidity position. Liquidity management are normally assessed by determining expected
cash outflow and cash inflow of the future. The committee of risk management uses
certain liquidity risk indicators to monitor liquidity risk.

3.2 SLR & CRR

Commercial banks have to maintain cash reserve ratio (CRR) and statutory liquidity
ratio (SLR) as regulatory requirements. The required ratio of CRR is 6.5% of total demand
and time liabilities. The required ratio of SLR is 5.5% for Islamic banks and 13% for
conventional banks.2 The banks maintain CRR in cash with Bangladesh Bank (BB), and
are allowed to hold government securities for maintaining SLR (Bangladesh Bank, 2017).

Besides maintaining SLR and CRR as a regulatory requirements, several others

liquidity indicator ratios like advance to deposit (ADR) ratio, maximum cumulative
outflow (MCO), medium term stable funding ratio, liquid assets to total deposit ratio,
liquid assets to short term liabilities ratio are calculated to monitor and to mitigate the
liquidity risk. The liquidity risk indicators suggested in Basel III are being implemented
from 2015.

3.3 Liquidity Ratio

The liquidity ratio indicates the amount of liquid assets as a percentage of total assets
available to meet the liquidity requirement. Cash and balance with Bangladesh Bank is

2 This rate is effective from 2014 (Bangladesh Bank Annual Report 2015-2016, p. 25)
RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 18
the most liquid asset and earns nothing for the banks. These are also used as assets for
CRR calculation. Other liquid assets such as balance with other commercial banks and
money at call and short notice provides avenue for keeping liquid assets. High amount of
liquid assets hamper banks’ profitability. To meet the liquidity demands immediately
banks have to keep certain amount of money as liquid assets.

Figure 3.1: Liquidy Ratio

30.00%
EBL
25.00% Mercantile
Brac
20.00%
DBBL

15.00% UCBL
IBBL
10.00%
SIBL
EXIM
5.00%
Shahjalal
0.00% AIBL
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Figure 3.1 and Figure 3.2 shows that the linear trend of liquidity is quite stable which
is above 14% on an average among the last 10 years. The variations among the banks
measured by standard deviations (SD) are shown in figure 3.3.

Figure 3.2: 10-Years Liquidy Figure 3.3: Variations in Liquidity

Ratio Trend Ratios
18.00% 7.00%
16.00% 6.00%
14.00% 5.00%
12.00%
4.00%
10.00%
3.00%
8.00%
6.00% 2.00%
4.00% 1.00%
2.00% 0.00%
0.00% 20 20 20 20 20 20 20 20 20 20
07 08 09 10 11 12 13 14 15 16
SD 5.8 4.2 4.2 4.3 4.0 4.4 4.6 5.2 4.0 2.9

Average Linear (Average) SD Linear (SD)

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 19

 The variations were in between 4% to 5% for the most of the years with a slightly
decreasing trend. The low degree of variations indicate that money market is doing their
job effectively. However, the variations can be reduced further by utilizing the money
market more effectively so that no one need to keep cash idle while others face liquidity
problems.

3.4 ADR

Advanced to Deposit Ratio (ADR) is also called the deployment ratio, financing to
deposit ratio or investment to deposit ratio in case of Islamic banks. ADR is the most
widely used measures of liquidity risk indicators. Higher ADR means higher liquidity risk
(Ali, 2013).

Figure 3.4: Advance to Deposit Ratio (ADR)

120.00%
IBBL
100.00% EXIM
Shahjalal
80.00%
SIBL

60.00% AIBL
EBL
40.00%
Mercantile

20.00% Brac
DBBL
0.00% UCBL
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

The ADR was quite stable among last 10 years except from 2012-2014. In this three
years, the growth of credit was lower than the growth of deposit. The liner trend in figure
3.5 shows slightly decreasing trend for the last 10 years indicates that the risk of being
illiquid is being reduced. The maximum allowable ADR was set as 85% for conventional
banks and 90% for Islamic banks from 2011 (Financial Stability Department, BB, 2017).
The limit was set by Bangladesh Bank to reduce any liquidity pressure on commercial
banks.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 20

