A Project Report On

Credit Risk Management: Policy Framework For Indian Banks

In Partial Fulfillment Of The Requirement Of The Requirement Of Paper CP-402 For The Degree Of Master Of Business Administration (M.B.A) (Session 2006-2008)

SUBMITTED TO:
M.M. Institute of Management (Mullana)

(Affiliated to Kurukshetra University, kurukshetra)

Under The Guidance Of: Mrs. Rimpi Walia MMIM, Mullana, (Ambala)

Submitted By: Mukta Bhateja MBA-2nd Year

PREFACE
Master of Business Administration is a course, which combines both theory and its applications as its contents of study in the field of management. As part and parcel of this course, every aspirant has to cover the research project report. The purpose of this research project report is to expose the student of management sciences real life situations and to provide an insight into the various functions who can visualize things what they have been taught in classrooms. Actually, it is the life force of management.

I was fortunate enough to get this opportunity of to prepare project report on Credit Risk Management: Policy Framework for Indian Banks. This is related to my specialization Finance.

This report is an attempt to present an account of practical knowledge and observations gathered. This research report includes the general information about Basel Capital Accord 1988-Accord and June 1999 Proposals, and the impact of its implementation in Indian Banks.

MUKTA BHATEJA MBA 4TH SEM MMIM, Mullana

ACKNOWLEDGEMENT
Inspiration and hard work always played a key role in the success of any venture. At the level of practice, it is often difficult to get knowledge without guidance. Project is like a bridge between theoretical and practical. With this willing, I joined this project.

There is always a sense of gratitude which one expresses to other for the helpful and needy services that render during all phases of life. I would like to do so as I readily wish to express my gratitude towards all those who have been helpful to me in getting this mighty task of training to a successful end.

It often happens that one is at loss of words when one is really thankful and sincerely wants to express ones feeling of gratitude towards other.

I am deeply indebted to Dr. Sanjiv Marwah (Director) and my worthy thanks to my teacher Mrs. Rimpi Walia (Guide) for their valuable contribution during the academic session & guidance in preparation of this project report.

Finally, it is efforts of my parents and friends and the Almighty GOD who have been a source of strength and confidence for me in this endeavor.

MUKTA BHATEJA MBA 4TH SEM MMIM, Mullana

DECLARATION

This is to certify that I Mukta Bhateja, the student of Maharishi Markandeshwar Institute of Management studying in M.B.A. (4th Sem.).Roll no. _____________ have submitted a project/ Dissertation report on the title "Credit Risk Management: Policy Framework For Indian Banks" for the partial fulfillment of Degree of Master of Business Administration (M.B.A) to Kurukshetra University,Kurukshetra.

I solemnly declared that the work done by me is original and no copy of it has been submitted to any other Universities for award of any other degree/diploma/fellowship or on similar title and topic.

Signature of Student MUKTA BHATEJA

EXECUTIVE SUMMARY
Risk is inherent in all aspects of a commercial operation and covers areas such as customer services, reputation, technology, security, human resources, market price, funding, legal, and regulatory, fraud and strategy. However, for banks and financial institutions, credit risk is the most important factor to be managed. Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual, another bank, financial institution or a country. Credit risk may take various forms, such as:

In the case of direct lending, that funds will not be repaid; In the case of guarantees or letters of credit, that funds will not be forthcoming from the customer upon crystallization of the liability under the contract; In the case of treasury products, that the payment or series of payments due from the counterparty under the respective contracts is not forthcoming or ceases; In the case of securities trading businesses, that settlement will not be effected; In the case of cross-border exposure, that the availability and free transfer of currency is restricted or ceases. Globalisation and financial innovation have over the last two decades or more multiplied and diversified the risks carried by the banking system. In response, the regulation of banking in the developed industrial countries has increasingly focused on ensuring financial stability, at the expense of regulation geared to realising growth and equity objectives. The appropriateness of this move is being debated even in the developed countries, which in any case are at a completely different level of development of their economies and of the extent of financial deepening and intermediation as compared to the developing world. Despite this and the fact that in principle the adoption of the core principles for effective banking supervision issued by the Basel Committee on Banking Supervision is voluntary, India like many other emerging market countries adopted the Basel I guidelines and has now decided to implement Basel II. India had adopted Basel I guidelines in 1999. Subsequently, based on the recommendations of a Steering Committee established in February 2005 for the purpose, the Reserve Bank of India had issued draft guidelines for implementing a New Capital Adequacy Framework, in line with Basel II. At the centre of these guidelines is an effort to estimate how much of capital assets of specified kinds should banks hold to absorb losses. This requires some assessment of likely losses that may be incurred and deciding on a proportion of liquid assets that banks must have at hand to meet those losses in case they are incurred. This required regulatory capital is defined in terms "tiers" of capital that are characterized by differing degrees of liquidity and capacity to absorb losses. The highest, Tier I, consists principally of the equity and recorded reserves of the bank. The higher the risk of loss associated with an investment the more of it must be covered in this manner, requiring assets to be risk-weighted. A 100 per cent risk loss implies that the whole of an investment can be lost under certain contingencies and a zero per cent riskweight implies that the asset concerned is riskless. 5

THREE PILLARS Under Basel I, risk-weights for different kinds of assets were pre-decided by the regulator and the regulatory capital required, measured on this basis, 8 per cent of the risk-weighted value of assets. In the transition to Basel II, risk-weights were linked to the external ratings by accredited rating agencies of some of these assets. Finally, banks were to be allowed to develop their own internal ratings of different assets and risk-weight them based on those ratings. This gives greater freedom to individual banks to assess their own economic capital after taking account of risks, resulting in a degree of regulatory forbearance. This is the first pillar of Basel II. The second pillar is concerned with the supervisory review process by national regulators for ensuring comprehensive assessment of the risks and capital adequacy of their banking institutions. The third pillar provides norms for disclosure by banks of key information regarding their risk exposures and capital positions and aims at improving market discipline. In India, the RBI had initially specified that the migration to Basel II will be effective March 31, 2007, though it expected banks to adopt only the rudimentary Standardised Approach for the measurement of credit risk and the Basic Indicator Approach for the assessment of operational risk. The Standardised Approach fixes risk-weights linked to external credit assessments, and then weights them using these fixed weights. The Basic Indicator Approach prescribes a capital charge of 15 per cent of the average gross income for the preceding three years to cover operational risk. Over time, as risk management skills improve, some banks were to be allowed to migrate to the Internal Ratings Based approach for credit risk measurement. The implementation of Basel II does provide Indian banks the opportunity to significantly reduce their credit risk weights and reduce their required regulatory capital, if they suitably adjust their portfolio by lending to rated but strong corporates, increase their retail lending and provide mortgage under loans with higher margins. This would, of course, change the proportion of lending in their portfolio and the direction of their lending. But, even if they do not resort to that change, ICRA estimates that the implementation of Basel II would result in marginally lower credit risk weights and a marginal release in regulatory capital needed for credit risk. Dealing with bad debt The exact amount of capital that banks would need would depend on the legacy of bad debt or non-performing assets they carry. Much of the discussion on Basel II is based on the presumption that the problem of bad debt has been substantially dealt with. In the recent past, banks have been able to reduce their provisioning needs by adjusting their nonperforming assets. The proportion of total NPAs to total advances declined from 23.2 per cent in March 1993 to 7.8 per cent in March, 2004.

INDEX OF CONTENTS
1 2 3 4 Preface ............................................................................................................................... 2 Acknowledgement ............................................................................................................. 3 Declaration ........................................................................................................................ 4 Executive Summary .......................................................................................................5-6

CHAPTER-1 Introduction to Topic.

1.1 1.2 1.3 The nature of credit risk.10 Credit risk management10-12 Credit risk Policy and strategy ......................................................................13.

CHAPTER-2 Introduction to Basel Committee Accord

2.1 About the Basel Committee.15 2.2 History of the Basel Committee.15-17 2.3 Basel Accord, 1988.17-20 2.4 The New Basel Capital Accord - An Explanatory Note Need for Revising/Improving the 1988-Accord - June 1999 Proposals.20-23 2.5 Pillar 1: Minimum capital requirements...23 2.5(1) Standardized Approach to Credit Risk..24 2.5(2) Internal Ratings-based (IRB) Approaches25 2.6 Pillar 2: Supervisory Review...26 2.7 Pillar 3: Market Discipline27

CHAPTER-3 RBI guidelines on credit risk management

3.1 Credit Rating Framework.29-32 3.2 Credit Risk Models...33 3.3 Techniques for Measuring Credit Risk.33-34 3.4 Managing Credit Risk in Inter-bank Exposure34-38 3.5 New Capital Accord: Implications for Credit Risk Management38-40 3.6 Comments of the Reserve Bank of India on New Capital Adequacy Framework...40-41

CHAPTER-5 Literature Review CHAPTER-6 Research Methodology 6.1 6.2 6.3 6.4 Objective of the Study Research Design. Methods of Data Collection Steps of Methodology

CHAPTER-7 Findings CHAPTER-9 Analysis and Interpretation. CHAPTER-10 Conclusion CHAPTER-11 Suggestions Bibliography

CHAPTER-1 INTRODUCTION TO TOPIC

1.1 THE NATURE OF CREDIT RISK

Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank's portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a bank's dealings with an individual, corporate, bank, financial institution or a sovereign. Credit risk may take the following forms

in the case of direct lending: principal/and or interest amount may not be repaid; in the case of guarantees or letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability; in the case of treasury operations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases; in the case of securities trading businesses: funds/ securities settlement may not be effected; in the case of cross-border exposure: the availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.

1.2 CREDIT RISK MANAGEMENT

In this backdrop, it is imperative that banks have a robust credit risk management system which is sensitive and responsive to these factors. The effective management of credit risk is a critical component of comprehensive risk management and is essential for the long term success of any banking organisation. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures. Building Blocks of Credit Risk Management: In a bank, an effective credit risk management framework would comprise of the following distinct building blocks: Organizational Structure Credit Risk Management Committee (CRMC) Operations/ Systems Organizational Structure Sound organizational structure is sine qua non for successful implementation of an effective credit risk management system. The organizational structure for credit risk management should have the following basic features: 1. The Board of Directors should have the overall responsibility for management of risks. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks. 2. CEO and heads of Credit, Market and Operational Risk Management Committees.

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It will devise the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit risk. For this purpose, this Committee should effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee and other risk committees of the bank, if any. It is imperative that the independence of this Committee is preserved. The Board should, therefore, ensure that this is not compromised at any cost. In the event of the Board not accepting any recommendation of this Committee, systems should be put in place to spell out the rationale for such an action and should be properly documented. This document should be made available to the internal and external auditors for their scrutiny and comments. The credit risk strategy and policies adopted by the committee should be effectively communicated throughout the organisation. Credit Risk Management Committee (CRMC) Each bank may, depending on the size of the organization or loan/ investment book, constitute a high level Credit Risk Management Committee (CRMC). The Committee should be headed by the Chairman/CEO/ED, and should comprise of heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The functions of the Credit Risk Management Committee should be as under: 1. Be responsible for the implementation of the credit risk policy/ strategy approved by the Board. 2. Monitor credit risk on a bank wide basis and ensure compliance with limits approved by the Board. 3. Recommend to the Board, for its approval, clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, 4. Decide delegation of credit approving powers, prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Operations / Systems Banks should have in place an appropriate credit administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases: 1. Relationship management phase i.e. business development. 2. Transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, on going monitoring and risk measurement. 3. Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans 4. On the basis of the broad management framework stated above, the banks should have the following credit risk measurement and monitoring procedures: 5. Banks should establish proactive credit risk management practices like annual / half yearly industry studies and individual obligor reviews, periodic credit calls that are documented, periodic visits of plant and business site, and at least quarterly

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management reviews of troubled exposures/weak credits Banks should have a system of checks and balances in place for extension of credit viz.: 1. Separation of credit risk management from credit sanction 2. Multiple credit approvers making financial sanction subject to approvals at various stages viz. credit ratings, risk approvals, credit approval grid, etc. 3. An independent audit and risk review function. 4. The level of authority required to approve credit will increase as amounts and transaction risks increase and as risk ratings worsen. 5. Every obligor and facility must be assigned a risk rating. 6. Mechanism to price facilities depending on the risk grading of the customer, and to attribute accurately the associated risk weightings to the facilities. 7. Banks should ensure that there are consistent standards for the origination, documentation and maintenance for extensions of credit 8. Banks should have a consistent approach towards early problem recognition, the classification of problem exposures, and remedial action. 9. Banks should maintain a diversified portfolio of risk assets; have a system to conduct regular analysis of the portfolio and to ensure ongoing control of risk concentrations. 10. Credit risk limits include, obligor limits and concentration limits by industry or geography. The Boards should authorize efficient and effective credit approval processes for operating within the approval limits. 11. In order to ensure transparency of risks taken, it is the responsibility of banks to accurately, completely and in a timely fashion, report the comprehensive set of credit risk data into the independent risk system 12. Banks should have systems and procedures for monitoring financial performance of customers and for controlling outstanding within limits. 13. A conservative policy for provisioning in respect of non-performing advances may be adopted. 14. Successful credit management requires experience, judgement and commitment to technical development. Banks should have a clear, well-documented scheme of delegation of powers for credit sanction. 15. Banks must have a Management Information System (MIS), which should enable them to manage and measure the credit risk inherent in all on- and off-balance sheet activities. The MIS should provide adequate information on the composition of the credit portfolio, including identification of any concentration of risk. Banks should price their loans according to the risk profile of the borrower and the risks associated with the loans.

