PNB Project Report

1.
1 Banking industry at a glance

Bank is the main confluence that maintains and controls the flow of money. Government uses it to control the flow of money by managing Cash Reserve Ratio (CRR) and thereby influencing the inflation level. The function of the bank include accepting the deposit from the public and other institutions and then to direct as loans and advance to parties for growth and development of industries. It extends loans for the purpose of education, housing etc and as a part of social d duty, uty, some percentage of agricultural sectors as decided by the RBI. The bank takes the deposit at the lower rate of interest and gives loan at the higher rate of interest. The difference in the transaction constitutes the main source of the income for the bank. This is known as Net Interest Margin.
Banking in India has undergone starling changes in terms of growth and structure. Organized banking was active in India since the establishment of the General Bank of India in 1786. The Reserve Bank of India (R (RBI) BI) was established as a central bank in 1995. The imperial bank of India, the biggest Bank at that time, was taken over by the Government to form State owned STATE BANK OF INDIA (SBI). RBI under took an exercise to reduce the fragmentation in the Indian B Banking anking Industry post independence by merging weaker banks with stronger banks. The total number of banks reduced from 566 in 1951 to 85 in 1969. With the objective of reaching out to the masses and servicing credit needs of all sections of people, the government ernment nationalized 14 large banks in 1969. This period saw the enormous growth in the number of branches and Banks branch network become wide enough to reach the weaker section of the society in a vast country like INDIA.
Major Banking Operations

The main in operations of a bank can be segregated into three main areas: (i) (ii) (iii) Balancing Profitability with Liquidity Management Management of Reserves Creation of Credit 1 Estimation of Loss Given Default at PNB
Main Operations of a Bank
Operations of Bank
Balancing Profitability with Liquidity Management
Management of Reserves
Creation of Credit
Balancing Profitability with Liquidity Management

Banks are commercial al concerns which provide various financial services to customers in return for payments in one form or another, such as interest, discount fees, commission etc. Their objective is to make profits. However, what distinguishes them from other business concerns rns is the degree to which they have to balance the principle of profit maximization with certain other principles.
Banks in general have to pay much more attention in balancing the profitability with liquidity. Therefore, they have to devote considerabl considerable e attention to liquidity management. Banks deal in other peoples money, a substantial part of which is repayable on demand. That is why, for banks unlike other business concerns liquidity management is as important as profitability management.
Management of Reserves
Banks are expected to hold voluntarily a part of their deposits in the form of ready cash which is known as cash reserves and the ratio of cash reserves to deposits is known as
2 Estimation of Loss Given Default at PNB
Cash Reserve Ratio (CRR). The Central Bank in every country is emp empowered owered to prescribe the reserve ratio that all banks must maintain. The Central Bank also undertakes as the lender of last resort, to supply reserves to banks in times of genuine difficulties. Since the banks are required to maintain a fraction of their de deposit posit liabilities as reserves, the modern banking system is also known as the fractional reserve banking.
Creation of Credit
Unlike other financial institutions, banks are not merely financial intermediaries but they can create as well as transfer money money. . Banks are set to create deposits or credit or money or it can be said that every loan given by bank creates a deposit. This has given rose to the concept of deposit multiplier or credit multiplier. The importance of this is that banks add to the money supply pply in the economy and hence, banks become responsible in a major way for changes in the economic activities.
Structure of Banking Industry

Scheduled banks
Scheduled commercial Banks
Scheduled cooperative Banks
Public sector banks
Regional rural Banks
Foreign Banks
Private sector Banks
Urban Cooperative Banks
State cooperative Banks
SBI & its subsidiaries
Nationalized Banks
Old private sector Banks
New private sector Banks 3
Estimation of Loss Given Default at PNB
1.2 COMPANY PROFILE Punjab National Bank (PNB)

VISION
"To be a Leading ding Global Bank with Pan India footprints and become a household brand in the Indo-Gangetic Gangetic Plains providing entire range of financial products and services under one roof"
MISSION
"Banking for the unbanked"
PUNJAB NATIONAL BANK

Established in 1895 at Lahore, ahore, Punjab National Bank (PNB) has the distinction of being the first Indian bank to have been started solely with Indian capital. It was founded by Lala Lajpat Rai. Now its headquarter is at Delhi. The bank was nationalized in July 1969 along with 13 other ther banks. Today, PNB is a professionally managed bank with a successful track record over 110 years. The bank has the largest branch network In India, with 6001 branches across 764 cities and serves over 72 million customers. Category Banking Services Services. Sector Banking and Finance. Tag line The name you can bank upon. USP Punjab national bank if one of big four banks of India.
Financial Performance (2012 (2012-2013)

The Banks business crossed Rs.7.28 lakh crore as on March 31, 2013 registering a growth of 4.0 % . This has positive impact on productivity indicators with business per employee increasing to Rs.11.65 crore. Business per branch increased to Rs.116.84 crore. Total deposits have touched Rs.3.91 lakh crore recording Growth of 3.2 % . Net advances advanc
are around Rs.3.08 lakh crore with growth 5.1 %. The Banks CASA deposits were showing an increase by 14.3% over the FY13. Capital & revenue are around 32677 which show the growth of 17.5%. Business Parameters (Rs. Crore) PARAMETERS Total Business Total Deposits Net advances Casa Deposit Capital and Revenue Source: Annual results 2013 Mar-13 Mar-12 Growth (%) 700285 391560 308725 153344 32677 673363 379588 293775 134129 27815 4.0 3.2 5.1 14.3 17.5
PARAMETER Business per employee Business per branch Source: Annual result 2011
Mar-13 Mar-12 11.65 116.84 11.32 116.03
Bank has also done well in profitability parameters viz. Operating profit and Net Income in absolute terms. Net Interest Income at over Rs.14875 crore during FY13 has been the highest ighest among all the Nationalized Banks. PNB is the first Nationalized Bank to cross Operating Profit of Rs. 10,000 crore. Earnings per share also increased to Rs.139.52 during the FY13.
Profit Parameters (Rs. Crore) PARAMETERS Operating Profit Net Profit Net Intt Income Source: Annual results 2013 5 Estimation of Loss Given Default at PNB Mar-13 Mar-12 Growth(%) 10907 4748 14857 10614 4884 13414 2.8 -2.8 10.8
Organization structure: PNB

The bank has its corporate office at New Delhi and supervises 69 circle offices under which branches function. ion. The delegation of powers is decentralized up to the branch level to facilitate
Board of Director
quick
decision
CMD
ED
GM(Credit)
GM(NPA & weak account)
GM(Retail & lending)
GM(Treasury )
GM(Deposits)
GM(Audit)
DGM
DGM
DGM
DGM
.......
AGM
AGM
AGM
.......
FUNCTIONAL
HEAD
CMD Chief Managing Director ED- Executive Director GM General Manager AGM Assistant General Manager DGM Deputy General Manager
Channels in PNB
Corporate Office (HO)
Circle Office(CO)
Circle Office(CO)
Circle Office(CO)
Branch Office(BO)
Large Corporate Branches
Mid Corporate Branches
Retail Hub
Specialized Branches eg. Agriculture
PRODUCT AND SERVICES

1. Savings Account 2. Current Account 3. Fixed Deposits Scheme 4. Credit Scheme 5. Social Banking 6. Corporate Banking
VARIOUS TYPES OF LOAN PROVIDED BY PNB

1. Agriculture & Allied Activity 2. Industry a. MSME Manufacturing b. Large Industry
3. Retail Loans of f which a. Housing b. Other Retail Loans car loan, housing loan, personal loan etc.. 4. Comm. Real estate 5. Services and Others
AREAS OF CONCERN FOR PNB FOR CURRENT YEAR

Loss of Number One position in Deposits, Net Profit and Return on Equity. Dependence on high c cost deposits to shore up the deposits base. Uncontrollable growth in NPAs. Lead over the immediate competitor getting reduced to Rs. 1115 crore. Lack of uniform growth in business of various Circles/Branches.
THE ACTION POINTS FOR THE CURRENT YEAR AREAS OF CONCERN DISCUSSED ABOVE
Focus on CASA: Sustainable growth in savings Deposits by offering wealth management services to the customers. Business value base current accounts be opened Retail credit especially the housing loans be marketed aggressively to record high growth. Wealth management products sales be maximized offering full range e.g. Gold coins to Insurance. Monitoring of Irregular Accounts be stepped up to prevent Slippages. NPA reduction by one on one meetings, immediately targeting freshly slipped sli accounts.
CREDIT ADMINISTRATION DIVISION (CAD)

