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Credit Risk Grading Model and Loan Performance of Commercial Banks in

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European Journal of Business and Management www.iiste.org
ISSN 2222-1905 (Paper) ISSN 2222-2839 (Online)
Vol.7, No.13, 2015

Credit Risk Grading Model and Loan Performance of

Commercial Banks in Bangladesh
Niaz Mohammad*
Lecturer, School of Business, Department of Accounting, American International University Bangladesh, House
58/B, Road#21, Kemal Ataturk Avenue, Dhaka-1212
Email: [email protected]

Azimun Nahar Onni

MBA student, Faculty of Business Administration, American International University Bangladesh
Email: [email protected]

Abstract:
In modern banking concept one of the most important functions of a bank or financial Institution is
“Management of Credit Risks”. Risk is inherent in all aspects of commercial operations. However for Banks,
credit risk is an essential factor that needs to be managed. Due to increase in the number of non-performing loans
and competition in the banking market, most of the commercial banks are strongly focus on credit risk
assessment. Credit risk arises due to the possibility that the borrower may fail to repay the loan. Following the
recent global financial crisis, which originated from poor management of credit risk, it is the most discussed
topic in the banking industry of Bangladesh. In order to establish the creditworthiness, credit analysts typically
use a combination of financial or accounting data and non-financial variables as well as a number of different
models, or analytical tools. Some of the methods involve a subjective approach; others are more systematic in
that they use quantitative techniques to evaluate a credit against objective benchmarks. This study develops a
credit risk grading model which will contribute significantly in the risk assessment.
Keywords: Credit risk, Credit risk management, Loan performance, Risk assessment, Risk grading model.

1. Introduction
Recently banks witnessed rising non-performing credit portfolios and these significantly contributed to
financial distress in the banking sector. So, a banker likes to adopt a number of sophisticated financial techniques
in credit appraisal process with a view to assessing the borrower’s business as well as financial position
rigorously. Credit risk grading plays a vital role to measure the risk identification. 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. It is evident from the current
financial and credit market crisis that credit institutions should pursue a more valid approach to credit risk
assignment based on realistic assumptions. The primary factor determining the quality of the bank’s credit
portfolio is the ability of each borrower to honor, on timely basis, all credit commitments made to the
bank. While assessing a credit proposal more emphasis shall be given on repayment potential of loans out of
funds generated from borrower’s business (cash flow) instead of realization potential of underlying
securities. A formal evaluation of borrower’s financial health and ability to repay debt obligation is called credit
rating which helps the bank to grade the concerned customer. (Hossain, M. H. & Chowdhury, H.A. 2011)

2. Objectives of this study

2.1 General Objective:
The overall objective of the study was to assess the effectiveness of credit risk grading systems on loan
performance in banks. This study was undertaken to get an in depth idea of the credit grading system of
commercial banks and understand its importance.

2.2 Specific objectives:

(a) To determine the effect of credit appraisal of financial institutions on their loan sanction.
(b) To evaluate the effect of credit risk grading adopted by banks on their loan performance.
(c) To evaluate the existing credit risk grading systems and propose a risk management model.

3. Literature review
Marrison (2002) articulate that the main activity of bank management is not deposit mobilization and giving
credit. Effective credit risk management reduces the risk of customer default. They add that the competitive
advantage of a bank is dependent on its capability to handle credit valuably. Bad loans cause bank failure as the
failure of a bank is seen mainly as the result of mismanagement because of bad lending decisions made with

