This is being made available for Risk Management Practice Group on Linkedin. RMPG Learning Series CRM Workshop Handouts: File 9 of 9

1. Agenda for Day 5
Presentation of Cases by Participants
Discussions on Issues Raised
Lunch Break
Session on current regulations in Bangladesh
IMaCS’ Recommendations to Banks
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 1

2. Regulatory framework: Banks
Minimum Capital • Tk. 200 crore
• 10%
Capital adequacy ratio
• 5% Core Capital
• Not more than % of capital in a bank may be acquired
Ownership without the approval of the Bangladesh Bank.
Foreign ownership • Up to xx%
• 365 days (in case of asset financing) , 180 days (in
Provisioning case of loans and other exposures)
Availability of deposit
insurance facility for • Yes
depositors
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 2

3. Categories of Loans
Continuous
Loan If any uncertainty or
doubt arises in respect
of recovery of any
Continuous Loan,
Demand Loan or Fixed
Short-term
Agricultural Categories Demand Term Loan, the same
and Micro of Loans Loan
will have to be
Credit
classified on the basis
of qualitative judgment
be it classifiable or not
on the basis of
Fixed Term
Loan objective criteria
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 3

4. Loan Classification
Past due/overdue • If not repaid/renewed within the fixed expiry date for repayment will be
treated as past due/overdue from the following day of the expiry date
Special Mention • A Continuous Loan/Demand loan/Term Loan which will remain
overdue for a period of 90 days or more, will be put into the "Special
Account Mention Account(SMA)"
• Sub-standard if it remains past due/overdue for 6 months or beyond but
Sub-standard less than 9 months.
Doubtful • `Doubtful' if for 9 months or beyond but less than 12 months
Bad-Debt • Bad-Debt' if for 12months or beyond
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 4

5. Provisioning Norms …1
Classified Continuous, Demand and Fixed Term Loans
Sub-standard 20%
Doubtful 50%
Bad/Loss 100%
Provision in respect of Short-term Agricultural and Micro-Credits is to be maintained
at the following rates
All credits except 'Bad/Loss'(i.e. 'Doubtful', 'Sub-standard', irregular and 5%
regular credit accounts)
'Bad/Loss' 100%
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 5

6. Provisioning Norms…2
Banks will be required to maintain General Provision
All unclassified loans (other than loans under Consumer 1%
Financing and Special Mention Account
Unclassified amount for Consumer Financing whereas it has to 5%
be maintained @ 2% on the unclassified amount for (i) Housing Finance and (ii)
Loans for Professionals to set up business under Consumer Financing Scheme.
Outstanding amount of loans kept in the 'Special Mention 5%
Account' (SMA) after netting off the amount of Interest Suspense.
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 6

7. Agenda for Day 5
Presentation of Cases by Participants
Discussions on Issues Raised
Lunch Break
Session on current regulations in Bangladesh
IMaCS’ Recommendations to Banks
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 7

8. Governance framework for Risk Management
Organization structure
with well defined roles
and responsibilities
Review of existing
policies, processes and Formulation of policies,
processes and formation
systems and
of different committees
modifications if required
Robust reporting and Monitor execution
analysis infrastructure for through periodic reviews
early warnings or done by these committees
monitoring trends
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 8

9. Risk Management Process and Tools
Post Sanction Pre
Pre Sanction Post disbursement Default
disbursement
DP report and stock
Appraisal audits
Execution of all Special Mention
documents Monitoring report Accounts report
Assessment through Branch Compliance
rating models Certificate
Meeting pre Loan Review
disbursement Mechanism NPA reporting
Prudential exposure conditions
limits Re-rating of large
accounts annually
Evaluate decoupling of Evaluate possibility of Sector wise, product wise
Sector wise, product wise
origination and assessment / setting up a centralized legal NPA and SMA rating
rating migrations
credit rating cell
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 9

