Department of Banking and Insurance

Credit Management
7th Semester Final Examination
Study Manual

Maker: The Notorious

 Course Title: Credit Management
Course Code: BI 404
INTRODUCTION
Makers: (The Notorious)
Sudipta Barua (6th Batch) Aysha Siddiquea ( 6th Batch)
Md. Obaidul Hasan (6th Batch) Nur Naher (6th Batch)
Department of Banking & Insurance
Faculty of Business Administration

1 Introduction to Bank Credit

Credit:
Credit is a financial concept that refers to the ability of an individual or entity to borrow
money or access goods and services with the understanding that they will repay the
borrowed funds or cover the cost of the goods and services at a later date.
Credit involves a creditor (lender or provider of goods/services) extending trust and
allowing the borrower (debtor or recipient) to use funds or resources temporarily, with
the expectation that they will be paid back, typically with interest or fees, over time.
Basic Differences between credit and Investment:

Factor Credit Investment

Purpose Borrowing money or Acquiring assets or
accessing goods/services financial instruments to
with an obligation to repay generate returns and
profits over time.
Ownership No ownership acquired, Ownership or stake in an
temporary use of funds asset or financial
and goods.
Risk and Return Lower risk for creditor; Varying risk level
returns for creditor depending on asset type,
(interest , fees ) borrower potential for higher return
bears repayment risk but also risk of losing
capital.
Timeframe Short to medium term Long term
Purpose of funds Immediate or near term Long term financial
expenses (car , education) objectives( retirement or
wealth accumulation)

Or,
1. Purpose:
 Credit: The primary purpose of credit is to borrow money or access
goods/services with the expectation of repayment. It is used to meet
immediate financial needs
 Investment: The primary purpose of investment is to use money to acquire
assets or financial instruments with the goal of generating returns or
profits over time. Investments are typically made to grow wealth

2. Ownership:
 Credit: When you use credit, you do not gain ownership of an asset.
Instead, you acquire the benefit of using borrowed funds or goods
temporarily, with an obligation to repay.
 Investment: Investment involves acquiring ownership or a stake in an
asset, such as stocks, bonds, real estate, or a business. Investors hold assets
with the expectation of benefiting from capital appreciation, income
generation, or both.
3. Risk and Return:
 Credit: Credit transactions are generally lower risk for the creditor (lender)
because they expect repayment with interest or fees.
 Investment: Investments come with varying levels of risk, depending on
the chosen asset or investment vehicle. Investments offer the potential for
higher returns, but they also carry the risk of losing some or all of the
invested capital.

4. Timeframe:
 Credit: Credit transactions are typically short to medium-term, with
borrowers expected to repay the borrowed funds within a specified
period, which could range from months to years.
 Investment: Investments are typically long-term in nature, and investors
often hold assets for an extended period, sometimes many years or even
decades, to achieve their financial goals.
5. Purpose of Funds:
 Credit: Credit is usually used to finance immediate or near-term expenses,
such as purchasing a car, paying for education, or covering everyday living
expenses.
 Investment: Investment involves allocating funds with the aim of achieving
long-term financial objectives, such as retirement savings, wealth
accumulation, or generating income over time.
6. Ownership of Risk:
 Credit: The borrower primarily bears the responsibility for managing and
mitigating the risk associated with credit. Failure to repay credit can
negatively impact the borrower's creditworthiness.
 Investment: Investors take on the risk associated with their investment
choices, such as market volatility or asset-specific risks. They have the
potential to benefit from investment gains but may also incur losses.
7. Returns:
 Credit: Credit transactions generate returns for the creditor in the form of
interest payments, fees, or other charges.
 Investment: Investments have the potential to generate returns through
capital appreciation, dividends, interest income, or rental income,
depending on the type of asset or investment.
 Types of Credit Facilities :
A) Funded and
B) Non-funded.

A. Funded Credit:
A funded credit facility means the actual disbursement of cash to the customer or to any
designated supplier of the customer. In order to provide a funded facility to a customer
the bank has to incur real liability beforehand, i.e; the bank has to arrange for funds
primarily through accepting deposits or otherwise .
Funded facility affects the balance sheet of the bank both in terms of increase of liability
and increase of assets. Funded credit facilities may be classified into four types:
i) Loans ii) Cash Credit iii) Overdraft and iv) Bill Purchased & discount.

Funded Credit Facilities:

1. Loans may be a 'demand loan' or 'time loan' or 'term loan'. A demand loan is payable on
demand which is allowed for a short period to meet short-term working capital needs. Time loan
is payable within one year and a term loan is allowed for one year to five years, usually for capital
expenditures such as the construction of a factory building, purchase of new machinery,
modernization of plant etc.

2. Cash Credit facility is allowed against pledge or hypothecation of goods. Under this
arrangement, the borrower can borrow at any time within the agreed limit and can deposit
money to adjust whenever he does have surplus cash in hand.

3. Overdraft is an arrangement between a banker and his customer by which the latter is
allowed to withdraw over and above his credit balance in his current account. This is a temporary
accommodation of funds to the client.

4. Bill discounted and purchased

Discount: Banks allow advances to the clients by discounting a bill of Exchange/promissory note
which matures after a fixed tenor) In this method, the bank calculates and realizes the interest at
a prefixed rate and credits the amount after deducting the interest from the amount of
instrument.
Purchase of bills:
Banks also make advances by purchasing bills, instead of discounting, which are accompanied by
documents of title of goods such as bill of lading or railway receipts etc.
B. Non Funded Credit
Non funded credit facility to a customer refers to a bank's commitment to a third party
on behalf of the customer. The bank's commitment essentially states that in the event of
occurrence / non-occurrence of a particular event, within a particular date, due to a
particular reason or reasons, a specific sum of money shall be paid by the bank to the
third party upon claim in a particular manner.

Did you know?

Such liabilities against these types of credit facilities are termed as 'contingent liability' and do not
affect the balance sheet of the bank at the time of commitment but contain the possibility.

Letter of Credit:
A banker's documentary credit is an instrument or letter issued by a bank on behalf of
and for the account of the buyer of the merchandise. A Letter of Credit (LC), also known
as a documentary credit, is a financial instrument used in international trade to facilitate
transactions between a buyer and a seller, especially when they may not have a well-
established business relationship or trust in each other.
It provides a guarantee to the seller that they will receive payment for the goods or
services they provide, as long as they meet the terms and conditions specified in the
letter of credit.
A banker's letter of credit gives the seller or the exporter:
a) Credit security- by eliminating the credit risk in the sale and the shipments of goods;
b) Credit facilities- by financing the sale when the goods are in transit; and
c) Exchange security- by assuring him that the required amount is available to him
under credit from the time he receives the buyer's order and the time of shipment and
presentation of shipping documents.
Principles of Sound Lending:
Lending of money to different kinds of borrowers is one of the most important functions
of commercial bank. Not only this, it is the most profitable business of the commercial
bank and the major source of income.
But lending is a risky business. The borrowers of a bank range from individuals to
partnership, companies, institutions, societies, corporations etc. engaged in such
activities as business, industry, transport, farming etc. The nature of their activities, the
location 'of business, financial stability, earning and repaying capacity, purpose of
advance, securities all differ and their degree of risks also differ.
Although all lending involve risks of default in repayment a bank has to go with it for
earning profit and economic upliftment as well. As such the banks are required to follow
certain basic principles of lending which are known as the principles of sound lending.
Risk involvement may be kept at minimum if the lending principles are followed.
To do the lending business profitably the following principles may be followed:

a) . Safety:
The very survival of a banker and for the matter of that safety of bank depends on
his/her loans and advances. The ideal position is when all the loans and advances
positions are fully secured.
Thus safety of the advances should be the first principle of lending. Now the question is
how to ensure safety of lending? To ensure the safety of lending the following most
essential elements of the borrower may be considered:-

Five C’s
Character Capacity Capital Conditions Collateral

Five P’s
Person Purpose Product Place Profit

Five M’s Man Management Money Materials Market

Five R’s Reliability Responsibility Resources Respectability Returns

b) Purpose:
The bank should not lend money for any purpose for which a borrower may want. So
another important point to be studied by a banker before lending is the purpose for
which the loan is required and also the resources from which the borrower is expected
to repay. Loans may be required for productive purposes, trading purposes, agriculture,
transport, self-employment etc. purpose of the loan should be productive.

C) Liquidity:
The banker while making advances must see to it that the money lent is not locked up
for a long time because, majority of commercial bank liabilities are payable
either on demand or after short notice. So the banker should be sure that loan would be
liquid. Otherwise, the liquidity position of a bank may be threatened. Thus liquidity of
money lent is another important principle of lending.

Liquidity means availability or readiness of bank funds on short notice. The liquidity of advance
means its repayment on demand on due date or after a short notice. The loan must have fair
chances of repayment according to repayment schedule.

So a commercial banker should normally grant short term advances which could be
recalled in time to satisfy the demand of the depositors. A bank cannot afford to lend
short period funds for a long term lending.

d) Security:
The security offered by a borrower for an advance is insurance to the banker. It serves as
the safety value for an unforeseen emergency. So another principle of sound lending is
the security of lending Security offered against loan may be various. The securities may
vary from gold and silver to goods of various types, immovable properties (land, building
etc.), life insurance policies, stock exchange securities, promissory notes, third party
guarantee etc.

The banker who has to see it that the title he/she get on them is not unsafe. Not
only this, the security accepted by a banker to cover a bank advance must be
adequate, readily marketable, easy to handle and free from any encumbrance.
e) Profitability:
Commercial banks obtain funds from shareholders and if dividend is to be paid on such
shares it can only be paid by earning profits. Even in the case of public sector banks
although they work on service motive they also have to justify their existence by earning
profits. This is not possible unless funds are employed profitably. In other words banking
is essentially a business which aims at earning a good profit. The working funds of a
bank are collected mainly by means of deposits from the public and interest has to be
paid on these deposits.

From out of the profit the banker has to pay interest on deposits, salary to the
staff, meet other expenses, build up reserves etc. So the banker should not enter
into a transaction unless fair return from it is assured.

Spread/Dispersal/Diversification:
The advances should be as much broad based as possible and must be in conformity
with the deposit structure. The advances should not be in one particular
direction/industry/activity or one or few borrowers because any adversity faced by
that particular industry will have serious adverse affect on the bank. Again, advances
should not be given in one area alone.
Here the principle is "Do not put all the eggs in the same basket".

National interest/social benefit:

Bank has a significant role in the economic development process of a country. They
should keep in mind the national developmental plan/programs while going for lending
but maintaining safety, liquidity and profitability.

MODERN CONCEPT OF LENDING PRINCIPLES:

Modern concept of lending presupposes a well developed loan proposal/loan
case/project. It will cover as many as six pertinent factors like Managerial,
Organizational, Technical, Marketing, Financial and Economic/Socio economic. These
are technically known as feasibility or viability study of a loan proposal / loan case /
project. By studying all these six factors if a banker is satisfied about the viability of a loan
proposal/loan case/project, then He/she can finance it i.e., grant for lending otherwise
not.
Managerial feasibility
Managerial feasibility will ensure the character / conduct, capacity/capability to run the
project/ activity, sincerity / honesty / integrity, education, experience, reputation of the
borrower.

Organizational feasibility
Organizational feasibility will see under what type of organization the activities will be
undertaken. Whether it is under proprietorship / sole trader ship or partnership or
private limited company, public limited company or cooperative societies or any state
corporation.

Technical side
Technical side will take care of location of business / activities/project, construction of
building/shed etc. requirements to be used like power, fuel, water, materials etc.

Marketing side
Marketing side will ensure about the marketability of the product(s) out of activities /
business/project.

Financial aspect
Financial aspect will tell total requirement of fund for the business/activities/projects and
how much will be required from bank, what amount will be given by the borrower
himself cash inflow and cash outflow, sale forecasts, balance sheet, profit and
loss account etc.

Economic aspect
Economic aspect will look into socio-economic benefit out of the business /
activities/ project. If it is found that fund can be provided to a particular
activity/business/project then sanction will be given.
After that proper documentation will be done by the banker. This is an integrated
approach of lending by bank which covers safety, liquidity, purpose, security,
profitability etc.
 DIFFERENT STAGES OF CREDIT OPERATION:
Credit operation starts with application submitted by the customer to the Relationship
Manager/ Credit Marketing Division and ends with recover/adjustment of the facility.
How- ever, the different stages of credit operation being practiced in commercial banks
are as under:

1st stage: Application received from the customer by Marketing Department/

Relationship Manager. The assessment originates from relationship manager.

2nd stage: Sending application and other relevant papers to Credit Risk
Management (CRM) Unit of Head Office for analysis.

3rd stage: After analysis if it is found feasible and complied with credit policy
of the bank,CRM unit place the credit proposal with recommendation of
Head Office Credit Committee and the Credit Committee under delegated
authority approves the credit proposals.

4th stage: Executive Committee of the Board approves the credit proposals
which are beyond the delegated authority of credit committee. The Board of
Directors reviews the proposals approved by the Executive Committee.

5th stage: upon receipt of approval / sanction letter from Head Office, the
branch / RM will arrange completion of the documentation formalities as per
sanction terms.

6th stage: After completion of documentation formalities, the branch / RM will send
a security compliance certificate to Credit Administration Department (CAD) under
CRM. The Head of CAD will conduct concurrent audit periodically to physically verify
the docu- ments, possession, and confirmation of title of property documents, if
necessary.

7th stage: Thereafter the approval for disbursement of the facility is to be

sent by CAD to the branch/RM.

8th stage: After disbursement, follow up and monitoring of the loan

account is the final stage of credit operation till adjustment of the same.
Question :
What is bank credit ? how does bank lending contribute to national economy ?
Bank lending plays a significant role in contributing to the national economy in several
ways. Here are some key ways in which bank lending contributes to the economic
growth and stability of a country:
1. Capital Formation: Bank lending provides individuals, businesses, and
governments with access to the capital they need to invest in productive
activities. This capital can be used to start or expand businesses, build
infrastructure, invest in technology, and more. This, in turn, leads to economic
growth by increasing the production capacity of the economy.
2. Job Creation: When businesses and individuals have access to loans, they can
undertake new projects, expand operations, and create job opportunities. Job
creation is essential for reducing unemployment rates and improving the
standard of living in a country.
3. Consumption and Demand: Personal loans, such as mortgages, auto loans, and
credit card debt, enable consumers to make purchases they might not be able to
afford outright. This contributes to increased demand for goods and services,
which, in turn, stimulates economic activity and supports retail, manufacturing,
and other industries.
4. Entrepreneurship: Bank lending provides aspiring entrepreneurs with the capital
needed to start new businesses. These startups often bring innovation,
competition, and new ideas to the market, which can lead to economic growth
and diversification.
Question:
What types of credit facilities are provided by bank ? [see discussion]
Question:
Explain the modern concept of lending principles [see discussion]
Question:
Discuss the different stages of credit operation [see discussion]

Question :
Is there any relationship between credit and investment ?? [see discussion]
4 Credit Assessment and Risk Grading

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Introduction to Credit Policy:

Credit Policy:
A credit policy is a set of guidelines and rules established by a business or financial institution to
manage and control the extension of credit to its customers or borrowers.
It outlines the terms and conditions under which credit will be granted, the criteria for
evaluating the creditworthiness of applicants, and the procedures for monitoring and
collecting outstanding debts.

A prescribed credit policy is inevitable for assessment of credit application judiciously.

The credit policy of any banking institution is a combination of certain accepted, time
tested standards and other dynamic factors dictated by the realities of changing
situations in different market places.
The accepted standards relate to safety, liquidity and profitability of the advance
whereas the dynamic factors relate to aspects such as the nature and extent of risk,
interest or margin, credit spread and credit dispersal. General guidelines about the
conduct of advances are issued by Head Office.

As per CRM guidelines as prescribed by Bangladesh Bank all banks should have established
Credit Policies ("Lending Guidelines") that 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.
The Lending Guidelines should be updated at least annually to reflect changes in the
economic outlook and the evolution of the bank's loan portfolio, and be distributed to all
lending/marketing officers.
Underlying Meaning of Credit Risk
Credit risk is one of the major risks ben faced by banks. This can be described as
potential loss arising from the failure of a counter party to perform according to
contractual arrangement with the bank. The failure may arise due to unwillingness of
the counter party or decline in economic condition etc.
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 Banks need to
manage the credit risk inherent in the entire portfolio as well as the risk in individual
credits or transactions.
The effective management of credit risk is a critical component of a comprehensive
approach to risk management and essential to the long-term success of any banking
organization.

Credit risk for counterparty arises from an aggregation of the following:

 Financial Risk
 Business/Industry Risk
 Management Risk
 Security Risk
 Relationship Risk
Each of the above mentioned key risk areas require to be evaluated in order to address
and mitigate the potential credit risk.

Financial Risk:
Risk that counterparties will fail to meet obligation due to financial distress. This typically
entails analysis of financials i.e. analysis of leverage, liquidity, profitability & interest
cover- age ratios. To conclude, this capitalizes on the risk of high leverage, poor liquidity,
low profit- ability & insufficient cash flow.

Business/Industry Risk:
Risk that adverse industry situation or unfavorable business condition will impact
borrowers' capacity to meet obligation. The evaluation of this category of risk looks at
parameters such as business outlook, size of business, industry growth, government
regulation, economic state of condition, market competition & barriers to entry/exit.
Management Risk:
Risk that counterparties may default as a result of poor managerial ability including
experience of the management, age, its succession plan and team work. On evaluating
management risk the followings should also be taken into consideration:
Performance, growth and profit record, consistency, flexibility, judgment. (Any real
blunder in the past.

Security Risk:
Risk that the bank might be exposed due to poor quality or strength of the security in
case of default is called security risk. This may entail strength of security & collateral,
location of collateral and support.

Relationship Risk:
From the viewpoint of a credit policy within a business, relationship risk primarily relates
to the potential challenges and uncertainties that can arise when extending credit to
customers. These risk areas cover evaluation of limits utilization, account performance,
conditions/covenants compliance by the borrower and deposit relationship.

Importance of Credit Risk Assessment:

We are now in the environment of constant changes and regulatory pressure The
banking sector is in the different phases of implementation of reformative measures
and so banking business is in the face of challenge and under the stiff competition.
We should not forget at the same time that the challenge creates opportunities but
harvesting of opportunities requires high degree of professionalism, managerial
tactfulness, strategic planning and at the same time not in breach of regulatory
prescriptions.
So doing banking business and attainment of desired business target is a
challenging task and calls for the expansion of earning assets with sustainable
sourcing of income and at the same time having top most priority to restrain the
growth of non-performing loans which eat in to the vitality of the financial health
and the deterrent for any financial institutions
Lack of proper credit assessment is identified to be one of the most important causes of
Non-Performing Loan.

Some identified causes of growth of Non-Performing Loans (NPL):

Pre- approval phase (Controllable Variables)

 Defectiveness in selection of potential borrower
 Mistake in selection of business-where to finance/not to finance
 Long drawn appraisement/ approval process.
 Poor appraisal technique
 End use/ purpose not identified
 Defective structuring of credit
 Under/over financing
 Mismatch of Asset (NWA)
 Imprudent Judgment/wrong conception about Sectoral viability/ volatility
 Unusual attachment of importance on collateral security.
 Wrongly conceived projections and not supported by adequate assumptions.

Post-approval phase:
 Poor Monitoring
 Improper/ inadequacy in loan documentation
 Poor IMS
 Un-favorable Investment Climate
 Economic Recession
 Inconsistent and erratic govt. fiscal policy
 Credit Culture promote loan default

It is to be mentioned that the pre-approval phase is the cardinal issue to address and it is
the major part of credit assessment.
ASSESSMENT OF CREDIT RISK
For the purpose of creating performing credit portfolio and to avoid growth of NPL
credit risk should be assessed at pre-approval phase on best effort basis. An appropriate
appraisal of risk in any credit exposure is highly subjective matter involving quantitative
and qualitative judgment.
Financial statements of the borrower/business enterprise do not always portray the
complete picture or the conclusive ground for credit judgment. In analyzing any credit
matter the analyst should follow three distinct and expedient steps.

Historical Analysis:
Evaluate the past performance and determine the major risk factors and
how they have been addressed in the past. It includes analysis of prevailing condition of
business and past performance which may foreshadow the difficulties or dictate the
likelihood of success.

Forecasting:
At time of forecasting please do not allow any personal liking or disliking factors to
dominate your judgment process which may give distorted result. After identification of
the nature of risk make a reasonable forecast of the probable future condition of the
borrower and draw the conclusion about the debt-servicing ability of the potential
borrower/enterprise.

Debt Structuring:
Structuring of credit facility to be done on the basis of judgment of credit worthiness
and right diagnosis of appetite for credit having required security coverage with the
focus on the control of lending relationship.

Techniques for Assessment of Credit Risk

A thorough credit and risk assessment should be conducted prior to the granting of
loans, and at least annually thereafter for all facilities. The results of this assessment
should be presented in a Credit Application that originates from the relationship
manager/account officer ("RM"), and is approved by Credit Risk Management (CRM).
It is essential that RMs know their customers and conduct due diligence on new
borrowers, principals, and guarantors to ensure such parties are in fact who they
represent themselves to be. All banks should have established Know Your Customer
(KYC) and Money Laundering guidelines which should be adhered to at all times.
Credit Applications should summaries the results of the RMs risk assessment and include,
as a minimum, the following details: ⚫
 Amount and type of loan(s)
 Proposed Purpose of loans,
 Loan Structure (Tenor, Covenants, Repayment Schedule, Interest)
 Succession plan/2nd line of management
 Bank Checking/CIB report/ Confidential opinion
 Security Arrangements

In addition, the following risk areas should be addressed for the purpose of appropriate
assessment of Credit risk:

Borrower Analysis:
The majority shareholders, management team and group or affiliate companies should
be assessed. Any issues regarding lack of management depth, complicated ownership
struc- tures or inter-group transactions should be addressed, and risks mitigated.

The following questions may be asked to assess the Management Risk:

Who is the borrower?

Whether any particular / special characteristic of borrower needs particular
attention. For example if the borrower is a trust, this calls for examination of trust
deed.
Are there adequate abilities and experience in senior management? Is there
adequate depth and succession planning?
Is there any conflict amongst owners/senior managers that could have serious
implications?
Is the manager Credit Officer satisfied about the character, ability, integrity and
experience of the borrower?
Industry Analysis:
The key risk factors of the borrower's industry should be assessed. Any issues regarding
the borrower's position in the industry, overall industry concerns or competitive forces
should be addressed and the strengths and weaknesses of the borrower relative to
its competition should be identified.

The following questions may be asked to assess the Business and

Industry Risk:
Are there any significant concentrations of sales (by customer, industry,
county,region)?
How does the borrower rate with its competitors in terms of market share? Can
increased direct production costs be easily passed on to customers?
Does the borrower deal in any specific product that may be subject to
obsolescence? Is the purpose of borrowing consistent with the objectives of the
Company?
Is the purpose legal? Does it contravene any rules and laws of the country and
any instruction issued by the Bangladesh Bank/Head Office ?

Supplier/Buyer Analysis:
Any customer or supplier concentration should be addressed, as these could have a
significant impact on the future viability of the borrower.

Market Risk:
Whether there is enough market for the products. The sufficient market data is to be
obtained. The clients / borrowers market share in the industry is to be ascertained. The
demand supply gap is to be addressed.
 Environmental Risk Analysis:
Environmental and climate change risk refers to the uncertainty or probability of losses that
originates from any adverse environmental or climate change events (natural or man made)
and/or non compliance of the prevailing national environmental regulations.

Land Location:
Borrowers may plan and or operate on land that is prone to environmental impacts by virtue
of its geographical location. Activities on land in the flood prone areas/along the coastal belt
are more vulnerable and sources of risk.

Regulatory non Compliance:

The borrower may plan or operate without technologies (eg. ETP) or management systems
that will ensure compliance to the prevailing environmental laws. In such a situation, the
borrowers are vulnerable to closure or shutting operations by the Department of
Environment (DOE).

Labor/Social Risk:
The borrower has to provide a safe and healthy working environment for its labor
/employees. If does not, then there is a potential for accidents, injury and death and also
exposure to occupational health issues.

Financial Analysis (Historical/Projected):

An analysis of a minimum of 3 years historical financial statements of the borrower
should be presented. Where reliance is placed on a corporate guarantor, guarantor
financial statements should also be analyzed. The analysis should address the duality
and sustainability of earnings, cash flow and the strength of the borrower's balance
sheet. Specifically, cash flow, leverage and profitability must be analyzed.
Where term facilities (tenor > I year) are being proposed, a projection of the borrower's
future financial performance should be provided, indicating an analysis of the
sufficiency of cash flow to service debt repayments.

The following questions may be asked to assess the Financial Risk:

Does the borrower produce financial statements on time?
Is working Capital Adequate?
Has the customer actual title to stock?
Have financial covenants been met?
Has there been any major sale of shares by directors?
In addition to above, for the purpose of financial analysis the followings should also be
taken.

Adherence to Lending Guidelines:

Credit Applications should clearly state whether or not the proposed application is in
compliance with the bank's Lending Guidelines The Bank's Head Office Credit
Committee should not approve Credit Applications that do not adhere to the bank's
Lending Guidelines. All the Banks should establish Credit Policies and Lending
guidelines to develop a strong Portfolio.

Interest Rate Risk:

The interest rate must be fixed based on different risk factors associated with the type of
business such as liquidity risk, commodity risk, equity risk, loan period risk. Interest rate
also arises from the movements of interest rate in the market. In assessing the pricing
and profitability, the credit officer must consider the income from ancillary business like
foreign exchange business, group business, volume of business etc.

Risk Grading
All Banks should adopt a Credit Risk Grading system. The system should define the risk
profile of borrower's to ensure that account management, structure and pricing are
Commensurate with the fisk involved. Risk grading is a key measurement of a Bank's
asset quality, and as such, it is essential that grading is a robust process. All facilities
should be assigned a risk grade. Where deterioration in risk is noted, the Risk Grade
assigned to a borrower and its facilities should be immediately changed.
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7 Credit Appraisal: Analysis of Financial Statement

INTRODUCTION:
The objective of this chapter is to familiarize the bankers with the tools and techniques
of financial analysis to analyze and interpret the data contained in the financial
statements of the customers, so that they can improve their lending decisions.

Definition of Financial Statements:

Financial statements also refer to annual report- a report issued annually by a firm to its
stockholders. The four basic statements contained in the annual report are:
1. Balance sheet.
2. Income statement.
3. Statement of retained earnings.
4. Statement of cash flows.

Balance sheet:
Balance sheet presents financial picture of an organization on a given date. It presents
the balance between the firm's assets and its liabilities, including the stockholder equity,
at a particular point in time, generally at the end of the fiscal year. The liability side
indicates the sources of funds.
On the other hand asset side implies the uses of fund, i.e. it shows the various sources
from where the organization has raised its funds. On the other hand, assets side implies
the uses of funds, i.e. it shows how these funds have been utilized by the organization.

Income Statement
The second basic financial statement is the company's income statement which presents
the gain or loss achieved during the firm's most recent period of operation. It shows the
working result of a company over a definite period of time. If balance sheet is compared
to a to a "still picture" or a "snap short" of a company, income statement can be
compared to a 'moving picture',

Statement of Retained Earnings:

The statement of retained earnings is associated with both balance sheet and
income statement. It shows how much money the firm has retained itself from its
earnings over the years, after it has paid dividend to the preferred and common
stockholders.
Statement of cash flow:
It is one of the important components of financial statement. It contains the statement
of sources and application of fund. Cash flow statement reveals the financial changes
that have resulted from the operation of a company and reports the flow of all funds
between two stated periods of time, generally the two most recent years.

