Appropriate single borrower exposure limit

One should not put all the eggs in one basket. This saying holds true today in the world of finance, not just for individuals considering their own investments, but also for banks to limit the maximum loss they could face in the event of the failure of one of their counterparties.

Diversification of risk is a key precept in banking. Bank supervisors have traditionally paid close attention to the avoidance of risk concentration by the banks under their jurisdiction. Central banks across the world recognise that monitoring banks’ large exposures is necessary for sound prudential regulation and effective supervision of banks and banking systems. Being overexposed to a single counterparty or a group of connected counterparties poses a risk to the safety and soundness of banks and also has implications for financial stability.

Bangladesh Bank has observed that some banks are extending credit facilities to large institutions or group of companies without assigning due importance/consideration to the capital size, business volume, financing requirements, ownership structure, stake/control in number of companies, state of professional management, accounting system, repayment capability etc. It has been observed that banks are extending credit facilities without adhering to credit discipline and compliances.

The Basel Committee on Banking Supervision’s minimum capital requirements are calculated using a risk model that assumes banks have well diversified portfolios. At the heart of the large exposure (LE) framework is the requirement that banks must limit their total exposures to any single counterparty to 25 per cent of the bank’s eligible capital. Large exposures regulation limits the maximum loss that a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank's solvency.

The Bangladesh Bank issued the BRPD Circular No. 01 dated 16 January 2022 instructing commercial banks to reduce the single borrower exposure limit to 25 per cent of a bank’s capital from 35 per cent as part of its measures to contain the concentration of loans among a small group of people. ‘The aggregate principal amount of funded and non-funded exposure to a single person or counterparty or a group shall not exceed 25 per cent of the capital at any point of time,’ said a BB circular. Even though the total limit, including funded and non-funded ones, was reduced to 25 per cent, the funded loan portion was kept unchanged at 15 per cent of a bank’s capital.

It sometimes happens that separate borrowers, despite dealing on an independent basis with the lending institution, represent a single risk because they are legally or economically interrelated. Thus, repayment difficulties would arise for all if any one of them experienced financial problems. The concept of "group" and the task of identification of the entities belonging to specific industrial groups must be understood. The commonality of management and effective control are the guiding principles in determining if a particular unit belongs to a group.

European Commission defined that a group of related clients means "two or more persons, whether natural or legal, holding exposures from the same credit institution and any of its subsidiaries, whether on a joint or separate basis, but who are mutually associated in that: (i) one of them holds directly or indirectly power of control over the other; or (ii) their cumulated exposures represent to the credit institution a single risk in so much as they are so interconnected with the likelihood that if one of them experiences financial problems the other or all of them are likely to encounter. repayment difficulties. By way of example of such interconnections the credit institution should take into consideration the following: (1) common ownership; (2) common directors; (3) cross guarantees; (4) direct commercial interdependency which cannot be substituted in the short term.

The level of exposure is usually determined by the sanctioned limit or outstanding, whichever is higher, shall be reckoned in respect of the funded as well as non-funded facilities, for arriving at the level of exposure. The credit exposure shall include funded and non-funded credit limits, underwriting and other similar commitments. The exposure on account of derivative products is also reckoned for the purpose.

The exposure includes credit exposer and Investment exposure. The credit exposure comprises of the following elements: (a) all types of funded and non-funded credit limits, (b) facilities extended by way of equipment leasing, hire purchase finance and factoring services. The investment exposure includes: (i) investments in shares and debentures of companies, (ii) investment in Public Sector Undertaking Bonds (PSU Bonds) (iii) investments in Commercial Papers (CPs). Bangladesh Bank also defined the exposure. It means credit exposure (funded and non-funded) and refers to all claims, commitments and contingent liabilities arising from on and off-balance sheet transactions, which include, but not limited to, outstanding loans/financing facilities, advances and receivables. These amounts comprise outstanding balance (i.e. principal amount and accrued interest/profit) which has not yet been repaid as on reporting date. In case of loans that are backed by cash and/or readily encashable securities maintained with the same bank (e.g. FDR of the same bank) under lien, exposure can be calculated after deducting the secured/covered amount from the outstanding balance of the associated loans.

According to the revised BB policy, banks having less than 3 per cent non-performing loans would be allowed to issue loans up to 50 per cent of respective bank’s loans and advances to large-scale borrowers. Earlier, the highest limit was 56 per cent for the banks having NPL up to 5 per cent. As per the latest BB circular, banks with NPL ranging between 3 and 5 per cent would be allowed to issue 46 per cent large loans against their total loans and advances.

The limit would be 42 per cent for the banks having NPL ranging between 5 per cent and 10 per cent, 38 per cent for the banks having NPL ranging between 10 per cent and 15 per cent, 34 per cent for the banks having NPL ranging between 15 per cent and 20 per cent, and 30 per cent for the banks with more than 20 per cent NPL.

Commercial banks in Bangladesh has tendency of financing big borrower to reduce management and operational costs. In isolated cases, banks may deliberately conceal from their supervisors that they are taking on exposures known to be related. In such cases, the management of the bank often has a connection with the borrowers.  The bankers try to deal with lower number of borrowers and comfort in the work places. The credit extended to SMEs are far below than the amount specified by BB. It has rightly intervened on such practices to reduce single exposure.

Limits for single exposures now generally fall within the range 10-40 percent of the total capital but 25 per cent would seem to be a desirable target for an upper limit to be achieved as soon as practicable by those countries currently using higher limits. The new limit of 25 per cent set by BB would reduce the risks of the banks and create scope for widening the number of loan beneficiaries.

The writer is a legal economist. He can be contacted at [email protected]