A Research Report on Credit Risk Management at ICICI

Bank, Bangalore

Submitted in partial fulfillment of the requirements of the MBA Degree

Bangalore University

Submitted by
DO THI BICH NGOC

Register Number
03XQCM6033

Under the guidance of

Prof.vISWANATH,

M.P.Birla Institute of Management,

Associate Bharatiya Vidya Bhavan,
Bangalore 560001
2003-05
 PART A. THEORETICAL SETTINGS

1. Research Extract

While financial institutions have faced difficulties over the years for a multitude of
reasons, the major cause of serious banking problems continues to be directly related to
lax credit standards for borrowers and counterparties, poor portfolio risk management, or
a lack of attention to changes in economic or other circumstances that can lead to a
deterioration in the credit standing of a bank's counterparties.

Credit risk is most simply defined as the potential that a bank borrower or counterparty
will fail to meet its obligations in accordance with agreed terms. The goal of credit risk
management is to maximise a bank's risk-adjusted rate of return by maintaining credit
risk exposure within acceptable parameters. Banks need to manage the credit risk
inherent in the entire portfolio as well as the risk in individual credits or transactions.
Banks should also consider the relationships between credit risk and other risks. The
effective management of credit risk is a critical component of a comprehensive approach
to risk management and essential to the long-term success of any banking organisation.

For most banks, loans are the largest and most obvious source of credit risk; however,
other sources of credit risk exist throughout the activities of a bank, including in the
banking book and in the trading book, and both on and off the balance sheet. Banks are
increasingly facing credit risk (or counterparty risk) in various financial instruments other
than loans, including acceptances, interbank transactions, trade financing, foreign
exchange transactions, financial futures, swaps, bonds, equities, options, and in the
extension of commitments and guarantees, and the settlement of transactions.

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

The sound practices set out in this document specifically address the following areas: (i)
establishing an appropriate credit risk environment; (ii) operating under a sound credit-
granting process; (iii) maintaining an appropriate credit administration, measurement and
monitoring process; and (iv) ensuring adequate controls over credit risk. Although
specific credit risk management practices may differ among banks depending upon the
nature and complexity of their credit activities, a comprehensive credit risk management
program will address these four areas. These practices should also be applied in
conjunction with sound practices related to the assessment of asset quality, the adequacy
of provision and reserves, and the disclosure of credit risk

A further particular instance of credit risk relates to the process of settling financial
transactions. If one side of a transaction is settled but the other fails, a loss may be
incurred that is equal to the principal amount of the transaction. Even if one party is
simply late in settling, then the other party may incur a loss relating to missed investment
opportunities. Settlement risk (i.e. the risk that the completion or settlement of a financial
transaction will fail to take place as expected) thus includes elements of liquidity, market,
operational and reputational risk as well as credit risk. The level of risk is determined by
the particular arrangements for settlement. Factors in such arrangements that have a
bearing on credit risk include: the timing of the exchange of value; payment/settlement
finality; and the role of intermediaries and clearing houses and reserves, and the
disclosure of credit risk

2. Introduction

i, Background of the study

Globalization is a buzzword and became widely use since 1990s. It has created two
trends in the financial sector that are the increasing of globalization of economic and
financial activity and the promotion of financial stability in all countries , both developed
and developing countries.

The globalisation of markets for final goods, financial and non-financial services, and
even factors of production has been one of the most striking developments of at least the
past two decades.

The other key trend, the increased focus on the promotion of financial stability, Our
concern to promote financial stability involves not only the promotion of price stability,
but also support for deep and robust financial markets, for sound financial institutions,
and for a stable overall infrastructure for the financial industry.

Why worry about these elements of a stable financial system in a modern market
economy? As we have seen, over the long term, economic and financial systems based on
open competition and global market forces can achieve outcomes that are far superior to
those possible in a highly regulated and controlled environment.

But that said, such market-based systems can, and do, display elements of vulnerability.
Markets can be disfunctional and they can be subject to failures and breakdowns. Investor
and borrower behaviour does not always produce sufficiently deep and liquid markets, or
prices that consistently reflect economic fundamentals.

When financial stability is lost, the costs can be grave not only for the financial sector
itself but also for the country economy as a whole.

So, the challenge is to promote sound risk management practices in financial institution
in a way that ensures that they are adequately capitalised and prudently managed – while
not hindering a their ability to pursue opportunities and profits responsibly. Well
capitalised and well managed financial institution can serve as efficient intermediaries of
credit, not only in good times, but also in periods of strain.

ii,Credit Risk Management.

- Credit Risk:
Credit risk is a significant element of the galaxy of risks facing the derivatives dealer and
the derivatives end-user. There are different grades of credit risk. The most obvious one
is the risk of default. Default means that the counterparty to which one is exposed will
cease to make payments on obligations into which it has entered because it is unable to
make such payments.

This is the worst case credit event that can take place. An intermediate credit risk occurs
when the counterparty's creditwoRthiness is downgraded by the credit agencies causing
the value of obligations it has issued to decline in value. One can see immediately that
market risk and credit risk interact in that the contracts into which we enter with
counterparties will fluctuate in value with changes in market prices, thus affecting the
size of our credit exposure. Note also that we are only exposed to credit risk on contracts
in which we are owed some form of payment. If we owe the counterparty payment and
the counterparty defaults, we are not at risk of losing any future cash flows.

Different aspects of credit risk: market risk, default rates and recovery rates

The two aspects of credit risk are the market risk of the contracts into which we have
entered with counterparties and the potential for some pejorative credit event such as
default or downgrade. The difficult thing is to try and calculate the probability of default
or of a negative credit event

Another difficulty in assessing credit risk is estimating the recovera rate. Det's sa that
ABC bank `efaults and thad we have an outstanding swap with ABC, the market value of
which is $10 million in our favor. It is not automatically true that we are not going to see
any of that $10 million once the smoke clears from the bankruptcy negotiations. We may
be able to receive a partial payment. The recovery rate is the rate at which we are paid in
the event of a negative credit event. If we are paid $2 million at the end of the day, then
the recovery rate here is 20%.

What was the expected value of the swap to us the day before ABC defaulted? Let's say
that we had estimated an ex ante default probability of 5% and a recovery rate of 20%.
Then, the expected value condition is straightforward.
Expected Value Swap=0.95($10 million) + 0.05($10 million x 0.20)=$9.6 million

This expected value of the swap is less than its current market value because of the
possibility of default and less-than-total recovery of the value of the swap in the event of
default.

There are two steps in calculating credit risk: estimating the credit exposure and
calculating the probability of default. Once we have calculated these two statistics, we
can quantify the credit risk.

The credit exposure is equal to the greater of the current replacement value of the
outstanding contracts plus the expected maximum increase in value of the contract over
the remaining life of the contract for a given confidence interval or zero. This potential
exposure can be calculated using the Value-at-Risk techniques we discussed in an earlier
article. If the sum of the current replacement value and the potential increase in value of
the contract is negative, then we have no exposure to the counterparty from a credit
perspective because we are obligated to make payments to them.

Credit risk is simply the product of this calculated credit exposure and the estimated
probability of default.

Credit risk is a significant element of any derivatives transaction. Because of the

significance of credit risk, dealers must account for it when they conduct swaps
transactions with their counterparties. This may mean that they charge a greater swap
spread when pricing the swap curve for a particular counterparty or it may mean that they
place greater conditions on the transaction.

- Credit Risk – Internal Ratings Based Approach

This section describes the IRB approach to credit risk. Subject to certain minimum
conditions and disclosure requirements, banks that have received supervisory approval to
use the IRB approach may rely on their own internal estimates of risk components in
determining the capital requirement for a given exposure. The risk components include
measures of the probability of default (PD), loss given default (LGD), the exposure at
default (EAD), and effective maturity (M). In some cases, banks may be required to use a
supervisory value as opposed to an internal estimate for one or more of the risk
components.

The IRB approach is based on measures of unexpected losses (UL) and expected
losses (EL). The risk-weight functions produce capital requirements for the UL portion.