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wrong appraisals of credit status or the repayment of nonperforming loans and excessive focus on giving loans to
certain customers. Goodhart (1998) states that poor credit risk management which results in undue credit risk
causes bank failure.
Saunders and Cornett (2006) found that to address the credit risks, banks and other financial
intermediaries should focus on the probability of default of the borrowers. There are several models available
to analyze credit risks, some of which are qualitative models and some are quantitative models.
Qualitative models indicate borrower specific factors and market specific factors.
Mosharrafa, R.A. (2013) found that credit risk grading technique is an important tool for credit
management as it helps a bank to understand various dimensions of risk involved in different credit transactions.
Lahsasna et al. (2010) emphasized that credit risk decisions are key determinants for the success of financial
institutions because of huge losses that result from wrong decisions. Poor evaluation of credit risk can cause
money loss (Gouvea 2007). Wu et al. (2010) stressed that credit risk assessment is the basis for credit risk
management in commercial banks and provides the basis for loan decision making. Furthermore, Angelini et al.
(2008) stressed that risks continues to provide a major threat to successful lending despite advancements in
credit evaluation techniques and portfolio diversifications. Credit risk assessment is an integral part of the loan
process in banking business. Both credit scores and credit ratings are credit risk assessment tools. Credit scoring
is a credit risk management technique that analyzes the individual borrower’s risk and is expressed in numerical
form. On the other hand, credit rating is often expressed as a letter grade, conveying the creditworthiness of a
business or government. Without a thorough risk assessment, banks have no way of knowing if capital reserves
accurately reflect risks or if loan loss reserves adequately cover potential short-term credit losses. Vulnerable
banks are targets for close scrutiny by regulators and investors, as well as debilitating losses. The Basel
committee has defined credit rating as a ‘summary indicator’ of the risk inherent in individual credit, embodying
an assessment of the risk of loss due to the default of a counter party by considering relevant quantitative and
qualitative information. Bangladesh has started preparations to implement the Basel-III framework for bank
companies from 2014 in line with the global standard. The global financial crisis and the credit crunch that
followed put credit risk management into the regulatory spotlight. As a result, regulators began to demand more
transparency. They wanted to know that a bank has thorough knowledge of customers and their associated credit
risk. And new Basel III regulations will create an even bigger regulatory burden for banks.
Treacy and Carey (2000) suggested that in designing a credit rating system, a bank should consider
numerous factors, including cost, efficiency of information gathering, consistency of rating produced, staff
incentives, nature of a bank’s business, and uses to be made of the internal ratings. Despite the advances in
science and technology that allow the development of expert system or statistical classification models, human
judgment is still an important ingredient in the credit assessment process. Also the rating process almost always
involves the exercise of human judgment because factors to be considered in assigning a rating and the weights
given to each factor differ significantly among borrowers.
Ernst and Young (2011) on behalf of the Institute of International Finance (IIF), surveyed 62 of the
largest banks to assess banks' progress in the implementation of risk governance principles and practices outlined
in the 2008 IIF report. Across the board, banks have embraced the IIF's principles to advance risk management,
risk governance and risk appetite. Among the 62 chief risk officers (CROs) and senior risk executives who
participated in our survey, the most common improvements cited included strengthened management, increased
control of liquidity risk and refined reporting systems.
Lawrence (2007) posits that lenders review the borrower’s business plan and financial
statements, they have a checklist (credit appraisal) of items to look at one of the being the number of financial
ratios that the financial statements reveal. These ratios are guidelines to assist lenders determine whether
the borrower will be able to service current expenses plus pay for the additional expense of a new loan.
Poudel (2012) appraised the impact of the credit risk management in bank’s financial
performance in Nepal using time series data from 2001 to 2011. The result of the study indicates that credit risk
management is an important predictor of bank’s financial performance. Mureithi, A.W (2010) found that credit
appraisal is carried out for various reasons, these are; as a selection tool, to quantify risk, to aid in decision
making, and to ensure good quality business with excellent credit worthiness. This makes the credit appraisal
process an important activity among the lending institutions. Causes of non-performing loans include;
unprofessional credit risk evaluation, moral hazard on part of management, lack of supervision of projects,
lengthy litigation process and intentional default incomplete, poor and unprofessional credit risk assessment and
valuation of credit appraisal model. An inefficient credit appraisal process is one of the causes of non-performing
loans of various lending institutions. Moti, H.O. et al. (2012) found that a key requirement for effective credit
management is the ability to intelligently and efficiently manage customer credit lines. In order to minimize
exposure to bad debt, over-reserving and bankruptcies, companies must have greater insight into customer
financial strength, credit score history and changing payment patterns.
However, it is necessary to rely on models and algorithms rather than human judgment in consumer

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lending because of the vast number of decisions involved (Khandai et al., 2010). This highlights the need for
accurate decision support model for credit admission evaluation and also for monitoring the ongoing health of
credit customers (West et al., 2005).A small improvement in the accuracy of the credit decision might reduce the
credit risk and translate into important future savings (Chen and Huang, 2003). Rahman, S. M. (2011) noted that
at the very outset the banking sector in Bangladesh provided huge amount of soft debt facilities to trade, industry
and farming activities for enhancing overall economic growth of the country and it was done as a part of social
commitment of the nationalized sector. Therefore, the bankers were more concerned to disburse credit to the
clients and not to control the credit flow. Credit Risk Grading system is a dynamic process and various models
are followed in different countries and different organizations for measuring credit risk. A more effective credit
risk grading model needs to be introduced in the Banking Sector of Bangladesh to make the credit risk grading
mechanism easier to implement.

