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  1. 1. Credit Risk Management at NBP A thesis Presented to The faculty of Management Sciences Bahria Institute of Management &Computer Sciences, Karachi In Partial Fulfillment Of the Requirement for the Degree Master in Business Administration By SUMAIRA SULTANA TALPUR June 2008
  3. 3. Credit Risk Management At NBP Bahria Institute of management and Computer Sciences ACKNOWLEDGEMENT By the grace of Almighty Allah, The most beneficent and most mercifully, I have finished my report and have been able to present. My special thank is reserved for my advisor Mr Ahsan Rizvi and My Examiner Mr Salman Ahmed Khan Whose guidance and motivation during my research was a stepping stone to the successful completion of the report, they guided me with a lot of encouragement and technical guidance in the preparation of this repot. I would also like to thank various persons from NBP, for their help in providing me valuable material relating to my thesis topic. Without the assistance of these people who were directly or indirectly involved in the successful completion of this project ,it would never have been possible for me to materialize this report successfully.
  4. 4. ABSTRACT Banks today is highly complex organization offering multiple services through various departments, each staffed by specialists in making different kind of financial decisions.Banks today realize that all these management decisions are intimately linked to each other. In a well managed bank all of these management decisions must be coordinated across the whole bank to ensure that they do not clash with each other. For the project I have selected topic “credit risk management” because of my personal interest in doing something in financial sector especially in the banking sector because banks today focus heavily on the managing risk, attempting to control the exposure to loss due to changes in the interest rate the inability or unwillingness of borrowers to repay their loans, changing currency prices and other risk laden factors. But effective management of risk requires careful coordination of decisions made on the asset side of a bank with the decision made on liabilities side. Thus bankers use different techniques of risk management that can be marshaled in a coordinative fashion to handle many risks. In the project NBP was taken to make the focused area of the project clear. During the study the operations and activities to see how the guidelines are implemented and what its impacts are on the performance of the respective bank. In the end of project I found out some important findings for the readers and also have given some recommendation for the bank to improvement and betterment in the business. In the new deregulation and liberal financial initiative is quite obvious that bank will have to be for more creative in responding to the challenges of a dynamic and competitive market place .it will have to develop skills and expertise to strike a balance between the prudent lending and a rapid portfolio which will be crucial in the new environment fund’s management equity, foreign currency and interest rate hedging, venture capital investment and mergers and acquisition technique.
  5. 5. It is highly encouraging to mention that due cognizance is being taken by the regulatory authority that is state bank of Pakistan and the financial institutions to improve the existing scenarios of the banking industry and individual bank, besides it is about time that the National Bank should perform outstanding through taking efficient and effective decisions about their business using different policies, techniques and methods for mitigating the risk and providing the highly derived services to the customers through this it will help the government for improving the performance of financial sector as well as economy of the country. It is real need of economy of our country that each sector understanding their responsibilities and performs well through adopting attractive policies according to the needs of time
  6. 6. TABLE OF CONTENTS S.NO CONTENTS P.NO 1 1.1.1 1.1.2 1.2 1.2.1 1.3 1.3.1 1.3.2 1.3.3 1.3.4 1.3.5 1.3.6 1.3.7 1.3.8 1.4 1.5 1.6 1.7 1.8 2.1 2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.2 2.3 2.3.1 2.3.2 2.4 2.5 CHAPTER NO # 1 Introduction…………………………………………… What is a bank………………………………………... History of NBP……………………………………….. What is risk…………………………………………… Risk faced by financial institutions…………………… What is risk Management……………………….......... Risk Management.............…………………………….. Board and Senior Management oversight……………... Risk Management Frame work Integration of Risk Management................................. Business line accountability.......................................... Risk Evaluation........................................................... Independent Review....................................................... Contingency Planning................................................. Statement of Problem.................................................. Significance of the study................................................ Scope........................................................................... Delimitations................................................................. Definition......................................................................... CHAPTER NO # 2 Research Design……………………………………….. Methodology…………………………………………... Investigation…………………………………………… Study Setting…………………………………………... Unit Analysis………………………………………….. Time Horizon………………………………………….. Respondents of the study……………………………… Research instruments………………………………….. Primary data collection……………………………….. Secondary data collection……………………………... Treatment of Data …………………………………….. Presentation Analysis………………………………….. 1 1 1-4 4-5 5-7 7-8 8-9 10 10-11 11 11 11-12 12 12-13 13 13 14 14 14-15 16 16 16 16 17 17 17 17 17 18 18 18
  7. 7. 3.1.1 3.1.2 3.1.3 3.2 3.3 3.4 3.5 3.6 4.1 4.2 5.1 5.2 5.3 CHAPTER NO # 3 Literature review........................................................... 5 C of credit worthiness................................................. Managing credit Risk...................................................... Components of credit Risk management....................... Board & senior management oversight.......................... Organizational Structure……………………………….. System and Procedures………………………………… Measuring Credit Risk................................................... Internal Risk Rating....................................................... Credit Risk Monitoring and Control............................... Risk Review…………………………………................ Delegation of authority………………………………… Benefit of managing Risk............................................... Local literature................................................................ Foreign literature............................................................. Gap to be a bridged by the study..................................... Areas of further Study................................................... CHAPTER NO # 4 Quantitative analysis of credit Risk Management at NBP............................................................................. Qualitative Analysis of Credit Risk Management At NBP................................................................................ CHAPTER NO # 5 Findings......................................................................... Conclusion..................................................................... Recommandation............................................................ APPENDEIX Questionnaire.................................................................. Bibliography..................................................................... 19 20-21 22 22 23 23 24-26 26 26-27 27-28 28 28 29 30-34 34 35-36 36 37-49 50-54 55-56 56-557 58
  8. 8. CHAPTER NO.1 Background of the Topic and Statement of the Problem Introduction Statement of problem Significance of the study Scope Delimitation Definitions
  9. 9. CHAPTER NO. 2 Research method and procedure Research design Respondent of the study Research instruments Treatment of the data Presentation analysis
  10. 10. CHAPTER NO.3 Review The Literature & Studies Local Literature Foreign Literature Gap To Be Abridge By This Study Areas For Further Studies
  11. 11. CHAPTER NO.4 Presentation Analysis Quantitative Analysis Qualitative Analysis
  12. 12. CHAPTER NO.5 Conclusion & Recommendations Findings Conclusion Recommendations
  13. 13. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 1 1.1 Introduction 1.1.1 What is a Bank? A bank is an institution which deals in money.broadley speaking, banks draw surplus money from the people who are not using it at the time, and lend to those who are in a position to use it for productive purposes. Modern banks have developed from very small beginings.the earlier bankers were gold-smiths. Crowther observe that “the present day banker has three ancestors: merchant, money lender and goldsmith. A modern bank is something of each of these. It is said money has two properties. It is flat so that it can be piled up, and it is round so that it can circulate. 1.1.2 History of NBP National Bank of Pakistan (the Bank) was established on November 9, 1949 under the National Bank of Pakistan Ordinance, 1949 in order to cope with the crisis conditions Which were developed after trade deadlock with India and devaluation of Indian Rupee in 1949. Initially the Bank was established with the objective to extend credit to the Agriculture sector. The normal procedure of establishing a banking company under the Companies Law was set aside and the Bank was established through the promulgation of An Ordinance due to the crisis situation that had developed with regard to financing of jute Trade. The Bank commenced its operations from November 20, 1949 at six important jute Centers in the then East Pakistan and directed its resources in financing of jute crop. The Bank’s Karachi and Lahore offices were subsequently opened in December 1949. The nature of responsibilities of the Bank is different and unique from other Banks/financial institutions. The Bank acts as the agent to the State Bank of Pakistan for Handling Provincial/Federal Government Receipts and Payments on their behalf. The Bank has also played an important role in financing the country’s growing trade, which has expanded through the years as diversification took place. Today the
  14. 14. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 2 Bank Finances import/export business to the tune of Rs. 52.7 billion, whereas in 1960 financing under this head was only Rs. 1.54 billion
  15. 15. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 2 Objects and Activities The Bank is providing all banking services of mercantile and commercial banking Permissible in the country, which include • Handling of treasury transactions for the Government of Pakistan as agent to the State Bank of Pakistan. • Providing services under a Trust Deed as Trustee to the National Investment Trust (NIT) including safe custody of securities on behalf of NIT. • Accepting of deposits of money on current, fixed, saving, term deposit and profit and Loss Sharing accounts. • Borrowing money and arranging finance from other banks. • Advancing and lending money to its clients. • Financing of projects, including technical assistance, project appraisal through Long- term / Short-term loans, term finance and Musharika certificates, etc. • Buying, selling, dealing, including entering into forward contracts of foreign exchange. • Financing of seasonal crops like cotton, wheat, rice, sugar cane, tobacco, etc. • Receiving of bonds, scraps, valuables, etc. for safe custody. • Carrying on agency business of any description other than managing agent, on behalf of clients including Government and local authorities. • Generating, undertaking, promoting, etc. of issue of shares and, bonds, etc. • Transacting guarantee and indemnity business. • Undertaking and executing trusts. • Joint venturing with foreign dealers, agents and companies for its representation Abroad. • Participating in "World Bank" and "Asian Development Bank's" lines of credit • . Providing personalized Hajj services to intending Hajjis.
