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1.

Literature Review
1.1 Adverse selection in corporate lending context
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, risk
management, and statistics. It refers to a market process in which undesired results occur when buyers
and sellers have asymmetric information (access to different information); the "bad" products or services
are more likely to be selected.
Adverse selection occurs when a product or service is selected by only a certain group of people who
offer the worst return for the company. Adverse selection occurs because of information asymmetries and
difficulties in selecting customers.
1.2 Consequence of adverse selection
Information imperfections, such as asymmetric information, are important frictions in financial markets.
Even in normal times, borrowers in credit markets often know more than lenders about the quality of the
collateral and the riskiness of their investments. If high- and low-risk borrowers are indistinguishable,
then high-risk borrowers benefit at the expense of low-risk borrowers. The resulting problem of adverse
selection (when high-quality borrowers choose not to participate in the market) leads to higher interest
rates and a decrease in lending.
In the presence of asymmetric information, a small increase in the interest rate can lead to a large
reduction in lending. A higher interest rate increases the likelihood that high-quality borrowers will
withdraw from the market, aggravating the problem of adverse selection. As a result, the average quality
of the borrowers falls, which in turn raises the interest rate even further. If adverse selection is severe
enough, the credit market may collapse. Adverse selection may cause banks to impose credit rationing
putting quantitative limits on lending to some borrowers.
1.3 Measures to tackle adverse selection
In some situations, the problem of adverse selection is mitigated by signaling: letting participants in the
marketplace who possesses inside information take actions that will reveal the nature of that unique
information of those potential participants.
In case of corporate customers, one signal could be the actions taken by an insider. An insider who knows
her company is experiencing financial turmoil may give off this signal by selling the companys stock. If
the public happens to see insiders selling out, they too may begin to sell, ultimately driving the value of
the companys stock lower in the financial marketplace. An astute banker may notice this falling stock
price and may choose a stringent evaluation of credit worthiness of that company.
By limiting the supply of loans, banks can reduce the average default risk and therefore alleviate adverseselection problems. Another way to reduce adverse selection is to require collateral for the loan. With
collateral, even if the borrower defaults, the lender can recover losses by selling the collateral. Therefore,
the asymmetric information about the borrowers default probability becomes less important.

1.4 Moral hazard in the context of corporate lending


Moral hazard is a special case of information asymmetry, a situation in which one party engaged in a
transaction has more information than another. In particular, moral hazard may occur if a party that is
insulated from risk has more information about its own actions and intentions than the party paying for
the unwanted outcome of the risk. Putting more broadly, moral hazard occurs when the party with more
information about its actions or intentions has a tendency to behave inappropriately from the perspective
of the party with less information.
1.5 Reasons of Moral Hazard
Moral hazard in the context of corporate lending arises because the debtor company does not take the full
consequences and responsibilities of not paying installments timely or being a defaulter altogether.
Therefore, the company has a tendency or incentive to act delinquently, leaving the banker to hold some
responsibility for the consequences of nonpayment.
In the heart of the moral hazard problem are a number of factors. First, an increase in the interest rate may
lead borrowers to choose investments with higher returns when successful but with lower probabilities of
success: hence, a rise in deposit rates could induce banks to adopt more risky investment strategies. A rise
in bank lending rates can have similar incentive effects on the bank's borrowers.
Secondly, the expectation that the government will bail out a distressed bank may weaken incentives on
bank owners to manage their asset portfolio prudently and incentives on depositors to monitor banks and
choose only banks with a reputation for prudent management.
Moral hazard becomes even more acute when the bank lends to projects connected to its own directors or
managers (insider lending). In such cases the incentives for imprudent (and fraudulent) bank management
are greatly increased in that all of the profits arising from the project are internalized (in the case of loans
to unconnected borrowers the project returns are split between lender and borrower), whereas that part of
the losses borne by depositors or taxpayers are externalized. Not surprisingly, insider lending is a major
cause of bank failure around the world.
1.6 Addressing Moral Hazard Problem
In principle, various measures are available to curtail moral hazard. They generally fall under the
following headings: (1) good corporate governance and management; (2) market discipline exercised by
depositors and other creditors; and (3) regulatory discipline exercised by supervisory and, in some
countries, deposit insurance authorities.
2. Client Assessment Criteria & Post Disbursement Monitoring at Dhaka Bank Limited (DBL) to
prevent Adverse Selection & Moral Hazard Problem
In its CRM policy, DBL set specific policy guidelines which include corporate philosophy of the Bank
under which lending guidelines, credit risk assessment & risk grading, approval authority, segregation of