4. Research methodology and design

To perform the study data sources are to be identified and collected, they are to be classified, analyzed,
interpreted and presented in a systematic manner. To furnish this, research information has been accumulated
from both the primary and secondary sources. The quantitative data for descriptive purposes and empirical
testing will be collected by a postal questionnaire. For the sampling purposes, this research will focus on the
banking sector and ten banks are taken as the sampling unit. Thus, in order to ensure every subsample gets an
appropriate representation, a stratified random sampling procedure is used.

4.1 Hypotheses
The following hypotheses were developed for empirical testing:
H₁: There is no significant relationship between credit appraisal and non-performing loan of commercial banks
H₂: There is no significant relationship between loan loss provisions and loan advances of commercial banks

5. Risk assessment and risk management

Risk assessment is the process of analyzing potential losses from a given hazard using a combination of known
information about the situation, knowledge about the underlying process, and judgment about the information
that is not known or well understood. The process of combining a risk assessment with decisions on how to
address that risk is called risk management. Risk management is part of a larger decision process that considers
the technical and social aspects of the risk situation. Risk assessments are performed primarily for the purpose of
providing information and insight to those who make decisions about how that risk should be managed.
Judgment and values enter into risk assessment in the context of what techniques one should use to objectively
describe and evaluate risk. Judgment and values enter into risk management in the context of what is the most
effective and socially acceptable solution.
The combined risk assessment and risk management process can be described as a six step process.
The first three steps are associated with risk assessment and the last three with risk management:

Figure 01: Combined risk assessment and risk management process

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Vol.7, No.13, 2015

5.1 Credit 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 risk 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. Borrower Risk Grades should be clearly stated on
Credit proposal.

5.2 Decision matrix of credit risk grading (CRG)

Since the credit risk is involved in different stages of loan sanction process, the following stages are identified
during credit risk grading calculation:
Table 01: Decision Matrix
Pre-sanction stage Grading stage Post sanction stage
(1) Feasible SUPERIOR (1) Performing
GOOD
ACCEPTABLE
(2) Conditional/ MARGINAL/WATCHLIST (2) Early warning account
Exceptionally Acceptable
(3) Non-feasible SPECIAL MENTION (3) Non-performing
SUB-STANDARD
DOUBTFUL
BAD/LOSS
From the matrix presented in the Table 01, it is found that after conducting CRG at pre sanction stage
based on clients information, a banker can select three risk categories viz. superior, good and acceptable as
feasible and marginal may be treated as exceptionally acceptable subject to the quality of security may
be offered by the client, his reputation etc. However, a borrower with special mentions, sub-standard,
doubtful and bad/loss rating at pre-sanction stage will be treated as not-feasible. A borrower with superior, good
and acceptable rating at post-sanction stage is a performing one. Borrower who is beginning to demonstrate
above average risk i.e. marginal/watch list or special mention at post-sanction stage will require banker’s
attention because it has become as early alert (warning) account. And rest of the ratings of a borrower at the post
sanction stage exhibit as non-performing or classified status.

5.3 Credit risk grading process

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 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 process is presented below:

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Key risk issues (Obtained

Credit application from Requirement and security CIB from Bangladesh
customer for credit
Bank)

Compliance of lending
Ownership and Price Net
Source of repayment guidelines by Bangladesh
Worth
bank & Credit policy

Corporate Management, labor and

Critical Success factors
objective/strategy other resources

Analysis of financial,
business, management, Preparation of credit risk Based on CRG score
security and relationship grading score accept/reject the customer
risk

Figure 02: Credit risk grading process in commercial banks

According to the score obtained by the customer, the loan is sanctioned and approved. A credit score
sheet is prepared for risk grading by the commercial banks.