  16. 16. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 3 Branch Network Presently the Bank is divided into 10 Groups headed by SEVPs/EVPs. Its field operations are controlled by 9 Regions reporting to as many Regional Chiefs, who control 40 Zones and 15 Single Branch Zones headed by Zonal Chiefs; 12 corporate branches and 1,395 domestic branches headed by Branch Managers. With the geographical development of its branches, the Bank has been able to extend its services to a much larger number of Pakistanis all over the country. Today it has more than 8.5 million accounts. Bank maintains its presence in all the major financial centers of the world through its 23 overseas branches and 5 representative offices. Of these, three Representative offices have recently been set up at Tashkent (Uzbekistan), Baku (Azerbaijan) and Almighty (Kazakhstan) to take advantage of the emerging opportunities in CIS countries. Bank’s role globally is well assisted by its network of correspondent banks Located strategically in Asia, America, Europe and Africa. Apart from having a vast branch network, Bank is at the forefront in the acquisition and Application of new technologies in every aspect of its banking facilities. It has acquired leased telephone lines for on-line banking. The Bank has 12 Regional Computer Centers To cover various on-line and batch system requirements of branches and controlling offices. Bank has also a presence on the Internet. It has modernized its services by installing Automated Teller Machines (ATMs) called "CASH LINK" at selected branches and presently 17 ATMs are operational in major cities. NBP Vision NBP vision and customer trust have made it one of the most profitable banks in the world. A universals banking franchise offering a complete range of financial solutions. NBP are the largest and strongest financial institution in Pakistan with a presence in 18 countries across the global. To be the pre-eminent financial institution in Pakistan and achieve market recognition both in the quality and delivery of service as well as the range of product offering.
  17. 17. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 4 NNBBPP MMiissssiioonn To be recognized in the market place by Institutionalizing a merit & performance culture, Creating a powerful & distinctive brand identity, Achieving top-tier financial performance, and Adopting & living out our core values. 1.2 What is risk? Risk arises when there is a possibility of more than one outcome and the ultimate outcome is unknown. Risk can be defined as the variability or volatility of unexpected outcomes. It is usually measured by the standard deviation of historic outcomes. Though all businesses face uncertainty, financial institutions face some special kinds of risks given their nature of activities. The objective of financial institutions is to maximize profit and shareholder value-added by providing different financial services mainly by managing risks. There are different ways in which risks are classified. One way is to distinguish between business risk and financial risks. Business risk Business risk arises from the nature of a firm’s business. It relates to factors affecting the product market. Financial Risk Financial risk arises from possible losses in financial markets due to movements in financial variables .It is usually associated with leverage with the risk that obligations and liabilities cannot be met with current assets. .
  18. 18. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 5 Another way of decomposing risk is between systematic and unsystematic components. Systematic risk Systematic risk is associated with the overall market or the economy. The systematic risk is non diversifiable. Parts of systematic risk, however, can be reduced through the risk mitigation and transferring techniques. Un systematic risk Unsystematic risk is linked to a specific asset of firm. While the asset-specific unsystematic risk can be mitigated in a large diversified portfolio. 1.2.1 RISKS FACED BY FINANCIAL INSTITUTIONS The risks that banks face can be divided into financial and non-financial ones. Financial risk can be further partitioned into market risk and credit risk. Non-financial risks, among others, include operational risk, regulatory risk, and legal risk.. Market Risk Market risk is the risk originating in instruments and assets traded in well-defined markets. Market risks can result from macro and micro sources. Systematic market risk result from overall movement of prices and policies in the economy. The unsystematic market risk arises when the price of the specific asset or instrument changes due to events linked to the instrument or asset. Volatility of prices in various markets gives different kinds of market risks. Thus market risk can be classified as equity price risk, interest rate risk, currency risk, and commodity price risk. As a result, market risk can occur in both banking and trading books of banks Interest Rate Risk Interest Rate Risk is the exposure of a bank’s financial condition to movements in interest rates. Interest rate risk can arise from different sources. Reprising risk arises due to timing differences in the maturity and reprising of Assets, liabilities and off-balance sheet
  19. 19. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 6 items. Even With similar reprising characteristics, basis risk may arise if the adjustment of rates on assets and liabilities are not perfectly correlated. Yield curve risk is the uncertainty in income due to changes in the yield curve. Finally instruments with call and put options can introduce additional Risks. Credit Risk Credit Risk is the risk that counterparty will fail to meet its obligations timely and fully in accordance with the agreed terms. This risk can occur in the banking and trading books of the bank. In the banking book, loan credit risk Arises when counterparty fails to meet its loan obligations fully in the stipulated Time. This risk is associated with the quality of assets and the Probability of default. Due to this risk, there is uncertainty of net-income and market value of equity arising from non-payment and delayed payment of principal and interest. Similarly, trading book credit risk arises due to a borrower’s inability or unwillingness to discharge contractual obligations in trading contracts. This can result in settlement risk when one party to a deal pays money or delivers assets before receiving its own assets or cash, thereby, exposing it to potential loss. Settlement risk in financial institutions particularly arises in foreign-exchange transactions. While a part of the credit risk is diversifiable, it cannot be eliminated completely. Liquidity Risk Liquidity Risk arises due to insufficient liquidity for normal operating requirements reducing the ability of banks to meet its liabilities when it falls due. This risk may result from either difficulties in obtaining cash at reasonable cost from borrowings (funding or financing liquidity risk) or sale of assets (asset liquidity risk). One aspect of asset-liability management in the banking business is to minimize the liquidity risk. While funding risk can be controlled by proper planning of cash-flow needs and seeking newer sources of funds to finance cash shortfalls, the asset. Liquidity risk can be mitigated by diversification of assets and setting limits of certain illiquid products.
  20. 20. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 7 Operational Risk Operational Risk is not a well-defined concept and may arise from human and technical Errors or accidents. It is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events. While people risk may arise due to incompetence and fraud, technology risk may result from telecommunications system and program failure. Process risk may occur due to various reasons including errors in model Specifications, inaccurate transaction execution, and violating operational control limits. Due to problems arising from inaccurate processing, record keeping, system failures, compliance with regulations, etc., there is a possibility that operating costs might be different from what is expected affecting the net income adversely. Legal Risk Legal Risks relate to risks of unenforceability of financial contracts. This relates to statutes, Legislation and regulations that affect the fulfillment of contracts and transactions. This risk can be external in nature (like regulations affecting certain kind of business activities) or internal related to bank’s management or employees (like fraud, violations of laws and regulations, etc.). Legal risks can be considered as a part of operational risk, Regulatory risk arises from changes in regulatory framework of the country. 1.3 What Is Risk Management Introduction The growth in the volume and complexity of financial markets, specially derivatives markets, and banking sector over the past few years, risk in banking industry arising from ill-conceived derivatives transaction, have increased concern over the risk measuring and managing by derivatives and other complex instruments into the global marketplace. At individual firm’s level. This poses an increasing threat to their ability to keep control over their exposure to risk in a diverse environment. At an aggregate level, there have been
  21. 21. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 8 some fears that default by one firm could spread out to others in the same country or even cross-borders, and become a financial crisis of huge proportions. This is a major concern not only for regulators, but also for markets participants’ altogether. In this context, risk management has become an essential part of firm and regulators activities. A risk management system is a valuable instrument for assessing the exposure to risk that participants in the financial sector in general are subject to. using such system, managers can measure risk across markets in terms of their potential impact on profit and loss, quantify capital allocation to market and dealers, establish meaningful risk limits and supervision performance. Risk system also provides a measure of the amount of capital necessary to provide a cushion against potential future losses, a vital element for the both managers and regulators. The financial marketplace strength, as a whole, ultimately depends upon individual firm’s ability to cover unexpected losses with capital reserves. Even firms using the best risk management system are statistically subject to losses, and then a proper capital cushion is essential. Not surprisingly, setting capital adequacy standards is at the core of regulators responsibilities, together with efficient surveillance and supervision of market participants. 1.3.1 Risk Management Risk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. It involves identification, Measurement, monitoring and controlling risks ensuring that: • The individuals who take or manage risks clearly understand it. • The organization’s Risk exposure is within the limits established by Board of Directors. • Risk taking Decisions are in line with the business strategy and objectives Set by BOD. • The expected payoffs compensate for the risks taken • Risk taking decisions are explicit and clear.