Commercial lending organization structure in PNB consists of branches, Mid Corporate Branches(MCB), Large Corporate Branches(LCB) and Head Office(HO). CAD looks after the proposal for all type of loans which fall within the preview of GMsGMs
HO/ED/CMD/MC/Board. Credit proposal goes through different level of sanctioning to enforce internal control and other practices to ensure that exception to policies, procedure and limits are reported in a timely manner to the appropriate level of management for action. Authority to handle loan proposals is distributed as detailed below: Loan proposals less than 35cr are dealt by MCB and LCB at their level and all other proposals are reffered to Circle Office which are f finally inally handled at Head Office. MCB handle proposals between Rs.5 crore and Rs.25 crore. CAD at Head Office prepares finals proposals which are then placed before ED, CMD, or MC as per the quantum of proposals. ED has authority to approve loan proposals les less s than Rs.75 crore. CMD approve proposals between Rs.75 crore and Rs.100 crore. Any proposal greater than Rs.100 Crore need the approval of management committee.
RISK MANAGEMENT DEPARTMENT (RMD)

The credit administration division is assisted by RMD and i industry ndustry desk for risk analysis and technical feasibility of credit proposals.Credit risk is the possibility of loss associated with changes in the credit quality of the borrowers or counter parties. In a banks portfolio, losses stem from outright defaul default t due to inability or unwillingness of a borrower or counter party to honour commitments in relation to lending, settlement and other financial transactions. PNB has an elaborate risk management structure in place. Credit Risk management structure at PNB involves
Integrated Risk Management Division (IRMD) IRMD frames policies related to credit risk and develops systems and models for identifying, measuring and managing credit risks. It also monitors and manages industry risks. Circle Risk Management Departm Departments (CRMDs) Risk Management Departments at circle level are known as CRMD. Their responsibilities include monitoring and initiating steps to improve the quality of the credit portfolio of the Circle, tracking down the health of the borrowers accounts through ough regular risk rating, besides assisting the respective Credit Committee in addressing the issues on risk. Risk Management Committee (RMC) It is a sub-committee committee of Board with responsibility of formulating
policies/procedures and managing all the risks. Credit Risk Management Committee (CRMC) It is a top level functional committee headed by CMD and comprises of EDs, CGMs/GMs of Risk Management, Credit, Treasury etc. as per the directives of RBI. Credit Audit Review Division (CARD) It independently condu conducts Loan Reviews/Audits.
The risk management philosophy & policy of the bank focuses reducing exposure to high risk areas, emphasizing more on the promising industries, optimizing the return by striking a balance between the risk and the return on assets and striving towards improving market share to maximize shareholders value. The bank has robust credit risk framework and has already placed credit risk rating models on central server based system PNB TRAC, which provides a scientific method for assessing ssing credit risk rating of a client. Taking a step further during the year, the bank has developed and placed on central server score based rating models in respect of retail banking. These processes have helped the bank to achieve fast & accurate delivery deliver of 10 Estimation of Loss Given Default at PNB
credit, bring uniformity in the system and facilitate storage of data & analysis thereof. The analysis also involves analyzing the projections for the future years.
RISK ANALYSIS
PNB has elaborate risk management structure, processes and procedures in place. For the appraisal of the loan proposals, RMD provides the risk ratings for the client and project based in the patented internal models of the PNB that have been developed based on statistical analysis of data. These models are placed on central se server rver based system PNB TRAC, which provides facility to assess credit risk rating of a client. This credit risk rating captures risk factors under four areas: Financial evaluation (40%) Business or industry evaluation (30%) Management evaluation (20%) Conduct duct of account (10%)
Various External Credit Agencies in India: 1. CIBIL 2. CARE 3. FITCH 4. ICRA
Factors determining credit risk: State of economy Wide swing in commodity prices Fluctuations in foreign exchange rates and interest rates Trade restrictions Economic sanctions Government policies 11 Estimation of Loss Given Default at PNB
CREDIT FACILITIES
PNB provides different types of credit facilities according to the banking norms and convenience of the clients. Different types of facilities provided are classified below:
FUND BASED FACILITIES ILITIES Fund based facilities are those that require immediate outlay of funds towards the borrowing party.
Overdraft Overdraft account is treated as current accounts. Normally overdrafts are allowed against the Banks own deposit, government securi securities ties approved shares and/or debentures of companies, life insurance policies, government supply bills, cash incentive and duty drawbacks, personal security etc. Demand loans Demand loan would be a loan, which is payable on demand in one shot i.e. bullet let repayment. Normally, demand loans are allowed against the banks own deposits, government securities, approved shares and/or debentures of companies, life insurance policies, pledge of gold/silver ornaments, mortgage of immovable property.
Cash credit advances Cash credit account is a drawing account against the credit granted by the bank and is operated in exactly the same way as a current account on which an overdraft has been sanctioned. In cash credit accounts the borrower is allowed to draw on account within the prescribed limit as and when required.
Bill finance Bill finance are the advances against the inland bills are sanctioned in the form of limits for purchase of bills or discount of bills or bills sent for collection. Bills are either payable on demand of after usage period.
NON FUND BASED FACILITIES While fund based credit facilities require immediate outlay of funds from the bank, nonnon fund based facilities basically include the promises made by banks in favor of third party to o provide monetary compensation on behalf of their client if certain situations emerge or certain conditions are fulfilled. The non non-fund fund based business is one of the main sources of bank income. Income is in the form of fees and commissions as compared to interest income in case of fund based lending. Non fund based credit plays an important role in trade and commerce. The borrowing clients of banks prefer to avail of the non non-fund fund based facilities mainly because: The facility does not require immediate outl outlay ay of funds and therefore the cost of such funds tend to be lower than the cost of fund based credit facilities. A bank guarantee(BG) or letter of credit(LOC) issued by a bank on behalf of its client is an off off-balance balance sheet item in the books of clients, hence he do not show up as debt or liability. For the lending banks, cost of providing non non-fund fund based facilities is significantly lower than the cost of providing fund fund-based facilities. Bank Guarantees BG may be financial of performance in nature. In a financia financial l guarantee, the issuing bank assumes an usual credit risk which is the domain of the banks. However, issue of a performance guarantee involved technical competency and managerial ability of a customer to ensure the performance of the contract for which guarantee arantee has been drawn. Issuing banks responsibility against the BG is
absolute. So proper appraisal needs to be done before issuing BG as it is the responsibility of the issuing bank to honor its guarantee when invoked. Letter of credit A document ument issued by a bank that guarantees the payment of a customers draft; substitutes the banks credit. It is an undertaking issued by bank on behalf of the buyer to the seller, to pay for the goods and services. All letters of credit are irrevocable, i.e. . cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. It is different from BG in the sense that in case of LOC, the issuing bank does not wait for the buyer to default, and for the sel seller ler to invoke the undertaking. While in BG, comes into play only when the principal party (the buyer) has fa failed iled to pay its supplier
SWOT Analysis of PNB