Adoption of the IRB approach across all asset classes is also discussed early in this
section, as are transitional arrangements. The risk components, each of which is defined
later in this section, serve as inputs to the risk-weight functions that have been developed
for separate asset classes. For example, there is a risk-weight function for corporate
exposures and another one for qualifying revolving retail exposures. The treatment of
each asset class begins with a presentation of the relevant risk-weight function(s)
followed by the risk components and other relevant factors, such as the treatment of
credit risk mitigates

1. Categorisation of exposures

Under the IRB approach, banks must categorise banking-book exposures into broad
classes of assets with different underlying risk characteristics, subject to the definitions
set out below
.
- Corporate
- Sovereign
- Bank
- Retail
- Equity

The classification of exposures in this way is broadly consistent with established

bank practice. However, some banks may use different definitions in their internal risk
management and measurement systems. While it is not the intention of the Committee to
require banks to change the way in which they manage their business and risks, banks are
required to apply the appropriate treatment to each exposure for the purposes of deriving
their minimum capital requirement. Banks must demonstrate to supervisors that their
methodology for assigning exposures to different classes is appropriate and consistent
over time.

Definition of corporate exposures

In general, a corporate exposure is defined as a debt obligation of a corporation,
partnership, or proprietorship. Banks are permitted to distinguish separately exposures to
small- and medium-sized entities (SME). Within the corporate asset class, five sub-
classes of specialised lending (SL) are identified. Such lending possesses all the
following characteristics, either in legal form or economic substance:
- The exposure is typically to an entity (often a special purpose entity (SPE)) which
was created specifically to finance and/or operate physical assets;
- The borrowing entity has little or no other material assets or activities, and therefore
little or no independent capacity to repay the obligation, apart from the income that it
receives from the asset(s) being financed;
- The terms of the obligation give the lender a substantial degree of control over
theasset(s) and the income that it generates; and
- As a result of the preceding factors, the primary source of repayment of the
obligation is the income generated by the asset(s), rather than the independent
capacity of a broader commercial enterprise.

The five sub-classes of specialised lending are project finance, object finance,
commodities finance, income-producing real estate, and high-volatility commercial real
estate. Each of these sub-classes is defined below.

Project finance
Project finance (PF) 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. This type of financing is usually for large, complex and expensive
installations that might include, for example, power plants, chemical processing plants,
mines, transportation infrastructure, environment, and telecommunications infrastructure.
Project finance may take the form of financing of the construction of a new capital
installation, or refinancing of an existing installation, with or without improvements.
In such transactions, the lender is usually paid solely or almost exclusively out of the
money generated by the contracts for the facility’s output, such as the electricity sold by a
power plant. The borrower is usually an SPE that is not permitted to perform any function
other than developing, owning, and operating the installation. The consequence is that
repayment depends primarily on the project’s cash flow and on the collateral value of the
project’s assets. In contrast, if repayment of the exposure depends primarily on a well
established, diversified, credit-worthy, contractually obligated end user for repayment, it
is considered a secured exposure to that end-user.

Object finance
Object finance (OF) 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. A primary source of these cash flows might be rental or
lease contracts with one or several third parties. In contrast, if the exposure is to a
borrower whose financial condition and debt-servicing capacity enables it to repay the
debt without undue reliance on the specifically pledged assets, the exposure should be
treated as a collateralised corporate exposure.

Commodities finance
Commodities finance (CF) 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. This is
the case when the borrower has no other activities and no other material assets on its
balance sheet. The structured nature of the financing is designed to compensate for the
weak credit quality of the borrower. The exposure’s rating reflects its self -liquidating
nature and the lender’s skill in structuring the transac tion rather than the credit quality of
the borrower.
The Committee believes that such lending can be distinguished from exposures
financing the reserves, inventories, or receivables of other more diversified corporate
borrowers. Banks are able to rate the credit quality of the latter type of borrowers based
on their broader ongoing operations. In such cases, the value of the commodity serves as
a risk mitigant rather than as the primary source of repayment.

Income-producing real estate

Income-producing real estate (IPRE) refers to a method of providing funding to real
estate (such as, office buildings to let, retail space, multifamily residential buildings,
industrial or warehouse space, and hotels) where the prospects for repayment and
recovery on the exposure depend primarily on the cash flows generated by the asset. The
primary source of these cash flows would generally be lease or rental payments or the
sale of the asset. The borrower may be, but is not required to be, an SPE, an operating
company focused on real estate construction or holdings, or an operating company with
sources of revenue other than real estate. The distinguishing characteristic of IPRE versus
other corporate exposures that are collateralised by real estate is the strong positive
correlation between the prospects for repayment of the exposure and the prospects for
recovery in the event of default, with both depending primarily on the cash flows
generated by a property.

High-volatility commercial real estate

High-volatility commercial real estate (HVCRE) lending is the financing of commercial
real estate that exhibits higher loss rate volatility (i.e. higher asset correlation) compared
to other types of SL. HVCRE includes:

- Commercial real estate exposures secured by properties of types that are

categorised by the national supervisor as sharing higher volatilities in portfolio
default rates;
- Loans financing any of the land acquisition, development and construction (ADC)
phases for properties of those types in such jurisdictions; and
- Loans financing ADC of any other properties 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. Commercial
ADC loans exempted from treatment as HVCRE loans on the basis of certainty of
repayment of borrower equity are, however, ineligible for the additional reductions for
SL exposures described in paragraph .

Where supervisors categorise certain types of commercial real estate exposures as

HVCRE in their jurisdictions, they are required to make public such determinations.
Other supervisors need to ensure that such treatment is then applied equally to banks
under their supervision when making such HVCRE loans in that jurisdiction.

Definition of sovereign exposures

This asset class covers all exposures to counterparties treated as sovereigns under the
standardised approach. This includes sovereigns (and their central banks), certain PSEs
identified as sovereigns in the standardised approach, MDBs that meet the criteria for a
0% risk weight under the standardised approach

Definition of bank exposures

Bank exposures also include claims on domestic PSEs that are treated like
claims on banks under the standardised approach, and MDBs that do not meet the criteria
for a 0% risk weight under the standardised approach.

Definition of retail exposures

An exposure is categorised as a retail exposure if it meets all of the following
criteria:
Nature of borrower or low value of individual exposures

- Exposures to individuals – such as revolving credits and lines of credit (e.g. credit cards,
overdrafts, and retail facilities secured by financial instruments) as well as personal term
loans and leases (e.g. installment loans, auto loans and leases, student and educational
loans, personal finance, and other exposures with similar characteristics) – are generally
eligible for retail treatment regardless of exposure size, although supervisors may wish to
establish exposure thresholds to distinguish between retail and corporate exposures.
- Residential mortgage loans (including first and subsequent liens, term loans and
revolving home equity lines of credit) are eligible for retail treatment regardless of
exposure size so long as the credit is extended to an individual that is an owner occupier
of the property (with the understanding that supervisors exercise reasonable flexibility
regarding buildings containing only a few rental units FRWKHUZLVHWKH\DUHWUHDWHGDV
corporate). Loans secured by a single or small number of condominium or co-operative
residential housing units in a single building or complex also fall within the scope of the
residential mortgage category. National supervisors may set limits on the maximum
number of housing units per exposure.
- Loans extended to small businesses and managed as retail exposures are eligible for
retail treatment provided the total exposure of the banking group to a small business
borrower (on a consolidated basis where applicable) is less than
¼PLOOLRQ6PDOOEXVLQHVVORDQVH[WHQGHGWKURXJKRUJXDUDQWHHGE\DQLQGLYLGXDO
are subject to the same exposure threshold.
- It is expected that supervisors provide flexibility in the practical application of such
thresholds such that banks are not forced to develop extensive new information systems
simply for the purpose of ensuring perfect compliance. It is, however, important for
supervisors to ensure that such flexibility (and the implied acceptance of exposure
amounts in excess of the thresholds that are not treated as violations) is not being abused.
Definition of equity exposures

In general, equity exposures are defined on the basis of the economic substance of
the instrument.
An instrument is considered to be an equity exposure if it meets all of the following
requirements:
- It is irredeemable in the sense that the return of invested funds can be achieved only
by the sale of the investment or sale of the rights to the investment or by the liquidation
of the issuer;
- It does not embody an obligation on the part of the issuer; and
- It conveys a residual claim on the assets or income of the issuer.