  22. 22. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 9 • Sufficient capital as a buffer is available to take risk In every financial institution, risk management activities broadly take place simultaneously at following different hierarchy levels. a) Strategic level It encompasses risk management functions performed by senior [management and BOD. For instance definition of risks, ascertaining institutions risk appetite, formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken. b) Macro Level It encompasses risk management within a business area or across business lines. Generally the risk management activities performed by middle management or units devoted to risk reviews fall into this category. c) Micro Level It involves ‘On-the-line’ risk management where risks are actually created. This is the risk management activities performed by individuals who take risk on organization’s behalf such as front office and loan origination functions. The risk management in those areas is confined to following operational procedures and guidelines set by management. Expanding business arenas, deregulation and globalization of financial activities emergence of new financial products and increased level of competition has necessitated a need for an effective and structured risk management in financial institutions. A bank’s ability to measure, monitor, and steer risks comprehensively is becoming a decisive parameter for its strategic positioning. The risk management framework and sophistication of the process, and internal controls, used to manage risks, depends on the nature, size and complexity of institutions activities. Nevertheless, there are some basic principles that apply to all financial institutions irrespective of their size and complexity
  23. 23. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 10 of business and are reflective of the strength of an individual bank's risk management practices. 1.3.2 Board and senior Management oversight To be effective, the concern and tone for risk management must start at the top. While the overall responsibility of risk management rests with the BOD, it is the duty of senior management to transform strategic direction set by board in the shape of policies and procedures and to institute an effective hierarchy to execute and implement those policies. To ensure that the policies are consistent with the risk tolerances of shareholders the same should be approved from board. 1.3.3 Risk Management Framework A risk management framework encompasses the scope of risks to be managed, the process/systems and procedures to manage risk and the roles and responsibilities of individuals involved in risk management. The framework should be comprehensive enough to capture all risks a bank is exposed to and have flexibility to accommodate any change in business activities. An effective risk management framework includes • Clearly defined risk management policies and procedures covering risk identification, acceptance, measurement, monitoring, reporting and control. • A well constituted organizational structure defining clearly roles and responsibilities of individuals involved in risk taking as well as managing it. Banks, in addition to risk management functions for various risk categories may institute a setup that supervises overall risk management at the bank. Such a setup could be in the form of a separate department or bank’s Risk Management Committee (RMC) could perform such function*. The structure should be such that ensures effective monitoring and control over risks being taken. The individuals responsible for review function (Risk review, internal audit, compliance etc) should be independent from risk taking units and report directly to board or senior management who are also not involved in risk taking
  24. 24. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 11 • There should be an effective management information system that ensures flow of information from operational level to top management and a system to address any exceptions observed. There should be an explicit procedure regarding measures to be taken to address such deviations. • The framework should have a mechanism to ensure an ongoing review of systems, policies and procedures for risk management and procedure to adopt changes. 1.3.4 Integration of Risk Management Risks must not be viewed and assessed in isolation, not only because a single transaction might have a number of risks but also one type of risk can trigger other risks. Since interaction of various risks could result in diminution or increase in risk, the risk management process should recognize and reflect risk interactions in all business activities as appropriate. While assessing and managing risk the management should have an overall view of risks the institution is exposed to. This requires having a structure in place to look at risk interrelationships across the organization. 1.3.5 Business Line Accountability In every banking organization there are people who are dedicated to risk management activities, such as risk review, internal audit etc. It must not be construed that risk management is something to be performed by a few individuals or a department. Business lines are equally responsible for the risks they are taking. Because line personnel, more than anyone else, understand the risks of the business, such a lack of accountability can lead to problems. 1.3.6 Risk Evaluation/Measurement Until and unless risks are not assessed and measured it will not be possible to control risks. Further a true assessment of risk gives management a clear view of institution’s standing and helps in deciding future action plan. To adequately capture institutions risk exposure, risk measurement should represent aggregate exposure of institution both risk
  25. 25. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 12 type and business line and encompass short run as well as long run impact on institution. To the maximum possible extent institutions should establish systems / models that quantify their risk profile, however, in some risk categories such as operational risk, quantification is quite difficult and complex. Wherever it is not possible to quantify risks, qualitative measures should be adopted to capture those risks. Whilst quantitative measurement systems support effective decision-making, better measurement does not obviate the need for well-informed, qualitative judgment. Consequently the importance of staff having relevant knowledge and expertise cannot be undermined. Finally any risk measurement framework, especially those which employ quantitative techniques/model, is only as good as its underlying assumptions, the rigor and robustness of its analytical methodologies, the controls surrounding data inputs and its appropriate application 1.3.7 Independent Review One of the most important aspects in risk management philosophy is to make sure that those who take or accept risk on behalf of the institution are not the ones who measure, monitor and evaluate the risks. Again the managerial structure and hierarchy of risk review function may vary across banks depending upon their size and nature of the business, the key is independence. To be effective the review functions should have sufficient authority, expertise and corporate stature so that the identification and reporting of their findings could be accomplished without any hindrance. The findings of their reviews should be reported to business units, Senior Management and, where appropriate, the Board. 1.3.8 Contingency Planning Institutions should have a mechanism to identify stress situations ahead of time and plans to deal with such unusual situations in a timely and effective manner. Stress situations to which this principle applies include all risks of all types. For instance contingency planning activities include disaster recovery planning, public relations damage control, litigation strategy, responding to regulatory criticism etc. Contingency plans should be reviewed regularly to ensure they encompass reasonably probable events that could
  26. 26. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 13 impact the organization. Plans should be tested as to the appropriateness of responses, escalation and communication channels and the impact on other parts of the institution. 1.4 Statement of Problem This research is conducted in order to highlight the “Credit Risk Management At NBP”. 1.5 Significance of the Study This research study would be significant to individual as well organization. National bank of Pakistan This thesis would help the individuals who are engaged in the national bank activities as it include all the policy measures suggested by me for the NBP bank to manage its credit risk and the way through which it can enhance the quality of thesis asset which in turn would improve its financial activities well being. Risk Management Professionals This research is also significant to financial risk management professional they would have an appreciation of the risk management policies of Pakistan or positive criticism for the improvement. Students This research work will also help students to enhance their knowledge about the risk management and corresponding policies of Pakistan
  27. 27. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 14 1.6 Scope • Due to timing constraints only one local bank NBP from whole financial sector is selected as a sample for analyzing the credit risk management. • This study will be conducted in urban areas of Karachi only. 1.7 Delimitation • Regulation and guide lines regarding credit risk management might change in future. • Changes in economic condition may prove to be a hurdle in application of these policies. • Political unstablitiy also my proved to be a hurdle in application of these policies. 1.8 Definitions ATM: Automated Teller Machines ADP: Asian Development Bank Bank: Lending and borrowing of money called bank. Creditor: One to whom money is owned. Cross-sectional: It means data will be collected once over a period of time Credit risk: The risk of loss through non-Payment or late payment of money owed Export: Things that are sale to other countries Foreign exchange: Foreign exchange is the relative price of currencies, as determined by market supply and demand.