Analysis and Interpretation of Financial Statements:

(Viewpoint of Lending Banker)

Analysis of financial statements means critical and systematic study of financial statements
with a view to obtaining some desired information. The financial statements carry lot of
data which have to be analyzed and such an analysis may help in getting meaningful
guidelines for arriving at certain conclusions when interpreted.
While "Interpretation" stands for the explanations of the accounting data as a starting point
for the discovery of economic facts about a business. Mere examination of the various
components of a set of financial statement cannot be expected to lead to certain
conclusions with regard to the financial status of a business.
After the statements have been broken down into meaningful components, it is desired
that whether the concern(business) has got Sufficient strength to meet its current
obligations, in that case, the amount of liabilities may be compared with the amount
current assets that the business has available to pay them.
If the analyst finds that the current assets are more than current liabilities, as such he can
term it a satisfactory situation. In all the cases, the balance sheet, as far as possible, should
be the latest. If the balance sheet furnished is more than six months old, a banker may ask
for a pro-forma balance sheet of a recent date, along with the past audited balance sheets.
It would be more meaningful and reliable if balance sheets of the last three to four years
are available and comparison is made. This will enable the banker to judge the company's
past and present performance and also help in foreseeing the future prospects.
Objectives of Analysis of Financial Statements:(****)
The objectives of analysis of financial statements are to obtain some indications
regarding the financial health of the business. If we consider it from the viewpoint of a
lending banker then the objective would be to improve decision in the case of
sanctioning of loans, supervision and follow-up of advances and nursing of sick projects.
The main objectives of analysis of financial statements can be summarized as follows:
To determine liquidity position of the organization.
To determine solvency position of the organization
To determine profitability position of the organization
To determine management efficiency of the organization.

Steps involved in the Analysis of Financial Statements:

There are three steps involved in the analysis of financial statements such as
(a) Re-classification of data,
(b) Comparison of data
(c) Interpretation of data.
In every stage, the analyst has to perform certain activities, so he should proceed
systematically and use the techniques developed for this purpose.

Reclassification of data:
This is the first and at the same times most important step in the analysis of financial
statements.
Questions may arise why reclassification is necessary ?
It is essential because data contained in the financial statements in most of the cases are
not suitable for meaningful comparison and logical interpretation. Items are arranged in
haphazard manner and they are not properly grouped. There may also be variation in
the placement of data within the statement from year to year.
Therefore, in order to facilitate comparison and correct interpretation of data, the
analyst should reclassify the items of the financial statements under proper heads. This is
the most important stage in the process of financial analysis.
 If some mistakes are committed at this stage, subsequently the comparison is bound
to be wrong and ultimately the interpretation would be definitely a wrong one.

The analyst should, therefore, be systematic and methodical in reclassification. Separate

format may be used for this purpose. Data contained in the financial statements should
be regrouped. The analyst should re-group every item of balance sheet and profit
and loss account.

Comparison of Data:
Reclassification is the first step in the analysis of financial statements. When the data
contained in the financial statements are properly grouped under appropriate heads
than the second step comes ie., comparison of data.

Techniques of Comparison:
Data Contained in the financial statements can be compared in two ways: horizontally &
vertically. When we study the relationship of the same item on varying dates in that
case, it becomes horizontal comparison. For example, if profit of the last year is
compared with this year, or current liabilities of the last year is compared with this year
and so no, then it becomes horizontal comparison.
On the other hand, vertical comparison involves the study of relationship on one item of
the same statement with another item or other items. For example, fixed assets are
compared with long term liabilities or long term liabilities with net worth and so on.

Procedures for Comparison:

Direct Comparison: it is similar to vertical comparison. When one item of the
statement is directly compared with another item of the same statement or another
statement, we may call it direct comparison..

Increase Decrease Comparison: It is similar to horizontal comparison. When

individual figures of one statement are compared with another statement of another
period to indicate increase or decrease in individual items during the period under
consideration this is called increase decrease comparison.

Trend comparison: When information are available for several periods, and if we take
a particular period as base, which is free from abnormalities, and compare the data of
the base period with items of the other statements to indicate the trend, then we call it
trend comparison.
Ratio : Ratio can be defined as an indicator of relationship between two variables
having cause and effect relationship or connected with each other, if we compare
figures of one item with another item and expressed in arithmetic terms it will be
ratio comparison.

RATIO ANALYSIS:
Ratio analysis is one of the useful and common methods of analyzing financial
statements. Absolute figures hardly convey any meaningful indication till they are
compared to other related figures. For example whether the operating profit is
adequate or not in an organization cannot be obtained, until we compare it with sales
figure as a percentage to it.
This percentage, if compared to similar other organizations, we get better information
regarding the efficiency and market position of the firm.

The usefulness of the ratio analysis lies in the fact that the data to be analyzed is
reduced and expressed in simple form, which makes it very easy to evaluate the
relationships between various related items as well as the changes that
have taken place.

Why it is important:
Ratio analysis is an important tool in the hands of the bankers for the examination of
financial liquidity, solvency, profit earning capacity and management efficiency of an
organization. Ratios of a company for a given year may also be compared to similar
ratios of other companies in the same trade. In the case of new enterprises, the
projected data can help in making such comparisons.
Broadly speaking a banker is very interested in the analysis and interpretation of rations
relating to the basic four aspects of the borrowing concern:

Liquidity
Ability to meet current dues out of current assets

Solvency
The ability to meet all long term liabilities out of the resources of the organization if need
arises

Profitability:
Capacity of the organization to generate profits and their rate of returns.

Activity:
Efficiency of the organization in utilization of available resources.
Liquidity:
Current Ratio:
The current ratio is a financial ratio that measures a company's ability to cover its short-
term liabilities with its short-term assets. It is calculated using the following formula:
Current Ratio = Current Assets / Current Liabilities
If this ratio is more than, 1, it suggests that the current assets are adequate to pay off its all
current liabilities. If it is 1, they are just sufficient and if less than 1, the company will be
unable to pay their current obligations when asked for which will be a unhappy situation.
A very high current ratio is not also desirable as it will indicate less efficient use of funds.
A high ratio will mean excessive dependence on long term sources and very little on
current sources, thus reducing profitability of the concern. Similarly a low current ratio
would mean too much strain on the working capital resources. It is generally believed that
an ideal current ratio should be 2:1.

The Quick or Acid Test Ratio

The acid-test ratio, also known as the quick ratio, is a financial ratio that measures a
company's ability to cover its short-term liabilities with its most liquid assets.
The quick or acid test ratio: (Current Assets – Inventories)/Current Liabilities
All current assets are not equally liquid. Cash is most liquid asset. Receivables can be
discounted and converted in to cash, similarly marketable securities. But inventory is the
most illiquid asset and it cannot be sold easily since the buyers are not readily available.
Here to test short-term liquidity more accurately inventory is deducted from current assets.
The ideal ratio in this case is 1:1.

The working capital turnover ratio:

The working capital turnover ratio is a financial ratio that measures how efficiently a
company uses its working capital to generate sales revenue.
Working Capital Ratio: (Net Sales/Net working capital)
The business people prefer to call their current assets as working capital, but from bankers'
point of view, it becomes necessary to deduct current liabilities from the current assets in
order to arrive at a current picture of working capital. Total current asset is called gross
working capital, while net working capital is equal to current assets current liabilities.
If the net working capital is too high, it may indicate less effective utilization of funds and
vice versa.
Solvency

So just as short-term solvency is tested by applying liquidity ratios, long term solvency can
be measured by solvency rations.

Debt Equity Ratio

Debt Equity Ratio: (Long term debt/Tangible net worth)
In the above ratio, debt represents long term liabilities only and not the current liabilities.
This ratio compares the owners' stake in the business with outside term liabilities. The
companies, where outside term liabilities are very high compared to owned funds it is
said to be trading on thin equity.
In the reverse case, where equity is too high it is said be trading on thick equity. Normally
a higher equity will mean a higher stake on owners and may be a healthy sing. The ratio
should not be more than 1:1.

Debt Service Coverage ratio:

DSCR: (Net Operating Income/Total Debt Service)
The debt service coverage ratio (DSCR), also known as the debt coverage ratio, is a
financial ratio used to assess a company's ability to cover its debt obligations, particularly
interest and principal payments, from its cash flow. It's a crucial measure for lenders and
investors to evaluate the financial stability and risk associated with a company's debt.
The adequacy of profit to meet the obligation in this regard is measured with the help of
this ratio. It indicates ability of the company to generate cash to pay interest and principle
repayments. An ideal debt service coverage ratio is greater than 1.The higher the ratio,
the more is the safety to the long term creditors.

Fixed Assets Coverage Ratio

This ratio indicates whether the value of fixed asset is sufficient to cover the
amount of the loan granted against them. The fixed assets figure should always be higher
because of the margin stipulated in loans.
(FACR)= (Net fixed assets after depreciation) /Long term debts secured by fixed assets)
Profitability

Operating Profit Ratio = (Operating Profit/Net sales) x 100

This ratio indicates the efficiency of the organization in generating profit through selling their
products. A high ratio will indicate the competitive strength of the borrower is quite good
while a low ratio will indicate that the competitors can force the exit of the firm by reduction of
their selling price.

The Return of Investment Ratio = (EBIT/Sales) x (Sales/Assets)

Individually the profit margin and asset turnover have certain weaknesses. The profit margin
ignores the money invested by the firm to earn the profit. On the other hand the asset
turnover does not consider the profits made on the use of the assets. To overcome these
individual weaknesses, the ratios may be combined to form return on investment.
The ROI is the key indicator of profitability of a firm.

Return of Equity Ratio = (Net operating profit after tax/Tangible Net Worth) x 100
This ratio reflects the earning power of the capital or equity introduced by the shareholders.
This ratio can prove useful to entrepreneurs in making investment decisions for an industrial
enterprise. When an entrepreneur invests his capital in an organization, he not only looses the
opportunity of earning interest by investing that money elsewhere but also bears the risks of
losing such money.
Hence this rate of return on capital should be higher than the alternative rates of return
available in the market.
 Activity

Inventory Turnover Ratio =

(Cost of Goods Sold) / 1/2(Opening inventory + closing inventory)
This ratio shows how quickly the goods are sold or how many times the inventory turns
over during a year. A high ratio would mean accumulation of minimum inventor and
thus a minimum chance of the stock to become obsolete. On the other hand, a low ratio
indicates dull business or a larger investment in inventory which has higher chance of
being obsolete. A rapid turnover of inventory also indicates sound controls and good
financial management.

Sundry Debtors Turnover Ratio:

Sundry Debtors turnover Ratio = { ( Sundry debtors+ Bills receivables)/Annual Credit
sales} X 365
The Sundry Debtors Turnover Ratio is a financial ratio that measures how efficiently a
company manages its accounts receivable. This ratio is also known as the Accounts
Receivable Turnover Ratio. It is used to evaluate how quickly a company collects
payments from its customers.

Sundry Creditors Turnover Ratio:

= {(Sundry Creditors + Bills payable)/ Annual Credit sales} X 365
The Sundry Creditors Turnover Ratio, also known as the Accounts Payable Turnover
Ratio, is a financial ratio that measures how efficiently a company manages its accounts
payable. It assesses how quickly a company pays its suppliers or creditors.

Interpretation of Data:
The financial statements carry volumes of Data. Mere glance over these data is not
possible to arrive at certain conclusions regarding the credit worthiness of the borrower.
So, the financial statement have to be analyzed an interpreted to get meaningful
conclusion. Thus interpretation means critically examining and drawing conclusions
from data contained in the financial statements.
An analysis of a single set of financial statement has a very limited value. The results of
an analysis can be useful only if they are compared with past results and to the
corresponding results of other enterprises in the same trade or industry.
Comparisons with other similar units in the same industry or with the results of the
industry as a whole are useful for judging the relative efficiency of the enterprise.

LIMITATIONS OF THE FINANCIAL STATEMENTS ANALYSIS:

Following are the limitations of the analysis of financial statements:

The Static Statement:

A balance sheet is prepared on a particular date and indicates balance on that date only.
These figures themselves do not give any trend unless compared to past balance sheets,
Even this comparison provides a picture of the past performance only and forecast for
future may not be correct as other factors like, market condition, management policies
which may affect the future operations.

The probability of window-dressing:

Business men in our country are usually tempted to window dressing which means
accounts are so manipulated that the vital facts are concealed and facts presented are
superficial.

The non-financial changes:

There may be so many changes which are not reflected financial position, are not
disclosed through balance sheets. For example, if some technical experts have left the
organization and the company have no alternative arrangement, if will definitely hampers
production and also profitability. But this fact cannot be obtained from the analysis of
financial statements. The personnel strength: Most valuable resources of an organization
are the human resources.

The personnel strength:

Most valuable resources of an organization are the human resources. The competence of
management, trained personnel and skilled labor etc. are the important factors for success
of the business but information are not available from the study of the financial
statements.

The physical productivity:

Financial statements contain the values in terms of money but not in physical quantity. For
example, sales figures have increased. These do not exactly mean the sales volume has
increased. It may be due to rising prices.
2021
1. What is financial statement analysis? Discuss the limitations of financial
statement analysis.
Financial statement analysis is the process of examining and evaluating a company's
financial statements to gain insights into its financial performance, position, and
potential future prospects. This analysis is crucial for making informed investment
decisions, assessing a company's creditworthiness, and understanding its overall
financial health.

Limitations of financial statement analysis:

Please go through the discussion.
2. What is solvency ratio? How can a bank measure solvency of any
borrower??
Solvency ratios are financial metrics that assess a company's ability to meet its long-term
debt and financial obligations. These ratios provide insights into a company's financial
stability, liquidity, and its capacity to endure economic challenges over an extended
period. Solvency ratios are important for both investors and creditors when evaluating a
company's creditworthiness and financial health.
To learn How can a bank measure solvency of any borrower? Please see the solvency
ratios.

2020.
1. What are the steps of analysis of financial statement ?
See the discussion.
Please discuss the activity ratios that are used in financial statement analysis.

2. Explain the objectives of financial statement analysis.

The objectives of analysis of financial statements are to obtain some indications regarding the
financial health of the business. If we consider it from the viewpoint of a lending banker then
the objective would be to improve decision in the case of sanctioning of loans, supervision and
follow-up of advances and nursing of sick projects.The main objectives of analysis of financial
statements can be summarized as follows:
To determine liquidity position of the organization.
To determine solvency position of the organization
To determine profitability position of the organization
To determine management efficiency of the organization.
Discuss about ratio and ration analysis:
Ratio : Ratio can be defined as an indicator of relationship between two variables having
cause and effect relationship or connected with each other, if we compare figures of
one item with another item and expressed in arithmetic terms it will be
ratio comparison.
RATIO ANALYSIS:
Ratio analysis is one of the useful and common methods of analyzing financial
statements. Absolute figures hardly convey any meaningful indication till they are
compared to other related figures. For example whether the operating profit is
adequate or not in an organization cannot be obtained, until we compare it with sales
figure as a percentage to it.
The usefulness of the ratio analysis lies in the fact that the data to be analyzed is
reduced and expressed in simple form, which makes it very easy to evaluate the
relationships between various related items as well as the changes that
have taken place.

What are the limitations of ratio analysis:

Please see the discussion.
 Security & documentation against bank credit
------------------------------------------------------------------------------------------------------------------------------------------

WHAT DOES SECURITY MEAN?

Security is a financial instrument or asset that is pledged to a bank to guarantee

repayment of a loan. The security can be in the form of real estate, stocks,
bonds, or other assets.
The purpose of security is to protect the bank from loss in the event that the
borrower defaults on the loan. If the borrower does default, the bank can sell
the security to recover its losses.

Types of Security
The type of security offered varies from place to place. Securities can be
classified into primary security & collateral security.

1) Primary security:

This is the asset that is being financed by the loan. For example, if a bank lends
money to a business to buy machinery, the machinery would be the primary
security.

Primary security:
 Must be of good quality and easily marketable.
 Must be sufficient to cover the amount of the loan.
 Must be legally enforceable.

2) Collateral security:
This is any other asset that the borrower offers to the bank as a guarantee in
case they default on the loan. For example, the borrower might offer their
house or car as collateral security.

Collateral security:
 Can be any asset that the borrower owns.
 Is not essential for the borrower's business.
 Is only used in case the borrower defaults on the loan.
The type of security that is required will vary depending on the loan amount,
the borrower's creditworthiness, and the nature of the business. In general,
banks prefer to have primary security, but they may also accept collateral
security.
Good collateral security must have the following characteristics /
eligibility of collateral ( y.q 2020, 2019)
 Tangible Transferable/negotiable:
 Easily marketable
 Price stability
 Durability (not perishable)
 Ascertain ability of market value
 Genuineness of title (free from encumbrance)
These are explained below :

Tangible and transferable/negotiable

Collateral must be something that the lender can physically take possession of
and sell if the borrower defaults on the loan. This means that it must be
tangible, such as a house, car, or jewelry. It must also be transferable or
negotiable, meaning that the lender can easily sell it to someone else.

Easily marketable

The collateral should be something that is easy to sell in a short period of time.
This means that it should be in demand and there should be a large market
for it. For example, a house is a good form of collateral because it is easy to sell
and there is always a demand for housing.

Price stability

The collateral should be something that holds its value well over time. This
means that it should not be volatile or subject to sharp price swings. For
example, stocks are not a good form of collateral because they can be very
volatile and their prices can fluctuate wildly.

Durability (not perishable)

The collateral should be something that is durable and will not lose its value
over time due to wear and tear or spoilage. For example, fresh produce is not
a good form of collateral because it is perishable and will quickly lose its value.

Ascertain ability of market value

The collateral should be something that has a clear and easily ascertainable
market value. This means that it should be something that is easy to appraise
and that there is a consensus on its value. For example, a house is a good
form of collateral because it is easy to appraise and there is a large market for
houses.
 Genuineness of title (free from encumbrance)

The collateral should be something that the borrower actually owns and that
is not encumbered by any other liens or claims. For example, a house that is
mortgaged to a bank is not good collateral because the bank has a lien on it

Valuation of Security

Valuation of security is the process of determining the worth of an asset that is

being offered as collateral for a loan. This is important for the lending banker
to ensure that the value of the security is sufficient to cover the amount of the
loan in case of default by the borrower.
Margin is the portion of the loan amount that is not covered by the security.
This is the borrower's contribution to the loan, and it acts as a cushion against
any possible losses to the lender.
The amount of margin required will depend on the nature and type of
security, the financial stability of the borrower, and the restrictions imposed by
the central bank. In general, a higher margin will be required for riskier assets
or borrowers.
The margin should be sufficient to cover the amount of the loan, as well as any
potential losses due to fluctuations in prices or other factors.
The lender should carefully monitor the borrower's financial condition and
take steps to increase the margin if necessary

CREATION OF CHARGES ON SECURITIES:

‘Charge’ in a transaction for value means that the creditor (bank) shall have
the right to take the property on which charge is created. A charge may be
classified as Fixed charge & floating charge

A fixed charge is a security interest that is created over a specific asset or

group of assets. The asset(s) that are subject to the fixed charge are known as
the charged assets. The charge holder has a right to take possession of the
charged assets if the borrower defaults on their loan.

A floating charge is a security interest that is created over a fluctuating pool of

assets. The assets that are subject to the floating charge are not specifically
identified, but they are generally the current assets of the borrower, such as
inventory, accounts receivable, and cash. The charge holder has a right to
take possession of the charged assets if the borrower defaults on their loan

The main difference between a fixed charge and a floating charge is the level
of control that the charge holder has over the assets that are subject to the
charge. The charge holder has greater control over the assets that are subject
to a fixed charge, as they cannot be disposed of without the charge holder's
consent. The charge holder has less control over the assets that are subject to
 a floating charge, as the borrower can continue to use and dispose of these
assets in the normal course of business.

How charges on the security can be created : (y/q 2019)

A charge creation of security is the process of creating a security interest in

property or assets as collateral for a loan. This means that the lender has a
legal right to seize the property or assets if the borrower defaults on the loan.
The method used depends upon

a) The type of property to be charged

b) The nature of advance
c) The degree of control over the debtors / borrowers property required by
the banker

Charges on the securities can be created in the following manner :

A. Mortgage:

A mortgage is a charge on immovable property (land or building)

created by the borrower in favor of the lender to secure a loan.
The borrower remains the owner of the property but gives the
lender the right to sell the property to recover the loan amount
in case of default. The owner of the property to be mortgaged is called
mortgagor & the bank receiving mortgage is mortgagee & the deed is known
as mortgage deed.

The borrower, known as the mortgagor, retains possession of the property,

but the lender, known as the mortgagee, has a charge on the property and
can sell it to recover the loan if the borrower defaults.

Classification of Mortgage: On the basis of transfer of title in the mortgaged

property mortgage can be classified as :
Simple/Registered Mortgage and Equitable Mortgage

1) Simple/Registered Mortgage: This type of mortgage involves the

transfer of the legal title to the property to the mortgagee (lender). The mortgage
deed is registered with the registrar's office. This is the most common type of
mortgage and is considered to be the safest for the lender. This method is
expensive as it involves registration charge & stamp duty. After adustment of the
loan the title of the property is to be redeemed.

2) Equitable Mortgage: This type of mortgage does not involve the

transfer of the legal title to the property. Instead, the mortgagor (borrower)
simply delivers the title deeds to the mortgagee as security for the loan. This type
of mortgage is less common and is not considered to be as safe for the lender.
Equitable mortgage no longer exist
B. Lien: ( Y.Q 2020 )

A lien is a right of a creditor to hold on to the property of a debtor until the

debt is paid. The lien arises by law or by agreement between the parties.
The conditions for right of exercise of lien are :

 Creditors possession of goods/ securities in the ordinary course of

business: This means that the creditor must have possession of the
debtor's property lawfully and as part of their normal business
operations. For example, a mechanic may have a lien on a customer's car
for unpaid repair bills, or a warehouse may have a lien on a customer's
goods for unpaid storage fees.
 The debtor has a lawful debt due to discharge to creditor: This means
that the debtor must owe the creditor a valid and enforceable debt. The
debt can be for any amount, but it must be a real debt and not a disputed
one.
 There must not be any contract to the contrary: This means that the
creditor's right to exercise a lien cannot be excluded or limited by
contract. For example, a contract between a mechanic and a customer
may specify that the mechanic does not have a lien on the customer's car
for unpaid repair bills. In this case, the mechanic would not be able to
exercise a lien on the car, even if the customer did not pay their bill.

There are two types of lien

1) Particular lien is a right of a creditor to retain possession of goods

belonging to the debtor until the debt is paid. The lien is only for the specific
debt that arose from the goods. For example, a tailor has a particular lien on
the shirt he made for his customer until the customer pays for the shirt.

2) General lien is a right of a creditor to retain possession of goods belonging

to the debtor until all debts owed to the creditor are paid. This type of lien is
typically only granted to certain types of businesses, such as bankers, factors,
wharfingers, and attorneys.

Here is a table summarizing the key differences between particular lien and
general lien:

Feature Particular lien General lien

Specific General balance of

Applies to
debt account

Granted to Anyone Certain types of

 businesses

Right to sell
No Yes (in some cases)
goods

C. Pledge:

A pledge is a bailment of goods by the borrower to the lender as security for a

loan. The borrower gives up possession of the goods to the lender until the debt
is paid.

Properties :

 The ownership of the goods remains with the pledgor.

 Delivery is necessary in order to complete a pledge.
 Right to sell-if the pledgor makes a default in the payment of the debt by
the stipulated time.

D. Hypothecation: (Y.Q 2020)

A hypothecation is a charge on movable property (goods) created by the

borrower in favor of the lender to secure a loan. The borrower retains possession
of the goods but gives the lender the right to sell the goods to recover the loan
amount in case of default.

# What is Hypothecation ? what are types of precautions requiring

the banker at the time of applying Hypothecation? ( Y.Q 2021)

Ans : precautions :

Assess the value of the goods being hypothecated. The banker should make sure
that the value of the goods is sufficient to cover the amount of the loan.

Insured the goods. The banker should ensure that the goods are insured against
damage or loss. This will protect the banker's interest in the event of a default.

Get a clear and concise hypothecation agreement. The hypothecation agreement

should be clear and concise, and it should specify the terms of the hypothecation,
such as the amount of the loan, the interest rate, and the security interest.

Register the hypothecation. In some jurisdictions, it is necessary to register the

hypothecation with the relevant authorities. This will give the banker priority over
other creditors in the event of a default.
Monitor the borrower's financial condition. The banker should monitor the
borrower's financial condition to make sure that they are able to repay the loan. If
the borrower's financial condition deteriorates, the banker may need to take
action, such as repossessing the goods.

E. Assignment:

An assignment is the transfer of a right, property, or debt from one person to

another. In banking, an assignment is typically used to transfer a debt from the
borrower to the lender.

Assignment can be classified as:

1 Legal assignment is a transfer of a right or interest in property from one person

(the assignor) to another (the assignee). It is a formal process that must be in
writing and signed by the assignor. The assignee must also give notice of the
assignment to the debtor. A legal assignment gives the assignee the right to sue
the debtor directly for the assigned debt.

2) Equitable assignment is a transfer of a right or interest in property that does

not meet all the requirements of a legal assignment. For example, an equitable
assignment may be oral or it may not be in writing. The assignee of an equitable
assignment does not have the right to sue the debtor directly, but they may be
able to enforce the assignment in court

In case of assignment following precautionary should be taken by the bankers:

1. Get the assignor to sign an irrevocable letter to the debtor instructing them
to pay the debt to the banker. This means that the debtor cannot legally pay
the debt to anyone else, even if they receive a subsequent assignment from
the assignor.

2. Get the debtor to acknowledge the assignment. This means that the debtor
must sign a document confirming that they have received notice of the
assignment and that they agree to pay the debt to the banker.

3. Check for prior assignments. The banker should ask the assignor if there are
any prior assignments of the debt. If there are, the banker should obtain
copies of these assignments and make sure that their own assignment has
priority.

4. Send a notice of assignment to the debtor. This will help to prevent the
debtor from making any subsequent assignments of the debt to other parties.

5. Follow up with the debtor regularly to ensure that they are making
payments to the bank.
6. Make sure that the assignment is for the whole amount of the debt.

# Differentiate between Hypothecation & lien ( Y.Q 2019)

Lien

A lien is a legal claim against property to satisfy a debt. The creditor

(lienholder) has the right to detain the property until the debt is paid. Liens
can be voluntary, meaning that the debtor agrees to the lien, or involuntary,
meaning that the lien is imposed by law.

Hypothecation

Hypothecation is a type of lien where the debtor retains possession of the

collateral. It is typically used for movable assets, such as vehicles and inventory.
In the event of default, the lender can seize and sell the collateral to recover
the debt.
 Key differences between lien and hypothecation

 Possession of collateral: In a lien, the lender may or may not have possession of
the collateral. In hypothecation, the debtor retains possession of the collateral.
 Type of assets: Liens can be used for both movable and immovable
assets, while hypothecation is typically used for movable assets.
 Enforceability: Liens can be enforced voluntarily (i.e., the debtor agrees to the
lien) or involuntarily (i.e., the lien is imposed by law). Hypothecation is typically
a voluntary lien.

Example of lien
A mechanic who repairs a car has a lien on the car until the repair bill is paid. This
is an involuntary lien, as it is imposed by law.

Example of hypothecation
A person who takes out a loan to buy a car hypothecates the car to the lender.
This is a voluntary lien, as the person agrees to the lien in order to get the loan.

How to create charge on the fixed and floating assets with RJSC:

1. Fill out Form No. XVIII of the RJSC. This form can be downloaded from
the RJSC website.
2. Attach the following documents to the form:

 General Letter of Hypothecation

 Statement of Stock under Hypothecation
 Supplementary Agreement

3. Sign all the documents and have them signed by two witnesses.

4. Submit the documents to the RJSC within 21 days of the date of

execution of the Letter of Hypothecation. The documents can be submitted in
person or by post.

5. Pay the registration fee to the RJSC. The registration fee is BDT 2250.00.

6. The RJSC will issue a Certificate of Registration of Charge. This

certificate will confirm that the charge has been registered with the RJSC.
 DOCUMENTATION AGAINST BANK CREDIT ( Y/Q 2020)
Documentation against bank credit refers to the process of creating and
executing legal documents that secure a bank loan. These documents provide
evidence of the borrower's obligation to repay the loan, and they also give the
bank the right to seize the borrower's assets if the loan is not repaid.