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1.4

CREDIT RISK POLICY AND STRATEGY

Policy and Strategy The Board of Directors of each bank shall be responsible for approving and periodically reviewing the credit risk strategy and significant credit risk policies. Credit Risk Policy 1. Every bank should have a credit risk policy document approved by the Board. The document should include risk identification, risk measurement, risk grading/ aggregation techniques, reporting and risk control/ mitigation techniques, documentation, legal issues and management of problem loans. 2. Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority, credit origination/ maintenance procedures and guidelines for portfolio management. 3. The credit risk policies approved by the Board should be communicated to branches/controlling offices. All dealing officials should clearly understand the bank's approach for credit sanction and should be held accountable for complying with established policies and procedures. 4. Senior management of a bank shall be responsible for implementing the credit risk policy approved by the Board. Credit Risk Strategy 1. Each bank should develop, with the approval of its Board, its own credit risk strategy or plan that establishes the objectives guiding the bank's credit-granting activities and adopt necessary policies/ procedures for conducting such activities. This strategy should spell out clearly the organisation's credit appetite and the acceptable level of risk-reward trade-off for its activities. 2. The strategy would, therefore, include a statement of the bank's willingness to grant loans based on the type of economic activity, geographical location, currency, market, maturity and anticipated profitability. This would necessarily translate into the identification of target markets and business sectors, preferred levels of diversification and concentration, the cost of capital in granting credit and the cost of bad debts. 3. The credit risk strategy should provide continuity in approach as also take into account the cyclical aspects of the economy and the resulting shifts in the composition/ quality of the overall credit portfolio. This strategy should be viable in the long run and through various credit cycles. 4. Senior management of a bank shall be responsible for implementing the credit risk strategy approved by the Board.

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CHAPTER-2 INTRODUCTION TO BASEL COMMITTEE ACCORD

2.1 ABOUT THE BASEL COMMITTEE

The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by

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exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision. The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. The present Chairman of the Committee is Mr Nout Wellink, President of the Netherlands Bank. The Committee encourages contacts and cooperation among its members and other banking supervisory authorities. It circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years. The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland, and is staffed mainly by professional supervisors on temporary secondment from member institutions. In addition to undertaking the secretarial work for the Committee and its many expert sub-committees, it stands ready to give advice to supervisory authorities in all countries. Mr Stefan Walter is the Secretary General of the Basel Committee.

2.2 History of the Basel Committee

The Basel Committee, established by the central-bank Governors of the Group of Ten countries at the end of 1974, meets regularly four times a year. It has four main working groups which also meet regularly. The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. The present Chairman of the Committee is Mr Nout Wellink, President of the Netherlands Bank, who succeeded Mr Jaime Caruana on 1 July 2006. The Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements - statutory or otherwise - which are best suited to their own national systems. In this way, the Committee encourages convergence towards common approaches

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and common standards without attempting detailed harmonisation of member countries' supervisory techniques. The Committee reports to the central bank Governors of the Group of Ten countries and to the heads of supervisory authorities of these countries where the central bank does not have formal responsibility. It seeks their endorsement for its major initiatives. These decisions cover a very wide range of financial issues. One important objective of the Committee's work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be adequate. To achieve this, the Committee has issued a long series of documents since 1975. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by end-1992. Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with internationally active banks. In June 1999, the Committee issued a proposal for a revised Capital Adequacy Framework. The proposed capital framework consists of three pillars: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. Following extensive interaction with banks, industry groups and supervisory authorities that are not members of the Committee, the revised framework was issued on 26 June 2004. This text serves as a basis for national rule-making and for banks to complete their preparations for the new framework's implementation. Over the past few years, the Committee has moved more aggressively to promote sound supervisory standards worldwide. In close collaboration with many non-G10 supervisory authorities, the Committee in 1997 developed a set of "Core Principles for Effective Banking Supervision", which provides a comprehensive blueprint for an effective supervisory system. To facilitate implementation and assessment, the Committee in October 1999 developed the "Core Principles Methodology". The Core Principles and the Methodology were revised recently and released in October 2006. In order to enable a wider group of countries to be associated with the work being pursued in Basel, the Committee has always encouraged contacts and cooperation between its members and other banking supervisory authorities. It circulates to supervisors throughout the world published and unpublished papers. In many cases, supervisory authorities in nonG10 countries have seen fit publicly to associate themselves with the Committee's initiatives. Contacts have been further strengthened by International Conferences of Banking Supervisors (ICBS) which take place every two years. The last ICBS was held in Mexico in the autumn of 2006. The Committee's Secretariat is provided by the Bank for International Settlements in Basel. The fifteen person Secretariat is mainly staffed by professional supervisors on temporary secondment from member institutions. In addition to undertaking the secretarial work for

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the Committee and its many expert sub-committees, it stands ready to give advice to supervisory authorities in all countries.

2.3 Basel Accord,1988

Credit management is the challenging functional area in a commercial bank. It calls for expert handling, assessing risk exposure at every stage and securing adequately the safety of funds exposed. In spite of best efforts there can be no full-proof safety standards, resulting in the unpreventable emergence of sticky or overdue credit periodically. Credit management is therefore a continuous search for more secure de-risking (effective riskmanagement) standards, and Asset-Liability Management strategies. Such risk-management expertise built and implemented helps at not eliminating risk altogether, but minimising the same. Risk management is a subject for advanced study in the western countries. The subject has also attracted the attention of our business managers recently. In the coming years riskmanagement and Asset-Liability Management strategies will receive increasing attention in India, as a consequence of deregulation measures implemented in Indian Banking by RBI and the Government of India. While banks face a variety of risks, the effect of "CreditRisk" is being severely felt in India. In fact the 1988 Basle Accord exclusively addresses at handling effectively credit-risks. However the proposed New accord to be implemented from 2004 hopes to cover other risks also. Relevant extract from the Consultative Paper issued by Basel Committee on Banking Supervision covering the New Capital Adequacy Framework speaks as under. "While the original Accord focused mainly on credit risk, it has since been amended to address market risk. Interest rate risk in the banking book and other risks, such as operational, liquidity, legal and reputational risks, are not explicitly addressed. Implicitly, however, the present Accord takes account of such risks by setting a minimum ratio that has an acknowledged buffer to cover unquantified risks." In India the first effort for standardisation of credit-assets for a better understanding of the inherent risk-component was made in the Eighties, when RBI introduced categorisation of bank-advances termed "Health Code" graded as per risk-content in each type of advance. The object of any coding system is standardization. RBI introduced the Health code system of commercial bank credit to bring industry level uniformity and intended for better transparency. All bank advances are categorized under eight health codes as underWhile Health Code provided for the categorisation of Bank-credit based on risk-exposure, it did not provide for risk-coverage on account of Credit-Assets turning non-productive or sticky . It is in this background that Prudential norms of Income recognition and provisioning for sticky accounts were introduced in 1992 when RBI considered it essential to accept Basel Committee Recommendations for Capital Adequacy. Brief description of measures implemented as per guidelines of RBI is given hereunder. Asset Classification The banks should classify their assets based on weaknesses and dependency on collateral

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securities into four categories: 1. Standard Assets- It carries not more than the normal risk attached to the business and is not an NPA 2. Sub-standard Asset - An asset which remains as NPA for a period not exceeding 24 months, where the current net worth of the borrower, guarantor or the current market value of the security charged to the bank is not enough to ensure recovery of the debt due to the bank in full. 3. Doubtful Assets- An NPA which continued to be so for a period exceeding two years (18 months, with effect from March, 2001). 4. Loss Assets - An asset identified by the bank or internal/ external auditors or RBI inspection as loss asset, but the amount has not yet been written off wholly or partly Capital Adequacy Ratio - Basle Accord 1988 The growing concern of commercial banks regarding international competitiveness and capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries. The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The document consists of two main sections, which cover a. the definition of capital and b. the structure of risk weights. Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian banks. According to these guidelines, the banks will have to identify their Tier-I and Tier-II capital and assign risk weights to the assets. Having done this they will have to assess the Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR which the Indian banks are required to meet is set at 9 percent. Tier-I Capital

Paid-up capital Statutory Reserves Disclosed free reserves Capital reserves representing surplus arising out of sale proceeds of assets

Equity investments in subsidiaries, intangible assets and losses in the current period and those brought forward from previous periods, will be deducted from Tier I capital. Tier-II Capital

Undisclosed Reserves and Cumulative Perpetual Preference Shares Revaluation Reserves General Provisions and Loss Reserves

Background of the Basel Accord of 1988 The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of

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the G10 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition. Capital is necessary for banks as a cushion against losses and it provides an incentive for the owners of the business to manage it in a prudent manner. The Existing Framework The 1988 Accord requires internationally active banks in the G10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their riskiness. The definition of capital is set (broadly) in two tiers, Tier 1 being shareholders' equity and retained earnings and Tier 2 being additional internal and external resources available to the bank. The bank has to hold at least half of its measured capital in Tier 1 form. A portfolio approach is taken to the measure of risk, with assets classified into four buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that some assets (essentially bank holdings of government assets such as Treasury Bills and bonds) have no capital requirement, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claim. However, virtually all claims on the nonbank private sector receive the standard 8% capital requirement. There is also a scale of charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc. This is the only complex section of the 1988 Accord and requires a two-step approach whereby banks convert their off-balance-sheet positions into a credit equivalent amount through a scale of conversion factors, which then are weighted according to the counterparty's risk weighting. The 1988 Accord has been supplemented a number of times, with most changes dealing with the treatment of off-balance-sheet activities. A significant amendment was enacted in 1996, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument.

Impact of the 1988 Accord The two principal purposes of the Accord were to ensure an adequate level of capital in the international banking system and to create a "more level playing field" in competitive terms so that banks could no longer build business volume without adequate capital backing. These two objectives have been achieved. The merits of the Accord were widely recognized and during the 1990s the Accord became an accepted world standard, with well over 100 countries applying the Basel framework to their banking system. However, there also have been some less positive features. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. The simple bucket approach with a flat 8% charge for claims on the private sector has given banks an incentive to move high quality assets off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the 1988 Accord does not sufficiently recognise credit risk mitigation techniques, such as collateral and guarantees. These are the principal

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reasons why the Basel Committee decided to propose a more risk-sensitive framework in June 1999. The June 1999 Proposal The initial consultative proposal had a strong conceptual content and was deliberately rather vague on some details in order to solicit comment at a relatively early stage of the Basel Committee's thinking.It contained three fundamental innovations, each designed to introduce greater risk sensitivity into the Accord. One was to supplement the current quantitative standard with two additional "Pillars" dealing with supervisory review and market discipline. These were intended to reduce the stress on the quantitative Pillar 1 by providing a more balanced approach to the capital assessment process. The second innovation was that banks with advanced risk management capabilities would be permitted to use their own internal systems for evaluating credit risk, known as "internal ratings", instead of standardized risk weights for each class of asset. The third principal innovation was to allow banks to use the gradings provided by approved external credit assessment institutions (in most cases private rating agencies) to classify their sovereign claims into five risk buckets and their claims on corporates and banks into three risk buckets. In addition, there were a number of other proposals to refine the risk weightings and introduce a capital charge for other risks. The basic definition of capital stayed the same. The comments on the June 1999 paper were numerous and can be said to reflect the important impact the 1988 Accord has had. Nearly all commentaries welcomed the intention to refine the Accord and supported the three Pillar approach, but there were many comments on the details of the proposal. A widely-expressed comment from banks in particular was that the threshold for the use of the IRB approach should not be set so high as to prevent well-managed banks from using their internal ratings. Intensive work has taken place in the eighteen months since June 1999. Much of this has leveraged off work undertaken in parallel with industry representatives, whose cooperation has been greatly appreciated by the Basel Committee and its Secretariat.

2.4 The New Basel Capital Accord - An Explanatory Note) Need for Revising/Improving the 1988-Accord - June 1999 Proposals)
More than a decade has passed since the Basel Committee on Banking Supervision (the Committee) introduced its 1988 Capital Accord (the Accord). The business of banking, risk-management practices, supervisory approaches, and financial markets each have undergone significant transformation since then. In June 1999 the Committee released a proposal to replace the 1988 Accord with a more risk-sensitive framework. Rationale for a New Accord: Need for more flexibility and Risk THE EXISTING ACCORD THE PROPOSED NEW ACCORD

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Focus on a single risk measure One size fits all Broad brush structure

More emphasis on banks' own internal methodologies, supervisory review, and market discipline Flexibility, menu of approaches, incentives for better risk management More risk sensitivity

Safety and soundness in today's dynamic and complex financial system can be attained only by the combination of effective bank-level management, market discipline, and supervision. The 1988 Accord focussed on the total amount of bank capital, which is vital in reducing the risk of bank insolvency and the potential cost of a bank's failure for depositors. Building on this, the new framework intends to improve safety and soundness in the financial system by placing more emphasis on banks' own internal control and management, the supervisory review process, and market discipline. Although the new framework's focus is primarily on internationally active banks, its underlying principles are intended to be suitable for application to banks of varying levels of complexity and sophistication. The Committee has consulted with supervisors worldwide in developing the new framework and expects the New Accord to be adhered to by all significant banks within a certain period of time. The 1988 Accord provided essentially only one option for measuring the appropriate capital of internationally active banks. The best way to measure, manage and mitigate risks, however, differs from bank to bank. An Amendment was introduced in 1996 which focussed on trading risks and allowed some banks for the first time to use their own systems to measure their market risks. The new framework provides a spectrum of approaches from simple to advanced methodologies for the measurement of both credit risk and operational risk in determining capital levels. It provides a flexible structure in which banks, subject to supervisory review, will adopt approaches which best fit their level of sophistication and their risk profile. The framework also deliberately builds in rewards for stronger and more accurate risk measurement. The new framework intends to provide approaches which are both more comprehensive and more sensitive to risks than the 1988 Accord, while maintaining the overall level of regulatory capital. Capital requirements that are more in line with underlying risks will allow banks to manage their businesses more efficiently. The new framework is less prescriptive than the original Accord. At its simplest, the framework is somewhat more complex than the old, but it offers a range of approaches for banks capable of using more risk-sensitive analytical methodologies. These inevitably require more detail in their application and hence a thicker rule book. The Committee believes the benefits of a regime in which capital is aligned more closely to risk significantly exceed the costs, with the result that the banking system should be safer, sounder, and more efficient.