  28. 28. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 15 Forward contract: future contract of buying /selling of currency for 90,180.etc days Import: Things that are buying from other countries Indemnity: A Compensation for loss Money lender: A person who give money to borrower. NBP: National Bank of Pakistan NIT: National Investment Trust Non-contrived: Natural environment/reality Ordinance: Here ordinance means law related to banks Risk: The variability or volatility of unexpected outcomes SBP: State Bank of Pakistan. Safe custody: Security of assets TFCs : Term finance certificates IRAF: Institute of risk assessment framework DFI: Direct foreign investment SME: Small medium enterprise SME means an entity, ideally not a public limited company, which does not employ more than 250 persons (if is manufacturing concern and 50 person (if it is traded service concern
  29. 29. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 16 2.1 Research design 2.1.1 Methodology “Descriptive study will be under taken” The reason being for the selection of this method is due to the nature of the data required considerable amount of secondary data is available regarding policies and guidelines Issued for credit risk management on websites, magazines, books, and news papers. Primary data will be collected in order to make certain areas under consideration more clear. 2.1.2 Investigation “Causal investigation will be conducted” Type of investigation conducted is causal. 2.1.3 Study setting “Field study is non-contrived setting” The research will be conducted in natural environment with no interference from the research.
  30. 30. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 17 2.1.4 Unit analysis National bank of Pakistan is related unit of analysis for the purpose of conducting the thesis. 2.1.5 Time horizon “Cross sectional” Time horizon is cross-sectional as data will be collected once over a period of 4 months. 2.2 Respondents of the study My immediate respondents will be personal of the NBP. 2.3 Research instruments 2.3.1 Primary date collection Structured questionnaire, face to face interviews and telephonic interviews will be conducted from the NBP personal
  31. 31. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 18 2.3.2 Secondary data collection 1. NBP website 2. Internet sources 3. Books 4. News papers 5. Magazines 2.4 Treatment of Data The primary data collected during primary collection phase would only be Analyzed in verbal context. 2.5 Presentation of analysis Presentation of the facts will be partially in quantitative form and partially in qualitative form. The quantitative form will consist of graph, charts tables whereas the qualitative part of the presentation will have articles. Interviews, details and explanations pertaining to the quantitative part of the presentation.
  32. 32. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 19 3.1 Literature Review Credit Risk Credit risk arises from the potential that an obligor is either unwilling to perform on an obligation or its ability to perform such obligation is impaired resulting in economic loss to the bank, Since the majority of bank’s earning assets are in the form of loan ,credit risk that is faced by the banks. When borrowers do not pay the interest on their loans or they do not repay their loans banks encounter financial difficulties. With the majority of a bank’s assets in the form of loans, the lending function plays a critical role in bank risk management the objective of the lending function is simple create value for the bank. The primary danger in granting credit is the chance that the borrower will not repay the loan on a timely basis. Thereby destroying value. Proper and prudent manager of credit risk is the way to create value in the lending function. Credit risk emanates from a banks dealing with individuals, corporate financial institutions or a sovereign. Credit risk arises from the poor loan quality and the problems with loan quality have been the major cause of bank failure symptoms of poor loan quality include high levels of non performing Loan’s, loan losses and examines. Classified loans (i.e.) standard, doubtful and loss. A high proportion of loans relative to total assets and rapid growth of loan portfolio are potential early warming signals of loan quality problems. This may indicate potential failures. In contrast high performance banks. tend to have high quality loan portfolio and characterized by low levels of non performing loan and loan losses.
  33. 33. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 20 3.1.2 5C’s of Credit worthiness 1. Character 2. Capacity 3. Capital 4. Condition 5. Collateral Character The business character of a borrower rests on such traits as honor, trustworthiness and commitment. The only good customers are the basically honors ones. The first of C’s is always character. In the final analysis, it is ultimately the character that determines the credit worthiness of borrower. How a borrower would respond to a real emergency when all the other C’s have turned bad is the real test of the character of the borrower this is also the most difficult of credit analysis, as it is predominantly judgmental. It is therefore, necessary to probe in to the most important of C’s into greater depth. A good borrower is expected to maintain a code of conduct relates to the use of funds by the borrower for the purpose for which they were lent. Capacity The capacity to honor commitments depends upon the ability of the business to generate cash flows. Cash flows are often equated with profit after tax, plus depreciation and all other non-cash expenditure but all the profit may not be available in cash, because a part of it is blocked in current is not by profit that one can pay bills or repay loans, but only by cash. A company may have a level of profit but at the same turn it may technically be insolvent, because it may not have enough cash to meet its obligations.
  34. 34. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 21 Capital Capital is the net worth of a business and provides that important cushion to with stand shocks coming from adverse changes in external (economics, financial, legal etc) and internal (strikes, lockout, breakdown etc) environment of the business, equity or net worth is therefore defined as risk capital whose operational purpose is to absorb environmental shocks, and financial purpose is to insulate the outside liability holders form the impact of there shocks. Condition As the banker is in the business of dealing with businesses, he should be aware and alert to the changing economic and financial environment in which his borrowers operate. Almost every industry suffers from cyclical fluctuations, price fluctuations, obsolescence, and competitive structure. Collaterals The best security of a lender is the thriving business on which the appraisal should focus. Whenever a bank is required to for close .the collaterals, it demonstrates that the lending decision in the first place was unsound, the demand for collateral as a condition for a loan is a sufficient indication that the borrower lacks the required level of credit worthiness. In fact collaterals. ether as third party guarantees or a real estate mortgage or a pledge of other financial or non-financial assets are meant to enhance the credit worthiness of the principal borrower .this is being increasingly used in credit securitization. The test of good collateral lies in its shift ability which, in other words means salability of assets. The higher the shift ability is, the better the collaterals.
  35. 35. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 22 3.1.3 Managing credit risk In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively losses may result from reduction in portfolio value due to actual or perceived deterioration in credit quality. Credit risk emanates from a bank’s dealing with individuals, corporate, financial institutions or a sovereign. For most banks, loans are the largest and most obvious source of credit risk; however, credit risk could stem from activities both on and off balance sheet. In addition to direct accounting loss, credit risk should be viewed in the context of economic exposures. This encompasses opportunity costs, transaction costs and expenses associated with a non-performing asset over and above the accounting loss Credit risk can be further sub-categorized on the basis of reasons of default. For instance the default could be due to country in which there is exposure or problems in settlement of a transaction. Credit risk not necessarily occurs in isolation. The same source that endangers credit risk for the institution may also expose it to other risk. For instance a bad portfolio may attract liquidity problem. Components of credit risk management A typical Credit risk management framework in a financial institution may be broadly categorized into following main components. • Board and senior Management’s Oversight • Organizational structure • Systems and procedures for identification, acceptance, measurement, Monitoring and control risks.
  36. 36. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 23 Board and Senior Management’s Oversight It is the overall responsibility of bank’s Board to approve bank’s credit risk strategy and significant policies relating to credit risk and its management which should be based on the bank’s overall business strategy. To keep it current, the overall strategy has to be reviewed by the board, preferably annually. The responsibilities of the Board with regard to credit risk management shall, interalia, include: • Delineate bank’s overall risk tolerance in relation to credit risk • Ensure that bank’s overall credit risk exposure is maintained at prudent Levels and consistent with the available capital • Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function • Ensure that the bank implements sound fundamental principles that facilitate the Identification, measurement, monitoring and control of credit risk. • Ensure that appropriate plans and procedures for credit risk management are in place. Organizational Structure To maintain bank’s overall credit risk exposure within the parameters set by the board of directors, the importance of a sound risk management structure is second to none. While the banks may choose different structures, it is important that such structure should be commensurate with institution’s size, complexity and diversification of its activities. It must facilitate effective management oversight and proper execution of credit risk management and control processes.
  37. 37. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 24 Systems and Procedures Credit Origination Banks must operate within a sound and well-defined criteria for new credits as well as the expansion of existing credits. Credits should be extended within the target markets and lending strategy of the institution. Before allowing a credit facility, the bank must make an assessment of risk profile of the customer/transaction. This may include • Credit assessment of the borrower’s industry, and macro economic factors. • The purpose of credit and source of repayment • The track record / repayment history of borrower. • Assess/evaluate the repayment capacity of the borrower. • The Proposed terms and conditions and covenants. • Adequacy and enforceability of collaterals. • Approval from appropriate authority Limit setting An important element of credit risk management is to establish exposure limits for single obligors and group of connected obligors. Institutions are expected to develop their own limit structure while remaining within the exposure limits set by State Bank of Pakistan. The size of the limits should be set on the credit strength of the obligor, genuine requirement of credit, economic conditions and the institution’s risk tolerance. Appropriate limits should be set for respective products and activities. Institutions may establish limits for a specific industry, economic sector or geographic regions to avoid concentration risk.