 Figure 3.5: 10-Years Trend of ADR
92.00%
90.00%
88.00%
86.00%
84.00%
82.00%
80.00%
78.00%
76.00%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Average 88.71% 89.04% 86.45% 90.09% 87.40% 83.29% 81.99% 82.12% 84.96% 87.39%

Average Linear (Average)

3.5 Liquidity Gap

The average deposits of banks are of short term maturity though the average loan or
investment assets bear longer term maturity. Banks provides this maturity
transformation facilities and are exposed to liquidity risk by providing this service. How
much a bank is exposed to maturity transformation risk can be calculated by calculating
the difference between total assets of specific maturity and total liabilities of that
maturity. Banks measure different maturity buckets for assets and liabilities. The
common practice in Bangladesh for reporting maturity buckets is for up to 1 months, 1-3
months, 3-12 months, 1-5 years, and more than 5 years. The assets and liabilities up to 3
months buckets3 are for this analysis.

3 The 3 months bucket is found by adding the assets and liabilities up to 1 month, and 1 to 3 months.
RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 21
 Figure 3.6: 3-Months Net Figure 3.7: Standard
Liquidity Gap Trend Deviation in Net Liquidity
2.00% Gap
1.50% 16.00%
Percentage of Total Assets

1.00%
14.00%
0.50%
12.00%
0.00%
-0.50% 10.00%
-1.00% 8.00%
-1.50% 6.00%
-2.00%
4.00%
-2.50%
-3.00% 2.00%
-3.50% 0.00%
2012 2013 2014 2015 2016 2012 2013 2014 2015 2016
Average -3.18% -0.81% -0.34% 1.32% 0.04% SD 11.11% 9.44% 13.75% 11.81% 11.72%

High positive and negative liquidity gap indicates the potential liquidity problems
(Ali, 2013).The net liquidity gap as a percentage of total assets is found negative from
2012 to 2014 and positive for 2015 and 2016. The negative gap shows that the banks face
lack of short term assets as compared to short term liabilities and the positive gap shows
the short term assets are higher than the funds banks raise. The negative gap shows banks
are exposed to liquidity transformation risk for this maturity of assets buckets. The
percentage however is very low indicates less risky position. But, this is not the case for
all the banks as the variations measures by standard deviations shown in figure 3.7 are
quite high, more than 10% among the last 5 years. The high variations show that some
banks have much higher liquidity gap than others.

3.6 Basel III Liquidity Risk Indicators

The time set to implement Basel III in Bangladesh is from 2015 to 2019. There are two
regulatory standards namely liquidity coverage ratio (LCR), and net stable funding ratio
(NSFR). LCR enables banks to withstand a month long liquidity stress and NSFR
emphasize on more long term funding to minimize the maturity mismatch ratio (Ali,
2013). LCR is calculated by dividing ‘stock of high quality liquid assets’ by ‘net cash
outflows over a 30 day time period’, and NSFR is calculated by diving ‘available stable
funding’ by ‘required stable funding’. LCR should be at least 100% and NSFR must be
greater than 100% (Basel Committee on Banking Supervision, 2010).

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 22

 Figure 3.8: Net Stable Funding Ratio (NSFR)
Average
AIBL
Shahjalal
EXIM
SIBL
IBBL
UCBL
DBBL
Brac
Mercantile
EBL
0.00% 20.00% 40.00% 60.00% 80.00% 100.00% 120.00% 140.00%

2016 2015

Figure 3.9: Liquidity Coverage Ratio (LCR)

Average
AIBL
Shahjalal
EXIM
SIBL
IBBL
UCBL
DBBL
Brac
Mercantile
EBL
0.00% 20.00% 40.00% 60.00% 80.00% 100.00% 120.00% 140.00% 160.00% 180.00% 200.00%

