“A Conceptual Framework for Selection of Entrepreneurs by Commercial Banks in Bangladesh”

“This Paper Aims at Making the Readers Known about the Credit Assessment Techniques for Selecting Entrepreneurs by

Commercial Banks in Bangladesh that add Value to the Banking Industry”

“A Conceptual Framework for Selection of Entrepreneurs by Commercial Banks in Bangladesh”

F-632: Law & Practice of Banking

Submitted To:MS. PALLABI SIDDIQUA

Assistant Professor

University of Dhaka

Submitted By:

NAME ID No:MD.ARMAN HOSSAIN A.B. 30006MD. ABU HANIF 30040HAFIZUR RAHMAN 30041MUHAMMAD NURUL AMIN 30078ABDUR RAZZAK 26012

Date of Submission: 15th December, 2015

December 15, 2015

Ms. Pallabi Siddiqua

Assistant Professor

University of Dhaka

Subject: Submission of the study titled “A Conceptual Framework for Selection of

Entrepreneurs by Commercial Banks in Bangladesh.”

Honorable Mam,

We are extremely delighted to submit our report to you titled “A Conceptual Framework for

Selection of Entrepreneurs by Commercial Banks in Bangladesh.”

This has been prepared as a partial requirement of the ‘Law and Practice of Banking’

course. We tried our level best to gather relevant information for preparing a complete

report by following your precious guidelines.

We are grateful to you for your continuous guidance in preparing this paper. Finally, we

would like to say adding some words that, we are ready to accept our unwilling errors

and omission which belong to us.

Thank you.

Yours Faithfully,

Md. Arman Hossain A.B.

ID # 30006

Muhammad Nurul Amin

ID # 30078

Hafizur Rahman

ID # 30041

Abdur Razzak

ID # 26012

Md. Abu Hanif

ID # 30040

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5. We have not allowed, nor will we in the future allow, anyone to copy our work with the intention of passing it off as their own work.

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Name ________________________________ (BLOCK LETTERS)

Signature ________________________ Date ___________________

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Executive Summary

The key inspiration of this study is to identify and narrate the techniques of credit

assessment for selecting the entrepreneurs by commercial banks in Bangladesh. By the

help of contemporary literature review, the study has been initiated to investigate the

financing criteria, risk factor, and recent risk management practices in Bangladesh with

analyzing the case studies in real life experience situation. The study has deployed by

using the secondary sources. This study found that the issues, such as, assessment of credit

application, assessment of business attractiveness (innovative idea, determination and

involvement by entrepreneur’s, capacity building, family support, value experience,

technology and networking, business prospects, legal aspects, verification of documents),

due diligence issues, analysis of business’s viability (Management aspects, technical

aspects, marketing aspects, financial aspects) and entrepreneur’s skills are important for

sanctioning credit. Moreover, we have found that in order to prevent and reduce loan

losses, decrease the risk of bank management, ensure the safety and profitability of credit

assets, improve the efficiency and quality of bank risk management, it is necessary to

evaluate the size and quality level of loan risk to support the decision-making process.

Therefore, it is necessary to identify the loan risks before risk assessment. Recognizing the

causes and types of loan risks, the bank will accurately forecast the potential risks. To

quantify the risk exposure, it should be graded as per credit risk score sheet by the

individual banks in line with the guidelines of CRG (Credit Risk Grading) Manual.

However For the purpose of performing credit activities in desired manner, each bank

needs to establish own credit policy in accordance with their business philosophy. Last but

not least, as part of the proactive strategic management term structure of loans and

deposits should be harmonized.

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Table of Content

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SI. Name of the Contents PageExecutive Summary iv

Chapter-1 Introduction 01-021.1 Background of the Study 011.2 Scope of the Study 021.3 Objectives of the Study 021.4 Limitations of the Study 02Chapter-2 Literature Review 03-052.1 Historical Development of the Process of Selecting Credit

Proposals04

2.2 Current Status of Entrepreneur’s Credit Access in Bangladesh 05Chapter-3 Economic Theory of Entrepreneurship Selection and

Performance06-08

3.1 Lending Technologies and the Supply of Entrepreneurs’ Credit 063.1.1 Financial Statement Lending 063.1.2 Small Business Credit Scoring 073.1.3 Asset-Based Lending 073.1.4 Factoring 073.1.5 Trade Credit 083.1.6 Relationship Lending 08Chapter-4 Selection Criteria for Financing Entrepreneurs 09-154.1 Assessment of the Credit Application 094.2

Loan Sanction and Approval Procedure09

4.3 Assessment of Business’s Attractiveness 11Chapter-5 Assessment of Risk of Commercial Bank Credit 16-235.1.1 Object Risks 175.1.2 Loan Terms Risks 175.1.3 Management Risks 175.1.4 System Environment Risks 175.2.1 Risk Assessment of Commercial Bank Loan 185.2.2 Establish a hierarchical model 185.3.1 Observation of Previous Practices of Lending Risk Analysis 195.3.2 Observations on Recent Risk Management Practices in Banks 205.3.3 Introduction of Credit Risk Grading System in Credit Operations 20Chapter-6 Policy Implication & Conclusion 24-256.1 Policy Implication 246.2 Conclusion 25

References 26-27Appendix 28-33

Case Study: 1 Bank Lending Decisions Using Projections 28Case Study: 2 Rejection of Credit because of the Repayment Uncertainty 29Case Study: 3 Mary Shops Around for the Best Deal 29Case Study: 4 Can an Ethical Bank Support Guns and Hydraulic Fracturing? 30Case Study: 5 Custom Portfolio Benchmark Report: Independent Lender 33

List of Figures:

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SI. Figures PageFigure-01 Safety Zones Surrounding the Funds Credited by a Bank 04

Figure-02 Stages of Credit Assessment 10Figure-03 Illustration of the Determinants of Probability of Default 14Figure-04 Analysis of Viability of Business for Entrepreneur’s Selection 15Figure-05 Analysis of Entrepreneur’s Skills 15Figure-06 Hierarchy Model of Commercial Bank Loan Risk 18

List of Tables:

SI. Figures PageTable-01 Disbursement of SME Credit by Banks and NBFIs (TK. in Cr.) 05

Table-02 Assessment of the Credit Application 09Table-03 Verification of Documents 13Table-04 Risk Factors of Commercial Bank Loan 16Table-05 Contents of Risk under LRA Manual 19Table-06 Contents of CRM Guidelines 20Table-07 A Typical Risk Grading System under CRG Manual 21Table-08 Decision Matrix of CRG 22

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1. Introduction:The criteria of entrepreneurs selection for financing banking and non banking financial institutions is a topic of significant research interest to academics and an issue of great importance to policy makers around the globe. The conceptual framework to which most of the current research literature adheres has proven to be quite helpful to advancing our understanding of the markets for providing funds to entrepreneurs in both developed and developing nations. However, the current framework presents an oversimplified model that overlooks some important distinctions across national financial institution structures and lending infrastructures and the way in which these elements of the financial system affect entrepreneurs’ credit availability. By financial institution structure, we mean the market presence of different types of financial institutions that provide credit, as well as the competition among these institutions. By lending infrastructure, we mean the rules and conditions set up mostly by governments that affect financial institutions and their abilities to lend to different potential borrowers. The differences in the financial institution structure and lending infrastructure may significantly affect the availability of funds to borrowers by affecting the feasibility with which financial institutions may employ the different lending technologies in which they have comparative advantages to provide funds to different types of enterprises or individuals.In Bangladesh a large number of financial institutions, both government and private, are now engaged in the development of small entrepreneurs through their credit programs. Objections raised against these institutions are, however that (i) there is no direct link between the credit and expansion of output of real goods and services; (ii) there is no built-in mechanism in these institutions for ensuring justice and kindness in the society; and (iii) they practice the age-old interest-based method. 1.1. Background of the Study:The banks act as an intermediary to mobilize the excess fund of surplus sectors to provide necessary finance, to those sectors, which are needed to promote for the sound development of the economy. Credit management is a dynamic field where a certain standard of long-range planning is needed to allocate the fund in diverse field and to minimize the risk and maximizing the return on the invested fund. The overall success in credit management depends on the banks credit policy, portfolio of credit, monitoring, supervision and follow-up of the loan and advance. Continuous supervision, monitoring and follow-up are highly required for ensuring the timely repayment and minimizing the default. We have got attached to the concept of “Selection of Entrepreneurs or Credit Assessment Techniques” (that we came across in our Law and Practice of Banking Course of EMBA Program) while we started our MBA at University of Dhaka and therefore after getting consent of guide teacher we have given entrepreneurs selection by financial institutions related topic. Consequently, we are also determined to know about the methods, techniques, special areas and viability of credit assessment techniques of financial institutions in Bangladesh. Therefore, it is important to provide suggestions to improve the

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credit assessment related problems in Bangladesh. As we did this study on “A Conceptual Framework for Selection of Entrepreneurs by Commercial Banks in Bangladesh.” for academic purpose within the limited time, this is conducted mainly basis on the operation and status of both public and private banks and these data are collected from different secondary sources.