2. Foundation and advanced approaches

For each of the asset classes covered under the IRB framework, there are three key
elements:
- Risk components FHVWLPDWHVRIULVNSDUDPHWHUVSURYLGHGE\EDQNVVRPHRIZKLFK
are supervisory estimates, that are Probability of Default (PD) , Loss Given Default
(LGD), Exposure at Default (EAD) and Effective Maturity (M)
- Risk-weight functions FWKHPHDQVE\ZKLFKUL sk components are transformed into
risk-weighted assets and therefore capital requirements.
- Minimum requirements FWKHPLQLPXPVWDQGDUGVWKDWPXVWEHPHWLQRUGHUIRUD
bank to use the IRB approach for a given asset class.

For many of the asset classes, the Committee has made available two broad
approaches: a foundation and an advanced. Under the foundation approach, as a general
rule, banks provide their own estimates of PD and rely on supervisory estimates for other
risk components.
Under the advanced approach, banks provide more of their own estimates of
PD, LGD and EAD, and their own calculation of M, subject to meeting minimum
standards. For both the foundation and advanced approaches, banks must always use the
risk-weight functions provided in this Framework for the purpose of deriving capital
requirements. The full suite of approaches is described below.
(i) Corporate, sovereign, and bank exposures
- Under the foundation approach, banks must provide their own estimates of PD
associated with each of their borrower grades, but must use supervisory estimates for the
other relevant risk components. The other risk components are LGD, EAD and M.
- Under the advanced approach, banks must calculate the effective maturity (M) and
provide their own estimates of PD, LGD and EAD.

Banks that do not meet the requirements for the estimation of PD under the corporate
foundation approach for their SL assets are required to map their internal risk grades to
five supervisory categories, each of which is associated with a specific risk weight.
This version is termed the ‘supervisory slotting criteria approach’.
Banks that meet the requirements for the estimation of PD are able to use the
foundation approach to corporate exposures to derive risk weights for all classes of SL
exposures except HVCRE. At national discretion, banks meeting the requirements for
HVCRE exposure are able to use a foundation approach that is similar in all respects to
the corporate approach, with the exception of a separate risk-weight function
Banks that meet the requirements for the estimation of PD, LGD and EAD are able
to use the advanced approach to corporate exposures to derive risk weights for all classes
of SL exposures except HVCRE. At national discretion, banks meeting these
requirements for HVCRE exposure are able to use an advanced approach that is similar in
all respects to the corporate approach, with the exception of a separate risk-weight
function.
Banks that meet the requirements for the estimation of PD, LGD and EAD are able
to use the advanced approach to corporate exposures to derive risk weights for all classes
of SL exposures except HVCRE. At national discretion, banks meeting these
requirements for HVCRE exposure are able to use an advanced approach that is similar in
all respects to the corporate approach, with the exception of a separate risk-weight
function.

(ii) Retail exposures

For retail exposures, banks must provide their own estimates of PD, LGD and EAD.
There is no distinction between a foundation and advanced approach for this asset class.

(iii) Equity exposures

There are two broad approaches to calculate risk-weighted assets for equity
exposures not held in the trading book: a market-based approach and a PD/LGD
approach.

The PD/LGD approach to equity exposures remains available for banks that adopt
the advanced approach for other exposure types.

(iv) Eligible purchased receivables

The treatment potentially straddles two asset classes. For eligible corporate receivables,
both a foundation and advanced approach are available subject to certain operational
requirements being met. For eligible retail receivables, as with the retail asset class, there
is no distinction between a foundation and advanced approach.

3. Adoption of the IRB approach across asset classes

Once a bank adopts an IRB approach for part of its holdings, it is expected to
extend it across the entire banking group. As we recognize however, that, for many
banks, it may not be practicable for various reasons to implement the IRB approach
across all material asset classes and business units at the same time. Furthermore, once on
IRB, data limitations may mean that banks can meet the standards for the use of own
estimates of LGD and EAD for some but not all of their asset classes/business units at the
same time.
 As such, supervisors may allow banks to adopt a phased rollout of the IRB
approach across the banking group. The phased rollout includes (i) adoption of IRB
across asset classes within the same business unit (or in the case of retail exposures
across individual sub-classes); (ii) adoption of IRB across business units in the same
banking group; and (iii) move from the foundation approach to the advanced approach
for certain risk components. However, when a bank adopts an IRB approach for an asset
class within a particular business unit (or in the case of retail exposures for an individual
sub-class), it must apply the IRB approach to all exposures within that asset class (or sub-
class) in that unit.
A bank must produce an implementation plan, specifying to what extent and when
it intends to roll out IRB approaches across significant asset classes (or sub-classes in the
case of retail) and business units over time. The plan should be exacting, yet realistic, and
must be agreed with the supervisor. It should be driven by the practicality and feasibility
of moving to the more advanced approaches. During the roll-out period, supervisors will
ensure that no capital relief is granted for intra-group transactions which are designed to
reduce a banking group’s aggregate capital charge by transferring credit risk among
entities on the standardised approach, foundation and advanced IRB approaches. This
includes, but is not limited to, asset sales or cross guarantees.
Some exposures in non-significant business units as well as asset classes (or
subclasses in the case of retail) that are immaterial in terms of size and perceived risk
profile may be exempt from the requirements in the previous two paragraphs, subject to
supervisory approval.
Notwithstanding the above, once a bank has adopted the IRB approach for all or
part of any of the corporate, bank, sovereign, or retail asset classes, it will be required to
adopt the IRB approach for its equity exposures at the same time, subject to materiality.
Supervisors may require a bank to employ one of the IRB equity approaches if its equity
exposures are a significant part of the bank’s business, even though the bank may not
employ an IRB approach in other business lines. Further, once a bank has adopted the
general IRB approach for corporate exposures, it will be required to adopt the IRB
approach for the SL sub-classes within the corporate exposure class.
 Banks adopting an IRB approach are expected to continue to employ an IRB
approach. A voluntary return to the standardised or foundation approach is permitted only
in 57 extraordinary circumstances, such as divestiture of a large fraction of the bank’s
creditrelated business, and must be approved by the supervisor.

Given the data limitations associated with SL exposures, a bank may remain on
the supervisory slotting criteria approach for one or more of the PF, OF, CF, IPRE or
HVCRE sub-classes, and move to the foundation or advanced approach for other sub-
classes within the corporate asset class. However, a bank should not move to the
advanced approach for the HVCRE sub-class without also doing so for material IPRE
exposures at the same time.

Credit Risk – The Standardised Approach

The following section sets out revisions to the 1988 Accord of BIS Committee for risk
weighting banking book exposures.

A. External Credit Assessment

1. The recognition process

National supervisors are responsible for determining whether an external credit
assessment institution (ECAI) meets the criteria listed in the paragraph below. The
assessments of ECAIs may be recognised on a limited basis, e.g. by type of claims or by
jurisdiction. The supervisory process for recognising ECAIs should be made public to
avoid unnecessary barriers to entry.

2. Eligibility criteria

An ECAI must satisfy each of the following six criteria.