2016 2015

Figure 3.8 and 3.9 shows that most of the banks maintains LCR and NSFR more than
the requirement of 100%. Figure 3.10 and 3.11 shows that the average LCR and NSFR is
satisfactory. The ratio is decreased from 2015 for both NSFR and LCR indicates banks are
minimizing excess liquid assets that earns almost nothing and long term funding that
costs high amount but maintains the regulatory requirements.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 23

 FIG U RE 3.10: 2 - YEARS FIG U RE 3.11: 2 - YEARS
LIQ U IDITY COVE RAG E NE T STABLE FU NDING
RATIO ( LCR) RATIO ( NSFR)

113.19%
134.92%

114.51%

109.42%
AVERAGE AVERAGE

2015 2016 2015 2016

3.7 Conclusion

The above analysis shows that banking industry in Bangladesh maintains healthy
liquidity conditions in overall. Banks maintains all the regulatory requirements on an
average. The Asset Liability Management Committee (ALCO) of each bank monitors the
liquidity risk by maintaining and analyzing these ratios. Banks normally uses liquidity
contingency plan to avert any unwarranted risk.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 24

 Chapter 4
Credit Risk Management

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 25

4.1 Introduction
Credit risk means the risk of credit loss those results from the failure of a borrower to
honor the borrower’s credit obligation to the financial institution. Credit risk is most
simply defined as the potential that a bank borrower or counterparty will fail to meet its
obligations in accordance with agreed terms (Basel Committee on Banking Supervision,
2000). To manage or minimize the credit risks the commercial banks of Bangladesh tries
to conduct the credit management activities in a very rigorous way. Credit risk
management is the process of managing the capital assets of banks and the loss of loan
reserves. The goal of credit risk management is to maximize a bank's risk-adjusted rate
of return by maintaining credit risk exposure within acceptable parameters. Normally
Banks use two approaches for managing and minimizing credit risk. These approaches
are given below:

1. Qualitative approaches

2. Quantitative approaches

4.2 Qualitative approaches

In Qualitative approaches theoretical aspects of credit management and minimization are
emphasized. In Bangladesh most of the banks normally conduct the borrower evaluation
activities to identify the potential credit risk or default risk of borrowers. In borrower
evaluation 5C analysis is commonly used by commercial banks of Bangladesh.

4.2.1 5C’S of Credit analysis

The Five C's Of Credit Analysis is an informal mnemonic of a set of Risk Factor that are
commonly thought be influential in determining Credit Quality, in particular for business
lending. In the following ways the banks determine the credit quality of a borrowers.

Character: Each lender has its own formula or approach for determining a borrower's
character, but this assessment typically includes analyzing the debtor's educational
background, personal or business references, and credit history or score. Although each
of these factors plays a role in determining the borrower's character, lenders place more
weight on the credit history and score. If a borrower has not managed past debt
repayment well or has a previous bankruptcy, his character is deemed less acceptable
than a borrower with a clean credit history.
RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 26
Capacity: Before an application for a loan can be approved, lenders must be sure that the
borrower has the ability to repay the loan based on the proposed amount and terms. For
business loan applications, the financial institution reviews the company's past cash flow
statements to determine how much income is expected from operations. Individual
borrowers provide detailed information about the type of income earned as well as the
stability of their employment.

Capital: Banks also analyze a borrower's capital level when determining

creditworthiness. Capital for a business loan application consists of personal investment
into the business, retained earnings and other assets owned by the business owner. For
personal loan applications, capital consists of savings or investment account balances

Collateral: Collateral, or guarantees, are additional forms of security that a borrowers

need to provide the banks. The reason the bank is interested in collateral is as a secondary
source of repayment of the loan. If the company is unable to generate sufficient cash flow
to repay the loan at some point in the future, the bank wants to be comfortable that it will
be able to recover its loan by liquidating the collateral and using the proceeds to pay off
the loan.

Condition: As a more subjective factor in creditworthiness, banks analyze the conditions

under which the loan is being made. They review conditions such as the strength or
weakness of the overall economic environment and the purpose of the loan.

