Theoretical development and previous studies.

CHAPTER 2
Theoretical Development and Previous studies
2.1 Asset Liability ana!ement
2.2 Credit ris".
2.# Credit Ris" ana!ement !uideline o$ %an!ladesh %an".
2.& Previous 'tudies.
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Theoretical development and previous studies.
Theoretical Development and Previous studies (
In this chapter asset/liability management, credit risk, Central Banks credit risk
management (CRM) guidelines and pervius studies are discussed!
2.1 Asset*Liability ana!ement+AL,(
Bankers make decisins every day abut buying and selling securities, "hether t make
particular lans , and h" t #und their investment and lending activities !$hese decisins
are based in part n (1) the ut lk #r interest rates and the ptential directin # change
in #uture interest rates (%) $he cmpsitin # the banks assets and liabilities and (&) the
degree # risk that bank management is "illing t take! Cllectively, these decisin a##ect
the banks net interest incme and balance sheet values! $he prcess # making decisins
abut the cmpsitin # assets and liabilities and cnducting risk assessment is kn"n
as asset/liability management! 'ecisin are usally made by the asset/liability
management cmmittee (()C*), "hich is respnsible #r the #inancial directin # the
bank! $he (lcs gal is t manage the surces and uses # #unds n the balance sheet
and ##+balancesheet activities "ith respect t interest rate risk and li,uidity! ()M is
generally vie"ed as shrt run in nature, #cusing n the day t day and "eek -t+"eek
balance sheet management necessary t achieve near term #inancial gals! $he traditinal
purpse # ()M has been t cntrl the si.e # a banks net interest incme, and is
assciated "ith /taka gap! ()M als cnsiders the e##ects # the changes n the value
# balance sheet items! $his gal is assciated "ith the /duratin gap!
(0raser,1up,2lari,%331)
Banks make lans "ith a variety # maturities and interest rates! *n the ther side # the
balance sheet, banks raise #unds "ith di##erent maturities and interest rates! $here#re net
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Theoretical development and previous studies.
interest incme depends n (1)the interest rates earned n assets and paid #r #unds,(%)the
taka amunt # the varius earning assets and liabilities and (&)the earnings mi4 # thse
#unds(rate 4 taka amunt)! *ther things being e,ual, an increase in the interest rates
earned n assets "ill increase the net interest incme, "hereas an increase in the interest
rate paid n #unding surces "ill reduce net interest incme! (n increase in the taka
amunt # #unds raised and invested (e!g!, by increasing the si.e # the bank) "ill
increase net interest incme! (ls shi#ting the earnings mi4 t"ard higher yielding assets
r less cstly surces # #unds "ill increase net interest incme! Because all the #actrs
invlved d nt remain cnstant, h"ever, changes in net interest incme "ill re#lect
changes in any # these three #actrs! $hese individual issues are nly sme # the
decisins an ()C* must cnsider!
C+rdinated asset/liability management is a relatively recent phenmenn! 0rm the end
# 5rld 5ar II until the early 1673s mst cmmercial banks btained their #unds #rm
relatively stable (and interest #ree) demand depsits and #rm small+time depsits!
Interest rate ceilings n depsits limited the e4tent t "hich banks culd cmpete #r
#unds by paying higher interest rates! *pening mre branches in rder t attract mre
#unds thrugh greater custmer cnvenience r cmmitting mre #unds t the advertising
budget "ere t" # the #e" "ays t attract mre #unds! (s a result, cre depsits(nt
sensitive t interest rates) made up the bulk # #und surces, "hich increased "ith the
gr"th # the natinal and lcal ecnmies! Mrever, the vlatility # interest rates "as
,uite small! In this envirnment, bank #unds management culd cncentrate n the
cntrl # assets! Bank #inancial management principally "as asset management!
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Theoretical development and previous studies.
2.2 Credit Ris"(
Banks primary surce # revenue is interest incme #rm their lan prt#lis and their
primary risk is credit risk! Credit risk can be de#ined as the risk t earnings and capital
that an bligr "ill #ail t meet the terms # any cntract "ith the bank, r ther"ise #ail
t per#rm as agreed! It is usually assciated "ith lans and investments!
Bankers kn" that lending is a risky business ant that sme # the lans "ill nt repaid!