Strengths 1. Diversified operations with 5100 branches. 2. Strong I. T support with best fit appro approach. 3. Schemes for small and medium scale businesses. 4. It is the second largest state state-owned owned commercial bank in India with about 5000 branches across 764 cities. 5. Its 56,000+ workforce serves over 37 million customers. Weakness 1. Less penetration in the urban areas. 2. Inadequate advertising and branding as compared to other banks. 3. Legal issues regarding employees caused a bad name of PNB. Opportunities 1. Small scale business banking across India. 2. Expansion in other countries for internation international al banking. 3. Installation of more ATMs and better customers services. Threats 1. Economic crisis and economic fluctuations. 2. Highly competitive environment. 3. Stringent Banking Norms by the RBI and the Governments.
WORKING OF THE RISK MA MANAGEMENT DIVISION (RMD) AT PNB. PNB
Risk Management is the process by which the Bank identifies, measures, monitors and controls its risk exposure in order to ensure that risks are within the tolerance level set by the Bank and are clearly understood at rele relevant levels across the Bank.
Risk is inherent part of Banks business. Effective Risk Management is critical to any Bank for achieving financial soundness.
Specifically, integrated risk management division at PNB has two important functions:
To protect the bank against Credit Risk Operational Risk Market Risk
The Board of Directors had constituted the Risk Management Advisory Committee (RMAC) which included IRMD officials and external professionals as its members. The Committee overseas the Risk R Management functions of the Bank with focus on the three risks mentioned above.
To protect from systemic risk.
AREA OF THE PROJECT: STUDY OF RISK COMPONETS UNDER AIRB APPROACH
The project mainly focuses on study and analysis of different risk components com and estimation of LGD and effective maturity of loans by PNB under IRB Approach. 15 Estimation of Loss Given Default at PNB
The aim of the study would be to know o What are the different credit risk o How to calculated Risk under AIRB Approach o Estimation of LGD
PURPOSE OF THE STUDY:
Indian economy is witnessing a new state of buoyancy during last couple of years. With the rise of tide, all sectors of economy are performing well and so is the small scale sector. A very large number of SMEs in sectors such as Engineering, Electricals, Plastics, Plastic Building hardware, Home Furnishing, Paints, Furniture, Industrial consumables are coming up. Secondly, the supply chains are increasingly getting organized necessitating linkages between small and large sector thus giving rise of the genuine medium sector sect in the country: a segment that retains the flexibility of small scale and of large enterprises. Keeping in view the heterogeneity of the sector, a significant number of sub-sectors sub are left out that are performing at below par or even struggling all to together. gether. These segments are finding difficult to adjust to the changed economic dynamics of new resurgent India. Most of the small enterprises in this segment belong to traditional and government procurement led sectors such as traditional textiles (handlo (handlooms), oms), stationery etc. .
2.1 Literature Review

Most of the published research deals with recoveries of bonds rather than bank loans, due to the proprietary nature of data for the latter. But data u unavailability navailability is not the only difference between bank loans and bonds. The list of relevant differences contains at least the following peculiarities (Schuermann, 2001; 2000): Bank loans are typically more senior in the c capital apital structure of the borrowers, which can clearly affect their recovery rates. Banks usually more actively monitor the evolving financial health of the obligor. Banks as private lenders better control the agency costs of the borrowers through tighter ter covenants, better renegotiation possibilities and closer monitoring. All these characteristics are pretty much tight to the notion of relationship banking. These differences are also a reason for somewhat different methodological approaches in estimating ing recovery rates. Nevertheless the fundamental characteristics of publicly traded debt, that can be associated with debt recovery rates turn out to be basically the same as the features of the privately placed bank loans and related recovery rates. So the th studies on corporate bonds report that recovery on individual bonds is affected not only by seniority and security, but also by the industry conditions at the time of default (Dermine and Carvalho, 2006). Altman et al. (2004) present a detailed review of the way credit risk models, developed during the last three decades, treat the recovery rate and its relationship with the probability of default of an obligor. Altman et al. (2004) also summarize and thoroughly discuss the empirical evidence on recovery rate calculation and RR PD relationship. In the rest of this section we briefly summarize published research on RR (LGD) measurement in case of defaulted bank loans, since our study focuses strictly on individual bank loan transactions. One of the widely quoted studies on LGD measurement of bank loans is the Asarnow and Edwards (1995) study. Asarnow and Edwards (1995) calculated loss in the eventof default (LIED) for 831 defaulted C&I 17 Estimation of Loss Given Default at PNB Amihud, Garbade and Kahan,
loans and 89 defaulted structured loans for the 24-year period (1970-1993) 93) in Citibank. They measured 34.79% LGD for the C&I loans and 12.75% LGD for structured loans by employing a discounted cash flows method. They delineated the components of LGD (or LIED) such as writeoffs, interest drag, cash interest collected, recoveri recoveries es and some other expense or income events. A clear evidence of bimodal distribution of LGD is reported, which was important finding for modelling credit loss volatility. Moodys bank loans study (Carty and Lieberman, 1996) comprised a sample of 58 bank loans. ans. Based on secondary market prices for defaulted bank loans they reported an average defaulted bank loan price of 71%. They did not observe a bimodal distribution, but reported a skewness toward the high end of the price scale.
In the same study, the authors thors measured the recovery rate for a sample of 229 small and medium-sized sized loans in the US. They reported an average recovery rate of 79% based on the present value of cash flows. Again, the distribution was highly skewed towards the high end of the scale. Hurt and Felsovalyi (1998) studied the characteristics of C&I bank loan defaults in Latin America and concentrate on bank loss measurement in case of default. For 1149 defaulted bank loans in the 1970 1996 period they measured 31.8% average loss in the event of default, which corresponded to 68.2% average recovery rate. They employed discounted cash flow approach. The LGD distribution proved to be highly skewed and reflected a large number of loans with small losses and a small number of loans with losses es approaching 100%. Loan size turned out to be important explanatory factor for measured loan losses in the event of default. Resuming the results of some recent works, Emery (2003) reports some referential values which are of interest to our research. Th The median RR on secured bank loans is 73.0% and 50.5% on senior unsecured bank loans. Several researches have also presented fairly high variance levels across industrial sectors (Verde, 2003). Schuermann (2004) recently highlighted the importance of the in industry dustry factor in determining LGD in a survey of the academic and practitioners literature.
One of the largest and more recent studies that focus on loans to small and medium sized enterprises was made by Standard & Poors Risk Solution Department (Franks, Servigny, Davydenko, 2004). It considers collateral as the key driver of recovery rates, which vary across banks within the same country and jurisdiction. Recovery rates also differ across countries where banks respond to different bankruptcy regimes and codes des by adjusting different lending practices. In France, for instance, banks demand higher levels of collateral and target specific forms of collateral. The recovery rate in France differs significantly (it is lower) from recoveries in the UK and Germany. In one of the lately published papers Gupton (2005) applied LossCalc Moodys KMV model to predict LGD and employed a dataset which included 1424 defaulted public and private firms. He studied LGD for defaulted loans, bonds and preferred stock for period January anuary 1981 December 2003 in Australia, New Zealand, Canada, Europe, Latin America, the United States and the United Kingdom, with at least seven years of data in each. The inclusion of any of the transition countries in the research is not reported. The most recent study on bank loan LGD rates was published by Dermine and Carvalho (2006) who investigated LGD characteristics for 374 corporate bank loans to small and medium size firms in Banco Commercial Portuguese over the period 1995 2000. The authors applied plied mortality analysis to defaulted bank loan recovery rates and tested empirically the determinants of recovery rates. Additionally they provided information on the direct costs incurred by a bank in recoveries on bad and doubtful loans. The average recovery overy rate measured in their study was 71%, which was in line with some earlier studies in the field. More importantly, they showed that the frequency distribution of bank loans LGD rates proved to be bimodal and in their multivariate analysis of the determinants rminants of loan losses they identified statistically significant explanatory variables such as size of the loan, collateral, industry sector, year dummies and age of the obligor (firm).
2.2 RISK MANAGEMENT AT PNB
Risk isk Management at PNB covers three main areas 1) Credit Risk 2) Market Risk 3) Operational Risk
The Board of Directors ultimately responsible for the management of the risk at the Bank. It approves the banks risk appetite, risk policies and procedures and the risk ris management infrastructure. The Risk Management Committee is a Board Committee that convenes monthly to be constantly apprised of banks risk profile and various risk issues. The Risk Management Division is independent from the line and reports directly to t the Risk Management Committee. It review risk exposure versus approved limits, drafts risk policies and assists line management in risk reduction strategies.
The risk management philosophy & policy of the Bank is an embodiment of the Banks approach to understand, measure and manage risk and aims at ensuring sustained growth of healthy asset portfolio. This would entail in reducing exposure in high risk areas, emphasizing more on the promising industries, optimizing the return by striking a balance between en the risk and the return on assets and striving towards improving market share to maximize shareholders value.
The Bank has robust credit risk framework and has already placed credit risk rating models on central server based system which provides a scientific ientific method for assessing credit risk rating of a client. Taking a step further during the year, the Bank has developed and placed on central server score based rating models in respect of retail banking. These processes have helped the Bank to achiev achieve e fast & accurate delivery of credit; bring uniformity in the system and facilitate storage of data & analysis thereof.
The Bank has in place a well defined organizational structure for market risk management functions, which looks into the process of ove overall rall management of market risk viz. interest rate risk & liquidity risk and implements methodologies for measuring and monitoring the same. Tools like stress testing, duration, modified duration, VaR etc are being used effectively in managing risk in the T Treasury reasury operations. The Bank has actively re-shuffled shuffled the portfolio to improve profitability within risk limits.
Despite high volatility of the liquidity position in the system during the year, the Banks liquidity position remained comfortable. Asset li liability ability management of the Bank is done on proactive basis to manage any eventuality. With Core Banking Solution (CBS) covering entire branch network, the Asset Liability Management in respect of all assets and liabilities is being done on daily basis.
2.2.1 CREDIT RISK

