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Management of NPA in Indian commercial banks - with special reference to xyz bank An analytical study of dollar price movement on INDIAN EQUITY MARKET ANALYSIS OF DEBT AND GILT FUNDS WITH SPECIAL EMPHASIS ON 23 BANKS.(ANY)

risk management in commercial banks


the banks are doing business by using others fund, so the credit risk rating system should be powerfull.
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Abstract 1 introduction 1.1. a study on credit risk management in bank.

1.1. Objectives of the research: The present study attempts to achieve the following objectives: 1. Analysis of trends in Non-Performing Assets of CORPORATION BANK. 2. Analysis of various credits provided by the corporation bank. 3. Studying the changes in NPA of the corporation bank in different year. 4. Studying the effectiveness of the risk management structure of the corporation bank. 5. Studying the effectiveness of internal credit rating mechanisms. 6. Evaluating the credit risk management practices in corporation. 7. Examining the role of Risk Based Supervision in strengthening credit risk management practices of corporation bank. 8. Suggesting a broad outline of measures for improving credit risk management practices0f corporation bank.

1.2 RISK MANAGEMENT IN COMMERCIAL BANK Banks are in the business of managing risk, not avoiding it.. Risk is the fundamental element that drives financial behaviour. Without risk, the financial system would be vastly simplified. However, risk is omnipresent in the real world. Financial Institutions, therefore, should manage the risk efficiently to survive in this highly uncertain world. The future of banking will undoubtedly rest on risk management

dynamics. Only those banks that have efficient risk management system will survive in the market in the long run. The effective management of credit risk is a critical component of comprehensive risk management essential for longterm success of a banking institution. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater significance in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the globe. India is no exception to this swing towards market driven economy. Better credit portfolio diversification enhances the prospects of the reduced concentration credit risk as empirically evidenced by direct relationship between concentration credit risk profile and NPAs of public sector banks.

A banks success lies in its ability to assume and Aggregate risk within tolerable and manageable limits.

1.2.1 Risk Management:

The future of banking will undoubtedly rest on risk management dynamics. Only those banks that have efficient risk management system will survive in the market in the long run. The effective management of credit risk is a critical component of comprehensive risk management essential for long-term success of a banking institution. Credit risk is the oldest and biggest risk that bank, by virtue of its very nature of business, inherits. This has however, acquired a greater significance in the recent past for various reasons. Foremost among them is the wind of economic liberalization that is blowing across the globe. India is no exception to this swing towards market driven economy. Competition from within and outside the country has intensified. This has resulted in multiplicity of risks both in number and volume resulting in volatile markets. A precursor to successful management of credit risk is a clear understanding about risks involved in lending, quantifications of risks within each item of the portfolio and reaching a conclusion as to the likely composite credit risk profile of a bank. The corner stone of credit risk management is the establishment of a framework that defines corporate priorities, loan approval process, credit risk rating system, riskadjusted pricing system, loan-review mechanism and comprehensive reporting system.

1.2.2 Significance of the study:

The fundamental business of lending has brought trouble to individual banks and entire banking system. It is, therefore, imperative that the banks are adequate systems for credit assessment of individual projects and evaluating risk associated therewith as well as the industry as a whole. Generally, Banks in India evaluate a proposal through the traditional tools of project financing, computing maximum permissible limits, assessing management capabilities

and prescribing a ceiling for an industry exposure. As banks move in to a new high powered world of financial operations and trading, with new risks, the need is felt for more sophisticated and versatile instruments for risk assessment, monitoring and controlling risk exposures. It is, therefore, time that banks managements equip them fully to grapple with the demands of creating tools and systems capable of assessing, monitoring and controlling risk exposures in a more scientific manner. Credit Risk, that is, default by the borrower to repay lent money, remains the most important risk to manage till date. The predominance of credit risk is even reflected in the composition of economic capital, which banks are required to keep a side for protection against various risks. According to one estimate, Credit Risk takes about 70% and 30%remaining is shared between the other two primary risks, namely Market risk (change in the market price and operational risk i.e., failure of internal controls, etc.). Quality borrowers (Tier-I borrowers) were able to access the capital market directly without going through the debt route. Hence, the credit route is now more open to lesser mortals (Tier-II borrowers). With margin levels going down, banks are unable to absorb the level of loan losses. There has been very little effort to develop a method where risks could be identified and measured.Most of the banks have developed internal rating systems for their borrowers, but there has been very little study to compare such ratings with the final asset classification and also to fine-tune the rating system. Also risks peculiar to each industry are not identified and evaluated openly. Data collection is regular driven. Data on industry-wise, region-wise lending, industry-wise rehabilitated loan, can provide an insight into the future course to be adopted. Better and effective strategic credit risk management process is a better way to manage portfolio credit risk. The process provides a framework to ensure consistency between strategy and implementation that reduces potential volatility in earnings and maximize shareholders wealth. Beyond and over riding the specifics of risk modeling issues, the challenge is moving towards improved credit risk management lies in addressing banks readiness and openness to accept change to a more transparent system, to rapidly metamorphosing markets, to more effective and efficient ways of operating and to meetmarket requirements and increased answerability to stake holders.

There is a need for Strategic approach to Credit Risk Management (CRM) in Indian Commercial Banks, particularly in view of; (1) Higher NPAs level in comparison with global benchmark (2) RBIs stipulation about dividend distribution by the banks (3) Revised NPAs level and CAR norms (4) New Basel Capital Accord (Basel II) revolution. According to the study conducted by ICRA Limited, the gross NPAs as a proportion of total advances for Indian Banks was 9.40 percent for financial year 2003 and 10.60 percent for financial year 20021. The value of the gross NPAs as ratio for financial year 2003 for the global benchmark banks was as low as 2.26 percent. Net NPAs as a proportion of net advances of Indian banks was 4.33 percent for financial

year 2003 and 5.39 percent for financial year 2002. As against this, the value of net NPAs ratio for financial year 2003 for the global benchmark banks was 0.37 percent. Further, it was found that, the total advances of the banking sector to the commercial and agricultural sectors stood at Rs.8, 00,000 crore. Of this, Rs.75,000 chore, or 9.40 percent of the total advances is bad and doubtful debt. The size of the NPAs portfolio in the Indian banking industry is close to Rs.1, 00,000 crore which is around 6 percent of Indias GDP2. The RBI has recently announced that the banks should not pay dividends at more than 33.33 percent of their net profit. It has further provided that the banks having NPA levels less than 3 percent and having Capital Adequacy Reserve Ratio (CARR) of more than 11 percent for the last two years will only be eligible to declare dividends without the permission from RBI3. This step is for strengthening the balance sheet of all the banks in the country. The banks should provide sufficient provisions from their profits so as to bring down the net NPAs level to 3 percent of their advances. NPAs are the primary indicators of credit risk. Capital Adequacy Ratio (CAR) is another measure of credit risk. CAR is supposed to act as a buffer against credit loss, With a view to moving towards International best practices and to ensure greater transparency, it has been decided to adopt the 90 days over due norm for identification of NPAs from the year ending March 31, 2004. The New Basel Capital Accord is scheduled to be implemented by the end of 2006. All the banking supervisors may have to join the Accord. Even the domestic banks in addition to internationally active banks may have to conform to the Accord principles in the coming decades. The RBI as the regulator of the Indian banking industry has shown keen interest in strengthening the system, and the individual banks have responded in good measure in orienting themselves towards global best practices.

1.2.3 Credit Risk Management (CRM) dynamics:

The world over, credit risk has proved to be the most critical of all risks faced by a banking institution. A study of bank failures in New England found that, of the 62 banks inexistence before 1984, which failed from 1989 to 1992, in 58 cases, it was observed that loans and advances were not being repaid in time. This signifies the role of credit risk management and therefore it forms the basis of present research analysis. Researchers and risk management practitioners have constantly tried to improve on current techniques and in recent years, enormous strides have been made in the art and science of credit risk measurement and management6. Much of the progress in this field has resulted form the limitations of traditional approaches to credit risk management and with the current Bank for International Settlement (BIS) regulatory model. Even in banks which regularly fine-tune credit policies and streamline credit processes, it is a real challenge for credit risk managers to correctly identify pockets of risk concentration, quantify extent of risk carried, identify opportunities for diversification and balance the risk-return tradeoff in their credit portfolio. The two distinct dimensions of credit risk management can readily be identified as preventive measures and curative measures. Preventive measures include risk assessment, risk measurement and

risk pricing, early warning system to pick early signals of future defaults and better credit portfolio diversification. The curative measures, on the other hand, aim at minimizing post-sanction loan losses through such steps as securitization, derivative trading, risk sharing, legal enforcement etc. It is widely believed that an ounce of prevention is worth a pound of cure. Therefore, the focus of the study is on preventive measures in tune with the norms prescribed by NewBasel Capital Accord. The study also intends to throw some light on the two most significant developments impacting the fundamentals of credit risk management practices of banking industry New Basel Capital Accord and Risk Based Supervision. Apart from highlighting the salient features of credit risk management prescriptions under New Basel Accord, attempts are made to codify the response of Indian banking professionals to various proposals under the accord. Similarly, RBI proposed Risk Based Supervision (RBS) is examined to capture its direction and implementation problems.