10. Policy for Internal Capital Adequacy Assessment Process :
Objectives
Enunciate Bank’s overall risk philosophy
Define acceptable risk measurement methodologies including risk mitigation
mechanisms
Ability to assess capital adequacy to ensure
Compliance with Bangladesh Bank guidelines
Adequate capital as buffer to ensure business stability simultaneously with rapid growth
Provide better internal governance environment and facilitate proactive Capital
Budgeting
Define organization structure and responsibilities for effective internal assessment
process including reporting mechanisms
Ensure continued validity and relevance of risk assessment methodologies through
periodical internal audit
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 10

11. ICAAP framework
Identification of RMD, CRMC, ORMC & ALM Cell
all material risks Based on materiality
Oversight Reporting of risks Measurement and Measurement methodology aligned with RBI
assessed
process and reporting of all guidelines
Reporting of CRAR
structure the material risks Scenarios sensitized to bank’s profile
Actions
Additional Capital for Capital cushion
Strategy for Required to manage unexpected scenarios
normal growth based on
ensuring capital Additional capital for understanding Stress testing framework to provide a measure of
adequacy capital cushion
increased risks of implicit risks
Linking capital
requirements to
Additional Capital for normal growth
the level of
Risks Additional capital for increased risks
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 11

12. Capital Planning
Stress test results
indicate a breach in
tolerance levels
Expected asset
Planned
growth with the
same portfolio mix investments
Notional capital
Strategy to acquire
Additional cushion for risks
riskier assets for
not mentioned in
higher target Capital Pillar I and could be
profitability or entry Requirement based on the stress
into new areas
test results
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 12

13. Importance of Risk Based Pricing
Aligns the incentive for a bank to balance risk with return
Pricing is a tool to maintain proactive provisioning
Necessary for value creation and preservation
Building block for credit risk management
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 13

14. Pre-requisites for “Risk Pricing” credit - A Bank must have the
capability to generate...
History of risk score of borrowers
Information on defaults associated with the risk score
of borrowers
Loss given default
Variance in loss given default
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 14

15. Computing Risk Premia - Expected Loss
Probability of Loss Given
Default (PD) Default (LGD)
Borrower PD Collateral LGD
Risk Score Type
1 .05% 1 5%
2 - 2 -
Exposure
Expected 3 - 3 -
at
Loss x x
(EL) = Default
(EAD)
4 - 4 -
5 10% 5 20%
6 - 6 -
7 - 7 -
8 - 8 -
9 - 9 -
10 100% 10 75%
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 15

16. Present status in many banks - How mis-pricing of risk is
harmful.
Risk-based
The cross-subsidy pricing • Good credit risks
subsidising the poor
Interest rate %
credit risk accounts
Subsidy
“Bad risks” • Threat of
under-priced Bank
pricing disintermediation leaves
banks with poor credit
risk accounts
Good credits
overpriced
AAA
• Already beginning to
BBB Risk happen in most markets
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 16

17. Risk Based Pricing - An example
Client: XYZ
Risk Grading B+
I Loan Size (Tk. Crore) 100
II Tenor (Years) 5
III Probability of Default 2%
IV Loss Given Default 50%
V Hurdle Rate on Equity (Share holder Expectation) 16%
VI Capital as % of funded assets 8%
VII Cost of Funds for 5 Yr Tenor (From FTP) 5.50%
1 Cost of Funds 5.50%
Risk Adjusted
2 Cost of Operation 1.00% Pricing
(1+2+3+4)
3 Return on Capital (I*V*VI) (Loan Size %) 1.28% =
4 Expected Loss (III*IV) 1.00% 8.78 %
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 17

18. RAROC is gaining popularity as it links investor aspirations to
Management goals
Shareholders demand optimum risk-adjusted return on their risk capital
Banks’ activities are increasingly arranged along business unit lines to improve
focus
Bank Management is able to allocate scarce capital among business units based on
their potential risk-adjusted performance
Performance Measurement Capital Allocation
Performance Budgeting Lending decision
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 18

19. 5 steps to RAROC of a loan/ business line/ portfolio
STEP 1: Calculate Net Interest Earned
STEP 2: Calculate Expected Loss
STEP 3: Calculate the Risk-Adjusted Spread
STEP 4: Calculate the Risk Capital to be allocated for that activity
STEP 5: Calculate RAROC from inputs of Step 3 and 4
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 19