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Structure of the New Accord - Three pillars of the New Accord

First pillar: minimum capital requirement Second pillar: supervisory review process Third pillar: market discipline

The new Accord consists of three mutually reinforcing pillars, which together should contribute to safety and soundness in the financial system. The Committee stresses the need for rigorous application of all three pillars and plans to work actively with fellow supervisors to achieve the effective implementation of all aspects of the Accord. The First Pillar: Minimum Capital Requirement The first pillar sets out minimum capital requirements. The new Accord maintains both the current definition of capital and the minimum requirement of 8% of capital to risk-weighted assets. To ensure that risks within the entire banking group are considered, the revised Accord will be extended on a consolidated basis to holding companies of banking groups. The revision focuses on improvements in the measurement of risks, i.e., the calculation of the denominator of the capital ratio. The credit risk measurement methods are more elaborate than those in the current Accord. The new framework proposes for the first time a measure for operational risk, while the market risk measure remains unchanged. For the measurement of credit risk, two principal options are being proposed. The first is the standardised approach, and the second the internal rating based (IRB) approach. There are two variants of the IRB approach, foundation and advanced. The use of the IRB approach will be subject to approval by the supervisor, based on the standards established by the Committee. The Second Pillar: Supervisory Review Process The supervisory review process requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks. The new framework stresses the importance of bank managementdeveloping an internal capital assessment process and setting targets for capital that are commensurate with the bank's particular risk profile and control environment. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. This internal process would then be subject to supervisory review and intervention, where appropriate. The implementation of these proposals will in many cases require a much more detailed dialogue between supervisors and banks. This in turn has implications for the training and expertise of bank supervisors, an area in which the Committee and the BIS's Financial Stability Institute will be providing assistance. The Third Pillar: Market Discipline The third pillar of the new framework aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can

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better understand banks' risk profiles and the adequacy of their capital positions. The new framework sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods. The core set of disclosure recommendations applies to all banks, with more detailed requirements for supervisory recognition of internal methodologies for credit risk, credit risk mitigation techniques and asset securitization

2.5 Pillar 1: Minimum capital requirements

While the proposed New Accord differs from the current Accord along a number of dimensions, it is important to begin with a description of elements that have not changed. The current Accord is based on the concept of a capital ratio where the numerator represents the amount of capital a bank has available and the denominator is a measure of the risks faced by the bank and is referred to as risk-weighted assets. The resulting capital ratio may be no less than 8%. Under the proposed New Accord, the regulations that define the numerator of the capital ratio (i.e. the definition of regulatory capital) remain unchanged. Similarly, the minimum required ratio of 8% is not changing. The modifications, therefore, are occurring in the definition of risk-weighted assets, that is in the methods used to measure the risks faced by banks. The new approaches for calculating risk-weighted assets are intended to provide improved bank assessments of risk and thus to make the resulting capital ratios more meaningful. The current Accord explicitly covers only two types of risks in the definition of riskweighted assets: (1) credit risk and (2) market risk. Other risks are presumed to be covered implicitly through the treatments of these two major risks. The treatment of market risk arising from trading activities was the subject of the Basel Committee's 1996 Amendment to the Capital Accord. The proposed New Accord envisions this treatment remaining unchanged. The pillar one proposals to modify the definition of risk-weighted assets in the New Accord have two primary elements: 1. substantive changes to the treatment of credit risk relative to the current Accord; and 2. the introduction of an explicit treatment of operational risk that will result in a measure of operational risk being included in the denominator of a bank's capital ratio. The discussions below will focus on these two elements in turn. In both cases, a major innovation of the proposed New Accord is the introduction of three distinct options for the calculation of credit risk and three others for operational risk. The

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Committee believes that it is not feasible or desirable to insist upon a one-size-fits-all approach to the measurement of either risk. Instead, for both credit and operational risk, there are three approaches of increasing risk sensitivity to allow banks and supervisors to select the approach or approaches that they believe are most appropriate to the stage of development of banks' operations and of the financial market infrastructure.

2.5(1) Standardised Approach to Credit Risk

The standardised approach is similar to the current Accord in that banks are required to slot their credit exposures into supervisory categories based on observable characteristics of the exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The standardised approach establishes fixed risk weights corresponding to each supervisory category and makes use of external credit assessments to enhance risk sensitivity compared to the current Accord. The risk weights for sovereign, interbank, and corporate exposures are differentiated based on external credit assessments. For sovereign exposures, these credit assessments may include those developed by OECD export credit agencies, as well as those published by private rating agencies. The standardised approach contains guidance for use by national supervisors in determining whether a particular source of external ratings should be eligible for banks to use. The use of external ratings for the evaluation of corporate exposures, however, is considered to be an optional element of the framework. Where no external rating is applied to an exposure, the standardised approach mandates that in most cases a risk weighting of 100% be used, implying a capital requirement of 8% as in the current Accord. In such instances, supervisors are to ensure that the capital requirement is adequate given the default experience of the exposure type in question. An important innovation of the standardised approach is the requirement that loans considered past-due be risk weighted at 150%, unless a threshold amount of specific provisions has already been set aside by the bank against that loan. Another important development is the expanded range of collateral, guarantees, and credit derivatives that banks using the standardised approach may recognise. Collectively, Basel II refers to these instruments as credit risk mitigants. The standardised approach expands the range of eligible collateral beyond OECD sovereign issues to include most types of financial instruments, while setting out several approaches for assessing the degree of capital reduction based on the market risk of the collateral instrument. Similarly, the standardised approach expands the range of recognised guarantors to include all firms that meet a threshold external credit rating. The standardised approach also includes a specific treatment for retail exposures. The risk weights for residential mortgage exposures are being reduced relative to the current Accord, as are those for other retail exposures, which will now receive a lower risk weight than that for unrated corporate exposures. In addition, some loans to small- and mediumsized enterprises (SMEs) may be included within the retail treatment, subject to meeting various criteria. By design the standardised approach draws a number of distinctions between exposures and transactions in an effort to improve the risk sensitivity of the resulting capital ratios. The same can also be said of the IRB approaches to credit risk and those for assessing the

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capital requirement for operational risk where capital requirements are more closely linked to risk. In order to assist banks and national supervisors where circumstances may not warrant a broad range of options, the Committee has developed the 'simplified standardised approach' outlined in Annex 9 of CP3. The annex collects in one place the simplest options for calculating risk weighted assets. Banks intending to adopt the simplified standardised methods are also expected to comply with the corresponding supervisory review and market discipline requirements of the New Accord.

2.5(2) Internal Ratings-based (IRB) Approaches

One of the most innovative aspects of the New Accord is the IRB approach to credit risk, which includes two variants: a foundation version and an advanced version. The IRB approach differs substantially from the standardised approach in that banks' internal assessments of key risk drivers serve as primary inputs to the capital calculation. Because the approach is based on banks' internal assessments, the potential for more risk sensitive capital requirements is substantial. However, the IRB approach does not allow banks themselves to determine all of the elements needed to calculate their own capital requirements. Instead, the risk weights and thus capital charges are determined through the combination of quantitative inputs provided by banks and formulas specified by the Committee.

Corporate, Bank and Sovereign Exposures The IRB calculation of risk-weighted assets for exposures to sovereigns, banks, or corporate entities uses the same basic approach. It relies on four quantitative inputs: 1. Probability of default (PD), which measures the likelihood that the borrower will default over a given time horizon; 2. Loss given default (LGD),which measures the proportion of the exposure that will be lost if a default occurs; 3. Exposure at default (EAD), which for loan commitments measures the amount of the facility that is likely to be drawn if a default occurs; and 4. Maturity (M), which measures the remaining economic maturity of the exposure. Implementation of IRB By relying on internally generated inputs to the Basel II risk weight functions, there is bound to be some variation in the way in which the IRB approach is carried out. To ensure significant comparability across banks, the Committee has established minimum qualifying criteria for use of the IRB approaches that cover the comprehensiveness and integrity of banks' internal credit risk assessment capabilities. While banks using the advanced IRB approach will have greater flexibility relative to those relying on the foundation IRB approach, at the same time they must also satisfy a more stringent set of minimum standards. The Committee believes that banks' internal rating systems should accurately and consistently differentiate between different degrees of risk. The challenge is for banks to

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define clearly and objectively the criteria for their rating categories in order to provide meaningful assessments of both individual credit exposures and ultimately an overall risk profile. A strong control environment is another important factor for ensuring that banks' rating systems perform as intended and the resulting ratings are accurate. An independent ratings process, internal review and transparency are control concepts addressed in the minimum IRB standards. Clearly, an internal rating system is only as good as its inputs. Accordingly, banks using the IRB approach will need to be able to measure the key statistical drivers of credit risk. The minimum Basel II standards provide banks with the flexibility to rely on data derived from their own experience, or from external sources as long as the bank can demonstrate the relevance of such data to its own exposures. In practical terms, banks will be expected to have in place a process that enables them to collect, to store and to utilise loss statistics over time in a reliable manner.

2.6 Pillar 2: Supervisory Review

The second pillar of the New Accord is based on a series of guiding principles, all of which point to the need for banks to assess their capital adequacy positions relative to their overall risks, and for supervisors to review and take appropriate actions in response to those assessments. These elements are increasingly seen as necessary for effective management of banking organisations and for effective banking supervision, respectively. Feedback received from the industry and the Committee's own work has emphasised the importance of the supervisory review process. Judgements of risk and capital adequacy must be based on more than an assessment of whether a bank complies with minimum capital requirements. The inclusion of a supervisory review element in the New Accord, therefore, provides benefits through its emphasis on the need for strong risk assessment capabilities by banks and supervisors alike. Further, it is inevitable that a capital adequacy framework, even the more forward looking New Accord, will lag to some extent behind the changing risk profiles of complex banking organisations, particularly as they take advantage of newly available business opportunities. Accordingly, this heightens the importance of, and attention supervisors must pay to pillar two. The Committee has been working to update the pillar two guidance as it finalises other aspects of the new capital adequacy framework. One update is in relation to stress testing. The Committee believes it is important for banks adopting the IRB approach to credit risk to hold adequate capital to protect against adverse or uncertain economic conditions. Such banks will be required to perform a meaningfully conservative stress test of their own design with the aim of estimating the extent to which their IRB capital requirements could increase during a stress scenario. Banks and supervisors are to use the results of such tests as a means of ensuring that banks hold a sufficient capital buffer. To the extent there is a capital shortfall, supervisors may, for example, require a bank to reduce its risks so that existing capital resources are available to cover its minimum capital requirements plus the results of a recalculated stress test.

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Other refinements focus on banks' review of concentration risks, and on the treatment of residual risks that arise from the use of collateral, guarantees and credit derivatives. Further to the pillar one treatment of securitisation, a supervisory review component has been developed, which is intended to provide banks with some insight into supervisory expectations for specific securitisation exposures. Some of the concepts addressed include significant risk transfer and considerations related to the use of call provisions and early amortisation features. Further, possible supervisory responses are outlined to address instances when it is determined that a bank has provided implicit (non-contractual) support to a securitisation structure.

2.7 Pillar 3: Market Discipline

The purpose of pillar three is to complement the minimum capital requirements of pillar one and the supervisory review process addressed in pillar two. The Committee has sought to encourage market discipline by developing a set of disclosure requirements that allow market participants to assess key information about a bank's risk profile and level of capitalisation. The Committee believes that public disclosure is particularly important with respect to the New Accord where reliance on internal methodologies will provide banks with greater discretion in determining their capital needs. By bringing greater market discipline to bear through enhanced disclosures, pillar three of the new capital framework can produce significant benefits in helping banks and supervisors to manage risk and improve stability. Over the past year, the Committee has engaged various market participants and supervisors in a dialogue regarding the extent and type of bank disclosures that would be most useful. The aim has been to avoid potentially flooding the market with information that would be hard to interpret or to use in understanding a bank's actual risk profile. After taking a hard look at the disclosures proposed in its second consultative package on the New Accord, the Committee has since scaled back considerably the requirements, particularly those relating to the IRB approaches and securitisation.The Committee is aware that supervisors may have different legal avenues available in having banks satisfy the disclosure requirements. The various means may include public disclosures deemed necessary on safety and supervision grounds or information that must be disclosed in regulatory reports. The Committee recognises that the means by which banks will be expected to share information publicly will depend on the legal authority of supervisors. Another important consideration has been the need for the Basel II disclosure framework to align with national accounting standards. Considerable efforts have been made to ensure that the disclosure requirements of the New Accord focus on bank capital adequacy and do not conflict with broader accounting disclosure standards with which banks must comply. This has been accomplished through a strong and co-operative dialogue with accounting authorities. Going forward, the Committee will look to strengthen these relationships given that the continuing work of accounting authorities may have implications for the disclosures required in the New Accord. With respect to potential future modifications to the capital framework itself, the Committee intends to also consider the impact of such changes on the amount of information a bank should be required to disclose.