1.2.4 The

problems of non performing assets

Introduction:

Liberalization and Globalization ushered in by the government in the early 90s have thrown open many challenges to the Indian financial sector. Banks, amongst other things, were set on a path to align their accounting standards with the International standards and by global players. They had to have a fresh look into their balance sheet and analyze them critically in the light of the prudential norms of income recognition and provisioning that were stipulated by the regulator, based on Narasimhan Committee recommendations. Loans and Advances as assets of the bank play an important part in gross earnings and net profits of banks. The share of advances in the total assets of the banks forms more than 60 percent7 and as such it is the backbone of banking structure. Bank lending is very crucial for it make possible the financing of agricultural, industrial and commercial activities of the country. The strength and soundness of the banking system primarily depends upon health of the advances. In other words, improvement in assets quality is fundamental to strengthening working of banks and improving their financial viability. Most domestic public sector banks in the country are expected to completely wipeout their outstanding NPAs between 2006 and 20088. NPAs are an inevitable burden on the banking industry. Hence the success of a bank depends upon methods of managing NPAs and keeping them within tolerance level, of late, several institutional mechanisms have been developed in India to deal with NPAs and there has also been tightening of legal provisions. Perhaps more importantly, effective management of NPAs requires an appropriate internal check and balances system in a bank. In this background, this chapter is designed to give an outline of trends in NPAs in Indian banking industry vis--vis other countries and highlight the importance of NPAs management. NPA is an advance where payment of interest or repayment of installment of principal (in case of Term loans) or both remains unpaid for a period of 90 days (new norms with effect from 31st March, 2004) or more.

Reasons for NPAs in India:

An internal study conducted by RBI shows that in the order of prominence, the Following factors contribute to NPAs.

Internal Factors:

diversion of funds for- expansion / diversification / modernization- taking up new projects- helping promoting associate concerns Time / cost overrun during the project implementation stage Business (product, marketing etc) failure Inefficiency in management Slackness in Credit Management and monitoring Inappropriate technology / technical problems Lack of co-ordination among lenders.

External Factors:

Recession Input / power shortage Price escalation Exchange rate fluctuation Accident and natural calamities etc. Changes in government policies in excise / import duties, pollution control orders etc.

Conclusion

Asset quality is one of the important parameters based on which the performance of a bank is assessed by the regulation and the public. Some of the areas where the Indian banks identified to for better NPA management like credit risk management, special investigative audit, negotiated settlement, internal checks & systems for early indication of NPAs etc., Capital Adequacy Requirements and the Behaviour of Commercial Banks in India:

The Development Research Group (DRG) in the Reserve Bank of India has brought out a study entitled Capital Adequacy Requirements and the Behavior of Commercial Banks in India: An Analytical and Empirical Study, the twenty-second in the DRG Study Series. The study is authored by Prof. D.M.Nachane, Shri Aditya Narain, Shri Saibal Ghosh and Shri Satyananda Sahoo. In the wake of the introduction of prudential regulation as an integral part of financial sector reforms in India, there has been a growing debate as to whether capital adequacy requirements are the best means to regulate the banking system. From cross country experiences, there is some evidence of a positive association between capitalization and risk assumption by banks due to the possibility that the one-size-fits-all capital adequacy ratio (CAR) causes bank leverage and asset risk to become substitutes. At policy levels, this has driven research into alternative regulatory methods. Against this background, the study investigates the relationship between changes in risk and capital in the Indian banking sector, with reference to public sector banks (PSBs). The study seeks to identify key variables impinging upon the capital adequacy of banks and to examine evidence for a shift in bank portfolios towards greater riskiness after the introduction of capital adequacy norms. The study also attempts to draw implications of the new capital adequacy framework proposed by the Basel Committee on Banking Supervision (BCBS) for the Indian financial system and evaluates alternative regulatory arrangements as complements to the CAR.

The major findings of the study are: Given the wide heterogeneity in terms of products and customer preferences among PSBs as well as the adjustment response of PSBs, the regulatory framework should be designed to encourage individual banks to maintain higher CAR, over and above the stipulated minimum, so as to reflect differential risk profiles. While capital remains a useful regulatory tool for influencing bank behaviour, there is no conclusive evidence that the introduction of CAR has led to risk aversion among banks. Prompt Corrective Action (PCA) based on capital might prove to be an effective strategy for arresting bank portfolio deterioration. Capital ratios of banks are a crucial determinant of banks ratings, in the short-term; this has implications for India in terms of the new BCBS proposal which are built on ratings. Alternative approaches such as value at risk (VaR) and Pre-commitment Approach (PA) are no substitutes for the wider risk management process of analyzing stress scenarios and monitoring operational and legal risk; they also suffer from limited applicability i.e. for entities with material trading activities. The PA needs to be further examined and refined before it can be considered for application in Indian banks. The DRG Studies series have an accent on policy-oriented research. They are released for wide circulation with

a view to generating constructive discussion among professional economists and policy makers on subjects of current interest. The views expressed in these studies are those of the authors and do not reflect the views of the Reserve Bank. .4. MANAGEMENT OF CREDIT RISK - A PROACTIVE APPROACH

Introduction:

Risk is the potentiality that both the expected and unexpected events may have an adverse impact on the banks capital or earnings. The expected loss is to be borne by the borrower and hence is taken care by adequately pricing the products through risk premium and reserves created out of the earnings. It is the amount expected to be lost due to changes in credit quality resulting in default. Whereas, the unexpected loss on account of individual exposure and the whole portfolio is entirely is to be borne by the bank itself and hence is to be taken care by the capital. Banks are confronted with various kinds of financial and non-financial risks viz., credit, market, interest rate, foreign exchange, liquidity, equity price, legal, regulatory, reputation, operational etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable importance to improve the ability to identify measure, monitor and control the overall level of risks undertaken.

Credit Risk::

The major risk banks face is credit risk. It follows that the major risk banks must Measure, manage and accept is credit or default risk. It is the uncertainty associated with borrowers loan repayment. For most people in commercial banking, lending represents the heart of the Industry. Loans dominate asset holding at most banks and generate the largest share of operating income. Loans are the dominant asset in most banks portfolios, comprising from 50 to 70 percent of total assets17. Credit Analysis assigns some probability to the likelihood of default based on quantitative and qualitative factors. Some risks can be measured with historical and projected financial data. Other risks, such as those associated with the borrowers character & willingness to repay a loan, are not directly measurable. The bank ultimately compares these risks with the potential benefits when deciding whether or not to approve a loan.

Components of credit risk:

The credit risk in a banks loan portfolio consists of three components: (1) Transaction Risk (2) Intrinsic Risk (3) Concentration Risk

(1) Transaction Risk: Transaction risk focuses on the volatility in credit quality and earnings resulting from how the bank underwrites individual loan transactions. Transaction risk has three dimensions: selection, underwriting and operations. (2) Intrinsic Risk: It focuses on the risk inherent in certain lines of business and loans to certain industries. Commercial real estate construction loans are inherently more risky than consumer loans. Intrinsic risk addresses the susceptibility to historic, predictive, and lending risk factors that characterize an industry or line of business. Historic elements address prior performance and stability of the industry or line of business.Predictive elements focus on characteristics that are subject to change and could positively or negatively affect future performance. Lending elements focus on how the collateral and terms offered in the industry or line of business affect the intrinsic risk. (3) Concentration Risk: Concentration risk is the aggregation of transaction and intrinsic risk within the portfolio and may result from loans to one borrower or one industry, geographic area, or lines of business. Bank must define acceptable portfolio concentrations for each of these aggregations. Portfolio diversify achieves an important objective. It allows a bank to avoid disaster. Concentrations within a portfolio will determine the magnitude of problems a bank will experience under adverse conditions.