Objectivity: The methodology for assigning credit assessments must be rigorous,
systematic, and subject to some form of validation based on historical experience.
Moreover, assessments must be subject to ongoing review and responsive to changes in
financial condition. Before being recognised by supervisors, an assessment methodology
for each market segment, including rigorous back testing, must have been established for
at least one year and preferably three years.
Independence: An ECAI should be independent and should not be subject to political or
economic pressures that may influence the rating. The assessment process should be as
free as possible from any constraints that could arise in situations where the composition
of the board of directors or the shareholder structure of the assessment institution may be
seen as creating a conflict of interest.
International access/Transparency: The individual assessments should be available to
both domestic and foreign institutions with legitimate interests and at equivalent terms. In
addition, the general methodology used by the ECAI should be publicly available.
Disclosure: An ECAI should disclose the following information: its assessment
methodologies, including the definition of default, the time horizon, and the meaning of
each rating; the actual default rates experienced in each assessment category; and the
transitions of the assessments, e.g. the likelihood of AA ratings becoming A over time.
Resources: An ECAI should have sufficient resources to carry out high quality credit
assessments. These resources should allow for substantial ongoing contact with senior
and operational levels within the entities assessed in order to add value to the credit
assessments. Such assessments should be based on methodologies combining qualitative
and quantitative approaches.
Credibility: To some extent, credibility is derived from the criteria above. In addition,
the reliance on an ECAI’s external credit assessments by indep endent parties (investors,
insurers, trading partners) is evidence of the credibility of the assessments of an ECAI.
The credibility of an ECAI is also underpinned by the existence of internal procedures to
prevent the misuse of confidential information. In order to be eligible for recognition, an
ECAI does not have to assess firms in more than one country.

B. Implementing Consideration
 1. The mapping process

Supervisors will be responsible for assigning eligible ECAIs’ assessments to the risk
weights available under the standardised risk weighting framework, i.e. deciding which
assessment categories correspond to which risk weights. The mapping process should be
objective and should result in a risk weight assignment consistent with that of the level of
credit risk reflected in the tables above. It should cover the full spectrum of risk weights.

When conducting such a mapping process, factors that supervisors should assess include,
among others, the size and scope of the pool of issuers that each ECAI covers, the range
and meaning of the assessments that it assigns, and the definition of default used by the
ECAI. In order to promote a more consistent mapping of assessments into the available
risk weights and help supervisors in conducting such a process.

Banks must use the chosen ECAIs and their ratings consistently for each type of
claim, for both risk weighting and risk management purposes. Banks will not be allowed
to “cherry-pick” the assessments provided by different ECAIs.

Banks must disclose ECAIs that they use for the risk weighting of their assets by type of
claims, the risk weights associated with the particular rating grades as determined by
supervisors through the mapping process as well as the aggregated risk-weighted assets
for each risk weight based on the assessments of each eligible ECAI.
2. Multiple assessments

If there is only one assessment by an ECAI chosen by a bank for a particular claim, that
assessment should be used to determine the risk weight of the claim. If there are two
assessments by ECAIs chosen by a bank which map into different risk weights, the
higher risk weight will be applied. If there are three or more assessments with different
risk weights, the assessments corresponding to the two lowest risk weights should be
referred to and the higher of those two risk weights will be applied.
 3. Domestic currency and foreign currency assessment
Where unrated exposures are risk weighted based on the rating of an equivalent exposure
to that borrower, the general rule is that foreign currency ratings would be used for
exposures in foreign currency. Domestic currency ratings, if separate, would only be used
to risk weight claims denominated in the domestic currency.

4. Short term/ long term assessment

For risk-weighting purposes, short-term assessments are deemed to be issuespecific.

They can only be used to derive risk weights for claims arising from the rated facility
In no event can a short-term rating be used to support a risk weight for an unrated
long-term claim. Short-term assessments may only be used for short-term claims
against banks and corporates. The table below provides a framework for banks’
exposures to specific short-term facilities, such as a particular issuance of commercial
paper.

Credit A1-P1 A2-P2 A3-P3 Others

assessment
Risk weight 20% 50% 100% 150%

The credit rating follows the methodology used by Standard and Poor’s and by Moody’s
Investors Service

If a short-term rated facility attracts a 50% risk-weight, unrated short-term claims cannot
attract a risk weight lower than 100%. If an issuer has a short-term facility with an
assessment that warrants a risk weight of 150%, all unrated claims, whether long-term or
short-term, should also receive a 150% risk weight, unless the bank uses recognised
credit risk mitigation techniques for such claims.
In cases where national supervisors have decided to apply option 2 under the standardised
approach to short term interbank claims to banks in their jurisdiction, the interaction with
specific short-term assessments is expected to be the followin
The general preferential treatment for short-term claims, applies to all claims on banks of
up to three months original maturity when there is no specific short-term claim
assessment.
When there is a short-term assessment and such an assessment maps into a risk weight
that is more favourable (i.e. lower) or identical to that derived from the general
preferential treatment, the short-term assessment should be used for the specific claim
only. Other short-term claims would benefit from the general preferential treatment.
When a specific short-term assessment for a short term claim on a bank maps into a less
favourable (higher) risk weight, the general short-term preferential treatment for
interbank claims cannot be used. All unrated short-term claims should receive the same
risk weighting as that implied by the specific short-term assessment.

MEASURING THE CREDIT RISK

There are various types of measuring credit risks, in the limitation of the research, we are
going to discuss the following techniques for measuring the credit risk.

1. VALUE-AT-RISK

Financial institutions and corporate Treasuries require a method for reporting their risk
that is readily understandable by non-financial executives, regulators and the investment
public and they also require that this mechanism be scientifically rigorous. The answer to
this problem is Value-at-Risk (VaR) analysis. VaR is a number that expresses the
maximum expected loss for a given time horizon and for a given confidence interval and
for a given position or portfolio of instruments, under normal market conditions,
attributable to changes in the market price of financial instruments.

Suppose that we are investment managers with positions in foreign exchange, fixed
income and equities. We need an assessment of what we can expect the worst case to be
for the position overnight with a 95% degree of confidence. The VaR number gives us
this measurement. For example, the portfolio manager might have 100 million dollars
under management and an overnight-95% confidence interval VaR of 4 million dollars.
This means that 19 times out of 20 his biggest loss should be less than 4 million dollars.
Hopefully, he is making money instead of losing money. You can also express VaR as a
percentage of assets, in this case 4%.

VaR is also useful when we want to compare the riskiness of different portfolios. Let us
now consider two portfolio managers. Each of them starts the year with 100 million
dollars under management. Bob makes a return of 30%, handily beating his target of
20%. Jerry makes a return of 20%, coming in on target. Who is the better fund manager?
The answer is, as economists always say, it depends. To make an accurate judgment,
many people believe that we need to compare the risk involved.

Let's say that A's average overnight

-95% VaR was 7 million dollars and B's average
overnight-95% VaR was 2 million dollars. One way of calculating Bob's return on risk
capital is as follows: 30 million dollars/7 million dollars=428.6% Using the same
method, B's return on risk capital is: 20 million dollars/2 million dollars=1000.0% It
could be reasonably argued that B is a better fund manager in that he used his risk capital
more efficiently. How many people when they invest in mutual funds know anything
about the risk that their portfolio managers take in generating a return? Most mutual
funds do not report this kind of risk-adjusted number, although some of them could use it
to justify or explain their actions.

This is especially important when evaluating how closely a portfolio manager conformed
to the stated risk tolerance of his fund. If the fund is advertising itself as a very low-risk
investment vehicle suitable for widows and orphans, the average daily VaR as a
percentage of assets is an interesting number, especially when compared to the same
number for more openly risky investments. Corporate Treasuries and Banks use VaR for
the same purpose. They need to have an idea of how their market exposures behave under
normal market conditions. It is a risk management cliché but you know that you have a
bad risk management regime in place if you are surprised by the extent of any gains or
losses that you sustain.

CALCULATING VALUE-AT-RISK

Value-at-Risk is scientifically rigorous in that it utilizes statistical techniques that have

evolved in physics and engineering. VaR is questionable in that it makes assumptions in
order to use these statistical techniques. Chief among these assumptions is that the return
of financial prices is normally distributed with a mean of zero. The return of a financial
price may be thought of as the capital gain/loss that one might expect to accrue from
holding the financial asset for one day.

