PREFACE

The topic of the report is “Credit risk measurement” and the main
objective of the study is to have a bigger picture of how the banks manage their
credit risk. The data from a Bank has been used in this analysis. A time-series
analysis of a five year financial data of the bank was done to examine the
relationship between profitability (ROE and ROA, separately) which are
performance indicators and loan losses (NPL/TL) which represent the credit risk
management effectiveness.

Attention of the study is geared towards:

1. Ascertaining why and how banking credit risk exposure is

evolving recently.
2. Seeing how banks use credit risk evaluation and assessment
tools to mitigate their credit risk exposure.
3. Ascertain the scope to which resourceful credit risk
management can perk up bank performance.

Five year financial data of Zarai Taraqiati Bank Limited (ZTBL) was
collected for analysis. The regression was done to develop a relationship
between the test variables. The objective was to ascertain the scope to which
resourceful credit risk management can liven up bank performance.
Table of Contents

Table of Contents...................................................................................................2
PROFILE OF THE BANK...........................................................................................2

PROFILE OF THE BANK

1.1 History of the Bank

Pakistan is basically an agricultural country, and finance has been needed

for its rapid development. With a view to meet this basic need the
Agricultural Development Finance Corporation was set-up in 1951, and
was entrusted with the task of providing financial facilities for the
development and modernization of agriculture, including:
• Forestry, • Animal • Dairy
• Fishery, Husbandry, Farming.
• Poultry,

Later on the Agricultural Development Bank of Pakistan was also

established in September 1957, under the Agricultural Development Bank
Act. The Bank is to provide credit in cash or in kind, warehousing and
storage facilities to agriculturists, cooperative societies and other bodies,
of which the majority of members are agriculturists. As the functions of
the Agricultural Development Finance Corporation and Agricultural
Development Bank were similar and since both were working with capital
provided by the Government, they were merged into one organization
known as Agricultural Development Bank of Pakistan on February 18.
1961. The Agricultural Development Bank of Pakistan is a banking
company for the purpose of the Banking Companies Ordinance and the
State Bank of Pakistan Act.

Zarai Taraqiati Bank Limited (ZTBL) erstwhile Agricultural Development

Bank of Pakistan (ADBP) is the premier financial institution geared towards
 the development of agriculture sector through provision of financial
services and technical know how. The restructuring of former ADBP is
being carried out with the aim to uplift the agriculture and rural sector by
raising farm productivity, streamlining the institutional credit and
increasing income generating capacity of the farming community. ZTBL
was incorporated as a Public Limited Company on 14th December, 2002
through repeal of ADB Ordinance of 1961.
The new corporate structure redefines the bank's status as a public limited
company registered under companies Ordinance'1984 with an
independent Board of Directors which aims at ensuring good governance,
autonomy, delivering high quality.

ZTBL is a key R.F.I of Pakistan providing affordable, rural and agriculture

financial/non-financial services to the rural Pakistan, comprising 68 % of
the total population. The Bank through a country-wide network of 341
branches is serving around half a million clients annually and over one
million accumulated account holders with the average loan size of around
Rs.89,000 serving 65%, 31% & 4 % of subsistence, economic and large
growers respectively.

1.2 Capital Structure of the Bank

The total assets of the Bank stand at Rs.84 billion with authorized capital
of Rs.25 billion as of 31.12.2005, with a nation-wide working strength
comprises 5500 employees. The share of ZTBL in total national
institutional agricultural credit remains around 35%. Authorized capital of
Zarai Bank is Rs 25 billion, comprising 2,500 million ordinary shares of Rs
10 each. As on December 31, 2008 the paid up capital was Rs 11.870
billion, almost all of which is owned by the Federal Government, leaving
token ownership to all the Provincial Governments.

Credit rating of ZTBL is very excellent from last year. Their credit rating is
“AAA” medium to long term.

2. CREDIT RISK MEASUREMENT

2.1 Credit Risk

Credit risk arises from non-performance by a borrower. It may arise from

either an inability or an unwillingness to perform in the pre-committed
contracted manner. This can affect the lender holding the loan contract, as
well as other lenders to the creditor. Therefore, the financial condition of
the borrower as well as the current value of any underlying collateral is of
considerable interest to its bank.

2.2 Credit Risk Management in ZTBL

Credit risk is the risk that arises from the potential that an obligor is either
unwilling to perform on an obligation or its capability to execute such
obligation is impaired resulting in economic loss to the Bank. Principally,
exposures are only approved when reasonably assured for repayment
capacity of counter party. Standardized procedures are adopted and under
no circumstances it exceeds approved credit lines. The Bank credit
appraisal structure comprises of well-defined credit appraisal, approval
 and review methods for the purpose of prudence in its lending operations
and ensuring credit across the bank. The Bank pays particular
concentration to the management of NPLs. An independent Special Asset
Management (SAM) department is operational at the head office.

At present Credit Risk is reviewed at the Bank level only. Credit portfolio,
disbursement, recovery and security value are critically analyzed on a
regular basis and Risk Gaps are reported to the Credit Risk Management
Committee proposing either to eliminate or to minimize the Risk Gaps.
During the last quarter of 2006, Risk Manager has also undertaken review
of SAM Portfolio. The process of developing recovery strategy for such
loans is in progress.
The Risk Management Policy of the bank is in the process of
implementation with broader Risk Management Framework of the Bank.