3.4 Strategic credit risk management:

The post liberalization years have seen significant pressure on banks in India, some of them repeatedly showing signs of distress. One of the primary reasons for this has been the lack of effective and strategic credit risk management system. Risk selection, as part of a comprehensive risk strategy that grows and supports from corporate priorities, is the foundation for future risk management. This is the underlying premise of an integrated proactive approach to risk management and entails a four step process:

Step 1. Establishing corporate priorities Step 2. Choosing the credit culture. Step 3. Determining credit risk strategy Step 4. Implementing risk controls

These steps (strategies) focus on reducing the volatility in portfolio credit quality and bank earnings performance. Strategic CRM will provide all bank personnel a clear understanding of the banks credit culture and of the risk acceptable in the loan portfolio. Senior management then manages the process and the portfolio to align them with corporate priorities.

3.5 Conclusion: Credit Risk Management in todays deregulated market is a big challenge. Increased market volatility has brought with it the need for smart analysis and specialized applications in managing credit risk. A well defined policy framework is needed to help the operating staff identify the risk-event, assign a probability to each, quantify the likely loss, assess the acceptability of the exposure, price the risk and monitor them right to the point where they are paid off. The management of banks should strive to embrace the notion of uncertainty and risk in their balance sheet and instill the need for approaching credit administration from a risk-perspective across the system by placing well drafted strategies in the hands of the operating staff with due material support for its successful implementation. The principal difficulties with CRM models are obtaining sufficient hard data for estimating the model parameters such as ratings, default probabilities and loss given default and identifying the risk factors that influence the parameter, as well as the correlation between risk factors. Because of these difficulties one should be aware that credit systems are only as good as the quality of the data behind them.

1.4.2 CONCENTRATION RISK PROFILE OF INDIAN COMMERCIAL BANKS Introduction: Risk selection is more important than risk management in determining a banks credit performance20.Credit risk strategy results from a bank s tolerance for risk as evidenced by how it selects, manages, and diversifies risk. Banks are moving away from a buy-and-hold strategy with respect to their loans. They are now syndicating risk, distributing the risk to enhance the value of their portfolio. When originating a loan, banks need evaluate how much incremental risk they are adding, how much they need to be compensated for taking that risk. Many banks look at each credit inside than across the enterprise to understand the incremental risk that the new loan is adding the loans. Portfolio theory applies equally to collections of credit risks as to equity and other investments. The purpose of having a portfolio of assets, instead of a single asset, is to reduce risk through diversification without sacrificing the rate of return. An efficient portfolio achieves a specified rate of return with the minimum possible risk for specified level of risk of for the maximum possible rate of return. The principle, which underlines portfolio management, is

diversification of risk .The objective of this chapter is to present a general framework for quantification of concentration risk followed by concentration risk profiling of public sector banks vis--vis private sector banks; and to explore the relationship between concentration risk profile and NPAs level.

Concentration risk:

A new methodology adopted to evaluate the volatility in portfolio performance predicated on the risk profile of the institution. The banking industry has relied heavily on prior experience as a predictor of future credit performance. Concentration risk 23 is the aggregation of transaction and intrinsic risk within the portfolio and may result from loans to one borrower or one industry, geographic area, or line of business. Senior management must define acceptable portfolio concentrations for each of these aggregations. The most conservative banks manage borrower exposure through restrictive house limits and maximum exposure to industries and lines of business. Many banks also have wisely sought to mitigate risk through geographic diversification. Aggressive banks have traditionally accepted hogs shares of individual borrower, lines of business, and industry exposures. Managing concentration limits will become a high priority for these lenders in the future because of the lingering pain from lessons leaned in commercial real estate, energy etc.

Concentration risk strategy:

The bank does have an opportunity to reduce their concentration in one line of business or industry. Outstanding would have to be replaced with more lending focused on lower risk lines of business and borrowers. Banks must constantly monitor the risk profile to determine it future lending practices are consistent with the desired risk profile

Selecting a Risk Strategy:

Using the risk profile as a frame of reference, management should select a risk strategy that will be consistent with long-term objectives for portfolio quality and performance. The three variable risk strategies in order of riskiness are: Conservative ,Managed and Aggressive. The selection of the appropriate strategy depends on a banks priorities and risk appetite. Most often, the choice is not made as part of a formal process but evolves as the bank seeks its desired risk posture through its lending practices. Consequently, few banks have a clear picture of the risk profile that will emerge. A selection of risk strategy with specific implementation plans provides a much better idea of the future risk profile.

The following guidance should help in understanding, which strategy best serves Managements intent;

(i) Conservative: Accepts relatively low levels of transaction, intrinsic and concentration risk. The strategy normally supports a values-driven culture. (ii) Managed: Accepts relatively low levels of risk in two categories but high levels in one category. For example: a bank that takes conservative levels of concentration and transaction risk but is more aggressive with intrinsic risk. The strategy normally promotes the immediate performance culture. (iii) Aggressive: Accepts relatively low levels of risk in one category, more aggressive risk in two categories. An example would be a bank that closely manages transaction risk but accepts higher levels of intrinsic and concentration risk. This strategy is normally employed in a production driven culture.Obviously, credit volatility rises as the levels and categories of risk are increased.The aggressive strategy requires more careful management because it operates closer to the danger zone. If risk in all three categories reaches high levels, the banks credit volatility becomes so great in a downturn that capital adequacy and survival could become real issues. Impact of concentration risk on NPAs level:

The concentration risk is an important component of the credit risk and is prompted by the concentration of the credit portfolio in one or two occupations or industries. It is desirable to achieve a diversified credit portfolio in order to minimize the occupation-wise concentration risk as well as industry-wise concentration risk. It has been the experience of the commercial banks that higher NPAs level is generally associated with high degree of concentration risk-both occupation-wise and industry-wise. In order to analyze the observed relationship between NPAs level and concentration risk, the relevant data is presented in this section. The highest level of NPAs, i.e., 24.8 percent in the year 1994 corresponds to the maximum index value in the same year. Similarly, the minimum level of NPAs, i.e., 9.36 percent in the year 2003 corresponds to the lowest index value in the same year. Overall, the decrease in occupation-wise concentration risk is matched by the corresponding decrease in NPAs level. An attempt was made to quantify the relationship between concentration-index and NPAs level by way of coefficient of correlation and the results found to be satisfactory in reinforcing our earlier observations. Table 4.1 lists the results. As observed earlier, there exists a strong positive relationship between occupation wise concentration-index and NPAs level in case of both the public sector banks and private sector banks with the coefficient of correlation value being 0.80 and 0.67 respectively. This is confirmed by the higher values of coefficient of determination of 0.64 and 0.45 for public sector banks and private sector banks respectively. Similarly, there exists a strong positive relationship between industry-wise concentration-index and NPAs level in case of public sector banks as confirmed by a very high

value of r2 = 0.78. But this is not clearly pronounced in the case of private sector banks as indicated by lower value of r2 = 0.27.

Conclusion:

Concentration risk is a very significant component of overall credit risk profile of a banking institution. A prudent credit risk management is based on the principle of diversified portfolio to avoid concentrations in any one or couple of occupations or industry. Trends in concentration risk profile of public sector banks during the post-liberalization period clearly indicate a paradigm shift in the portfolio approach to credit risk management. The occupation-wise and industry-wise concentrations reduced significantly during the study period. On the contrary, the trends in concentration risk profile of private sector banks signify an opposite direction. The occupation-wise concentration risk increased substantially from 37 percent in 1999 to 59 percent in 2003. Both the approaches suggested for quantification of concentration risk yielded satisfactory results. Under the profile-score method, with a score of less than 10 for public sector banks, and more than 10 for private sector banks, it is concluded that public sector bank s risk profile is low while that of private sector bank s risk is moderate. Similarly, under the concentration-index method it was found that there exists strong relationship between occupation-wise concentration risk profile and NPAs level with higher values of coefficient of determination of 0.64 and 0.45 for public sector banks and private sector banks respectively. Similarly, strong positive relationship between industry-wise concentration risk and NPAs level in case of public sector banks, as confirmed by high value of r2=0.78. But same is not pronounced in case of private sector banks. Based on these results it can be concluded that

1. The declining trends in Non-Performing Assets (NPAs) in public sector banks during the post-liberalization period is an outcome mainly caused by the improved credit portfolio diversification. 2. The concentration risk profile of credit portfolio of private sector banks is higher than that of public sector banks impacting adversely the NPAs level of private sector banks vis--vis public sector banks.

1.