From the above discussion the following characteristics of documents are

found:-

1. It should be written statement of facts.

2. The fact should cover legal aspects.
3. It must be an evidence of certain transactions.
4. It should be signed by the persons having authority and legal status
5. There might be some witnesses.
6. It should be stamped as per types of documents

Importance of Documentation

 Documentation helps to safeguard the bank's interests by providing a

written record of the loan agreement.
 Complete and correct documentation enables the bank to take legal
action against the borrower.
 Documentation is necessary for the bank to charge securities to the
borrower.
 Documentation also helps to protect the borrower.

Types of Documents: ( Y/Q 2020)

Documents related to securing loans and advances are classified into the
following 2 (Two) categories:

Charge documents are pre-formatted and printed forms provided by the bank to
the borrower. These documents create a charge on the borrower's assets, such as
property or equipment, as security for the loan.

Legal documents are provided by the borrower to the bank. These documents
certify the borrower's legal status, borrowing power, and title to the assets being
used as security

Steps towards completion of Documentation formalities:

A. Obtaining of the instruments documents

B. Stamping
C. Execution.
D. Witnessing.
E. Registration.
F. Preservation.

A. Obtaining of the instruments documents

The documents to be obtained depend upon 3 factors.:

 Legal status of the borrower

 Type of facility
 Nature of security

Obtaining of the instruments/documents include :

1 ) BASIC CHARGE DOCUMENTS Documents -- i) Demand Promissory Note, ii)

Letter of arrangement, iii) Letter of continuity, iv) Letter of revival

2)OTHER CHARGE DOCUMENTS---- i) Letter of Hypothecation with

Supplementary Agreement. 11) Letter of pledge with Supplementary
Agreement in) Letter of Guarantee iv) Letter of Trust Receipt v) Letter of Lien vi)
Letter of disclaimer vii) General letter of Counter Guarantee viii) Letter of
indemnity ix) Credit Sanction advice accepted by the borrower.

3) LEGAL DOCUMENTS---
i. Memorendum and Articles of Association (Limited Company).
ii. Registered partnership deed (Partnership firm).
iii. Trade License

4) Documents based on nature of ownership of the borrower

i. Limited company
ii. Partnership firm
iii. Proprietorship firm

5) Other documents

Stamping of Documents:
 Stamping of documents is a legal requirement for bank credit.
 There are two types of stamps used for loan documentation: non-judicial
stamps and adhesive stamps.
 Non-judicial stamps are used for deeds, agreements, undertakings, and
powers of attorney.
 Adhesive stamps are affixed on various charge documents and forms.
 The nature and value of stamps required for different types of charge
documents will be on the basis of government/NBR circular
 B. Execution:

Execution of documents is the process of signing documents to make them

legally binding. In the context of bank credit formalities, the execution of
documents is one of the steps towards completion of the loan process.

There are a number of important things to keep in mind when executing

documents for a bank loan:

 The documents must be signed by the person(s) who are authorized to do

so, either in their official capacity or personal capacity.
 The documents must be filled in with permanent ink or be typed.
 The signatories must sign in full according to their specimen signatures
kept with the bank.
 The documents must be executed in the presence of a manager or
authorized officer of the bank.
 If the document comprises more than one page, all the pages must be
signed by the signatories.
 The date and place of execution must be mentioned.
 There should be no blank spaces in any of the documents.
 As far as possible, there should be no cutting, overwriting, alterations,
insertions, or cancellations in any documents. Any alterations that are
made must be authenticated under full signature by the signatories.
 The date on the promissory note must be the same as on other relevant
documents

Witnessing

The following documents must be attested by at least 2 witnesses.

Mortgage deed: This document is the legal agreement between the borrower
and the bank that creates the lien on the property. It is important to have this
document witnessed to ensure that both parties understand and agree to its
terms.

Sale deed: This document transfers ownership of the property from the seller to
the buyer. It is important to have this document witnessed to ensure that the
transfer of ownership is valid and legal.

Gift deed: This document transfers ownership of the property from one person to
another as a gift. It is important to have this document witnessed to ensure that
the gift is voluntary and irrevocable.

Assignment of life insurance policy: This document transfers ownership of a life

insurance policy from one person to another. It is important to have this
document witnessed to ensure that the assignment is valid and binding.

Will: This document is a legal declaration of a person's wishes for the distribution
of their property after their death. It is important to have a will witnessed to
ensure that it is valid and enforceable.
C. Registration:
Registration is not applicable for all documents. In the following few cases
registration of documents is necessary to give legal effect to the instruments.

 The assignment of an insurance policy to be registered with the

respectivw insurance company
 The mortgage deed vetted by the legal retainer to be registered with the
office of the sub-Registrar
 Fixed & floating charges on the assets of a limited company to be
registered with the Registrar of Joint Stock Company

Preservation of Documents:
 Upon completion of all the documentation formalities “ documentation
checklist” to be prepared consisting of the list of documents
 The checklist should be examined & signed by the authorized officer
 Documents should be kept in safe custody preferably in the vault
 Separate files to be maintained for each customer
 Documents Movement Register should be maintained under the
supervision & signature of an authorized officer

# What is the difference between charge documents & legal

documents ? ( y.q 2021 )
Ans :

The main difference between charge documents and legal documents is that
charge documents create a security interest in property that is being used to
secure a loan, while legal documents provide evidence of the borrower's legal
status and authority to borrow money.

Charge documents are a type of security agreement that gives the lender a
right to take possession of the borrower's property if the borrower defaults on
the loan. They typically include the following:

 A demand promissory note, which is a written promise to repay the loan

with interest.
 A letter of arrangement, which outlines the terms of the loan agreement.
 A letter of continuity, which ensures that the security interest survives
changes in the borrower's ownership of the property.
 A letter of revival, which allows the lender to reinstate the loan if the
borrower defaults and then brings the loan current.

Legal documents are any documents that establish the borrower's legal status
and authority to borrow money. They typically include the following:
  The borrower's memorandum and articles of association (for a limited
company) or registered partnership deed (for a partnership firm).
 The borrower's trade license.

# Documentation failure is a common trend in Bangladeshi

Banking industry. Can you suggest for any process how better
documentation standard can be maintained? ( y/q 2020, 2019 )
Ans :

Create a standard documentation checklist. This checklist should list all of the
required documents for each type of loan or advance. The checklist should be
clear and concise, and it should be updated regularly to reflect changes in
regulations.

Train bank staff on documentation requirements. All bank staff who are involved
in the loan origination process should be trained on the documentation
requirements. This training should cover the purpose of each document, the
information that should be included in each document, and the steps involved in
completing each document.

Use electronic document management systems. Electronic document

management systems can help to improve the efficiency and accuracy of
documentation processing. These systems can help to track the status of
documents, ensure that documents are completed on time, and prevent lost or
misplaced documents.

Establish a system of checks and balances. A system of checks and balances

should be established to ensure that all documents are properly reviewed and
approved before a loan is approved. This system should involve multiple levels of
review, and it should include a process for resolving any discrepancies or errors in
the documentation.

Implement a system of penalties for non-compliance. Banks should implement a

system of penalties for non-compliance with documentation requirements. This
will help to ensure that borrowers and bank staff take the documentation process
seriously

# Discuss the method of loan monitoring (y/q 2021, 2020)

There are a variety of methods that can be used for loan monitoring, but some
of the most common include:
Regular financial statement reviews: Lenders will typically require borrowers to
submit periodic financial statements, such as balance sheets and income
statements. These statements can be used to track the borrower's financial health
and identify any changes that could impact their ability to repay the loan.

Cash flow analysis: Lenders may also conduct cash flow analysis to assess the
borrower's ability to generate enough cash to cover their monthly loan payments.
This analysis can be done by reviewing the borrower's bank statements or by
using a cash flow forecasting tool.

Site visits: In some cases, lenders may conduct site visits to the borrower's business
or property. This can help them to get a better understanding of the borrower's
operations and assess the collateral that is securing the loan.

Credit reports: Lenders may also obtain credit reports on borrowers to track their
payment history and credit utilization. This information can be used to identify
borrowers who are at risk of default.

Loan performance monitoring: Lenders may use automated systems to track loan
performance, such as tracking the borrower's payment history, outstanding
balance, and interest rate. This information can be used to identify borrowers
who are at risk of default and take corrective action.
 CREDIT RISK MONITORING AND CONTROL
------------------------------------------------------------------------------------------------------------------------------------------------

Why Credit Risk Monitoring is needed?

The success or failure of any bank is so closely tied to the quality of its loan portfolio,
bank lending practices are subject to close scrutiny from Central Bank and Board of
Directors. Practically every bank complements the governmental supervisory process
with its own credit risk monitoring functions. The scope and depth of an in-bank credit
risk monitoring effort varies among banks.
However, in today's complex commercial lending environment, some form of internal
oversight has become mandatory. Establishing an efficient and effective credit
monitoring system would help senior management to monitor the overall quality of the
total credit portfolio and its trends and helps to reassess credit strategy/policy
accordingly before encountering any major setback.

Loan Monitoring is need for the following purposes:

To minimize credit loss
To ensure return flow of fund
To ensure compliance with the terms and conditions as mentioned in sanction letter.
Problem solving/ to establish early alert process
For taking timely corrective action
Review of borrower relationship/loan facilities.

a) Methods of Loan Monitoring:

Off-site Monitoring

 Periodic reports
 Operating statement and cash flow
 Identification of company's major suppliers so that information regarding
payment behavior can be collected.
 Communication by letter and telephone call.
On-site Monitoring

 Visit factory premise

 Informal meeting with the borrower- by inviting for lunch/dinner
 Physical inspection to verify status of collateral security.
 b) How to implement effective Credit Risk Monitoring System

The heart of an effective loan monitoring program lies open communication between
the bank and the borrower. A bank that has a lending relationship with a borrower
who calls at the first sign of an adverse event is more likely to avoid a problem loan than
a bank with a comprehensive loan review and audit program but with a borrower who
is intent upon hiding a deteriorating financial situation. Another essential ingredient is
complete and accurate credit files.
Credit files are the backbone of loan monitoring because they contain all the documents
(Correspondence and memos, financial statements, credit reports, loan agreements,
collateral records and so forth) that provide a loan officer, bank examiner, loan auditor
and other interested parties with a historical and ongoing record of the borrowing
relationship.
Finally, most bank loan monitoring programs include:

(a) A periodic review of all or selected loans to ensure that they are consistent with
bank loan policy, documentation requirements, profitability requirements, and so forth;

b) Grading of loan quality as measured by key indicators; and

(c) External and internal audits that consider not on the quality of the bank's loan
portfolio, but may also encompass the entire lending function from bank loan policy on
down.
The central figure in setting the tone for bank/borrower communications, maintaining
credit files and conducting or participating in loan reviews, grading and audits is the
commercial loan officer. As the one person at the bank who has dealt with the client
during every stage of the commercial lending process, the loan officer is in a position to
anticipate problems and work with the client to resolve them.
Consequently, the best and most comprehensive bank loan monitoring program is
destined to fail without well-trained and conscientious loan officers who diligently
review the financial statements as they are submitted, who keep accurate and up do
date credit files, stay abreast of economic and regulatory events and most importantly in
touch with the borrower.
 Responsibilities of the Loan Officer
Communication with the borrower:

To effectively monitor a loan, communication between bank and borrower must

come first. As obvious as this might seem, it is surprising how many loan officers
fail to capitalize on the relationship established during the analysis and approval
of the commercial lending request.

In fact, many business executives complain that their loan officer virtually
disappears after the loan has been made. This gives clients the impression that
the lender's principal interest was only in making the loan. Most clients appreciate
a call from their loan officer inquiring how the business is going, what its
prospects for growth are and other questions that show that the bank and
borrower are partners with the common goal of having the business prosper.

An occasional phone call or periodic visit is not only prudent loan monitoring it is
good customer relations as well.

Finally, the loan officer should make the effort to visit the company's premises
from time to time. Such visits promote good customer relations and are important
for thorough credit administration.

The loan officer should also perform/ maintain the following tasks in order to
ensure effective monitoring system.

a) Credit Files

The commercial loan officer has a major hand in the creation, maintenance, and
updating of the client's credit files.

Credit files represent a written record of the relationship between the bank and its
borrowers and as such, are indispensable to the smooth operation of the commercial
lending function.

Practically everyone associated with lending in a bank has, at one time or another, had
occasion to refer to a credit file. Bank counsel turns to credit files in the event of
litigation or to research and clarify legal concerns and bank auditors and examiners rely
on credit files as their primary Source of information when investigating a borrowing
relationship.

For loan officer credit files have innumerable uses, they provide:

 A record of the lending relationship and how it has evolve over time
 A reference source for internal credit checks and in the exchange of credit
information with other financial institutions
 A picture of the client total account relationship that may prove useful in selling
other bank products and services
 A source of financial data in, for example, comparing the performance of several
companies within an industry

Content and Organization of Credit Files

Although many bank employees may contribute to and use the information in
credit files, usually the loan officer has ultimate responsibility for their contents
and organization However, the fact that the loan officer bears responsibility for
the credit file does not mean it should be handled as though the officer is its sole
user. Anyone in the bank should be able to pick up a credit file and quickly find
the information needed without interpretation from the loan officer.

Every bank has its own style for organizing the contents of its credit files.
Whatever the arrangement, it is important that all files follow the same
consistent format Although organizational practices vary from bank to bank,
information in credit files is usually grouped into the following general
categories:

Copies of Loan documents.

This section includes copies of promissory note, loan agreements, guarantees,

corporate resolutions, Partnership agreements, and subordination agreements.
Original documents are usually held in a separate collateral file.

Financial information.

This section includes balance sheets, income statements, spreadsheets, funds

flow statements, cash budgets, pro forma statements, personal financial
statements, business plans, tax returns, the loan application, and financial
statements of guarantors, if any.

Credit inquiries and reports.

This section holds the reports of Credit Information Bureau (CIB) and any private
credit investigations. It may also include records of telephone inquiries, credit
correspondence and bankruptcy notices.

Collateral information.

Any information relating to the collateral securing the loan would be included in
this section. Copies of documents might include security agreements and
assignments of interest in deposit accounts, stocks, and other property. insurance
 policies; landlord waivers; and mortgages or deeds of trust. Again origi nals
would be held in a separate collateral file.

LOAN REVIEW AND RATING

A bank loan portfolio is made up of thousands of loans, each of which has been
approved independently of the others. Over time, some of the loans become poor
credit risks (due to deteriorating collateral, improper documentation and so forth);
others deviate from bank loan policy, and sometimes too many loans are made to
companies in a specific industry. To safeguard against these and other risks, banks
periodically conduct an independent, after-the-fact review of some or all of the loans in
their portfolio. Such a review serves to

 Identify loans that have the potential of becoming problem loans

 Examine bank lending procedures and ensure that they comply with loan policy
and Bangladesh Bank regulations
 Asses the overall quality and composition of the loan portfolio
 Ascertain the adequacy of bank loan loss reserves (a reserve account set up by
the bank against which loan losses are charged)
 Evaluate the competency of bank loan officers

c) Organization and the scope of the bank loan review program

The organization and scope of a loan review program varies from bank to bank. The
size and condition of the loan portfolio, cost and staffing considerations are some of
the factors that have a bearing on which loans will be reviewed, when they will be
reviewed and who has responsibility for reviewing them.
Banks with large and diversified loan portfolios usually establish a separate loan
review department that is staffed by highly trained, specialized personnel who report
to the bank president or an appropriate committee. Smaller banks, with their more
limited loan volume and personnel resources, either use one employee who is in
charge of loan review and compliance, bring in an outside consultant, or call upon a
committee of senior loan officers.
The scope of the loan review program also depends on the bank. A bank with a
portfolio of loans to businesses in a troubled industry may opt to review all of its
loans every three months until conditions in the industry improve Some banks
cannot afford a frequent review of all loans. Instead, a graduated review system,
based on the quality of each loan, is often the best course.
Decisions about which loans to review and how often are also based on loan size
and complexity. Credit arrangements involving large borrowings or collateral that
could rapidly deteriorate in value might be scheduled for regular reviews.
 A Loan Review Checklist

A thorough loan review entails going over many of the steps in the commercial lending
process: interview notes are reread, credit reports are verified again, memos and
correspondence with the client are reviewed, financial statements are reanalyzed,
documentation is reaffirmed, collateral records are checked and so on.

The apparent duplication of effort is necessary, however, because the key to loan review
is to obtain independent, objective appraisal of credit quality. Again, the resources
committed in loan review vary from bank to bank. Generally, each loan is analyzed to
determine its conformity to bank loan policy; its purpose; the sources and terms of
repayment; the financial condition of the borrower, the presence of documentation,
checks on collateral and loan profitability; and compliance with regulations.

Evaluating the loan in each of these areas should provide a comprehensive picture of its
overall credit quality. The reviewer can then recommend what specific actions, if any,
are needed to strengthen the existing credit arrangement.

Conformity to bank loan policy.: Every bank has a written loan policy that sets forth
management's lending philosophy and provides a formal set of procedures for carrying
it out. A bank loan policy is the one document that provides a framework for all lending
practices. It should be read, reread and then continually referred to by all loan officers.
In the absence of a bank loan policy (or when it is ignored), the bank invariably falls
victim to random,

Did You Know ??

Most bank loan policies contain:

 A description of the bank's system for approving loans
 An explanation of lending authorities (limits to which loan officers can lend
without seeking additional approval)
 An explanation of the bank's system for reviewing, rating and auditing loans
 A statement of lending standards, exceptions to standards and loan approval
authorities
 Definitions of desirable and undesirable loans-types, terms, collateral, pricing,
geographic market, documentation and so forth a general statement of good
lending practices
 A general statement of good lending practices
Inconsistent loan decision making.

One lender may be turning down loans that are perfectly acceptable by the
bank's standards, while another lender is approving loans that exceed his or her
lending authority or are to businesses the bank has no experience with. Because
of the dangers inherent in any significant deviation from bank loan policy, all
loans should be reviewed for conformity with the policy.

Purpose.

During the loan review, it is essential to check the purpose of the loan, which
should be clearly identified in the loan documents. The reviewer should also
consider whether the stated use of the loan is appropriate for that particular
borrower. Obviously, a credit arrangement in which no specific reason is given
for the loan leaves the bank with no recourse in ensuring that its funds were
used properly. It might later be discovered, for example, that a working capital
loan was used to satisfy some short-term debt obligations rather than finance the
company's purchase of inventory.

Loan repayment source and term.

The primary and secondary repayment sources of the loan and its terms should
also be evaluated during a loan review. Both the repayment sources and terms
should be clearly defined in loan documents and should conform with bank loan
policy and the borrower's credit needs. No loan should ever be made without
considering how it will be repaid.

Financial condition of the borrower.

A loan reviewer should also evaluate the financial condition of the borrower, any
improvements or deterioration in income and balance sheet accounts, cash flow,
key ratios and so forth. Other areas of interest include the borrower's record of
loan payments, the borrower's continued ability to meet the loan payments and
the effect, if any, of developments in competition, legislation, the economy
and other external factors.

Documentation.

A physical inspection of the documents in the credit file is usually part of a

loan review. This is done partly to ensure that all documents are properly
prepared and signed and fillings have been made and updated. Guarantees
should be current and properly signed. Depending on bank policy, the
circumstances of the violations and the seriousness of the violations, appropriate
action can be taken.
Collateral.

While collateral is never the primary repayment source for a loan, many loan
losses are a direct result of collateral that was lost, improperly documented, or in
such poor condition that it had little liquidation value. Therefore, a loan review
should also include a physical inspection of collateral and an examination of
collateral records.

Credit checks.

The client's files should also be reviewed to verify that credit inquires were made
and are current. Reviewers should consider whether any unusual
credit inquires (in nature or volume) have been received from other
parties, whether agency credit reports are current and whether the
borrower's payments to other creditors appear to be in order.

Profitability.

Of obvious importance in a loan review is whether the loan has been profitable
to the bank. This can be determined by calculating loan revenue (interest earned
on the loan, earning creditors and other income) and loan cost (administrative
expenses and so forth) and then taking into account the average loan amount
outstanding to arrive at the percentage yield on the loan to date.
CREDIT RISK GRADING

(This Part of the discussion is based on the Bangladesh Bank

Guidelines for Credit Risk Grading)

DEFINITION OF CREDIT RISK GRADING (CRG)

 The Credit Risk Grading (CRG) is a collective definition based on the pre-specified
scale and reflects the underlying credit-risk for a given exposure.
 A Credit Risk Grading deploys a number/ alphabet/ symbol as a primary summary
indicator of risks associated with a credit exposure.
 Credit Risk Grading is the basic module for developing a Credit Risk
Management system.

Credit Risk Grading (CRG) is a system used by financial institutions, such as banks,
to assess the creditworthiness of borrowers or counterparty risk associated with
lending. It's a method for evaluating and categorizing the credit risk of individual
loans or credit exposures within a bank's portfolio. The purpose of credit risk
grading is to make informed decisions about lending and to manage the risk
associated with different borrowers.

FUNCTIONS OF CREDIT RISK GRADING

Well-managed credit risk grading systems promote bank safety and soundness by
facilitating informed decision-making. Grading systems measure credit risk and
differentiate individual credits and groups of credits by the risk they pose. This
allows bank management and examiners to monitor changes and trends in risk
levels. The process also allows bank management to manage risk to
optimize returns.
HOW TO COMPUTE CREDIT RISK GRADING

The following step-wise activities outline the detail process for arriving at credit risk
grading.

Step I: Identify all the Principal Risk Components

Credit risk for counterparty arises from an aggregation of the following:

• Financial Risk

• Business/Industry Risk • Management Risk

• Security Risk

• Relationship Risk

Each of the above mentioned key risk areas require to be evaluated and aggregated to
arrive at an overall risk grading measure.

a) Evaluation of Financial Risk:

Risk that counterparties will fail to meet obligation due to financial distress. This typically
entails analysis of financials i.e. analysis of leverage, liquidity, profitability & interest
coverage ratios. To conclude, this capitalizes on the risk of high leverage, poor liquidity,
low profitability & insufficient cash flow.

b) Evaluation of Business/Industry Risk:

Risk that adverse industry situation or unfavorable business condition will impact
borrowers' capacity to meet obligation. The evaluation of this category of risk looks at
parameters such as business outlook, size of business, industry growth, market
competition & barriers to entry/exit. To conclude, this capitalizes on the risk of failure
due to low market share & poor industry growth.

c) Evaluation of Management Risk:

Risk that counterparties may default as a result of poor managerial ability including
experience of the management, its succession plan and team work.

d) Evaluation of Security Risk:

Risk that the bank might be exposed due to poor quality or strength of the security in
case of default. This may entail strength of security & collateral, location of collateral and
support.
e) Evaluation of Relationship Risk:

These risk areas cover evaluation of limits utilization, account performance,

conditions/covenants compliance by the borrower and deposit relationship.
EARLY WARNING SIGNALS (EWS)

Early Warning Signals (EWS) indicate risks or potential weaknesses of an exposure

requiring monitoring, supervision, or close attention by management.
If these weaknesses are left uncorrected, they may result in deterioration of the
repayment prospects in the Bank's assets at some future date with a likely prospect of
being downgraded to classified assets.
Early identification, prompt reporting and proactive management of Early
Warning Accounts are prime credit responsibilities of all Relationship Managers and
must be undertaken on a continuous basis.
Despite a prudent credit approval process, loans may still become troubled. Therefore, it
is essential that early identification and prompt reporting of deteriorating credit signs be
done to ensure swift action to protect the Bank's interest. The symptoms of early
warning signals as mentioned below are by no means exhaustive and hence, if there
are other concerns, such as a breach of loan covenants or adverse market rumors that
warrant additional caution, a Credit Risk Grading Form (Appendix-D) should be
presented.
Irrespective of credit score obtained by any obligor as per the proposed risk grade score
sheet, the grading of the account highlighted as Early Warning Signals (EWS) accounts
shall have the following risk symptoms.

a) Marginal/Watch list (MG/WL-4): if-

 Any loan is past due/overdue for 60 days and above.
 Frequent drop in security value or shortfall in drawing power exists.

b) Special Mention (SM-5): if-

 Any loan is past due/overdue for 90 days and above
 Major document deficiency prevails (such deficiencies include but not limited
to; board resolution for borrowing not obtained, sanction letter not accepted by
client, charges/hypothecation over assets favoring bank not filed with Registrar,
Joint Stock Companies, mortgage not in place, guarantees not obtained, etc.)
 A significant petition or claim is lodged against the borrower.

The Credit Risk Grading Form of accounts having Early Warning Signals should be
completed by the Relationship Manager and sent to the approving authority in Credit
Risk Management Department. The Credit Risk Grade should be updated as soon as
 possible and no delay should be there in referring Early Warning Signal accounts or any
problem accounts to the Credit Risk Management Department for their early
involvement and assistance in recovery.

Year Questions:
A. What is Credit Risk Grading (CRG)? Year 2021
Answer: See the lecture manual.
 When does a loan to be classified as marginal/watch
list? Year 2021
 Answer:
The classification of a loan as "marginal" or on a "watch list" typically depends on the
financial institution's internal policies and guidelines, as well as regulatory requirements.
However, there are some common factors that can lead to a loan being classified as
marginal or placed on a watch list:

1. Deteriorating Creditworthiness of the Borrower: If the financial condition of the

borrower begins to weaken, such as a decline in their income, profitability, or credit
score, the loan may be flagged for closer monitoring.
2. Payment Delinquency: If the borrower starts missing payments or paying late, it can
trigger concerns and lead to the loan being placed on a watch list.
3. Economic or Industry-Specific Factors: Changes in the economic environment or
industry-specific factors can impact the borrower's ability to repay the loan. For example,
a recession or adverse industry conditions can affect a borrower's business and financial
health.
4. Loan Covenants Violation: If the borrower violates any loan covenants or terms
specified in the loan agreement, it can trigger a watch list classification.
5. Collateral Valuation Issues: If the collateral securing the loan (if applicable) experiences a
decrease in value, it can raise concerns about the loan's riskiness.
6. External Credit Ratings: If an external credit rating agency downgrades the borrower's
credit rating, the loan may be classified as marginal.
7. Interest Rate Sensitivity: Loans with variable interest rates may be closely monitored if
there is a significant interest rate change that could impact the borrower's ability to
service the debt.
8. Past Performance: Historical performance of the borrower, including any prior defaults
or restructurings, may also be considered when placing a loan on a watch list.
9. Special Mention in Regulatory Examinations: During regulatory examinations, if
examiners identify issues with a loan, they may recommend placing it on a watch list or
classifying it as marginal.
10. Management's Assessment: The financial institution's management, including its credit
risk and loan review teams, often plays a significant role in determining which loans
should be classified as marginal or placed on a watch list.

It's important to note that the specific criteria and thresholds for classifying loans can
vary from one financial institution to another. Also, the terminology used (e.g.,
"marginal," "watch list," "substandard," "non-performing") can differ between institutions
and may be subject to regulatory definitions. Typically, when a loan is classified as
marginal or placed on a watch list, it triggers enhanced monitoring, potential loan
restructuring, or other risk mitigation measures to address the concerns and reduce the
risk of default.

B. According to CRG, What are the risk rating grades?

Year 2020
 Answer:
CRG, which stands for Credit Risk Grading, is a system used to assess the credit risk
associated with borrowers or loans in the context of banking and financial institutions.
The specific risk rating grades used in a CRG system can vary from one institution to
another, and they are often customized to suit the institution's risk assessment
framework. However, there are commonly used systems that assign risk rating grades
ranging from high credit quality to poor credit quality. Here's an example of a typical
CRG system with risk rating grades:

1. High Credit Quality:

 CRG 1: Very Low Risk
 CRG 2: Low Risk
2. Satisfactory Credit Quality:
 CRG 3: Moderate Risk
 CRG 4: Acceptable Risk
3. Fair Credit Quality:
 CRG 5: Marginal Risk
 CRG 6: Watch List
4. Poor Credit Quality:
 CRG 7: Substandard
 CRG 8: Doubtful
 CRG 9: Bad & Loss

In this system, CRG 1 and CRG 2 represent borrowers or loans with the lowest credit risk,
while CRG 9 represents those with the highest credit risk. Borrowers or loans classified
as CRG 5 or higher are typically considered to be of greater concern and may require
closer monitoring, risk mitigation strategies, or loan restructuring.