5.4 Main components in credit risk grading model

Table 02: Main variables in credit risk grading
Variable Description
Return on The is the ratio of net operating profit that a company earns from its business operations in a
Asset(ROA) given period of time to the amount of the company’s total asset
Non- performing These are credits which the banks perceive as possible losses of funds due to loan
Loans (NPL) default.
Loan loss This is an amount of money that a bank set aside from its annual earnings as a
provisions (LLP) precaution against possible loss of a non performing loan, or to off-set a lost credit facility.
Loans and This is a facility granted to a bank customer that allows the customer make use of banks funds
Advances (LA) which must be repaid with interest at an agreed period
Liquidity (LR) This is the ability of a bank to meet its short term obligation as and when due.
Capital This is the index regulatory authorities use to determine the optimum amount of money (i.e
Adequacy Ratio equity, retained earnings, and other reserves) that a bank must have to be able to take certain
(CAR) levels of risk endangering deposits funds, or its existence

5.5 Basic Framework of Credit Risk Grading

As per recommendation of the Financial Sector Reform Project (FSRP), Bangladesh Bank made it mandatory for
the Banks to conduct a “Lending Risk Analysis (LRA)” in the prescribed format before sanction of a loan which
is still in force. Later, Bangladesh Bank instructed all commercial Banks to develop its own credit risk grading
system vide its Guidelines on Credit Risk Management. In the said Guideline, Bangladesh Bank provided a

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sample Risk Grading Model and advised Banks to design their own model in line with that one.

6. Findings of the study

6.1 Credit appraisal and non performing loans
The study sought to establish the linking between return on assets and the level of nonperforming loans in
financial intermediaries by conducting a regression analysis with level of non-performing loans as the dependent
variable as indicated by the loan repayments of the clients at any given time. Return on assets variables were
identified as the lending period of the loans, frequency of review of loans given and credit approval
considerations. Thus the regression model was:
NPL = βₒ+ β₁X₁ + β₂X₂+ β₃X₃+ ε
Where NPL was the level of non-performing loans,
βₒ is the regression constant, β₁..... β₃ are the coefficients of regression model,
X₁ is the lending period of the loans,
X₂ is frequency of loan review and
X₃ is the considerations in credit approval.
The regression statistics are given in the tables below.
R R square Adjusted R square Standard error of the estimate
0.345 a 0.1190 0.031 0.46208
Here a denotes a constant means lending period of the loans, frequency of loan review, considerations in credit
approval.
The model statistics show that when the independent variables (lending period of the loans, frequency of loan
review and considerations in credit approval) and dependent variable interact, the model has a Pearson's
correlation coefficient (R) of 0.365 and coefficient of determination (R Square) of 0.133 signifying a positive but
weak or negligible association between the two.

6.2 Analysis of variance

Sum of square Degree of freedom Mean square F Sig.
Regression 3.561 3 .544 1,360 0.192 a
Residual 23.133 25 .331
Total 26.964 28
The Analysis of Variance (ANOVA) shows that the f-value is 1.360 at 0.192 significance level (p>0.05)
suggesting that the relationship between the two (independent and dependent variables) could be out of chance
and nothing else.

6.3 Regression co-efficient

Beta Standard error
Constant 0.342 0.29
Lending period of loans 0.198 0.219
Frequency of loan review -0.006 0.084
Credit approval -0.071 0.132
So, the regression thus becomes Non-performing loan (NPL) =0.342+0.198 X₁-0.006 X₂-0.71 X₃

6.4 Results interpretation

It can be seen that taking the independents variables’ value at zero, the level of non-performing loans would be
0.342. A unit increase in lending period of the loans would lead to a 0.198 increase in NPL, a unit increase in
frequency of loan review would lead to a 0.006 decrease in NPL and a unit increase in considerations in credit
approval would lead to a 0.071 decrease in NPL. This signifies that the period of loan repayment increases the
chances of loan defaults while frequency of loan reviews and credit approval considerations decreases chances of
loan defaults which ultimately lead to reduce loan loss provisions.