Credit Risk Management Procedures

Each bank must apply a consistent evaluation and rating scheme to all its investment opportunities in order for credit decisions to be made in a consistent manner and for the resultant aggregate reporting of credit risk exposure to be meaningful. To facilitate this, a substantial degree of standardization of process and documentation is required. This has lead to standardized ratings across borrowers and a credit portfolio report that presents meaningful information

on the overall quality of the credit portfolio. In Table 1, a credit-rating procedure is presented that is typical of those employed within the commercial banking industry. The form reported here is a single rating system where a single value is given to each loan, which relates to the borrower's underlying credit quality. At some institutions, a dual system is in place where both the borrower and the credit facility are rated. In the latter, attention centers on collateral and covenants, while in the former, the general credit worthiness of the borrower is measured. Some banks prefer such a dual system, while others argue that it obscures the issue of recovery to separate the facility from the borrower in such a manner. In any case, the reader will note that in the reported system all loans are rated using a single numerical scale ranging between 1 and 10. For each numerical category, a qualitative definition of the borrower and the loan's quality is offered and an analytic representation of the underlying financials of the borrower is presented. Such an approach, whether it is a single or a dual rating system allows the credit committee some comfort in its knowledge of loan asset quality at any moment of time. It requires only that new loan officers be introduced to the system of loan ratings, through training and apprenticeship to achieve a standardization of ratings throughout the bank. Given these standards, the bank can report the quality of its loan portfolio at any time, along the lines of the report presented in Table 2. Notice that total receivables, including loans, leases and commitments and derivatives, are reported in a single format. Assuming the adherence to standards, the entirety of the firm's credit quality is reported to senior management monthly via this reporting mechanism. Changes in this report from one period to another occur for two reasons, viz., loans have entered or exited the system, or the rating of individual loans has changed over the intervening time interval. The first reason is associated with standard loan turnover. Loans are repaid and new loans are made. The second cause for a change in the credit quality report is more substantive. Variations over time indicate changes in loan quality and expected loan losses from the credit portfolio. In fact, credit quality reports should signal changes in expected loan losses, if the rating system is meaningful. Studies by Moody's on their rating system have illustrated the relationship between credit rating and ex post default rates. A similar result should be expected from internal bank-rating schemes of this type as well. However, the lack of available industry data to do an appropriate aggregate migration study does not permit the industry the same degree of confidence in their expected loss calculations. For this type of credit quality report to be meaningful, all credits must be monitored, and reviewed periodically. It is, in fact, standard for all credits above some dollar volume to be reviewed on a quarterly or annual basis to ensure the accuracy of the rating associated with the lending facility. In addition, a material change in the conditions associated either with the borrower or the facility itself, such as a change in the value of collateral, will trigger a re-evaluation. This process, therefore, results in a periodic but timely report card on the quality of the credit portfolio and its change from month to month.

Generally accepted accounting principles require this monitoring. The credit portfolio is subject to fair value accounting standards, which have recently been tightened by The Financial Accounting Standards Board (FASB). Commercial banks are required to have a loan loss reserve account (a contra-asset) which is accurately represents the diminution in market value from known or estimated credit losses. As an industry, banks have generally sought estimates of expected loss using a two-step process, including default probability, and an estimate of loss given default. This approach parallels the work of Moody's referred to above. At least quarterly, the level of the reserve account is re-assessed, given the evidence of loss exposure driven directly from the credit quality report, and internal studies of loan migration through various quality ratings. Absent from the discussion thus far is any analysis of systematic risk contained in the portfolio. Traditionally mutual funds and merchant banks have concerned themselves with such risk exposure, but the commercial banking sector has not. This appears to be changing in light of the recent substantial losses in real estate and similar losses in the not-too-distant past in petrochemicals. Accordingly, many banks are beginning to develop concentration reports, indicating industry composition of the loan portfolio. This process was initially hampered by the lack of a simple industry index. SIC codes were employed at some institutions, but most found them unsatisfactory. Recently, however, Moody's has developed a system of 34 industry groups that may be used to report concentrations. Table 3 reports such an industry grouping to illustrate the kind of concentration reports that are emerging as standard in the banking industry. Notice that the report indicates the portfolio percentages by sector, as well as commitments to various industries. For the real estate portfolio, geography is also reported, as Table 4 suggests. While this may be insufficient to capture total geographic concentration, it is a beginning. For the investment management community, concentrations are generally benchmarked against some market indexes, and mutual funds will generally report not only the absolute percentage of their industry concentration, but also their positions relative to the broad market indexes. Unfortunately, there is no comparable benchmark for the loan portfolio. Accordingly, firms must weigh the pros and cons of specialization and concentration by industry group and establish subjective limits on their overall exposure. This is generally done with both guidelines and limits set by senior management. Such a report is not the result of any analytical exercise to evaluate the potential downside loss, but rather a subjective evaluation of management's tolerance, based upon rather imprecise recollections of previous downturns. In addition, we are seeing the emergence of a portfolio manager to watch over the loan portfolio's degree of concentration and exposure to both types of risk concentration discussed above. Most organizations also will report concentration by individual counterparty. To be meaningful, however, this exposure must be bank wide and include all related affiliates. Both of these requirements are not easily satisfied. For large institutions, a key relationship manager must be appointed to assure that overall bank exposure to a particular client is captured and monitored. This level of data accumulation is never easy, particularly across time zones.

Nonetheless, such a relationship report is required to capture the disparate activity from many parts of the bank. Transactions with affiliated firms need to be aggregated and maintained in close to real time. An example of this type of report is offered here as Table 5, drawn from one particular client report. Each different lending facility is reported. In addition, the existing lines of credit, both used and open, need to be reported as well. Generally, this type of credit risk exposure or concentration report has both an upper and lower cut-off value so that only concentrations above a minimum size are recorded, and no one credit exposure exceeds its predetermined limit. The latter, an example of the second technique of risk management is monitored and set by the credit committee for the relationship as a whole.

Table 1 A TYPICAL CREDIT RATING SYSTEM The following are definitions of the risk levels of Borrowing Facility:

1Substantially Risk Free Borrowers of unquestioned credit standing at the pinnacle of credit quality. Basically, governments of major industrialized countries, a few major world class banks and a few multinational corporations. 2 Minimal Risks Borrowers of the highest quality. Almost no risk in lending to this class. Cash flowsover at least 5 years demonstrate exceptionally large and/or stable margins of protection and balance sheets are very conservative, strong and liquid. Projected cash flows (including anticipated credit extensions) will continue a strong trend, and provide continued wide margins of protection, liquidity and debt service coverage. Excellent asset quality and management. Typically large national corporations.

3 Modest Risks Borrowers in the lower end of the high quality range. Very good asset quality and liquidity; strong debt capacity and coverage; very good management. The credit extension is considered definitely sound; however, elements may be present which suggest the borrower may not be free from temporary impairments sometime in the future. Typically larger regional or national corporations.

4 Below Average Risk The high end of the medium range between the definitely sound and those situations where risk characteristics begin to appear. The margins of protection are satisfactory, but susceptible to more rapid deterioration than class 3 names.

Some elements of reduced strength are present in such areas as liquidity, stability of margins and cash flows, concentration of assets, dependence upon one type of business, cyclical trends, etc., which may adversely affect the borrower. Typically good regional or excellent local companies.

5 Average Risks Borrowers with smaller margins of debt service coverage and where definite elements of reduced strength exist. Satisfactory asset quality and liquidity; good debt capacity and coverage; and good management in all critical positions. These names have sufficient margins of protection and will qualify as acceptable borrowers; however, historic earnings and/or cash flow patterns may be sometimes unstable. A loss year or a declining earnings trend may not be uncommon. Typically solid local companies. May or may not require collateral in the course of normal credit extensions.

6 Attention Risk Management Borrowers who are beginning to demonstrate above average risk through declining earnings trends, strained cash flow, increasing leverage, and/or weakening market fundamentals. Also, borrowers which are currently performing as agreed but could be adversely impacted by developing factors such as, but not limited to: Deteriorating industry conditions, operating problems, pending litigation of a significant nature, or declining collateral quality/adequacy. Such borrowers or weaker typically require collateral in normal credit extensions.

Borrowers generally have somewhat strained liquidity; limited debt capacity and coverage; and some management weakness. Such borrowers may be highly leveraged companies which lack required margins or less leveraged companies with an erratic earnings record. Significant declines in earnings, frequent requests for waivers of covenants and extensions, increased reliance on bank debt, and slowing trade payments are some events which may occasion this categorization.

7 Potential weaknesses Borrower exhibits potential credit weakness or a downward trend which, if not checked or corrected, will weaken the asset or inadequately protect the banks position. While potentially weak, the borrower is currently marginally acceptable; no loss of principal or interest is envisioned. Included could be turnaround situations, as well as those previously rated 6 or 5, names that have shown deterioration, for whatever reason, indicating a downgrading from the better categories. These are names that have been or would normally be criticized Special Mention by regulatory authorities.