Credit Risk is the potential that a bank borrower/counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of credit risk to the bank. These losses could take the form outright default or alternatively, losses from changes in portfolio value arising from actual or perceived deterioration in credit quality that is short ort of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters.
Credit risk consists of primarily two components, viz. Quantity of risk, which is nothing but the outstanding loan balance as on the date of default and the Quality of risk, viz. the severity ity of loss defined by the Probability of Default & the recoveries that could be made in the event of default. Thus credit risk is a combined outcome of Default Risk and 21 Estimation of Loss Given Default at PNB
Exposure Risk. The elements of Credit Risk are Portfolio risk comprising Concentration Risk as well as Intrinsic Risk and Transaction Risk comprising migration/down gradation risk as well as Default Risk. At the transaction level, credit ratings are useful measures of evaluating credit risk that is prevalent across the entire organization w where here treasury and credit functions are handled. Portfolio analysis help in identifying the concentration of credit risk, default/migration statistics, recovery data, etc.
In general, Default is not an abrupt process to happen suddenly and past experience dictates that, more often than not, borrowers credit worthiness and asset quality declines gradually, which is otherwise known as migration. Default is an extreme event of credit migration. Off balance sheet exposures such as foreign exchange forward cont contracts, racts, swaps options etc are classified in to three broad categories such as full Risk, Medium Risk and Low risk and then translated into risk weighted assets through a conversion factor and summed up.
The management of credit risk includes: a) Measurement through credit rating/scoring, b) Quantification through estimate of expected loan losses, c) Pricing on a scientific basis, and d) Controlling through Management. The Committee permits banks a choice between two broad methodologies for calculating their capital requirements for credit risk. One alternative, the Standardised Approach, will be to measure credit risk in a standardised manner, supported by external credit assessments. The other alternative, the Internal Ra Ratings-based based Approach, which is subject to the explicit approval of the banks supervisor, would allow banks to use their internal rating systems for credit risk. effective Loan Review Mechanism and Portfolio
The following section sets out revisions to the 1988 Accord for risk weighting banking book exposures. posures. Exposures that are not explicitly addressed in this section will retain the current treatment; however, exposures related to securitisation are dealt with in Section IV. Furthermore, the credit equivalent amount of Securities Financing Transactions Transaction (SFT) and OTC derivatives that expose a bank to counterparty credit risk16 is to be calculated under the rules set forth . In determining the risk weights in the standardised approach, banks may use assessments by external credit assessment institutions recognised as eligible for capital purposes by national supervisors in accordance with the criteria defined in paragraphs. Exposures should be risk risk-weighted weighted net of specific provisions. AAA Credit Assessment Risk Weight to AA0% 20% A+ to A ABBB+ to BBB50% 100% 150% 100% BB+ to BBelow BUnrated
At national discretion, a lower risk weight may be applied to banks exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded19 in that currency. rency. Where this discretion is exercised, other national supervisory authorities may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign (or central bank) funded in that currency.For the purpose of risk weighting eighting claims on sovereigns, supervisors may recognise the country risk scores assigned by Export Credit Agencies (ECAs). To qualify, an ECA must publish its risk scores and subscribe to the OECD agreed methodology. Banks may choose to use the risk scores s published by individual ECAs that are recognised by their supervisor, or the consensus risk scores of ECAs participating in the Arrangement on Officially Supported Export Credits.21 The OECD agreed methodology establishes eight risk score categories associated sociated with minimum export insurance premiums. These ECA risk scores will correspond to risk weight categories as detailed below. ECA risk scores Risk weight 0-1 0% 2 20% 3 50% 4 to 6 100% 7 150% 23 Estimation of Loss Given Default at PNB
Claims on banks There are two options for claims aims on banks. National supervisors will apply one option to all banks in their jurisdiction. No claim on an unrated bank may receive a risk weight lower than that applied to claims on its sovereign of incorporation. Under the first option, all banks incorporated porated in a given country will be assigned a risk weight one category less favourable than that assigned to claims on the sovereign of that country. The second option bases the risk weighting on the external credit assessment of the bank itself with claims s on unrated banks being risk risk-weighted weighted at 50%. Under this option, a preferential risk weight that is one category more favourable may be applied to claims with an original maturity25 of three months or less, subject to a floor of 20%. This treatment will be e available to both rated and unrated banks, but not to banks risk weighted at 150%. The two options are summarised in the tables below. Option 1 Credit assessment Sovereign Risk of AAA to AAA+ Ato BBB+ BB+ to Below B150% 100%
to BBB- B100% 100%
weight 20%
50%
under Option 1 Option 2 Credit assessment Banks Risk of AAA to AAA+ Ato BBB+ BB+ to Below B150% 50%
to BBB- B50% 100%
weight 20%
50%
under Option 2 Risk weight for 20% short-term claims26 Option 2 under 20% 20% 50% 150% 20%
2.2.2 MARKET RISK

Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on on-/off-balance balance sheet positions posit will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the banks earnings and capital due to changes in the market level of interest rates or prices of sec securities, urities, foreign exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as wel well l as commodity price risk of a bank that needs to be closely integrated with the banks business strategy.
Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a given portfolio. Identification of future c changes hanges in economic conditions like economic/industry overturns, market risk events, liquidity conditions etc that could have unfavorable effect on banks portfolio is a condition precedent for carrying out stress testing. As the underlying assumption kee keep p changing from time to time, output of the test should be reviewed periodically as market risk management system should be responsive and sensitive to the happenings in the market.
a) Liquidity Risk:
Bank Deposits generally have a much shorter contractu contractual al maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible fundi funding of the off-balance balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off off-balance balance sheet items. Liquidity risk consists of Funding Risk, Time Risk & Call Risk 25 Estimation of Loss Given Default at PNB
b) Interest Rate Risk Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability of an institutions financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liabi liability off-balance balance sheet items and cash flow. Hence, the objective of interest rate risk management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken a and nd affect risk return trade-off. trade Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing pricing mismatches and is measured both from the earnings and economic value perspective.
Earnings perspective involves analyzin analyzing g the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) equivalent to the difference between total interest income and total interest expense.
In n order to manage interest rate risk, banks should begin evaluating the vulnerability of their portfolios to the risk of fluctuations in market interest rates. One such measure is Duration of market value of a bank asset or liabilities to a percentage change chan in the market interest rate. The difference between the average duration for bank assets and the average duration for bank liabilities is known as the duration gap, which assess the banks exposure to interest rate risk. The Asset Liability Committee (A (ALCO) LCO) of a bank uses the information contained in the duration gap analysis to guide and frame strategies. By reducing the size of the duration gap, banks can minimize the interest rate risk.
Economic Value perspective involves analyzing the expected cash inflows on assets minus expected cash out flows on liabilities plus the net cash flows on off off-balance balance sheet
items. The economic value perspective identifies risk arising from long long-term term interest rate gaps. The various types of interest rate risks are detail detailed below:
There are different techniques such as a) the traditional Maturity Gap Analysis to measure the interest rate sensitivity, b) Duration Gap Analysis to measure interest rate sensitivity of capital, c) simulation and d) Value at Risk for measuremen measurement t of interest rate risk. The approach towards measurement and hedging interest rate risk varies with segmentation of banks balance sheet. Banks broadly divide the asset into Trading Book and Banking Book. While trading book comprises of assets held primar primarily ily for generating profits on short term differences in prices/yields, the banking book consists of assets and liabilities contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity/p maturity/payment ayment by counter party.
Thus, while price risk is the prime concern of banks in trading book, the earnings or changes in the economic value are the main focus in banking book.
Value at Risk (VaR) is a method of assessing the market risk using standard statistical s techniques. It is a statistical measure of risk exposure and measures the worst expected loss over a given time interval under normal market conditions at a given confidence level of say 95% or 99%. Thus VaR is simply a distribution of probable outcome of future losses that may occur on a portfolio. The actual result will not be known until the event takes place. Till then it is a random variable whose outcome has been estimated.
As far as Trading Book is concerned, bank should be able to adopt standardized method or internal models for providing explicit capital charge for market risk.
c) Forex Risk Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or
forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward transactions may produce mismatches. There is also a settlement risk aris arising ing out of default of the counter party and out of time lag in settlement of one currency in one centre and the settlement of another currency in another time zone. Banks are also exposed to interest rate risk, which arises from the maturity mismatch of fo foreign reign currency position. The Value at Risk (VaR) indicates the risk that the bank is exposed due to uncovered position of mismatch and these gap positions are to be valued on daily basis at the prevalent forward market rates announced by FEDAI for the rema remaining maturities.
Currency Risk is the possibility that exchange rate changes will alter the expected amount of principal and return of the lending or investment. At times, banks may try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk.
By setting appropriates limits limits-open position and gaps, stop-loss loss limits, Day Light as well as overnight t limits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and well defined division of responsibilities between front, middle and back office the risk element in foreign exchange risk can be managed/monitored.
d) Country Risk This his is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization. It is the possibility that a country will be unable to service or repay debts to foreign lend lenders ers in time. It comprises of Transfer Risk arising on account of possibility of losses due to restrictions on external remittances; Sovereign Risk associated with lending to government of a sovereign nation or taking government guarantees; Political Risk w when hen political environment or legislative process of country leads to government taking over the assets
of the financial entity (like nationalization, etc) and preventing discharge of liabilities in a manner that had been agreed to earlier; Cross border ris risk k arising on account of the borrower being a resident of a country other than the country where the cross-border cross asset is booked; Currency Risk, a possibility that exchange rate change, will alter the expected amount of principal and return on the lending or investment. In the process there can be a situation in which seller (exporter) may deliver the goods, but may not be paid or the buyer (importer) might have paid the money in advance but was not delivered the goods for one or the other reasons.
As per the RBI guidance note on Country Risk Management published recently, banks should reckon both fund and non non-fund fund exposures from their domestic as well as foreign branches, if any, while identifying, measuring, monitoring and controlling country risk. It advocates ocates that bank should also take into account indirect country risk exposure. For example, exposures to a domestic commercial borrower with large economic dependence on a certain country may be considered as subject to indirect country risk. The exposures should be computed on a net basis, i.e. gross exposure minus collaterals, guarantees etc.
Netting may be considered for collaterals in/guarantees issued by countries in a lower risk category and may be permitted for banks dues payable to the respective countries. RBI further suggests that banks should eventually put in place appropriate systems to move over to internal assessment of country risk within a prescribed period say by 31.3.2004, by which time the new capital accord would be implemented. The system sy should be able to identify the full dimensions of country risk as well as incorporate features that acknowledge the links between credit and market risks. Banks should not rely solely on rating agencies or other external sources as their only country riskmonitoring tool.
With regard to inter-bank bank exposures, the guidelines suggests that banks should use the country ratings of international rating agencies and broadly classify the country risk
rating into six categories such as insignificant, low, mode moderate, rate, high, very high & offoff credit. However, banks may be allowed to adopt a more conservative categorization of the countries. Banks may set country exposure limits in relation to the banks regulatory capital (Tier I & II) with suitable sub limits, if ne necessary, cessary, for products, branches, maturity etc. Banks were also advised to set country exposure limits and monitor such exposure on weekly basis before eventually switching over to real tie monitoring. Banks should use variety of internal and external sourc sources es as a means to measure country risk and should not rely solely on rating agencies or other external sources as their only tool for monitoring country risk. Banks are expected to disclose the Country Risk Management policies in their Annual Report by way y of notes.
2.2.3 OPERATIONAL RISK
Always banks live with the risks arising out of human error, financial fraud and natural disasters. The recent happenings such as WTC tragedy, Barings debacle etc. has highlighted ted the potential losses on account of operational risk. Exponential growth in the use of technology and increase in global financial inter inter-linkages linkages are the two primary changes that contributed to such risks. Operational risk, though defined as any risk that th is not categorized as market or credit risk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. In order to mitigate this, internal control and internal audit systems are used as the pri primary mary means.
Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk. Insurance cover is one which mitigates operational risk. Operational risk events are associated with weak links in internal contro control l procedures. The key to management of operational risk lies in the banks ability to assess its process for
vulnerability and establish controls as well as safeguards while providing for unanticipated worst-case case scenarios.
Operational risk involves break breakdown down in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss. Putting in place proper corporate governance practices by itself would serve as an effective e risk management tool. Bank should strive to promote a shared understanding of operational risk within the organization, especially since operational risk is often inter-wined wined with market or credit risk and it is difficult to isolate.
Over a period of time, me, management of credit and market risks has evolved a more sophisticated fashion than operational risk, as the former can be more easily measured, monitored and analysed. And yet the root causes of all the financial scams and losses are the result of operational rational risk caused by breakdowns in internal control mechanism and staff lapses. So far, scientific measurement of operational risk has not been evolved. Hence 20% charge on the Capital Funds is earmarked for operational risk and based on subsequent data/feed-back; back; it was reduced to 12%. While measurement of operational risk and computing capital charges as envisaged in the Basel proposals are to be the ultimate goals, what is to be done at present is to start implementing the Basel proposal in a phased manner anner and then carefully plan in that direction.
2.3 Calculation of Credit Risk

The New Basel Accord, expected to be implemented at year year-end end 2006, will require internationally active banks to use more risk sensitiv sensitive e methods for calculating credit risk capital requirements
As per the norms, there are two approaches of calculating credit risk are
1) Standardized Approach 2) Internal Ratings Based (IRB) Approach
Standardized Approach It refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.
Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk.
In many countries ries this is the only approach the regulators are planning to approve in the initial phase of Basel II Implementation.
Internal Ratings Based (IRB) Approach
This approach has two parts -
1. Advanced internal rating rating-based approach (A-IRB) 2. Foundation internal rnal ratings ratings-based approach (F-IRB)
Advanced internal rating rating-based approach (A-IRB)
Under this approach the banks are allowed to develop their own empirical model to quantify required capital for credit risk.
In this approach quantitative models are de developed veloped to estimate the PD (probability of default), EAD (Exposure at Default), LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the est estimated RWA.
Banks can use this approach only subject to approval from their local regulators.
Foundation internal ratings ratings-based approach (F-IRB) Under this approach the banks are allowed to develop their own empirical model to estimate the PD (probabil (probability of default) for individual clients or groups of clients
Banks are required to use regulator's prescribed LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Assets). Then total required capital is calculated as a fixed percentage of the estimated RWA.
Definitions of Default and Loss Default By definition, a debt instrument can experience a loss only if there has been a default. However, there is no standard definition of what constitutes a default. D Different
definitions may be used for different purposes. Typically a default occurs when any of the following conditions are met:
A loan is placed on non-accrual accrual A charge-off off has already occurred The obligor is more than 90 days past due The obligor has filed bankruptcy 33 Estimation of Loss Given Default at PNB
The BIS reference definition of default for purposes of the New Basel Accord reflects many of these events: A default is considered to have occurred with regard to a particular obligor when one or more of the following events has t taken place. (a) It is determined that the obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full; (b) A credit loss event associated with any obligation of the obligor, such as charge-off, charge specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees; (c) The obligor is past due more than 90 days on any credit obligation; or (d) The obligor has filed for bankruptcy or similar protection from creditors. The measured ured loss in the event of default, and likewise the LGD (percentage of exposure), will clearly depend on the definition of default adopted. Many instances of defaults under the definition may result in no loss incurred. For example, a firm may go 90 days past due on a loan payment and subsequently make good on all of its obligations. This event would count as a default but would result in full recovery. A bank that ignores such events will under-estimate estimate recovery rates since the exposure and 100% recovery wont be included in the banks loss data. The banks model will consequently yield an
2.4 Components of Credit Risk