It's important to note that the specific criteria and definitions for each rating grade can
vary between financial institutions and may be influenced by regulatory guidelines.
Additionally, CRG systems may include additional subcategories or ratings within each
 grade to provide a more granular assessment of credit risk. Borrowers or loans are
assigned a particular CRG based on various factors, including financial health,
repayment history, collateral, and overall creditworthiness.

C. Discuss the following techniques for assessing the

credit risk – I) Environmental Analysis. II) Financial
Analysis. Year 2020
 Answer:
Assessing credit risk is a critical part of the lending and credit underwriting process for
financial institutions. Two key techniques for assessing credit risk are Environmental
Analysis and Financial Analysis. Let's discuss each of these techniques in detail:

I) Environmental Analysis:

Environmental analysis, also known as macroeconomic analysis or industry analysis,

involves assessing the broader economic and industry-specific factors that can impact
the creditworthiness of a borrower. This analysis provides a contextual understanding of
the external factors that may affect the borrower's ability to meet their financial
obligations. Here are some key aspects of environmental analysis:

1. Economic Conditions: Evaluate the overall economic environment, including factors like
GDP growth, inflation, interest rates, and unemployment rates. A strong economy
generally supports borrowers' ability to repay loans.
2. Industry Trends: Assess the specific industry in which the borrower operates. Look for
trends, competitive dynamics, and regulatory changes that could affect the borrower's
business.
3. Market Conditions: Consider market conditions that can influence the borrower's
revenue and profitability, such as supply and demand, pricing dynamics, and consumer
behavior.
4. Government Policies: Examine government policies and regulations that might impact
the borrower's industry or business operations.
5. Global Events: Assess how global events like geopolitical tensions, trade disputes, or
pandemics may affect the borrower's business and the broader economy.

Environmental analysis helps financial institutions identify potential risks that are beyond
the control of the borrower and may impact their ability to repay the loan. It provides
valuable context for making lending decisions and risk assessments.

II) Financial Analysis:

Financial analysis is a detailed examination of a borrower's financial statements,

performance, and creditworthiness. It focuses on the borrower's historical and current
financial health and provides insights into their ability to service debt. Key components
of financial analysis include:
1. Financial Statements: Review the borrower's financial statements, including the income
statement, balance sheet, and cash flow statement. Analyze trends, growth, and
financial ratios.
2. Profitability: Assess the borrower's profitability, margins, and the consistency of earnings.
A stable and profitable business is more likely to meet its financial obligations.
3. Liquidity: Evaluate the borrower's liquidity position by examining their current assets,
current liabilities, and working capital. Adequate liquidity ensures they can meet short-
term obligations.
4. Leverage: Analyze the borrower's level of debt compared to equity. High leverage can
indicate increased financial risk.
5. Cash Flow Analysis: Review the borrower's cash flow to determine their ability to
generate cash from operations and meet debt service requirements.
6. Credit History: Check the borrower's credit history, including their repayment track
record on existing loans or credit lines.
7. Collateral: Assess the quality and value of any collateral securing the loan.

Financial analysis provides quantitative insights into a borrower's financial stability and
creditworthiness. It helps determine the appropriate loan terms, interest rates, and credit
limits.

Both environmental and financial analysis are essential components of a comprehensive

credit risk assessment process. Combining these techniques allows financial institutions
to make informed lending decisions, mitigate risks, and tailor loan structures to
individual borrower profiles and economic conditions.

D. What are the components of Credit Risk? Year 2020

 Answer:
Credit risk, also known as default risk, is the risk that a borrower may fail to meet their
contractual obligations to repay a loan or debt. It is a significant concern for financial
institutions and lenders. The components of credit risk encompass various factors that
contribute to the likelihood of a borrower defaulting on their obligations. Here are the
key components of credit risk:

1. Borrower's Creditworthiness: This is a fundamental component and includes an

assessment of the borrower's financial health, credit history, and overall ability to repay
the debt. Factors such as income, assets, liabilities, and credit scores play a crucial role in
determining creditworthiness.
2. Financial Stability: Evaluating the financial stability of the borrower is essential. Financial
stability involves analyzing the borrower's income, cash flow, profitability, and liquidity.
A stable financial position reduces the likelihood of default.
3. Loan Terms and Conditions: The terms and conditions of the loan agreement, including
interest rates, repayment schedules, and covenants, impact credit risk. More favorable
terms can reduce the risk of default, while unfavorable terms can increase it.
4. Collateral: If the loan is secured by collateral (e.g., real estate, assets, or inventory), the
quality and value of the collateral are important factors. Adequate collateral can mitigate
credit risk by providing a source of repayment in case of default.
5. Market and Industry Factors: The borrower's industry and market conditions can affect
credit risk. Factors such as competition, regulatory changes, and economic trends can
impact a borrower's ability to repay debt.
6. Economic Conditions: Broader economic conditions, such as economic cycles, inflation
rates, and unemployment levels, can influence credit risk. A weak economy may
increase the risk of default.
7. Credit Policies and Procedures: The credit risk management policies and procedures of
the lending institution also play a role. Effective risk assessment and mitigation strategies
can reduce credit risk.
8. Diversification: The diversification of a lender's loan portfolio can affect credit risk. A well-
diversified portfolio that includes loans to borrowers from different industries and
geographic regions can spread risk more effectively.
9. Regulatory and Legal Factors: Compliance with regulatory requirements and adherence
to legal standards are important in managing credit risk. Violations or legal disputes can
increase the risk of default.
10. Counterparty Risk: In cases of derivative contracts or complex financial transactions,
counterparty risk represents the risk that the other party may default on their
obligations.
11. Credit Concentration Risk: This risk arises when a significant portion of a lender's
portfolio is concentrated in loans to a few borrowers or industries. If these borrowers or
industries experience financial difficulties, it can lead to higher credit risk.
12. Credit Monitoring and Management: The effectiveness of ongoing credit monitoring,
risk management, and early warning systems are critical components in identifying and
addressing credit risk in a timely manner.
13. External Ratings and Reports: External credit ratings and reports from credit rating
agencies can provide valuable insights into the credit risk associated with specific
borrowers or debt securities.

Understanding and managing these components of credit risk is essential for financial
institutions to make informed lending decisions, set appropriate risk appetite, and
implement risk mitigation strategies to minimize the impact of defaults on their
portfolios.

E. Why should we carry out credit risk grading? Year 2019

 Answer:
Credit risk grading is a crucial process carried out by financial institutions and lenders for several
important reasons:

1. Risk Assessment: Credit risk grading allows lenders to assess and quantify the level of risk associated
with a particular borrower or loan. By assigning a risk grade, lenders can categorize borrowers into
different risk categories, which helps in making informed lending decisions.
2. Risk Differentiation: It helps differentiate between borrowers with varying levels of creditworthiness.
Lenders can use risk grades to distinguish between high-risk and low-risk borrowers, allowing them
to allocate resources and set terms and conditions accordingly.
3. Credit Decision Making: Credit risk grading provides a basis for making credit decisions, including
whether to approve or decline a loan application. It also guides decisions regarding loan terms,
interest rates, and credit limits.
4. Portfolio Management: Lenders often have a portfolio of loans and credits. Credit risk grading assists
in managing the overall credit portfolio by identifying concentrations of risk and enabling risk
diversification strategies.
5. Risk Pricing: Lenders can use risk grades to determine appropriate pricing for loans. Higher-risk
borrowers may be charged higher interest rates to compensate for the increased risk, while lower-
risk borrowers may receive more favorable terms.
6. Risk Monitoring: After a loan is extended, ongoing monitoring of the borrower's creditworthiness is
crucial. Credit risk grading provides a benchmark for tracking changes in a borrower's risk profile
over time and initiating corrective actions if necessary.
7. Regulatory Compliance: Many regulatory authorities require financial institutions to have a
structured credit risk grading system in place as part of their risk management and compliance
frameworks. Compliance with these regulations is essential for the safety and soundness of financial
institutions.
8. Risk Mitigation: When a borrower is assigned a higher risk grade, lenders may implement risk
mitigation measures such as stricter covenants, increased collateral requirements, or more frequent
monitoring to minimize potential losses.
9. Credit Loss Estimation: Credit risk grading assists in estimating potential credit losses within a loan
portfolio. This is important for provisioning and ensuring that adequate reserves are set aside to
cover expected losses.
10. Credit Reporting: Credit risk grades can be reported to credit bureaus and other credit reporting
agencies. This information can impact a borrower's credit score and affect their ability to obtain
credit from other lenders.
11. Investor Confidence: For financial institutions that securitize or sell loans to investors, credit risk
grading provides transparency and confidence to investors about the quality of the underlying
assets.

In summary, credit risk grading is a systematic and structured approach that helps lenders assess,
manage, and mitigate credit risk effectively. It supports sound credit decision-making, regulatory
compliance, risk diversification, and ultimately helps lenders maintain a healthy and profitable loan
portfolio while minimizing losses from defaults.

F. How do you interpret superior and substandard grade?

Year 2019
 Answer:
The interpretation of "superior" and "substandard" grades in the context of credit risk grading may
vary depending on the specific credit risk grading system used by a financial institution. However, in
a general sense, these grades can be interpreted as follows:

Superior Grade:

A "superior" grade typically indicates the highest level of creditworthiness and the lowest level of
credit risk for a borrower or a loan. Here's how to interpret a "superior" grade:
1. Very Low Credit Risk: A superior grade suggests that the borrower or the loan being assessed poses
very little credit risk. This means that the borrower is highly likely to meet their financial obligations
and repay the loan on time.
2. Strong Financial Health: Borrowers assigned a superior grade are usually financially strong, with a
stable income, healthy cash flow, and a solid balance sheet. They have a history of consistent and
reliable financial performance.
3. Low Probability of Default: The likelihood of the borrower defaulting on the loan is extremely low.
Lenders can have a high degree of confidence in the borrower's ability to repay the debt.
4. Favorable Loan Terms: Borrowers with a superior credit risk grade may be eligible for more favorable
loan terms, including lower interest rates and more flexible repayment options.
5. Minimal Monitoring: Lenders may require minimal monitoring for loans or borrowers with a superior
grade because the risk of default is so low.

Substandard Grade:

A "substandard" grade, on the other hand, represents a lower level of creditworthiness and a higher
level of credit risk. Here's how to interpret a "substandard" grade:

1. Elevated Credit Risk: A substandard grade indicates that the borrower or the loan being assessed
poses a higher level of credit risk. There is a significant risk that the borrower may not fully meet their
financial obligations.
2. Financial Challenges: Borrowers with a substandard grade may have financial challenges, such as
inconsistent income, limited cash flow, or a weaker balance sheet. They may have a history of
financial difficulties or missed payments.
3. Increased Probability of Default: The likelihood of the borrower defaulting on the loan is higher
when they are assigned a substandard credit risk grade. Lenders need to be cautious and may
implement risk mitigation measures.
4. Less Favorable Loan Terms: Borrowers with a substandard credit risk grade may be offered less
favorable loan terms, including higher interest rates and more stringent repayment conditions, to
compensate for the increased risk.
5. Enhanced Monitoring: Lenders typically require closer and more frequent monitoring of loans or
borrowers with a substandard grade to proactively address any issues that may arise.

It's important to note that the specific criteria and definitions for superior and substandard grades
can vary between financial institutions and credit risk grading systems. The above interpretations
provide a general understanding of how these grades are commonly used, but the exact meaning
may differ based on the institution's policies and guidelines. Additionally, credit risk grading systems
often include other intermediate grades between these extremes to provide a more nuanced
assessment of credit risk.

G. How would you measure management risk and

security risk? Year 2019
 Answer:
Measuring management risk and security risk involves assessing the likelihood and potential impact
of various factors that can affect an organization's management and the security of its operations.
These risks can vary widely depending on the industry, the nature of the organization's activities, and
its specific circumstances. Here's how you can measure each of these risks:

Measuring Management Risk:

 Management risk refers to the risk associated with the competence, decisions, and actions of an
organization's leadership team. It encompasses a range of factors related to the effectiveness of
management in achieving the organization's goals and safeguarding its interests. To measure
management risk:

1. Management Competence: Assess the qualifications, experience, and track record of key executives
and leaders within the organization. Evaluate whether they have the necessary skills to make
informed decisions and navigate complex challenges.
2. Corporate Governance: Evaluate the organization's corporate governance structure, including the
composition and independence of the board of directors, the presence of audit and risk committees,
and adherence to governance best practices.
3. Strategic Planning: Examine the organization's strategic planning processes, including its ability to set
clear goals and objectives, adapt to changing market conditions, and implement effective strategies.
4. Financial Management: Analyze the financial management practices of the organization, including
budgeting, financial reporting, and risk management. Assess the transparency and accuracy of
financial disclosures.
5. Ethical Conduct: Evaluate the organization's commitment to ethical conduct and compliance with
laws and regulations. Assess whether there have been any ethical lapses or legal issues involving
management.
6. Succession Planning: Consider the organization's approach to succession planning and leadership
continuity. Assess whether there are plans in place to ensure smooth transitions in leadership roles.
7. Stakeholder Relationships: Examine the organization's relationships with key stakeholders, such as
shareholders, customers, suppliers, and employees. Assess whether management effectively
communicates and manages these relationships.
8. Crisis Management: Analyze the organization's readiness to respond to crises and unexpected
events. Evaluate the effectiveness of crisis management plans and procedures.

Measuring Security Risk:

Security risk refers to the risk of harm, loss, or damage to an organization's physical assets,
information, technology infrastructure, and personnel. It encompasses various aspects of security,
including physical security, cybersecurity, and operational security. To measure security risk:

1. Threat Assessment: Identify and assess potential threats and vulnerabilities that could pose security
risks to the organization. These threats may include physical threats (e.g., natural disasters, theft,
vandalism) and cyber threats (e.g., data breaches, cyberattacks).
2. Security Controls: Evaluate the adequacy and effectiveness of security controls and measures in place
to mitigate identified threats. This includes physical security measures, access controls, data
encryption, and cybersecurity defenses.
3. Incident Response: Assess the organization's incident response capabilities. Evaluate whether there
are well-defined procedures for responding to security incidents and breaches, including
communication plans and containment strategies.
4. Security Awareness: Measure the level of security awareness and training among employees. Well-
informed and trained staff can be a critical defense against security threats.
5. Compliance: Ensure that the organization complies with relevant laws, regulations, and industry
standards related to security. Non-compliance can increase security risk.
6. Third-Party Risk: Evaluate the security practices of third-party vendors and partners that have access
to the organization's data or systems. Assess their security controls and assess potential risks they
may introduce.
7. Regular Assessments: Conduct regular security risk assessments and testing, including vulnerability
assessments, penetration testing, and security audits.
8. Security Investments: Assess the organization's budget allocation for security measures and whether
it aligns with the identified security risks and needs.

Measuring management risk and security risk requires a comprehensive and systematic approach
that involves evaluating various factors, conducting assessments, and implementing appropriate risk
management strategies to mitigate these risks effectively. It is an ongoing process that should adapt
to changing circumstances and emerging threats.
H. What do you mean by lending? Is it good or bad? Year
2019
 Answer:
Lending refers to the practice of providing financial resources, typically in
the form of loans, to individuals, businesses, or organizations in exchange
for the promise of repayment with interest. Whether lending is good or
bad depends on various factors, including responsible lending practices,
the borrower's ability to repay, and the purpose of the loan. Responsible
lending can support economic growth and financial stability, while
irresponsible lending or borrowing can lead to financial problems and
instability. It's important to assess each lending situation on a case-by-case
basis.
I. Credit risk grading is the basic module of for developing
a credit risk management system? Explain. Year 2018
 Answer:
 Credit risk grading is indeed a fundamental building block in the
development of a credit risk management system. It provides a systematic
and standardized way to evaluate and categorize the creditworthiness of
borrowers or counterparties. By assigning specific risk grades, financial
institutions can assess the likelihood of default and the potential impact of
default on their loan portfolios. This information is essential for making
informed lending decisions, setting appropriate interest rates, terms, and
loan limits, and establishing risk management policies.
 Furthermore, credit risk grading allows financial institutions to monitor the
credit quality of their loan portfolio over time, identify potential areas of
concern, and take proactive measures to mitigate risks. It serves as a critical
tool for regulatory compliance, portfolio diversification, and overall risk
management. Whether in a small, mid-sized, or large financial institution, a
well-implemented credit risk grading system is essential for sound credit
risk management and maintaining the stability and profitability of the
institution.
J. In which sector an individual can use the CRG? Year
2018
 Answer:
An individual can use Credit Risk Grading (CRG) primarily in the financial
sector. CRG is a risk assessment tool commonly employed by banks, credit
unions, and other financial institutions when evaluating the
 creditworthiness of borrowers seeking loans or credit facilities. It helps
individuals or businesses understand how their creditworthiness is
perceived by lenders, which can affect their ability to secure loans, interest
rates, and loan terms. While individuals themselves do not typically assign
CRG grades, they can access their credit reports, which may include credit
scores and information used by lenders to determine credit risk. These
reports influence their ability to obtain credit in various sectors, including
personal loans, mortgages, and credit cards.
K. According to regulatory definition how a loan can be
differentiate as classified loan by objective criteria? Year
2018
 Answer:
The classification of loans by objective criteria, as defined by regulatory authorities,
typically involves categorizing loans into different classifications based on the level of risk
or the likelihood of repayment. These classifications can vary from one regulatory
authority to another but often include the following categories:

1. Standard/Performing Loans: These are loans where borrowers are meeting all their
repayment obligations, and there is no significant risk of default. They are considered
low-risk loans.
2. Substandard Loans: Substandard loans have weaknesses that may lead to some degree
of loss if not addressed. These weaknesses could be related to the borrower's financial
condition or repayment capacity.
3. Doubtful Loans: Doubtful loans have a high risk of default. There are usually substantial
weaknesses in the borrower's financial condition, and full recovery of the loan is
uncertain.
4. Bad and Loss Loans: Bad and loss loans are considered uncollectible. The likelihood of
recovery is very low, and they are written off as losses.

The specific criteria for classifying loans into these categories often include factors like
the borrower's payment performance, financial health, collateral quality, and other
relevant indicators. Regulatory authorities provide guidelines and standards that
financial institutions must follow when determining loan classifications. Accurate loan
classification is crucial for risk assessment, provisioning, and regulatory compliance.
L. Why credit monitoring is needed? Is it helpful to
present a loan review checklist? How? Year 2018
 Answer:
Credit monitoring is essential for several reasons, particularly in the context of lending
and managing credit risk:

1. Early Warning System: Credit monitoring serves as an early warning system, alerting
lenders to any changes in a borrower's creditworthiness. This allows lenders to detect
potential issues before they escalate into serious problems.
2. Risk Mitigation: Monitoring helps in identifying deteriorating credit quality or financial
stress in borrowers. Lenders can then take proactive measures to mitigate the risk, such
as restructuring loans, requiring additional collateral, or adjusting the loan terms.
3. Portfolio Management: It enables financial institutions to manage their loan portfolios
effectively by tracking the overall credit quality and diversification of loans. This helps in
balancing risk exposure across different borrowers and industries.
4. Compliance: Regulatory requirements often mandate regular credit monitoring as part
of a financial institution's risk management practices. Compliance with these regulations
is crucial to avoid penalties and ensure the stability of the institution.
5. Default Prevention: By monitoring borrower behavior and financial performance,
lenders can intervene when necessary to prevent defaults and protect their interests.
6. Credit Policy Adherence: Credit monitoring helps ensure that borrowers are adhering to
the terms and conditions of their loans, including timely payments and compliance with
covenants.

A loan review checklist is a valuable tool for credit monitoring. It helps lenders
systematically assess and track various aspects of the loan and the borrower's
creditworthiness. Here's how a loan review checklist can be helpful:

1. Structured Assessment: A checklist provides a structured approach to reviewing loans,

ensuring that all critical elements are evaluated consistently.
2. Timely Detection: It helps identify issues early by highlighting deviations from the
established criteria, such as missed payments or financial distress.
3. Documentation: A checklist ensures that all necessary documentation is in place,
reducing the risk of missing critical information.
4. Objective Evaluation: It allows for an objective assessment of the loan's performance
and the borrower's credit quality, reducing the likelihood of biased decisions.
5. Tracking: A checklist can be used to track the loan's progress over time, making it easier
to identify trends and take appropriate actions.
6. Reporting: It facilitates reporting to management and regulatory authorities,
demonstrating compliance with risk management practices.

Overall, credit monitoring, facilitated by a loan review checklist, is a proactive approach

to risk management that helps financial institutions maintain the health of their loan
portfolios and make informed decisions about credit risk.

M. What are the uses of CRG in credit risk monitoring

system? Year 2018
 Answer:
Credit Risk Grading (CRG) plays a crucial role in a credit risk monitoring system within
financial institutions. Here are some of its primary uses in credit risk monitoring:

1. Risk Assessment: CRG provides a standardized framework for assessing and categorizing
the credit risk associated with borrowers. It helps determine the risk level of each
borrower or loan, facilitating risk-based decision-making.
2. Portfolio Management: CRG helps financial institutions manage their loan portfolios
effectively by categorizing loans into risk grades. This categorization allows for the
diversification of risk exposure and helps in balancing the overall portfolio risk.
3. Loan Origination: It aids in evaluating loan applications by assessing the
creditworthiness of potential borrowers. Lenders can use CRG to determine whether to
approve a loan, set interest rates, and establish terms and conditions.
4. Early Warning System: CRG serves as an early warning system by identifying borrowers
whose credit risk profile may be deteriorating. Lenders can take proactive measures to
mitigate risks, such as restructuring loans or requesting additional collateral.
5. Credit Policy Adherence: CRG helps ensure that borrowers are adhering to the terms
and conditions of their loans. Any deviation from the expected credit risk grade can
trigger a review and potential action.
6. Regulatory Compliance: Many regulatory authorities require financial institutions to
have a structured credit risk grading system in place. Compliance with these regulations
is essential for the safety and soundness of institutions.
7. Reporting: CRG allows for reporting on the credit quality of the loan portfolio to
management, boards of directors, and regulatory authorities. It provides transparency
and accountability.
8. Risk Mitigation: By identifying higher-risk borrowers, CRG enables lenders to implement
risk mitigation strategies, such as setting aside provisions for expected credit losses.
9. Credit Review: CRG serves as a foundation for conducting periodic credit reviews.
Lenders can review loans with higher risk grades more frequently to assess changes in
the borrower's creditworthiness.
10. Loan Performance Tracking: CRG allows lenders to track the performance of loans over
time. This helps in identifying trends and taking timely actions to address emerging
credit issues.
In summary, CRG is an integral part of credit risk monitoring systems within financial
institutions. It provides a structured and standardized approach to assessing credit risk,
enabling lenders to make informed lending decisions, manage portfolios, and
proactively address credit-related challenges.
N. Mention the loan monitoring method. Year 2018
 Answer: See Lecture Manual.

Reference:

1. Credit Operations and Risk Management In Commercial Banks.

By M.A Matin
2. Credit Risk Grading Manual (Bangladesh Bank)
 LOAN CLASSIFICATION AND PROVISIONING
------------------------------------------------------------------------------------------------------------------------------------------------------------
1.0 INTRODUCTION
Loan Classification means to categorize the debt information in a systematic manner.
The objectives/importance of loan classification is:
1. To find out Net Worth of a bank;
2. To assess the financial soundness of a bank;
3. To calculate the required provision and the amount of interest suspense;
4. Strengthen credit discipline;
5. To improve loan recovery position and
6. Basel II and Basel III devote a great deal of distinction between
"expected losses" and unexpected losses" on the bank's loan
portfolio, expected losses can be assigned to loans based on a loan
classification system.
7. To put the bank on sound footing in order to develop sound banking practices in
Bangladesh.

POLICY ON LOAN CLASSIFICATION AND PROVISIONING

The process of gradually upgrading the policies on loan classification and provisioning
to the international level is going on. Measures have been taken to strengthen the credit
discipline and the process of classification has been simplified.

Categories of Loans:
a) Continuous loan: This type of loan has no repayment schedule. It has only a
specific limit on Credit Operations and Risk Management in Commercial Banks. For the
purpose of loan classification, all types of loans and advances will be divided under an
expiry date. Such as, cash credit and an overdraft.

b) Demand loan: These are loans for fixed amounts which become due whenever the
banks so loan can be considered as demand loan. Such as: forced LIM, PAD/TR, FDBP,
IDBP etc.

c) Fixed-term loans: These are loans with a contractually fixed schedule for
repayment.

d) Short-Term Agricultural and Micro Credit: Short-term agricultural loans will

include the short-term credits as listed under the Annual Credit Program issued by the
Agricultural Credit and Financial Inclusion Department (ACFID) of Bangladesh Bank.
Credits in the agricultural sector repayable within less than 12 months will also be
included herein.
Short-term Micro-Credits will include any micro-credit not exceeding an amount
determined by ACFID of Bangladesh Bank from time to time and repayable within less
than 12 months, be those termed in any names such as Non-agricultural credit, Self-
reliant Credit, Weaver's Credit or Bank's individual project credit.

Basis for loan classification

1. Objective criteria
2. Qualitative Judgment Criteria
3. Improvement in Classification
4. Accounting of the Interest of Classified Loans
5. Maintenance of Provision
A. Objective criteria Three major bases for loan classification under objective criteria are
as follows;

1. Past Due/Over Due

I. Any continuous loan if not repaid within the fixed expiry date for repayment or
after the demand by the bank will be treated as past due/overdue from the
following day of the expiry date.
II. Any demand loan if not repaid within the fixed expiry date for repayment or after
the demand by the bank will be treated as past due/overdue from the following
day of the expiry date.
III. In case of any instalment (s) or part of instalment (s) of a fixed term loan is not
repaid within the fixed expiry date, the amount of unpaid instalment (s) will be
treated as past due/overdue from the following day of the expiry date.
IV. The Short-term Agricultural and Micro-Credit if not repaid within the fixed expiry
date for repayment will be considered past due/overdue after six months of the
expiry date.

2. All unclassified loans under Special Mention Account (SMA) will be

treated as standard.
3. A Continuous loan, Demand Loan or à Term Loan which will remain overdue for a
period of 02 (two) months or more, will be put into a "Special Mention Account (SMA)".
This will help banks to look at accounts with potential problems in a focused manner
and it will capture early warning signals for accounts showing first signs of weakness.
Loans in the SMA will have to be reported to the CIB of Bangladesh Bank.
Any continuous loan will be classified as:
Sub Standard: If it is past due/overdue for 03 (three) months or more but less
than six months.
Doubtful: If it is past due/overdue for 06 (six) months or more but less than nine
months.
Bad & loss: If it is past due/overdue for 09 (nine) months or more

Any demand loan will be classified as under:

Substandard: If it remains past due/overdue for (03) three months or beyond but
less than six months from the date of expiry or claim by the bank or the date of
creation of the loan.
Doubtful: If it remains past due/overdue for (06) six months or more but less than
nine months from the date of expiry or claim by the bank or from the date of
creation of the forced loan.
Bad & loss: If it remains past due/overdue for (09) nine months or more from the
date of expiry or claim by the bank or from the date of creation of forced loan.

In the case of Short-term Agricultural and Micro-Credit if it is not adjusted

within the stipulated date it will be treated as an irregular loan and can be classified as
under:
 Sub Standard: After 12 (twelve) months of the date of becoming irregular.
 Doubtful: After 36 (thirty-six) months of the date of becoming irregular.
 Bad & loss: After 60 (sixty) months of the date of becoming irregular.