8 Definite Weaknesses; No Loss A borrower with well defined weakness that jeopardize the orderly liquidation of the debt. Borrowers that have been or would normally be classified Substandard by regulatory authorities. A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor. Normal repayment from this borrower is in jeopardy, although no loss of principal is envisioned. There is a distinct possibility that a partial loss of interest and/or principal will occur if the deficiencies are not corrected.

9 Potential Losses A borrower classified here has all weaknesses inherent in the one classified above with the added provision that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Serious problems exist to the point where a partial loss of principal is likely. The possibility of loss is extremely high, but because of certain important, reasonably specific pending factors, which may work to the advantage and strengthening of the assets, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation, capital injection, perfecting liens on additional collateral, and refinancing plans.

10 Losses Borrowers deemed incapable of repayment of unsecured debt. Loans to such borrowers are considered uncollectible and of such little value that their continuance as active assets of the bank is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future. NEW BASEL CAPITAL ACCORD - IMPLICATIONS FOR CRM PRACTICES OF COMMERCIAL BANKS IN INDIA Introduction: On 26
th

June, the Basel committee on banking supervision published a document by name international

convergence of capital measurement and capital standards, which is commonly known as Basel -2 documents. the key objective of the new framework is to adjust banks capital requirement more closely to the actually incurred risk than in the past and to take account of resent innovations in the financial market as well as in institutions risk management strategies.basel-1 focused only on minimum capital requirement to be maintained by banks and the measurement methodology was more of broad brush approach. The new basel-2 accord has 3 pillars: minimum capital requirements, supervisory review process, and market discipline

The first pillar defines minimum capital requirements. The minimum requirement of an 8% ratio of capital to risk weighted assets remains unchanged. Also the definition of capital remains same. How ever, there is new addition in the form of capital charges for operational risk. In the case of Indian banks, RBI has prescribed minimum of 9% to risk weighted asset as in the past. The second pillar requests the supervisors to validate the internal process of the banks with regards to assessment of adequacy of capital having regards to inherent risk in the various business lines and control functions. under this pillar, supervisors can advise banks to maintain higher capital(more than the prescribed minimum) if it views that risk inherent in the business is more warranting higher capital. The third pillar aims make sure that market participants better understand banks risk profiles. This requires a higher degree of disclosure, including its risk management methods and the way the bank calculates its capital Under basel-2, there are three approaches for calculation of capital for credit risk viz. standardized approach, internal rating based (IRB)-foundation and IRB advanced. Foreign banks operating in India and Indian banks having operational presence outside India have to adopt standardized approach for computing capital requirement for credit risk with the effect from march 31,2008.all other commercial bank(excluding local area bank and regional rural banks)have to migrate to the said approach by march 31,2009.

Standard approach In the standard approach the credit risk exposures have to be classified in to following: Sovereign Bank Multilateral development banks Corporate Public sector undertaking Primary dealers Retailers Residential property Commercial real estate High risk categorization viz. ,venture capital fund, consumer credit, capital market exposures ,non-deposit taking NBFC Other assets- staff loans, jewels loans and other Non-performing assets(NPAS)

Off-balance sheet Failed transactions Securitization exposures In the standardized approach treatment of non performing assets is different and hence this class of assets has to be segregated from the overall risk portfolio and dealt separately. Sovereigns Domestic sovereign: both fund based and non-fund based claims on central government guaranteed claims will attract a zero risk weight. Direct loan / investment in state government securities will attract zero risk weight. State government guarantee claims will attract 20% risk weight. Claims on RBI, DICDCI and credit guarantee fund trust form small industries (CGTSI) will carry a zero risk weight as n the case of claims on central government. claims on ECGC will attract risk weight of 20%. Foreign sovereign: claim on foreign sovereign will attract risk weight as per the rating assignment to those claims by international rating agencies. RBI has approved the following three rating agencies viz., Fitch, Moodys and standard and Poors, whose rating can be applied for claims on foreign sovereigns, banks, public sector enterprises, and non-resident corporate .the mapping of the rating of these international rating agencies with the risk weight have been prescribed by RBI. Depending on the rating assigned by these rating agencies, the risk weights vary from 0% to 150%. Unrated categories get a risk weight of 100%. Claims denominated in domestic currency of the foreign sovereigns met out of the resources in the same currency in the jurisdiction of that sovereign will attract a zero risk weight.

Banks All claims on banks have to be segregated into claims on scheduled and non scheduled banks. Further, all claims under these two categories have to be further segregated into investment which are eligible for capital status for the investee entity and which is not exceeding 10% of the investing bank capital fund(A) and others (B). in respect of claims on scheduled banks falling under B category and which comply with the minimum CRAR prescribed by RBI has to be risk weighted at 20%. Claims on non scheduled bank falling under B category, which comply with the minimum CRAR prescribed by RBI has to be risk weighted at 100%.in respect of claims on banks both scheduled and non scheduled falling under B categories, which do not comply with minimum CRAR position. In respect of investments made on scheduled and non scheduled banks falling under A category and where the investee company has maintained minimum CRAR, risk weight stall be higher of 100% or the risk weight as per the rating assigned by the extended rating agency. Where the CRAR position is below 9% differential higher risk weights have been prescribed both in the case of scheduled and non scheduled banks depending on the CRAR position.

Claims on foreign bank have to be risk weighted based on rating given by international rating agencies and this range from 20%to 150% depending on the rating. Unrated category get a risk weight of 50%.claims on banks which are denominated in domestic foreign currencies met out of the resources in the same currency raised in that jurisdiction can be risk weighted at 20% provided the said bank meets the minimum CRAR prescribed by the concerned bank regulation.

Multilateral development bank Claims on MDBs, BIS and IMF carries risk weight of 20%

Corporate Claims on corporate have to be risk weighted depending on the ratings by the rating agencies .RBI has for this purpose approved four rating agencies viz., CARE , CRISIL, FITCH and ICRA. The mappings of the rating of these external rating agencies with the risk weight have been prescribed by RBI. The riskweights range from 20% to 150% depending on the rating assigned by the rating agencies. Unrated exposures get risk weight of 100%lit is assumed that portfolio of unrated exposures constitutes mix of different quality of assets and therefore risk weight is prescribed at 100%. Under pillar-2, RBI can stipulate higher risk weight if it views that the risk inherent in the portfolio is higher. In order to persuade the corporate extended with higher credit limits to get themselves rated, RBI has prescribed that for the financial year 2008-09,all corporate extended with credit limits in excess Rs.50crore and which are unrated will be risk weighted at 150%. For the financial year 2009-10,this threshold limit will be reduced to include corporate extended with credit limits in excess of Rs10crore. All restructured standard assets of corporate will have to be risk weighted at 12% until satisfactory performance under the revised payment schedule has been established for one year from the date when the first payment of interest/principal falls due under the revised schedule. Claims on non resident corporate will be risk weighted based on the ratings given by the international rating agencies and the risk weights vary from 20% to 150% depending on the rating. Unrated exposures carry risk weights of 100%.

Public sector entities Claims on domestic public sector entities have to be risk weighted in a manner similar to corporate. Claims on foreign PSEs have to be risk weighted based on the ratings assigned by the international rating agencies, which range from 20% to 150% depending on the rating. Unrated exposures carry risk weight of 100%l

Primary dealers Claims on primary dealers will have to risk weighted in a manner similar to corporate. Retail Retail claims have to be risk weighted at 75%. A claim has to satisfy the following four criteria to be recognized as retail. Counter party: person(s) or small business and include partnership firm, private limited companies, public limited companies ,co-operative societies, trusts etc. small business is one where the to all average is less than Rs50crore. The turnover criteria is linked to the average of the last three years in the case of existing entities; projected turnover in the case of new entities; and both actual and projected turnover for entities which are yet to complete three years. Products: the exposure takes the form of any of the following: Revolving credits and lines of credit Personal term loans and leases Small business facilities and commitments Granularity: gross exposure counterparty (group) below 0.2% total retail. Low value: maximum aggregated retail exposure to one counter party should not exceed the absolute threshold limit of Rs5crore.

Residential property As per basel-2 document in respect of loans extended to individuals for acquiring residential property that is or will be occupied by the borrower or that is rented have to be risk weighted at 35% having regard to its safe characteristics. How ever, considering the default rate in India, RBI has prescribed higher 50% risk weight for loans up to Rs.20lakh and 75% risk weight for loans above Rs.25lakh, provided loan to value ratio is note more than 75%. Where the loan to value ratio is above 75%, risk weight has to be 100%.