  38. 38. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 25 Credit Administration Ongoing administration of the credit portfolio is an essential part of the credit process. Credit administration function is basically a back office activity that support and control extension and maintenance of credit. A typical credit administration unit performs following functions: a. Documentation It is the responsibility of credit administration to ensure completeness of documentation (loan agreements, guarantees, transfer of title of collaterals etc) in accordance with approved terms and conditions. Outstanding documents should be tracked and followed up to ensure execution and receipt b. Credit Disbursement The credit administration function should ensure that the loan application has proper Approval before entering facility limits into computer systems. Disbursement should Be affected only after completion of covenants, and receipt of collateral holdings. In case of exceptions necessary approval should be obtained from competent authorities. c. Credit monitoring After the loan is approved and draw down allowed, the loan should be continuously Watched over. These include keeping track of borrowers’ compliance with credit terms, identifying early signs of irregularity, conducting periodic valuation of Collateral and monitoring timely repayments. d. Loan Repayment The obligors should be communicated ahead of time as and when the principal/markup installment becomes due. Any exceptions such as non-payment or late payment should be tagged and communicated to the management. Proper records and updates should
  39. 39. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 26 also be made after receipt. e. Maintenance of Credit Files Institutions should devise procedural guidelines and standards for maintenance of credit files. The credit files not only include all correspondence with the borrower but should also contain sufficient information necessary to assess financial health of the borrower and its repayment performance. It need not mention that information should be filed in organized way so that external / internal auditors or SBP inspector could review it easily. f. Collateral and Security Documents Institutions should ensure that all security documents are kept in a fireproof safe under dual control. Registers for documents should be maintained to keep track of their movement. Procedures should also be established to track and review relevant insurance coverage for certain facilities/collateral. Physical checks on security documents should be conducted on a regular basis. Measuring credit risk. The measurement of credit risk is of vital importance in credit risk management. A number of qualitative and quantitative techniques to measure risk inherent in credit portfolio are evolving. To start with, banks should establish a credit risk rating framework across all type of credit activities. Internal Risk Rating Credit risk rating is summary indicator of a bank’s individual credit exposure. An internal rating system categorizes all credits into various classes on the basis of underlying credit quality. A well-structured credit rating framework is an important tool for monitoring and controlling risk inherent in individual credits as well as in credit portfolios of a bank or a business line. The importance of internal credit rating framework becomes more eminent due to the fact that historically major losses to banks stemmed from default in loan portfolios. While a number of banks already have a system for rating
  40. 40. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 27 individual credits in addition to the risk categories prescribed by SBP, all banks are encouraged to devise an internal rating framework. An internal rating framework would facilitate banks in a number of ways such as • Credit selection • Amount of exposure • Tenure and price of facility • Frequency or intensity of monitoring • Analysis of migration of deteriorating credits and more accurate • Computation of future loan loss provision • Deciding the level of Approving authority of loan. . Credit Risk Monitoring & Control Credit risk monitoring refers to incessant monitoring of individual credits inclusive of Off-Balance sheet exposures to obligors as well as overall credit portfolio of the bank. Banks need to enunciate a system that enables them to monitor quality of the credit portfolio on day-to-day basis and take remedial measures as and when any deterioration occurs. Such a system would enable a bank to ascertain whether loans are being serviced as per facility terms, the adequacy of provisions, the overall risk profile is within limits established by management and compliance of regulatory limits. Establishing an efficient and effective credit monitoring system would help senior management to monitor the overall quality of the total credit portfolio and its trends. Consequently the management could fine tune or reassess its credit strategy /policy accordingly before encountering any major setback. The banks credit policy should explicitly provide procedural guideline relating to credit risk monitoring. At the minimum it should lay down procedure relating to • The roles and responsibilities of individuals responsible for credit risk monitoring
  41. 41. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 28 • The assessment procedures and analysis techniques (for individual loans & overall portfolio) • The frequency of monitoring • The periodic examination of collaterals and loan covenants • The frequency of site visits • The identification of any deterioration in any loan Risk review The institutions must establish a mechanism of independent, ongoing assessment of credit risk management process. All facilities except those managed on a portfolio basis should be subjected to individual risk review at least once in a year. The results of such review should be properly documented and reported directly to board, or its sub committee or senior management without lending authority. The purpose of such reviews is to assess the credit administration process, the accuracy of credit rating and overall quality of loan portfolio independent of relationship with the obligor. Delegation of Authority Banks are required to establish responsibility for credit sanctions and delegate authority to approve credits or changes in credit terms. It is the responsibility of banks board to approve the overall lending authority structure, and explicitly delegate credit sanctioning authority to senior management and the credit committee. Lending authority assigned to officers should be commensurate with the experience, ability and personal character. It would be better if institutions develop risk-based authority structure where lending power is tied to the risk ratings of the obligor.
  42. 42. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 29 3.2 Benefits of managing risk The new risk measurement and management techniques are associated with, and in some cases are driving, a number of important changes in financial systems, including • A better appreciation of the types of risk to be considered and of the relationships among them • Better understanding of the drivers and dynamics of each type of risk and of how to model and manage risk. • New instruments and markets that support risk transformation and risk shifting such as securitization and derivative products. • Changes in the industrial organization of financial system: 1. Larger financial institutions can be more efficiently managed, adding impetus to trends toward greater concentration. 2. New kinds of institutions, such as hedge funds and boutique securitization sponsors. 3. A blurring of traditional classifications of types of institutions by type of risk borne, aided by new instruments and by entry into each others markets. • Greater attention to legal, accounting, regulatory and other “financial infrastructure”. • The new techniques flourish in environments that support good data and enforceable contracts. • Changes in the nature and incidence of systematic risk. • Changes in the appropriate structure of regulatory and central bank policy.
  43. 43. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 30 3.3 Local Literature Evolution of banking supervision The first prudential regulation regarding the corporate/commercial banks was issued in 1992.Since then there have been amendments in these regulations. In 1997 the amendment in banking law has given autonomy to SBP in the area of banking supervision. In 2003 SBP has also issued risk management guidelines covering the guidelines for all the risk that a banking industry can encounter. After 1997 SBP has been playing a major role in managers, supervising and controlling the activities of banks. After the privatization of the major bank in Pakistan and with the introduction of corporate governance in the banking sector the banks themselves have also formulated their own credit policies to ensure the better management of credit, keeping in view the risk management guidelines, prudential regulations credit risk management guidelines 2003 and other circulars issued by SBP from time to time regarding the lending function. Prudential Regulations The prudential regulations for corporate and commercial banks include a separate section for the risk management which includes the regulations regarding the management of credit risk. These regulations include: 1. Limit on exposure (fund based/non Fund based)to a single person 2. Limit on exposure (fund based/Non-fund based) to any group. 3. Limit on exposure against contingent liabilities. 4. Minimum condition for taking any exposure 5. Limit on exposure against unsecured financing facilities. 6. Linkage between financial indicators of the borrower and the total exposure from financial institutions.