B. Qualitative Judgment Criteria: On the basis of the qualitative judgment a loan will be
classified under the following situations:
i) Loss of capital due to any change in business condition under which loan was
allowed.
ii) If the recovery of the loan is uncertain due to an adverse business environment.
iii) Frequent rescheduling or if the rules regarding rescheduling are not met.
iv) Frequent propensity of excess over the approved limit. v) If the value of the collateral
decreases
vi) If the case is lodged towards recovery of the loan.
vii) If the loan is allowed without the approval of the appropriate authority.
  If there is any probability to change the prevailing situation by taking appropriate
measures in spite of the above-mentioned reasons or any other reasons for
which the loan may be turned into defective then on the basis of the qualitative
judgment it will be classified as sub-standard.
 In spite of taking appropriate measures if the chance of recovery is uncertain it
will be classified As doubtful and
 In spite of all out effort if there is no probability to recover the loan it will be
classified as bad and loss.
For incorporating qualitative judgment, banks must focus on the likelihood that the
borrower will repay all amounts due in a timely manner, using their own judgment and
the following assessment factors:

1. Special Mention:
 Assets must be classified not higher than Special Mention if any of the
following deficiencies of Bank Management is present: the loan was not
made in compliance with the Bank's internal policies, failure to maintain
adequate and enforceable documentation; or poor control over collateral.
 Assets must be classified as not higher than Special Mention if any of the
following deficiencies of the obligor is present: occasional overdrawn within
the past year; below average or declining profitability; barely acceptable
liquidity; problems in strategic planning.

2. Sub-standard
 Assets must be classified no higher than Sub-standard if any of the following
deficiencies of the obligor is present: recurrent overdrawn, low account
turnover, competitive difficulties. location in a volatile industry with an acute
drop in demand; very low profitability that is also declining: inadequate
liquidity: cash flow less than repayment of principal and interest; unjustifiable
lack of external audit; pending litigation of a significant nature.
 Asset must be classified no higher than Sub-standard if the primary sources of
repayment are insufficient to service the debt and the bank must look to
secondary sources of repayment, including collateral.
 Assets must be classified no higher than Sub-standard if the banking
organization has acquired the asset without the types of adequate
documentation of the obligor's net worth, profitability, liquidity, and cash
flow that are required in the banking organization's lending policy, or there
are doubts about the validity of that documentation.
3. Doubtful
Assets must be classified no higher than Doubtful if any of the following deficiencies of
the obligor is present:
 permanent overdrawn;
 location in an industry with poor aggregate earnings or loss of markets;
 serious competitive problems;
 failure of key products;
 operational losses, illiquidity, including the necessity to sell assets to meet
operating expenses;
 cash flow less than required interest payments; very poor management; non-
cooperative or hostile management;
 serious doubts about the integrity of management; doubts about true ownership;
and
 complete absence of faith in financial statements.

4. Bad/Loss
Assets must be classified no higher than Bad/Loss if any of the following deficiencies of
the obligor are present:
 the obligor seeks new loans to finance operational losses;
 location in an industry that is disappearing;
 location in the bottom quartile of its industry in terms of profitability;
 technological obsolescence;
 very high losses;
 asset sales at a loss to meet operational expenses;
 cash flow less than production costs;
 no repayment source except liquidation;
 presence of money laundering, fraud, embezzlement, or other criminal activity;
 no further support by owners.
C. Improvement in Classification:
From time to time, in the judgment of the bank, the condition of a loan may improve
and it may be justified to move it to a more favourable classification category. The
decision to move a loan to a more favourable classification category must be
accompanied by an analysis showing that there has been improvement in the payment
performance of the loan and/or in the financial condition of the borrower.
 The decision to move a loan from Bad/loss to Doubtful or Substandard, or from
Doubtful to Substandard, may, with appropriate justification, be taken by the
Chief Credit Officer, with the concurrence of the Chief Financial Officer.
 The decision to move a loan from Substandard, Doubtful, or Bad/Loss to Special
Mention Account or to declassify it completely must be taken by the Board of
Directors, with appropriate justification presented by the branch manager who
originated the loan in question and the Managing Director.

Bangladesh Bank will respond to the bank within 15 days of receiving such a request.
However, in any case where there is a lingering disagreement between the classification
determined by bank management and the classification determined by Bangladesh
Bank, the judgment of the Bank will prevail. Any loan classified during Bangladesh
Bank's on-site inspection on the basis of qualitative judgment cannot be declassified
without the consent of Bangladesh Bank.

D. Accounting of the Interest of Classified Loans:

If any loan or advance is classified as 'Sub-standard' and 'Doubtful, interest accrued on
such loan will be credited to the Interest Suspense Account, instead of crediting the
same to the Income Account. In case of rescheduled loans the unrealized interest, if any,
will be credited to the Interest Suspense Account, instead of crediting the same to the
Income Account. As soon as any loan or advance is classified as 'Bad/Loss, charging of
interest in the same account will cease.
In case of filing a lawsuit for recovery of such loan, interest for the period till filing of the
suit can be charged in the loan account in order to file the same for the amount of
principal plus interest. But interest thus charged in the loan account has to be preserved
in the 'interest Suspense account.
If any interest is charged on any 'Bad/Loss' account for any other special reason, the
same will be preserved in the "interest Suspense account. If a classified loan or part of it
is recovered i.e., the real deposit is effected in the loan account, first, the interest
charged and accrued but not charged is to be recovered from the said deposit and the
principal is to be adjusted afterwards.
E. Maintenance of Provision:

a) General Provision: Banks will be required to maintain General Provision in the

following way:
1. @ 0.25% against all unclassified loans of Small and Medium Enterprise (SME)
as defined by the SME & Special Programs Department of Bangladesh Bank
from time to time and @1% against all unclassified loans (other than loans
under Consumer Financing, Loans to Brokerage House, Merchant Banks,
Stock dealers etc, Special Mention Account as well as SME Financing).
2. @ 5% on the unclassified amount for Consumer Financing whereas it has to
be maintained @ 2% on the unclassified amount for (1) Housing Finance, (ii)
Loans for Professionals to set up business under the Consumer Financing
Scheme.
3. @2% on the unclassified amount for Loans to Brokerage houses, Merchant
Banks, Stock dealers, etc.
4. The rate of provision on the outstanding amount of loans kept in the 'Special
Mention Account' will be the same as the rate stated in para (1), (2), (3) of this
section which one is applicable, i.e. @0.25% against all SMA loan of Small and
Medium Enterprise (SME). @ 5% on the SMA amount for Consumer Financing,
@2% on the SMA amount for Housing Finance, Loans for Professionals to set
up business under the Consumer Financing Scheme, Loans to Brokerage
House, Merchant Banks, Stock dealers, etc. and @ 1% against all other
unclassified loans
5. @ 1% on the off-balance sheet exposures. (Provision will be on the total
exposure and the amount of cash margin or value of eligible collateral will not
be deducted while computing Off-balance sheet exposure).

b) Specific Provision: Banks will maintain provision at the following rates in respect of
classified Continuous, Demand and Fixed Term Loans:
(1) Sub-standard: 20%
(2) Doubtful: 50% (3) Bad/Loss: 100%

c) Provision for Short-term Agricultural and Micro-Credits:

(1) All unclassified credits (irregular and regular): 2.5%
(2) Classified as 'Sub-Standard' and Doubtful: -5%
(3) Classified as Bad/Loss: 100%
 Provisions to Cover All Expected Losses
The expressed minimum percentages of provisions in Paragraph 4 for exposures in
each classification category are absolute minimums, and banks are encouraged to set
aside higher provisions if expected losses on the loan pools (for general provisions) or
individual loans (for specific provisions) warrant.

The base for Provision

For eligible collaterals of the following types, the provision will be maintained at the
stated rates in Para 4 on the outstanding balance of the classified loans less the amount
of Interest Suspense and the value of eligible collateral:

a. Deposit with the same bank under lien against the loan.
b. Government bond/savings certificate

For all other collaterals, the provision will be maintained at the stated rates in Para 4 on
the balance calculated as the greater of the following two amounts:
i. The outstanding balance of the classified loan less the amount of Interest
Suspense and the value of eligible collateral; and
ii. 15% of the outstanding balance of the loan.
However, the basis for the provision shall be further reviewed towards closer
convergence with international best practice standards.
 Eligible Collateral
Year Quest 2021,2020,2019: Define “Eligible Collateral” according to
provision policy.
In the definition of 'Eligible Collateral' as mentioned in the above paragraph the
following collateral will be included as eligible collateral in determining the base
for provision:
-100% of the deposit under lien against the loan
-100% of the value of government bond/savings certificate under lien.
-100% of the value of the guarantee given by the Government or Bangladesh
Bank
-100% of the market value of gold or gold ornaments pledged with the bank.
-50% of the market value of easily marketable commodities kept under the control
of the bank
-Maximum 50% of the market value of land and building mortgaged with the bank
-50% of the average market value for the last 06 months or 50% of the face value,
whichever is less, of the shares traded in the stock exchange.

Determination of Market Value of Eligible Securities (Year quest:2019)

In determining the market value of easily marketable commodities, land and
buildings, banks are advised to follow the instructions mentioned below:
(a) Easily marketable goods will mean pledged, easily encashable/saleable goods
that remain under full control of the bank. However, the concerned bank branch
official will conduct periodic inspections to verify whether issues such as the
suitability of goods for use, expiry period, appropriateness of documentary
evidence, to date insurance cover, same will have to be assessed by the
professional assessor from time to time.
(b) For land and building, banks will have to ensure that title documents are in
order and the concerned land and building will have to be valued by the
professional valuation firm along with the completion of proper documentation in
favour of the bank. In the absence of a professional valuation firm. certificate in
favour of such valuation will have to be collected from the specialised engineer.
Nevertheless, temporary houses including tin-shed structures shall not be shown
as buildings.
(c) In order to facilitate the on-site inspection by our Department of Bank
Inspection, banks are also advised to maintain a complete statement of eligible
securities on a separate sheet in the concerned loan file. Information such as
description of eligible securities, their assessment by recognized firm, marketability
of the commodity, control of the bank, and reasons for considering eligible
securities etc. will have to be included in that sheet.
Year Quest 2021,2020: What is securitization? How are the Key players
involved in the securitization process?
Answer:
Securitization is a financial process that involves pooling various types of contractual
debt, such as mortgages, auto loans, or credit card debt, and converting them into
marketable securities. These securities are then sold to investors, providing a source
of liquidity to the originating institution, such as a bank or a financial company.

Key players involved in the securitization process include:

1. Originators: These are the institutions that create the pool of assets, such as
banks or mortgage lenders.
2. Sponsor: The sponsor selects the assets to be securitized and often initiates the
process. It can be the originator or another entity.
3. Special Purpose Vehicle (SPV): Also known as a bankruptcy-remote entity, the
SPV is created to hold the pooled assets and issue the securities. It isolates the
securitized assets from the originator's or sponsor's balance sheet.
4. Rating Agencies: These agencies assess the risk associated with the securitized
assets and assign credit ratings to the securities based on their evaluation.

5. Investors: These can be individuals, institutions, or other entities that purchase

the securities. They receive payments based on the performance of the
underlying assets.
6. Servicer: The servicer is responsible for collecting payments from the
borrowers of the underlying assets and distributing them to the investors of
the securities.
7. Trustee: The trustee ensures that the securitization process follows the agreed-
upon terms and conditions. They act on behalf of the investors and oversee
the flow of funds between various parties.
8. Regulators: Government agencies or regulatory bodies oversee the
securitization market to ensure compliance with regulations and to maintain
the stability and integrity of the financial system.
These key players work together to facilitate the securitization process, which allows
financial institutions to manage risk, enhance liquidity, and provide additional
lending capacity.
Year Quest 2021: What is a standby letter of credit? Discuss the pros and
cons of it.
Answer:
A Standby Letter of Credit (SBLC) is a financial instrument issued by a bank on behalf of
a client that guarantees payment to a beneficiary if the client fails to fulfil a contractual
commitment. It serves as a safety net, ensuring that the beneficiary will receive the
agreed-upon payment even if the client is unable to fulfil their obligations.

Pros of Standby Letter of Credit:

1. Financial Security: Beneficiaries are assured of payment, providing financial
security and encouraging business transactions.
2. International Trade: Commonly used in international trade, allowing parties from
different countries to engage in business with reduced risk.
3. Creditworthiness: Enhances the client's credibility, as the issuing bank's
involvement indicates their financial stability.
4. Flexible Terms: Can be tailored to specific requirements, accommodating various
types of transactions and agreements.
5. Dispute Resolution: Helps resolve disputes by providing a clear mechanism for
payment if contractual obligations are not met.

Cons of Standby Letter of Credit:

Cost: Banks charge fees for issuing SBLCs, which can be significant and add to the
overall transaction costs.
Complexity: The process of obtaining and managing SBLCs can be complex, requiring a
thorough understanding of international trade regulations and banking procedures.
Potential for Misuse: In some cases, SBLCs can be misused for fraudulent activities,
leading to legal complications and financial losses.
Tying Up Capital: Both the client and the bank need to allocate a certain amount of
capital, which might otherwise be used for other investments.
Dependence on Banks: Relies heavily on the issuing bank's reliability, and any issues
with the bank could jeopardize the transaction.
It's essential for businesses to carefully weigh the advantages and disadvantages before
opting for an SBLC, considering factors such as the nature of the transaction, the
credibility of the parties involved, and the overall cost implications.
Year quest:2019 What is loan securitization? Does credit securitization
reduce bank risk?
Answer: Loan securitization is a financial process where loans, such as mortgages,
auto loans, or credit card debt, are bundled together and sold to investors as
securities. These securities are typically sold to various investors in the form of bonds.
The cash flows from the underlying loans, such as the monthly mortgage payments
from homeowners, are used to pay the investors who hold these securities.
Securitization serves several purposes, including reducing the risk for the original
lender by transferring it to investors, freeing up capital for the lender to issue more
loans, and providing investors with an opportunity to invest in a diversified pool of
loans. However, it also played a role in the 2008 financial crisis when mortgage-
backed securities, a type of securitized loan, experienced significant defaults, leading
to a global economic downturn.

Credit Securitization
Credit securitization can help reduce bank risk in certain situations, but it can also
create new risks if not managed properly.
When a bank securitizes its loans (such as mortgages or auto loans), it transfers the
credit risk associated with those loans to investors who purchase the securities. By
doing so, the bank can remove these loans from its balance sheet, freeing up capital
that can be used for new lending activities. This process helps the bank reduce its
exposure to default risk and can enhance its overall financial stability.
However, it's important to note that if the securitization is not conducted prudently
and the underlying loans are of poor quality or the risks are not adequately disclosed
to investors, it can lead to significant problems. For example, during the 2008 financial
crisis, the securitization of subprime mortgages contributed to widespread financial
instability when these mortgages defaulted at higher rates than expected, causing the
value of mortgage-backed securities to plummet and triggering a crisis in the banking
and financial sectors.
So, while credit securitization has the potential to reduce bank risk, it needs to be done
cautiously, with careful attention to the quality of the underlying loans and
transparent communication of risks to investors. When managed properly, it can help
banks manage their risk exposure effectively.
 18 OFF- Balance sheet financing in
banking & credit derivatives
----------------------------------------------------------------------------------------------------------------------

Introduction:

The banking industry is facing many risks, such as interest rate changes and
loan defaults. To reduce these risks, banks are using a variety of risk
management tools, such as securitization, loan sales, and credit derivatives.

These tools help banks to manage risk more effectively and to generate fee
income. Risk management tools can help banks to reduce their exposure to
risk and to improve their financial performance. The use of risk management
tools is becoming increasingly important for banks as they seek to remain
competitive in the global financial markets.

SECURITIZING BANK LOANS AND OTHER ASSETS

Securitization is The process of combining individual loans of similar

characteristics into a pool and selling debt securities that draw interest on
principal payments from the pool of loans ( y.q 2021, 2020)

Process :

1. A bank pools together a group of income-generating assets, such as

mortgages or consumer loans.

2. The bank sells securities that represent claims against these assets to investors
in the open market.

3. As the assets pay out, the income stream flows to the holders of the
securities.

4. The bank receives the money it expended to acquire the assets and uses
those funds to acquire new assets or to cover operating expenses.
In effect, securitization allows banks to transform illiquid assets into liquid
securities that can be traded on the open market. This can help banks raise new
funds and reduce their risk exposure.
Here are some of the benefits of securitization for banks:

 It can help banks raise new funds to finance their operations.

 It can help banks reduce their risk exposure by transferring some of the
risk to investors.
 It can help banks improve their liquidity by making it easier to sell their
assets.

Key Players in the Securitization Process ( y.q 2021, 2020)

The chart is described below :

1. The originator (a bank or other lender) pools together a group of loans.

2. The loans are then transferred to a special purpose entity (SPE), which is a
legal entity created specifically for this purpose.
3. The SPE issues securities to investors, which are backed by the cash flows
from the loans in the pool.
4. The trustee collects the cash flows from the loans and distributes them to
the investors.
 The securitization process can provide a number of benefits for the
originator, including:

 The ability to remove the loans from its balance sheet, which can improve
its capital ratios and reduce its risk profile.
 The ability to raise new capital by issuing securities.
 The ability to earn fees by servicing the loans or by guaranteeing the
securities.

The securitization process can also provide benefits for investors,

including:

 The opportunity to invest in a diversified pool of loans.

 The potential for higher yields than traditional investments.
 The ability to reduce their exposure to credit risk.

However, the securitization process also carries some risks,

including:

 The risk of default on the underlying loans.

 The risk of interest rate fluctuations.
 The risk of liquidity problems.

Beginning of Securitization- the Home mortgage Market

Securitization:
The process of combining individual loans of similar characteristics into a pool and selling
debt securities that draw interest on principal payments from the pool of loans. This turns
illiquid assets of individual loans into marketable securities that can be bought, sold, and
traded on the secondary markets.

Mortgage securitization:
A specific type of securitization that involves pooling mortgages together and selling
securities backed by those mortgages. This allows mortgage originators to sell mortgage
loans from their books and use the money to make more loans
.
Impact of securitization on banks:
Securitization can have a significant impact on banks, both positive and negative. On the
positive side, it can allow banks to recycle loan money to homeowners without retaining
the loan assets on their books. This can free up capital for banks to make more loans. On
the negative side, securitization can make it more difficult for banks to compete for loans,
as corporations and other borrowers may be able to get better terms by issuing securities
directly to investors.
Does Credit Securitization Reduce Bank Risk?

Credit securitization is the process of pooling individual loans together and

selling them off to investors. This can help banks reduce their exposure to
individual financial risks. Investors can also benefit from securitization by
diversifying their portfolios.

Some argue that securitization can reduce bank risk by transferring credit risk
to other investors. This can free up banks' capital, allowing them to lend more
money to borrowers. Additionally, securitization can help to diversify banks'
portfolios, making them less vulnerable to losses from defaults on individual
loans.

However, others argue that securitization can actually increase bank risk. This
is because securitization can create moral hazard, whereby banks are
encouraged to take on riskier loans in the knowledge that they can then sell
them off to other investors.

Additionally, securitization can make it more difficult for investors to assess the true
risk of the underlying assets, which can lead to financial instability. However, the
securitization model can be abused, which can lead to asset bubbles. It is important
to use securitization responsibly to avoid the risks of asset bubbles.

SALES OF LOANS TO RAISE FUNDS

Banks can sell loans to raise funds.The loans sold by banks usually have a
maturity of 90 days or less, but loans with longer maturities are also sold.The
loan sales market in the United States received a boost during the 1980s when
there was a wave of mergers and corporate buyouts.

The selling bank retains servicing rights on the sold loans, which means they
collect interest and principal payments from borrowers and pass the proceeds
along to loan buyers. Loan sales can take place in several different forms,
including participation loans, assignments, and loan strips.

In a participation loan, the purchaser is an outsider to the loan contract between

the bank selling the loan and the borrower. In an assignment, ownership of the
loan is transferred to the buyer, who thereby acquires a direct claim against the
borrower. In a loan strip, the buyer is entitled to a fraction of the expected
income from a loan.

With strips, the selling bank retains the risk of borrower default and usually has
to put up some of its own funds to support the loan until it reaches maturity.
 STANDBY LETTER OF CREDIT ( y.q 2021 )

Standby letters of credit (SLCs) are a type of financial guarantee that is used to
enhance the credit standing of a borrower.

 SLCs are issued by banks and are a contingent obligation, meaning that
the bank only has to pay out if the borrower defaults on their obligations.
 SLCs can be used for a variety of purposes, such as performance bonds,
bid bonds, and advance payment guarantees.
 The key advantages of SLCs for banks are that they earn fees, help
customers borrow more cheaply, and are relatively low-cost to issue.

The demand for SLCs has grown rapidly in recent years due to the following
factors:

 The growth of direct finance

 The perception of increased economic risk
 The opportunity for banks to earn fee income
 The low cost of issuing SLCs

Pros & cons of Standby letter of credit ( y.q. 2021 )

Pros:

 Provides a high level of security for the beneficiary, as the bank is

obligated to pay the amount stated in the SBLC if the applicant defaults.
 Can be used to improve the creditworthiness of the applicant, making it
easier to obtain financing or win contracts.
 Can be used to reduce the risk of non-payment, which can save the
beneficiary time and money.
 Can be used to facilitate international trade, as it provides a way to
guarantee payment even when the buyer and seller are located in
different countries.

Cons:

 Can be expensive to obtain, as the bank will charge a fee for issuing the
SBLC.
 Can be time-consuming to get approved, as the bank will need to carefully
assess the applicant's financial situation.
 The beneficiary may not be able to access the SBLC payment if the issuing
bank fails or becomes insolvent.
Riskiness of Funded Loans versus Off-Balance-Sheet Financing in
Banks

Funded loans are considered to be riskier than off-balance-sheet financing

because they represent a direct obligation of the bank. If the borrower
defaults on a funded loan, the bank will be required to make good on the
loan.

Off-balance-sheet financing refers to a variety of transactions that do not

appear on the bank's balance sheet. These transactions can include loan
commitments, letters of credit, and securitizations. Off-balance-sheet financing
can be used to reduce the riskiness of a bank's balance sheet by transferring
some of the risk to other parties

Studies have shown that direct loans carry substantially higher market risk
premiums than do credit letters. This means that investors are willing to accept
a lower return on credit letters because they are considered to be less risky
than direct loans.

Standby credits, loan sales and securitizations are considered to be less risky
than direct loans because they do not represent a direct obligation of the
bank. However, these transactions can still be risky if the borrower defaults on
the underlying loan.

The use of off-balance-sheet financing can affect the performance of banks. If

a bank uses too much off-balance-sheet financing, it may be exposed to more
risk than it can handle. This can lead to financial problems for the bank.

As the spread between bank's interest income and interest expenses is getting
lower, off-balance-sheet financing may be considered as an additional source
of income in banking sector of Bangladesh. However, banks should carefully
consider the risks involved before using off-balance-sheet financing.

Funded loans are considered to be riskier than off-balance-sheet financing.

However, off-balance-sheet financing can also be risky, and banks should
carefully consider the risks involved before using it.

Credit Derivatives: A Rapidly Developing alternative to

Securitizations and Loan sales

Credit derivatives are financial contracts that allow market participants to

transfer or hedge credit risk, enabling them to manage their overall credit
exposure and reduce potential losses. They are a rapidly developing
alternative to securitizations and loan sales, which are two other methods of
reducing credit risk.
One type of credit derivative is a credit swap, in which two lenders agree to
exchange (a portion of) their customers' loan repayments. This can help to
spread out the risk in each lender's loan portfolio, as well as provide a more
stable rate of return.

For example, Banks A and B may find a swap dealer, such as a large
insurance company, that agrees to draw up a credit swap contract between
the two banks. Bank A then transmits an amount (perhaps $100 million) in
interest and pricipal payments that it collects from its credit customers to the
dealer Bank B also sends all or a portion of the loan payments its customers
make to the same dealer The swap dealer will ultimately pass these payments
along to the other bank that signed the swap contract.

Credit derivatives can be a useful tool for managing credit risk, but they also
carry some risks. It is important to carefully consider the risks and benefits of
credit derivatives before using them.

Total return swap

Another type of credit derivative is a total return swap, in which a financial

institution guarantees a swap partner a specific rate of return on their credit
assets. This can help to reduce the riskiness of the swap partner's investment.A
total return swap is a financial contract in which two parties agree to
exchange the total return of an asset.

Example of a Total Return Swap

In the example, Bank A agrees to pay Bank B the total return on a loan, which
includes interest payments, principal payments, and any appreciation in the
loan's market value. In return, Bank B agrees to pay Bank A the London
Interbank Offered Rate (LIBOR) plus an interest rate spread.

This means that Bank B is effectively taking on the credit risk of the loan. If the
borrower defaults on the loan, Bank B will be responsible for the losses.
However, Bank B also benefits from any appreciation in the value of the loan.

Total return swaps can be used by investors to hedge against risk or to

speculate on the future performance of an asset. They can also be used by
banks to manage their balance sheets.

Credit option

A credit option is a financial derivative that gives the buyer the right, but not
the obligation, to buy or sell a credit asset at an agreed-upon price and date.
The credit asset can be a loan, bond, or other debt security.

Credit options can be used by banks, investors, and other financial institutions
to hedge against credit risk. They can also be used to speculate on the future
value of credit assets.

Example of a Credit Option

For example, a bank worried about default on a large $100 million loan it has
just made might approach an options dealer about an option contract that
pays off if the loan declines significantly in value or completely turns bad. If the
bank's borrowing customer pays off as promised, the bank collects the lour
revenue it expected to gather and the option issued by the dealer (option-
writer) will go unused. The bark involved will, of course, lose the premium it
paid to the dealer writing the option
 Credit Default Swaps

 A credit default swap (CDS) is a financial contract between two parties.

 The buyer of the CDS pays a premium to the seller in exchange for
protection against the default of a third party, called the reference entity.
 The reference entity can be a company, a government, or another
financial institution.
 If the reference entity defaults, the seller of the CDS is obligated to pay the
buyer the face value of the CDS, minus any recovery value.
 CDS can be used to hedge against credit risk, speculate on the
creditworthiness of a company, or generate income.

Suppose, for example, the bank has recently made a total of 100 million-dollar
commercial real estate loans to support the building of several investment projects
in various cities. Fearing that several of these 100 loans might turn sour because of
weakening local economic conditions, it purchases a put option that pays off if
more than two of these commercial real estate loans are defaulted. Thus, for each
commercial real estate loan that fails to pay out, the bank may receive $1 million
less the resale value of the building used to secure the loan.

In another example of a credit default swap may seek out a guarantor institution to
unload the risk on one of its loans of case of default. For example suppose Bank a
Swap the credit risk from a five year, $ 100 milling construction loan to Bank B.
Typically. A will pay B a fee based upon the loans par or face value (for example ½
percent of $ 100 million or $ 500,000). For its part, B agree to pay Aa stipulated
amount of money or a fixed percentage of the value of the loan only if default
occurs. There may be a so called materiality threshold, a minimum amount of loss
required before any payment occurs. If the swap ends in an actual default, the
amount owed is normally the face value of the loan less the current market value of
the defaulted asset.

In the example, the bank is buying a CDS to protect itself against the default of a
portfolio of commercial real estate loans. If more than two of the loans default, the
bank will receive a payout from the seller of the CDS.
CDS are a complex financial instrument, and there are many different ways they
can be used. However, they can be a useful tool for managing credit risk

.
 Risks Associated with Credit Derivatives

Counterparty risk: The risk that the counterparty to the credit derivative contract
will default on its obligations.

Legal risk: The risk that the credit derivative contract will be invalidated by a court
of law.

Regulatory risk: The risk that the regulatory environment for credit derivatives will
change, making them less attractive or even illegal.

Market liquidity risk: The risk that there will be no market for the credit derivative
contract if it needs to be sold.

Model risk: The risk that the models used to price and manage credit derivatives
are inaccurate.

These risks can be significant, and they should be carefully considered before
using credit derivatives. However, credit derivatives can also be a valuable tool for
managing credit risk, and they can help banks to reduce their exposure to losses
from defaults.

PROSPECT OF INTRODUCTION OF CREDIT DERIVATIVES IN THE

BANKING SECTOR OF BANGLADESH:

 Credit derivatives are financial instruments that allow banks to transfer or

exchange credit risk.
 They can be used to hedge against the risk of default on loans, or to
speculate on the creditworthiness of borrowers.
 The introduction of credit derivatives in Bangladesh could help banks to
manage their credit risk more effectively, and could also help to develop
the country's financial markets.