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CHAPTER-3 RBI GUIDELINES ON CREDIT RISK MANAGEMENT

3.1 Credit Rating Framework

A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations associated with a simplistic and broad classification of loans/exposures into a "good" or a "bad" category. 28

The CRF deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit exposure. Such a rating framework is the basic module for developing a credit risk management system and all advanced models/approaches are based on this structure. In spite of the advancement in risk management techniques, CRF is continued to be used to a great extent. These frameworks have been primarily driven by a need to standardise and uniformly communicate the "judgement" in credit selection procedures and are not a substitute to the vast lending experience accumulated by the banks' professional staff. Basic Architecture of CRFs The following elements outline the basic architecture and the operating principles of any CRF. Grading system for calibration of credit risk Operating design of CRF GRADING SYSTEM FOR CALIBRATION OF CREDIT RISK The grades (symbols, numbers, alphabets, descriptive terms) used in the internal credit-risk grading system should represent, without any ambiguity, the default risks associated with an exposure. The grading system should enable comparisons of risks for purposes of analysis and top management decision-making. It should also reflect regulatory requirements of the supervisor on asset classification (e.g. the RBI asset classification). It is anticipated that, over a period of time, the process of risk identification and risk assessment will be further refined. The grading system should, therefore, be flexible and should accommodate the refinements in risk categorisation. Nature of Grading System for the CRF The grading system adopted in a CRF could be an alphabetic or numeric or an alphanumeric scale. Since rating agencies follow a particular scale (AAA, AA+, BBB etc.), it would be prudent to adopt a different rating scale to avoid confusion in internal communications. Besides, adoption of a different rating scale would permit comparable benchmarking between the two mechanisms. Several banks utilise a numeric rating scale. The number of grades for the "acceptable" and the "unacceptable" credit risk categories would depend on the finesse of risk gradation. Normally, numeric scales developed for CRFs are such that the lower the credit-risk, the lower is the calibration on the scale.

Illustration

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A rating scale could consist of 9 levels, of which levels 1 to 5 represent various grades of acceptable credit risk and levels 6 to 9 represent various grades of unacceptable credit risk associated with an exposure. The scale, starting from "1" (which would represent lowest level credit risk and highest level of safety/ comfort) and ending at "9" (which would represent the highest level of credit risk and lowest level of safety/ comfort), could be deployed to calibrate, benchmark, compare and monitor credit risk associated with the bank's exposures and give indicative guidelines for credit risk management activities. Each bank may consider adopting suitable alphabetic prefix to their rating scales, which would make their individual ratings scale distinct and unique.

OPERATING DESIGN OF THE CRF Which Exposures are Rated? The first element of the operating design is to determine which exposures are required to be rated through the CRF. There may be a case for size-based classification of exposures and linking the risk-rating process to these size-based categories. The shortcoming of this arrangement is that though significant credit migration/deterioration/erosion occurs in the smaller sized exposures, these are not captured by the CRF. In addition, the size-criteria are also linked with the tenure-criteria for an exposure. In several instances, large-sized exposures over a short tenure may not require the extent of surveillance and credit monitoring that is required for a smaller sized long-tenure exposure. Given this apparent lack of clarity, a policy of 'all exposures are to be rated' should be followed. The Risk-Rating Process The credit approval process within the bank is expected to replicate the flow of analysis/ appraisal of credit-risk calibration on the CRF. As indicated above the CRF may be designed in such a way that the risk rating has certain linkages with the amount, tenure and pricing of exposure. These default linkages may be either specified upfront or may be developed with empirical details over a period of time. The risk rating assigned to each credit proposal would thus directly lead into the related decisions of acceptance (or rejection), amount, tenure and pricing of the (accepted) proposal. For each proposal, the credit/ risk staff would assign a rating and forward the recommendation to the higher level of credit selection process. The proposed risk rating is either reaffirmed or re-calibrated at the time of final credit approval and sanction. Any revisions that may become necessary in the risk-ratings are utilised to upgrade the CRF system and the operating guidelines. In this manner, the CRF maintains its "incremental upgradation" feature and changes in the lending environment are captured by the system. The risk-rating process would be equally relevant in the credit-monitoring/ surveillance stage. All changes in the underlying credit-quality are calibrated on the risk-scale and corresponding remedial actions are initiated. Assigning & Monitoring Risk-Ratings

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In conventional banks, the practice of segregating the "relationship management" and the "credit appraisal" functions is quite prevalent. One of the variants of this arrangement is that responsibilities for calibration on the risk-rating scale are divided between the "relationship" and the "credit" groups. All large sized exposures (above a limit) are appraised independently by the "credit" group. Generally, the activities of assigning and approving risk-ratings need to be segregated. Though the front-office or conventional relationship staff can assign the risk-ratings, the responsibilities of final approval and monitoring should be vested with a separate credit staff. Mechanism of Arriving at Risk-Ratings The risk ratings, as specified above, are collective readings on the pre-specified scale and reflect the underlying credit-risk for a prospective exposure. The CRF could be separate for relatively peculiar businesses like banking, finance companies, real-estate developers, etc. For all industries (manufacturing sector), a common CRF may be used. The peculiarity of a particular industry can be captured by assigning different weights to aspects like entry barriers, access to technology, ability of new entrants to access raw materials, etc. The following step-wise activities outline the indicative process for arriving at risk-ratings. 1. 2. 3. 4. 5. 6. 7. 8. 9. Step I: Identify all the principal business and financial risk elements Step II: Allocate weights to principal risk components Step III: Compare with weights given in similar sectors and check for consistency Step IV: Establish the key parameters (sub-components of the principal risk elements) Step V: Assign weights to each of the key parameters Step VI:Rank the key parameters on the specified scale Step VII: Arrive at the credit-risk rating on the CRF Step VIII: Compare with previous risk-ratings of similar exposures and check for consistency Step IX: Conclude the credit-risk calibration on the CRF

The risk-rating process would represent collective decision making principles and as indicated above, would involve some in-built arrangements for ensuring the consistency of the output. The rankings would be largely comparative. As a bank's perception of the exposure improves/changes during the course of the appraisal, it may be necessary to adjust the weights and the rankings given to specific risk-parameters in the CRF. Such changes would be deliberated and the arguments for substantiating these adjustments would be clearly communicated in the appraisal documents. 2.5.5 Standardisation and Benchmarks for Risk-Ratings In a lending environment dominated by industrial and corporate credits, the assignors of risk-ratings utilise benchmarks or pre-specified standards for assessing the risk profile of a potential borrower. These standards usually consist of financial ratios and credit-migration statistics, which capture the financial risks faced by the potential borrower (e.g. operating and financial leverage, profitability, liquidity, debt-servicing ability, etc.). The business risks associated with an exposure (e.g. cyclicality of industry, threats of product or technology substitution etc.) are also addressed in the CRF. The output of the creditappraisal process, specifically the financial ratios, is directly compared with the specified benchmarks for a particular risk category. In these cases, the risk rating is fairly

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standardised and CRF allocates a grade or a numeric value for the overall risk profile of the proposed exposure. Illustration The CRF may specify that for the risk-rating exercise: i. ii. iii. iv. v. vi. If Gross Revenues are between Rs.800 to Rs.1000 crore - assign a score of 2 If Operating Margin is 20% or more - assign a score of 2 If Return on Capital Employed (ROCE) is 25% or more - assign a score of 1 If Debt : Equity is between 0.60 and 0.80 - assign a score of 2 If interest cover is 3.50 or more - assign a score of 1 If Debt Service Coverage Ratio (DSCR) is 1.80 or more - assign a score of 1

The next step would be to assign weights to these risk-parameters. In an industrial credit environment, the CRF may place higher weights on size (as captured in gross revenues), profitability of operations (operating margins), financial leverage (debt: equity) and debtservicing ability (interest cover). Assume that the CRF assigns a 20% weightage to each of these four parameters and the ROCE and DSCR are given a 10% weightage each. The weighted-average score for the financial risk of the proposed exposure is 1.40, which would correspond with the extremely low risk/highest safety level-category of the CRF (category 1). Similarly, the business and the management risk of the proposed exposure are assessed and an overall/ comprehensive risk rating is assigned. The industrial credit environment permits a significantly higher level of benchmarking and standardisation, specifically in reference to calibration of financial risks associated with credit exposures. For all prominent industry-categories, any lender can compile profitability, leverage and debt-servicing details and utilise these to develop internal benchmarks for the CRF. As evident, developing such benchmarks and risk-standards for a portfolio of project finance exposures, as in the case of the bank, would be an altogether diverse exercise. The CRF may also use qualitative/ subjective factors in the credit decisions. Such factors are both internal and external to the company. Internal factors could include integrity and quality of management of the borrower, quality of inventories/ receivables and the ability of borrowers to raise finance from other sources. External factors would include views on the economy and industry such as growth prospects, technological change and options. Interaction with External Credit Assessment Institutions (ECAI) The benefits of such a CRF system, in addition to those described above, could include a more amenable interaction with rating agencies and regulatory bodies. As regards investment ratings the parameters laid down in para 4.1 of the Risk Management Guidelines issued by RBI in October, 1999 may be followed, i.e., the proposals for investments should also be subjected to the same degree of credit risk analysis, as any loan proposals. The proposals should be subjected to detailed appraisal and rating framework that factors in financial and non-financial parameters of issuers, sensitivity to external developments, etc. The maximum exposure to a customer should be bank-wide and include all exposures assumed by the Credit and Treasury Departments. The coupon on nonsovereign papers should be commensurate with their risk profile. The banks should exercise

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due caution, particularly in investment proposals, which are not rated and should ensure comprehensive risk evaluation. There should be greater interaction between Credit and Treasury Departments and the portfolio analysis should also cover the total exposures, including investments. The rating migration of the issuers and the consequent diminution in the portfolio quality should also be tracked at periodic intervals.

3.2 Credit Risk Models

A credit risk model seeks to determine, directly or indirectly, the answer to the following question: Given our past experience and our assumptions about the future, what is the present value of a given loan or fixed income security? A credit risk model would also seek to determine the (quantifiable) risk that the promised cash flows will not be forthcoming. The techniques for measuring credit risk that have evolved over the last twenty years are prompted by these questions and dynamic changes in the loan market. The increasing importance of credit risk modelling should be seen as the consequence of the following three factors: 1. Banks are becoming increasingly quantitative in their treatment of credit risk. 2. New markets are emerging in credit derivatives and the marketability of existing loans is increasing through securitization/ loan sales market." 3. Regulators are concerned to improve the current system of bank capital requirements especially as it relates to credit risk. Importance of Credit Risk Models Credit Risk Models have assumed importance because they provide the decision maker with insight or knowledge that would not otherwise be readily available or that could be marshalled at prohibitive cost. In a marketplace where margins are fast disappearing and the pressure to lower pricing is unrelenting, models give their users a competitive edge. The credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines. The outputs of these models also play increasingly important roles in banks' risk management and performance measurement processes, customer profitability analysis, risk-based pricing, active portfolio management and capital structure decisions. Credit risk modeling may result in better internal risk management and may have the potential to be used in the supervisory oversight of banking organisations.

3.3 Techniques for Measuring Credit Risk

The following are the more commonly used techniques: 1. Econometric Techniques such as linear and multiple discriminant analysis, multiple regression, logic analysis and probability of default, etc. 2. Neural networks are computer-based systems that use the same data employed in the econometric techniques but arrive at the decision model using alternative implementations of a trial and error method.

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3. Optimisation models are mathematical programming techniques that discover the optimum weights for borrower and loan attributes that minimize lender error and maximise profits. 4. Rule-based or expert are characterised by a set of decision rules, a knowledge base consisting of data such as industry financial ratios, and a structured inquiry process to be used by the analyst in obtaining the data on a particular borrower. 5. Hybrid Systems In these systems simulation are driven in part by a direct causal relationship, the parameters of which are determined through estimation techniques. Domain of application: These models are used in a variety of domains: Credit approval Models are used on a stand alone basis or in conjunction with a judgemental override system for approving credit in the consumer lending business. The use of such models has expanded to include small business lending. They are generally not used in approving large corporate loans, but they may be one of the inputs to a decision. Credit rating determination: Quantitative models are used in deriving 'shadow bond rating' for unrated securities and commercial loans. These ratings in turn influence portfolio limits and other lending limits used by the institution. In some instances, the credit rating predicted by the model is used within an institution to challenge the rating assigned by the traditional credit analysis process.Credit risk models may be used to suggest the risk premia that should be charged in view of the probability of loss and the size of the loss given default. Using a mark-tomarket model, an institution may evaluate the costs and benefits of holding a financial asset. Unexpected losses implied by a credit model may be used to set the capital charge in pricing. Early warning: Credit models are used to flag potential problems in the portfolio to facilitate early corrective action. Common credit language: Credit models may be used to select assets from a pool to construct a portfolio acceptable to investors at the time of asset securitisation or to achieve the minimum credit quality needed to obtain the desired credit rating. Underwriters may use such models for due diligence on the portfolio (such as a collateralized pool of commercial loans). Collection strategies: Credit models may be used in deciding on the best collection or workout strategy to pursue. If, for example, a credit model indicates that a borrower is experiencing short-term liquidity problems rather than a decline in credit fundamentals, then an appropriate workout may be devised.