1.2 . Scope of the Study:

This study is focused on the techniques of credit assessment for entrepreneurs’ selection in Bangladesh, economic theory of credit assessment, selection criteria for credit application, assessment of risk factors of commercial banks, and the entrepreneur’s skills of passing the credit assessment technique. This study will also cover the historical models of credit assessment in the context of commercial banks. Moreover, this study covers several case studies towards the bank’s perspectives. Finally, a range of suggestions are to be provided to promote this entrepreneur’s selection process.

1.3. Objectives of the study 1.3.1. Overall objective: The study will try to identify the techniques of credit assessment for selecting the entrepreneur by commercial banks of Bangladesh with its historical economic theory and models and also to find the suggestions behind the problems related to successful borrowing process in Bangladesh.1.3.2 Specific objectives: The specific objectives of the study will be:

To study the economic theory of entrepreneurship selection and performance in Bangladesh.To analyze and identify the selection criteria for financing entrepreneurs in Bangladesh.To identify the risk factors of commercial bank loans and recent risk management practices of Banks in Bangladesh.To suggest some guidelines for better regulations to strengthen the credit assessment techniques in Bangladesh.

1.4 Limitations of the Study:It is very common to have flaws in every study. Followings are the limitations of this study:

All the work and information in this study depends on the commercial banks. Due to lack of time we can’t study about other financial institution’s techniques of selecting entrepreneurs in Bangladesh.

Lack of time availability for surveying the customers was another limitation for preparing this report that’s why we can’t include any primary data for this study.

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2. Literature Review:In the new millennium, the world is experiencing rapid progression in technology and human development for attaining high efficiencies and long term sustainability. In its efforts for making the world a better place to live in, nations worldwide have also realized the increasing poverty levels due to wealth concentration and its inequitable distribution, especially in the developing world. The increasing poverty may hamper the process of growth and development in all spheres. Therefore, it becomes imperative that the populations in lower income groups should be involved in the economic activity by empowerment approaches. Since the poor may not be engaged in formal financial services, therefore, emergence of microfinance institutions took place dealing with micro credit schemes, savings and insurance plans to uplift the economic lifestyles of the lower income groups.

Although the major objective of credit rating is to determine the ability and willingness of a borrower to pay at the agreed terms, the rating does a bit more than just classifying the borrowers into ‘pass’ and ‘fail’ categories. 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. When assigning a loan applicant to a particular grade, Crouhy et al. (2001) suggested that banks should analyze three different categories of variables – quantitative, qualitative and legal. The quantitative analysis concentrates mainly on financial analysis and is often based on a firm’s financial reports. The four main quantitative factors used in the assessment model include net income, total operating income, total equity capital and total asset values.

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. According to Treacy and Carey (2000), the rating process almost always involves the exercise of human judgment because factors to be considered in assigning a rating and the weights given to each factor can differ significantly among borrowers. Indeed, experienced lenders take credit ratings and reports as inputs for decision-making process. The key reason for the models to be tempered with judgment and common sense is because they do not fully explain the subjective factors involved in the rating.

Credit assessment helps the banker to ensure selection of right type of loan proposals and right type of borrower. For selecting the borrower security should not the only thing to be relied upon. So responsibilities of the bankers to investigate the client from different view point i.e. the strength and weakness of the client so that the client will be able to repay the bank loan as repayment schedule with profit. To prevent future financial crises, it is absolutely necessary to improve the borrowers’ financial

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literacy, the lenders’ process of transparency and to better assess loan product affordability and suitability.

2.1 Historical Development of the Process of Selecting Credit Proposal in Bangladesh:

All the bankers were seen quite enthusiastic in the early 1990s when a broad based Financial Sector Reforms Program (FSRP) was undertaken in the financial sector for improving the efficiency of the banks. Under the said program, much emphasis were given in the process of selecting a credit proposal, risk analysis, credit pricing, classification and provisioning thereof. In 1993, Bangladesh Bank made the first regulatory move to introduce the best practices in this area through the introduction of the Lending Risk Analysis (LRA) manual for all credit exposures undertaken by a bank in excess of Tk.10 million. Bankers were asked to prepare Financial Spread Sheet (FSS) to cover financial trend analysis through comparative and common-size financial statements, cash and funds flow analysis, measuring credit scores like Z score and Y-score along with Lending Risk Analysis (LRA) for a particular amount of credit. The concept of security in credit has been changed by adopting new techniques of credit analysis. The bankers started understanding that the collateral or customer’s pledge for credits is just one of the safety zones that a banker must keep for giving overall protection against the funds which is given to the customers and the liquidate value of the collateral or pledged goods must be equal or greater than the exposed risk value of credit sanctioned. But from a number of studies it is found that the legal system in our country sometimes makes it difficult for the bankers to repossess and sell out the collateral taken against the credit. So it is clear that the income and cash flow from business are to be the primary safety zones of a credit (Figure-1) and these are actually preferred sources of ensuring repayment of credit.

Figure-1: Safety Zones Surrounding the Funds Credited by a Bank

Source: Rose, Peter S. (1996), “Banking Credit: Policies and Procedures”The most outer or remote safety zone of a credit is the guarantee from the borrowers or cosigners where they pledged their personal assets to back the credit taken from the

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bank. Before taking any personal guarantee, banker must have the idea about personal net-worth of the person (s) which may help in mitigating risk. Very recently the Focus Group on risk management has prepared an industry best practice guidelines titled ‘Credit Risk Management Guidelines’ for the scheduled banks in Bangladesh under the leadership of Bangladesh Bank with a view to managing risk exposure effectively. To shed light this purpose and improving the credit portfolio of the banks, the guidelines consists of some directional policy frameworks and procedural methods like credit policy, credit risk assessment and risk grading system, segregation of duties of approval authority, internal audit, preferred organizational structure and responsibilities, approval process, credit administration, credit monitoring and credit recovery. To supplement the policy frameworks another manual on risk grading has also been prepared under the leadership of Bangladesh Bank. Risk Grading Manual mainly deals with the credit risk grading process by considering the principal risk components associated with the clients, early warning signals (EWS), credit risk grading review, MIS on credit risk grading, financial spread sheet (FSS), etc. It is expected that these guidelines along with the grading system will improve the risk management culture, establish minimum standards for segregation of duties and responsibilities, and will assist in the on going improvement of the banking sector of Bangladesh.

2.2 Current Status of Entrepreneur’s Credit Access in Bangladesh:

Bangladesh Bank’s Endeavors Economists consider Entrepreneurship as an important factor of production in addition to three traditional factors: land, labor and capital. This is because; the traditional factors of production like land, labor and capital independently cannot make any value addition in the economy without the role of “Entrepreneurs”. In Bangladesh, mostly SMEs represent this important factor of production and play as most important actor to drive the economy. More than 90% of the total industrial units in Bangladesh belong to SME sector. Including cottage and micro industries, this sector is estimated about 98-99 percent of total industrial units/enterprises.

Table-1: Disbursement of SME Credit by Banks and NBFIs (TK. in Cr.)