2.3 Basel II – What does it say about credit risk.

Basel 2 categorizes risks into three classes:-
• Credit risk • Operational risk
• Market risk
Credit Risk
The calculation of capital requirement against market risk remains
unchanged, however the methodologies provided for capital against credit
risk are more complicated and risk sensitive. The Accord gives a hierarchy
of 3 alternative approaches for the purpose that vary in terms of
sophistication, and adoption of a particular approach depends on the risk
measurement capabilities and strength of the systems in place in a bank.
The framework introduces two broad approaches in the measurement of
credit risk. The "standardized approach" and the "internal rating based
approach” each has two subclasses.

STANDARDIZED APPROACH
 Simplified standardized approach.
 Standardized approach.

INTERNAL RATING BASED APPROACH

 Foundation internal rating based approach
 Advanced internal rating based approach
1. METHODOLOGY

A time-series analysis of a five year financial data of the bank was done to
examine the relationship between profitability (ROE and ROA, separately) which
are performance indicators and loan losses (NPL/TL) which represent the credit
risk management effectiveness.

The banks manage credit risk for two main purposes: to enhance interest
income (profitability) and to reduce loan losses (bad debts) which results from
credit default. It is thus expected that banks with lower loan losses (non
performing loans) have better credit risk management practice. Profitability
(ROA, ROE) is used as proxy for credit risk management indicators. Accordingly
the following hypotheses are tested:
1. Banks with higher profitability (ROE, ROA) have lower loan losses (Non-
Performing Loans/ Total Loans).
2. Banks with higher interest income (net interest/Average total assets,
interest net /total income) also have lower bad loans (NPL).

3.1Data Description

Financial data of Zarai Taraqiati Bank Limited (ZTBL) was collected for
analysis. The regression was done to develop a relationship between the
test variables. The objective was to ascertain the scope to which
resourceful credit risk management can liven up bank performance.

2. ANALYSIS OF DATA
4.1Performance indicators of ZTBL

Rs. In millions
2008 2007 2006 2005
Non performing Loans 12,985 16,708 20,104 23,424
Share Capital 12,522 11,869 11,869 11,869
Total Equity 17,365 14,955 13,237 12,817
Total Loans (Advances) 69,923 61,313 61,514 52,925
Loan Provisions for the year 1,922 3,090 1,767 4,732
Total provisions for the year 1,924 3,657 3,826 4,744
Cumulative Loan provisions 7,806 9,221 9,776 11,819
Total Assets 102,340 93,386 85,451 82,504
ROA 2.54% 1.11% 0.49% -0.16%
ROE 14.98% 6.91% 3.17% -1.01%

4.2Definitions

Capital Adequacy
Non-Performing Loans/Capital NPL/C

Asset Quality Standards

Non- Performing Loans/Total Loans NPL/TL
Loans Provisions/Non-Performing Loans LP/NPL
Loans Provisions/Total Loans LP/TL
Total Provisions/Total Assets TP/TA

Profitability Standards
Net Profits/ Average Shareholders' Equity ROE
Net Profits/Average Total Assets ROA

4.3Summarization of Variables

Year ROE ROA NPL/TL LP/NPL LP/TL TP/TA NPL/C

2005 -1.01% 0.16% 44.26% 20.20% 8.94% 5.75% 197.4%
2006 3.17% 0.49% 32.68% 8.79% 2.87% 4.48% 169.4%
2007 6.91% 1.11% 27.25% 18.49% 5.04% 3.92% 140.8%
2008 14.98% 2.54% 18.57% 14.80% 2.75% 1.88% 103.7%

4.4 ROE vs. Percentage of NPL

The diagram above shows a negative correlation between ROE and NPL as
expected. Since Non-performing loans is an indicator to poor credit risk
management. Therefore it is expected that better credit risk management is
related to lower non-performing loans.

4.5Regression result of ROA on NPL/TL

4.6Regression result of ROE on NPL/TL

4.7Result and Findings

The results of ROA on NPL/TL show that non-performing loan of ZTBL is
significantly negatively related to profitability (table 4.5). The standardized
coefficient value of -2.766 shows that 1 percent increase in non-performing
loans decreases profitability (ROA) by 2.766 percent. The significant level is
0.143 and since it is greater than 0.05 we do not reject our Ho therefore we
conclude that banks with higher profitability have lower loan losses.

The results of ROE on NPL/TL show that non-performing loan of ZTBL is

significantly negatively related to profitability (table 4.6). That is, 1 percent
increase in non-performing loans decreases profitability (ROE) by 15.937
percent. The significant level is 0.133 and since it is greater than 0.05 we do
not reject our Ho therefore we conclude that banks with higher interest
income have lower bad loans.
 3. CONCLUSION
This study shows that there is a significant relationship between bank
performance (in terms of profitability) and credit risk management (in terms of
loan performance). Better credit risk management results in better bank
performance. Thus, it is of crucial importance that banks practice prudent credit
risk management and safeguarding the assets of the banks and protect the
investors’ interests.

The study also reveals that banks with good or sound credit risk
management policies have lower loan default ratios (bad loans) and higher
interest income (profitability).

This has led to accept hypothesis and conclude that banks with higher
interest income have lower non-performing loans, hence good credit risk
management strategies.