There are four risk components within the IRB approach to corporate, bank, and sovereign exposures, which ich build off the structure of banks rating systems.
1) Exposure At Default 2) Loss Given Default 3) Probability Of Default 4) Maturity 34 Estimation of Loss Given Default at PNB
2.4.1 Exposure at default (EAD)

Exposure at Default (EAD): It is a level of exposure to a borrower a at t the time of default. The EAD for funded exposure will be provided by National Supervisor under foundation approach. Our bank has started collection of LGD & EAD data for accounts defaulted on or after 31.03.2004 and having outstanding balance of Rs. 20 lac (since changed to Rs. 50 lac) and above.
A-IRB Approach ] Calculation Of EAD [ Under A EAD for non bund based transactions = Undrawn Credit Line * Credit Conversion Factor
EAD for fund based transactions = (Amount withdrawn + (Undrawn Credit Line * Credit Conversion Factor) By the borrower
2.4.2 Probability of Default (PD)

Probability of default measures the likelihood that the borrower will default over a given time-horizon horizon i.e. What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as an year. PNB already has Risk Rating System in place for the last 7 years and the history of default rates is being tracked since last 7 years for Large Corporate & 5 years for Mid Corporate. There are several statistical techniques available to estimate PD using historical default rate and our bank is working on th them.
Calculation of PD: When calculating the probability of default, for each combination of exposure and guarantee, the system assigns a PD to every exposure that is calculated according to either of the IRB approaches. This PD is alter used to calculate the capital requirement. The PD calculation is dependent on the relevant rating. The system uses the transaction to determine which rating to assign to the single transaction. One possible method of PD estimation is based on historical data, where estimat estimates es are made per each rating grade. The key element in PD estimation is the definition of default. Definitions which trigger earlier defaults will automatically produce higher PDs. Also, in order to be able to compare PDs across different rating systems or for data pooling, both the rating processes and the definition of default have to be identical. The calculation of the historical PD is not very complex. The PD itself does not include a loss component but only the number of defaults within the given time period.
Basel II requires banks to estimate 1 1-year PDs based on long-term term averages. This can be achieved by generating yearly pseudo pseudo-obligor obligor pools, where each obligor is placed according to his rating at the beginning of the year, and taking the aver average age of the pools (a minimum of five years is required in Basel II). In this way there will be less variation in the PD estimation from year to year.
The following steps are commonly used:
Analyse the credit risk aspects of the counterparty / portfolio Map the counterparty to an internal risk grade which has an associated PD: and Determine the facility specific PD. This last step will give a weighted Probability of Default for facilities that are subject to a guarantee or protected by a credit derivative. The weighting takes account of the PD of the guarantor or seller of the credit derivative. Once the probability of default has been estimated, the related credit spread and valuation of the loan or bond is the next step. A popular approach to this critical criti element of credit risk analysis is the "reduced form" modeling approach of the Jarrow-Turnbull Turnbull model. model..
2.4.3 Loss Given Default (LGD)

Subject to certain additional minimum requirements, supervisors may permit banks to o use their own internal estimates of LGD for various asset classes such as corporate, sovereign and bank exposures. Since it directly affects your provisioning as well as capital requirement under IRB, proper collateral should be taken and actual valuati valuation on should be used to minimize losses to bank in case of default.
Masurement asurement and Estimation of LGD Loss Given Default is the credit loss incurred if an obligor of the bank defaults.
LGD = 1 Recovery Rate
where, Recovery = Present Value of { Cash flows received from borrower after the date of default recovery } Costs incurred by the bank on
Recovery rate = Recovery (as calculated above)/ Exposure on the date of default
LGD is usually defined as the ratio of losses to exposure at defaul default. t. Once a default event has occurred, loss given default includes three types of losses: The loss of principal The carrying costs of non non-performing performing loans, e.g. interest income foregone Workout expenses (collections, legal, etc.) There are broa broadly dly three ways of
measuring LGD for an instrument: 1. Market LGD: observed from market prices of defaulted bonds or marketable loans soon after the actual default 2. Workout LGD: The set of estimated cash flows resulting from the w workout orkout and/or collections process, properly discounted, and the estimated exposure
3. Implied Market LGD: LGDs derived from risky (but not defaulted) bond prices using theoretical asset pricing model.
Market LGD
For defaulted bonds and loans oans which trade in the market, one may observe prices directly so long as a trade has actually occurred. The rating agency recovery studies are based on this approach. The actual prices are based on par = 100 (cents on the dollar) and can thus be easily y translated into a recovery percentage (or LGD as 100% minus the 38 Estimation of Loss Given Default at PNB
percentage recovery). These prices have some desirable properties since they are observed early and are a reflection of market sentiment at that time. After all, they are the result of a market rket transaction and hence less subject to debate about proper valuation. These prices reflect the investors expected recovery, suitably discounted, and thus include recoveries on both discounted principal and missed interest payments as well as
9
restructuring uring costs and uncertainty of that restructuring process. In the Moodys dataset, for example, they are observed in the market one month after the first occurrence of the default event. This price is therefore the markets expected present value of eventual even recovery. Workout LGD LGD observed over the course of a workout is a bit more complicated than the directly observed market LGD. Attention needs to be paid to the timing of the cash flows from the distressed asset. Measuring this timing will impact downstream estimates of realized LGD. The cash flows should be discounted, but it is by no means obvious which discount rate to apply. For example, the debt restructuring could result in the issuance of risky assets such as equity or warrants, or less ri risky sky ones such as notes, bonds or even cash. In principle the correct rate would be for an asset of similar risk. Importantly, once the obligor has defaulted, the bank is an investor in a defaulted asset and should value it accordingly, possibly at the ba banks nks hurdle rate. Inappropriate candidates include the coupon rate (set ex ante of default, so too low) and the risk risk-free free (or Treasury) rate. Implied Market LGD An entirely different approach one could take to obtain an estimate of LGD is to look at credit dit spreads on the (much larger universe of) non non-defaulted defaulted risky (e.g. corporate) bonds currently traded. Although these new methods have not yet fully migrated into the banks credit risk arena, they are used in the trading room for fixed income products and credit derivatives and as such are often used as a check against more conventional credit rating
models. Moreover, some credit portfolio models require credit spreads as an input parameter. free (i.e. Treasury) bonds is an indic indicator ator of the risk premium The spread above risk-free demanded by investors. However, this spread reflects EL, and thus both PD and LGD, as well as liquidity premiums. Only recently have models been developed which allow one to separately identify these two parameters from bond spre spreads ads (see, for instance, Bakshi, Madan and Zhang (2001) and Unal, Madan and Guntay (2003).
3.1 OBJECTIVE OF THE STUDY
The main objective of the study is to understand the concept, significance and calculation of Different risk components and estimation of LGD
Though the Risk Management area is very wide and elaborated, the project covers it entirely albeit concise manner. The project involves calculation of Loss Given Default (LGD) for retail sector.
At this point of time, there is no bank in India which has fully adopted the Basel II norms, each bank is in the process of implementing them
Although, I was offered many other topics by my project guide, I chose this one because it was a unique topic and will provide me a lot of knowledge about the Basel norms, which have become very important in the banking industry.
3.2 SCOPE OF STUDY