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3.4 Managing Credit Risk in Inter-bank Exposure

During the course of its business, a bank may assume exposures on other banks, arising from trade transactions, money placements for liquidity management purposes, hedging, trading and transactional banking services such as clearing and custody, etc. Such transactions entail a credit risk, as defined, and therefore, it is important that a proper credit evaluation of the banks is undertaken. It must cover both the interpretation of the bank's financial statements as well as forming a judgement on non-financial areas such as management, ownership, peer/ market perception and country factors. The key financial parameters to be evaluated for any bank are: 1. Capital Adequacy 2. Asset Quality 3. Liquidity 4. Profitability 5. Banks will normally have access to information available publicly to assess the credit risk posed by the counter party bank. Capital Adequacy Banks with high capital ratios above the regulatory minimum levels, particularly Tier I, will be assigned a high rating whereas the banks with low ratios well below the standards and with low ability to access capital will be at the other end of the spectrum. Capital adequacy needs to be appropriate to the size and structure of the balance sheet as it represents the buffer to absorb losses during difficult times. Over capitalization can impact overall profitability. Related to the issue of capitalization, is also the ability to raise fresh capital as and when required. Publicly listed banks and state owned banks may be best positioned to raise capital whilst the unlisted private banks or regional banks are dependant entirely on the wealth and/ or credibility of their owners. The capital adequacy ratio is normally indicated in the published audited accounts. In addition, it will be useful to calculate the Capital to Total Assets ratio which indicates the owners' share in the assets of the business. The ratio of Tier I capital to Total Assets represents the extent to which the bank can absorb a counterparty collapse. Tier I capital is not owed to anyone and is available to cover possible losses. It has no maturity or repayment requirement, and is expected to remain a permanent component of the counter party's capital.The Basel standards currently require banks to have a capital adequacy ratio of 8% with Tier I ratio not less than 4%. The Reserve Bank of India requirement is 9%. The Basel Committee is

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planning to introduce the New Capital Accord and these requirements could change the dimension of the capital of banks. Asset Quality The asset portfolio in its entirety should be evaluated and should include an assessment of both funded items and off-balance sheet items. Whilst non performing assets and provisioning ratios will reflect the quality of the loan book, high volatility of valuations and earnings will reflect exposure to the capital market and sensitive sectors. The key ratios to be analysed are 1. Gross NPAs to Gross Advances ratio, 2. Net NPAs to Net Advances ratio 3. Provisions Held to Gross Advances ratio and 4. Provisions Held to Gross NPAs ratio. Commercial banks are increasingly venturing into investment banking activities where asset considerations additionally focus on the marketability of the assets, as well as the quality of the instruments. Preferably banks should mark-to-market their entire investment portfolio and treat sticky investments as "non-performing", which should also be adequately provided for. Liquidity Commercial bank deposits generally have a much shorter contractual maturity than loans, and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. The key ratios to be analysed are 1. Total Liquid Assets to Total Assets ratio (the higher the ratio the more liquid the bank is), 2. Total Liquid Assets to Total Deposits ratio (this measures the bank's ability to meet withdrawals), 3. Loans to Deposits ratio and 4. Inter-bank deposits to total deposits ratio. It is necessary to develop an appropriate level of correlation between assets and liabilities. Account should be taken of the extent to which borrowed funds are required to bolster capital and the respective redemption profiles.

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Profitability A consistent year on year growth in profitability is required to provide an acceptable return to shareholders and retain resources to fund future growth. The key ratios to be analysed are: 1. Return on Average Assets (measures a bank's growth/ decline in profits in comparison with its balance sheet expansion/ contraction), 2. Return on Equity (provides an indication of how well the bank is performing for its owners), 3. Net Interest Margin (measures the difference between interest paid and interest earned, and therefore a bank's ability to earn interest income) and 4. Operating Expenses to Net Revenue ratio (the cost/income ratio of the bank). The degree of reliance upon interest income compared with fees earned, heavy dependency on certain sectors, and the sustainability of income streams are relevant factors to be borne in mind.The ability of a bank to analyse another bank on the above lines will depend upon the information available publicly and also the strength of disclosures in the financial statements. Banks should be rated (called Bank Tierings) on the basis of the above factors. An indicative tiering scale is: BANK TIER 1 2 3 4 5 6 7 8 9 DESCRIPTION Low risk Modest risk Satisfactory risk Fair Risk Acceptable Risk Watch List Substandard Doubtful Loss

The tiering system enables a bank to establish internal parameters to help determine acceptable limits of exposure to a particular bank/ banking group. These parameters should be used to determine the maximum level of (a) and (b) above, maximum tenors for term products which may be considered prudent for a bank and settlement limits. Medium term

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loan facilities and standby facilities should be sanctioned very exceptionally. Standby lines, by their very nature, are likely to be drawn only at a time when the risk in making funds available is generally perceived to be unattractive.Bank-wise exposure limits should be set taking into account the counter party and country risks. The credit risk management of exposure to banks should be centralised on a bank-wide basis.The rating scale for bank rating should be in tandem with CRF to synthesize credit risk on account of all activities for the bank as a whole.

3.5 New Capital Accord: Implications for Credit Risk Management

The Basel Committee on Banking Supervision had released in June 1999 the first Consultative Paper on a New Capital Adequacy Framework with the intention of replacing the current broad-brush 1988 Accord. The Basel Committee has released a Second Consultative Document in January 2001, which contains refined proposals for the three pillars of the New Accord - Minimum Capital Requirements, Supervisory Review and Market Discipline. The Committee proposes two approaches, for estimating regulatory capital. viz., 1. Standardised and 2. Internal Rating Based (IRB) Under the standardised approach, the Committee desires neither to produce a net increase nor a net decrease, on an average, in minimum regulatory capital, even after accounting for operational risk. Under the Internal Rating Based (IRB) approach, the Committee's ultimate goals are to ensure that the overall level of regulatory capital is sufficient to address the underlying credit risks and also provides capital incentives relative to the standardised approach, i.e., a reduction in the risk weighted assets of 2% to 3% (foundation IRB approach) and 90% of the capital requirement under foundation approach for advanced IRB approach to encourage banks to adopt IRB approach for providing capital. The minimum capital adequacy ratio would continue to be 8% of the risk-weighted assets, which cover capital requirements for market (trading book), credit and operational risks. For credit risk, the range of options to estimate capital extends to include a standardised, a foundation IRB and an advanced IRB approaches. Standardised Approach Under the standardised approach, preferential risk weights in the range of 0%, 20%, 50%, 100% and 150% would be assigned on the basis of ratings given by external credit assessment institutions.

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Orientation of the IRB Approach Banks' internal measures of credit risk are based on assessments of the risk characteristics of both the borrower and the specific type of transaction. The probability of default (PD) of a borrower or group of borrowers is the central measurable concept on which the IRB approach is built. The PD of a borrower does not, however, provide the complete picture of the potential credit loss. Banks should also seek to measure how much they will lose should a borrower default on an obligation. This is contingent upon two elements. First, the magnitude of likely loss on the exposure: this is termed the Loss Given Default (LGD), and is expressed as a percentage of the exposure. Secondly, the loss is contingent upon the amount to which the bank was exposed to the borrower at the time of default, commonly expressed as Exposure at Default (EAD). These three components (PD, LGD, EAD) combine to provide a measure of expected intrinsic, or economic, loss. The IRB approach also takes into account the maturity (M) of exposures. Thus, the derivation of risk weights is dependent on estimates of the PD, LGD and, in some cases, M, that are attached to an exposure. These components (PD, LGD, EAD, M) form the basic inputs to the IRB approach, and consequently the capital requirements derived from it. IRB Approach The Committee proposes two approaches - foundation and advanced - as an alternative to standardised approach for assigning preferential risk weights. Under the foundation approach, banks, which comply with certain minimum requirements viz. comprehensive credit rating system with capability to quantify Probability of Default (PD) could assign preferential risk weights, with the data on Loss Given Default (LGD) and Exposure at Default (EAD) provided by the national supervisors. In order to qualify for adopting the foundation approach, the internal credit rating system should have the following parameters/conditions: 1. Each borrower within a portfolio must be assigned the rating before a loan is originated. 2. Minimum of 6 to 9 borrower grades for performing loans and a minimum of 2 grades for non-performing loans. 3. Meaningful distribution of exposure across grades and not more than 30% of the gross exposures in any one borrower grade. 4. Each individual rating assignment must be subject to an independent review or approval by the Loan Review Department. 5. Rating must be updated at least on annual basis. 6. The Board of Directors must approve all material aspects of the rating and PD estimation. 7. Internal and External audit must review annually, the banks' rating system including the quantification of internal ratings. 8. Banks should have individual credit risk control units that are responsible for the design, implementation and performance of internal rating systems. These units should be functionally independent. 9. Members of staff responsible for rating process should be adequately qualified and trained. 10. Internal rating must be explicitly linked with the banks' internal assessment of capital adequacy in line with requirements of Pillar 2.

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11. Banks must have in place sound stress testing process for the assessment of capital adequacy. 12. Banks must have a credible track record in the use of internal ratings at least for the last 3 years. 13. Banks must have robust systems in place to evaluate the accuracy and consistency with regard to the system, processing and the estimation of PDs. 14. Banks must disclose in greater detail the rating process, risk factors, validation etc. of the rating system. Under the advanced approach, banks would be allowed to use their own estimates of PD, LGD and EAD, which could be validated by the supervisors. Under both the approaches, risk weights would be expressed as a single continuous function of the PD, LGD and EAD. The IRB approach, therefore, does not rely on supervisory determined risk buckets as in the case of standardised approach. The Committee has proposed an IRB approach for retail loan portfolio, having homogenous characteristics distinct from that for the corporate portfolio. The Committee is also working towards developing an appropriate IRB approach relating to project finance. The adoption of the New Accord, in the proposed format, requires substantial upgradation of the existing credit risk management systems. The New Accord also provided in-built capital incentives for banks, which are equipped to adopt foundation or advanced IRB approach. Banks may, therefore, upgrade the credit risk management systems for optimising capital.

3.6 Comments of the Reserve Bank of India on New Capital Adequacy Framework
INTERNAL RATINGS-BASED APPROACH RBI recognises the inherent attractiveness of the approach that is based on banks own quantitative and qualitative assessment of its credit risk. However, RBI believes that an internal ratings-based approach should form the basis for setting capital charges for all banks and that the option should not be limited only to sophisticated banks. National supervisors could set minimum standards and sound practices, including key characteristics of the rating systems and process. The internal ratings-based approaches should also be subjected to validation by the national supervisors. ASSET SECURITISATION RBI agrees with the Committees proposals to assign risk weights on the basis of external credit assessments (by domestic credit rating agencies) and convert off-balance sheet securitized receivables, to a credit equivalent at 20% and risk weighted on the basis of obligors weighting. However, it should be ensured that in such off-balance sheet securitised receivables, banks should not develop innovative structures, which could conceal the real nature of credit risk transfer. Further, differential risk weighting treatment between securitised assets and claims on corporates would encourage regulatory arbitrage. For instance, while the claims on corporates rated A+ to A- are assigned a risk weight of 100%, such pool of loans when

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securitised with very little or no credit enhancement, would be risk weighted at 50%, a whopping 50% reduction, eventhough no change in the risk profile of the claims had occurred. The issue needs reconsideration by the Basel Committee. CREDIT RISK MODELS RBI is in agreement with the Committees proposal that credit risk modelling may prove to result in better internal risk management and may have the potential to be used in the supervision of banks. However, significant hurdles, principally concerning data availability and model validation still need to be cleared before these objectives are met. Conceptually, though the proposal is good, the adoption of credit risk models as an alternative for setting capital charge in emerging markets is severely constrained by data limitations and model validation. The historical data support and modelling capabilities of banks in such countries are also not of international standards. Thus, model-based approach could be adopted only when the banks develop sufficient expertise and database to estimate the economic capital. SUPERVISORY REVIEW PROCESS THE SECOND PILLAR RBI is in agreement with the Committees proposals that each financial institution critically assesses its capital adequacy and future capital needs in relation to risk profile and that supervisors should have a method for reviewing the internal capital adequacy assessments of individual banks and discussing internal capital targets set by the banks. RBI also agrees with the Committee that national supervisors should intervene at an early stage to prevent capital from falling below prudent levels. At the same time, the burden of estimating economic capital may not be mandated to smaller banks, which are not offering complex products and operating predominantly in domestic / segmented markets. RBI also agrees that supervisors should have the mandate to require banks to hold capital in excess of minimum regulatory capital ratios. MARKET DISCIPLINE THE THIRD PILLAR RBI is in agreement with the Committees views that increased disclosures, enhanced transparency and market discipline are becoming an important tool of supervision. However, at the same time, national supervisory authority should also consider the ability of the market to logically interpret the available information; otherwise, there is a possibility of over reaction to insignificant events or factors, which can destabilise the system

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CHAPTER-4 LITERATURE REVIEW

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The Basel Committee on Banking Supervision, hosted by the BIS, issued a paper on Sound practices for managing liquidity in banking organisations in February 2000. The Committee is currently taking a fresh look at liquidity risk in the context of banks' growing reliance on market liquidity to distribute risk, and their associated vulnerability to market liquidity shocks. Some of the areas being reviewed which have been much in the news lately include the growing links between market and funding liquidity, the use of stress testing exercises, and the impact of "originate to distribute" strategy on the funding liquidity of institutions. A stocktaking of the current regulatory frameworks for liquidity risk management is also being undertaken. Based on the findings, the Committee will identify issues that may need to be addressed.
.

First, on all important issues, workings group are constituted or technical reports are prepared, generally encompassing a review of the international best practices, options available and way forward. The group membership may be internal or external to the RBI or mixed. Draft reports are often placed in public domain and final reports take account of inputs, in particular from industry associations and self-regulatory organizations. The reform-measures emanate out of such a series of reports, the pioneering ones being: Report of the Committee on the Financial System (Chairman: Shri M. Narasimham), in 1991; Report of the High Level Committee on Balance of Payments (Chairman:Dr. C. Rangarajan) in 1992; and the Report of the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham) in 1998. The three important issues were offered in the Speech by Mr Malcolm D Knight, General Manager of the BIS, at the Federation of Indian Chambers of Commerce and Industry (FICCI) Indian Banks' Association (IBA) Conference, Mumbai, 12 September 2007.

in the context of globalisation and the move towards global banking. First, market participants need to understand the changing nature of risk in the context of the increasing use of innovative and complex instruments that can be traded across markets and borders. In particular, credit risk transfer and liquidity risk management need to be looked at from a fresh perspective. Second, disclosures need to keep pace with market developments. The enhanced disclosures under international financial reporting standards (IFRS) and Basel II will strengthen market discipline and contribute to the soundness of the international financial system. Third, good governance is important for supervisory agencies and central

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banks. It lends credibility to their actions and enhances their legitimacy as public policy institutions.