Period Target Sub-Categories Total Women Entrepre

neurTrading Manuf-

acturingService

2010 38,858.12 35,040.5 15,147.72 3,355.68 53,543.93 1,804.98

2011 56,940.13 34,382.6 15,805.95 3,530.85 53,719.44 2,048.45

2012 59,012.78 44,225.2 21,897.33 3,630.90 69,753.42 2,244.01

2013 74,186.87 27,769.5 11,869.35 2,209.75 41,848.56 1,492.77

Grand Total

228,997.9 141,418 64,720.35 12,727.2 218,865.4 6,700.39

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Source:www.dhakachamber.com/Handbook of Entrepreneurship Development.pdf

3. Economic Theory of Entrepreneurship Selection and Performance:

The theoretical literature proposes several determinants of entrepreneurship selection and performance. Among them are attitude to risk, access to capital, labor market experience, economic conditions, family background, psychological traits, income diversification, access to credit, and education. This section briefly reviews the theoretical arguments on the relationship between schooling and entrepreneurship.The level of education might influence the propensity to become self-employed through several channels (Le 1999). Education enhances managerial ability, which increases the probability of entrepreneurship (Calvo and Wellisz 1980; Lucas 1978). Working in the opposite direction, higher levels of education might generate better options (more lucrative paid wage employment under better working conditions) and thus decrease the likelihood of entrepreneurship. It remains unclear what the predicted effect of these offsetting forces might be. Education may also influence entrepreneurship performance in several ways.According to the Mincerian specification of the determinants of individual earnings, the main factors affecting earnings are schooling and experience. This specification and the implied positive returns to schooling have found empirical support in the wage sector. This reasoning would seem to apply in other occupational sectors as well, such as entrepreneurship, but little systematic work has been done on the subject. Schooling is acknowledged both for its productive effect on the quality or quantity of labor supplied, as assumed by Mincer, and for its value as a signal of productive ability in labor markets without complete information (Riley 2002; Spence 1973). For entrepreneurs, the education signal may be helpful in dealing with clients, suppliers, bankers, and so on, and thus raise productivity.

3.1 Lending Technologies and the Supply of Entrepreneurs’ Credit:

Researchers looked more closely at each of the lending technologies: the five transactions technologies (financial statement lending, small business credit scoring, asset-based lending, factoring, and trade credit) and the relationship lending technology. In addition to a brief description of each technology, they highlighted the nature of the information used in underwriting by each technology (e.g., soft vs. hard), and how each technology solves the opacity problem. They also discussed how the financial institution structure and the lending infrastructure affect the feasibility and efficacy of each technology.

3.1.1 Financial Statement Lending:

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Financial statement lending involves underwriting loans based on the strength of a borrower’s financial statements. There are two requirements for this technology. First, the borrower must have informative financial statements. Second, the borrower must have a strong financial condition as reflected in the financial ratios calculated from these statements. The loan contract that arises out of the analysis of these financial statements may reflect a variety of different contracting elements including collateral, personal guarantees and/or covenants. However, under financial statement lending, the lender will view the expected future cash flow of the company as the primary source of repayment.Financial statement lending, unlike all of the other lending technologies, it is reserved for transparent firms. Importantly, however, the efficacy of financial statement lending depends crucially on the lending infrastructure. Specifically, it depends on the existence of a strong information environment, particularly with respect to accounting standards and credible auditors.

3.1.2 Small Business Credit Scoring:Small business credit scoring is a transactions lending technology based on hard information about the SME and its owner. The information on the owner is primarily personal consumer data (e.g., personal income, debt, financial assets, and home ownership) obtained from consumer credit bureaus. This is combined with data on the SME collected by the financial institution and in some cases from commercial credit bureaus (e.g., Freldman 1997, Mester 1997). It is equally clear that this technology may be applied to very opaque SMEs, given that much of the information that determines the score is based on the personal history of the owner, rather than the SME.

3.1.3 Asset-Based Lending:Under asset-based lending, the financial intermediary looks to the underlying assets of the firm (which are taken as collateral) as the primary source of repayment. For working capital financing, banks use short-term assets, such as accounts receivable and inventory. For long-term financing, they use equipment.The pledging of collateral by itself, however, does not distinguish asset-based lending from any of the other lending technologies. Collateralization with accounts receivable, inventory and/or equipment is often associated, for example, with financial statement lending, relationship lending, and credit scoring where collateral is used a secondary source of repayment. Under asset-based lending, in contrast, the extension of credit is primarily based on the value of specific borrower assets rather than the overall creditworthiness of the borrower. There is relatively little empirical evidence on asset-based finance. Exceptions are recent studies that find evidence consistent with practitioner and conventional wisdom that asset-based finance is associated with riskier borrowers (Carey, Post, and Sharpe 1998, Klapper 1998). One study empirically examines the informational opacity of asset-based borrowers does not find evidence of it.

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3.1.4 Factoring:As we noted earlier factoring involves the purchase of accounts receivable by a “lender” known as a factor. Like asset-based lending underwriting focuses on the value of an underlying asset rather than the overall value/risk of the firm. In some sense it is a cousin of asset-based lending. Factoring may be a particularly valuable technology in countries with weak lending infrastructures. Because factoring involves removing the underlying asset from the bankruptcy estate, it is still feasible in countries with weak commercial laws on security interests, weak collateral registration systems, and/or weak bankruptcy systems. It can also work well in weak information environments if the receivables are associated with large obligors or obligors located in strong information environments. For example, the receivables of an Estonian firm whose customers are located in Germany might be an ideal candidate for factoring because the factor can efficiently assess the value of the receivables (i.e., the creditworthiness of the German account obligors) even though the factor can not easily assess the overall creditworthiness of the Estonian client company.

3.1.5 Trade Credit:Many of the procedures and processes associated with the other lending technologies appear to be utilized in underwriting trade credit. For example, credit scoring and similar quantitative techniques have long been a part of the underwriting process used by credit managers. For larger accounts, financial statements are analyzed as part of the underwriting process. No doubt, soft information and mutual trust play a role in some trade credit underwriting similar to relationship lending. However, a compelling argument can be made that trade credit is a distinct lending technology.Researchers have suggested comparative advantages in funding (Schwartz 1974), production/inventory management, price discrimination (Meltzer 1960, Schwartz and Whitcomb 1979, Brennan, Maksimovic, and Zechner 1988, Mian and Smith 1992, Petersen and Rajan 1997) or product quality guarantees (Long, Malitz, and Ravid 1993). Finally, the importance of trade credit as a source of SME financing offers a compelling reason to view it as separate technology.

3.1.6 Relationship Lending:Relationship lending is designed to address information problems that are not feasible or cost-effectively solved by the other technologies. Under relationship lending, the lender acquires proprietary information about the borrower and the business over time with respect to the provision of loans. Relationship lenders collect information beyond that which is available on the firm’s financial statements and information that is readily available to the public. This includes information on the entrepreneur’s local business environment and the entrepreneur and the SME’s interaction with that environment. The labor-intensive nature of relationship lending likely makes it quite costly. These costs may be passed on to the borrower in the form of higher fees and a higher interest rate. As we emphasized earlier, under many circumstances opaque borrowers have an alternative to

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relationship borrowing. In very strong lending environments, asset-based lending may be feasible for those borrowers with good quality accounts receivables, inventory and equipment.

4. Selection Criteria for Financing Entrepreneurs: 4.1 Assessment of the Credit Application:After the submission of all the required documents, the financial institution will assess Credit application. Borrower can refer to the client charter displayed at the financial institution brochure, website to find out the duration needed by the financial institution to process his/her application. In assessing their Credit application, the financial institution would look for certain basic requirements which are summarized as follows:

Table-2: Assessment of the Credit Application

The viability of potential borrower’s business.Whether the risks are acceptable based on the lending guidelines of the financial institution.

Whether the Credit is for business development.

Borrower’s credit history with the financial institution.

Borrower’s key management and business style i.e. conservative, aggressive, prudent etc.

Borrower’s succession plan, age and health.

Sources of capital e.g. from the shareholders of the business.

Sufficiency of borrower’s financial commitment in the business.

Borrower’s capacity or ability of the business to repay the Credit.

Security offered by borrower to mitigate weaknesses.

Source: www.dhakachamber.com/Handbook of Entrepreneurship Development.pdf

Financial institutions do conduct credit checks and study the conduct of the business current accounts, repayment records of their Credits and trade facilities. Some financial institutions have already put in place their Credit evaluation matrix in the form of scores as part of their credit evaluation processes.