20. RAROC: Step 1 of 5
STEP 1 Calculate Net Interest Earned
Net Interest earned = (Interest Rate –
STEP 2 Calculate Expected Loss Interest Expenses) x Amount of Loan
STEP 3 Calculate the Risk-Adjusted Spread
1.Interest rate is market determined on which
STEP 4 Calculate the Risk Capital to be allocated for that acti
vity
the banker has limited control
STEP 5 Calculate RAROC from inputs of Step 3 and 4
2.Interest expense depends on bank’s cost of
funds and is given by ALM
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 20

21. RAROC: Step 2 of 5
Expected Loss = Probability of Default
x Loss Given Default x Amount of loan
STEP 1 Calculate Net Interest Earned
1.Probability of Default can be derived from
STEP 2 Calculate Expected Loss transition matrix
STEP 3 Calculate the Risk-Adjusted Spread
2. Loss given default is the proportion of
STEP 4 Calculate the Risk Capital to be allocated for that acti
vity money lost after recoveries on a defaulted
account
STEP 5 Calculate RAROC from inputs of Step 3 and 4
-
STEP 5 Calculate RAROC from inputs of Step 3 and 4
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 21

22. RAROC: Step 3 of 5
Risk Adjusted Spread *=
Net Interest Earned (Step 1)
STEP 1 Calculate Net Interest Earned
Less: Expected Loss (Step 2)
STEP 2 Calculate Expected Loss
Less: Administrative Expenses
STEP 3 Calculate the Risk-Adjusted Spread
Add: Non-interest income
STEP 4 Calculate the Risk Capital to be allocated for that acti
vity This is similar to risk-based pricing , but
RAROC goes a step further
STEP 5 Calculate RAROC from inputs of Step 3 and 4
* The spread is in absolute amount
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 22

23. RAROC: Step 4 of 5
STEP 1 Calculate Net Interest Earned
Capital Allocated *= Standard Risk
Weight (of an asset) x Minimum
STEP 2 Calculate Expected Loss Regulatory capital x Loan amount
STEP 3 Calculate the Risk-Adjusted Spread
*Capital allocated may be Regulatory Capital
STEP 4 Calculate the Risk Capital to be allocated for that acti
vity
STEP 5 Calculate RAROC from inputs of Step 3 and 4
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 23

24. RAROC: Step 5 of 5
RAROC =
Risk-Adjusted Spread (Step 3)
STEP 1 Calculate Net Interest Earned
Risk Capital (Step 4)
STEP 2 Calculate Expected Loss
STEP 3 Calculate the Risk-Adjusted Spread
If the RAROC is higher than the “Hurdle
STEP 4 Calculate the Risk Capital to be allocated for that acti
vity
activity rate” a loan is acceptable in terms of
risk/return
STEP 5 Calculate RAROC from inputs of Step 3 and 4
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 24

25. Credit Risk framework under Basel II
Align regulatory capital
Credit Risk more closely with economic
capital
Measurement
Standardised
IRB Method
Method
Regulatory
Supervisory Risk Foundation
weights and Credit Risk
Mitigation
Advanced Economic Capital
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 25

26. Ownership and policy review
The policy would be reviewed regularly to incorporate
Additional material risks as and when they arise and are measurable
Changes in risk measurement methodology based on regulatory
directives or implementation of various tools
Reporting by different functions and levels
Risk Management Department would review and maintain the policy
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 26

27. Recommendations for Systems supporting credit process
Risk Management Solution to be used for capturing origination data
Sanction process workflow to be automated based on defined rules
Credit rating to be automated and centralized
User profiles to avoid conflicts of interest and decouple rating from
origination
Capture data for rejected loan application and make it available in a
centralized manner
Collateral management can be done using Risk Management Solution
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 27

28. DISCUSSIONS
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 28

29. All the contents of the presentation are confidential and
should not be published, reproduced or circulated without the
written consent of IFC, Bangladesh Bank and IMaCS.
IM aCS 2010
Printed 11-M ay-11
For Classroom discussion only Page 29