The report seeks to present a comprehensive picture of the variou various s risk inherent in the bank. The risks can be broadly classified into three categories: Credit Risk Market Risk Operational risk
Within each of these broad groups, an attempt has been made to cover as comprehensively as possible, the various sub groups. C Credit redit risk entails four main components viz Probability of Default (PD), Exposure at Default (EAD), Loss given Default (LGD) and Maturity (M). 41 Estimation of Loss Given Default at PNB
3.3 Data Collection Method
Secondary Sources of Informatio Information
Discussions with the project guide and staff members Since I have never been a student of risk management, interaction with the project guide and other staff members in the same department helped me in understanding the various technicalities pertaini pertaining ng to my topic. Interactions become even more important than reading, because not much literature was available on Maturity.
Discussions with various other department heads. heads.Interaction with the AGM`s of different departments helped me in analyzing how the he departments coordinated with themselves and how Maturity will be used by different departments for their own purpose.
Discussions with other trainees traineesAlthough I was the only one working on this topic, but discussion with other trainees helped me in so solving lving various issues of data collection and analysis.
3.4Limitation Limitation of the study:
The data availability is proprietary and not readily shared for dissemination.
The study is not very exhaustive and many concepts could not be covered as they are not approachable.
The study is being done keeping in mind the policies of the Head Office.
Due to the ongoing process of globalization and increasing competition, no one model or method will suffice over a long period of time and constant up gradation will be required.
4.1 Loss Given Default

Loss Given Default is a common parameter in Risk Models and also a parameter used in the calculation of Minimum Capital requirement under Basel Ba II for a banking institution. LGD is the credit loss incurred if an obligor defaults. Loss Given Default is facility facility-specific specific because such losses are generally understood to be influenced by key transaction characteristics such as the presence of collateral teral and the degree of subordination LGD is calculated in different ways, but the most popular is Gross LGD, where total losses are divided by exposure at default (EAD) Another method is known as Blanco LGD, in which losses are divided by the unsecured portion ortion of a credit line (where security covers a portion of EAD) Gross LGD is most popular amongst academics because of its simplicity and because academics only have access to bond market data, where collateral values often are unknown Blanco LGD is popul popular ar amongst some practitioners (banks) because banks often have many secured facilities, and banks would like to decompose their losses between losses on unsecured portions and losses on secured portions due to depreciation of collateral quality Blanco LGD calculation is also a subtle requirement of Basel II, but most Indian banks are not sophisticated enough at this time to make those types of calculations.
LGD is fixed and based on supervisory values: for instance, 45% for senior unsecured claims and 75% for or subordinated claims
The flexibility to determine LGD values tailored to a banks portfolio will likely be a motivation for a bank to want to move from the foundation to the advanced IRB approach. The appropriate degree of flexibility depends, of cour course, se, on what a bank knows about LGD generally and about differentiated LGDs in particular; consequently supervisors must be able to evaluate what a bank knows.
4.2 Measurement and Estimation of LGD

LGD is usually defined as th the e ratio of losses to exposure at default. Once a default event has occurred, loss given default includes three types of losses: The loss of principal The carrying costs of non non-performing performing loans, e.g. interest income foregone Workout expenses (collec (collections, tions, legal, etc.) There are broadly three ways of measuring LGD for an instrument: 1) Market LGD: observed from market prices of defa defaulted ulted bonds or marketable loan soon after the actual default 2) Workout LGD: The set of estimated cash flows resulting from the t workout and/or Collections process, properly discounted, and the estimated exposure 3) Implied Market LGD: LGDs derived from risky (but not defaulted) bond prices using a theoretical asset pricing model.
4.2.1 Market LGD

For defaulted bonds and loans which trade in the market, one may observe prices directly so long as a trade has actually occurred. The rating agency recovery studies are based on this approach. The actual prices are based on par = 100 (ce (cents nts on the dollar) and can thus be easily translated into a recovery percentage (or LGD as 100% minus the percentage recovery). These prices have some desirable properties since they are 45 Estimation of Loss Given Default at PNB
observed early and are a reflection of market sentiment at that time time. . After all, they are the result of a market transaction and hence less subject to debate about proper valuation. These prices reflect the investors expected recovery, suitably discounted, and thus include recoveries on both discounted principal and mis missed sed interest payments as well as restructuring costs and uncertainty of that restructuring process.In the Moodys dataset, for example, they are observed in the market one month after the first occurrence of the default event. This price is therefore the m markets arkets expected present value of eventual recovery.
4.2.2 Workout LGD
LGD observed over the course of a workout is a bit more complicated than the directly observed market LGD. Attention needs to be paid to the timing of the cash flows from the distressed asset. Measuring this timing will impact downstream estimates of realized LGD. The cash flows should be discounted, but it is by no means obvious which discount rate to apply. For example, the debt restruc restructuring turing could result in the issuance of risky assets such as equity or warrants, or less risky ones such as notes, bonds or even cash. In principle the correct rate would be for an asset of similar risk. Importantly, once the obligor has defaulted, the ba bank nk is an investor in a defaulted asset and should value it accordingly, possibly at the banks hurdle rate. Inappropriate candidates include the coupon rate (set ex ante of default, so too low) and the risk risk-free free (or Treasury) rate.
4.2.3 Implied Market LGD

An entirely different approach one could take to obtain an estimate of LGD is to look at credit spreads on the (much larger universe of) non non-defaulted defaulted risky (e.g. corporate) bonds currently traded. Although th these ese new methods have not yet fully migrated into the banks credit risk arena, they are used in the trading room for fixed income products and credit derivatives and as such are often used as a check against more conventional credit rating
models.
Moreover, r, some credit portfolio models require credit spreads as an input
parameter. free (i.e. Treasury) bonds is an indicator of the risk premium The spread above risk-free demanded by investors. However, this spread reflects EL, and thus both PD and LGD, as well as liquidity premiums. Only recently have models been developed which allow one to separately identify these two parameters from bond spreads (see, for instance, Bakshi, Madan and Zhang (2001) and Unal, Madan and Guntay (2003). Unal, Madan and Guntay (2003) 3) find that on average, recovery rates obtained in this way lie systematically below the physical recovery rates (their terminology) as implied by studies such as Altman and Kishore (1996).
4.3 Calculation of LGD:

LGD is weighting that represents the proportion of EAD that will be lost if default occurs. It is derived within a Credit Risk Model by taking account of any collateral or security that applies to the transaction/facility and the degree of sub subordination ordination of facility
Calculation of LGD is further classified into two types based on time value of money.
Historical LGD: It is the loss incurred in the account in the event of defaults without taking into account time value of money
Economic LGD: It t is the loss incurred in the account in the event of defaults after taking into account time value of money.
Here we calculated workout LGD after discounting for time value of money. While discounting there are issues regarding the rate to be used. There are various options available, viz., funding rate, distress loans rate, contract rate, current comparable market rate, opportunity cost of funds, cost of capital etc. 47 Estimation of Loss Given Default at PNB
4.4 Default and loan recovery measurement

Punjab National Bank consider sider a bank borrower (an obligor) as being in default when a payment has been missed for more than 90 days as is recommended by the Basel II capital adequacy rules. Translating this recommendation into loan credit rating system, as enforced By the national al banking sector regulator5, it would mean that every obligor with a Rating worse than or equal to C is shifted into the recovery process. As no data have been available on the market price of loans as at the default date, Pnb decided to apply the discoun discounted ted cash flow approach to calculate recovery rates. This approach asks for calculation of the present value of actually recovered cash flows related to each specific loan. Therefore we decided to take the average interest rate.
.
4.5 STEPS S IN CALCULATION OF LGD