Commercial real estate Claims secured by commercial real estate is defined as the fund based and non fund based exposures secured by mortgages on commercial real estates ( office buildings, retail space, multi-tenanted commercial premises, multi-family residential buildings, multi-tenanted commercial premises, industrial or warehouse space, hotels, land acquisition development and construction etc.). Exposure to entities for setting up Special Economic Zones (SEZs) or for acquiring units in SEZs which includes real estates would also be treated as commercial real estate exposure. These exposures attract risk weight of 150%.

High risk categories Exposures to venture capital fund attract risk weight of 150% Consumer credit, including personal loans and credit card receivables but excluding education loan will attract risk weight of 125% or higher, if warranted by the external rating(or,the lack of it) of the counter party. Capital market exposures and claims on non-deposit taking NBFCs attract risk weight of 125%.

Other assets Loans and advances to banks own staff which are fully covered by superannuation benefits and/ or mortgage of flat/house have to be risk rated at 20%.other loans and advances to banks own staff is eligible for inclusion under regulatory retail and hence risk rate shall be 75%. Loans up toRs.1lack against gold and silver ornaments carry a concessional risk weight of 50%. All other asset shall attract risk weight of 100%.

Non performing asset (NPAs) The unsecured portions of NPA (other than residential mortgage loan) net of specific provision have to be risk weighted as follows: 150% risk weight when specific provisions are less than 20% of the outstanding amount of the NPA; 100% risk weight when specific provisions are st least 20% of the outstanding amount of the NPA. 50% risk weight when specific provisions are at least 50% of the out standing amount of NPA. Where a NPA is secured by land and building (having a valuation report from approved valuer, which is not older than three years) and plant and machinery is good working condition (with value not higher than the depreciated value as reflected in the audited balance sheet, which is not older than 18 months), risk weight shall be 100% when provisions reach 15% of the outstanding amount. In respect of NPAs under housing loans, risk weight shall be 100% net of specific provisions. If specific provision reaches level of 20%, risk weight shall be 75%. If the specific provisions are 50% or more the risk weight shall be 50%.

Off-balance sheet items The risk-weighted amount of an off-balance sheet exposure is calculated by means of two- step process:

(a)

The notational amount of the transaction is converted in to a credit equivalent amount, by multiplying

the amount by the specified credit conversion factor (in the case of non-market related off-balance sheet items.) (b) The resulting credit equivalent amount is multiplied by the risk weight applicable to the counterparty

or to the purpose for which the bank has extended the finance or the type of asset, which ever is higher. In the case of financial guarantees the CCF is 100%,where as performance guarantees attract CCF of 50%.CCF for documentary LCS collateralized by the underlying shipment is 20%, whereas in the case of other LCS,CCF is 50%. Basel-2 requires capital charge for unuttilised limites. Unutilized limits which are not unconditionally cancelable by the bank with out prior notice to the borrower and which have original maturity of one year, the CCF is 20% and unuttilised limite with original maturity of over one year, the CCF is 50%. The following transations are considered as claims on banks: Guarantee issued by banks against the counter guarantees of other banks. Bills discounted by banks which have been accepted by another bank. The credit equivalent amount of off the balance sheet items are calculated on the bases of the current exposure method. In respect of following market related off-balance sheet items, capital requirement is exempted: (a) Foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or

lees; and (b) Instrument traded on futures and options exchanges which are subject to daily market- to- market

and margin payments.

Failed transaction In respect of delivery -viruses- payment (DvP) transactions ,if the payment is not effected five business days after the settlement date, capital charge is to be calculated by multiplying the positive current exposure of the transaction by the appropriate factor prescribed by RBI depending on the number of working days lapsed after the settlement date. In respect of non-DvP transactions (free deliveries) after the first contractual payment / delivery leg, the bank that has made the payment will treat its exposure as loan if the second leg has not been received by the end of the business day. If five business days after the second contractual payment / delivery date the second leg has not yet effectively taken place the bank that has made the first payment leg will have to deduct from capital the full amount of the value transferred plus replacement cost, if any. This treatment will apply until the second payment / delivery leg is effectively made. Securitization exposures Banks exposures to a securitization transaction, referred to as securitization exposures, can include, but are not restricted to the following: as investor, as credit enhancer, as liquidity provider, as underwriter, as provider of credit risk mitigants. Cash collaterals provided as credit enhancements shall also be treated as securitization

exposures. An originator in a securitization transaction which does not meet the minimum requirements prescribed by RBI in terms of guidelines issued on securitization shall have to hold capital against all of the exposures as if they had not been securitized. Additionally, the originator will have to deduct gain on sale on such transaction from Tier 1 capital. The same treatment will have to be applied where the bank has provided implict support to a securitization. In respect of rated on-balance sheet securitization exposures, bank shall calculate risk weighted amount by multiplying the amount (after deduction of specific provisions) of the exposures by the applicable risk weight depending on the rating. The risk weight ranges from 20% to 350%. In respect of exposures with BB ratings the risk weight is 350%. Separate risk weights have been prescribed for originators of the securitization transaction and others. In respect of commercial real estate securitization exposures the risk weights corresponding to the ratings are different and ranges from 50% to 400%. In respect of exposures with BB ratings, the risk weight is 400%. Separate risk weights have been prescribed by originators of the securitization transaction and others. Any rated securitization exposure with long term rating of B+ and below when not held by an originator, and a long term rating of BB+ and below when held by the originator have to deducted 50% from Tier 1 and 50% from Tier 2 capital. Any unrated securitization exposure, except an eligible liquidity facility, should be deducted 50% from Tier 1 and 50% from Tier 2 capital. In the case of unrated and ineligible liquidity facility, both drawn and undrawn portions shall be deducted 50% from Tier 1 and 50% from Tier 2 capital. The holdings of securities devolved on the originator through underwriting should be sold to third parties within three-month period following the acquisition. In case of failure to off-load within the stipulated time limit, any holdings in excess of 20% of the original amount of issue, including secondary market purchases, shall have to be deducted 50% from Tier 1 and 50% from Tier 2 capital. In respect of off-balance sheet securitization exposures, the CCF is 100%. After applying the CCF and arriving at credit equivalent, if it is a rated exposures risk weighted amount is to be calculated by multiplying with the applicable risk weight. If the off-balance sheet exposure is not rated, it must be deducted from capital as in the case of funded exposures. When a bank other than the originator provides credit protection to a securitization exposure, it must calculate capital requirement on the covered portion as if it were an investor in that securitization. If a bank provides protection to an unrated credit enhancement, it must treat the credit protection provided as if it were directly holding the unrated credit enhancement. The treatment in the case of unrated liquidity facilities shall be as follows: (a) The drawn and undrawn portions of an unrated liquidity facilities would attract a risk weight equal

to the highest risk weight assigned to any of the underlying individual exposures covered by this facility. (b) The undrawn portion of an unrated eligible liquidity will attrct CCF of 20% if original maturity is one

year or less and 50% if original maturity is more than one year.

Guidelines on External ratings Bank should use the chosen credit ratings agencies and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. To be eligible for risk weighting purposes, the rating should be in force. The rating agency should have reviewed the rating at least once during the previous 15 months. For assets in the banks portfolio that have contractual maturity of less than or equal to one year, short term ratings would be relevant and for others long term ratings. Cash credit exposures should have to be treated as long term exposures. If an issuer has a long term exposure with an external long term rating that warrants a risk weight of 150%, all unrated claims on the same counterparty, whether short term or long term will receive 150% risk weight, unless the bank uses recognized credit risk mitigation techniques for such claims. Short term ratings are issue-specific. They cannot be generalized to other short-term claim. Short term assessments can be used only in the case of short term claims against banks and corporates. The unrated short term claim on counterparty will attract a risk weight of at least one level higher than the risk weight applicable to the rated short term claim on that counterparty. Banks should use only solicited rating from the chosen credit rating agencies. No ratings issued by the credit rating agencies on an unsolicited basis should be considered for risk weight calculation. If there are two ratings accorded by chosen credit rating agencies which map into different risk, weights, the higher risk weight should be applied. If there are three or more ratings accorded by chosen credit rating agencies with different risk weights , the ratings corresponding to the two lowest risk weights should be referred to and the higher of those two weights should be applied. i.e. the second lowest risk weight. Issue rating can be applied to an unassessed claim of same counterparty only if this unassessed claim ranks pari passu or senior to the rated debt instrument in all respects and the maturity of the rated debt instrument. No recognition of credit risk mitigation techniques should be taken into account if the credit enhancement is already relected in the issue specific rating by the credit rating agency. Credit Risk Mitigation The following securities are considered as eligible collaterals: Cash on deposit, including Certificate of deposit Gold of value equivalent to 99.99 purity