For example, in the case of foreign exchange, if I own one Canadian dollar against being
short 1 US dollar, I will earn a return overnight if the Canadian dollar appreciates against
the US dollar. One way of expressing the return is the difference between the current
price and the previous period's price, divided by the previous period's pric
e. JP Morgan
has developed a methodology for calculating VaR for simple portfolios (i.e. portfolios
that do not include any significant options components) called RiskMetrics. The success
of RiskMetrics has been so great that Morgan has spun off the RiskMetrics group as a
separate company.

RiskMetrics forecasts the volatility of financial instruments and their various correlations.
It is this calculation that enables us to calculate the VaR in a simple fashion. Volatility
comes into play because if the underlying markets are volatile, investments of a given
size are more likely to lose money than they would if markets were less volatile.
Volatility here refers to the distribution of the return around the mean. A volatile market
is one in which the returns can vary greatly around the mean while a calm market is one
in which the returns vary little around the mean.

Correlation is important, too. Modern portfolio theory is familiar to many people who
intentionally diversify their investments. If we invest all of our money in a set of financial
instruments that move in the same direction and with the same relative speed, that is a
riskier portfolio than if we invest in a portfolio of financial instruments that move in
different directions at different speeds. If the instruments in the former portfolio all move
down, we will lose money on each of these instruments whereas we would expect to
make money on some instruments and lose money on the remaining instruments in the
latter portfolio. Hopefully, in the case of the latter portfolio, we make more money than
we lose, on average.

Earlier, we stated that volatility was both dynamic and persistent. That is to say, volatility
changes over time but it moves in a trending fashion. Correlation is dynamic, too.
Correlations move with less persistence than volatilities. It is easy to see how complex
the management of financial price risk can be with a portfolio containing more than two
or three instruments. For more information, visit the RiskMetrics web site at
http://www.riskmetrics.com. Once optionality is involved, it becomes computationally
difficult to calculate the VaR, in some cases requiring statistical simulation of the
portfolio. The reason for this is because of the convexity of option products.
Straightforward VaR calculation underestimates or overestimates the VaR, depending on
whether or not one is long or short convexity (i.e. whether one owns or has sold options).

2. SCENARIO ANALYSIS

In describing VaR, we have emphasized the fact that VaR is only good for calculating an
expected maximum loss under normal market conditions. Because of the generally
idiosyncratic nature of financial prices, we must have a way of understanding the
implications for our portfolio of abnormal market conditions. Scenario analysis is the tool
we use for this purpose. Consider the portfolio manager from our original example in this
article who has an overnight-95% VaR of 4 million dollars on underlying assets of 100
million dollars. The VaR number that our calculator generates describes his expected loss
under normal market conditions. An important, critical adjunct procedure to VaR
measurement is scenario analysis. In scenario analysis, the portfolio manager will
simulate various hypothetical evolutions of events in order to determine their effect on
the value of the portfolio.

Any portfolio manager must understand what the weak spot is in his portfolio. Naturally,
this is the first set of scenarios to simulate. By determining the change in value of his
portfolio under stressful conditions (called "stress-testing"), the portfolio manager has a
better perception of where the risks in his portfolio lie. At that point, he can make trades
that reduce this risk to levels with which he is comfortable. At the very least, he has an
appreciation of what will happen so that if the worst-case does take place unexpectedly,
he can act more decisively and more quickly to manage his portfolio. Without this kind of
stress-testing, he will be forced to react in a moving market, a situation that can
exacerbate his market losses. In a complex derivatives portfolio, stress-testing that
reveals excessively risky exposures either to movements in the underlying cash rate or
shifts in implied volatility or interest rates (or combinations of these factors) is said to
identify "risk holes."

For example, an options portfolio that is short a great deal of short-dated options around a
particular strike is said to have a "gamma hole" around that strike and date (analogous to
space and time, in a physical sense). If the underlying rate were to move to the same level
as the strike price around the same time as the options were maturing or just before, the
portfolio would become very difficult to manage and the profitability of the portfolio
could become intolerably volatile. The bottom line here is that all of these ways of
measuring risk must be interpreted in terms of the preferences of the investor or the
institution managing the risk.

3. Expected and Unexpected Loss Measurement

Once current and potential credit exposures are calculated, expected and unexpected
losses may be determined using estimated default probabilities and recovery rates.
Expected credit losses are defined as the mean of the credit loss distribution based on the
distribution of credit exposures, the default probability of the counterparty, and the
expected recovery rate if a counterparty were to default. Unexpected credit losses are
defined as an extreme (e.g., 99 percent confidence interval) level of loss derived from the
credit loss distribution determined. Expected credit loss calculations are used to
determine expected net returns to the portfolio, and unexpected credit losses are used to
determine extreme potential credit losses to the portfolio, similar to the market risk losses
estimated by value at risk.

Expected and unexpected loss measurement requires even more data about the
counterparty—specifically default probabilities and recovery rates. Historic default
probabilities are available from public rating agencies, such as Standard & Poor’s and
Moody’s. Default probabilities may also be determined using vendor methodologies,
such as KMV’s Credit Monitor, the RiskMetrics Group’s Credit Manager, Credit Suisse
First Boston’s Credit Risk +, and Moody’s RiskCalc. Where default probability
methodologies rely on historic data, questions about applicability exist due to the small
number of data points available. Other methodologies that do not rely on historic default
data rely on certain assumptions about firms and markets that must be considered.
Historic recovery rates on senior securities are available from Standard & Poor’s and
Moody’s.

MANAGING CREDIT RISK

WHY MANAGING THE RISK?

- Increase share holders value
ƒValue creation
ƒValue preservation
ƒCapital optimization
- Instill confidence in the market place
- Alleviate regulatory constraint and distortions there of.
CREDIT DERIVATIVES

A credit derivative is a financial instrument used to mitigate or to assume specific forms

of credit risk by hedgers and speculators. These new products are particularly useful for
institutions with widespread credit exposures. Some observers suggest that credit
derivatives may herald a new form of international banking in which banks resemble
portfolios of globally diversified credit risk more than purely domestic lenders.

CREDIT SWAPS

Corporate bonds trade at a premium to the risk-free yield curve in the same currency. US
Corporate Bonds trade at a premium (called a credit spread) to the US Treasury curve.
The credit spread is volatile in and of itself and it may be correlated with the level of
interest rates. For example, in a declining, low interest rate environment combined with
strong domestic growth, we might expect corporate bond spreads to be smaller than their
historical average. The corporate who has issued the bond will find it easier to service the
cash flows of the corporate bond and investors will be hungry for any kind of premium
they can add to the risk-free rate.

Imagine the fund manager who specializes in corporate bonds who has a view on the
direction of credit spreads on which he would like to act without taking a specific
position in an individual corporate bond or a corporate bond index.

One way for the fund manager to take advantage of this view is to enter into a credit
swap.

Let's say that the und

f manager believes that credit spreads are going to tighten and that
interest rates are going to continue to decline.

He would then want to enter into a swap in which he paid the corporate yield at six-
month intervals against receiving a fixed yield equal to the inception Treasury yield plus
the corporate credit spread. That is to say, at the six-month reset for the tenor of the swap,
the fund manager agrees to pay a cash flow determined to be equal to the current annual
yield on some benchmark corporate bond or corporate bond index in consideration for
receiving a fixed cash flow.

This is an off-balance sheet transaction and the swap will typically have zero value at
inception.

If corporate yields continue to fall (i.e. through a combination of a lower risk-free rate
and a lower corporate credit spread than the one he locked in with the swap), he will
make money. If corporate yields rise, he will lose money.

1998 was a dynamic year for corporate bond spreads with the backup in interest rates in
the aftermath of the Russian devaluation-inspired liquidity crisis concentrated mainly in
corporate yields. The volatility of these spreads was extreme when compared to their
historical movement. Credit swaps would have been an excellent way to play this spread
volatility.

Moreover, credit swaps (particularly ones based on a spread index) are clean structures
without the messy difficulty of finding individual corporate bond supply, etc.