4.2 Loan Sanction and Approval Procedure:

The bank gives emphasis on a comprehensive view of the capital, capacity, integrity of the borrower, adequacy, nature of security, compliance with all legal formalities, and completion of all documentation and finally a constant watch on the account. Where advances are granted against the guarantee of a third party, the guarantor must be subjected to the same credit assessment as made for the principal borrower. Some important element of a good loan policy include: the required adequate documentation that is necessary for each loan application must be kept in the Bank’s credit files, a presentation of policies and procedures for setting loan interest rates and fees and the terms for repayment of loans are also required, lines of responsibility in making assignments and reporting information within the loan department, operating

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procedures for soliciting, reviewing, evaluating, and making decisions on customer loan applications etc. The stages of credit approval are done both at the branches and at the corporate office level according to the sequence of Figure-2.

Step-1

Step-2

Step-3

Step-4

Step-5

Step-6

Step-7

Step-8

Step-9

Step-10

Step-1110

At first the client applies for the loan in a prescribed form to the branch. It covers the type of loan facility, personal information, and business information. Branch Manager or the Officer-in-charge of the credit department conducts the initial interview with the

The bank sends a letter to Credit Information Bureau (CIB) of Bangladesh Bank for obtaining a credit inquiry report of the customer from them.

If CIB report is positive on that particular borrower and categorized as a prospective borrower then the bank will scrutinize the required documents: financial documents of the company for the last three to five years& personal net worth of the borrower(s)

Bank officials of the credit department will inspect the project for which the loan is applied.

This is the credit analysis phase. Loan proposal is evaluated by financial spreadsheet analysis which consists of a series of quantitative techniques. Here analyze the risks associated with a particular loan and to judge the financial soundness and worthiness of the borrower.

The produced documents related with the collateral will be asked to regularize or up to date by the applicant.

At this stage based on the analyses the branch prepares a loan proposal. The proposal contains, Name of the borrower (s), Nature of credit, Purpose of the credit, Extent of the credit, Collateral, Margin, Interest rate, Repayment schedule and Validity.

The credit line is approved by using the manager’s discretionary power and considering lending criteria. Then issue a sanction letter to the client. If the value of the credit line is above the branch manager’s limit then it is send to head office or zonal office for final approval with.

Head office processes the credit proposal and afterwards puts forward for approval from the board of directors.

An approval letter is sent to the branch. The branch then issues a sanction letter to the borrower with a duplicate copy which is duly signed by the borrower and is returned to the branch of the bank.

After issuing the sanction advice, the bank will collect necessary charge documents. Charge documents vary on the basis of types of facility, types of collateral.

Figure-2: Stages of Credit Assessment

Step-12 4.3 Assessment of Business’s Attractiveness:Innovative Idea may attract investor or Venture Capital: Ideas and innovation: The first step in any innovation process is to generate ideas. No idea is a silly idea and it is critical that as many people as possible are engaged – which means gathering ideas both internally and externally. The process should be consulted with staffs, partners, customers, funders and even competitors. Determination: First entrepreneurs have to fix up the right area of business where they have specific knowledge, experience etc. If you can not choose specific sector or you have no previous knowledge, then you may follow the following chronology:They must try to find a strong network with the specific target Industry, organization, service people or liaison with this area people of that area so that before starting their venture must get the clear picture what business they want to do. Capacity Building: Credit Risk Manager will identify the extra ordinary quality or scope by which entrepreneurs can attract and prove that their work speed, style and understanding are very professional and speedy considering the people surrounding them. The entrepreneur should practice in respect of documentation, presentation, use of technology, attitude, and behavior, follow up any job, overcome any challenge, fix up target. Utilizing brain, eye, attitude, confidence and movement etc.Family Support: A clear and focused family blessing and support is essential and crucial to become qualified in credit assessment technique.Value Experience: CRM also measures the positive attitude of the entrepreneurs, experience of failure and success story etc. Redundancy: Redundancy i.e., back up is a fundamental thing to be ensured before initiating a business.Entrepreneurs should calculate the alternative scope if they fail to reach or comply with the target. Moreover, they should think earlier how to re-stand after any failure or accident and how much they have the capability to cope up with unwanted situation.Marketing Challenge: CRM also evaluates the marketing aspects that create value to the viability of credits success. Entrepreneurs must have to attain those criteria.Technology & Networking: Use of Technology: Proper and smart use of technology will place anyone ahead of others. Entrepreneurs should have modern technological equipments, i.e., mobile, laptop; and good knowledge on email, web browsing, etc.Business Trend: Trend is a pattern that is followed and practiced over the times. To be a successful entrepreneur, one’s have to follow the ongoing business but must prove that they have added a lot of values and diversification test or opportunity.Location of Business:A perfect employer/businessman always emphasizes on proper site selection. Proper place, targeted consumers, availability of labors, machine set up etc. all is somehow

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Finally loan is disbursed by the branch through a loan account in the name of the borrower and monitoring of the loan starts formally.

included in site selection. Statistics shows, most of the consumers’ oriented business flourished in the place of different popular markets, jostling arenas etc.Associate/ Partner Organizational: Do they have any partnership or association with other organizations, If yes, they have to give a brief description of their partner/ associate organizations.Succession Plan: In absence of the proprietor, who will manage the business? Legal Aspects:Business Social Responsibility (BSR): What activities entrepreneurs will undertake to fulfill responsibility towards the community?10. Research and Development (R&D): Whether there are areas or issues related to entrepreneurs’ proposed business that need to be studies further, prospects in terms of the present and future development of the business.11. Training & Development: Entrepreneurs must have to mention their will to build the capacity/skills of management and employees.Name Clearance: Whatever the type of business entrepreneurs involved in, there needs a specific name. A perfect name can lead mileages of the goods or the business. If it is partnership business, it is important to choose the name jointly with the partners. Borrowers can also start their business as private limited or public limited company with stunning name they have chosen.Trade License and Other Documents: Trade license represents with acceptability to run their business. The business would not be legal without trade license. It is primary duty to collect trade license and other documents for starting the business.Bank Accounts and Business TIN: Bank Accounts and Business TIN are also important for a business. For this the entrepreneur must open a bank account in a specific bank and collect TIN from NBR.Environmental Issues: Mentioning of environmental issues such as : waste management, sustainable development of raw materials, ecological balance, etc, How will borrower use green technology/ energy efficient equipment in your business, Do they require any clearance from Department of Environment? Which category does your business fall in terms of location and influence on environment?Ethical Issues: Mentioning what actions borrower will take to maintain ethical standards of their business in terms of monopoly, fairness in the market, loss/profit, etc.Intellectual Property Issues: Mentioning how borrower will protect the name of their business, its products and services in terms of patent, design, trademark, Licensing, copyright etc.Working Environment: Mentioning how they will promote peace and harmony in the working environment.Networking Linkage/ Partnership: Mentioning how they will establish and maintain sound partnership with stake holders.Safety and Security Issues: What measures borrower will implement to ensure the safety and security of the employees and the organization?

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Use of ICT: Mentioning borrowers’ planning to use ICT (e.g. accounting software, e-commerce, MIS) to manage your business, how ICT will be applied in your business.

Verification of Documents:Financial institutions need the documents to verify the following in general:

Table-3: Verification of Documents

The existence of the company/ business, its directors/business owner’s legality of

borrowing.

The business operations risks and management depth, experience and expertise of the

owners.

The financial strength and repayment capability (including the cash flow) of the borrower.

The business net worth and gearing of borrower.The operating risks of the business.The strategy plans of the borrower to mitigate such risks and maximize profitability.

The proposed facilities are in line with the borrowing needs.

The amount applied for reflects the requirements of the business based on existing or

projected turnover.

The overall risk associated with the proposed borrowing

Source: www.bankinginfo.com.my/_system/media/downloadables/sme_loans.pdf.

Borrowers must have to make full disclosure of all financial information and ensure that it is accurate at the time of their application. Declaration of the correct information will also ensure that their Credit application will be processed in a timely manner. However, most Financial Institutions have an application checklist that lists out the documents required.