Step 1: Cleaning of Data To start with, the first job in hand was to collect data from CBS system. For collecting the data, initially the logic was explained and then the data was extracted from the CBS system. The following logic has been applied:
1. The account should have been classified as NPA and should be a clo closed sed account as at March 31, 2011. 2. The data set should include the following data points: Sol ID Customer ID Name Account Number Account Open Date 48 Estimation of Loss Given Default at PNB
NPA Date Closure Date Outstanding standing as at NPA Date Limit Scheme Code Transaction Date Transaction Particulars Transaction Type Transaction Amount
The last four particulars pertained to a separate file. The data was received in the following format:
This file was in the *.TXT fo format rmat and it needed to be converted and cleansed for further utilization.
Step 2: Data Cleaned
The data was received in the above format and it needed to be converted into Excel files. After conversion, the process of data cleaning began, which meant aligning the data in a sequential format and removing anomaly, if any.
Step 3: Data Sorting This was the most important part of the exercise and on its accuracy; the success of the project was dependent. Its reason being that, any relevant transaction, i if f left out, could under valuate or over valuate the final LGD. Hence, this was the most tedious part of the project and consumed maximum time and effort for final outcome. It required in depth understanding of Credit function, operating CBS, and NPA norms. Some of the important logical functions could be highlighted as treatment of:
Derecognized Interest Recorded Interest Excess Recovery Reversal of Bank Charges, Interest 50 Estimation of Loss Given Default at PNB
After completion of task, the final outcome looked as below:
For operational efficiency, iency, we got a computer program me prepared (on Visual Basic) platform, which mechanized the above steps. On account of this, once the macro was run, system would pick eligible files and merge relevant transactions with them. After merger, it was our job to pick the relevant transactions. For that purpose, we used the following logic: Y Null F N If the transaction was to be used If the transaction was to be ignored If the LGD was 100% prima facie If the account was outside the purview of our sample
Our main objective here was to pick only those transactions which depicted actual recovery from the customer and ignore any other credit transaction. Similarly, all the bank charges and recorded interest, post crystallization of NPA amount, were to be included in our calculation purpose. 51 Estimation of Loss Given Default at PNB
Step 4: Calculations Net Present Value for each account was calculated. Next steps are relatively simple and the only task remains is to calculate weighted average LGD for the entire Circle.
Pooling was done and LGD was modified to 0 or 100, upgraded accounts were added.
Step 5: Result Sheet
4.6
Database
We have included in our sample all the defaulted Accounts from various pools in and circle. The sample consists nsists of 7 circle offices of 7 different cities in default. needed for the calculation of LGD Consists of 7085 A/C (Approximately) of 7 differ The dataset with all the required information ent cities that defaulted in the period from 2005 to 2011 and were ere closed down by the end of 2011. According to experts recovery process takes on Average 2-3 3 years before the case is closed down. In our sample of 7085 loans the Average recovery period is 2 years. All the data used in the sample were collected interna internally lly by the CBS of the PNB, within the risk management division. We observe that the series of 7085 default cases 28.09% of the observed bad loans were defaulted from 2005 2005-2011.
4.7 Analysis
Number of account under various pools in & circles with thei their r respective Average LGD
Types of ACCOUNT
NO. of ACCOUNT
Avg. of adjusted Lgd
Advance against gold Agriculture Consumer loan Conveyance loan Education loan Housing loan Loan against property,lease Not retail Pension loan to pensioner Retail others SME manufacturing SME services SME services/ manuf. Staff Trading Transport N/A
3 2025 751 274 18 229 37 2 132 1 421 152 1723 18 1168 125 6 TOTAL(7085)
12.2669354 23.74456149 29.55286678 22.49125918 27.7457973 16.5521101 16.3626403 07.183501895 09.341707798 50.3848472 31.57187877 37.17971737 31.57780909 14.63250114 33.07245717 32.22125458 17.49598008 AVERAGE(28.09396882)
Number of Accounts with their respective circles and LGD

NO. OF CIRCLES NO. of ACCOUNT Avg. of adjusted Lgd
CIRCLE 1 CIRCLE 2 CIRCLE 3 CIRCLE 4 CIRCLE 5 CIRCLE 6 CIRCLE 7
1077 341 781 845 2010 1278 754 TOTAL (7086)
26.31384594 32.95248989 25.62498651 27.15179636 30.17993325 24.26246762 33.08153192 AVERAGE (28.10411629)
Circle taken
1. Number of account under various pools in & circles
2. Average LGD of various Pools
3. Circle wise Number of accounts
4. Average LGD Circle Wise
5.1 Conclusion Punjab National bank, the second largest Public Sector Bank has consistently shown the better performance over the past years, which is evitable from the analysis of the growth of deposits as compared with its peer banks. SME sector has the potential to provide these banks large amount of business in the coming years as government is encouraging Entrepreneurship in this country, resulting in which Punjab National Bank can offer more number of products and facilities in future. As highest number of loans are taken by the SME sector i.e. 2296 and average LGD is 33%. Approving loans to SME sector rather than approving consumer loan However LGD is still high currently.
5.2 Observations/Result
In past the observed LGD for PNB has been high. From the study it is concluded that the LGD for the last 6 years i.e. have been 28.03%, %, which means on accounts that have defaulted and have turned into to NPA has shown a loss of 28.03%
5.3 Recommendations There here must be a better pre sanctioning and post sanctioning process conducted by the bank to reduce LGD. Centralize Banking system of the bank must be standardized. For accounts that have been turned to NPA and are deleted from database should be kept for reference in other menus of central banking system in case recovery is Possible. . Such accounts should not be closed or waved off.
Bibliography
Risk Management System in Banks Internal paper published by PNB
Guidance note on Credit Risk Management RBI (1999)
What do we know about Loss Given Default Till Schuermann (Feb 2004)
Papers on Research Methodology Arindam Bandopadhyaya (Distributed during Term II)
Master Circular of RBI on C Capital apital Adequacy Norms as at July 2, 2009(www.rbi.org.in)
The RMA Journal May 2003: Preparing for Basel II, Modeling Requirements. Introductory Chapters from Loss Given Default : DE SERVIGNY & OLIVIER RENAULT University of Oxford (May 2001) LGD Rating for a portfolio of retail loans Basel committee on banking supervision (2001) the internal ratings based approach Basel committee on banking supervision (Feb 2005) Studies on the validation of internal rating systems Working paper No.14 Dynamic prediction of LGD at Moody,s KMV Nadeem A. Siddiqui and Meiqing Zhang(2004): A general methodology for modelling loss given default The RMA Journal (May 2004)

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1.

1 Banking industry at a glance

Major Banking Operations

Main Operations of a Bank

Balancing Profitability with Liquidity Management

Balancing Profitability with Liquidity Management

2 Estimation of Loss Given Default at PNB

Structure of Banking Industry

Scheduled commercial Banks

Scheduled cooperative Banks

Public sector banks

Regional rural Banks

Private sector Banks

Urban Cooperative Banks

State cooperative Banks

SBI & its subsidiaries

Old private sector Banks

New private sector Banks 3

Estimation of Loss Given Default at PNB

1.2 COMPANY PROFILE Punjab National Bank (PNB)

PUNJAB NATIONAL BANK

Financial Performance (2012 (2012-2013)

4 Estimation of Loss Given Default at PNB

Mar-13 Mar-12 11.65 116.84 11.32 116.03

Organization structure: PNB

GM(NPA & weak account)

GM(Retail & lending)

6 Estimation of Loss Given Default at PNB

Corporate Office (HO)

Large Corporate Branches

Mid Corporate Branches

Specialized Branches eg. Agriculture

PRODUCT AND SERVICES

VARIOUS TYPES OF LOAN PROVIDED BY PNB

7 Estimation of Loss Given Default at PNB

AREAS OF CONCERN FOR PNB FOR CURRENT YEAR

8 Estimation of Loss Given Default at PNB

CREDIT ADMINISTRATION DIVISION (CAD)

RISK MANAGEMENT DEPARTMENT (RMD)

9 Estimation of Loss Given Default at PNB

Various External Credit Agencies in India: 1. CIBIL 2. CARE 3. FITCH 4. ICRA

12 Estimation of Loss Given Default at PNB

13 Estimation of Loss Given Default at PNB

SWOT Analysis of PNB

14 Estimation of Loss Given Default at PNB

WORKING OF THE RISK MA MANAGEMENT DIVISION (RMD) AT PNB. PNB

To protect from systemic risk.

AREA OF THE PROJECT: STUDY OF RISK COMPONETS UNDER AIRB APPROACH

PURPOSE OF THE STUDY:

16 Estimation of Loss Given Default at PNB

2.1 Literature Review

18 Estimation of Loss Given Default at PNB

19 Estimation of Loss Given Default at PNB

2.2 RISK MANAGEMENT AT PNB

20 Estimation of Loss Given Default at PNB

2.2.1 CREDIT RISK

22 Estimation of Loss Given Default at PNB

to BBB- B100% 100%

to BBB- B50% 100%

24 Estimation of Loss Given Default at PNB

2.2.2 MARKET RISK

26 Estimation of Loss Given Default at PNB

27 Estimation of Loss Given Default at PNB