Another example of a credit swap might be the exchange of fixed flows (determined by
the yield on a corporate bond at inception) against paying floating rate flows tied to the
risk-free Treasury rate for the corresponding maturity.

Naturally, swaps are flexible in their design. If you can imagine a cash flow exchange,
you can structure the swap. There might be a cost associated with it but you can certainly
put it on the books.

CREDIT DEFAULT SWAPS

A credit default swap is a swap in which one counterparty receives a premium at pre-set
intervals in consideration for guaranteeing to make a specific payment should a negative
credit event take place.

One possible type of credit event for a credit default swap is a downgrade in the credit
status of some preset entity.

Consider two banks: First Chilliwack Bank and Banque de Bas.

Chilliwack has made extensive loans in its corporate credit portfolio to a property
developer called Churchill Developments. It is looking for some kind of insurance
against a downgrade of Churchill by the major ratings agency, a real possibility since the
main project Churchill has taken on is running into unforeseen delays. Chilliwack
approaches Banque de Bas with the concept of a credit default swap. They pay Banque de
Bas a premium every six months for the next five years in exchange for which de Bas
agrees to make payments to Chilliwack of a pre-set amount should Churchill be
downgraded.

De Bas now has exposure to Churchill, a position they could not take directly because
they are not part of Churchill's lending syndicate.

Chilliwack has some degree of protection against a Churchill credit downgrade. This
reduction in their overall credit profile means that they do not need to hold as much
capital in reserve, freeing Chilliwack up to take other business opportunities as they
present themselves.

OPTIONS ON CREDIT RISKY BONDS

Finally, our fund manager from the first example could use an options position to take
advantage of his view on the level of the corporate yield.

If he believed that corporate yields were set to fall through some combination of lower
risk-free interest rates and tighter corporate bond spreads, then he could just buy a call on
a corporate bond of the appropriate maturity.

These are just a few of the examples of credit derivatives. Institutional investors often use
credit derivatives when positioning themselves in emerging markets for the ease of
transaction in the same way that they might use equity swaps. Fund managers can use
credit derivatives to hedge themselves against adverse movements in credit spreads.
Corporates can use credit swaps to hedge near-term issues of corporate bonds. Banks and
other financial institutions can use credit derivatives to optimize the employment of their
capital by diversifying their portfolio-wide credit risk.

3 .Profile of ICIC Credit Risk Management

Credit risk, the most significant risk faced by ICICI Bank, is managed by the Credit Risk
Compliance & Audit Department (CRC & AD) which evaluates risk at the transaction
level as well as in the portfolio context. The industry analysts of the department monitor
all major s`cto0s ald evolve a sectoral outlook, whqch as an important input to the
portfolio planning process. The department has done detailed studies on default patterns
of loans and prediction of defaults in the Indian context. Risk-based pricing of loans has
been introduced.

The functions of this department include:

• Review of Credit Origination & Monitoring

o Credit rating of companies/structures

o Default risk & loan pricing

o Review of industry sectors

o Review of large exposures in industries/ corporate groups/ companies

o Ensure Monitoring and follow-up by building appropriate systems such as

CAS
 • Design appropriate credit processes, operating policies & procedures

• Portfolio monitoring

o Methodology to measure portfolio risk

o Credit Risk Information System (CRIS)

• Focussed attention to structured financing deals

o Pricing, New Product Approval Policy, Monitoring

• Monitor adherence to credit policies of RBI

During the year, the department has been instrumental in reorienting the credit processes,
including delegation of powers and creation of suitable control points in the credit
delivery process with the objective of improving customer response time and enhancing
the effectiveness of the asset creation and monitoring activities.

Availability of information on a real time basis is an important requisite for sound risk
management. To aid its interaction with the strategic business units, and provide real time
information on credit risk, the CRC & AD has implemented a sophisticated information
system, namely the Credit Risk Information System. In addition, the CRC & AD has
designed a web-based

Risk Management Structure:

Centralized risk management with integrated treasury operations

- Board : Set risk limits

- Risk management committee:

o Identity, monitor and measure risk profile

o Develop policies and procedures

o Verifying pricing models

o Reviewing Risk Models

o Identify New Risks

o Risk Limites in terms of CAR – VAR

RISK MANAGEMENT STRUCTURE

Risk management Committee

Credit Policy Committee

Asset Liability Management
Committee
RISK IN LENDING

Risk in lending

Interest Rate Risk Forex Risk Credit Risk Counter Party Country Risk
Risk

Default Risk Portfolio Risk

Intrinsic Risk

Concentration Risk

INTRINSIS RISK:

- Deficiencies in Loan policies and procedures

- Absence of Prudential Credit conc. Limits
- Inadequately defined lending limits
- Deficiency in appraisal
- Excessive dependence collateral
- Inadequate risk pricing
- Absence of post sanction surveillance

CONCENTRATION RISK
 - State of Economy
- Volatility in
o Equity market
o Commodity Market
o Foreign Exchange Market
o Interest Rate
- Trade restriction
- Economic Sanction
- Government Policies

Instrument of Credit Risk Management

- Credit Approving Authority

- Prudential Limits
- Risk Rating
- Risk Pricing
- Portfolio Management
- Loan review mechanism

RISK RATING
- Rating reflects underlying credit risk of loan book
- Encompass industry risk, business risk, financial risk , risk management
- Specify cutoff standards/ critical parameters
- Separate rating framework for large corporate, small borrowers, traders etc..
- Account for un hedged market risk exposure of borrowers
4. Research Design
a. Research Objectives
The ultimate objective of this research is to critically evaluate the effect of the credit
risk on the financial institution especially in the banking sector and how these
organisations manage and control such risks. In the process of such evaluation, this
research will try to get an insight as to how the credit risk works, what their effects
on financial institution, and which tools and methods the financial institution use to
measure and control those risks.
To sum up, the research objectives are enlisted below:
1. To understand the specific types of credit risk and how to measure credit risk.
2. To identify the tools and methods which are used by financial institution and how
they safe guard financial institution against unexpected losses arising from credit risk.

b. Statement of the problem

In managing risk, financial institution must decide which risks to take, which to
transfer, and which to avoid altogether. Accepting credit risk, though, is
fundamentally the business of banking and other institutions and is the activity which
most banks see as their principal competitive advantage.

In recent years, leading banks have devoted increased attention to measuring credit
risk and have made important gains, both by employing innovative and sophisticated
risk modeling techniques and also by strengthening their more traditional practices.

From the above point of view, my research will focus on 1 basic question : How does
financial institution manages credit risk? To get a clear idea for the research question,
it will come up with extra questions such as : What is the type and role of credit risk
in financial institution? How are they measured? and What are methods and tools
does the financial use to manage and control the risk?

c. Needs and importance of the study

Because taking risk is an integral part of the financial institution system, it is not
surprising that banks have been practicing risk management ever since there have
been banks--the industry could not have survived without it. The only real change is
the degree of sophistication now required to reflect the more complex and fast-paced
environment.

Risk exists and banks as well as financial institutions must accept risk if they are to
thrive and meet an economy's needs. But they must manage the risks and recognize
them as real. Risk matters. Whether or not it is temporarily ignored, it will eventually
come out. Recognizing that fact and dealing with it will benefit lending institutions
and the economies in which they operate. Indeed, given globalization, we must all
adopt increasingly sophisticated risk management practices in the years ahead.

d. Methodology of data collection

The universe of the study was financial institutions, with respect to focus on banking
sector and credit department. Methodology is based on Primary Data and Secondary
information.

Primary Data:

The procedure followed in collection of primary data is through personal interview with
those who have knowledge in the credit risk control sector.

Secondary Data:

Secondary Data for credit risk management will be mainly collected from the available
press and issues of Bank for International Settlements , magazines, books, and internet.

Statistical tools and techniques for analysis:

- The data which is collected though both primary and secondary sources
will be tabulated on the datasheet.
- Various diagrams will be used with the help of appropriate statistical
techniques such as averages, percentages, regression, standard deviation
etc

e. Limitations of the study

- The study is subject to the views and statistics as expressed by the concerned officials of
the financial institution, especially the banking sector.