Due Diligence Issues The due diligence phase will vary depending upon the nature of their business proposal. The process may last from three weeks to three months, and they should expect multiple phone calls, emails, management interviews, customer references, product and business strategy evaluations and other such exchanges of information during this time period.

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Estimation of Probability of Default The probability of default refers to the ability or capacity of a borrower to service/repay debt obligations. The higher this ability, the less likely the borrower will default. For a corporate borrower, its repayment ability is determined by various factors including business and financial performance, industry trends, management experience and strategies, funding lines, parental support etc. To determine what factors are relevant, we turn to: Academic theory/research – which highlight various indicators from corporate financial statements that are predictive of creditworthinessPast experience – although not necessarily perfect, the past is a useful predictor of the future. Thus, a bank can use its past experience to identify key default drivers and develop a rating model.

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Qualitative Factors

Quantitative Factors

Figure-3: Illustration of the Determinants of Probability of Default

Source: ageconsearch.umn.edu/.../2/NC_1014_Dodson_FSA_defaults_finalt.pdf

Entrepreneur’s selection technique also covers certain Areas, such as:

Some skills that are measured by the financial institutions before granting credits:

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Figure-4: Analysis of Viability of Business for Entrepreneur’s Selection

Figure-5: Analysis of Entrepreneur’s Skills

Source: https://books.google.com/books?isbn=8192050084

Source: journal.ui.ac.id/index.php/jbb/article/view/788/750

5. Assessment of Risk of Commercial Bank Credit:

The loan business is one of the main assets businesses in commercial bank. In the management process of commercial banks, the existence of loan business is bound to loan risk, and thus need to manage the loan risk. Therefore, in order to prevent and reduce loan losses, decrease the risk of bank management, ensure the safety and profitability of credit assets, improve the efficiency and quality of bank risk management, it is necessary to evaluate the size and quality level of loan risk to support the decision-making process. Loan risk refers to the possibility of loss that commercial banks can not recover the principal and interest according to the agreed loan contract, due to a variety of unforeseen uncertainties. Loan risk is mainly involving the non-performing loans. According to the degree of loan risk, loan classification system classified loans into five categories: normal; interest; secondary; doubt; loss.Based on the loan risks’ identification and estimation, and combining with other factors, commercial banks assess the probability of the credit risk occurrence or possible losses, and then decide to take appropriate measures. Effective risk assessment can prevent the generation of non-performing loans, strengthen the management of bank loan quality, and improve the efficiency and quality of bank risk management. Risk assessment is an important part of loan risk management in commercial bank.

Table-4: Risk Factors of Commercial Bank Loan

Loan Risk Factors in

Commercial Banks

Object risks

Borrower credit riskRisk of borrower repayment abilityRisk of borrower repayment willingRisk of project profitabilityRisk of project potential

Loan terms risks

Risk of loan wayLoan duration riskLoan amount riskLoan use risk

Management risks

Bank cognition riskOperation risk

Staff moral hazard

Intermediary risk

System environment risksPolicy riskInterest rate riskRisk of economical periodic fluctuation

Source: www.pucsp.br/.../34/ Risk Factors of Commercial Bank Loan/pdf.It is necessary to identify the loan risks before risk assessment. Recognizing the causes and types of loan risks, the bank will accurately forecast the potential risks. Considering the multiple factors affecting loan risks, this article classifies the loan risks in commercial bank into four categories: the object risk, loan terms risk, management risk and system environment risk.

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5.1.1 Object Risks:Bank loans object is an important factor that can influence the bank recover the loan principal and interest according to contract, and lead to changes of the possibility of loan loss. Loan object risks include borrower credit risk, risk of borrower repayment ability, risk of borrower repayment willing, risk of project profitability, risk of project potential.Generally, banks can not fully grasp the basic conditions of loan companies which include enterprise risk preferences, financial situation, repayment capacity, and industry development potential. It is difficult to make an exact check. Once the external market environment and internal conditions change, business operations will change in the loan period. It will influence the companies’ repayment capacity at maturity. If the project which loans lent to is at large size, taking a long time, and with no experience to draw on. The project itself has a greater risk which will bring uncertainty to bank loan recovery. Project potential and project profitability will also influence loans recovery of commercial banks. 5.1.2 Loan Terms Risks:Loan terms refer to the loan amount, loan duration, loan purpose and etc. These factors will have an impact on the loan recovery of bank according to the contract. Bank loan is including credit loans, secured loans (mortgage, pledge and guarantee) and Discount Notes. In general, secured loans take more risk than the credit loans. The longer the loan term is, the greater the impact has. The bank, company and project will subject to various uncertainties, the safety of loan recovery will be more difficult to determine. The greater the amount of loans is, the greater the likelihood of strategic default of the borrower is. Banks can maintain a moderate, reasonable structure by coordinating long, medium and short-term loan ratio. Loan funds invest to non-real economy bear greater risks than to invest in the real economy. 5.1.3 Management Risks:Banks' own management also causes credit risk: Firstly, cognition risk. Bank does not fully understand the loan risks, focusing on quantity expansion and market share, ignoring the upgrade of the loans quality. It makes loans share high proportion in total bank assets. Secondly, the operational risk. Data collection, processing, computing and electronic system failures will bring banks into too much investment of loan management. Low level of bank credit management, such as loan status and responsibility is unknown, incomplete vetting mechanism, improper financial regulation, policy makers and managers make errors in the process of management, and etc. will bring uncertainties of the loan disbursement and recovery. Thirdly, the moral hazard. Bank credit officers at the personal interests release loan that does not meet the conditions deliberately. Fourthly, the intermediary risk. Intermediaries with weak sense of integrity, incomplete management systems related to the intermediary increase the loan risk of commercial banks. 5.1.4 System Environment Risks:The system environment risks involve policy risk, interest rate risk, risk of economical periodic fluctuation. Government's financial policies or relevant laws, regulations make great changes, or important measures are introduced. It will bring the financial market

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fluctuation; commercial banks will have uncertain earnings. This is policy risk. Currently, domestic commercial banks obtain income by deposit and loan interest rate differential, so interest rates have a direct impact on the commercial banks.

5.2.1 Risk Assessment of Commercial Bank Loan – AHP (Analytic Hierarchy Process):

AHP is a decision making method that decompose the relevant elements of the decision-making problem into several levels, then make qualitative and quantitative analysis according to the levels model. AHP analysis in-depth the nature, influencing factors and the intrinsic relationship of the complex decision-making problem, reduce to different levels, form a hierarchical structure model, make the decision-making process mathematical with less Quantitative information. 5.2.2 Establish a Hierarchical Model:The top of a hierarchy model is the target to be achieved by AHP. Here is commercial bank loan risk. The middle layer refers to the content that achieves the overall goal, namely index layer. For example, the factors affecting loan risk include the loan object, the loan term, the bank management and environment. Factors at the bottom support the factors at middle layer, namely sub-index layer. Loan object risks include borrower credit risk, risk of borrower repayment ability, risk of borrower repayment willing, risk of project profitability, risk of project potential. Define the set of loan risks as A, loan object risks A1, loan terms risks A2, management risks A3, system environment risks A4, define weight as W=(W1 ， W2 ， W3 ， W4,), then subdivide the four factors, A1=(S1、S2、S3、S4、S5)，A2=(S6、S7、S8、S9)，A3=(S10、S11、S12、S13) A4=(S14、S15、S16).

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Figure-6: Hierarchy Model of Commercial Bank Loan Risk

Source: www.pucsp.br/.../34/ Risk Factors of Commercial Bank Loan/pdf.

5.3.1 Observation of Previous Practices of Lending Risk Analysis:The Financial Sector Reform Program (FSRP) was introduced in the early nineties in Bangladesh with a view to bringing about financial discipline by undertaking appropriate reform measures in the financial sector. The program was undertaken by the Government of Bangladesh with combined support of the World Bank and USAID under the ‘Structural Adjustment Program’. The program mainly covered the banking institutions in the financial sector and suggested several reform measures. Among the measures that FSRP recommended, the Lending Risk Analysis (LRA) constitutes as an important measure. LRA was prescribed for taking sound credit decision in consolidated form on the basis of analyzing risks involved in borrower’s business and security. With a view to ensuring better credit risk management, the use of LRA was made mandatory in case of sanctioning or renewing large credits until the adoption of Credit Risk Grading (CRG) in 2003. At present LRA has been replaced by the CRG.