$here#re they set aside a reserve #r e4pected lsses, usually 1+% 8 # ttal lans and
leases! I# the lsses e4ceed the amunt set aside, the e4cess amunt # lsses is deducted
#rm bank capital! I# the lsses are large enugh t eliminate mst # the banks capital,
the bank "ill #ail unless additinal capital is added!(0raser,1up,2lari,%331)
$he amunt # #inancial leverage (bank capital relative t the asset) is imprtant! Banks
rati # capital t assets declined #rm mre than 93 8 in the 1:;3s t less than 13 8 in
the 1663s! ( small capital base puts banks at greater risk # #ailure i# it e4periences large
lsses!
In rder t e4amine the prcess # bank gr"th and #ailure, "e can make #ive simpli#ying
assumptins<
0irst, the stakehlders in a bank include sharehlders, managers, emplyees, custmers,
and the cmmunities they serve! =ach # these stakehlders "ants t ma4imi.e persnal
utility! $hey see higher gr"th # assets, lans and pr#its as means t an end! >imply
stated, everyne "ants the bank t gr" in rder t bene#it their "n psitin!
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Theoretical development and previous studies.
>ecnd, sme bank lans g bad vertime because # #actrs uni,ue t the individual
brr"er! (lternatively, changes in macrecnmic r internatinal cnditins might
adversely a##ect a large number # brr"ers, causing them t de#ault! >uch
macrecnmic and internatinal #actrs include, but are nt limited t, shcks in interest
rates and e4change rates, "idespread asset price de#latin, and glbal cntagin!
$hird, "e assume that sme bank has an e4cess cncentratin # lans t a single grup
# brr"ers! In cuntries "ith develped capital market like the ?nited >tates, nt being
ade,uately diversi#ied is cnsidered pr management! In a develping cuntry "ith
repressed #inancial markets, banks d nt have the same pprtunities t diversi#y their
prt#lis as banks in develped capital market! 0inancial repressin implies that the
gvernment intervenes heavily in the ecnmy and in the #inancial markets! In >uth
2rea ,#r e4ample, natinali.ed banks in the 1673s "ere tld by the gvernment t
make lans t chaebls, large cnglmerate business grups, t #inance gvernment
directed investment pr@ects! $he credit "rthiness # the chaebls "as nt an issue
because the gvernment /encuraged the banks t lend t them!
0urth, the lans are nt backed by cllateral!
0i#th, the lan t value rati is 133 8! $hat is, the banks lend 1338 # the amunt # the
value # the underlying asset!
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Theoretical development and previous studies.
2.# Credit Administration as per Credit Ris" ana!ement !uideline issued by the
Central %an"(
$he credit administratin #unctin is critical in ensuring that prper dcumentatin and
apprvals are in place prir t the disbursement # lan #acilities! 0r this reasn, it is
essential that the #unctins # Credit (dministratin be strictly segregated #rm
relatinship Management/Marketing in rder t avid the pssibility # cntrls being
cmprmised r issues nt being highlighted at the apprpriate level!
Credit (dministratin shuld be in place t ensure the #ll"ing<
2.#.1 Disbursement(
>ecurity dcuments are prepared in accrdance "ith apprval teams and are
legally en#rceable! >tandard lan #acility dcumentatin that has been revie"ed
by legal cunsel shuld used in all cases! =4ceptins shuld be re#erred t legal
cunsel #r advice based n authri.atin #rm an apprpriate e4ecutive in CRM!
'isbursement under lan #acilities are nly be made "hen all security
dcumentatin is in place! CIB reprt shuld re#lect/include the name # all the
)enders "ith #acility, limit and utstanding! (ll #rmalities regarding large lans
and lans t directrs shuld be guided by Bangladesh Bank circulars and related
sectin # Banking cmpanies act! (ll credit apprval terms have been met!
2.#.2 Custodial Duties(
)an disbursements and the preparatin and strage # security dcuments
shuld be centrali.ed in the reginal credit centers!
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Theoretical development and previous studies.
(pprpriate insurance cverage is maintained (and rene"ed n a timely basis) n
assets pledged as cllateral!
>ecurity dcumentatin is held under strict cntrl, pre#erably in lcked #irepr#
strage!
2.#.# Compliance re-uirements(
(ll re,uired Bangladesh Bank returns are submitted in the crrect #rmat in a
timely manner!
Bangladesh Bank circulars/regulatins are maintained centrally, and advised t all
relevant departments t ensure cmpliance!
(ll third party service prviders(valuers,la"yers,insurers,CA(s etc!) are apprved
and per#rmance revie"ed n an annual basis! Banks are re#erred t Bangladesh
Bank circular utlining apprved e4ternal audit #irms that are acceptable!