Market discipline across countries and industries, MIT Press, 2004 gives the two important initiatives that require the effective management of the transition process were . The Basel II regulatory and supervisory framework for banking institutions, which is now in the process of being implemented by most jurisdictions in both advanced and emerging market economies, has important change management implications for banks and supervisory agencies alike. The framework requires implementation of three "pillars". Pillar 1 aligns a bank's holding of regulatory capital with the underlying risks in its specific business. Pillar 2 requires each bank to operate a comprehensive internal capital allocation process and the supervisors to review banks' methodologies for risk management. Pillar 3 fosters transparency and public disclosures by banks that are intended to promote market discipline. Basel II implementation requires, inter alia, improvements in banks' risk management systems, enhancement of data management and IT capabilities, and upgrading of human resource skills. Each jurisdiction should determine its schedule for Basel II implementation over the next few years, based on a consideration of all the relevant factors. In order to ensure adequate preparedness on the part of all stakeholders and to facilitate a smooth transition to Basel II, India has extended the time frame for its implementation. Indian banks that have a foreign presence and foreign banks that operate in India will implement Basel II by March 2008, while all other Indian banks will do so no later than March 2009. Two dimensions of liquidity risk are well known: funding liquidity risk and market liquidity risk. Funding liquidity risk relates to a firm not being able to efficiently meet both expected and unexpected current and future cash flow and collateral needs without affecting either the daily operations or the financial condition. Market liquidity risk relates to the difficulty a firm has in offsetting or eliminating a position without significantly affecting the market price because of inadequate market depth or a market disruption. The same factors could trigger both types of liquidity risk. The management of liquidity risk in financial groups, Joint Forum Report, Bank for International Settlements, May 2006.

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CHAPTER-6 RESEARCH METHODOLOGY

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6.1 OBJECTIVES
1. To identify the sources of credit risk and financial vulnerability. 2. To determine the minimum Capital Adequacy ratio necessary to reduce the risk. 3. To study Basel committee recommendations on credit risk management. 4. To determine the Credit Granting Standards and Credit monitoring process. 5. To determine the techniques of prevention of credit risk.

6.2 RESEARCH METHODOLOGY

PROBLEM DEFINITION To assess and analyze the credit risk faced by the Indian banking sector and to determine the techniques to minimize this risk. ANALYTICAL RESEARCH The study utilizes a combination of theoretical frameworks so in it, I have to use facts and information already available and will analyze these facts and information to make a critical evaluation of the material.

6.3 DATA COLLECTION METHOD

Data Collection can be broadly classified into two categories: Primary Data: Primary Data are those collected a fresh and for first time and thus happen to be original in character. Secondary Data: Secondary Data are those, which have already been collected, and which have already been passed through the statistical process, secondary data can be collected from: Books Journals & Magazines Websites The project includes secondary source of data. The data collected through these sources will be organized, analyzed and interpreted so as to draw conclusion and arrive at appropriate recommendations. The secondary sources of data includes: Academic Journals, Government reports like Basel committee reports of RBI credit and monetary policy, and books on credit risk management.

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6.5 STEPS OF METHODOLOGY

Collection Of Data

Organising the Data

Presentation of Data

Analysis of Data

Interpretation

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COLLECTION OF DATA The data has been collected through Books,Journals & Magazines,Websites.

ORGANISING THE DATA The data collected during data collection process are organized and presented in a comprehensible sequence to make them more meaningful.

PRESENTATION After the data has been properly organized, it is ready for presentation. The main objectives of presentation are to put collected data into an easy readable form.

ANALYSIS OF DATA After organizing and presenting the data, the researcher then has to proceed towards conclusion by logical inferences. The raw data is then analyzed: By bringing raw data to measured data. Summarizing the data.

INTERPRETATION Interpretation means to bring out meaning of data or to convert mere data into information. From the analysis of data the various conclusions are find out on the basis of logical inferences.

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CHAPTER-7 FINDINGS

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1. CAPITAL ADEQUACY RATIO The Basel II norms for capital adequacy, aims to reduce risk in the financial system by closely aligning capital requirements to the underlying credit, market and operational risks; executing new supervisory review processes and improving market disclosure. Banks that embrace the Basel II norms will be better geared to optimize capital allocation and improve their competitiveness in the market place. The first pillar establishes a way to quantify the minimum capital requirements. While the new framework retains both existing capital definition and minimal capital ratio of 8%, some major changes have been introduced in measurement of the risks. The main objective of Pillar I is to introduce greater risk sensitivity in the design of capital adequacy ratios and, therefore, more flexibility in the computation of banks' individual risk. This will lead to better pricing of Risks. Capital Adequacy Ratio signifies the amount of regulatory capital to be maintained by a bank to account for various risks inherent in the banking system. The Capital Adequacy ratio is measured as: Total Regulatory Capital (unchanged) = Bank's Capital (minimum 8%) Credit Risk + Market Risk + Operational Risk Regulatory capital is defined as the minimum capital, banks are required to hold by the regulator, i.e. "The amount of capital a bank must have". It is the summation of Tier I and Tier II capital.

2. TECHNIQUES OF SETTING CREDIT LIMITS. The commonly used techniques of setting credit limits which is used by Credit Agencies are:

a) Financial Statements: Financial statements are also used in assigning Credit Limits. Mainly ratios or factors like net worth and working capital are taken and trended or compared to Industry norms or standards. If a customer shows liquidity and efficiency as per industry norms then a more confident approach can be taken in setting the credit limits. One has to also consider if short-term liquidity is important or meaningful to the nature of your credit or is long-term liquidity more consequential For Example: Some companies will take the Tangible Net worth [Total tangible assets Total liabilities. From the Balance Sheet] and assign anywhere between 5% to 15% of the Tangible Net worth as a credit limit for the customer provided the customer has shown pre-tax profits. Others consider Net Working Capital [Current Assets-Currents Liabilities] because it measures the short-term liquidity of a company. While doing such analysis one has to also 50

consider elements outside the domain of the financial statements before making a conclusive decision. For example the company that is being assessed might have suits or judgments against them. On the other hand the financial statements could be unaudited or company prepared. Another ratio that is of importance to lenders is the Debt to Equity Ratio. The ratio is typically calculated by combining noted payables and all secured debt (such as short term and long term bank loans and debentures) and dividing it by net worth. The ratio shows how the company is leveraged and illustrates the stake of the lenders as opposed to the owners. A secured creditor (like a bank) may request to maintain a certain level of Debt to Equity. Otherwise upon default such loans become payable upon demand, which could lead to sale of assets to prepayment of the loan. If this ratio is within industry norms and to the satisfaction of the secured lender then a more liberal approach can be taken in setting the credit limit for this customer. The contribution to the credit limit can range anywhere from 5% to 15% of the customers Net Worth. The Days Sales Outstanding also known as D.S.O is a rough indication of the quality of a companys receivables. It is calculated by dividing the net receivables by average daily sales. If the DSO is in line with the norms for the industry then a liberal approach can be taken in setting the limit for this customer. The formula that is used with DSO is that, for each day of deviation from the norm or the selling terms you add or subtract .10% of the Net Worth. b) Past Performance: Credit Limit in this case is based on the past history of the customer as per the information contained in your books. The two elements that you would consider and weigh would be the past: Payment performance Purchase Pattern c) Need Based: In this case Credit Limits are set based on the needs of the customer. It could be set to accommodate the first Requested Credit Limit or the Size of the first Order. It should not be done in isolation but by a combination of the other methods. In a survey that was conducted by the Conference Board one of the most popular techniques used for setting credit limits was by using the information and ratings given by credit agencies.

3. RBIS ASSOCIATION WITH THE BASEL COMMITTEE RBIs association with the Basel Committee on Banking Supervision dates back to 1997 as India was among the 16 non-member countries that were consulted in the drafting of the Basel Core Principles. Reserve Bank of India became a member of the Core Principles Liaison Group in 1998 and subsequently became a member of the Core Principles Working Group on Capital. Within the Working Group, RBI has been actively participating in the deliberations on the New Accord and had the privilege to lead a group of six major non-G10 supervisors which presented a proposal on a simplified approach for Basel II to the Committee. Commercial banks in India will start implementing Basel II with effect from March 31, 2007. They will adopt Standardized Approach for credit risk and Basic Indicator Approach

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for operational risk, initially. After adequate skills are developed, both at the banks and also at supervisory levels, some banks may be allowed to migrate to the Internal Rating Based (IRB) Approach. 4. BASEL COMMITTEE RECOMMENDATIONS ON CREDIT RISK MANAGEMENT One of the unique aspects of Basel II is its comprehensive approach to risk measurement in the banking entities, by adopting the now-familiar three-Pillar structure, which goes far beyond the first Basel Accord. To recapitulate, these are: Pillar 1 the minimum capital ratio, Pillar 2 the supervisory review process and Pillar 3 the market discipline. The Pillar 1 provides a menu of alternative approaches, from simple to advanced ones, for determining the regulatory capital towards credit risk, market risk and operational risk, to cater to the wide diversity in the banking system across the world. Pillar 2 requires the banks to establish an Internal Capital Adequacy Assessment Process (ICAAP) to capture all the material risks, including those that are partly covered or not covered under the other two Pillars. The ICAAP of the banks is also required to be subject to a supervisory review Pillar 3 prescribes public disclosures of information on the affairs of the banks to enable effective market discipline on the banks operations. The Basel II proposed the broad set of requirements that have profound implications on some practices within the Banks. The need to allocate capital to safe guard Banks against unexpected losses arising from credit risk requires that they implement systems for quantifying their exposure to credit risk. The advanced implementation options of Basel II explicitly require financial institutions to assess the credit exposure for each customer and for each credit facility using the following measures:

Probability of Default (PD) - the probability that a specific customer will default within the next 12 months. Loss Given Default (LGD) - the percentage of each credit facility that will be lost if the customer defaults. Exposure at Default (EAD) - the expected exposure for each credit facility in the event of a default.

Once the Banks are able to assess the PD, LGD and EAD for its customers and for its credit facilities, the calculation of the minimum capital requirement is straightforward.

6. CREDIT-GRANTING STANDARDS AND CREDIT MONITORING PROCESS 52

An essential part of any supervisory system is the independent evaluation of a bank's policies, practices and procedures related to the granting of loans and making of investments and the ongoing management of the loan and investment portfolios.Supervisors need to ensure that the credit and investment function at individual banks is objective and grounded in sound principles. The maintenance of prudent written lending policies, loan approval and administration procedures, and appropriate loan documentation are essential to a bank's management of the lending function. Lending and investment activities must be based on prudent underwriting standards that are approved by the bank's board of directors and clearly communicated to the bank's lending officers and staff. It is also critical for supervisors to determine the extent to which the institution makes its credit decisions free of conflicting interests and inappropriate pressure from outside parties. Banks must also have a well-developed process for ongoing monitoring of credit relationships, including the financial condition of significant borrowers. A key element of any management information system should be a data base that provides essential details on the condition of the loan portfolio, including internal loan grading and classifications.

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CHAPTER-9 ANALYSIS AND INTERPRETATION

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BASEL I FRAMEWORK.
It was the first ever attempt at harmonizing the banks capital standards across the countries, for securing greater international competitive equality and to obviate regulatory capital as a source of competitive inequality. The Accord, in its was only in 1996 that an amendment was made to cover the market risks also. The had adopted a risk-sensitive approach for making the banks capital more responsive riskiness of their operations. This meant that a bank with a higher risk profile would have to maintain a higher quantum of regulatory capital while also ensuring the minimum capital ratio. The framework also stipulated, for the first time, a regulatory capital charge for the off-balance sheet business of the banks so as to capture their risk exposures more comprehensively. Pursuant to the recommendations of the Committee on the Financial System (the first Narsimham Committee, 1991), this framework was implemented in India in 1992 in a phased manner. THE IMPERATIVES FOR BASEL II With the passage of time, it was realised that the Basel I framework had several limitations. The limitations related mainly to the underlying approach as also a less-thancomprehensive scope of the Accord in capturing the entire risk universe of the banking entities. Let me dwell a little more on these aspects. 1. The Accord had an approach under which the entire exposures of banks were categorized into three broad risk buckets viz., sovereign, banks and corporates, with each category attracting a risk weight of zero, 20 and 100 per cent, respectively. Such a risk weighting scheme did not provide for sufficient calibration of the counterparty risk since, for instance, a corporate with AAA rating and one with C rating would attract identical risk weight of 100 per cent and require the same regulatory capital charge, despite significant difference in their credit standing. This, in turn, engendered a rather perverse incentive for the banks to acquire higher-risk customers in pursuit of higher returns, without necessitating a higher capital charge. Such bank behaviour could potentially heighten the risk profile of the banking systems as a whole. The design of the Accord was, therefore, viewed as distorting the incentive structure in the banking markets and dissuading better risk management. 2. The Accord addresses only the credit risk and market risk in the banks operations, ignoring several other types of risks inherent in any banking activity. For instance, the operational risk, that is, the risk of human error or failure of systems leading to financial loss, was not at all addressed as were the liquidity risk, credit concentration risk, interest rate risk in the banking book, etc. 3. Since 1988, the emergence of innovative financial products had transformed the contours of the banking industry and its business model the world over. The credit-risk transfer products, such as securitization and credit derivatives, enabled removal of on-balance sheet exposures from the books of the banks when they perceived that the regulatory capital requirement for such exposures was too high and hiving off such exposures would be a better strategy. The Basel I framework did not accommodate such innovations and was, thus, outpaced by the market developments. In this background, a need was felt to create a more comprehensive and risk-sensitive capital adequacy framework to address the infirmities in the Basel-I Accord. The Basel