4.2.2 Credit Risk Management processes of commercial banks in Bangladesh

1. Credit Processing/Appraisal
Credit processing is the stage where all required information on credit is gathered and
applications are screened. Credit application forms should be sufficiently detailed to
permit gathering of all information needed for credit assessment at the outset. In this
connection, a bank has a checklist to ensure that all required information is, in fact,
collected. banks set out pre-qua action screening criteria, which would act as a guide for
their officers to determine the types of credit that are acceptable. For instance, the
criteria may include rejecting applications from blacklisted customers. These criteria
would help institutions avoid processing and screening applications that would be later
rejected.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 27

2. Credit-approval/Sanction
A bank has in place written guidelines on the credit approval process and the approval
authorities of individuals or committees as well as the basis of those decisions. Approval
authorities are sanctioned by the board of directors. Approval authorities will cover new
credit approvals, renewals of existing credits, and changes in terms and conditions of
previously approved credits, particularly credit restructuring, all of which are fully
documented and recorded. Prudent credit practice requires that persons empowered
with the credit approval authority should not also have the customer relationship
responsibility.

3. Credit Documentation
Documentation is an essential part of the credit process and is required for each phase of
the credit cycle, including credit application, credit analysis, credit approval, credit
monitoring, and collateral valuation, and impairment recognition, foreclosure of
impaired loan and realization of security. The format of credit files must be standardized
and files neatly maintained with an appropriate system of cross-indexing to facilitate
review and follow up.

4. Credit Administration
Every commercial bank of Bangladesh need to ensure that their credit portfolio is
properly administered, that is, loan agreements are duly prepared, renewal notices are
sent systematically and credit files are regularly updated. Normally a bank allocates its
credit administration function to a separate department or to designated individuals in
credit operations, depending on the size and complexity of its credit portfolio (Credit Risk
Management: Industry Best Practices2005, Bangladesh Bank).

5. Disbursement
Once the credit is approved, the customers are advised of the terms and conditions of the
credit by way of a letter of offer. The duplicate of this letter is duly signed and returned
to the institution by the customer. The facility disbursement process start only upon
receipt of this letter and should involve the completion of formalities regarding
documentation, the registration of collateral, insurance cover in the institution’s favor
and the vetting of documents by a legal expert.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 28

6. Monitoring and Control of Individual Credits
To safeguard banks against potential losses, problem facilities are needed to be identified
early. A proper credit monitoring system will provide the basis for taking prompt
corrective actions when warning signs point to deterioration in the financial health of the
borrower. Examples of such warning signs include unauthorized drawings, arrears in
capital and interest and deterioration in the borrower’s operating environment (Morton
Glantz, 2002).

7. Monitoring the Overall Credit Portfolio (Stress Testing)

An important element of sound credit risk management is analyzing what could
potentially go wrong with individual credits and the overall credit portfolio if
conditions/environment in which borrowers operate change significantly. The results of
this analysis are then be factored into the assessment of the adequacy of provisioning and
capital of the institution. Such stress analysis can reveal previously undetected areas of
potential credit risk exposure that could arise in times of crisis (Morton Glantz, 2002).

4.3 Quantitative approaches

In Quantitative approaches mathematical model and analysis of credit management and
minimization are emphasized. Although in Bangladesh usage of quantitative approaches
or models is not popular unlike qualitative approaches for managing and minimizing
credit risk. Numerous models can be used for credit risk of a particular. These models
are:

 liner probability model,

 linear discriminant models,
 Mortality rate approach,
 RAROC model,
 Option model etc.
Among them the most important and popular model is Linear discriminant models or
Altman’s discriminant function. This model is mostly applicable for the commercial banks
of Bangladesh to manage and minimize their credit risk. The details and the application
of the model for the commercial banks of Bangladesh have been discussed below:

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 29

4.3.1 Altman Z-Score
The Altman Z-Score (named after Edward Altman, the New York University professor
who devised it) is a statistical tool used to measure the likelihood that a company will go
bankrupt. The formula may be used to predict the probability that a firm will go into
bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-
to-calculate control measure for the financial distress status of companies in academic
studies. The Z-score uses multiple corporate income and balance sheet values to measure
the financial health of a company. Altman Z-Score can be used for the bankruptcy of
manufacturing industry, financial industry and other industry. Different variables are
used for different industry. In this report the model is used for determining the
bankruptcy of financial industry.