2.#.& Credit onitorin!(
$ minimi.e credit lsses ,mnitring prcedures and systems shuld be in place that
prvide and early indicatin # the deterirating #inancial health # a brr"er! (t a
minimum, systems shuld be in place t reprt the #ll"ing e4ceptins t relevant
e4ecutives in CRM and RM (Relatinship Manager) team!
Aast due principal r interest payments, past due trade bills, e4cesses, and breach
# lan cvenants!
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)an terms and cnditins are mnitred, #inancial statements are received n a
regular basis and any cvenant breaches r e4ceptins are re#erred t CRM and
the RM team #r timely #ll"+up!
$imely crrective actin is taken t address #indings # any internal, e4ternal r
regulatr inspectin/audit!
(ll brr"er relatinship/lan #acilities are revie"ed and apprved thrugh the
submissin # a Credit applicatin at least annually!
Cmputer system must be able t prduce the abve in#rmatin #r central/head
##ice as "ell as lcal revie" ! 5here autmated systems are nt available , a manual
prcess shuld have the capability t prduce accurate e4ceptin reprts! =4ceptins
shuld be #ll"ed up n and crrective actin taken in a timely manner be#re the
accunt deterirates #urther!
Credit Administration( A case study o$ )irst 'ecurity %an" Ltd.
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Theoretical development and previous studies.
2.& Previous 'tudy(
In a cmprehensive study Ch"dhury (16:B), bserved that C+peratives, i# rightly
rgani.ed and directed can help e4pansin # ur ecnmy! $he recgnitin # the
need #r invlvement # banks in #inancing agriculture thrugh c+peratives in the
early si4ties "as #ll"ed by the mass reali.atin # the signi#icant rle played b the
c+peratives sectr in develpment # Bangladesh agriculture! $he c+perative
"rks as alternative channels # #inancing agriculture since then! >ince the
develpment activities in the pverty stricken and unemplyment hilled agr+based
ecnmy # Bangladesh are cantered arund cnstant struggle against ecnmic
cnstraints the rle # institutinal #inance #r c+perative can hardly be ver+
emphasi.ed! =##rts shuld be made t increase credit #l" t c+perative sectr and
its better administratin t achieve the b@ectives # reducing pverty and
unemplyment and # ensuring scial @ustice!
2halily etal (166;) in a simple yet su##icient detailed mdel sh"n as t h" banks
"uld behave as a pr#it ma4imiser in a liberali.ed envirnment! $hey argued that a
bank might nt prduce a certain kind # lan i#< a) e##ective rate # interest "as
l"er #r that lan than thse # ther types # lanC b) marginal #actr cst #
prducing # that certain kind # a lan "as higher than # ther types # lan!
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Theoretical development and previous studies.
In anther study Rny and 2abir(1666) bserved the prbable lending behavir #
banks i# they actually perate as a pr#it ma4imiser! (s a pr#it ma4imiser the =astern
Banks credit disbursement in the industrial sectr is much higher due t its higher
rate # recvery! It is als bserved that plitical interventin cupled "ith crruptin
is a ma@r #actr behind the accumulatin # a large amunt # classi#ied lan, lans
made t insider parties is a ma@r #actr #r the private banks! $he reasn #r l"
amunt # classi#ied lan can be traced t the "nership structure # a Bank!
In a study D,ue and 2han(%331) bserved that thugh substantial ecnmic
underpinnings cnsistent "ith market ecnmy and liberali.atin have been
"itnessed in Bangladesh but the develpment # e##icient banking system has nt
been attained! It is als bserved that #r the psitive gr"th # the banks
pr#itability, Bank shuld nt pen ne" branch by deplying huge amunt # asset!
Instead, they shuld imprve their #inancial management techni,ues, intrduce
mdern tls and techni,ues t increase pr#itability! It is als bserved that
natinali.ed banks are very much desirable #rm scial pint # vie", at the same
time it can nt be pr#itable like #reign banks r private cmmercial banks that are
guided nly by pr#it mtive! It is bserved that "hen scial cnsideratins supersede
#inancial criteria, banks can hardly avid #inancial lss! 0rtunately this "as nt true
#r ECBs!$heir pr#it is in increasing trend! But the ther type # Banks in
gvernment sectr that is develpment banks have becme crippled! $his is due t
their design! $he /supply leading strategy that is prviding cheap #und "ith the
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Theoretical development and previous studies.
develpment banks creates distrtins in the #inancial market! I# the natinali.ed
banks "ant t survive in this cmpetitive envirnment they must imprve themselves,
"hich "ill ensure cmpetitin amng private and public sectr banks and ultimately,
"ill lead t a balanced and develped banking system!
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