The following are some of the key benefits of introducing credit derivatives in
the banking sector of Bangladesh:

Hedge against credit risk: Credit derivatives can be used to hedge against the risk
of default on loans. This can help banks to protect their profits and assets in the
event of a borrower default.

Reduce capital requirements: The use of credit derivatives can help banks to
reduce their capital requirements. This is because credit derivatives can transfer
some of the credit risk from the bank to another party.
Increase liquidity: The introduction of credit derivatives could help to increase
liquidity in the banking sector. This is because credit derivatives can be used to
trade credit risk, which can help to make it easier for banks to buy and sell loans.

Develop financial markets: The introduction of credit derivatives could help to

develop the country's financial markets. This is because credit derivatives can
provide a new way for investors to participate in the financial markets.

However, there are also some risks associated with the introduction of credit
derivatives, such as:

Complexity: Credit derivatives can be complex instruments, and it is important for

banks to understand the risks involved before using them.

Counterparty risk: Credit derivatives involve counterparty risk, which is the risk
that the other party to the contract will default.

Market volatility: Credit derivatives can be volatile instruments, and their prices
can fluctuate significantly.
 Non Performing Loans (NPL)
-----------------------------------------------------------------------------------------------------------------------------------

NON-PERFORMING LOANS (NPL).

Non-performing loans (NPLs), also known as non-performing assets (NPAs) or bad loans,
are loans that a financial institution, such as a bank, has extended to borrowers but
which have stopped generating interest income for the lender. In other words, these
are loans where the borrower has failed to make scheduled interest or principal
payments for an extended period, typically 90 days or more.

NPLs are a concern for financial institutions because they can negatively impact their
financial health and profitability. When a significant portion of a bank's loan portfolio
consists of non-performing loans, it can lead to several problems:

1. Loss of Interest Income: NPLs result in a loss of income for the lender, as they are not
earning interest on these loans. This can reduce the institution's overall profitability.
2. Risk of Default: If a large percentage of loans become non-performing, it can pose a risk
to the institution's solvency and may lead to financial distress or even bankruptcy.
3. Capital Adequacy: Regulatory authorities often require financial institutions to maintain
a certain level of capital to absorb losses from non-performing loans. When NPLs
increase, a bank may need to set aside more capital, reducing its capacity to lend and
grow.
4. Resource Allocation: Banks and other lenders must allocate resources to manage and
recover non-performing loans. This involves legal and administrative expenses, which
can further erode profitability.
5. **Credit Risk: ** A high level of NPLs can also signal poor credit risk assessment and
management practices within the institution, which can affect its reputation and ability
to attract new borrowers.
 The cost of NPL to Banks
All problem loans exact, to some degree, a toll on the bank. The most obvious cost is
when a problem loan ultimately results in a charge-off and the bank loses whatever
principal and interest remained to be collected. However, bank loan loss figures tell only
part of the story. Every problem loan has other, less apparent costs that, in the long run,
can be just as damaging to bank profitability. Some of these less visible costs are as
follows.

Damaged reputation.

The foundation of banking is built on trust. A bank can attract the capital it needs for
loans and other investments only if its depositors and investors have confidence in
the bank's ability to prudently handle their money. Above all, this means making few
bad loans. An excessive number of problem loans damages the bank's reputation in
the eyes of its customers and investors. Once that happens, profitability declines, it
becomes increasingly difficult to attract capital, and growth is hindered.

Increased administrative expense.

A problem loan demands far more attention from bank personnel. The loan officer must
devote time to working with the borrower, and the added loan review and audit
requirements tie up other bank employees as well. The extra time spent on a
problem loan is basically unproductive it merely serves to protect the bank's assets
and does not generate additional revenue. Furthermore, if outside appraisers,
consultants and other specialists must be brought in, additional costs will be
incurred by the bank.

Lowered employee morale.

When a bank has an excessive number of problem loans or charge-off, employee

morale often suffers. An unprofitable bank cannot reward its employees with large
salary increases and bonuses and if the loan situation is particularly bad, hiring
freezes or layoffs may occur. As a result, the best loan officers and other key
personnel may jump ship. The bank then must either train new employees or pay a
premium to attract people as qualified as those who left.

Increased legal expenses.

A problem loan may eventually have to be resolved in a protracted workout session or

bankruptcy court. If so, by the time litigation is finalized and a settlement rendered, the
bank's recovery may be substantially reduced by attorneys' fees and court costs. The
prospect of sizable legal expenses often forces the bank to accept an early resolution of
a problem loan at a steep discount.
Increased regulatory expenses.

A bank saddled with an unusually high number of problem loans may find itself subject
to increased regulatory oversight and control from government authorities. Special
reports may have to be filed with bank regulators, with the cost borne by the bank.
In many instances, the bank has to establish special audit committees and institute
more stringent loan approval processes-for example, advances or a renewed line of
credit to criticized borrowers may need special approval from the board of directors.
When regulatory controls such as these are imposed on a bank, the increased
personnel commitment and added delays in getting the requisite approvals may cause
loan opportunities to be lost and eventually hurt bank profitability.

Lost lending and investment opportunities.

Capital tied up with a problem loan is unavailable to be lent or invested for more useful
and profitable purposes. Thus the cost of a problem loan can, therefore, extend beyond
the mere loss of principal and interest on the loan.

Major Causes of NPL

Most often, a problem loan is the result of not one but several factors. And, just as
frequently, a problem loan situation began, or was at least made worse by lender error
at some point in the commercial lending process. An understanding of the more
common causes of problem loans is the first step to their identification and resolution.

Lender Error
Avoiding problem loans begins with a careful and thorough evaluation of the loan
request and an equally committed follow-up effort, the basic principles of which were
covered in the earlier chapters of this text. Any significant breakdown in the commercial
lending process, from a poor loan interview to inadequate monitoring, may result in a
bad loan. Some of the more common lender errors are as follows:

Poor Loan Interview;

Banks can be victimized by a lender who simply cannot say no. A poor interview most
often occurs when the loan officer is dealing with a friend or a representative of one of
the community's largest employers. Rather than ask tough, probing questions about the
company's financial situation, the lender opts for friendly banter instead. Sometimes a
loan officer may be intimidated or conned. For whatever reason, he or she may allow a
loan request that should have been rejected during the initial interview to proceed to
financial analysis and beyond. With each subsequent step, it becomes increasingly hard
to reject the request. Another common failing is the inability to ask the right questions
or to pursue a line of questioning when the responses appear wrong or evasive.
Inadequate Financial Analysis:
Many loans become problems when a lender considers the financial analysis to be
unimportant; that, instead, the true test of whether a loan will be repaid lies in a
handshake, the eyes or some other subjective measure of the client. While it is true that
some characteristics, such as the ability to overcome adversity, do not appear on
financial statements, a complete analysis of income statements, balance sheets, ratios,
cash flow and so forth provide the most reliable information. Together, they present an
objective measure of performance that can be compared with those of similar
companies.

Improper loan structuring:

Another cause of problem loans is the failure of the loan officer to properly structure the
loan. Problems often arise when the lender fails to understand the client's business and
the industry and environment in which it operates. Without this knowledge, it is difficult
to anticipate future financing needs and to choose the appropriate loan type, amount,
and repayment terms. Most borrowers, regardless of financial health, find it difficult to
repay debts that do not coincide with their cash flow cycle.
A reliance on so-called windshield appraisals, in which collateral is cursorily inspected
from a far (such as from the driver's seat of the loan officer's car), is a common pitfall.
Another is the overvaluing of collateral.

Inadequate loan documentation:

The failure to completely and accurately document the obligations of the bank and
borrower in the lending arrangement also contributes to problem loans. For example, a
complete listing of affirmative and negative covenants is essential to ensure that the
borrower does not engage in some practice that may jeopardize repayment of the loan.
Similarly, a bank's protection against loss is endangered if collateral is not properly
identified and the bank's right to it is not established.

Inadequate monitoring:
Many problem loans can be kept off the books if the loan officer closely follows the
loans he or she has made. Financial statement reviews, occasional on-site visits and
collateral inspections, periodic credit checks and other loan monitoring tasks must be
performed to ensure that the company's financial position remains good and the terms
of the loan agreement are being met. Inadequate follow-up allows small problems to
become big ones until the bank faces a total breakdown in repayment. One key to
avoiding problem loans is a strong commitment to supervising and directing to the
lending function. An ill-defined loan policy or an overemphasis on making loans at the
expense of quality credit can create an environment in which problem loans can
develop.
Poor Business Practices
Many problem loans can be attributed to poor business practices. Included in this
general categorization are bad management, product deterioration, poor marketing
and poor financial controls.

Bad management.
A leading cause of problem loans is bad management, which may not have been
evident when the loan was approved. In particular, small businesses often lack
management depth. For example, a company started by engineers or other technically
oriented persons may grow to the point where finance, marketing and sales personnel
must be brought in. Without qualified management to set up and coordinate these
various company functions, bad decisions may be made. Without trained succession
management, problems may arise when the founder or owner relinquishes control or is
absent for an extended period. Furthermore, if only one person is making all the
decisions, the infusion of ideas and creativity that is needed to help the company grow
may falter. The primary cause of business failure, though, is simply incompetent or
inattentive management. Those heading the company must be able to manage the
various departments effectively while providing good short and long-term planning that
capitalizes on opportunities and is prepared to react to any adverse circumstance.

Product deterioration.
A problem loan often surfaces after a product or service sold by a business is no longer
competitively priced or of consistent quality. Increases in labor or material costs or failure
to modernize equipment and keep pace with the latest production techniques can price
a product out of the market or force the company to cut corners and short-change
quality. Regardless of the reason, the bottom line is a decline in profitability and an
eventual inability to service debt.

Poor marketing
Bad loans can also arise if a company has poor marketing practices. A business must
have a well-defined plan for advertising, selling and distributing its products, Failure to
do so will invariably lead to declining sales and profitability. Another cause of problem
loans is the inability to anticipate and respond to changing markets (as when consumer
tastes shift or a competitor introduces a new product).

Poor financial controls.

Poor financial controls are the downfall of many companies. Systems must be in place
to monitor accounts receivable and inventory; to ensure product quality; to control
overhead and other expenses; and to prevent fraud and theft. A business must also
have defined budgets and financial projections against which performance can be
measured and adjustments made. In the absence of good controls, no company will be
successful for long, regardless of how well it makes and markets its product.
Environmental factors: Some problem loans result from a business's inability to cope
with the consequences of such natural disasters as fires, droughts, floods and
hurricanes. In the case of a manufacturer, a change in environmental conditions may
cause a shortage in raw materials, thus leading to a price increase in its finished product.

Economic factor:
Economic downturns and changes in taxes and interest rates can hamper a business's
ability to service its debt. For example, during recessionary periods, many companies
struggle with their cash flow as sales slow, costs increase and interest rates rise.
Companies particularly susceptible to a recession and therefore prime candidates for a
problem loan include those that have high fixed costs that cannot be reduced
significantly, have few salable assets and cannot generate cash other than through sales
or borrowing and sell a product with an elastic demand.
Changes in tax policies can also prove beneficial to some companies and burdensome
to others. However, the loan officer should not be quick to single out economic factors
as the sole cause of a problem loan. Good management can often overcome or at least
ride out the economic swings that will affect any business.

Competitive factors:
The introduction of a strong competitor can wreak havoc on companies in the same
market. Vulnerable companies may experience lost sales, increased costs (associated
with retaining key personnel, increasing the advertising and sales effort and so forth),
and a declining profit margin. All of these changes can have implications for a
company'sgrowth and its ability to repay debt.

Legal factors:
The limitation of law is another vital point of stuck up loans. The procedure of legal
action against the defaulting borrower is still a time-consuming matter as well as very
expensive one which a banker wants to avoid. Sometimes, the law enforcing authority
cannot or do not implement the decree against the defaulting borrowers for reasons
unknown. At that time a banker becomes very helpless. The act of disposing collateral
security is still a risky procedure in our country. The defaulting borrower gets this
opportunity which arises from limitation of law. The cunning defaulting borrower
knows the limitation of law and also knows how to escape from the legal action. And
that is why a loan becomes stuck up or classified.

Technological factors:
Problem loans may also be caused by technological developments. High-tech
companies can see their financial fortunes suddenly reversed by the introduction of a
more advanced product by a competitor. Another factor is whether a business can keep
pace with others in its market through the development of technically advanced
equipment that increases production speed or quality.

How to detect NPL.

Loans rarely become problem loans or losses overnight. Usually, a gradual deterioration
in credit quality occurs that is accompanied by numerous warning signs. If detected in
time, the loan officer can take action to prevent the problem loan from developing or at
least move to minimize bank losses in the event a default does occur. The key to
minimizing problem loans is to note the telltale symptoms when they occur, rather than
waiting for a major breakdown in repayment. Early recognition of problem loans gives
the loan officer an opportunity to work with the borrower and take some type of
remedial action before a loan workout or loss becomes inevitable. To detect problem
loans at an early stage, the loan officer should;
 Analyze financial statements thoroughly and on a regular basis
 Keep lines of communication open with the borrower with frequent telephone
calls, correspondence and site visits
 Stay alert to direct or indirect signs supplied by third parties
 look at the borrower's total account relationship with the bank

1. Early Warning Signs from Financial Statements.

Early Warning Signs from Financial Statements An analysis of the borrower's financial
statements can reveal many of the symptoms of a potentially problem loan. The major
tools of financial analysis are the income statement, balance sheet, ratios and cash flow
statement.
Comparing income statements and balance sheets from year to year (or period to
period) or with an external standard (for example, industry averages) is useful in
spotting trends that may lead to a problem loan. Ratio analysis, by looking at the
relationship between one or more income statement or balance sheet, can reveal poor
coverage, liquidity, leverage, activity and profitability positions. Cash flow statements
help the loan officer uncover any problems the borrower might have in obtaining
adequate cash to finance operations and repay debt.
Detecting problem loans through the analysis of financial statements assumes, however,
that the loan officer is receiving financial statements regularly from the borrower, the
statements are reviewed thoroughly and not just stuffed into a credit file and that the
loan officer understands financial statements and knows how to interpret the figures.
Some early financial warning signals that may warrant close observation include:
  Failure to receive statements in a timely fashion slowdown in receivables
collection period deterioration in customer's cash position.
 percentage of accounts receivable
 slowdown in inventory turnover
 decline in current assets as a percentage of total assets
 deterioration of the liquidity/working capital position
 marked changes in mix of trading assets
 rapidly changing concentrations in fixed assets
 large increase in reserves
 Concentration in non-current assets other than fixed assets.
 high concentration of assets in intangibles
 disproportionate increases in current debt
 substantial increases in long-term debt
 low equity relative to debt
 significant changes in balance sheet structure
 presence of debt due to or due from officers and stockholders
 unqualified audit
 change of accountants declining sales
 rapidly expanding sales
 major gap between gross and net sales margins
 rising costs and narrowing profit
 rising sales and falling profits
 rising levels of bad debt losses
 disproportionate increases in overhead relative to sales
 rising levels of total assets relative to sales or profits
 operating losses

2. Early Warning Signs from Contacts with the Borrower

Early Warning Signs from Contacts with the Borrower many reasons. For one, it helps in
gathering non-financial clues that may indicate a potential problem loan. Some early
warning signs, such as poorly maintained equipment, deteriorating inventory, or
underutilized personnel are best spotted during a plant visit. Similarly, during a
telephone conversation a client may allude to some personal or financial difficulty that
would not have appeared on an income statement or balance sheet. Frequent contacts
with the borrower can provide important advance information about a company's
conditions. Early warning signs to look for during telephone calls, meetings, plant visits
and other contacts with the borrower include:

 changes in behavior or personal habits of key people marital problems

 change in attitude toward the bank or loan officer cooperation
  failure to perform personal obligations changes in management, ownership or
key personnel
 illness or death of key personnel
 inability to meet commitments on schedule
 recurrence of problems presumed to be solved
 inability to plan
 poor financial reporting and controls
 fragmented functions
 venturing into acquisitions, new business, new geographic area or new product
line
 desire and insistence upon taking business gambles and unwarranted risk
 unrealistic pricing of goods and services
 neglect or discontinuance of profitable lines
 delay in reacting to declining markets or economic conditions
 lack of visible management succession
 excessive growth that strains the capacity of the owner to manage and control
 labor problems
 change in the nature of the company's business
 poor operating controls

Early Warning Signs from Third Parties

Transactions between the borrower and third parties can often provide an alert loan officer
with some insight into the likelihood of a problem loan occurring. For example, an
insurance cancellation notice may be a warning signal. A financially strapped customer
who is deciding which bills to pay often opts to first drop insurance coverage. Later on, it
may be bank loan payments. Some early warning signs from third party sources include:

 calls from existing suppliers requesting credit information to open new credit lines

 appearance of other lenders in the financial picture, especially collateral lenders

 an insurance company that sends a cancellation for nonpayment of a premium

 legal notices that are served against the borrower for such things as tax liens,
judgments or garnishments

 delayed payments to trade suppliers or a request from the company for extended
terms, resulting in a refusal to ship to the company

 Delayed payment of payroll to the employees.

 merchandise sold to the borrower under a purchase money security interest

 cash-on-delivery sales
 Early Warning Signs form the Bank
Although the borrower may be meeting the terms and conditions of all current loan
obligations, signs of a deterioration of the account relationship with the bank may
still exist one obvious indicator is declining deposit balances. Another is requests for
loan renewals and extensions. Such requests may simply be in response to slow-
paying receivables or some other unforeseen event; however, the loan officer should
be alert to a repeated pattern, which may be indicative of a deeper problem. Early
banking warning signals that may merit further investigation include

 declining bank balances

 poor financial planning for fixed-asset requirements or working capital

requirements

 heavy reliance on short-term debt

 marked changes in the timing of seasonal loan requests

 sharp jumps in the size or frequency of loan requests

 loans where the purpose is simply working capital

Management of NPL
The management of non-performing loans (NPLs) is a critical function for banks and
financial institutions to protect their financial stability and recover as much value as
possible from troubled loans. Effective NPL management involves several strategies and
processes. Here's a comprehensive overview of how to manage NPLs:

1. Early Detection and Classification:

 Early detection of NPLs is essential. Loans that have become non-performing
should be promptly identified and classified according to established criteria.
2. Establish Clear Policies and Procedures:
 Develop clear and consistent policies and procedures for managing NPLs,
including classification, provisioning, and recovery efforts.
3. Loan Restructuring:
 Evaluate the feasibility of loan restructuring for borrowers facing temporary
financial difficulties. Restructuring may involve extending the loan term, reducing
interest rates, or adjusting repayment schedules to make it easier for borrowers to
meet their obligations.
4. Collateral Evaluation:
 Assess the value and quality of collateral, if any, securing the loans. If collateral is
available, it can be used to recover part of the loan amount in case of default.
5. Provisioning:
 Set aside provisions in accordance with regulatory requirements and prudent risk
management practices to cover potential losses from NPLs.
6. Legal Action:
 When necessary, initiate legal proceedings to recover outstanding amounts. This
may include foreclosure on collateral, filing lawsuits, or seeking court judgments
against defaulting borrowers.
7. Debt Sales or Securitization:
 Consider selling NPLs to specialized debt collection agencies or through
securitization to transfer the risk and free up capital. However, this should be
carefully evaluated to ensure it's economically viable.
8. Loan Recovery Units:
 Establish dedicated loan recovery units or departments staffed with professionals
experienced in NPL management and negotiation with borrowers.
9. Negotiations and Settlements:
 Engage in negotiations with borrowers to reach settlements that are mutually
acceptable and result in the recovery of a significant portion of the outstanding
debt.

Step in Resolving Non-Performing Loans.

Assessing the Situation

One of the first steps in resolving a problem loan is to take stock of the situation. This
involves an evaluation of the bank's and borrower's strengths and weaknesses, which
can then be used to formulate a course of action. A loan officer who discovers that the
value of the bank's collateral has declined markedly and essentially represents no
security for the loan, may decide that a strong effort of lending additional money in
exchange for obtaining other security for the loan. If, on the other hand, the bank
controls the collateral and can sell it, net of costs, for a sum that covers the remaining
balance of the loan, then the loan officer may opt for that course instead

In drafting an appropriate response to the problem loan the loan officer should

 Evaluate the borrower

 Know the bank's position
 Review documentation
 Evaluate the collateral situation
 Closely monitor any other bank accounts held by the borrower
 Possibly consult with bank counsel or more experienced loan officers
Evaluating the Borrower
When considering a loan request, one goal of the loan officer is to accurately assess
each of the five Cs of the borrower. Often, however, it is not possible to measure
character and other qualities until they have been tested by adversity, as when a
business is faltering.
In such cases, the loan officer should take the time to re-evaluate the borrower in light
of the new circumstances. For example, one important consideration is the borrower's
willingness to recognize the problem and desire to work with the bank in solving it. An
uncooperative or untrustworthy borrower probably means that a workout session is
fruitless and the bank should try to collect as much as it can on the loan.

Knowing the Bank's Position

Bank policy may dictate to some extent how problem loans are to be addressed. A bank
with a few bad credits and the likelihood for strong future earnings, may decide that it
can afford the time and effort involved in a protracted loan workout. On the other
hand, a bank saddled with numerous bad loans that are consuming a disproportionate
amount of personnel resources, may feel that it is better off to get back as much as it can
on the loan and expense the rest.

Reviewing Documentation
The loan officer should carefully review all pertinent documents in the credit file. Before
sitting down with the borrower, it is also imperative to have a good understanding of
the rights and obligations of both bank and borrower under the loan agreement-for
example, the specific affirmative and negative covenants that were reached.

Evaluating the Collateral Situation

The loan officer should also evaluate the collateral situation, comparing the availability
and value of the collateral against the indebtedness of the borrower. To offer any sort of
protection against loss, the collateral must be located, possession taken and sold.
Improper documentation, third-party claims and deteriorating values can jeopardize
recovery and may therefore determine the approach the bank takes with the borrower.

Monitoring the Borrower's Bank Accounts

The borrower's bank accounts should be closely monitored from the time a problem
loan is identified. The bank's leverage is greater if it has the right to set off account
deposits in the event of delinquent loan payments. This assumes, however, that deposit
balances are being maintained. It may therefore be necessary to impose controls on the
borrower's bank accounts to prevent any large withdrawals (not related to normal
business practices) that may jeopardize the bank's ability to collect on the loan.

Meeting with More Knowledgeable Bank Personnel

 The bank's attorney or perhaps a senior lender may be able to help define the loan
officer's choices in dealing with a delinquent borrower. An attorney can recommend or
caution against pursuing certain legal remedies and a senior loan officer can assist in
doing an in-depth analysis of financial statements, ensuring documentation
completeness, evaluating collateral, restructuring the loan, and preparing pro-formas
and cash budgets that will be necessary in ensuring the future repayment of debt.

Meeting with the Borrower

Having formulated a preliminary game plan, the next step is to schedule a meeting with
the borrower. This should be done soon after learning of the problem loan. Doing
nothing risks further deterioration of the borrower's financial condition, jeopardizes the
bank's collateral position and may result in more astute creditors taking advantage of
the bank's inaction.

3. Previous Year Questions.

A. What are the costs of Non- Performing Loans to the banks? Year 2021
Answer: See the lecture material.
B. What is lender error? Discuss about some common lender errors. Year
2021
Answer:
Lender errors encompass a range of mistakes and oversights made by financial
institutions or lenders during the loan origination and servicing processes. These errors
can have significant consequences, both for the lending institution and borrowers. Here
are some common lender errors:

1. Inaccurate Credit Assessment: One of the most fundamental errors is inaccurately

assessing a borrower's creditworthiness. This can lead to loans being extended to
individuals or businesses that do not have the financial capacity to repay, resulting in a
higher likelihood of defaults.
2. Flawed Underwriting Procedures: Lenders sometimes fail to follow proper underwriting
procedures, such as not verifying income or employment information. This oversight can
result in loans that are riskier than originally perceived.
3. Documentation Mistakes: Errors in loan documentation, such as incorrect loan terms or
missing signatures, can lead to legal disputes and complications in the loan repayment
process.
4. Improper Loan Structuring: Poorly structured loans, with unrealistic repayment
schedules or interest rates, can make it difficult for borrowers to meet their obligations
and increase the chances of default.
5. Communication Failures: Lenders may not adequately communicate the terms and
conditions of loans to borrowers, leading to misunderstandings and disputes.
6. Regulatory Non-compliance: Failing to adhere to regulatory requirements and
guidelines can result in legal and compliance issues for lenders.

These errors can undermine the financial health of lending institutions, lead to non-
performing loans (NPLs), and damage their reputation. For borrowers, such errors can
result in financial distress, legal challenges, and damaged credit. To mitigate lender
errors, financial institutions must invest in robust risk management practices, thorough
due diligence, and effective communication with borrowers, while adhering to
regulatory standards.

C. What are the proper early warning signs of problem loan? Discuss.
Year2021
Answer: See the lecture material.
D. Define recovery management. Year 2020
Answer: Recovery management, in the context of finance and lending, refers to the
systematic process of attempting to reclaim and rehabilitate non-performing or
delinquent assets, such as loans or debts. This process involves various strategies and
actions, including negotiations, restructuring, legal proceedings, or collateral liquidation,
aimed at recovering as much value as possible from troubled assets. The primary goal of
recovery management is to minimize financial losses for the lender or financial institution
while resolving the borrower's financial difficulties through mutually agreed-upon
arrangements or legal means. Effective recovery management is critical for maintaining
the institution's financial health and mitigating the impact of non-performing loans on its
portfolio.

E. What are the major causes of non-performing loan? Year 2020

Answer: See the lecture material.
F. Discuss the components of capital and minimum capital requirements
according to BASEL III. Year 2020
Answer: Basel III is an international regulatory framework for banking that aims to
strengthen the capital adequacy of financial institutions and improve the stability of the
global banking system. It introduced new capital requirements and redefined the
components of capital to ensure greater resilience against financial shocks. The key
components of capital and minimum capital requirements under Basel III are:

1. Common Equity Tier 1 (CET1) Capital:

 CET1 capital is the highest quality capital and consists of common equity
elements, including common shares, retained earnings, and other
 comprehensive income. It serves as the core equity capital that can absorb losses
without triggering insolvency.
2. Additional Tier 1 (AT1) Capital:
 AT1 capital includes instruments that are less permanent than CET1 capital but
still contribute to a bank's loss-absorbing capacity. These instruments have certain
loss-absorption features and may include perpetual preferred shares and
contingent convertible bonds (CoCos).
3. Tier 2 (T2) Capital:
 Tier 2 capital includes subordinated debt and other instruments that provide
additional loss-absorbing capacity. T2 capital is considered less permanent than
CET1 and AT1 capital.
4. Minimum Capital Requirements:
 Basel III establishes minimum capital requirements that banks must meet to
maintain financial stability. These requirements include:
 Common Equity Tier 1 (CET1) Capital Ratio: Banks are required to maintain
a CET1 capital ratio of at least 4.5% of risk-weighted assets (RWA).
 Tier 1 Capital Ratio: Banks must maintain a Tier 1 capital ratio of at least 6%
of RWA.
 Total Capital Ratio: Banks must maintain a total capital ratio of at least 8%
of RWA.
 Leverage Ratio: Basel III introduced a leverage ratio, requiring banks to
maintain a minimum Tier 1 capital-to-assets ratio to limit excessive
leverage.
5. Capital Conservation Buffer:
 Banks are required to maintain a capital conservation buffer of 2.5% of CET1
capital above the minimum CET1 capital requirements. This buffer is intended to
absorb losses during economic downturns and is designed to promote the
conservation of capital.
6. Countercyclical Buffer:
 Basel III allows national regulators to impose a countercyclical buffer, which can
vary depending on the credit conditions and systemic risks in a particular
jurisdiction. This buffer ranges from 0% to 2.5% of RWA.
7. Systemically Important Bank (SIB) Buffer:
 SIBs, or globally important banks, are required to maintain an additional buffer of
CET1 capital to address their systemic importance and potential impact on the
financial system. The size of the SIB buffer depends on the bank's systemic
significance.
8. Other Macroprudential Buffers:
 Basel III also introduced other macroprudential buffers, such as the domestic
systemically important bank (D-SIB) buffer, to address specific risks and
vulnerabilities in a banking system.