- The primary data collected for the research is limited to the few public financial
institutions only.

- The actual identity of financial institution is kept confidential due to the sensitive nature
of the topic.
5. Literature review

a. Purpose of review of literature.

The purpose of review of literature was to identify the problem statement, understand
the secondary data that has been gathered in this field of study and to make new
findings on the problem statement.

b. Methodology of the review of literature.

Methodology of literature review encompasses different facets of information

sources concerning credit risk management.

Sources of information for the literature review are as follows:

- Banking magazines
- Internet
- Newspaper publications and articles

Whatever is Happening to Indian Banking?

By C.P. Chandrasekhar (Financial News)

Currently, banks seem to be the prime targets of the government's reforming zeal.
Having encouraged foreign acquisition, consolidation and universalization in the
banking system, the Finance Ministry's current thrust seems to be to find a host of
new areas of activity for these institutions. According to unconfirmed reports, the
Reserve Bank of India (RBI) has approved a proposal from the government to amend
the Banking Regulation Act to permit banks to trade in commodities and commodity
derivatives. This offer to banks, of one more new avenue of speculative investment
by removal of a prohibition on commodity trading that has been in existence for long,
merely furthers the fundamental changes that have been under way in India's banking
sector.
These changes impinge upon the nature of the institutions, operations and instruments
that constitute the sector. Institutional changes include: a rapid increase in the number
of new private sector banks; a process of consolidation of banks that thus far has
principally affected the private banking sector but is now being consciously promoted
in the public sector as well; privatization of equity in public sector banks; mergers of
banks and other financial institutions, particularly development banking institutions;
and the creation of universal banks that are in the nature of financial supermarkets,
offering customers a range of products from across the financial sector such as debt
products, investment opportunities in equity, debt and commodity markets and
insurance products of different kinds.

Implicit in these institutional changes are changes in the operations of the

increasingly ''universalized'' banks. The most crucial change has been an increasing
reluctance of banks to play their traditional role as agents who carry risks in return for
a margin defined broadly by the spread between deposit and lending rates.
Traditionally, banks accepted small deposits that highly liquid investments protected
against capital and income risk. They in turn made large investments in highly illiquid
assets characterized by a significant degree of capital and income risk. This made
banks crucial intermediaries for facilitating the conversion of savings into investment.

Given this crucial role of intermediation conventionally reserved for the banking
system, the regulatory framework which had the central bank at is apex, sought to
protect the banking system from possible fragility and failure. That protective
framework across the globe involved regulating interest rates, providing for deposit
insurance and limiting the areas of activity and the investments undertaken by the
banking system. The understanding was that banks should not divert household
savings place in their care to risky investments promising high returns. In developing
countries, the interventionist framework also had developmental objectives and
involved measures to direct credit to what were ''priority'' sectors in the government's
view.
In recent years, liberalization and ''denationalization'' have changed all that and forced
a change in banking practices in two ways. First, private players are unsatisfied with
returns that are available within a regulated framework, so that the government and
the central bank have had to dilute or dismantle regulatory measures as is happening
in the case of priority lending as well as restrictions on banking activities in India.
Second, even public sector banks find that as private domestic and foreign banks,
particularly the latter, lure away the most lucrative banking clients because of the
special services and terms they are able to offer, they have to seek new sources of
finance, new activities and new avenues for investments, so that they can shore up
their interest incomes as well as revenues from various fee-based activities.

In sum, the processes of liberalization noted above fundamentally alter the terrain of
operation of the banks. Their immediate impact is a visible shift in the focus of bank
activities away from facilitating commodity production and investment to lubricating
trade and promoting personal consumption. Interest rates in these areas are much
higher than that which could be charged to investments in commodity production.
According to a study (Consumer Outlook 2004), conducted by market research firm
KSA Technopak, Indian consumers are increasingly financing purchases of their
dream products with credit that is now on offer, even without collateral. "Personal
credit offtake has increased from about Rs 50,000 crore in 2000 to Rs 1,60,000 crore
in 2003, giving an unprecedented boom to high-ticket item purchases such as housing
and automobiles," the study reportedly found.

But there are changes also in the areas of operation of the banks, with banking entities
not only creating or linking up with insurance companies, say, but also entering into
other ''sensitive'' markets like the stock and real estate
rkets.
ma It should be expected
that this growing exposure to non-collateralized personal debt and entry into sensitive
sectors would increase bank vulnerability to default or failure. The effects on bank
fragility became clear after the stock scam of the late 1990s. The RBI's Monetary and
Credit Policy Statement for the year 2001-2002 had noted that: ''The recent
experience in equity markets, and its aftermath, have thrown up new challenges for
the regulatory system as well as for the conduct of monetary policy. It has become
evident that certain banks in the cooperative sector did not adhere to their prudential
norms nor to the well-defined regulatory guidelines for asset-liability management
nor even to the requirement of meeting their inter-bank payment obligations. Even
though such behaviour was confined to a few relatively small banks by national
standards, in two or three locations, it caused losses to some correspondent banks in
addition to severe problems for depositors.''

Interestingly, this increase in financial fragility has been accompanied by the

emergence of new instruments in the banking sector. Derivatives of different kinds
are now traded in the Indian financial system, including crucially, credit derivatives.
Most derivatives, financial instruments whose value is based on or derived from the
value of something else, are linked to interest rates or currencies. Credit derivatives
are based on the value of loans, bonds or other lending instruments.

A working group of the Reserve Bank of India had recommended in 2003 that
scheduled commercial banks may initially be permitted to use credit derivatives only
for managing their credit risks. But banks were not permitted to take long or short
credit derivative positions with a trading intent. Credit derivatives were seen as
helping banks manage the risk arising from adverse movements in the quality of their
loans, advances, and investments by transferring that risk to a protection seller. Using
credit derivatives banks can: (1) transfer credit risk and, hence, free up capital, which
can be used in other opportunities; (2) diversify credit risk; (3) maintain client
relationships, and (4) construct and manage a credit risk portfolio as per their risk
preference.

Banks in India have quickly responded to this opportunity. For example, soon after
the introduction of interest rate futures in India, Citigroup concluded three
securitization deals worth Rs 570 crore ($126.6 million), where yields on government
securities or the call money rate, were used as the benchmark for pricing floating rate
payments for investors. The underlying receivables arise from a large number of fixed
rate loan contracts made for financing commercial vehicles and construction
equipment. The risk here is being shared with mutual funds, who are reportedly the
major investors.

Even the conservative State Bank of India (SBI) has taken a plunge into the credit
derivatives market to cope with the risk arising from its growing loan portfolio. The
bank had recorded a growth of almost Rs 36,000 crore or 25 per cent in its loan
portfolio on a year-on-year basis till September 2004, staring from a total loan assets
position of Rs 1,35,000 crore in the corresponding period of the previous year. Of this
credit growth recorded by the bank, more than 40 per cent had been contributed by
retail assets. Credit derivatives offered an opportunity to hedge against the risks being
accumulated in this manner.

It should be clear that credit derivatives are an industry response to the increasing
fragility which comes with the changed nature of banking practices. Derivatives of
this kind permit the socialization of the risks associated with the liberlaization-
induced transformation of banking. These trends are in keeping with changes in the
international banking industry as well. As The Economist, London, put it: ''The
world's leading banks decided some years ago that lending is a mugs' game. They
began to get rid of their loans, repackaging them and selling them off as securities, or
getting others to re-insure their risk.''