7. Problems in existing credit risk grading model

In the existing credit risk grading model in Bangladesh, qualitative and quantitative factors are considered in 40%
and 60% weight respectively. These guidelines are prepared in June 2007 for banks are laid down in the table
below:

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Vol.7, No.13, 2015

Table 03: Existing credit risk grading score

Quantitative factors (60%) Weight Qualitative factors (40%) Weight
Capital adequacy 15% Management 10%
Asset quality 15% Regulatory environment 10%
Earnings quality 15% Risk management 5%
Liquidity and external fund mobilization 10% Sensitivity to market risk 5%
Size of the bank & Market presence 5% Ownership and corporate governance 5%
Accounting quality 3%
Franchise value 2%
In the existing grading manual risk management, sensitivity to market risk accounting quality and
corporate governance issues are insignificant as compared to other qualitative factors. The importance of
qualitative factors is increasing day by day and in 2012, corporate governance guideline is issued by Bangladesh
bank. In risk management, focus is given on market risk management only but there are other risks like
operational risk, liquidity risk and reputation risk must be taken into consideration. For accounting quality,
whether policies for income recognition is documented and accounted for in the financial statements of the bank
and provision and valuation of investments are taken into consideration but there is a possibility of window
dressing of accounting figures. Accountants just play with the numerical numbers. They may manipulate the
financial information if management wants. For this reason there is a need to modify the existing system of risk
grading. Both qualitative and quantitative factors must be balanced to evaluate any client’s performance. Only
numerical facts and figures don’t give guarantee that quantitative factors are presented in a true and fair view. So
Bangladesh bank must increase more weight towards qualitative factors specifically accounting quality,
corporate governance and risk management.

8. Proposed risk grading model

There is a need to modify the existing risk grading model and need more concentration on qualitative factors.
Bangladesh Bank must make mandatory to environmental risk management guidelines to make to understand
and manage risks that arise from environmental concerns which bring a focus on planning and implementing
policies and procedures to mitigate environmental risks. The proposed risk grading model is laid down below:

Figure 03: Proposed Risk Management Model

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9. Conclusion and proposed courses of action

Recent global financial crisis has shown the dire effect of reckless lending. Following the global financial
meltdown regulatory bodies all over the world have become conscious about implementing stricter credit risk
management policies. Recently Commercial banks have been able to develop a coordinated system of Analyzing,
Processing, Sanctioning, Controlling and Monitoring the Credits backed by fully automated system, which
facilitates management of credit risk grading in an efficient manner. The quality of assets of the Bank improved
gradually as a result of effective management of credit risks in recent time which would help to recoup the
downturn and to boost up the overall financial conditions. To sum up the following points must be taken into
consideration:
The banking industry is extremely competitive and constantly changing. Rival banks are introducing new
products and services and taking new measures to manage credit risk. Therefore it becomes mandatory for
each market player to know what others are doing. This requires R&D activities and proactive action to
meet challenges.
There is no alternative of providing adequate training to the employees. More credit analysts may be
recruited to reduce pressure on existing employees.
Workshops may be arranged for employees working in credit department to keep them up-to-date. This
will also increase their efficiency.
Credit risk grading is an ever evolving subject. Banks must be flexible enough to incorporate any new
practice in its credit risk grading policy.
Whenever a potential borrower approaches for financing, environmental risk pertaining to his business/
collateral is to be assessed and the mitigating factors there against should be considered.
Credit must be granted according to bank’s delegation of authority. It means the branch manager is not
authorized to sanction more loans which he/she is not authorized to do so.
Banks must make proper and exhaustive documentation before disbursement and to ensure proper
supervision, monitoring and follow up each credit so that the possibility of non-performing loan in
reduced.

References
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of economics and finance 48, pp 733-755
Chen, M., & Huang, S.,(2003) Credit scoring and rejected instances reassigning through evolutionary
computation techniques Exp System Application 24, pp:433-441
Ernst and Young. (2011). “Making strides in financial services management” Institute of international finance.
Goodhart, C.A.E.(1998). The Central Bank and Financial System, London, McMillan press Ltd.
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models. In: POMS 18th Annual Conference, Dallas, Texas, USA May 4-7, 2007
Hossain, M.M. and Chowdhury, H.A. (2011) Credit risk management strategies of private commercial banks in
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Moti, H. O., Masinde, J. S., Mugenda, N. G., & Sindani, M. N. (2012). Effectiveness of credit management
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Poudel, R. P. S. (2012), “The impact of credit risk management in financial performance of commercial banks in
Nepal”. International Journal of arts and commerce, Vol 1, No 5, pp-9-15
Rahman, S. M. (2011). Credit risk management practices in Banks: An appreciation, Journal of Islamic
Economics, Banking and Finance, Vol. 7, No. 3, pp: 37-38
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Treacy, W. F. and Carey, S. M. (2000). “Credit risk rating system at large US banks”. Journal of Banking
and Finance, 24, pp 167-201
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