According to the model, Z = 6.56*X1 + 3.26*X2 + 6.2*x3 + 1.05*X4

Where,

X1 = Working Capital / Total Assets. This measures liquid assets as financial firm in
trouble will usually experience shrinking liquidity

X2 = Retained Earnings / Total Assets. This indicates the cumulative profitability of the
financial firm, as shrinking profitability is a warning sign.

X3 = Earnings before Interest and Taxes / Total Assets. This ratio shows how productive
a bank or financial firm in generating earnings, relative to its size.

X4 = Market Value of Equity / Total Liabilities. This offers a quick test of how far the
company's assets can decline before the firm becomes technically insolvent (i.e. its
liabilities exceed its assets).

If Z > 2.60, the financial condition of particular institution or industry is healthy.

If Z < 1.10, the financial condition of particular institution or industry is unhealthy

If Z is between 1.10 and 2.60 the financial condition of particular institution or industry
is in grey zone indicating that the particular institution or industry is indifferent and
within near future there is a possibility of being bankrupt.

To conduct the study 10 commercial banks have been taken as a sample based on
judgmental sampling to represent the overall situation all commercial banks in

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 30

Bangladesh. The possibility of bankruptcy or credit risk of selected banks of Bangladesh
from 2007 to 2016 by using the Altman’s Z score model has been given below:

Table 4.1: Z score of commercial banks (2007 – 2016)

Year Value of Z Financial
position
2007 6.56*.463714+ 3.26*.013618+ 6.72*.119907 + Healthy or
1.05*.092592 =3.99 sound
position
2008 6.56*.513121+ 3.26*.017045+ 6.72* .111789+ Healthy or
1.05*.101496 = 4.27 sound
position
2009 6.56*.498966+ 3.26*.015299+ 6.72* .101367+ Healthy or
1.05*.093469 =4.10 sound
position
2010 6.56*.437111+ 3.26*.01328+ 6.72* .087783+ Healthy or
1.05*.098271= 3.48 sound
position
2011 6.56*.492267+ 3.26*.010994+ 6.72* .088983+ Healthy or
1.05*.097696 = 4.10 sound
position
2012 6.56*.496789 + 3.26*.009117+ 6.72*.083981 + Healthy or
1.05*.089709 =3.94 sound
position
2013 6.56* .49074+ 3.26*.009505+ 6.72* .084943+ Healthy or
1.05*.095889= 3.79 sound
position
2014 6.56*.49605 + 3.26*.00929+ 6.72* .071247+ Healthy or
1.05*.0887828 = 3.85 sound
position
2015 6.56*.43057 + 3.26*.015873+ 6.72*.065677 + Healthy or
1.05*.085424 = 3.40 sound
position
2016 6.56* .389261+ 3.26*.014615+ 6.72* .054881+ Healthy or
1.05*.082657= 3.06 sound
position
Source: Annual Report of 10 Commercial banks (2007-2016)

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 31

 FIG U RE 4.1: TRE ND O F Z SCO RE

4.27
3.99

4.1

4.1

3.94

3.85
3.79

3.79
3.48

3.4

3.06
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 AVERAGE

Source: Annual Report of 10 Commercial banks (2007-2016)

Explanation:
Here the Z score 0f 2007 has been used to determine the financial condition of banks for
2008. In 2007 the value of Z is 3.99 which indicates the financial condition (in terms of
credit risk) of selected commercial banks of Bangladesh is in a healthy and sound
position. It is not only in case of 2007 but also for all the years till 2016 where the Z value
score is higher than 2.60. According to the model if the Z score of particular institution or
industry in particular year is higher than 2.60 it is seemed as healthy position.