Securities issued by Central and State Governments Kisan Vikas Patra and National Savings Certificates provided no lock-in-period is operational Life insurance policies with a declared surrender value. Rated debt securities attracting 100% or lesser risk weight Unrated bank bonds listed on recognized exchange and classified as senior debt. Equites in BSE-SENSEX, BSE-200, S&P CNX NIFTY and Junior NIFTY. Mutual funds investing in the above. Banks are required to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either, occasioned by market movements. These adjustments are referred to as haircuts. The application of haircuts will produce volatility adjusted amounts for both exposure and collateral. The volatility adjusted amount for the exposure will be higher than the exposure and the volatility adjusted amount for the collateral will be lower than the collateral, unless either side of the transaction is cash. The haircut for each type of collateral is prescribed by RBI. Almost all exposures viz., loans and investments are in cash, the haircuts on exposures would be Zero. On the other hand, exposures of banks , arising out of repostyle transactions would require upward adjustment for volatility, as the value of security sold / lent / pledged in the repo transaction, would be subject to market volatility. Hence, such exposures shall attract haircut. Additionally where the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take account of possible fluctuation in exchange rates. The haircut for currency mismatch is 8%. Adjusted exposure after risk mitigation is calculated as: E*= E x (1+He) C x (1-Hc-Hfx) Where: E* E = exposure after risk mitigation (floor:0) = current value of the exposure for which the collateral qualifies as a risk mitigant.

He = haircut appropriate to the exposure C = current value of the collateral

Hc = haircut appropriate for the collateral Hfx = haircut for currency mismatch. On-Balance Sheet Netting

On balance sheet netting between loans / advances and deposit is allowed where banks have legally enforceable netting arrangement, involving specific lien with proof of documentation. In the said case haircut for the deposits is O. Haircut for currency mismatch at 8% has to be taken into account when deposits are not in the same currency as the exposure.

Guarantees Guarantees from sovereigns, sovereign entities, banks and primary dealers are accepted under the condition that the risk weight of the guarantor must be lower than the risk weight of the counterparty of the exposure. If the guarantor is another type of entity it must have a rating of AA(-) or better. This would include guarantee provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor. The rating of the guarantor should be an entity rating which has factored in all the liabilities and commitments (including guarantees) of the entity. For a fully covered exposure, the risk weight of the guarantor or protection provider is substituted for the risk weight of the direct counterparty. In case of partial protection (proportional cover) the protected portion receives the risk weight of the protection provider. The unprotected portion keeps the risk weight of the underlying counterparty. Maturity Mismatch Maturity mismatch occurs when the residual maturity of collateral is less than that of the underlying exposure. Where there is maturity mismatch and the CRM has an original maturity of less than one year, the CRM is not recognized. As a result, the maturity of collateral for exposure with original maturities of less than one year must be matched to be recognized. In all cases , collateral with maturity mismatches will no longer be recognized when they have a residual maturity of three months or less. When there is maturity mismatch with recognized credit risk mitigants the following adjustments will be applied. Pa = P x (t-0.25) (T-0.25) Where Pa = value of credit protection adjusted for maturity mismatch P = credit protection adjusted for any haircuts t = min ( T, residual maturity of the credit protection arrangement )expressed in years) T = min( 5, residual maturity of the exposure )expressed in years

In the case of loans collateralized by the banks own deposits , even if the tenor of such deposits is less than three months or deposits have maturity mismatch vis--vis the tenor of the loan, adjustment for maturity mismatch as discussed above will not apply provided an explicit consent of the depositor has been obtained for adjusting the maturity proceeds of the deposits against the loan or for renewal of such deposits till the full repayment of the underlying loan. Treatment of pools of CRM techniques In the case where a bank has multiple CRM techniques covering a single exposure, the bank will be required to subdivide the exposure into portions covered by each type of CRM technique and the risk weighted assets of each portion has to be calculated separately. When credit protection provided by a single protection provider has differing maturities , they must be subdivided into separate protection as well. Supervisory Review Process Under Pillar-II- Supervisory Review Process , RBI has issued guidelines as per which banks are required to have well documented Internal Capital Adequacy Assessment Process (ICAAP) through which they can assure the RBI that adequate capital is indeed held for the various risks to which they are exposed. RBI as supervisor would review and evaluate the internal capital adequacy assessment process and is empowered to initiate appropriate action is it is not satisfied with the banks ICAAP . RBI can also direct banks to hold additional capital above the minimum level if it feels that the risk in a particular portfolio is higher. The ICAAP document should be approved by the banks Board. ICAAP document should also indicate steps taken to mitigate the various risks apart from holding capital. Market Discipline Under third pillar market discipline , banks are required to make the following additional disclosures in the financial statements in the area of credit risk: Qualitative Disclosures: - Definition of past due and impaired - Discussion of the banks credit risk management policy -Names of the credit rating agencies used for each class of exposure -Description of the process used to transfer public issue ratings onto comparablassets in the banking book -Policies and processes for collateral valuation and management -Information about risk concentration within the mitigation taken Quantitative Disclosures: - Geographical distribution of exposures, fund based and non - fund based separately.

- Industry type distribution of exposures , fund based and non - fund based separately. - Classification of banks outstandings in the following three major risk buckets and those that are deducted. Below 100% risk weight 100% risk weight More than 100% risk weight Deducted - Total exposure covered by eligible financial collaterals, after application of haircuts . - Details about the securitized assets. Conclusion The standardized approach of Basel-II is definitely superior to the existing capital adequacy framework in the sense that it is more risk sensitive while earmarking the capital required for each exposure. Depending on the risk inherent in each exposure based on the ratings assigned by the external rating agency , the capital is required to be maintained. Further, it has provided wide range of eligible collaterals , which can be adjusted with the exposure subject to application of haircuts for arriving at net exposure on which the risk weights are applied. Haircuts are to be applied to the repo style exposure and the collateral to take care of future fluctuations in the value of either, occasioned by market movements. The new framework also prescribes haircuts for currency mismatch and maturity mismatch. It also provides capital adequacy framework for new activities undertaken by the banks viz., securitization exposures. In order to implement the new framework , the banks need to immediately initiate the following action points: Banks need to upgrade the technology to capture the required data. The source of data and flow of data should be identified. To bring awareness among the staff, trainings on Basel-II framework to be provided. Importance of proper entry of data fields in the Core banking System/other software system in use to be stressed. External ratings assigned to the borrowers should also be used for risk management and pricing Banks need to select and procure appropriate software system for computation of capital under standardized approach. For disclosures to be made under Pillar-III , the said software system should provide the required MIS.

Banks should also frame ICAAP document to properly review the capital assessment process.

BASEL II GUIDELINES INTERNAL RATING BASED (IRB) APPROACH Overview As the name suggests, this approach is dependent on usage of good internal rating system in the Bank for rating of the borrowers. Although Banks in India are required to adopt Standardized Approach of Basel-II for computation of capital for credit risk by 31.03.2008 /31.03.2009, they are also required to put in place a proper internal rating system for rating of the borrowers so that at a later date migration to internal rating based approach becomes possible. Under this approach banks will have to rely on their own internal estimates of risk components viz., probability of default(PD), exposure at default (EAD)and loss given default (LGD) and effective maturity (M) for calculation of expected loss and unexpected loss. Expected loss will have to be covered by provisions and capital will have to be provided for the unexpected loss. Banks will have to seek approval of its internal rating system in place from the supervisors before migrating to IRB approach. Under IRB there are two approaches viz., foundation approach and advanced approach. Under foundation approach, EAD and LGD numbers will be provided by the supervisors, whereas in the case of advanced approach all estimates of risk components will have to be provided by the banks which however, have to be validated by the supervisors. Categorization of Exposures The categorization of exposures under IRB is as under: -Corporate Small and medium-sized entities (SME) Sub classes for specializes lending -Project finance (PF) -Object Finance (OF) -commodities Finance (CF) -Income-producing real estate (IPRE) -high volatility real estate (HVRE) Purchased receivables -sovereign -Bank

-Retail Residential property Qualifying revolving retail exposures All other retail exposures -Equity Definitions for proper classifying of the exposures are furnished hereunder Corporate: Corporate exposure is defined as debt obligation of corporation, partnership, or proprietorship. Banks may further classify corporate there are separate 5 sub-classes of specialized lending viz., project finance, commodities finance, income-producing real estate, and high volatility commercial real estate. Project finance is a method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the exposure. Object finance refers to a method of funding the acquisition of physical assets (e.g. ships, aircraft, satellites, railcars and fleets) where the repayment of the exposure is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender. Commodities finance refers to structured short term lending to finance reserves, inventories, or receivables of exchange traded commodities (e.g. crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the exposure. Income producing real estate refers to method of providing funding to real estate where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. High-volatility commercial real estate is the financing of commercial real estate that exhibits higher loss rate volatility. These types of real estate are categorized by the national supervisors. Loans financing land acquisition, development and construction where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain (e.g. the property has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), unless the borrower has substantial equity at risk. Purchased Receivables include receivables that are purchased from unrelated, third party sellers (as in the case of asset backed securitization exposures); it must have been generated on an arms length basis between the seller and the obligor and purchasing bank has claim on all proceeds from the pool of receivables or a pro-rata interest in the proceeds. Sovereign:

This asset class covers all exposures to counterparties treated as sovereigns under the standardized approach. Bank: This asset class covers exposures to banks.