These components of capital and minimum capital requirements under Basel III aim to
enhance the resilience of banks and minimize the likelihood of financial crises by
ensuring that they maintain adequate capital to absorb losses and continue operating
safely during adverse economic conditions.
 G. Explain briefly the overall objectives of BASEL. Year 2020
Answer: The overall objectives of the Basel framework, which includes Basel III and its
predecessors (Basel I and Basel II), are to enhance the stability and soundness of the
global banking system. These objectives are achieved through the following key goals:

1. Risk Reduction: Basel seeks to reduce the risk of financial instability by establishing
minimum capital requirements for banks. Adequate capital cushions help banks absorb
losses, reducing the likelihood of bank failures and systemic crises.
2. Risk Sensitivity: Basel II and III introduce risk-sensitive capital requirements, meaning that
the amount of capital banks are required to hold is proportionate to the risks they face.
This approach encourages better risk management practices and ensures that capital
levels are aligned with the risks a bank takes.
3. Promotion of Sound Banking Practices: Basel encourages banks to adopt best practices
in risk management, internal controls, and governance. It emphasizes transparency and
disclosure to enable market participants to assess a bank's risk profile.
4. Enhanced Market Discipline: Basel III promotes market discipline by requiring banks to
disclose information about their capital, risk exposures, and risk management practices.
This transparency helps investors and counterparties make informed decisions.
5. Protection of Depositors and Creditors: Basel aims to safeguard the interests of
depositors and creditors by ensuring that banks have sufficient capital to cover losses.
This helps prevent the need for government bailouts or taxpayer-funded rescues.
6. Level Playing Field: Basel seeks to create a level playing field among international banks
by establishing common regulatory standards. This reduces the risk of regulatory
arbitrage and competitive disadvantages among banks operating in different
jurisdictions.
7. Adaptability to Market Changes: Basel frameworks are periodically updated to adapt to
evolving market conditions and lessons learned from financial crises. Basel III, for
example, was developed in response to weaknesses exposed during the global financial
crisis of 2008.

In summary, the overall objectives of Basel are to strengthen the resilience of the
banking sector, promote prudent risk management, protect the financial system from
systemic risks, and enhance transparency and market discipline. The Basel framework
plays a vital role in maintaining financial stability and mitigating the potential adverse
effects of banking crises on the global economy.

H. Why recovery management is needed to develop a non performing

loan? Year 2019
Answer: Recovery management is essential in developing non-performing loans
(NPLs) for several critical reasons:
1. Mitigating Losses: NPLs represent loans where borrowers have failed to meet their
repayment obligations, leading to potential financial losses for the lending institution.
Recovery management aims to minimize these losses by actively working to recover as
much of the outstanding debt as possible.
2. Preserving Asset Quality: NPLs can erode the asset quality of a bank's loan portfolio,
affecting its overall financial health and capital adequacy. Effective recovery
management helps maintain the quality of assets and ensures that NPLs do not drag
down the institution's financial stability.
3. Enhancing Liquidity: Recovering funds from NPLs injects liquidity back into the bank,
allowing it to redeploy these resources for new lending opportunities, investments, or
other productive uses. This can improve the bank's overall financial position.
4. Regulatory Compliance: Regulatory authorities often require banks to actively manage
and resolve NPLs as part of their prudential regulations. Non-compliance with these
regulations can result in penalties and regulatory scrutiny.
5. Maintaining Investor and Stakeholder Confidence: Effective recovery management
demonstrates to investors, shareholders, and stakeholders that the bank is taking
proactive measures to address and rectify its problem loans. This can help maintain
confidence in the institution's ability to manage risk.
6. Preserving Reputation: Timely and fair resolution of NPLs can protect the bank's
reputation. Delinquent borrowers who experience respectful and constructive
engagement from the bank are more likely to remain loyal customers in the future.
7. Minimizing Legal and Operational Risks: Failure to manage NPLs effectively can lead to
legal disputes, operational inefficiencies, and additional costs. Recovery management
aims to streamline these processes, reducing legal risks and expenses.
8. Compliance with Regulatory Capital Requirements: Prudential regulations often require
banks to maintain minimum capital levels as a percentage of risk-weighted assets. NPLs
can consume capital, and by effectively recovering NPLs, the bank can release capital
that can be used for other purposes, such as lending or investments.

In summary, recovery management is a crucial process for financial institutions to

develop non-performing loans. It helps mitigate financial losses, maintain asset quality,
enhance liquidity, and ensure compliance with regulatory requirements. Effective
recovery management is essential for the overall health and stability of a bank or
lending institution.

I. Detect the sources of Early sign:

1. An insurance co that sends cancellation for nonpayment of a
premium.
2. Cash on delivery sales
3. Heavy reliance on short term debt
4. Sharp jumps in the size or frequency of loan request.
5. Marital problems.
6. Unqualified audit.
 7. Slowdown in inventory turnover.
8. Venturing into acquisition.
9. Receivables from affiliate companies.
10. Labor problems

Answer: Early signs of financial distress or potential non-performing loans (NPLs) can
come from various sources. Here's an assessment of the provided sources:

1. An insurance company that sends cancellation for nonpayment of a premium: This is a

clear financial warning sign, as it indicates the policyholder's inability to meet financial
obligations, which may be indicative of broader financial distress.
2. Cash on delivery sales: While COD sales can indicate a cautious approach to credit risk,
they may also suggest that customers are unable or unwilling to extend credit terms,
which could be a sign of financial stress.
3. Heavy reliance on short-term debt: Excessive short-term debt can indicate a liquidity risk,
especially if the company struggles to roll over or repay this debt when it matures.
4. Sharp jumps in the size or frequency of loan requests: Frequent loan requests or large
increases in borrowing needs may suggest that a company is facing financial challenges
or capital constraints.
5. Marital problems: Marital problems may indirectly impact an individual's financial
stability, leading to difficulties in meeting loan obligations or causing stress-related
financial issues.
6. Unqualified audit: An unqualified audit opinion typically indicates that the financial
statements are free from material misstatements. However, repeated qualifications or
significant issues raised in the audit could signal financial problems.
7. Slowdown in inventory turnover: A significant slowdown in inventory turnover may
suggest declining sales, which can be a sign of financial distress, especially if coupled
with inventory write-downs.
8. Venturing into acquisitions: While acquisitions can be strategic, they also involve
financial risks. Expanding through acquisitions may strain a company's finances if not
managed well.
9. Receivables from affiliate companies: While receivables from affiliates are not inherently
problematic, they can become a concern if the affiliate companies themselves are facing
financial difficulties or if the receivables are not being paid.
10. Labor problems: Labor problems, such as strikes or disputes, can lead to disruptions in
operations, which may impact a company's financial health.

It's important to note that these early signs should be considered in context and often
require further investigation to assess their significance accurately. Early detection and
proactive management are key to addressing potential financial distress or NPLs
effectively. Financial institutions and lenders often use a combination of financial
metrics, qualitative information, and risk analysis to identify early warning signs.
 J. Define corporate governance considering respective elements, pillars
and act. Year 2019
Answer: Corporate governance is a system of rules, practices, and processes that a
company puts in place to guide its overall management and operations. It involves a
framework that ensures transparency, accountability, and the protection of
stakeholders' interests, including shareholders, employees, customers, and the broader
community. Corporate governance typically consists of several key elements, pillars, and
acts, which collectively contribute to its effectiveness:

1. Elements of Corporate Governance:

a. Board of Directors: The board is responsible for setting the company's strategic
direction, overseeing management, and representing shareholders' interests. It
comprises independent directors, executives, and often includes committees such as the
audit committee and compensation committee.
b. Shareholder Rights: Protecting and promoting the rights of shareholders, including
voting rights, access to information, and the ability to participate in important company
decisions.
c. Transparency and Disclosure: Ensuring that the company provides accurate and
timely information to shareholders and the public, including financial reports,
performance metrics, and corporate policies.
d. Accountability: Holding management accountable for their decisions and actions,
both internally and externally. This includes implementing mechanisms for performance
evaluation and compensation alignment.
e. Ethical Conduct: Promoting ethical behavior and integrity within the organization,
often through the establishment of a code of conduct and ethics policies.
f. Risk Management: Implementing effective risk management practices to identify,
assess, and mitigate risks that could impact the company's financial health and
reputation.
2. Pillars of Corporate Governance:
a. Responsibility: Ensuring that those in positions of authority, including the board and
management, fulfill their duties and responsibilities toward the company and its
stakeholders.
b. Accountability: Holding individuals and the organization accountable for their actions
and decisions, including financial and operational performance.
c. Fairness: Treating all stakeholders equitably and ensuring that no one group or
individual benefits at the expense of others.
d. Transparency: Providing clear, accurate, and accessible information about the
company's financial and operational performance, as well as its governance practices.
3. Corporate Governance Acts:
a. Sarbanes-Oxley Act (SOX): Enacted in the United States, SOX imposes strict financial
reporting and corporate governance requirements on publicly traded companies. It
focuses on enhancing the accuracy and reliability of corporate disclosures.
b. UK Corporate Governance Code: This code provides guidelines for corporate
governance practices in the United Kingdom, emphasizing the role of non-executive
directors, transparency, and accountability.
 c. Dodd-Frank Wall Street Reform and Consumer Protection Act: In the U.S., this act
includes provisions related to corporate governance, executive compensation, and
shareholder rights.
d. King IV Report on Corporate Governance: Developed in South Africa, this report
outlines principles and practices for ethical and effective corporate governance.

Corporate governance acts, such as SOX and the UK Corporate Governance Code, serve
as legal frameworks that companies must adhere to in their governance practices to
protect the interests of shareholders and other stakeholders. These elements, pillars, and
acts collectively aim to create a framework of checks and balances that ensure
responsible and ethical management of a company.

K. What are the components of management quality? Year 2019

Answer: Management quality encompasses various components that collectively
determine the effectiveness and efficiency of an organization's leadership and decision-
making processes. The components of management quality include:

1. Leadership: Effective leadership is at the core of management quality. It involves setting

a clear vision, mission, and strategic direction for the organization, and inspiring and
guiding employees toward achieving these objectives.
2. Strategic Planning: A well-defined and dynamic strategic planning process is crucial. It
involves setting long-term goals, formulating strategies to achieve them, and regularly
reviewing and adjusting these strategies in response to changing circumstances.
3. Decision-Making: Management quality is evident in the quality of decision-making. This
includes the ability to make informed, timely, and data-driven decisions that align with
the organization's goals and values.
4. Risk Management: Effective management quality includes the ability to identify, assess,
and manage risks appropriately. This involves implementing risk mitigation strategies
and ensuring that risks are within acceptable tolerance levels.
5. Resource Allocation: Efficient allocation of resources, including financial, human, and
technological assets, is essential. Management must prioritize and allocate resources to
projects and initiatives that provide the most value and support strategic objectives.
6. Communication: Open, transparent, and effective communication is a key component.
Managers should communicate the organization's goals, strategies, and progress to
employees, stakeholders, and external partners.
7. Performance Measurement and Monitoring: Management quality involves establishing
key performance indicators (KPIs) and metrics to assess the organization's performance.
Regular monitoring and evaluation help identify areas for improvement and track
progress toward goals.
8. Employee Engagement and Development: Quality management includes creating a
positive work environment where employees are engaged, motivated, and have
opportunities for growth and development.
9. Ethical Standards: Upholding high ethical standards is crucial. Management quality
requires adherence to ethical principles and values in all organizational activities.
10. Customer Focus: Prioritizing customer needs and satisfaction is essential. Quality
management ensures that products and services meet or exceed customer expectations.
11. Innovation and Adaptation: Effective management quality encourages innovation and
the ability to adapt to changing market conditions and emerging trends.
12. Financial Management: Sound financial management practices, including budgeting,
cost control, and financial reporting, are integral components of management quality.
13. Legal and Regulatory Compliance: Ensuring compliance with laws, regulations, and
industry standards is essential to protect the organization's reputation and avoid legal
issues.
14. Conflict Resolution: Effective management quality includes the ability to address
conflicts and disputes in a constructive and fair manner.
15. Continuous Improvement: A commitment to continuous improvement is fundamental.
Management should foster a culture of learning and innovation to drive ongoing
enhancements in processes and performance.
16. Succession Planning: Ensuring a smooth transition of leadership is important.
Management quality includes preparing and developing potential leaders within the
organization.

Collectively, these components of management quality contribute to an organization's

ability to achieve its objectives, adapt to change, and maintain a strong competitive
position in the marketplace. Effective management quality is a critical factor in long-term
success and sustainability.

L. Explain why Non Performing Loan (NPL) is increasing in Bangladesh.

Year 2018
Answer: The increase in Non-Performing Loans (NPLs) in Bangladesh can be
attributed to several factors:

1. Economic Challenges: Economic instability or downturns can lead to an increase in

NPLs as borrowers struggle to repay loans due to reduced income, business difficulties,
or job losses. Economic factors, such as the COVID-19 pandemic, can significantly
impact borrowers' ability to service their debts.
2. Default Culture: A prevailing culture of loan defaults, where borrowers may
intentionally default on loans without facing significant consequences, can contribute to
higher NPLs. This culture may undermine borrowers' commitment to repay.
3. Lax Credit Underwriting: Weak credit risk assessment and underwriting practices by
banks and financial institutions can result in loans being extended to borrowers with
inadequate creditworthiness. This can increase the likelihood of defaults.
4. Political Interference: Political pressure on banks to extend loans to politically connected
or influential individuals or entities, often without proper due diligence, can lead to a
higher incidence of non-performing loans.
5. Lack of Collateral and Guarantees: Inadequate collateral or guarantees for loans can
make it challenging for banks to recover funds in case of default, leading to higher NPLs.
6. Overconcentration in Certain Sectors: High exposure to specific sectors, such as real
estate or textiles, can result in a domino effect of defaults if those sectors face economic
challenges.
7. Regulatory Challenges: Weak regulatory oversight and enforcement can contribute to
NPL growth. Effective regulatory measures are essential for ensuring that banks adhere
to prudent lending standards.
8. Legal Delays: Lengthy legal processes and difficulties in enforcing loan recovery through
the legal system can delay the resolution of NPLs and discourage banks from pursuing
recovery efforts.
9. Lack of Debt Restructuring Framework: An absence of effective debt restructuring
mechanisms can limit the ability to renegotiate loan terms and provide relief to
struggling borrowers.
10. Global Economic Factors: External economic factors, such as changes in global interest
rates or trade dynamics, can affect the financial health of borrowers in Bangladesh,
potentially leading to NPLs.

To address the rising NPL issue in Bangladesh, it is crucial for banks, regulatory
authorities, and policymakers to implement measures that enhance credit risk
assessment, strengthen regulatory oversight, promote responsible lending practices,
and facilitate efficient loan recovery mechanisms. Additionally, promoting financial
literacy and borrower education can help reduce loan defaults and contribute to a
healthier lending environment.

M. What are the costs of NPL to the Banks? Year 2018

Answer: See the lecture material.
N. How can control this difficulty? Year 2018
Answer: Controlling the rise of Non-Performing Loans (NPLs) in Bangladesh and
similar contexts requires a multifaceted approach involving regulatory, institutional, and
economic measures. Here are strategies to help control this difficulty:

1. Strengthen Regulatory Oversight:

 Regulators should enforce stricter lending standards and governance practices,
ensuring that banks conduct thorough credit risk assessments and adhere to
prudential regulations.
2. Enhance Risk Assessment and Underwriting:
 Banks should improve their credit risk assessment processes, including due
diligence on borrowers' creditworthiness, repayment capacity, and collateral
valuations.
3. Promote Responsible Lending:
 Encourage banks to adopt responsible lending practices, including proper
assessment of borrowers' ability to repay and avoiding undue political or sectoral
pressure.
4. Diversify Loan Portfolios:
  Banks should diversify their loan portfolios across various sectors to reduce
concentration risk. Overexposure to specific sectors can lead to systemic
vulnerabilities.
5. Asset Quality Review (AQR):
 Conduct regular AQRs to identify and address NPLs and potential issues
proactively. This helps in early detection and resolution.
6. Implement Prudential Guidelines:
 Enforce stringent prudential guidelines for risk management, capital adequacy,
and provisioning requirements to ensure that banks are adequately prepared for
loan losses.
7. Create Debt Restructuring Framework:
 Establish a clear and effective debt restructuring framework that allows
struggling borrowers to renegotiate loan terms and avoid default.
8. Strengthen Legal Framework:
 Reform the legal framework for loan recovery, making it more efficient and
expeditious, and addressing issues like lengthy legal proceedings.
9. Enhance Credit Information Systems:
 Improve credit reporting systems to facilitate information sharing among financial
institutions and promote responsible borrowing behavior.
10. Financial Literacy and Education:
 Promote financial literacy programs to educate borrowers about financial
management and the responsibilities associated with taking on debt.
11. Political Neutrality:
 Ensure that banks operate without political interference in lending decisions to
prevent imprudent lending practices.
12. Supervisory Capacity Building:
 Enhance the capacity of supervisory authorities to monitor and regulate banks
effectively, with a focus on early warning systems.
13. Crisis Management Plans:
 Develop and regularly update crisis management plans to respond swiftly to
emerging financial crises, including NPL-related challenges.
14. Collaboration with International Organizations:
 Collaborate with international financial organizations and agencies for technical
assistance, capacity building, and best practice sharing.
15. Market Discipline:
 Encourage market discipline by ensuring that investors and creditors hold banks
accountable for their risk management practices.

Controlling the rise of NPLs is an ongoing process that requires collaboration among
banks, regulators, and other stakeholders. A proactive approach, combined with
effective regulatory oversight and prudent risk management, can help mitigate the
impact of NPLs on the financial system and support economic stability.
 Corporate governance & credit discipline

 Underlying meaning of corporate governance ( Y/Q 2020)

Corporate governance is the system of rules, practices, and processes by
which a company is directed and controlled. It is concerned with how
companies are managed and how they interact with their stakeholders, such
as shareholders, employees, creditors, customers, and the public.

Credit discipline is the willingness and ability of a borrower to repay their

debts. It is important for both borrowers and lenders, as it helps to ensure that
loans are made responsibly and that borrowers are able to meet their financial
obligations.

There is a strong link between corporate governance and credit discipline.

Companies with good corporate governance practices are more likely to be
well-managed and to have sound financial controls in place. This makes them
less likely to default on their debts.

Globalization involves the movement of four economic parameters. These are :

 Physical capital in terms of machinery
 Financial capital in terms of money invested in capital market or in FDI
 Technology
 Labour moving across national borders

Corporate Governance (CG) represents the value framework, the ethical

framework & the moral framework under which business decisions are taken.
When investments take place across national border, the investors want to be
sure that not only is their capital handled effectively & adds to the creation of
wealth, but the business decisions are also taken in a manner which is not
illegal or involving moral hazard.

 Elements of corporate governance (******)(Y/Q-2019)

Corporate governance consists of five important elements, such as :

1. Good board practices

2. Effective control process
3. Transparent disclosure
4. Well-defined rights of the shareholders &
5. The board’s commitment to ensure effective corporate Governance
Practice
These are explained below

1. Good board practices

This means that the board of directors is made up of qualified and independent members
who are able to provide oversight and guidance to management. The board should have
clear roles and responsibilities, and it should meet regularly to discuss the company's
performance and strategy.

2. Effective Internal control process

This means that the company has in place a system of internal controls to manage risks and
ensure that its financial and operational information is accurate and reliable. The control
process should be regularly reviewed and updated to ensure that it is effective.

3. Transparent disclosure
This means that the company provides timely and accurate information to its shareholders
and other stakeholders about its financial performance, operations, and risks. The company
should also disclose information about its corporate governance practices and policies.

4. Well-defined rights of the shareholders

This means that the company's shareholders have the right to vote on important matters,
such as the election of directors and the approval of major transactions. The shareholders
should also have the right to access information about the company and to hold the board of
directors accountable for its performance.

5. The board’s commitment to ensure effective corporate Governance Practice

This means that the board of directors is committed to upholding high standards of corporate
governance. The board should be proactive in identifying and addressing potential problems,
and it should be willing to take action to protect the interests of shareholders and other
stakeholders.

Pillars of CG (****)(Y/Q -2019)

The above five elements of corporate governance stands on the
following four pillars :
1. Accountability
2. Fairness
3. Transparency &
4. Responsibilities

Accountability means that the board of directors and management are

responsible for their actions and that they can be held accountable for their
decisions.
 Fairness means that all shareholders should be treated equally and that the
company should not favor one group of shareholders over another.

Transparency means that the company should disclose all relevant

information to its shareholders in a timely and accurate manner.

Responsibility means that the board of directors and management have a

duty to act in the best interests of the company and its shareholders.

These four pillars are essential for building trust between the company and its
shareholders, and they are also important for attracting and retaining
investors.

 Legal measures of Corporate governance (****)(Y/Q-2019)

To govern corporate environment in Bangladesh, following legal measures

are in practice:

Bangladesh Bank Order 1972: This law regulates the banking sector of
Bangladesh. It establishes the Bangladesh Bank as the central bank of the country
and gives it the power to supervise and regulate all commercial banks and
financial institutions.

Bank Companies Act 1991: This law provides a framework for the
incorporation, management, and operation of banks in Bangladesh. It also
prescribes certain corporate governance norms that banks must follow.

Financial Institutions Act 1993: This law regulates all financial institutions in
Bangladesh other than banks. It also prescribes certain corporate governance
norms that financial institutions must follow.

Securities & Exchange Commission Act 1993: This law establishes the Securities
and Exchange Commission (SEC) of Bangladesh and gives it the power to
regulate the securities market of the country. The SEC also issues various
guidelines and regulations on corporate governance, which listed companies
must follow.

Companies Act 1994: This law provides a general framework for the
incorporation, management, and operation of companies in Bangladesh. It also
prescribes certain corporate governance norms that all companies must follow.

Bankruptcy Act 1997: This law provides a framework for the rehabilitation and
liquidation of insolvent companies in Bangladesh.
 Corporate governance in banks & financial institutions
Corporate governance in banks and financial institutions is a system of rules
and procedures that ensures that these institutions are managed in a fair,
transparent, and accountable manner. It is important for banks and financial
institutions to have good corporate governance because they play a vital role
in the economy and have a significant impact on the lives of individuals and
businesses.

Banks and financial institutions are responsible for managing large amounts
of money and other assets. This means that it is important to have a system in
place to prevent fraud and mismanagement.

Corporate governance helps to ensure that banks and financial institutions are
run in the best interests of all stakeholders, including shareholders, depositors,
borrowers, and the general public.

Key elements of corporate governance in banks and financial institutions

include:

 A strong and independent board of directors

 Clear and transparent policies and procedures
 Effective risk management systems
 Strong internal controls
 Ethical business practices

Good corporate governance in banks and financial institutions is important for

a number of reasons:

 It helps to protect depositors and other stakeholders.

 It helps to promote financial stability.
 It helps to build trust and confidence in the banking system.
 It can help to reduce the risk of financial crises.

Here are some examples of how corporate governance can help to protect
depositors and other stakeholders:

 A strong and independent board of directors can help to prevent

management from making risky decisions that could put the bank at risk.
 Clear and transparent policies and procedures can help to ensure that the
bank is managed in a fair and equitable manner.
 Effective risk management systems can help to identify and mitigate risks
to the bank.
 Strong internal controls can help to prevent fraud and other irregularities.
 Ethical business practices can help to build trust and confidence with
customers and investors.
 How do good corporate governance practices bring stability in
banking industry of Bangladesh? Discuss. ( y/Q 2021)

Good corporate governance practices can bring stability to the banking

industry of Bangladesh in a number of ways:

Reduced risk of fraud and mismanagement. Good corporate governance

practices help to ensure that banks are managed in a transparent and
accountable manner, which can reduce the risk of fraud and
mismanagement. For example, an independent board of directors can provide
oversight of management and help to prevent them from engaging in risky or
unethical behavior.

Improved risk management. Good corporate governance practices can also

help banks to improve their risk management capabilities. For example, a well-
functioning risk management committee can help to identify and assess risks, and
to develop and implement strategies to mitigate those risks.

Stronger financial performance. Good corporate governance practices are

often associated with stronger financial performance. This is because well-
governed banks are more likely to make sound business decisions and to manage
their resources efficiently.

Increased public confidence. Good corporate governance practices can help

to increase public confidence in the banking system. This is important because
banks rely on public trust in order to attract deposits and investments.

 Responsibilities & Authorities of Board of Directors’

The Board of Directors (BOD) is responsible for the overall governance of a

bank. This includes setting the bank's strategic direction, overseeing
management, and ensuring compliance with all applicable laws and
regulations.

The BOD's responsibilities can be broadly divided into three categories:

Work-planning and strategic management: The BOD is responsible for setting

the bank's objectives and goals, and developing strategies and work plans to
achieve them. This includes making decisions about the bank's product and
service offerings, target markets, and risk appetite.

Credit and risk management: The BOD is responsible for developing and
overseeing the bank's credit and risk management policies and procedures.
This includes ensuring that the bank's loan portfolio is well-managed and that
the bank is adequately protected against various risks, such as credit risk,
market risk, and operational risk.
Internal control management: The BOD is responsible for establishing and
maintaining an effective internal control system. This includes ensuring that
the bank has adequate policies and procedures in place to prevent fraud,
ensure the accuracy of financial reporting, and safeguard the bank's assets.

To effectively carry out its responsibilities, the BOD must have a clear
understanding of the bank's business and the risks it faces. The BOD should
also be composed of individuals with the necessary skills and experience.

Here are some examples of the BOD's responsibilities:

 Approving the bank's annual budget

 Setting the bank's risk appetite
 Overseeing the bank's lending practices
 Reviewing the bank's financial statements
 Ensuring that the bank complies with all applicable laws and regulations

The BOD is ultimately responsible for the safety and soundness of the bank. By
effectively carrying out its responsibilities, the BOD can help to ensure that the
bank is well-managed and financially stable.

The BOD's authority comes from the fact that it is elected by the bank's
shareholders. This means that the BOD is accountable to the shareholders for
the bank's performance

The BOD's authorities include:

 Establishing the bank's policies and procedures

 Approving the bank's budget and business plans
 Declaring dividends
 Issuing new shares
 Merging or acquiring other banks

 How corporate governance affects credit discipline

Corporate governance is the system of rules, practices, and processes by
which a company is directed and controlled. It includes the rights and
responsibilities of the board of directors, the management team, and the
shareholders. Sound corporate governance is important for a number of
reasons, including:

 It helps to ensure that the company is run in a transparent and

accountable manner.
 It helps to protect the interests of shareholders and other stakeholders.
 It helps to reduce the risk of fraud and corruption.
 It helps to promote long-term financial success.
Credit discipline is the practice of making sound lending decisions and
managing credit risk effectively. It is important for banks to have a strong
credit culture in order to protect their depositors and shareholders.

 Problems Caused by Lack of Sound Corporate Governance (***)

The problems caused by lack of sound corporate governance in the banking
sector are well-documented. Some of the most common problems include:

Non-performing loans (NPLs): NPLs are loans that are not being repaid by the
borrower. They can be a major problem for banks, as they can lead to losses
and financial instability.

Provisions and capital shortfall: Banks are required to hold provisions against
NPLs. If a bank has a lot of NPLs, it may need to raise additional capital to meet
its regulatory requirements.

Eroded credit discipline: When there is weak corporate governance, there is a

greater risk that bank managers will make poor lending decisions. This can
lead to an increase in NPLs and other financial problems.

Managerial weaknesses: Poor corporate governance can lead to a number of

managerial weaknesses, such as a lack of accountability and transparency.
This can make it difficult for banks to identify and address problems early on.

Excessive interference from government and owners: Government and

owners can sometimes interfere in the management of banks for their own
personal or political gain. This can lead to poor lending decisions and other
problems.

 The Importance of Management Quality

Management quality is one of the most important factors in determining the
success of a bank. A good management team will be able to make sound
lending decisions, manage credit risk effectively, and deal with problems
promptly and efficiently.