The average Z score from 2007 to 2016 of the commercial banks based on selective banks
as ample is 3.79. So it can be recommended that the financial condition of the industry is
in a healthy, optimal or sound position. From this graph an important point is realized
that from 2016 to 2015 the Z sore is somewhat less compared to those in other years
because in these year the liability of banks is higher than that in other year. So finally it is
concluded that there is no possibility of bankruptcy in the banking industry in near future
as its position is sound and healthy based on Altman’s Z score.

4.3.2 The reason for choosing Altman Z-Score over other models
 Altman Z-Score is a popular model used by most of the company from financial to
manufacturing company.
 The model uses more variables of financial statements of a company for finding
the possibility of defaulting.
 The Z score provides a quantitative measurement into a company’s financial
health.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 32

  The Z-Score highlights factors contributing to a company’s financial health and
uncovers emerging trends that indicate improvements or deterioration in
financial condition.
 The Z-score is based on actual financial information derived from the operating
performance of the business enterprise. It avoids biases of subjective assessments,
conflicts of interest, brand and large company bias.
 The Z-Score employs no theoretical assumptions or market inputs external to the
company’s financial statements.
 This provides users of the Z score with a consistent view and understanding of a
company’s true financial health
 The variables like working capital, Retained earnings, market value of equity etc.
which are very sensitive increases the reliability of the model.

4.4 Conclusion

It is evident from the data of last ten years is that the banking industry in Bangladesh is overall
healthy in their credit rating and credit risk assessment. However, the trend is in decreasing
mode showing some problems in the industry.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 33

 Chapter 5
Operational Risk

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 34

5.1 Introduction
Operational risk is defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems, or from external events. Operational risks vary in their
components. Some are very high occurrence with low impact and some are low
occurrence with high impact risks. Third consultative paper of Basel-II recommended
following event based classification of operational risks:
» Internal fraud;
» External fraud;
» Employment practices and workplace safety;
» Client, products and business practices;
» Damage to physical assets;
» Business disruption and system failure;
» Execution, delivery and process management.

5.2 Fundamental principles of operational risk management

Principle 1: The board of directors should take the lead in establishing a strong risk
management culture. The board of directors and senior management should establish a
corporate culture that is guided by strong risk management and that supports and
provides appropriate standards and incentives for professional and responsible behavior.
In this regard, it is the responsibility of the board of directors to ensure that a strong
operational risk management culture exists throughout the whole organization.
Principle 2: Banks should develop, implement and maintain a Framework that is fully
integrated into the bank’s overall risk management processes. The Framework for
operational risk management chosen by an individual bank will depend on a range of
factors, including its nature, size, complexity and risk profile.

5.2.1 Governance

5.2.1.1 The Board of Directors

Principle 3: The board of directors should establish, approve and periodically review the
Framework. The board of directors should oversee senior management to ensure that the
policies, processes and systems are implemented effectively at all decision levels.
Principle 4: The board of directors should approve and review a risk appetite and
tolerance statement for operational risk that articulates the nature, types, and levels of
RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 35
operational risk that the bank is willing to assume.

5.2.1.2 Senior Management

Principle 5: Senior management should develop for approval by the board of directors a
clear, effective and robust governance structure with well defined, transparent and
consistent lines of responsibility. Senior management is responsible for consistently
implementing and maintaining throughout the organization policies, processes and
systems for managing operational risk in all of the bank’s material products, activities,
processes and systems consistent with the risk appetite and tolerance.

5.2.2 Risk Management Environment

5.2.2.1 Identification and Assessment

Principle 6: Senior management should ensure the identification and assessment of the
operational risk inherent in all material products, activities, processes and systems to
make sure the inherent risks and incentives are well understood.
Principle 7: Senior management should ensure that there is an approval process for all
new products, activities, processes and systems that fully assesses operational risk.

5.2.2.2 Monitoring and Reporting

Principle 8: Senior management should implement a process to regularly monitor
operational risk profiles and material exposures to losses. Appropriate reporting
mechanisms should be in place at the board, senior management, and business line levels
that support proactive management of operational risk.

5.2.2.3 Control and Mitigation

Principle 9: Banks should have a strong control environment that utilizes policies,
processes and systems; appropriate internal controls; and appropriate risk mitigation
and/or transfer strategies.

