Credit Risk Grading

Sheikh Mozaffar Hossain

GM, BB
sheikh.mozaffar@bb.org.bd

Introduction
The

major source of Income of the banks is income

from loans and advances
And the major source of loans and advances is money
taken as deposits from the customers, which has
- Cost implication and
- Repayment obligation to the depositors
Credit culture is changing continuously
Loans and advance have to be managed in such a way
as the default risks are minimized
If adequate steps are not taken, if not monitored
properly, risks incidence will increase.

Credit Risk
Credit

risk is the possibility that a borrower or counter

party will fail to meet its obligations in accordance with
agreed terms.
Credit risk arises from the back's dealing with / lending
to the corporate, individual and other financial
institutions
To minimize losses, banks should have comprehensive
credit risk management policies & procedure in place
Major percentage of assets is subject to Credit risk
For Banks , credit risk is an essential factor that needs to
be managed

Credit Risk Management

The selection of the best available credit risk grade

from the available option
CRM-Steps
- Risk Identification
- Risk Assessment
- Risk Grading
- Risk Pricing
- Risk Monitoring

Credit Risk Grading

The

Credit Risk Grading (CRG) is a collective definition

based on the pre-specified scale and reflects the
underlying credit-risk for a given exposure.
It is an aggregation of Grading across the borrowers,
activities and lines of business, which reflects the quality
of a loan
It is an important tool of CRM to understand dimension
of risk in the disbursement of a loan
Credit Risk Grading is the basic module for developing a
Credit Risk Management system.

It is a risk grading tool that influences

- Lending decision at the pre section stage
- Precautionary measures by review of
grading at post section stage
It is based on pre-specified scale reflecting the credit
risk exposure
Number /Alphabet is used as summery indicator of risk

Function of CRG
Well-managed

credit risk grading systems promote bank

safety and soundness by facilitating informed decisionmaking.
Grading systems measure credit risk and differentiate
individual credits and groups of credits by the risk they
pose.
This allows bank management and examiners to monitor
changes and trends in risk levels.
The process also allows bank management to manage
risk to optimize returns.

Use of CRG
CRG

matrix allows application of uniform standards to

credits to ensure a common standardized approach to
assess the quality of individual obligor, credit portfolio
of a unit, line of business, the branch or the Bank as a
whole.
CRG output is relevant for individual credit selection,
wherein either a borrower or a particular exposure/
facility is rated.
CRG largely constitutes obligor level analysis.
CRG is also relevant for surveillance and monitoring,
internal MIS and assessing the aggregate risk profile of a
Bank. It is also relevant for portfolio level analysis.

Grading Short name and Number of CRG

Grading

Short Name

Number

Superior

SUP

Good

GD

Acceptable

ACCPT

Marginal/ Watch list

MG/WL

Special Mention

SM

Sub Standard

SS

Doubtful

DF

Bad & Loss

BL

Where

SUP 1 Fully covered by cash / Government /

international bank guarantee
GD 2 Strong repayment capacity, excellent liquidity and
low leverage, strong earnings and cash flow,
good management skill, covered by the guarantee
of a top tier local Bank (Aggregate Score of 85).
ACCPT 3
Borrowers have adequate liquidity, cash
flow
and earnings & good track record,
normally
be secured by acceptable
collateral (Aggregate
Score of 75-84)
MG/WL 4
Warrants greater attention, thin cash
flow
and/or inconsistent earnings,
borrower incurs a
loss Loan
repayments routinely fall past due
(Aggregate Score of 65-74 )

SM 5 Potential weakness / Close monitoring required,

Severe management problems exist, consecutive
losses, negative net worth, excessive leverage,
An Aggregate Score of 55-64 based
SS 6 Weak financial condition, capacity or inclination
to repay is in doubt, weaknesses jeopardize the
full settlement of loans. An Aggregate Score of
45-54 based
DF 7 Repayment unlikely and the possibility of loss
is extremely high. An Aggregate Score of 35-44
based on the Risk Grade Score Sheet
BL 8 No progress in obtaining repayment / legal
options have been pursued. Proceeds expected
from the liquidation or realization of security may
be awaited. An Aggregate Score of less than 35

Regulatory definition of loan classification

For

the purposing of preparation of CL and maintaining

provisions all loans and advances will however, be
classified on the basis of
(A) objective criteria and
(B) Qualitative Judgment
as per prudential regulations of Bangladesh Bank