  44. 44. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 31 • Exposure against shares/TfCs • Classification and provisioning of assets • Monitoring • Margin payment State Bank Guidelines on Internal Control This article mainly talks about the internal control of credit risk. It has discussed various prudential policies and guidelines for the improvement in effectiveness and efficiency of banking operations. I have taken few paragraphs that were related to the guidelines. They are as follows: There has been always there in the form policies, plans and processes an affected by the board of directors and performed on continuous basis by the senior management and all levels of employees with in the banks/DFI.s. In the general internal controls are simply good business practices, adequate checks and balances and include any thing, which serves to safeguard bank’s assets and improve the effectiveness and efficiency of the operations. the issue of new guide lines aims at bringing our local practices to the level of the best practices in the developed world .it is more re-focusing attention to the key areas having strong bearing on the existence, organizational structure ,growth and profitability of our banks and DFI.s. A few decades ago almost all banks and DFI.s used to have statement of policies adopted by the respective boards of directors these policies were periodically amended to met the new challenges. The purpose was served well for quite sometimes these days the prudential regulations. Various Risk management guides and the proposed guidelines aim to achieve the same objectives admittedly the ICs are important for the good governance and improved performance of the corporate sector as well as the banks and DFI.s and therefore must be properly complied with. The supervisory authorities must require the banks and the DFI.s to institute procedures and practices for recruitment on merit, extensive training, and fair compensation
  45. 45. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 32 including promotion to employees at the different tiers of the hierarchy. This should be followed in practices as well. No amount of the policies and guidelines are going to help much if the employees are not fully motivated and trained. In term of the principles regarding management oversight and the control culture. the board of the directors have responsibility for approving and periodically reviewing the overall business strategies and significant policies of the banks, setting acceptable levels for these risks approving the organizational structure, and ensuring that senior management takes the steps necessary to identify, measure, monitor and control these risks, and ensuring that senior management is monitoring effectiveness of the internal control system. the board of the directors in ultimately responsible for ensuring that an adequate and effective system of internal controls is established and maintained further, the board of the directors and the senior management are responsible for the promoting high ethical and integrity standards, and for the establishing a culture with in the organization that emphasizes and demonstrates to all levels of personnel the importance of internal controls. The SBP has been doing very well by issuing new guidelines and by amending the existing ones as per needs of the current situation. The New Shape of Banking The following paragraph has been extracted from the article written by Shabbir kazmi It states that shift to guidelines driven framework will require internal effort by the banks, In addition the SBP supervision should be Stricter for successful implementation. There new areas require Expertise, system and procedures, controls, techniques, the banks, have to strike a balance between prudent lending and the rapid build up of risky protforlio.the Gradual transition from prudential regulation to a guidelines driven framework would would require in house risk management capacity within the banks and further elimination of weaker banks from the system. The banking regulation and supervision are risk based and are fully compliant with prescribed by the based committee. The risk management practices are being modified to
  46. 46. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 33 conform to Basel II rules. The financial soundness indicators show a healthy and sound banking system with high degree financial stability. Under the new system the control banks has to follow a cohesive supervisory approach whereby the findings from on-site inspection periodic reports from the off-site surveillance and market information will be integrated to produce a comprehensive assessment and composite internal risk rating of each banking institution. The banks which have low ratings or show high probability of deterioration is financial soundness will then be taken up for prompt corrective actions. Commercial banks: New Challenges Ahead All the measure taken is for the smooth implementation of Basel II this article also states the same. For achieving consolidated supervision, cooperation with other regulatory bodies, both foreign and local, will be intensified leading to enhanced off-site monitoring and targeted on site inspections of the cross boarder branches. In the medium to long term a smooth transaction form Basel I to Basel II and institutionalization of stress testing will strengthen the existing risk management regime. Guidelines on risk management BSD circular The following extract has been taken from the circular of SBP to all banks and DFI.s It summarizes the fact that all of these measures are taken in order to facilitate the Basel II implementation in future. Banks are encouraged to put in place an effective risk management strategy based on the attached guidelines. These guidelines are flexible in the sense that banks can adopt them in line with the size and complexity of these businesses. As against the prudential regulations which need to be fully compiled with at all times for every transaction both in letter and sprit the adoption of these guidelines will also facilitate the banks in their preparation for the implementation of new Basel capital accord is introduced in Pakistan these guidelines will converge with the requirement of the accord and will become
  47. 47. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 34 enforceable regulation. The banks are, therefore encouraged to take necessary steps for their implementation the banks are also expected to provide necessary training to their concerned staff in risk management through institute of bankers or other training institutions/experts having expertise in this area. IMF World Bank Assessment Total non-performing loans (NPLs) of commercial banks have maintained their downward trend this has partly reflected an increase in the amount of gross loans but also has been recently facilitated by the SBP, write-off guidelines, issued in October 2002, which enabled the banks to clear stock of old NPLs more aggressively this process is likely to continue in near future, since banks have any long maintained a practices to keep NPLs on their books indefinitely even after 100% provisioning. Banks have generally been reluctant to write bad loans out of concern that this would compromise their legal position in pursuing loan recovery. 3.4 Foreign Literature Federal Reserve Banks of Philadelphia supervision, Regulations and Credit Informally defined credit culture is the way things get done around in any bank precise definition of credit .culture is the sum of all the characteristics of an organization unique behavior in its extension of credit .It not only encompass the tangible written policies and procedures, but also intangible, such as ideas, traditions, skills, attitudes, philosophies and standards credit culture is developed overtime, and then communicated and passed on. It is the true sprit behind the rules. Credit culture is the entical micro piece of the credit risk management process, since an appropriate credit culture determines not only banks profitability but also its very survival a sound effective credit risk management in any bank. A bank without a sound credit culture is like a ship in the dark during a raging storm. When the rocks appears. It is too late to change course, and certain disaster waits.
  48. 48. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 35 3.5 Gap to be a bridged by the study The first prudential regulations regarding the corporate /commercial bank were issued in 1992.since then there have been amendments in those regulations. In 1997 the amendment in banking law has given autonomy to SBP in the area of banking supervision. In 2003 SBP has also issued risk management guidelines covering the guidelines for all the risks that a banking industry can encounter after 1997 SBP has been playing a major role in managing, supervising and controlling the activities of banks. After the deregulation banks have ventured in to consumer finance, house finance, and SMEs which is undoubtedly a spur for the restoration of economic activity in the country ,but and increased the credit risk because there are concerns that the banking system does not enjoy the same level of skills, expertise and loan appraisal systems in there sectors as compared to acceleration in lending to control and manage the risk SBP has issued risk management guidelines and prudential regulations for corporate/commercial banks, consumer financing and SMEs and has promulgated new recovery laws, after all these major steps taken by SBP .the banking system is expected to be strong enough to respond to unanticipated incidents more effectively now. The success of these measures is visible from the fact that the heavenly pace of accumulation of Non-Performing loans (NPLs) has been contained.NPLs of the banking system have come down significantly from what they used to be a few year back. Moreover, the low interest rate regime has also reduced significantly the burden on debt repayment capacity of borrowers, this coupled with the substantial increase in liquidity and profitability of the corporate sector as well as rising income levels have reduced the chances of large scale loan defaults, as witnessed in the past. this report main emphasis would be on the guidelines as the new guiding and supervisory tool for the new era of economy in our country As nothing has been done in this aspect of banking, there is no gap to be abridged by this study As a matter of fact, these guidelines were issued for the first time in Pakistan before policies and prudential regulations were issued that banks were bound to follow. It is first of its kind .It is a transitions from prudential regulations to a guideline driven framework. not only this, the adoption of these guidelines will also facilitate the banks in the preparation for the implementation of Basel II is introduced in Pakistan .These guidelines will converge
  49. 49. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 36 with the requirement of the Accord and will become enforceable regulation. The study will try to conclude that the new guidelines are feasible and flexible enough for our banking sector and that there is no such hesitation or difficulties in adopting it. In addition, the efforts made by the banks in successful implementation of these guidelines. If there were any hesitation in the adoption, what were the reasons? To make these aspects NBP will be analyzed as the sample. 3.6 Areas for further studies During the research process, as banks have undertaken the diversification of assets, embarked on to new areas of banking (i-e) consumer financing,SMEs and etc .Limited guidelines are present in ways of conducting the business thus SBP can take initiatives in facilitating these areas of banks .Moreover, the guideline describes general way of mitigating risks Its is deficient in the specifications in how to cater for individual type of banking activity .After my research I have come to know that vast Study (development of detailed guidelines) could be undertaken on these topic individually so as to enhance the banking sector of ours and bring it to the international standards.
  50. 50. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 37 4.1 Quantitative Analysis of Credit Risk Management at NBP • What are the board and senior management oversight/strategy and significant policies Related to credit risk and its management? Boards of Directors are responsible for approving and reviewing NBP Risk Management Strategy and policy whereas senior management responsible for Implementing approved policies considering risk factor at minimum level • How are the policies embedded in the culture of the organization? It is the responsibility of each & every individual to follow and implement Policies Starting from BOD, senior Management, Middle management and Bottom line Managers. • What are your credit strategy and your preferred level of diversification Concentration in each lending segments? NBP level of diversification concentration in each lending segments totally Depend on the movement of industries. • How often is it reviewed? NBP reviewed its credit strategies at least once throughout the year
  51. 51. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 38 • What is your banks overall risk tolerance in relation to credit risk? NBP risk tolerance in relation to credit risk depend on various sectors ie Industrial Breakup, per party/per Group exposure, top borrowers including PSE& others and top group etc • How do you monitor the compliance of credit limit set by the board and how often it is reviewed? NBP Credit monitoring function is monitoring the credit limit set by the board and it is reviewed on every quarter. • Does your organization structure help in credit risk management? Choices Responses Yes 95% No 5% Yes NBP structure help in credit Risk management Organization structure help in credit risk management 95% 5% Yes No
  52. 52. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 39 • How do you delegate the credit approving power? NBP use Bank Discretionary process for delegation of credit approvals • Is your credit organization functions separate from other activities e.g. Monitoring and Controlling? Yes bank credit organization function separate from other activities Choices Responses Yes 90% No 10% Credit orgranization function seperate from other activities 90% 10% Yes No
  53. 53. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 40 • At the time of credit origination what factors NBP taken in considered and evaluated With respect to old and new clients? There are different factors which include credit history of the client, Industry analysis, security analysis, PR compliance, Risk rating (external as well as internal). • Is your credit administration function effective? Choices Responses Yes 80% No 20% Credit Administration function effectiveness 80% 20% Yes No Yes NBP credit administration function is effective.