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Committee on Banking Supervision (BCBS), therefore, after a world-wide consultative process and several impact assessment studies, evolved a new capital regulation framework, called International Convergence of Capital Measurement and Capital Standards: A Revised Framework, which was released in June 2004. The revised framework has come to be commonly known as Basel II framework and seeks to foster better risk management practices in the banking industry. ENHANCING RISK MANAGEMENT UNDER BASEL II; One of the unique aspects of Basel II is its comprehensive approach to risk measurement in the banking entities, by adopting the now-familiar three-Pillar structure, which goes far beyond the first Basel Accord. To recapitulate, these are: Pillar 1 the minimum capital ratio, Pillar 2 the supervisory review process and Pillar 3 the market discipline. The Pillar 1 provides a menu of alternative approaches, from simple to advanced ones, for determining the regulatory capital towards credit risk, market risk and operational risk, to cater to the wide diversity in the banking system across the world. Pillar 2 requires the banks to establish an Internal Capital Adequacy Assessment Process (ICAAP) to capture all the material risks, including those that are partly covered or not covered under the other two Pillars. The ICAAP of the banks is also required to be subject to a supervisory review Pillar 3 prescribes public disclosures of information on the affairs of the banks to enable effective market discipline on the banks operations. GUIDELINES ISSUED BY RBI As, RBI has already issued the guidelines for the new capital adequacy framework in regard to Pillar 1 and Pillar 3 on April 27, 2007. As regards Pillar 2, the banks have been advised to put in place an ICAAP, with the approval of the Board. A two-stage implementation of the guidelines is envisaged to provide adequate lead time to the banking system. Accordingly, the foreign banks operating in India and the Indian banks having operational presence outside India are required to migrate to the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk with effect from March 31, 2008. All other Scheduled commercial banks are encouraged to migrate to these approaches under Basel II in alignment with them, but, in any case, not later than March 31, 2009. It has been a conscious decision to begin with the simpler approaches available under the framework, having regard to the preparedness of the banking system. As regards the market risk, under Basel II also, the banks will continue to follow the Standardised-Duration Method as already adopted under the Basel I framework. For migration to the advanced approaches available under the framework, prior approval of the RBI would be required.

PILLAR 2 CONSIDERATIONS While the implications of Pillar 1 and Pillar 3 are fairly well known in the banking community, the importance of Pillar 2 in the new framework is perhaps not that well 56

understood. I would, therefore, like to take this opportunity to dwell a little more on the criticality of effective implementation of Pillar 2 by the banks while adopting the new framework, in view of its importance. As I mentioned earlier, the Pillar 2 of the framework deals with the Supervisory Review Process (SRP). The objective of the SRP is to ensure that the banks have adequate capital to support all material risks in their business as also to encourage them to adopt sophisticated risk management techniques for monitoring and managing their risks. This, in turn, would require a well-defined internal assessment process within the banks through which they would determine the additional capital requirement for all material risks, internally, and would also be able to assure the RBI that adequate capital is actually held towards their all material risk exposures. The process of assurance could also involve an active dialogue between the bank and the RBI so that, when warranted, appropriate intervention could be made to either reduce the risk exposure of the bank or augment / restore its capital. Thus, ICAAP is an important component of the Supervisory Review Process. What is important to note here is that the Pillar 1 stipulates only the minimum capital ratio for the banks whereas the Pillar 2 provides for a bank-specific review by the supervisors to make an assessment whether all material risks are getting duly captured in the ICAAP of the bank. If the supervisor is not satisfied in this behalf, it might well choose to prescribe a higher capital ratio, as per its assessment. 13. I would like to emphasise that the ICAAP under the Pillar 2 is the element which makes the Basel II framework comprehensive in its sweep by addressing the entire risk domain of the banks. As I mentioned, the ICAAP is expected to address all material risks facing the bank but the three main areas in particular viz., those aspects not fully captured under the Pillar 1 process; factors not taken into account by Pillar 1 process; and the factors external to the bank. Another dimension of the ICAAP would be to monitor compliance with the Pillar 1 and Pillar 3 requirements. Thus, illustratively, we would expect the banks ICAAP to take account of the credit concentration risk, interest rate risk in the banking book, business and strategic risk, liquidity risk, and other residual risks such as reputation risk and business cycle risk. The challenge for the banks would be to quantify these risks and then, to translate those consistently into an appropriate amount of capital needed, commensurate with the banks risk profile and control environment. Needless to say, this would call for instituting sophisticated risk management systems, including a robust stress-testing and economic capital allocation framework, coupled with strong validation mechanisms to ensure the integrity of the entire ICAAP, to be able to achieve the objectives underpinning the ICAAP and the Supervisory Review envisaged under Pillar 2. I am sure; the Pillar 2 dimension would be receiving the high priority it deserves in the implementation strategy of the banks. It is useful to note that the ICAAP, as its name suggests, is envisaged to be essentially a bank-driven process, which would of course be subject to a supervisory review.

BASEL II IMPACT ON INDIAN BANKS There are broadly two sets of reasons often given for capital regulation in banks in particular. One is depositor protection and the second is systemic risk. Banks are often thought to be a source of systemic risk because of their central role in the payments system and in the allocation of financial resources, combined with the fragility of their financial structure. Banks are highly leveraged with relatively short-term liabilities, typically in the

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form of deposits, and relatively illiquid assets, usually loans to firms or households. In that sense banks are said to be "special" and hence subject to special regulatory oversight. Before 1988, many central banks allowed different definitions of capital in order to make their country's bank appear as solid than they actually were. In order to provide a level playing field the concept of regulatory capital was standardized in BASEL I. Along with definition of regulatory capital a basic formula for capital divided by assets was constructed and an arbitrary ratio of 8% was chosen as minimum capital adequacy. However, there were drawbacks in the BASEL I as it did not did not discriminate between different levels of risk. As a result a loan to an established corporate was deemed as risky as a loan to a new business. Also it assigned lower weight age to loans to banks as a result banks were often keen to lend to other banks. The BASEL II accord proposes getting rid of the old risk weighted categories that treated all corporate borrowers the same replacing them with limited number of categories into which borrowers would be assigned based on assigned credit system. Greater use of internal credit system has been allowed in standardized and advanced schemes, against the use of external rating. The new proposals avoid sole reliance on the capital adequacy benchmarks and explicitly recognize the importance of supervisory review and market discipline in maintaining sound financial systems. THE THREE PILLAR APPROACH The capital framework proposed in the New Basel Accord consists of three pillars, each of which reinforces the other. The first pillar establishes the way to quantify the minimum capital requirements, is complemented with two qualitative pillars, concerned with organizing the regulator's supervision and establishing market discipline through public disclosure of the way that banks implement the Accord. Determination of minimum capital requirements remains the main part of the agreement, but the proposed methods are more risk sensitive and reflect more closely the current situation on financial markets.

FIRST PILLAR: MINIMUM CAPITAL REQUIREMENT The first pillar establishes a way to quantify the minimum capital requirements. While the new framework retains both existing capital definition and minimal capital ratio of 8%, some major changes have been introduced in measurement of the risks. The main objective of Pillar I is to introduce greater risk sensitivity in the design of capital adequacy ratios and, therefore, more flexibility in the computation of banks' individual risk. This will lead to better pricing of Risks. Capital Adequacy Ratio signifies the amount of regulatory capital to be maintained by a bank to account for various risks inherent in the banking system. The Capital Adequacy ratio is measured as: Total Regulatory Capital (unchanged) = Bank's Capital (minimum 8%) Credit Risk + Market Risk + Operational Risk Regulatory capital is defined as the minimum capital, banks are required to hold by the

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regulator, i.e. "The amount of capital a bank must have". It is the summation of Tier I and Tier II capital. MEASUREMENT OF CREDIT RISK The changes proposed to the measurement of credit risk are considered to have most far reaching implications. Basel II envisages two alternative ways of measuring credit risk. THE STANDARDIZED APPROACH The standardized approach is conceptually the same as the present Accord, but is more risk sensitive. The bank allocates a risk-weight to each of its assets and off-balance-sheet positions and produces a sum of risk-weighted asset values. Individual risk weights currently depend on the broad category of borrower (i.e. sovereigns, banks or corporates). Under the new Accord, the risk weights are to be refined by reference to a rating provided by an external credit assessment institution that meets strict standards. THE INTERNAL RATINGS BASED APPROACH (IRB) Under the IRB approach, distinct analytical frameworks will be provided for different types of loan exposures. The framework allows for both a foundation method in which a bank estimate the probability of default associated with each borrower, and the supervisors will supply the other inputs and an advanced IRB approach, in which a bank will be permitted to supply other necessary inputs as well. Under both the foundation and advanced IRB approaches, the range of risk weights will be far more diverse than those in the standardized approach, resulting in greater risk sensitivity. SECOND PILLAR: SUPERVISORY REVIEW PROCESS The supervisory review process requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. This internal process would then be subject to supervisory review and intervention, where appropriate.

THE THIRD PILLAR: MARKET DISCIPLINE The third pillar of the new framework aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can better understand banks' risk profiles and the adequacy of their capital positions. The new framework sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods. The core set of disclosure recommendations applies to all banks, with more detailed requirements for supervisory recognition of internal methodologies for credit risk, credit risk mitigation techniques and asset securitization. CHALLENGES FOR INDIAN BANKING SYSTEM UNDER BASEL II

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A feature, somewhat unique to the Indian financial system is the diversity of its composition. We have the dominance of Government ownership coupled with significant private shareholding in the public sector banks and we also have cooperative banks, Regional Rural Banks and Foreign bank branches. By and large the regulatory standards for all these banks are uniform. Costly Database Creation and Maintenance Process: The most obvious impact of BASEL II is the need for improved risk management and measurement. It aims to give impetus to the use of internal rating system by the international banks. More and more banks may have to use internal model developed in house and their impact is uncertain. Most of these models require minimum 5 years bank data which is a tedious and high cost process as most Indian banks do not have such a database Additional Capital Requirement: In order to comply with the capital adequacy norms we will see that the overall capital level of the banks will raise a glimpse of which was seen when the RBI raised risk weightages for mortgages and home loans in October 2004. Here there is a worrying aspect that some of the banks will not be able to put up the additional capital to comply with the new regulation and they may be isolated from the global banking system. Large Proportion of NPA's: A large number of Indian banks have significant proportion of NPA's in their assets. Along with that a large proportion of loans of banks are of poor quality. There is a danger that a large number of banks will not be able to restructure and survive in the new environment. This may lead to forced mergers of many defunct banks with the existing ones and a loss of capital to the banking system as a whole.

Relative Advantage to Large Banks: The new norms seem to favor the large banks that have better risk management and measurement expertise. They also have better capital adequacy ratios and geographically diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of inter-bank loans that will effectively price them out of the market. Thus banks will have to restructure and adopt if they are to survive in the new environment.

HURDLES ON THE WAY The road to the Basel-II will not be an easy one for Indian banks. The significant hurdles on its way are: IT infrastructure: The technology infrastructure in terms of computerisation is still in a nascent stage in most Indian banks. Computerisation of branches, especially for those

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banks, which have their network spread out in far flung areas, will be a daunting task. Penetration of information technology in banking has been successful in the urban areas, unlike in the rural areas where it is insignificant. Data management: Collection of data for the last three to four years, a requirement for conforming to the provisions of Basel-II is another difficult task. Due to a late start in computerisation, most Indian banks lack robust data capture, cleansing and management practices, and this will serve as the single largest limitation in adopting the accord. Moreover, to get rid of the common tradition of individuals maintaining paper work, will be another daunting task. Risk Management Resources: Experts say that dearth of risk management expertise in the Asia Pacific region will serve as a hindrance in laying down guidelines for a basic framework for the new capital accord. Communication gap: An integrated risk management concept, which is the need of the hour to align market, credit and operational risk, will be difficult due to significant disconnect between business, risk managers and IT across the organisations in their existing set up. Huge Investment: Implementation of the Basel-II will require huge investments in technology. According to estimates Indian banks, especially those with a sizeable branch network, will need to spend well over $50-70 million on this. In a recent survey conducted by the Federation of Indian Chambers of Commerce & Industry (FICCI), 55 per cent of the respondents' claim that Indian banks lack adequate preparedness to be able to conform to the Basel-II provisions . Whereas, 50 per cent of public sector banks have expressed their preparedness in meeting these guidelines, only 25 per cent of the old and new private sector and foreign banks are likely to be ready to meet them. According to the survey, concerns of the Indian banks in implementing these norms are:

51.6 per cent said due to low levels of computerisation, 87 per cent said due to absence of robust internal credit rating mechanism, 80.6 per cent said due to lack a strong management information system, And 58 per cent said due to lack of sufficient training and education to reach the levels to conform to the provisions of Basel-II. The FICCI survey was based on feedback from more than 75 respondents including leading bankers, financial institutions, intermediaries and other market players in India.

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Finance minister P Chidambaram, speaking at a conference, Indian Banking: Realising Global Aspirations, said that one of the major threats to the health of the Indian banking sector is the high level of non performing assets (NPAs). This problem has to be tackled by improving credit quality in terms of better skills, better risk management systems and improvements in monitoring and follow up. On the whole, the system of supervision and accountability within public sector banks, and many old private sector banks needs to be improved. Bank management need to compare their own systems to those of the global banks, in which the quality of credit appraisals is far superior, supervision is strict and penalties for serious mistakes instantaneous. Although the level of bad loans in the banking system remains worryingly high, Indian banks were not caught in the financial crisis that rocked East Asian economies in 1997-98. Thus, they are typically healthier than those in some other Asian countries, such as Thailand. A more practical approach is necessary to understand the current risk management framework in the Indian banking industry and the successive progression to the Basel-II in a phased manner. The steering committee formed by the RBI needs to become functional, instead of being present only on paper. Regular meeting and consultations with the banks is essential to guide them in adopting the strategy. Though, they have a long way to go, the new capital regulation requirements have given Indians banks a chance to re-look at their risk strategies, revamp and hone their current policies to strengthen their immune system against any risk disaster.