How to calculate CRG

Step-1:

Identify all principal risk component

Financial Risk: Probability of failure to meet obligation
due to financial distress
- High leverage (relationship with Liability and Net
Worth)
- Poor liquidity (relationship with Current Assets &
Current Liability)
- Low profitability (relationship with Sales & Profit)
- Insufficient cash flow (relationship with Earning
and Interest on Debt )

 Business

/ Industry risk: Adverse industrial situation/

unfavorable business condition to affect repayment
(amount of sales, age of the business, prospects, growth,
competition level, exit entry barrier are considered)
Management risk: Probability of default due to poor
management capacity (experience of senior management,
succession and team work are considered)
Security Risk: Probability of default due to poor quality
of security ( primary security, collateral & guarantee are
considered)
Relationship risk: Risk in terms of borrower relationship
(account condition, utilization of limit, compliance of
covenants & personal accounts are considered)

Credit Risk components & Parameter

CREDIT RISK

Business/Industry
Risk

Financial Risk

Size of Business
Leverage

Relationship Risk

Experience

Security
Coverage

Account
Conduct

Succession

Collateral
Coverage

Utilization of
Limit

Team Work

Support

Compliance of
Covenants/Cond
ition

Age of
Business
Liquidity

Security Risk

Management Risk

Business
Outlook
Profitability
Industry Growth
Personal
Deposits

Coverage
Market
Competition

Barriers to
Business

 Step-2

: Distribution of weights to risk component

Principal risk component
Weight
1. Financial Risk
50 %
2. Business/Industry Risk
18 %
3. Management Risk
12 %
4. Security Risk
10 %
5. Relationship Risk
10 %
Investment risk for counterparty arises from an
aggregation of the above risks.

Step 3: Establish the Key Parameters

Principal Risk
Components:

Key Parameters:

Financial Risk

Leverage, Liquidity, Profitability & Coverage

ratio.

Business/Industry Risk

Size of Business, Age of Business, Business

Outlook, Industry Growth, Competition &
Barriers to Business

Management Risk

Experience, Succession & Team Work.

Security Risk

Security Coverage, Collateral Coverage and

Support.

Relationship Risk

Account Conduct ,Utilization of Limit,

Compliance of covenants/conditions & Personal
Deposit.

 Step

4: Assigning weights to Key Parameters

FR Leverage
=
50% Liquidity
total

15 ID
=
15 18%
total

Size of
Business
Age of
Business

5 MR
=
3 12%
total

Experience

Team
Work

Profitabil- 15
ity

Business
Outlook

Coverage 5

Industrial
Growth

Market
2
Competition

Business
Barriers

Success- 4
ion
3

SR
=
total
10%

Primary

Collateral

Guarantee

RR
=
1o%
total

Account Conduct 5
Utilization Limit

Compliance
Covenant

Personal Deposit 1

 Step

5: Input data to arrive at Score on the key

parameters
After the risk identification & weightage assignment
process (as mentioned above), the next steps will be to
input actual parameter in the score sheet to arrive at the
scores corresponding to the actual parameters.
MS Excel based credit risk scoring sheet to arrive at a
total score on each borrower
The entire XL sheet named, CRG is protected except the
particular cells to input data.

 Step

5: (contd.)
Input data accurately in the cells which are BORDERED
& are colored YELLOW
Some input cells contain DROP DOWN LIST for some
criteria corresponding to the Key Parameters. Click to the
input cell and select the appropriate parameters from the
DROP DOWN LIST
All the cells provided for input must be filled in order to
arrive at accurate risk grade.

 CRG

score sheet has following columns for all the five

principal risk components
- Criteria
- Weight
- Parameter
- Score
- Actual Parameter
- Score obtained
- Risk Grade

The Criteria & their calculation

1. Leverage: Total Liabilities / Net worth - Source FS
(balance sheet)
2. liquidity: Current Asset / Current liability - Source FS
(balance sheet)
3. Profitability: Operating profit / Sales - Source FS
(income statement)
4. Coverage: Earning before intt. & tax / intt. paid Source FS (income statement)
5. Size of business: Sales amount of business - Source FS
(income statement)
6. Age of business: For how many years the borrower is
engaged in same line of business - Source Date of
establishment

The Criteria & their calculation

7.

8.

9.

10.