Lending Risk Analysis (LRA) was involved in assessing the likelihood of non repayment of credits (mainly credit risk) from the borrowers as per credit agreement by analyzing some sort of risks associated with the borrowers’ business and security. Business risk, the prime component of credit risk, was viewed from two angles viz. industry risk and company risk.

Table-5: Contents of Risk under LRA Manual

Source: FSRP Bangladesh, Credit Risk Analysis, June 1993.

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5.3.2 Observations on Recent Risk Management Practices in Banks in Bangladesh:Bangladesh Bank issued its BRPD Circular No. 17 dated October 07, 2003 advised all the scheduled banks to put in place an effective risk management system by December, 2003 based on the certain guidelines furnished to them. It appears from the circular that the banking industry is completely different from other industries in terms of the diversity and complexities of the risks they are exposed to. For sustainable performance of the banks in view of the deregulation and globalization, the banks must be capable of managing their risks. Credit Risk ManagementGuidelines involves in assessing and managing credit risks associated with the selection process of a potential borrower, credit structuring (amount, duration, purpose, repayment, and support), approval process of credit, credit documentation (security and disbursement), credit administration, credit monitoring and recovery functions of a bank or financial institution. At the selection stage, credit risk grading is essential to keep the credit risk exposure at a tolerable level.

Table-6: Contents of CRM Guidelines

Source: Bangladesh Bank (2003), Managing Core Risks in Banking: Credit Risk Management, Dhaka: Bangladesh Bank, Head Office.

5.3.3 Introduction of Credit Risk Grading (CRG) System in Credit Operations:The risks associated with the borrower or counter-party need to be carefully and critically analyzed before funding to the client’s business. To quantify the risk exposure, it should be graded as per credit risk score sheet by the individual banks in line with the guidelines of CRG Manual. Risk grading is a key measurement of a bank’s asset quality and it is a robust process. Therefore borrower’s risk grade should be clearly stated on the credit application form for using credit decision making process. In CRG Manual, five risk components viz. financial risk, industry/business risk, management risk, security risk and relationship risk have been identified which are responsible of failing to meet the obligations by the borrowers. These risk components are rated based on the some basic parameters. Note that there are twenty parameters under the five risk components to reflect the risk exposure. Financial risk comes from the financial distress of the counterparty. It includes identification of extent of leverage through debt-equity ratio, liquidity of the borrower through current ratio, profitability performance through

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operating profit margin and coverage through debt-service coverage ratio. Business/Industry risk arises due to adverse change in business or industry situation. In order to assess the borrower’s business/industry risk the size of borrower’s business in terms of annual sales volume, age of business, industry growth, market competition and entry & exit barriers are to be assessed. Management risk is conducted in assessing the competence and risk taking propensity of the management. It covers the parameters like experience, second line/succession plan and team work of the management. Security risk is assessed by analyzing the primary security, collateral security and support. Relationship risk is considered under CRG by assessing the account conduct, utilization of limit, compliance of covenants and balance of personal deposits. There is a wide range of risk exposure or grading system in the present practices where superior is the top position and bad & loss is the worst position. In between superior and bad & loss there are six types of risk exposures say, good, acceptable, marginal/watch list, special mention, substandard and doubtful.

Table-7: A Typical Risk Grading (Credit Rating) System under CRG Manual

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Source: Bangladesh Bank (2005), Credit Risk Grading Manual, Dhaka, Bangladesh.The uses of CRG in credit decision making is shown in the Table-4. From the matrix presented in the Table-4 it is found that after conducting CRG at pre sanction stage based on client’s 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. The rest of the ratings of a borrower at the post sanction stage exhibit as non-performing.

Table-8: Decision Matrix of Credit Risk Grading

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Source: Bangladesh Bank (2005), Credit Risk Grading Manual, Dhaka, Bangladesh.

Out of the eight categories of risk exposures mentioned under the guidelines, four risk exposures or grading are determined as per the prevailing loan classification and provisioning rules of the central bank. Therefore, central bank’s rules for credit classification shall be applied irrespective of risk rating under CRG sheet in case of risk exposures like special mention, sub-standard, doubtful and bad & loss.

The analysis is based on different factors influencing the borrower’s behavior towards a successful FI (Financial Institutions) model. These factors are interdependent and have a major impact on decision making loan disbursement. The borrower’s behavior is derived from their educational, cultural, economic, political and communal facets. These facets have a sound influence on behavioral and attitudinal aspects of individuals. An in-depth analysis in each of the broad parameters revealed the following:

Educational FacetEducation plays a vital role in shaping up a personality and enabling an individual to think in a broader perspective with intellect and wisdom. It also enables the capacity building of an individual, which facilitates in effective decision making.It also reflects their lack of intellect to understand the complexity of any micro finance model, which creates skepticism in understanding the phenomenon of repayment based on principal amount, mark up and other hidden charges. The borrowers are keen to obtain fund in any way to establish their businesses without having in depth information about

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the compounding rate of interest, schedule of charges, installment framework and redress in case of delinquencies. They are only required to sign the undertaking to be eligible for the loan. Lack of education discourages the potential borrowers to apply for micro financing, as it sounds quite confusing and vague in terms of its implementation from the borrowers’ perspective.

Cultural facetThe behavior of individuals is persuaded by cultural factors including religions, nationalities, geographic regions, racial groups etc. Culture is an integral part of every society and shapes the wants and behaviors of individuals. The influence of culture on behavior varies from country to country; therefore financial institutions are very careful in analyzing the culture of different groups, regions or even countries. Every society possesses some form of social class which is important to the financial institutions because the behavior of people in a given social class is similar. In this way financing activities could be tailored according to different social classes.

Economic facetEconomic facet has a great influence on the behavior of borrowers. If the income and savings of the individual is high then he/she is least attracted to debt financing. On the other hand, the individual with low income and savings is more attracted towards debt financing. The selection of income group and the means of income are very important.

6. Policy Implication & Conclusion 6.1 Policy Implication:

In spite of the positive developments observed the following reactive and proactive measures are suggested regarding the selection of entrepreneurs:

All the banks should have comprehensive credit risk management policies and procedures to ensure earnings at acceptable level and minimize losses in their portfolio. The policies will provide directional guidelines to perform credit related activities properly and efficiently. Credit policy, credit assessment and risk grading system, approval procedures, and internal auditing system are the major areas of credit risk management policy. Procedural guidelines consist of some set rules of activities to conduct specific credit function effectively.

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For the purpose of performing credit activities in desired manner, each bank needs to establish own credit policy in accordance with their business philosophy. The bank’s credit philosophy its general goals and objectives including the mission and vision of the banks are reflected in its credit policy. Thus industry and business segment focus, types of credit facilities, single client or group limits, credit caps, discouraged business types, credit facility parameters, system of approval etc. shall be incorporated in the credit policy in black and white with a view to providing overall framework of credit activities. However it should cover, at a minimum, what constitutes proper credit support, risk based pricing and documentation of credit for safety.

Now in a deregulated environment, banks are no longer considered as passive takers. Therefore after the introduction of prudential credit policy, the banks must stand ready to meet all the legitimate demands for credit facilities at all the times by customizing their credit policy. While looking into the matter of customizing credit policy, the changes in economic outlook and the evolution of bank’s credit portfolio should be taken into account. The credit policy can also be modified and tuned to match the changing credit related rules and regulations of the country and all the modifications and changes must be approved by the managing director or chief executive officer and board of directors.

As part of the proactive strategic management term structure of loans and deposits should be harmonized. The management of the bank should review their systems, policies, processes and product prices in line with the changing market reality. In order to reduce the classified loans and advances bank should be more cautious regarding preparing credit proposal, approval, disbursement, and monitoring and documentation formalities for a loan. Diversification of loan portfolio in different sectors is required to reduce large loan risk.