NOT WHEN BUT HOW? The important decision for India is not whether to stay on Basel I or move to Basel II, but of which of the many alternatives on offer, should be adopted. Given the lack of rating penetration, the Standardized Approach yields little in linking capital to risk while the IRB approach looks complex to implement and difficult to monitor. In the event of some banks adopting IRB Approach, while other banks adopt Standardised Approach, banks adopting IRB Approach will be much more risk sensitive than the banks on Standardised Approach, since even a small change in degree of risk might translate into a large impact on additional capital requirement for the IRB banks. For banks adopting Standardised Approach the relative capital requirement would be less for the same exposure and would be inclined to assume exposures to high risk clients, which were not financed by IRB banks. As a result, high risk assets could flow towards banks on Standardised Approach which need to maintain lower capital on these assets. Similarly, low risk assets would tend to get concentrated with IRB banks which need to maintain lower capital on these assets. Hence, system as a whole may maintain lower capital than warranted. Keeping in view the above complications we suggest as a transitional tool, a Centralized Rating Based(CRB) approach where the RBI dictates a rating scale and asks banks to rate 62

borrowers according to that centralized scale. The great benefit of the approach is that the RBI would be able to monitor and control banks' ratings and hence monitor and control their capital sufficiency in relation to risk much more effectively. These kinds of comparisons combined with simple procedures for spotting outliers and keeping a track of the different banks' ratings of the main borrowers from the financial system will be extremely valuable tools for a RBI. Finally the CRB approach should be used as a precursor to IRB. Once the CRB approach is working the RBI could then work with banks to approve their own rating scales and rating methodology using the basic CRB approach as a reference tool

CONCLUSION

Since exposure to credit risk continues to be the leading source of problems in banks worldwide, banks and their supervisors should be able to draw useful lessons from past experiences. Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred. The Basel Committee is issuing this document in order to encourage banking supervisors globally to promote sound practices for managing credit risk. Although the principles contained in this paper are most clearly applicable to the business of lending, they should be applied to all activities where credit risk is present.

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The sound practices set out in this document specifically address the following areas: establishing an appropriate credit risk environment; operating under a sound credit-granting process; maintaining an appropriate credit administration, measurement and monitoring process; and ensuring adequate controls over credit risk.Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these four areas. These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk, all of which have been addressed in other recent Basel Committee documents. It would be far easier for the larger banks to implement the norms, raising their quality of risk-management and capital adequacy. This combined with the higher cost of capital for smaller players would queer the pitch in favour of the former. The larger banks would also have a distinct advantage in raising capital in equity markets. Emerging Market Banks can turn this challenge into an advantage by active implementation and expanding their horizons outside the country. The Basel II definition of a banking company is very broad and includes banking subsidiaries such as insurance companies. In India and in many other emerging countries there is no single regulator to govern the whole bank as per Basel II. In India IRDA, SEBI, NABARD & RBI would regulate different aspects of Basel II. The consolidated balance sheet of the bank has to conform to CAR regulations . In India, Regulatory capital norms do not apply to Insurance companies. Recently, in the falling bond markets scenario LIC & other Insurance companies have acted as saviours for the banks by purchasing their long tenure bonds. Consequently, the Interest Rate Risk brone is very high. The complex banking structure in India is another stumbling block. The Pillar II implementation is the more difficult portion of the three pillars. Risk Audits in banks are still in their nascent stages in India. The availability of trained risk auditors is another problems. Basel II calls for a Risk Management structure in banks with Risk Management committees for Credit, Market & operational Risk formulating the Risk Management standards. While banks in India are implementing this, it has remained a ceremonial process without the training at the grass root level to see every activity with the lens of risk. One of the two approaches prescribed for Credit Risk in Basel II is the standardised approach, which makes use of external credit ratings for attaching risk weights. Being the easier of the two approaches and also because of the continuity from the Basel I norms it is most likely to be implemented in emerging countries. One of the major problems is the availability of credit ratings in emerging countries. While India has been fortunate in this respect with three major Credit Rating agencies in CRISIL, FITCH & ICRA in this field many emerging countries are not so equipped. Even in India the penetration of credit ratings is not deep. The supply-demand imbalance would make it even more difficult for smaller players to get ratings, High prices making credit more costly for them. Various models have been proposed for the Internal Rating Based Credit Risk Assessment. A major problem is data availability. In India, a large no. of PSU banks are still in the process of computerisation. The extent of historical data required to formulate and then convincingly test Indigenous IRB models is simply not available. The IRB based approach being one of the more stringent approaches is the more ideal of the two to strengthen the financial system. The actual implementation of an IRB based model for credit risk mitigation would require excellent information retrieval and assessment capabilities. A high-end IT Infrastructure with Risk Management Software collating real-time information is needed. This preparedness is not there in a majority of banks in emerging markets Hurrying into an IRB based approach could cost banks dearly because of the High Capital Expendituresinvolved. Inaccurate IRB models could defeat the very purpose of better risk mitigation

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SUGGESTIONS
1) Banks should have written credit policies that define target markets, risk acceptance criteria, credit approval authority, credit origination and maintenance procedures and guidelines for portfolio management and remedial management.

2) Banks should establish proactive credit risk management practices like annual / half yearly industry studies and individual obligor reviews, periodic credit calls that are documented, periodic plant visits, and at least quarterly management reviews of troubled exposures/weak credits.

3) Business managers in banks will be accountable for managing risk and in conjunction with credit risk management framework for establishing and

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maintaining appropriate risk limits and risk management procedures for their businesses.

4) Banks should have a system of checks and balances in place around the extension of credit.

5) The Credit Approving Authority to extend or approve credit will be granted to individual credit officers based upon a consistent set of standards of experience, judgment and ability.

6) The level of authority required to approve credit will increase as amounts and transaction risks increase and as risk ratings worsen.

7) Every obligor and facility must be assigned a risk rating.

8) Banks should ensure that there are consistent standards for the origination, documentation and maintenance for extensions of credit.

9) Banks should have a consistent approach toward early problem recognition, the classification of problem exposures, and remedial action.

10) Banks should maintain a diversified portfolio of risk assets in line with the capital desired to support such a portfolio.

11) Credit risk limits include, but are not limited to, obligor limits and concentration limits by industry or geography.

12) In order to ensure transparency of risks taken, it is the responsibility of banks to accurately, completely and in a timely fashion, report the comprehensive set of credit risk data into the independent risk system.

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13) The credit risk strategy and policies should be effectively communicated throughout the organisation. All lending officers should clearly understand the bank's approach to granting credit and should be held accountable for complying with the policies and procedures.

14) Commitment to new systems and IT will also determine the quality of the analysis being conducted. There is a range of tools available to support the decision making process. These are:

Traditional techniques such as financial analysis. Decision support tools such as credit scoring and risk grading. Portfolio techniques such as portfolio correlation analysis.

Keeping in view the foregoing, each bank may, depending on the size of the organization or loan book, constitute a high level Credit Policy Committee also called Credit Risk Management Committee or Credit Control Committee, etc. to deal with issues relating to credit policy and procedures and to analyse, manage and control credit risk on a bank wide basis. The Committee should be headed by the Chairman/CEO/ED, and should comprise heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The Committee should, inter alia, formulate clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Concurrently, each bank may also set up Credit Risk Management Department (CRMD), independent of the Credit Administration Department. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. The CRMD should also lay down risk assessment systems, monitor quality of loan portfolio, identify problems and correct deficiencies, develop MIS and undertake loan review/audit. Large banks may consider separate set up for loan review/audit. The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio.

1. Measure, control and manage credit risk on a bank-wide basis within the limits set by the Board/ CRMC 2. Enforce compliance with the risk parameters and prudential limits set by the Board/ CRMC. 3. Lay down risk assessment systems, develop MIS, monitor quality of loan/ investment portfolio, identify problems, correct deficiencies and undertake loan review/audit. Large banks could consider separate set up for loan review/audit.

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4. Be accountable for protecting the quality of the entire loan/ investment portfolio. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio.

THE BIBLIOGRAPHY

WEBSITES

www.bis.org www.worldbank.com www.rbi.org.in www.creditguru.com www.iba.org www.Moodys.com www.knowledgestorm.com www.creditquest.com www.bankersindia.com www.moneycontrol.com www.thehindubusinessline.com

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JOURNALS, PAPERS & ARTICLES

Implementation of the new basel capital accord in emerging market Implementation of Basel II: An Indian Perspective Kishori J. Udeshi Deputy Governor Reserve Bank of India World Bank Conference ICFAI Professional Banker Issues BOOKS Credit Risk Management SK Bagchi The Indian Economy: A Different View By Ajit Mozoomdar Indian Financial System: By MY Khan

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Page 1
Survey on state of preparedness of Commercial banks in respect to Basel II

1 Basel II A Challenge and an Opportunity to Indian Banking: Are we ready for it? Survey Highlights As the deadline of implementing Basel-II approaches, Indian banks are still preparing to solve the risk puzzle for a more transparent and risk-free financial base. The road to the Basel-II will not be an easy one for Indian banks. FICCI has conducted a survey to analyze the state of preparedness of commercial banks (which includes Public sector banks, Private banks and foreign banks) in Implementation of Basel II norms. The survey questionnaire covered some of the most important aspects related to Implementation of Basel II. Based upon the data collated, some of the important findings of the survey are enumerated as below:
I. GENERAL STATE OF PREPAREDNESS

87 percent of the respondents were confident of meeting the deadline of implementing the Basel II norms by 31
st

March 2007. These banks have already prepared the detailed Implementation Roadmap as been instructed by Reserve Bank of India. 80 per cent of these banks faced Data Collection as the biggest challenge in preparing the Basel II roadmap. They also expressed that they require an ongoing support from the regulatory authorities in this regard. 77 percent of respondent banks are still in the process of putting in place a robust Management Information System (MIS) in order to comply with the requirements of Pillar III Market Discipline of the new norms. Page 2
Survey on state of preparedness of Commercial banks in respect to Basel II

2
II. CAPITAL REQUIREMENT

54 percent of the banks are technologically equipped to face the future challenges being posed by the Basel II norms. These banks have already put in place the core banking solutions. Also enough attention has been focused upon networking the banks. All the respondent banks already have 70-90 % level of computerization in their bank. However 60 percent of these banks are of an opinion that lower level of computerization would not hinder their progress in implementing these norms. Perhaps this is because banks feel that lower level of the computerization in the rural areas is not likely to effect the implementation of Basel II norms because the bulk of banks operations are in urban areas, which already have 100% computerization. 87 percent of respondent banks have already estimated the incremental capital required for this purpose in their organization. 27 per cent banks expect their capital requirements to increase by 1-2 % while 20 per cent banks expect their capital requirements to increase by more than 3 % during the implementation stage of Basel II norms.* .
Capital Increment during Implemenatation stage
13% 27% 7% 20% 0%

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5% 10% 15% 20% 25% 30% Less than 1.0 % b/w 1-2% b/w 2-3% more than 3%

*
The rest of the respondent banks didnt quote the figure.

Page 3
Survey on state of preparedness of Commercial banks in respect to Basel II

3 All the respondents believe that there are sufficient resources available for raising the higher amount of capital needed for this purpose. 62 percent of banks would prefer to raise the requisite capital by a combination of Tier I and Tier II. To a question on the need of further regulatory relaxations, 50% of the respondent banks voiced that IFR (Investment Fluctuation Reserve) surplus and the Hybrid capital should be considered in Tier I. Some of the other relaxations desired by the banks were treatment of Investment Allowance Reserve as Tier I since it is created from post tax profits and Foreign currency translation reserve as Tier II capital 80 percent of respondent banks expect that there would be an increase in their capital adequacy requirements in their organization as a result of these norms while the rest expect the same to fall as they expect their Capital adequacy ratio to improve. 62 percent of the respondent banks believe that there is a high degree of relationship between the size of the banks and associated risk. Since the complexity of the new framework may be out of reach for many smaller banks, majority of the respondents agree to the fact that this would trigger off a need for consolidation in Indian banking system.
III. IMPACT ON CREDIT

87 percent of the respondent banks quoted that increased capital requirements imposed by the Basel accord will not make their banks more risk averse towards credit dispensation. Merely 13% felt that implementation of Basel II could have an adverse impact on banks lending to commercial sector. Small and Medium enterprises and Farm and rural sectors are likely to be the most affected sectors. Page 4
Survey on state of preparedness of Commercial banks in respect to Basel II

4 IV. EXPECTATIONS FROM THE REGULATORS 87% of the respondents were completely satisfied with the support given by the RBI in respect to Basel II implementation. However some of them felt that there should be consistency in implementation of these norms in terms of timing and approach. Further there should be greater consultation with internationally active banks that face significant cross-border implementation challenges. To a question on comfort level with the stricter disclosure requirements under the Basel II norms, 50 percent of respondents expressed that they were completely comfortable with these requirements, whereas rest felt that they were comfortable to some extent. Operational risk measurement is one of the new planks of the Basel II accord. 73 percent of respondents quoted that capital allocation to operational risk will not be

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counter productive. They instead believe that explicit charge on operational risk will direct more focus on it, which will further enhance operational risk management and operational efficiency for the banks. Also such an allocation would create a cushion for the claims or losses on this account. However the remaining felt that in the Indian context, capital requirements are too high as the Indian banks, unlike their foreign counterparts are not much involved in speculative activities such as derivatives. Hence the capital requirement for operational risk should be lower for the Indian Banks than what is specified in Basel II Accord.

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