Business outlook DD: It is a qualitative factor, for

favorable (if the growth is consistent) highest point is
allocated
Industry growth DD: It is the overall condition of all
other business of the same industry - Source industry
website, BB quarterly review, economic trend
Market competition DD: Position of the borrower with
regard to profitability and stability in comparison with
its competitors - Source annual report, web site,
assumption
Entry & Exit Barriers DD: Whether it is easy or difficult
to enter into the business go out of the business - Source
Qualitative, Market data

The Criteria & their calculation (contd.)

11.
12.

13.

14.

Experience DD: Experience of MD & other senior

management - Annual report
Second line of succession DD: Whether the owner /
director of the borrower / company has successor who
cam run the business in his / their absence Source
collected personally
Team work DD: The extent of team work prevailing in
the organization. Qualitative factor, depends on the
companys performance
Security coverage (primary) DD: Security coverage
status. If 1st charge (created with RJSC) highest point
Source loan application, bank

The Criteria & their calculation (contd.)

15.

16.

17.

18.

Collateral coverage DD: For registered mortgage

borrower gets highest point Source loan application,
bank
Support (guarantee) DD: For personal guarantee with net
worth borrowers get highest point Source loan
application, bank
Account conduct DD: Whether the borrower has been
maintaining satisfactorily conducted account or not
Source historical and zero for new client
Utilization of limit: For existing client, to what extent
the borrower utilized the approved limit. Source
historical. For new client forecasted

The Criteria & their calculation (contd.)

19. Compliance of covenants DD: Whether borrower
provided all required documents
20. Personal deposits DD: Whether the owner / borrower
has any deposit in personal name Source account of
the director / owner
Let us fill up the CRG score sheet practically

 Step

6: Arrive at the Credit Risk Grading Based on the

total score obtained

Number

RG / Short name

Score

Superior

SUP

Good

GD

Acceptable

ACCPT

75-84

Marginal/Watchlist

MG/WL

65-74

Special Mention

SM

55-64

Sub-standard

SS

45-54

Doubtful

DF

35-44

Bad & Loss

BL

<35

100% cash covered

Government guarantee
International Bank guarantees
85+

Applicability and Process of CRG

Applicable for all exposure except for CF, SE & SAMC
Not applicable for SUP grade
Applicable for both New & Renewal cases
Effectiveness of CRG depends on the Quality of
information
Information on a borrowing should be a) readily
available, b) current, c) dependable
RM will collect information as per prescribed data
collection checklist
RM should also fill up Limit Utilization form

 CRG

to be originated by RM & then it is an ongoing

process
Relationship Manager shall complete the Credit Risk
Grading Score Sheet and shall arrive at a risk grading in
consultation with a Senior Relationship Manager and
document it as per Credit Risk Grading Form
All credit proposals (new or renewal) should accompany
- Data collection check list; Limit Utilization form; CRG
Score Sheet & CRG form
- Credit officer to pass on the approved CRG Form to
Credit Administration Department and Corporate
Banking Unit for MIS record
Any subsequent revision of CRG should be done by
appropriate approving authority of CRG form

Exception of CRG

Head of Credit Risk Management may also

downgrade/classify an account
- in the normal course of inspection of a Branch or
- during the periodic portfolio review.

Recommendation

for upgrading of an account has to be

well justified by the recommending officers.

In

case an account is rated marginal, special mention or

unacceptable credit risk as per the risk grading score
sheet, this may be substantiated and credit risk may be
accepted if
-

the exposure is additionally collateralized through cash

collateral, good tangible collaterals and stron guarantees.

These are exceptions and should be exceptionally

approved by the appropriate approving authority.

Whenever required an independent assessment of the

credit risk grading of an individual account may be
conducted by the Head of Credit Risk Management or
by the Internal Auditor documenting
- as to why the credit deteriorated and
also pointing out the lapses.

32

Review of CRG
CRG should be updated periodically after investment.
Review frequency depends on the Risk Grade as under
Risk Grade

Minimum Frequency

SUP

Annually

GD

Annually

ACCPT

Annually

MG / WL

Half yearly

SM

Quarterly

SS

Quarterly

DF

Quarterly

BL

Quarterly

Concluding Remarks
Credit

Risk Grading is usually performed by using

software
Most of the data is taken from Financial Statements of
the borrower
Risk grading does not imply credit decision
Risk grading and other factors ends up with credit
decision