Bank should focus more on agricultural and industrial credit and discourage consumer durable finance. SME is the thrust sector of Bangladesh economy and Government also put stress to financial sectors to provide more finance to SME sector for microeconomic development. The Bank should formulate separate SME financing guidelines and enhance credit facility to this sector.Banks need to improve reporting of SME loan variables. Financial institutions should separate reporting of financial information for non-employer and employer-firms. Moreover, they need to assure detailing of the loans composition, with indication of the different underlying products (e.g. overdrafts / lines of credit / leases / business mortgages or credit cards / securitized loans) and disclosure of such elements in the loan definition.

Financial Institutions should provide comprehensive information about government guarantees at a central government level and corresponding guaranteed loans amount, as well as about the portion of the debt that is guaranteed. They can also offer more comprehensive information on government programs that ease borrower’s access to finance.

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Financial Institutions should detailing the definition of collateral and improve reporting, using demand-side surveys to compensate for lack of supply-side data.

Besides strengthening the capital structure of the banking sector, intense international competition and globalization brought the positive effect of the financial consolidation in the foreground. Because of the consolidation, productivity and efficiency of most banks will increase due to economies of scale and economies of scope. Therefore, the encouragement of the mergers and acquisitions to be taken place among banks, come out as a constructive proposal.

Bank should make proper and exhaustive documentation before disbursement and to ensure proper supervision, monitoring and follow up of each credit.

6.2 Conclusion:

“Banks are in the business of managing credit risk, not avoiding it……”

Like any other segment of the economic policy, credit is very important for any financial institution as it generates profit and gear up economic activities of the country. In other words, credit is a business entity and it is input in the production process of the country. Since credit has an inherent risk, therefore proper utilization of the loans are essential to meet the requirements of the borrower. The loan applied for by the borrower must not be employed for unproductive purpose. In this regard, the bank must closely follow the progress of the loan and the way the borrower is utilizing the funds. In the assessment processes the bank will determine any fraudulent activities on the part of the borrower. The bank always trying to improve their credit policy for minimizing loss and maximizing profit and various measures are undertaken to develop the credit management system.

“……A bank’s success lies in its ability to assume and aggregate risk within tolerable and manageable limits.”

References

Bangladesh Bank (2003), Managing Core Risks in Banking: Credit Risk Management, Dhaka: Bangladesh Bank, Head Office.

Bangladesh Bank (2005), Credit Risk Grading Manual, Dhaka: Bangladesh Bank, Head Office.

Brennan, M., V. Maksimovic, and J. Zechner, 1988, Vendor financing, Journal of Finance No.43, 1127-1141.

Calvo, G. and S. Wellisz. 1980. Technology, entrepreneurs and firm size, Quarterly Journal of Economics No.95, 663-678.

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Carey, M., M. Post, and S.A. Sharpe, 1998, Does corporate lending by banks and finance companies differ? Evidence on specialization in private debt contracting, Journal of Finance No. 53, 845-878.

Crouhy, M., D. Galai, and R. Mark (2001), Prototype Risk Rating System, Journal of Banking and Finance, No. 25, 47-95.

Evangelos P. Koumanakos, “Bank Lending Decisions Using Projections”, American University of Sharjah, UAE, Journal of Business Case Studies First Quarter 2007 Vol: 3, No: 1.

Fredland, J.E. and Little R.D., (1981). Self-employed Workers: Returns to Education and Training. Economics of Education Review, No.1, (3), 315-337.

FSRP Bangladesh (1993), Credit Risk Analysis Manual, Dhaka: Bangladesh Bank, Head Office.

Kabir, G., Jahan, I., Chisty, M. H. and Hasin, M. A. A. (2010). Credit risk assessment and evaluation system for industrial project. International Journal of Trade Economics and Finance, No. 1(4), 331-341.

Klapper, L., 1998, Short-term collateralization: Theory and evidence, New York University

working paper.

Le, A.T. 1999. Empirical studies of self-employment, Journal of Economic Surveys No. 13(4),

381-416.

Long, M.S., I.B. Malitz, and S.A. Ravid, 1993, On trade credit, quality guarantees, and product

marketability, Financial Management No. 22, 117-127.

Lucas, R.E. 1978. On the size distribution of business firms, Bell Journal of Economics No. 9(2),

508-523

Meltzer, A.H., 1960, Mercantile credit, monetary policy, and size of firms, Review of Economics

and Statistics No. 42, 429-437.

Mester, L.J., 1997, What’s the point of credit scoring? Business Review, Federal Reserve Bank of

Philadelphia, September/October, 3-16.

Mian, S., and C. Smith, 1992, Accounts receivable management policy: Theory and evidence,

Journal of Finance No. 47, 169-200.

Petersen, M.A. and R.G. Rajan, 1997, Trade credit: Theories and evidence, Review of Financial

Studies No. 10, 661-669.

Riley, J.G. 2002. Weak and strong signals. Scandinavian Journal of Economics, No. 104(2), 213-

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Rose, Peter S. (1996), “Commercial Bank Management”, 3rd edition, Boston: Irwin-McGraw-Hill Publishing.

Schwartz, R.A., 1974, An economic model of trade credit, Journal of Financial and Quantitative

Analysis No. 9, 643-657.

Schwartz, R.A., and D. Whitcomb,1979, The trade credit decision, in Handbook of Financial

Economics, edited by J. Bicksler, Amsterdam: North Holland.

Spence, A.M., 1973, Market Signaling: Information Transfer in Hiring and Related Processes,

Cambridge, MA: Harvard University Press.

Treacy, W. F. and S. M. Carey (2000), Credit Risk Rating System at Large U.S. Banks, Journal of

Banking and Finance, No. 24, 167-201.Alam and others, (n.d.).

Websites

http://www.bangladesh-bank.org) [Accessed November 27, 2015].

www.dhakachamber.com [Accessed November 05, 2015].

www.bankinginfo.com. [Accessed December 03, 2015].

https://ageconsearch.umn.edu [Accessed December 10, 2015].

https://books.google.com [Accessed November 05, 2015].

http://www.moneysmart.gov.au [Accessed December 05, 2015].

http://www.creditsmart.org.au [Accessed December 09, 2015].

Appendix

Case study-1: Bank lending decisions using projections

Loan Application

Assume that PAPERBASIS’s working capital line of credit is approaching its renewal date. Mr. Tison- the manager and business owner of the firm, wants to renew the line at a higher (by 10%) amount and at better terms. He thinks sales will slightly increase, but in his opinion, the present € 500.000 working capital line should not be necessary for

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receivables and inventory financing. Further, Mr. Tison indicated that he will not need to spend external funds on new equipment.

Process of Bank Assessment

Mr.Tison’s request is very typical. Every business owner is interested in making money. The starting point for making money is focusing on revenue, as Tison has done. It is the starting point for virtually every planning or budgeting process, whether highly informal and carried around in the owner’s head or very structured and contained in countless papers and reports. Though acknowledged, balance sheet accounts are often an afterthought. In making his request, Mr. Tison did not necessarily comment on his precise expectations about accounts receivable/payable or inventory. He intuitively ignores that even if sales increase his accounts receivables/payables and inventories are likely to decrease and as a consequence (held other parameters constant) borrowing needs to be lower, at least in the short term.

In order to assess a loan application it is important to proceed in an orderly manner. First of all if the application is long time after the reporting date a bank should ask for additional financial information or updated firm’s financial statements. Additionally, banks usually ask for recent balances of key accounts, such as working capital, reserves, debtors, creditors, other bank loans etc, and comparative list with the previous year levels. Based on these reports and any relative information concerning the company’s stated objectives it is possible to complete an initial projection for the basic risk factors.

Bank’s Decision

Bank decided to reject the credit because of the abnormality in projections.

Source: Evangelos P. Koumanakos, “Bank Lending Decisions Using Projections”, American University of Sharjah, UAE, Journal of Business Case Studies First Quarter 2007 Vol: 3, No: 1.

Case study-2: Sally’s loan is rejected because of the probability of repayment uncertainty

Sally applied for a business loan at her bank. She wanted to borrow $10,000 to buy machinery. She thought the bank would accept her loan application as her sales projection is enough to cover her loan repayments. Sally was disappointed when the bank rejected her application. They felt she would not be able to make the loan repayments as she also

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has a $5000 debt to pay off and no savings in her bank account. Sally decided to focus on paying off her debt and build up some savings before she applied for another loan.