Retail Exposures: Loans to individuals, residential mortage loans, loans extended to small business with some threshold limit (say upto Rs. 5 crore as in the case of standardized approach), will all come under the category of retail exposures. The exposure must be one of a large pool of exposure, which are managed by the Bank on pooled basis. Within the retail asset class, banks are required to identify separately three sub-classes viz., exposures and all other retail exposures. Qualifying revolving retail exposures are those where customers outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the bank; such exposures are to the individuals and maximum exposure being upto say Rs. 5 crore. Equity Exposures: An instrument is considered to be an equity exposures if its is irredeemable in the sense that the return of invested funds can be achieved only by the sale of the investment or sale of rights to the investment or by the liquidation of the issuer; it does not embody an obligation on the part of the issuer, it conveys a residual claim on the assets or income of the issuer. Expected Losses and Unexpected Losses: While it is never possible to know in advance the losses a bank will suffer in a particular year, a bank can forecast the average level of credit losses it can reasonably expect to experience. These losses are referred to as Expected Losses (EL). Actual losses may be higher than the mean loss. Losses above expected levels are usually referred to as Unexpected Losses (UL). EL has to be covered by provisions and for the UL portions banks will have to provide capital. For arriving at EL and UL, banks will have to build database on the following: Probability of default (PD) per rating grade, which gives the average percentage of obligors that default in this rating grade in the course of one year. Banks will have to put in place different rating models for different borrower segments like Large Corporates, SMEs, Banks, NBFCs, Contractors, Real Estate Developers etc. The rating grades under each model will have to mapped to common rating scale of the Bank. PDs will have to be arrived for each grade under the common rating scale. If t here are say 500 borrowers under a particular rating grade at the beginning of the year and at the end of the year we find that 4 have fallen to the defaulted (NPA) category, the default percentage can be said to be 0.8%. This data on PDs for each rating grade has to be available for a period of 5 years and from this data the mean PD has to be arrived, which is to be used for estimation of PD for future years.

Exposure at default (EAD), which gives an estimate of the amount outstanding (drawn amount plus likely future draw downs of yet undrawn lines) in case the borrower defaults. At the time of borrower falling to default (NPA) category there will be outrstanding under the fund based limiots. Further, additional liability may arise on account of crystallization of bills under LC or invocation of BGs. EAD is the aggregate amount outstanding / crystallized after the account fails to default category. This figure when divided by the total sanctioned limits extended to the borrower, give EAD in percentage terms. This data will have to be built for every exposure defaulted for a period of next 7 years (one economic cycle) rating category wise and based on the study of such historical data estimate of EAD has to be made. Loss given default (LGD), which gives the percentage of exposure the bank might lose in case the borrower defaults. For each of the defaulted exposure, the Bank will have to ca[ture the following information: a) b) c) d) e) Date of default EAD figure Nature, seniority, share and value of security Amount and date of recovery made in the credit after default Expenses incurred on the credit after default for legal proceedings, maintenance of security,

recoveries etc. The bank will discount the cash flows (at market interest rate as prevailing during the period of recover) and work out the Present Value of the net recovery in the credit as at the time of default. The net recovery as percentage of EAD will give the recovery rate (%). 100 minus the recovery rate (%) will yield the Loss Given Default (LGD), expressed in percentage terms. This will have to be computed for each of the defaulted exposure for a period of next 7 years (one economic cycle to take into account downturn conditions) to arrive at overall estimated LGD. The above variables PD, EAD and LGD can be used to compute expected loss from the credit portfolio, the formula being (Exposure Committed x PD% x EAD% x LGD %) The standard Deviation of PD about the expected loss will generate the Unexpected Loss the measure of dispersion or degree of uncertainty surrounding the expected loss outcome on a one standard deviation basis or 1 sigma basis (equivalent basis (equivalent to 68% confidence level). This Unexpected Loss number when multiplied by 3 would give the unexpected loss at 99.87% confidence level. Capitalo Requirement under IRB Corporate, Sovereign and Bank exposures. Expected loss calculation under Basel II is similar to way explained in the previous section. As regards capital requirement calculation the formula prescribed for each asset class is different. The derivation of risk-weighted assets is dependent on estimates of the PD, LGD, EAD and, in some cases, effective maturity (M), for a given exposure, as

contrasted to the tabular risk weights in the standardized approach. The formula for capital requirement and riskweighted assets in the case of corporate, sovereign and bank exposures not in default are as under:

Standard normal distribution (N) applied to threshold and conservative value of systematic factor.

Inverse of the standard normal distribution (G) applied to PD to derive default threshold

Inverse of the standard normal distribution (G) applied to confidence level to derive conservative value of systematic factor

Capital requirement (K) = [LGD*N[(1 R)^-0.5*G(PD) + (R / (1 R))^0.5*G(0.999)] -PD * LGD] * (1 1.5 x b(PD))^(-1) x (1 + (M 2.5) * b (PD)) Risk-weighted assets (RWA) = K*12.5*EAD While building the formula for arriving at risk weights, it is considered that capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to. Under the formula, all systematic (or system wide) risks, that affect all borrowers to a certain degree, like industry or regional risks, are modeled with only one (the single) systematic factor. PDs have to be estimated by the Banks based on past data. These PDs are to be transformed into conditional PDs. The conditional PDs reflect defaults rates given an appropriately conservative value of the systematic risk factor. The conditional expected loss for an exposure is estimated as the product of the conditional P)D and the downturn LGD for that exposure. The total economic resources (capital plus provisions and write-offs) that a bank must hold to cover the sum of UL and EL for an exposure is equal to that exposures conditional expected loss. Adding up these resources across all exposures yields sufficient resources to meet a portfolio-wide Value-at-Risk target. Subtracting EL from the conditional expected loss for an exposure yields a UL-only capital requirement. Conclusion:

The response to Basel Accord II reforms world over is not uniform and spontaneous. Basel-II is known for complicated risk management models and complex data requirements. Big international banks, as those in the US, prefer this new version, as they perceive that their superior technology and systems would make themBasel compliant and provide an edge in the competitive environment, in the form of lower regulatory capital. Indian banks do not perceive any immediate value in the new norms as they are globally insignificant players with

simple and straight forward balance-sheet structures. This is clearly vindicated by the sample study according to which 57 per cent of the executives of public sector banks are sceptical about Basel Accord II norms, particularly in respect of investment cost and the complexity of proposed internal rating system. As against this, the private sector banks with supposedly more investment in technology related infrastructure are in favour of the proposals under New Basel Capital Accord as vindicated by the sample study according to which 67 percent of executives of private sector banks are in-favour for New Basel Capital Accord. However, putting Basel II in place is going to be far more challenging than Basel I. The adoption of Basel II will boost good Risk Management practices and good corporate governance in banks. However, the cost of putting in place robust system today is viewed in an increasingly number of countries as a price worth paying to prevent such crisis. Assuming that the banks can get over the technological and operational hurdles, switching over to BaselII norms can no doubt turn the Indian banks, mainly the public sector banks, more efficient and competitive globally. This, in turn, will help strengthen the financial sector to undertake further reforms including capital account convertibility more confidently.

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Narayana Rao K.V.S.S.

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Good collection. Please give references. That will make it possible for readers to go and view the original sources. You can write messages for visitors and fellow authors in Knol Bulletin Board November 2008 http://knol.google.com/k/narayana-rao-kvss/-/2utb2lsm2k7a/427#

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