5.2.2.4 Business Resiliency and Continuity

Principle 10: Banks should have business resiliency and continuity plans in place to
ensure an ability to operate on an ongoing basis and limit losses in the event of severe
business disruption.

5.2.2.5 Role of Disclosure

Principle 11: A bank’s public disclosures should allow stakeholders to assess its

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 36

approach to operational risk management.

5.3 Operational Risk Approaches

There are two approaches for Operational Risk. They are the following-
» Qualitative Approach
» Quantitative Approach

5.3.1 Qualitative Approach

5.3.1.1 Views of BOD on system to reduce Operational Risk

Operational risk is the risk of loss or harm resulting from inadequate or failed of internal
processes, people and systems or from external events. Capability to carry out a large
number of transactions effectively and accurately while complying with applicable laws
and regulations constitute operational risk management activities of the bank.

The policy for operational risks including internal control & compliance risk is approved
by the Board taking into account relevant guidelines of Bangladesh Bank. Audit
Committee of the Board directly oversees the activities of Internal Control & Compliance
to protect against all operational risk.

5.3.1.2 Performance Gap of Executives and Staffs

Training and knowledge sharing is the best way to reduce knowledge gap. Banks should
arrange trainings on a regular basis for its employees to develop their expertise.

5.3.1.3 Potential external events

Banking business operates in an umbrella of inter-related between socioeconomic and
political environment. There are certain risk factors which are external in nature and can
affect directly or indirectly the business of the bank. The risk factors are mentioned below:
» Macro-economic condition;
» Regulatory changes;
» Change in demand;
» Volatility in equity market;
» Changes in market conditions;
» Political instability;
» Threat of vandalism to the bank’s sophisticated physical outlets including

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 37

 IT equipment’s etc.

5.3.1.4 Policies and processes for mitigating operational risk

The Banks have adopted policies which deal with managing different Operational Risk.
Banks strongly follow KYC norms for its customer dealings and other banking operations.
The Internal Control and Compliance Division of the Banks, the inspection teams of
Bangladesh Bank and External Auditors conduct inspection of different branches and
divisions at Head Office of the Banks and submit reports presenting the findings of the
inspections. Necessary control measures and corrective actions have been taken on the
suggestions or observations made in these reports.

5.3.2 Quantitative Approach

The Banks have adopted Basic Indicator Approach (BIA) to compute capital charge
against operational risk under Basel-III as per Bangladesh Bank Guidelines.

5.3.2.1 The Basic Indicator Approach

Banking corporations using the Basic Indicator Approach must hold capital for
operational risk equal to the average over the previous three years of a fixed percentage
(denoted α) of positive annual gross income. Figures for any year in which annual gross
income is negative or zero should be excluded from both the numerator and denominator
when calculating the average. The charges may be expressed as follows:

KBIA= [∑ (GI1…n×α)] /N
Where,
KBIA = capital charge under the Basic Indicator Approach;
GI = annual gross income, where positive, over the previous three years;
N = number of the previous three years for which gross income is positive;
α = 15%, as determined by the Basel Committee, connecting between the requisite level
of capital and Indicator GI.

Gross income is defined as net interest income plus net non-interest income. It is intended
that this measure should:
(i) Be gross of all provisions (e.g., interested not yet paid);
(ii) Be gross of operating expenses, including fees paid to outsource service providers;

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 38

(iii) Exclude realized profit/losses from the sale of securities in the banking book; and
(iv) Exclude extraordinary or irregular items as well as income derived from insurance.

5.4 Capital Requirement for the selected banks under BIA from 2010 to 2016

We have selected ten banks as a sample for our study. We have taken ten years data
for calculating capital requirement under basic indicator approach.

35000
2007
30000
2008
25000
2009
20000
2010
15000
2011
10000 2012
5000 2013
0 2014
2015
2016

Figure-5.2: Gross Income of the selected banks

4500
4000
3500 2010
3000
2011
2500
2000 2012
1500 2013
1000
2014
500
0 2015
2016

Figure-5.1: Capital Requirement of the selected banks for operational risk

From normal sense, we know that there is a positive relationship between the bank size
and operational risk. Above we see that the capital requirement of the selected banks has
increased as the gross income of the banks increases.