Source: www.moneysmart.gov.au › Borrowing & credit

Case study- 3: Mary shops around for the best deal

During the past three months, Mary applied for four loans, two mortgage loans and one cash advances. In the end, she decided to take up one loan for new plant. She decided not to take out a mortgage loan.

Before March 2014: As credit providers cannot see how many applications were approved and/or taken up by Mary, they may assume she now has a mortgage loan, a cash advances and a loan for her plant. As such, she may be considered a risk and may find it hard to obtain credit.From March 2014: A licensed credit provider who is participating in comprehensive credit reporting might see that Mary has only taken out one mortgage loans and has a satisfactory repayment history. If Mary applies for further credit, a credit provider will have a better picture of her current arrangements and can make a more accurate credit assessment. 

Source: http://www.creditsmart.org.au/case-studies-and-faqs

Case study-4: Can an ethical bank support guns and hydraulic fracturing?

As the founder and president of a new ethical bank focused on environmental sustainability, Jay McGuane realized that he and his board needed to set guidelines about which loans to approve and which to reject on “values” grounds. In his eagerness to start

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running the business, he’d put the issue off, but the bank was already confronting two problematic requests, one involving fracking and another concerning guns.

Without clear ethics rules, Jay worried that his already divided directors would fall into bitter squabbling, which could lead to resignations, negative media attention, and a flight of investors. Ethical banking had seemed so benign when Jay had decided to enter the industry. Now it seemed like a hornet’s nest.

A Green Vision

Jay hadn’t needed this job. At age 50, he had years of entrepreneurship behind him. He had founded a bank in Maryland, expanded it to six branches and $400 million in assets, and sold it for a substantial profit. While looking for his next project, he happened to see the movie An Inconvenient Truth again and decided, during the sleepless night afterward, to build something meaningful out of his concern for the environment, his love of his native Colorado, and his knowledge of banking. The result was Rocky Mountain Green Bank, a company with a mission to promote environmental stewardship.

He established himself in Colorado Springs and assembled a board of directors: Four successful entrepreneurs, a lawyer, an ex-mayor of the city, a former executive in the Maryland bank (who had been more than willing to make the move West), a doctor who was a school friend and sometime hunting partner, and an evangelical (and ardently environmentalist) leader of a megachurch Jay had attended a few times.

To drive home its mission, the board hired a famous architect to make the bank’s headquarters an environmental showcase, with prototype solar-power windows, a set of wind turbines, and a butterfly roof that channeled rain and meltwater into underground cisterns. Bike racks and charging stations for electric cars ringed the building. Every lightbulb was an LED.

Articles and TV segments about the building and about Jay, the returned native son with a passion for the environment, helped attract local depositors and small borrowers, who’d grown disenchanted with the big national and global banks. Rocky Mountain Green Bank’s promise of timely, personalized service sounded good to a lot of people. And Jay’s track record in Maryland drew investors, who were eager to see their money double or triple in a few years, when (they assumed) he would sell the bank. Deposits grew at a healthy rate, but to succeed financially, the bank needed to make big loans to a few strong companies. So far, that hadn’t happened.

Moreover, the values-based approach was proving harder to implement than Jay had anticipated. In the branch’s second-floor boardroom, with its soaring view of the mountains, rifts among the directors had started to appear. The first sign of conflict had come up in a discussion of what Jay thought was a nonissue: a gym for employees.

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“Oh, come on,” Neitha Wellman said, shaking her head. “Are you going to have a personal trainer on-site, too?”

“Actually, yes,” Jay said. “Two afternoons a week.”

She rolled her eyes. “Since when does a gym or a personal trainer have anything to do with being green?”

An avid fly fisher and former bouldering champion, Neitha considered herself a pragmatic environmentalist, but she detested the idea of the “nanny state.” She actively campaigned for Libertarian candidates—in fact, she had been at a rally at a mall when a shooter had gone after a Congressional candidate and the people waiting to shake his hand. A picture of her doing CPR on a wounded child, who later died, had been all over the internet, though she’d refused to discuss the incident. Two other board members had agreed with her about the gym, so Jay had scaled back those plans and hadn’t even mentioned his healthy-eating initiative, an agreement with a catering company to make sandwiches, salads, and smoothies on-site.

Twin Debates

Neitha had been the one to solicit the first problematic loan application. She’d been talking to the head of a Colorado engineering company that developed pumping systems used in hydraulic fracturing—fracking—and wanted to expand into making the polymers, emulsions, and surfactants the industry relied on. These materials, the executive had said, would be significantly less toxic than those currently in use. Though ambivalent about fracking in general, Neitha had recommended that the executive approach Rocky Mountain Green Bank, and he had seemed interested. On hearing about this interaction, Neitha’s fellow directors were divided. One side touted the economic and employment benefits of fracking, while the other insisted that the environmental and seismic risks outweighed any good that could come from it. The 300-million-year-old sedimentary rock under the Denver Basin in eastern Colorado contained one of the country’s largest gas deposits, and a number of local engineering firms were working on solutions for drilling, injecting, and waste disposal. It was a growth industry, but warnings from experts about the risks of groundwater contamination and seismic instability seemed to increase every day. “Look, let’s not get worked up about a loan application we haven’t even received,” Jay said, trying to lower the temperature in the room. “But when we are approached by a company like this one, we have to be ready. We need to be talking about how to make loans that reflect our mission.”

Jay promised that he would research the guidelines other ethical companies used to make values-based decisions, solicit opinions from each director individually, and come back to the group with a proposal. The next day, Jay visited the board member he knew best, Fred Keeler, a gastroenterologist who had been trained at Harvard. “I’m a believer in the

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precautionary principle,” he told Jay. “It’s the idea that in order to act, all you need is partial evidence—not proof.” Bans on smoking in public areas were a perfect example, he said: Many of them went into effect before the dangers of secondhand smoke had been proved. He quoted from a mural that he said could still be seen near Harvard Square: “Indication of harm, not proof of harm, is our call to action.” So if it looks bad, it is bad, Jay thought ruefully. Hoping for a more nuanced perspective, Jay went next to the pastor, the Reverend Clyde Dahlberg, who, to Jay’s surprise, advocated a completely evidence-based approach: “Make two columns, one for adverse environmental effects, one for the positives,” he said matter-of-factly. “Figure out a way to quantify the effects, then do the math.” Simple.

It was while he was wrapping up his meeting with Clyde that Jay received an e-mail from the bank’s chief loan officer. “Wow—three million dollars,” he blurted out.“What’s this?” Clyde asked. Jay wished he hadn’t said anything: The e-mail was about an official application from Field Force, a large, local firm that had been talking informally with Jay about a multimillion-dollar loan to expand its business. In some ways, it was just the type of loan the bank needed: Field Force was a solid performer, a growing source of local jobs, and a good corporate citizen, with a record of support for military-related philanthropic initiatives like the Wounded Warrior project. But its business was manufacturing lightweight small arms technologies, so-called LSATs, for the U.S. government.

“A gun manufacturer?” Clyde asked in horror.

“A military contractor,” Jay said.

“A gun manufacturer,” Clyde corrected him. “In the state of Colorado? After Columbine and Aurora and Arapahoe High School? You’d better not do anything on that without a board decision. I’d put it on the agenda for next week’s meeting if I were you.”

Decision: Bank’s rejected both applications because of ethical issues though the credit’s had huge prospects.

Source: https://hbr.org/2014/01/case-study-can-an-ethical-bank-support-guns-and-

fracking

Case Study-5: Custom portfolio benchmark report- Independent finance lender

Situation:

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President, major office equipment finance company needed to increase approval rate while maintaining credit losses in acceptable range.

Critical Issues:

Lender operated vendor financing programs with a goal to be first-choice financing source among vendors.

Solution:Developed a custom portfolio benchmark report showing marketing, credit, and collections performance versus that of comparable peers.

Demonstrated a flat market share within equipment segments over a three-year period.

Demonstrated that long-term delinquency trends were the lowest 10 percent among their peers.

Results:

Approval rate was increased by 1 percent.

Origination volume was increased by $50 million.

No material change in credit quality.

Source: http://www.paynetonline.com/market-intelligence/case-studies

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