  54. 54. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 41 • How do you measure creditworthiness of your customer? CIB Report from SBP and Credit Worthiness report from other banks reflecting past histories are helpful which considering credit worthiness. Furthermore cash flow Analysis & ratio analysis must be considered. • Reputation of clients often influences the credit worthiness? Does it lead to Name Lending? Choices Responses Yes 5% No 95% Reputaion of Cllients often influence the Credit Worthiness 5% Yes No NO In NBP lending on Names are restricted.
  55. 55. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 42 • How often do you monitor and report loan portfolio? Loan portfolio is monitor & repotted at the end of every Quarter. • What is your strategy/action plans to deal with problems of loan? Every loan must have its contingency planning for e.g. continuously follow up on The client, sending of legal notices, restricting of limit, security perfection Analysis etc • What techniques do you is employing measuring credit risk? NBP measure risk Through Industry analysis, security analysis, financial analysis, Policies (Internal), SBP PR-complience, credit worthiness etc. • What is your organization internal credit risk rating and how often is reviewed? NBP has its own internal credit risk rating for corporate /commercial clients and on every quarter it is reviewed. • How is credit risk monitored and controlled? Credit monitoring unit with the Help of Business Unit Perform this task at NBP.
  56. 56. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 43 • Do you have credit risk management department, what are to functions? Choices Responses Yes 100 No 0% Seperate Crdit Risk Managmenet Department 100% Yes No Yes NBP have credit risk management department at individual as well as at enterprise level. At enterprise level credit Policies are formulated along with credit rating tool (internal). Furthermore credit review is also done randomly on the credit portfolio for making recommendations of credit quality etc
  57. 57. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 44 • Does your organization have risk management committee? What do they do? Choices Responses Yes 98% No 2% Risk Management Committe 98% 2% Yes NO Yes NBP has risk management committee that is responsible for reviewing and approving risk management frame work including prudential policies and methodologies, credit, market, operational risk & control.
  58. 58. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 45 • Is you reviewing of Risk management independent? Choices Responses Yes 90% No 10% Review of Risk Management Independent 90% 10% Yes NO Yes NBP review Risk management department independent looking after credit, market, and operational risk along with Basel II compliance.
  59. 59. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 46 • Are you following SBP risk management guidelines for commercial banks and DFI 2003 or institution Risk Assessment form work? Choices Responses Yes 80% No 20% Follow SBP Risk Management guidelines 80% 20% Yes No Yes NBP follow SBP Guidelines for Risk Assessment.
  60. 60. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 47 • Is SBP guidelines computable and flexible with you organization and economic and Political environment of Pakistan? Choices Responses Yes 60% No 40% SBP guideline flexible and computable 60% 40% Yes No Yes SBP Guidelines flexible and computable with NBP.
  61. 61. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 48 • Expanding business arenas, deregulation and globalization of financial activities Emergencies of new financial products and increased level of competition has necessities a need for an effective and structured risk management in financial Institution is your system capable of handling in credit risk how? NBP system is capable for Risk handling 5% Yes NO As far as NBP is Concerned it has its own and intact internal policies which are formulated & implemented on every level on Continuous basis therefore it has strong capability to face any competition. Choices Responses Yes 95% No 5%
  62. 62. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 49 • Has the guidelines help in bridging the gap between the acceleration in banking activity and skill and expertise required by banks for Appraisal? Choices Responses Yes 85% No 15% Guidelines help in bridging the Gap between the acceleration in banking activity and skill and expertise required by bank for Appraisal 85% 15% Yes No Yes SBP guidelines helping bridging the gap between the acceleration in banking activity and skill and expertise required by banks for Appraisal
  63. 63. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 50 • Are these guidelines help in the implementation of Basel ll? Choices Responses Yes 90% No 10% SBP Guidelines Help in implemetation of basel II 90% 10% Yes No Yes SBP Guidelines help in implementation of Basel II
  64. 64. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 51 4.2 Qualitative analysis of credit risk management at NBP In a short span of time NBP has transformed in to leading market player. The strength lies in offering customer –oriented solutions that are backed by a liquid balance sheet. This can be attributed to the successful strategic and operational repositioning of the bank by management confronted with the dual challenges of appreciably lower spreads and intense competition the past result depict the success of the bank’s restoring initiatives that were aimed at streamling of domestic operations and empowerment of the field to facilitate decision-making, teamwork and communication NBP is better Positioned to pursue their drive for diversification of revenue base to preserve their margins and ensure optimum returns for stake holders. These results have been possible due to the commitment and dedication of their staff. The other main contributing factor behind the success of NBP is the implementation and continuous monitoring of these guidelines issued by SBP and risk management framework. NBP management continually strive to adopt the best corporate governance practices to safeguard the interest of depositors, customers and shareholders. Thus implementation of SBP credit risk management guidelines for commercial banks and DFI.s is not a surprise like any other financial institutions. NBP risk management activity broadly takes place simultaneously at following different hierarch levels. 1. Strategic level 2. Macro level 3. Micro level: At NBP the board is fully aware of its responsibilities established by the code of corporate Governance issued by the securities and exchange commission of Pakistan (SECP).The board has approved the vision,mission,core values, objectives and NBP strategic Plan 2003-2007
  65. 65. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 52 The senior management has transformed strategic direction set by board in the shape of policies and procedures and established an effective hierarchy to execute and implement these policies. To ensure that the policies are consistent with the risk tolerance of shareholders. The same should be approved from board. The bank has a comprehensive framework of written policies and procedures on all major areas of operations such as credit, treasury operations,finance,Internal audit and compliance approved by the board and is constantly reviewed .They also ensure that the credit risk remains with in the limit set by the senior management .To make sure that the risk tolerance is efficient the bank has effective budgeting system in place annual budget of the bank is approved by the board and monthly comparison of actual results with the budget are prepared and reviewed by the senior management and corrective actions are taken when necessary. This not only acts as providing direction to the employees but serve to monitor and control the performance of the bank. This way no outside regulatory authorities is required instead everything is managed internally and independently. Moreover the preferred segment of lending and level varies with requirement of the client and bank policies but like all other financial institutions NBP prefers to lend for short term. This is so because short term loans are less prone to credit risk. The essence of its efficiency lies with clear communication of these policies down the line it is the responsibility of senior management to ensure effective implementation of these policies. The human resource development at NBP has also played a vital role in its outstanding performance .the on going transformation of the bank would not have Yield the desired result unless it was complemented by a comprehensive training program aimed at inculcating a customer focus approach which developing core competencies now each individual in the bank is competent to handle any situation at his sphere of influence in addition to the regular training program at the regional staff colleges ,several initiated were undertaken to better orient the bank staff with the recently promulgated state bank prudential regulation and guidelines the retail banking products launched by the bank as well new trends in risk management and derivative instruments. The importance of organizational structure is not ignored at NBP .The bank has clearly defined organizational structure which support clear line of communication and
  66. 66. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 53 reporting relationship there exist a properly defined financial and administrative power of various committees and key management personnel, which supports delegations of authority and accountability. In addition the limit of the authority of various management levels. All the powers were exercised by the relevant authorities with in the materiality thresholds. One more attribute of NBP success lies with the implementation of comprehensive information technology system .NBP has under gone a paradigm shift by synchronizing the adaptation of technology with product development as it is a tool for optimizing customer satisfaction round the clock payment of utility bills in important cities is now in place and branches covering 80% of the bank’s business will soon be fully automated on a real time basis while the ‘one-link” ATM switch sharing arrangement will serve to enhances the 24 hour banking facility available to customers,NBP is expanding its owned ATM base as well. The growing portfolio of products and services has reinforced the need for a proactive and effective risk management operation. NBP has made great strides in strengthening. This area as a comprehensive risk management manual was developed in line with the regulatory guidelines. The manual ensures timely and accurate identification of bank’s exposure and serve to control and mitigate the various risks. The system of internal control is sound design and has been effectively implemented and monitored throughout the year the board is responsible for establishing and maintaining the system of internal control in the bank and for its ongoing monitoring. However such as a system is designed to manage rather than eliminate the risk of failure to achieve objectives and provide reasonable but not absolute assurance against material misstatements or loss. The process used by the board to review the efficiency and effectiveness of the system of internal control includes the following. The board has formed an audit committee comprising of three non-executive directors the audit committee has written the audit committee has written terms of reference in the firm, of a charter (deed), which has been approved by the board of Directors. The committee is responsible for the oversight of the internal audit function and reviews its approach and methodology from time to time. It also receives and reviews the internal