So, we can conclude the conclusion that if the bank size is increased, the threat of

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 39

operational risk will also be increased.

5.5 Conclusion
We can conclude the conclusion that if the bank size is increased, the threat of operational
risk will also be increased.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 40

 Chapter 6
Conclusion

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 41

6.1 Introduction

This chapter conclude the paper by portraying the findings of the research and
suggesting some recommendations that concerned authority and banks management can
take to reduce and mitigate their risk exposure up to a certain level.

6.2 Findings of the research

6.2.1 Findings on Interest rate risk management

 Almost all the banks in Bangladesh uses the interest sensitive gap management
compare to duration gap management technique.
 On an average, all the commercial banks except some banks, are asset sensitive
rather than liabilities sensitive as they have a positive IS gap, positive relative
IS ratio and interest sensitivity ratio more than 1.
 More rate sensitive assets over the liabilities indicate that the banks are prone
to interest rate risk when the interest rate decreases in the market. Too
positive gap indicates significant loss for the banks. But the banks will be
benefited if the interest rate increases as the net interest margin will be
increased.

6.2.2 Findings on Liquidity risk management

 The trend of liquidity ratio is quite stable which is above 14% on an average
among the last 10 years with a slight variations from 4% to 5%.The low
variations indicates the money market is doing the job effectively and
sufficient liquid instruments are available in the market.
 ADR ratio is also quite stable and remains below the maximum level set by
Bangladesh Bank. The ratio has a slightly decreasing trend among the last 10
years indicates that the deposit is growing more rapidly than that of credit.
 The net liquidity gap is very low indicates less riskiness. However, the
variations are quite high more than 10% indicates some banks are in risky
position.
 The LCR and NSFR remains more than 100% for last two years. The percentage
for 2016 however decrease from 2015.
RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 42
6.2.3 Findings on Credit risk management
 The financial condition of commercial banks in Bangladesh is very sound and
healthy in terms of credit risk. There is a little possibility of being bankrupt in near
future.
 Altman Z- Score can properly be applied by any banks in Bangladesh for
identifying their credit risk if they want.
 The amount of variables (used in the model) like working capital, retained
earnings, EBIT, market value of equity is stable over the years which shows a
bright scenario for the commercial banks in Bangladesh.

6.2.4 Findings on Operational risk management

 Operational risks of the banks are increased year by year.
 There is a positive relationship between the bank size and operational risk.

6.3 Recommendations

6.3.1 Recommendations for Interest rate risk management

 The banks should reduce the rate sensitive assets or increase the rate sensitive
liabilities to make the gap zero or close to zero.
 The banks may use the duration gap model to see the effects of the interest rate
on the net worth of the bank.

6.3.2 Recommendations for Liquidity risk management

 New money market instruments can be introduced so that the liquidity ratio
variations among the banks reduced further.
 The maximum level of ADR ratio can be increased further so that the banks can
contribute more positively to the country’s economy.
 Banks should emphasize on more stable funding to reduce the maturity
transformation risk.
 Bangladesh Bank should monitor the LCR and NSFR of commercial banks so
that they maintains the ratio more than 100%.

6.3.3 Recommendation on Credit risk management

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 43

  Besides using 5 Cs analysis the banks can use PRISM model of credit risk
management for identifying the credit risk. In PRISM, P= Perspective, R=
repayment, I= Intention, S = Safeguards, M= Management.
 The banks should focus more on the Altman Z-Score model for identifying their
credit risk. Besides they can use other model to be in a safe zone regarding credit
risk.
 The banks should always maintain its financial variables or items stable and
consistent to be free from credit risk.

6.3.4 Recommendation for Operational risk management

 Banks should emphasize more on qualitative approach to minimize operational
risk.

RISK MANAGEMENT OF COMMERCIAL BANKS IN BANGLADESH 44

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