The CAMELS rating system is a commonly used tool for assessing bank
management quality. The CAMELS rating is based on six components: capital
adequacy, asset quality, management, earnings, liquidity, and sensitivity to
market risk

Management rating is based on a variety of factors, including the quality of

the board's monitoring and support, financial performance, development and
implementation of policies and procedures, risk management, internal and
external audit functions, concentration and delegation of authority,
compensation policies, and overall performance.
 Corporate governance plays a critical role in management quality. When
companies adhere to strong corporate governance practices, such as
transparency, accountability, and fairness, they are more likely to have well-
functioning boards and management teams. This can lead to better decision-
making, reduced risk, and improved financial performance.

Public sector banks in Bangladesh have historically had higher levels of non-
performing loans than foreign banks. This is partly due to the fact that public
sector banks are often pressured to make loans to borrowers who may not be
creditworthy. Foreign banks, on the other hand, are more likely to make
decisions based on sound commercial principles.

Corporate governance is essential for ensuring credit discipline in the banking

sector. When banks have strong corporate governance practices in place, they
are less likely to make risky loans. This can help to reduce the level of non-
performing loans and improve the overall health of the banking system.

Management rating is based on a variety of factors, but corporate governance

is a particularly important one. Banks with strong corporate governance
practices are more likely to have well-functioning boards and management
teams, which can lead to better decision-making, reduced risk, and improved
financial performance. This is essential for ensuring credit discipline and
maintaining a stable and efficient banking sector.

 Components of management quality: ( y/q-2019)

Management is the most important element for a successful operation of a
bank. Management is the composition of 4 components that represents the
management quality of a bank. These are:

1. Capital adequacy
2. Asset quality
3. Earning & Management quality = ( C+ A+ E + L )/4
4. Liquidity position

These are explained below :

Capital adequacy: This refers to the bank's ability to absorb losses and remain
solvent. It is measured by the ratio of the bank's capital to its risk-weighted
assets. A higher capital adequacy ratio indicates a stronger bank.

Asset quality: This refers to the quality of the bank's loans and investments. It is
measured by the percentage of non-performing loans and the level of loan loss
reserves. A lower percentage of non-performing loans and a higher level of loan
loss reserves indicate a better asset quality.

Earning: This refers to the bank's ability to generate profits. It is measured by the
bank's return on assets and return on equity. A higher return on assets and return
on equity indicate a better earning capacity.
Liquidity position: This refers to the bank's ability to meet its short-term
obligations. It is measured by the bank's liquidity ratios, such as the loan-to-
deposit ratio and the cash reserve ratio. A lower loan-to-deposit ratio and a
higher cash reserve ratio indicate a better liquidity position.

 Corporate governance Vs productivity & profitability (Y/Q 2020)

Corporate governance is a set of rules and practices that ensure that a company is
managed in a transparent and accountable manner. It helps to protect the interests of
shareholders and other stakeholders, and to promote good business practices.

Productivity is the efficiency with which a company produces outputs. Profitability is the
company's ability to generate profits.

Corporate governance and productivity and profitability in banks

There is a positive relationship between corporate governance and productivity and
profitability in banks. This is because good corporate governance helps to:

 Reduce the risk of fraud and mismanagement

 Improve decision-making
 Increase transparency and accountability
 Enhance investor confidence

All of these factors can lead to increased productivity and profitability.

Credit discipline and corporate governance

Credit discipline is the process of ensuring that loans are made to borrowers who are
likely to repay them. It is important for banks to maintain credit discipline in order to
reduce the risk of bad loans.

Corporate governance plays a vital role in maintaining credit discipline. For example, a
well-functioning board of directors can help to ensure that loans are made in a sound
and prudent manner.

How corporate governance can lead to increased productivity and

profitability in banks
Corporate governance can lead to increased productivity and profitability in banks in a
number of ways. For example:

 A well-functioning board of directors can help to develop and implement sound

business strategies.
 A strong risk management framework can help to reduce the risk of fraud and
mismanagement.
 A culture of transparency and accountability can lead to better decision-making and
increased employee engagement.
 Enhanced investor confidence can lead to lower borrowing costs and increased
access to capital
 The Basel Framework and Credit Risk

Basel Accords?

Year Quest 2018: Why Banks Should Comply with BASEL accords?
The Basel Accords refers to a set of banking supervision regulations set by the Basel
Committee on Banking Supervision (BCBS). They were developed between 1980 and
2011, undergoing several modifications over the years.
The Basel Accords were formed with the goal of creating an international regulatory
framework for managing credit risk and market risk. Their key function is to ensure that
banks hold enough cash reserves to meet their financial obligations and survive in
financial and economic distress. They also aim to strengthen corporate governance, risk
management, and transparency.

Year Quest, 2018, 2020: Explain Briefly the overall objectives of the BASEL Framework.
The regulations are considered the most comprehensive set of regulations governing
the international banking system. The Basel Accords can be broken down into Basel I,
Basel II, and Basel III.

Basel I
The foundations of the framework were laid by the Basel Committee in 1988 with the
first standard, the Basel Accord. This established the first global minimum capital
requirements for international banks, in order to improve the stability of the financial
sector and maintain confidence in bank solvency. Banks were required at the time to
maintain a minimum of 8% of regulatory capital measured in terms of credit risk-
weighted assets. The accord was amended in 1996 to incorporate market risk
regulation. This meant that a bank's 8% minimum level for regulatory capital was
measured as a percentage of its total risk-weighted assets, which consisted of credit risk
and market risk positions.

A key limitation of Basel I was that the minimum capital requirements were determined
by looking at credit risk only. It provided a partial risk management system, as both
operational and market risks were ignored.
Basel II (Year Quest, 2018: Did Bangladeshi Banks comply with BASEL II
accord properly)

In 2004, the revised Basel framework "International Convergence of Capital

Measurement and Capital Standards" (Basel II) was published. The fundamental goal of
the Basel Committee was to further strengthen the soundness and stability of the
international banking system.

Basel II comprised three pillars.

 Pillar 1: encompassed the calculation of capital requirements based on bank risks

(credit, market and operational risk).
 Pillar 2: Further focal points were the specification of basic principles for
qualitative banking supervision and risk management in banks and
 Pillar 3: the introduction of supervisory disclosure requirements to strengthen
market discipline.

Basel II, an extension of Basel I, was introduced in 2004. Basel II included new regulatory
additions and was centred around improving three key issues – minimum capital
requirements, supervisory mechanisms and transparency, and market discipline.
Basel II created a more comprehensive risk management framework. It did so by
creating standardized measures for credit, operational, and market risk. Banks needed to
use these measures to determine their minimum capital requirements.
Basel II created standardized measures for measuring operational risk. It also focused on
market values, instead of book values, when looking at credit exposure. Additionally, it
strengthened supervisory mechanisms and market transparency by developing
disclosure requirements to oversee regulations. Finally, it ensured that market
participants obtained better access to information.

Basel III
The Global Financial Crisis of 2008 exposed the weaknesses of the international
financial system and led to the creation of Basel III. The Basel III regulations were created
in November 2010 after the financial crisis; however, they are yet to be implemented.
Their implementation has constantly been delayed in recent years and is expected to
occur in January 2022.
Basel III identified the key reasons that caused the financial crisis. They include poor
corporate governance and liquidity management, over-levered capital structures due to
a shortage of regulatory restrictions, and misaligned incentives in Basel I and II.
Basel III strengthened the minimum capital requirements outlined in Basel I and II. In
addition, it introduced various capital, leverage, and liquidity ratio requirements.
Also, Basel III included new capital reserve requirements and countercyclical measures
to increase reserves in periods of credit expansion and to relax requirements during
periods of reduced lending. Under the new guideline, banks were categorized into
different groups based on their size and overall importance to the economy. Larger
banks were subjected to higher reserve requirements due to their greater importance to
the economy.

Basel III Objectives and Timeline

The global economic crisis has provided an opportunity for a fundamental restructuring
of the approach to risk and regulation in the financial sector. In response to the
deficiencies in financial regulation revealed by the late 2000s financial crisis, Basel-III has
been developed as a third of the Basel Accords. Basel III refers to the latest capital and
liquidity standards prescribed by the Bank of International Settlement (BIS). Bangladesh
has entered into the Basel-III regime effective from January 01, 2015, and full
implementation of Basel-III will be from January 2020. Basel-III is set to strengthen bank
capital requirements and introduce new regulatory requirements on bank liquidity and
bank leverage.
According to BCBS, the Basel-III proposals have main two objectives;
 To strengthen global capital and liquidity regulations with the goal of promoting
a more resilient banking sector.
 To improve the banking sector's ability to absorb shocks arising from financial
and economic stress which, in turn, will reduce the risk of a spillover from the
financial sector to the real economy.
To achieve these objectives, the Basel-III proposals are broken down into three parts on
the basis of the main areas they address:
1. Capital reform (including quality and quantity of capital, complete risk coverage,
leverage ratio and the introduction of capital conservation buffers, and a counter-
cyclical capital buffer)
2. Liquidity reform (short-term and long-term ratios)
3. Other elements relating to general improvements to the stability of the financial
system.
CAPITAL ADEQUACY FRAMEWORK UNDER BASEL-III
(Year Quest,2018: Why BASEL III has been used as a capital adequacy framework by
commercial banks of Bangladesh?)
Capital to Risk-weighted Asset Ratio
The capital to Risk-weighted Asset Ratio (CRAR) is calculated by taking eligible
regulatory capital as numerator and total RWA as a denominator

Total Eligible Capital

CRAR = --------------------------------------------------------------
Credit RWA+ Market RWA + Operational RWA
In order to calculate Capital to Risk-weighted Asset Ratio (CRAR), banks are required to
calculate their Risk-Weighted Asset (RWA) on the basis of credit, market and operational
risks. Total RWA will be determined by multiplying the amount of capital charge for
market risk and operational risk by the reciprocal of the minimum CRAR and adding the
resulting figures to the sum of risk-weighted assets for credit risk

Components of Capital and Minimum Capital Requirement (Year Quest

2020,2021)
(Year Quest 2018: Explain the tier 1 and Tier 2 capital according to BASEL III)
For the purpose of calculating capital under the capital adequacy framework, the capital
of the banks shall be classified into two tiers. The total regulatory capital will consist of
the sum of the following categories:

1) Tier 1 Capital (going-concern capital')

a) Common Equity Tier 1 Capital
For the local banks, Common Equity Tier 1 (CET 1) capital shall consist of the sum of the
following items:
i. Paid up Capital
ii. Non-repayable share premium account
iii. Statutory reserve iv. General reserve
iv. General Reserve
v. Retained earnings
vi. Dividend equalization reserve
vii. Minority interest in subsidiaries2
Less: Regulatory adjustments applicable on CET 1 (refer to Guidelines on RBCA,
Published by Bangladesh Bank in December 2014 for details.

For the foreign banks operating in Bangladesh, Common Equity Tier 1 (CET 1) shall
consist of the following items:
i. Funds from the Head Office for the purpose of meeting the capital adequacy
ii. Statutory reserve kept in books in Bangladesh
iii. Retained earnings
iv. Actual gain/loss kept in books in Bangladesh
Less: Regulatory adjustments applicable on CETI (refer to Guidelines on RBCA, Published
by Bangladesh Bank on December 2014 for details)

b) Additional Tier 1 Capital

For the local banks, Additional Tier 1 (AT 1) capital shall consist of the following items.
i. Instruments issued by the banks that meet the qualifying criteria for AT1
(Details as per RBCA guideline Annex 4)
ii. Minority Interest i. e; ATI issued by consolidated subsidiaries to third parties
(for consolidated reporting only); refer to RBCA guideline Annex 2 for further
details
Less: Regulatory adjustments applicable on AT1 capital (refer to Guidelines on RBCA,
Published by Bangladesh Bank on December 2014 for details)"

For the foreign banks operating in Bangladesh, Additional Tier 1 (AT 1) shall consist
of the following items:
i. Head office borrowings in foreign currency by foreign banks operating in
Bangladesh for inclusion in Additional Tier 1 capital which comply with the
regulatory requirements
ii. Any other item specifically allowed by Bangladesh Bank from time to time for
inclusion in Additional Tier 1 capital;
Less: Regulatory adjustments applicable on AT 1 (refer to Guidelines on RBCA, Published
by
Bangladesh Bank on December 2014 for details)
2. Tier 2 Capital (gone concern capital')
Tier 2 capital, also called 'gone-concern capital', represents other elements which fall
short of some of the characteristics of the core capital but contribute to the overall
strength of a bank.

For the local banks, Tier 2 capital shall consist of the following items:
i. General Provisions".
ii. Subordinated debt/ instruments issued by the banks that meet the qualifying
criteria for Tier 2 capital (refer to Annex 4, RBCA Guideline for details)
iii. Minority interest i. e; Tier -2 issued by consolidated subsidiaries to third parties
as specified in Annex 2, RBCA guideline.
Less: Regulatory adjustments applicable on Tier 2 capital

For the foreign banks operating in Bangladesh, Tier 2 capital shall consist of the
following items
i. General provision
ii. Head office borrowings in foreign currency received that meet the criteria of
Tier 2 debt capital
Less: Regulatory adjustments applicable on Tier 2 capital (refer to Para 3.4, Guidelines on
RBCA, Published by Bangladesh Bank in December 2014 for details)

MEASURES SUGGESTED BY BASEL III TO DIFFUSE

THREATS OF ECONOMIC CRISIS
The Basel III has identified the reasons for Bank failure in the recent financial crisis. The
main reasons for the crisis as identified in the Basel III document,
 use of excessive leverage,
 gradual erosion of level and quality of capital base,
 insufficient liquidity buffer, pro-cyclicality and
 excessive interconnectedness among systematically important institutions.

The measures suggested by Basel III to diffuse the threats as mentioned above have
been discussed below:

1. Introduction of Leverage Ratio:

The formal banks also accumulated excessive leverage in their balance sheet while
maintaining the necessary risk-based capital ratio. The de-leveraging process and the
price slump in the shadow banking system greatly affected these banks. As such they
were compelled to reduce their leverage in a forced manner that caused huge losses,
reduced capital ratio and contracted the availability of credit in the economy.
It is apparent that the excessive leverage of the banks contributed to the crisis. Even the
banks having the necessary risk-based capital ratio were also in crisis because of
excessive leverage. It means that the capital ratio alone is not sufficient to protect the
stability of the financial sector. As such, Basel III introduces a simple, transparent, non-
risk-based regulatory leverage ratio to constraint leverage in the banking sector and
supplements risk-based capital ratio as a safeguard against model risk. The leverage ratio
is calculated by dividing tier 1 capital by total exposure.

2. Increase Quality and Quantity of Capital Base:

Another reason of the failure of banks to withstand the shock of the financial crisis was
substandard quality and inadequacy of capital. The capital of banks lacked good
proportion of high-quality capital like common shares and retained earnings in the pre-
crisis period. Short-term subordinated debt was used as tier-3 capital which did not have
the strength to provide support during the prolonged crisis. Rather the debts matured
within a short period of time and banks faced extra pressure to redeem the debts. At the
onset of the crisis, the banks made large distributions of capital in the form of cash
dividends, share-buy-back and generous compensation with the market signalling that
they were sufficiently strong, which actually weakened the position of the banks.
To increase the quality and quantity of the capital base of the banks, Basel III has
introduced the following measures:
 Tier 1 capital has been divided into two parts: Common Equity Tier 1 (CET 1) and
Additional Tier 1(AT 1) Minimum Tier 1 capital has been set at 6 per cent out of
which CET 1 is 4.5 per cent and AT 1 is 1.5 per cent. However, the minimum
capital requirement has been kept unchanged from Basel II.
 The definition of capital has been made stringent. Tier 3 capital has been
eliminated.
 A buffer CET 1 capital named Capital Conservation Buffer has been proposed
@2.5 per cent in addition to the minimum capital requirement. The restriction has
been put in the distribution of profit (cash dividend and discretionary bonus to
staff) until the buffer is developed.
In addition, the banks are required to deduct goodwill and other intangible assets,
deferred tax assets, shortfall in provision, defined benefit pension fund assets and
liabilities, and investment in shares of financial institutions (including bank, NBFI and-
insurance) in excess of 10 per cent of bank's capital, investment in own share, gain on
sale related to securitization transaction etc. from their capital.
 3. Introduction of Liquidity Standard as a complement to the
Capital Standard:
As mentioned above insufficient liquidity buffer was one of the reasons for the financial
crisis. The banks excessively relied on short-term low-cost funding to create long-term
assets. They also failed to maintain high-quality long-term assets to stand out in the
stressed condition. During the crisis, they faced many difficulties in meeting their
liquidity needs, which necessitated intervention from the central bank. The crisis
revealed that the supervisory standard on liquidity is of equal importance as capital to
maintain the stability of the financial sector. Accordingly, Basel III introduced a liquidity
standard as a complement to the capital standard.
Basel III developed two minimum standards for liquidity.
1. Liquidity Coverage Ratio (CR): The objective of LCR is to promote short-term
resilience of the bank's liquidity risk profile by ensuring that it has a sufficient
high-quality liquid asset to survive in a significant stress scenario fasting for one
month.

2. Net Stable Funding Ratio (NSFR): The objective of NSFR is to promote resilience
over a field horizon of one year by requiring banks to fund the activities with
store-stable sources of funding.
Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are the pros and
cons of the Basel-III framework. The LCR is a new liquidity standard introduced by the
Basel Committee to ensure that a bank maintains an adequate level of unencumbered,
high-quality assets that can be converted into cash to meet its liquidity needs for 30
calendar days. The NSFR is a longer-term liquidity monitoring tool.
The objective of LCR is to promote short-term resilience of the bank's liquidity risk profile
by ensuring that it has a sufficient high-quality liquid asset to survive in a significant
stress scenario fasting for one month. The objective of NSFR is to promote resilience over
a field horizon of one year by requiring banks to fund the activities with store-stable
sources of funding

4. Countercyclical Buffer to address Pro-cyclicality

Pro-cyclicality was also responsible for deepening the global financial crisis:
 Pro-cyclicality favours the banking system during the buoyant period but was
adversely hit at the time of the crisis
 When the economy runs well, the bank's capital rises from higher profit and
lower provision requirements.
  The amount of risk-weighted assets becomes low as the borrowers can favorable
rating owing to an optimistic economic outlook. As a result, bank can earn high
credit growth supported by a good capital ratio.
 As the economic scenario reverses, the bank's capital undergoes pressure from
lower profitability coupled with an increase in provision requirement Risk
weighted asset rises owing to lower rating by borrower. Consequently, banks'
capital ratio decreases, which compels them to reduce their lending activities. The
resultant credit crunch adversely affects the economy and lengthens the crisis.

To address pro-cyclicality, Basel III suggested a countercyclical buffer. This buffer varies
from 0 to 2.5 per cent at the discretion of the national supervisory authority. The buffer
is to be built up at the time of high credit growth that may signal a build-up of system-
wide risk and is withdrawn when such threat disappears.

5. Limit Interconnectedness among Systematically Important Institutions

Excessive interconnectedness among financial institutions also made the financial crisis
so severe. Financial institutions were engaged in an array of complex transactions,
which rapidly transmitted the crisis from one institution to another.
To limit the interconnectedness among financial institutions, Basel III suggested a
number of measures. These measures include:
 The bank's capital will be deducted for investment in shares of financial
institutions (bank, NBFI and insurance) in excess of 10% of the bank's capital
 The use of central counterparties has been encouraged in the over-the-counter
derivatives
 Higher capital requirement has been imposed for derivative products and
 The capital surcharge has been made applicable for systematically important
banks

5.0 IMPLICATION OF BASEL-III, ON THE BANK'S

STRATEGIES AND OPERATIONS
Year quest 2021: How do good corporate governance practices bring Stability in
Banking Industry of Bangladesh? Discuss.
Bangladesh has started preparations to implement the Basel-Ill in Bank companies from
January 2015 in line with the global standard. The Banking regulation on capital
requirements known as Basel-III will have a significant effect on the overall banking
systems and economies. On the positive side, fortified capital and liquidity requirements
will make Bangladesh's banking sector safer. On the other side, the enhanced safety will
incur additional costs, since it is expensive for banks to hold extra capital and to be more
liquid.
However, the likely impact of Basel-Ill on overall banking strategies and operations will
be as under:
1. Loans and other banking services will be more expensive and harder to obtain which
will result in slower economic growth due to higher credit costs and reduced credit
availability.
2. Bank's profitability may decline by 30% upon full implementation of Basel-III. If the
banks are not able to recover their consequential increased costs from the borrowers,
the IRR will be reduced.
3: The impact of Basel-III is widespread and will affect the bank's day-to-day decision-
making in lending. funding, treasury, capital, liquidity and operations. All these are
interrelated and directly affect the bank's profitability.
4. The Basel-III introduces a lot of modifications in terms of stringent capital
requirements and leverage ratios. It proposed an increase in the minimum common
equity requirement from 2% to 4.5%. In addition, banks are required to hold a capital
conservation buffer of 2.5% to withstand any future stress bringing the total common
equity requirements to 7%. The most significant challenge the Banking sector of
Bangladesh will be facing while implementing Basel-Ill is the need to balance the
interests of the businesses against the needs of the regulator.
5. In order to meet the new capital requirements, banks can issue new equity and
increase retained earnings by reducing dividend payments, increasing operating
efficiency, decreasing non-performing loans and other costs.
6. Optimization of RWA is the best course of action that management of the bank might
choose, to generate value for the bank at minimum cost in terms of funding and
operational structuring. It can be implemented by maximizing the Risk-Adjusted Rate of
Return with limited or constrained capital.
7. The introduction of two liquidity ratios to address the short-term and long-term
nature of liquidity and funding will likely drive the banks away from sourcing shorter-
term deposit funding arrangements and more towards longer-term funding
arrangements the consequent impact on the pricing and margin that are achievable
The macro-prudential aspects of Base-Ill are largely enriched in the capital buffers. Both
the buffers i. e; the capital conservation buffer and countercyclical buffer are intended to
protect the banking sector from periods of excess credit growth.
 6.0 LENDING POLICY VS BASEL-III
Year Quest: 2021: How would evaluate the 6%-9% interest ceiling set by Bangladesh
Bank? Discuss the impact mainly in the Bank Credit management.
In order to be able to mitigate the impact of the requirement of additional capital ratio
under Basel III banks should improve or revise the existing credit policies. It requires
having appropriate methodologies that enable them to assess adequate capital for the
credit exposures to individual borrowers or counterparties as well as at the whole
portfolio level.
For more sophisticated banks, the credit review assessment of capital adequacy, at a
minimum should cover four areas:
1. risk rating systems,
2. portfolio analysis aggregation securitization/complex credit derivatives, and
3. large exposures and
4. risk concentrations.
a) Internal risk ratings are an important tool in monitoring credit risk, Internal risk
ratings should be adequate to support the identification and measurement of risk
from all credit exposures, and should be integrated into an institution's overall
analysis of credit risk and capital adequacy. The rating system should provide
detailed ratings for all assets not only for classified or problem assets. Loan loss
reserves should be included in the credit risk assessment for capital adequacy.
Thus capital adequacy will comprise of:
 Specific provisions are maintained against past-due claims.
 Minimum regulatory capital is maintained against past due claims (net of specific
provisions) and
 Some extra funds may be required to be maintained which will make the cushion
adequate equivalent up to the risk profile level.

b) The analysis of credit risk should adequately identify any weaknesses at the portfolio
level, including any concentrations of risk. It should also adequately take into
consideration the risks involved in managing credit concentrations and other portfolio
issues through such mechanisms as securitization programs and complex credit
derivatives.
For the purpose of ensuring minimum capital charge with respect to credit risk, the
credit policy of the bank should incorporate the following:
 Introduction of comprehensive risk assessment techniques Establishing a method
for calculating risk-adjusted rate of return
 Using credit derivatives to manage credit risk exposure
 Minimizing risk-weighted assets
  Obtaining adequate collateral/coverage
 Regular benchmarking of the security value vis-à-vis outstanding should be a part
of the credit culture
 Achieving the appropriate asset mix- under Basel-III increase in the proportion of
short-term assets to manage the Net Stable funding ratio (NSFR) will be required.
 More emphasis should be given on syndicated loan Floating rate vs. fixed rate on
lending
 Ensure that businesses credit customers are correctly charged for the capital costs
of the business they are doing
 Ensure that Basel-Ill capital implications are taken into account for new business
and consider how existing long-dated business can be revisited
 Strengthening post-disbursement follow-up and monitoring system

7.0 ACTIONS TO BE CONSIDERED FOR IMPLEMENTING BASEL-III

For the purpose of implementing Basel-IH, the actions required to be taken may be
grouped under three categories as follows:
A. Actions to consider with respect to Capital Management
 Carry out appropriate scenario planning and impact assessments to ensure the
development of a successful capital strategy
 Identify which businesses have the most attractive fundamentals under Basel-Ill
and which businesses in the Bank's portfolio should be considered for exiting,
and growing. or diverting
 Ensure managers have adequate incentives to optimize the use of capital
 Identify the changes needed to fine-tune/lower capital consumption
 Consider how to address the pricing implications arising from changes in the
capital requirements for certain products Review whether the same business
models can continue under a different structure, minimizing capital penalties

B. Actions to consider in respect of Liquidity Management

 Ensure understanding of the current liquidity position in sufficient detail and
possession of knowledge of where the stress points are
 Ensure management has adequate incentive to optimize the use of capital
 Consider the impact of new liquidity sales on profitability and whether it has
been factored into key business processes and pricing
 Check that liquidity planning, governance and modelling are in line with leading
industry practice Determine an appropriate series of liquidity stress tests and how
these will change over time
 Gain awareness of the likely implementation timetable for different elements of
the global and national frameworks being proposed
 C. Actions to consider with respect to General Capital Planning
 Ensure that businesses are correctly charged for the capital costs of the business
that they are doing
 Ensure that Basel-III capital implications are taken into account for new business
and consider how existing long-dated business can be revisited
 Examine how non-core businesses can be reduced or restructured
 Examine the performance of existing assessment methodologies

Year Quest: 2021: How would evaluate the 6%-9% interest ceiling set by Bangladesh
Bank? Discuss the impact mainly in the Bank Credit management.
Bangladesh Bank Interest Impact
The Bangladesh Bank's decision to set a 6%-9% interest ceiling can have significant
implications for bank credit management. Such an interest rate cap affects various
aspects of the banking sector:
1. Credit Availability: A lower interest rate ceiling can make borrowing more
affordable for businesses and individuals, potentially increasing the demand for
credit. However, if the rates are too low, banks might become reluctant to lend,
fearing reduced profitability.
2. Risk Management: Banks may become more cautious in their lending practices to
mitigate the risks associated with lower interest rates. This caution could lead to
stricter eligibility criteria for borrowers, impacting small businesses and individuals
with lower credit ratings.
3. Profit Margins: Banks rely on the interest rate spread (the difference between the
interest earned on loans and paid on deposits) for profitability. A narrow interest
rate spread due to low ceilings could affect the banks' profit margins, potentially
impacting their ability to cover operational costs and invest in new technologies.
4. Investment in the Economy: Lower interest rates could stimulate investments in
various sectors, potentially boosting economic growth. However, if banks are not
making sufficient profits due to the interest rate ceiling, their ability to contribute
to economic development through loans and investments might be constrained.
5. Savings and Deposits: Lower interest rates on loans might lead to reduced
interest rates on savings accounts. This could discourage saving among the
population, affecting individuals who rely on interest income from their savings.
6. Market Competition: Banks might face increased competition due to the interest
rate ceiling. To maintain profits, they could focus on improving operational
efficiency, and customer service, and exploring fee-based services to remain
competitive.
7.
 8. Government Policies: The government's fiscal and monetary policies, in
conjunction with the interest rate ceiling, play a crucial role. Coordinated efforts
are necessary to ensure stability in the financial sector while promoting economic
growth.

In summary, while a 6%-9% interest ceiling can enhance credit affordability and
stimulate economic activity, it also poses challenges for banks' credit management,
potentially affecting their profitability, risk management strategies, and overall
contribution to the economy. Effective monitoring and adjustment of policies are
essential to strike a balance between promoting economic growth and maintaining the
stability of the banking sector.
The End