duties, and internal control & compliance guidelines have been specifically set to establish a benchmark
in order to prevent the intentional or accidental adverse selection problem. On the other hand, the
procedural guidelines of the policy is outlined with approval process, credit administration, credit
monitoring, and credit recovery to help the employees correct any inadvertently performed adverse
selection mishaps to be rectified in an efficient manner.
2.1 Lending Guidelines
a. Industry & Business Segment Focus:
The Bank focused on Industry and Business Segmentation to diversify the concentration or pool of
exposures effect, whose collective performance has the potential to affect the bank negatively even if
each individual client of an industry is financially sound. To reduce this effect, the bank directed
industry specific expansion, reduction or maintenance of status quo, and exposure cap in terms of
lending; it also specified exceptions where lending can be opted beyond these guidelines which must
cite clear & financially viable supportive logic favoring the exceptions and be duly approved by the
Board of Directors.
b. Types of Loan Facilities & Parameters:
Depending upon the nature of financing in respect of purpose, security as well as repayment terms,
loan facilities in DBL have been put under following broad categories:
Overdrafts
Cash Credit
Demand Loan
Term Loan
Short Term Loan
House Building Loan
Transport Loan
Lease Finance
Syndicated Loan
Foreign Bills Purchased
Letter of Credit as well as Back-to-Back
Payment against Documents [PAD]
Loan against Imported Merchandise [LIM]
Loan against Trust Receipt [LTR]
Time Loan
Packing Credit
Export Cash Credit
Foreign Documentary Bill Purchased [FDBP]
Inland Documentary Bill Purchased [IDBP]
Inland Bills Discounting
Bank Guarantee
Similar Islamic Banking Products
Consumer Loans: Credit Card, Education Loan, Home Loan, Car Loan
SME Loans
Offshore Banking Facilities
Agricultural Finance

These loan facilities categorize different customer needs and satisfy the exact ones that in the
very first place diminish the probability of adverse selection by a great lot. The set parameters against
each loan facility help credit managers identify customer needs quickly and cater them accordingly.

c. Single/Group borrower limit/Large loan ceiling/Product wise lending caps


The bank manages its credit risk through segregating client exposure through complying
Bangladesh Bank Circular regarding the subject and limiting the funded facilities up to 15% of total
capital and total exposure up to 35% of the same. It also maintains a separate large loan ceiling
schedule regarding portfolio management options. The bank also depicted in its policy a product wise
lending cap to manage its advances in a better way.

d. Discouraged Business Sectors


In its guidelines, the bank restricted a number of business sectors persuasion to which is strongly
discouraged and some of which is completely restricted as well.

e. Covenants & security/collateral needed:


The guidelines set out specific documentation covenants & security/collateral needed separately
for limited companies, partnership firm, project finance, readymade garments industries etc.

f. Others:
The policy also includes guidelines on clients credit rating (both foreign & domestic) to reduce
default risk along with cross border risk, specified credit principles, loan pricing strategy etc.

2.2 Credit Risk Assessment & Risk Grading:

Though the bank understands that the future of a credit can anytime go off course due to
unforeseeable events, it also emphasizes on the complete and proper appraisal of credit proposals to
minimize the probable loss arising from future loan classifications. It compels that any and every credit
facilities should be reassessed on an annual basis beyond its regular periodic assessment.

Hence, the policy outlines that while assessing credit risk


through a documented process, a credit risk analyst as well as a
financial analyst must scrutinize and include the reflection of the
following in the credit proposal:

Credit policy of DBL


Diversification of Banks Portfolio
Familiarity with the borrower
Integrity
Purpose
Competence
Credit investigation
Optimum level of credit worthiness
Extent of facility
Borrowers stake in real terms
Source and terms of repayment
Repayment period
Risk factors
Balance sheet analysis
Profitability
Net spread
Security
Risk appraisal: Business, Finance, Management, Security, Relationship
Risks of & Recommendation on the Proposal
Financial Statements Analysis
Risk Grading (as per Bangladesh Bank Rules)

2.3 Post Disbursement Monitoring Guidelines:

The banks CRM policy includes in its latter part the monitoring process & recovery of loans
classified. The policy states that there will be the following types of monitoring processes with
simultaneous client correspondence in effect:
Ongoing monitoring of accounts: specific directional guidelines & techniques
Weekly Monitoring: Expired, Excess of Limit, Overdue accounts
Onsite visit: Frequency of Clients business/mortgaged property visit & immediate call report with
specified contents
Central Early Alert Report: Branch through Monitoring Unit to Management Credit Committee
Continuous client correspondence as well as arrangement of inter-alia meetings between banks &
clients senior as well as top management

2.4 Credit Recovery Guidelines

To emphasize the recovery activities more, the bank segregated legal affairs & recovery division
from monitoring, processing and marketing function. Hence, the recovery division will solely
oversee the following relevant activities process flows of which are described as detailed guidelines
in the policy:
To undertake necessary recovery responsibilities of classified accounts from SMA to BL
To complete the transfer of account as per outlined Account Transfer Procedure
To comply with related Bangladesh Bank Guidelines and prevalent laws of land
To prepare periodic action plan
Quarterly Classified Loan Review
Ensure, implement & follow up of proper & timely legal action as well as court proceedings
Proper negotiation process with the classified borrowers outside court proceedings for mutually
favorable repayment
Annual Review of third party recovery agents performance
Approval for inclusion/deduction of recovery agents along with enlistment of panel lawyers
Conducting monthly recovery meeting and periodic portfolio review meeting

Non-Performing Loan (NPL) monitoring through quarterly updates & action plans
NPL Provisioning & Write off procedure
Periodic Incentive Program to boost up recovered amount

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