  67. 67. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 54 and external audit reports to the internal control account and related matters. The committee on a continuous basis reviews the material control weaknesses and areas of concern and actions are taken by executive management to address these issues. The board has setup an effective internal audit function. All the branches, regins and groups are subject to audit .All the internal audit reports are accessible to the audit committee and important pints rising out of audit are reviewed by the audit committee and important points requiring board’s attention are brought into their notice. internal audit department of the bank conducts the audit of all branches, region and groups at head office level on ongoing basis to evaluate the efficiency and effectiveness of internal control system and proper follow up of irregularities and control weaknesses is carried out. The board received confirmations/representatives form all group and regional heads on annual basis confirming effectiveness of the internal control system established and maintained by them with in their function. Moving further observing the performance of NBP one can conclude that its system and procedures for conducting the business is full intact for effective credit risk management system plays a vital role. It helps in identification, acceptance, measurement, monitoring and controlling risk. At NBP the system and personnel organize themselves in a manner that the risk is identified at the earliest stage possible. this is done through various ways such as credit assessment of the borrowers industry, and macro economic factor, the purpose of credit and source of settlement, repayment, history of borrowers and proper valuation of collateral in addition the measurement and acceptance is guided by the authority given by the given management then the credit limit is reviewed to keep it current with the dynamic environment of today’s banking. Lastly the monitoring and controlling of risk is independent of all the other departments, It is performed by the credit risk department moving further the internal control system of audit committee also plays a vital role in the monitoring of the elements that might negatively affect the bank’s credit risk exposure.
  68. 68. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 55 5.1 Findings At the start of the project it seemed that the study I have undertaken will not reap fruits as I expected because any official paper that is brought about in Pakistan are fanaticized in the paper but never get implemented. Similar was the case was with the guidelines unintentionally at the back of my mind I had conducted that hypotheses will never be proven correct. As time went by and I got more engrossed in the study the information uncovered to me was unanticipated .the interviews, questionnaire and the analysis of the financial performance of the bank revealed the changes that have taken place not only in the paper but is sprit as well. The main finding: The guidelines are the transition form prudential regulation to guideline driven framework for risk management. It is flexible enough be customized according to the need and size of the respective bank. Looking at the performance and interviewing the personnel of regulatory authority and bank representatives it can be concluded that guidelines are flexible and efficient for the local efficient for the local banking industry During the literature review the SBP’s guidelines were also compared with guidelines of other developing countries. As a result the guidelines are fully applicable in Pakistan because other countries are also practicing it and are termed as the combination of the best practice in industry. Local commercial banks are fully complying with the guidelines with necessary modification as per requirement of their banks and are happy with the result .they have achieved so far as a result of its implementation. The banks are taken to implement any further guidelines issued by SBP that will result in the betterment of the bank and as a whole of banking industry. The main
  69. 69. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 56 upcoming guideline seems to be in the form of Basel II which will be enforced in due course. 5.2 Conclusion The topic of my project is “Credit Risk management at NBP” following SBP credit risk management guidelines in their credit risk management department”. In the starting I mentioned the reason Why I Chose this topic and it is the real need of time that NBP understand their operations and activities in well manners and adopt outstanding policies for handling different problems and contribute in the economy of the country, at the same time SBP playing its role by coming up with efficient and practical guiding principal for the banking sector. For the project the research was designed in a manner that fulfills the requirement of the study and does justice to the cause. In other words while designing the research I considered that it should serve the cause properly and shall be inline with the purpose of the study. The purpose of the study is “descriptive” in nature, as it aimed to collect more appropriate information about implementation of SBP’s credit risk management guidelines at NBP bank. In addition the performance of NBP was analyzed with respect to guidelines. The method of conducting this research was based on primary as well as secondary data. Structured Questionnaire, face to face interviews were held with different representatives of bank. I have also adopted the secondary data approach for that I went through the news papers, internets, book, magazines, annual reports of NBP Then SBP library was also considered. For the project I selected NBP the reason being that I wanted to see whether the guidelines are practical and implemented in both private and public sector .In the preceding chapter, I have discussed what credit risk is? What exactly the guidelines is about and how does it helping mitigating the credit risks that banks are exposed to .During the literature review I also found out that the guidelines are similar in nature with other developing countries guidelines with affcourse due modification according to
  70. 70. Credit Risk Management At NBP Bahria Institute of Management and Computer Sciences 57 their environment. In addition the experts are completely satisfied with the guidelines. They believe that it is a step towards institutionalization of the internal control which in turn will render them to excel and achieve the international standards. Moving into the practical aspect of the project looking at the annual report and concluding the performance of the bank clearly reveals that the guidelines are efficient and viable for our country according to the political and economic environment .one must not be mistaken that all of the practices and improvement in banking sector was brought about after the guidelines were issued but the tremendous turnaround is addressing the issue pertaining to credit risk is only credited to the new guidelines. Although the practices in the bank previously were in place and different regulations were passed but never made am impact as comparable to this besides no such guidelines were in past. After analyzing the whole project I evaluated that as the country moved towards a more open, libral and sophisticated financial structure, The authorities in the light of experience of other countries realized the importance of a strong regulatory guideline framework to sustain the confidence of savers and ensures the healthy development of banks moreover the bank is even cooperative in adopting these principles. The banker believe that if the guidelines are in foot steps of Basel II then there should not be problem in practicing it once it is enforced as the regulation. In the end of project I found out important finding from the whole study and I also given the recommendation for the betterment and improving the performance of the bank. I hope that all the findings and recommendations are of great help for the readers of this project and enhance their knowledge in the sphere. The new financial environment where in there is intense competition between a large number of institutions in the content of greater integration with global economy has to be accompanied by the new volatility in the risk and nature of funds base. It is the low cost producer and mitigating risk expense that will be able to meet the challenge and capitalize on the opportunities managing risk in it will be key determinants of how successful a bank can respond to market needs.
  71. 71. Credit Risk Management At NBP Bahria institute of Management and Computer Sciences 58 5.3 Recommendations SBP should make aggressive policies for NBP so as to match the International standards around the world. • SBP should continue to focus on the Economic condition of the country. • SBP should make separate supervisory department for Commercial Banks. • SBP should protect bank from unnecessary regulatory risk. • As NBP have expanded its business arena SBP should provide related and appropriate guidelines. • NBP should eliminating unnecessary management and other layers; it helps the bank in reducing cost and effective communication. • NBP should have excellent employees with necessary skill for the smooth and control of operations. • Job rotation of employees should take place in different departments so that they have knowledge of the whole organization. • Proper training should be provided so that the employees are better equipped to handle the credit management and sharpen their analytical skill. • Bank should employ excellent accounts software for the accuracy. • The banks should employ cutting edge technology because this is the only source of meeting the ever rising demand of the customers and survive in the competition market.
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  74. 74. APPENDIX
  75. 75. BIBLIOGRAPHY BOOKS Deservinging & Renault Measuring and Managing credit Risk Hrishikes Bhattacharia Credit Risk Analysis ANNUAL STATEMENT NBP JOURNALS Journal of the institute of Banks Pakistan MAGIZIES Pakistan and gulf Economist State Bank Guidelines On Internal Control (By Muhammad Bashir Chaudry) The New Shape of Banking Commercial banks: New Challenges Ahead (By: Shabbir H.Kazmi) IMF World Bank Assessment (Recorder report Islamabad) INTERNET