From the point of view of the banks this effort has been extremely fruitful. Thus,
when there was a major melt down in corporate America, as a result of financial fraud
and accounting malpractice, leading to the closure of giants like Enron and
WorldCom, leading banks that had lent large sums to them appeared unaffected.
According to one estimate, loans totalling $34 billion were wiped out through these
bankruptcies. But far less amounts showed up as losses in the bank's accounts and, in
the second quarter of 2003, Citigroup reported a 12 per cent increase in profits and
J.P. Morgan Chase a 78 per cent increase.
 It should be clear that these losses have to show up somewhere in the accounts of the
financial system, but as the Bank of International Settlements (BIS) argued, it is not
easy to trace them. ''The markets lack transparency about the ultimate distribution of
credit risks,'' it declared. One reason could be that these losses were being borne by
insurance companies, which would be treating them like any other casualty loss so
that they are not identifiable. The BIS sees this conundrum as being the result of the
substantial growth of the practice of credit-risk transfer—the shifting of risk from
banks on to the buyers of securities and loans, and on to the sellers of credit
insurance.

In sum, the traditional image of the great banks with armoured vaults has little to do
with the banks of today. The latter appear to make loans and then pass them on as
quickly as possible, pocketing the margin. That allows them to take bigger risks in
trading securities, derivatives, and foreign exchange. But these risks do not go away.
At the end of 2002, though non-bank entities accounted for just 10 percent of the
syndicated loan market in the US, they held 22.6 per cent of the bad or doubtful
loans. The same is now happening in India, increasing the fragility of a host of non-
bank financial institutions, such as pension funds, mutual funds and life-insurance
companies. Unfortunately, rather than recognise this danger, the Finance Ministry is
keen on ensuring changes of the kind described above through a State-directed
process of financial engineering. The full implications of the resulting changes would
be revealed only in the days to come. But the experience elsewhere provides cause for
concern.

Presentation at Basel British Swiss Chamber of Commerce, Basel, 2 February 2004

During those years I was part of the International Monetary Research Programme that
was operated jointly by the LSE and the Graduate Institute of International Studies at the
University of Geneva. That experience taught me both about international finance and
about the special challenges confronting the Swiss economy in Europe, and on the
broader global stage.

So it has been a special pleasure for me to renew my work in both these areas since my
arrival here in Basel 10 months ago.

Promoting the twin goals of sustained non-inflationary economic growth and financial
stability has been the overarching mission of the BIS throughout its history. And this is
what I want to talk to you about today.

But first let me say just a few words about what the BIS is and does. The Bank was
founded in 1930, making it world’s oldest international financial institution. Its
immediate task was to act as trustee and agent for the international loans intended to
finalise settlement of the reparations stemming from World War I – hence the name: the
Bank for International Settlements. However, this name did not fully reflect the nature of
the Bank’s primary m ission even in 1930, and it certainly does not do so today.

The primary intention of the Bank’s founders’ was to create a focus for cooperation
among central banks. First, the BIS was to act as the bank for central banks. It would
accept deposits of a portion of the foreign exchange reserves of central banks and invest
them prudently to yield a market return. We still do this today, managing a balance sheet
of some USD 230 billion, equivalent to about CHF 290 billion.

The second important role of the BIS is to provide a forum for policy discussions and
international cooperation among central banks. Over the years, the BIS has established a
rich structure of meetings in which governors and other senior central bankers can
exchange information and opinions on the state of the world economy and its
implications for monetary and financial stability policies.

And the solid foundations for these discussions are the economic analysis and statistical
work that are performed by the BIS staff.
I think it is no exaggeration to say that – through these activities – the BIS has left an
indelible mark on the history of international financial cooperation over the past seven
decades. Let me just take three examples from the years following World War II.

First, I think of the reconstruction of Europe after the Second World War. Back in 1950,
the BIS was asked to become the agent of the European Payments Union, which was
established to restore order to the system of payments for imports and exports among the
countries of Europe in the early postwar years. The EPU was highly successful:
multilateral convertibility of the European currencies in international payments for
current goods and services was restored earlier than foreseen. And in 1958, its task
completed, the EPU was wound up – a true success story!

My second example relates to the monetary unification of Europe. From the mid-1970s to
the early 1990s, the BIS was the key meeting place for European central bankers as they
laid the groundwork for monetary union. Some of you will remember the Delors Report,
which outlined the essential blueprint for the creation of a unique new European
Monetary Union and the establishment of a European Central Bank. The Report was
drafted in the late 1980s, here in Basel, in a meeting room on the first floor of the BIS.

My third example is the creation, by central bank governors, of a number of key

permanent committees of experts on various aspects of the international monetary and
financial system. Let me give just one illustration. In the early 1970s, discussions about
how to enhance prudential supervision of the commercial banking industry resulted in the
creation of the Basel Committee on Banking Supervision. This influential Committee has
flourished, and is now in the process of finalising the so-called Basel II Accord. I will say
more about this shortly.

I could give you many other illustrations of the contributions that the BIS has made to
international financial cooperation.

But I would prefer to talk about two broad trends that have motivated most of our
initiatives in this arena over the past decade. One trend is the increasing globalisation of
economic and financial activity. The other trend is the greatly increased focus on the
promotion of financial stability, in all countries, both developed and developing.

The globalisation of markets for final goods, financial and non-financial services, and
even factors of production has been one of the most striking developments of at least the
past two decades.

And it is perhaps in the area of financial services that one can find some of the most
compelling evidence of the impact of globalisation. In the early 1980s, cross-border
transactions in securities in the major industrial countries represented less than 10% of
GDP. Today, these transactions swamp GDP in most of them.

As of the end of 2002, the stock of cross-border claims on the books of banks in the
major financial centres was close to USD 14 trillion. To put this in perspective: it is
equivalent to just under half of the annual output of the total world economy in 2002.

The other key trend, the increased focus on the promotion of financial stability, is closely
tied to the first issue of globalisation, and has very much shaped the activities of the BIS
in recent years. Our concern to promote financial stability involves not only the
promotion of price stability, but also support for deep and robust financial markets, for
sound financial institutions, and for a stable overall infrastructure for the financial
industry.

Why worry about these elements of a stable financial system in a modern market
economy? Well, I am convinced that, over the long term, economic and financial systems
based on open competition and global market forces can achieve outcomes that are far
superior to those possible in a highly regulated and controlled environment.

But that said, such market-based systems can, and do, display elements of vulnerability.
Markets can be dysfunctional and they can be subject to failures and breakdowns.
Investor and borrower behaviour does not always produce sufficiently deep and liquid
markets, or prices that consistently reflect economic fundamentals. And, as we have seen
in the cases of Enron and, more recently, Parmalat, the essential tools of transparency and
oversight that financial markets require – the standards of accounting, reporting and
auditing practices applied to financial transactions – can be unacceptably deficient.

When financial stability is lost, the costs can be grave not only for the country in which
the financial turmoil emerges, but also for the international financial system as a whole.
We saw this in the 1990s when confidence in international capital flows was shaken. First
the Mexican crisis in 1994/95 and then the Asian crisis in 1997/98 undermined the
confidence of international investors and imposed significant economic and social costs
on all affected countries.

In order to foster a global dialogue, the BIS has enlarged its membership since the mid-
1990s, to move from an exclusive focus on the industrial countries to include, by the
beginning of the new millennium, the central banks of a number of large and systemically
important emerging market countries. Now, alongside the Chairmen or Governors of the
US Federal Reserve Board, the ECB or the Bank of Japan, the Governors of the People’s
Bank of China, the Central Bank of Brazil, the Reserve Bank of India and other
systemically important emerging economies participate actively in the meetings we
organise, whether in Basel, through our offices in Hong Kong SAR and Mexico, or in
collaboration with central banks around the world.

Financial stability issues occupy a prominent place on the agenda of central bank
governors when they meet every other month at the BIS. Central banks are not directly
responsible for each and every aspect of financial stability, but they are the guardians of
the overall soundness of their national financial systems. And so they attach great
importance to the careful monitoring of the various building blocks of the financial
system.

Finally, let me focus on one of these building blocks which is now very much in the
news: promoting the soundness of commercial banks.

Banks are among the most important players in the global financial system. They process
enormous volumes of payments resulting from countless transactions in the economy
each day. They safeguard our savings and circulate credit, the lifeblood of any economy,
to businesses and consumers alike.

Commercial banks clearly play a special role in the workings of the financial system.
And so central bankers take a special interest in encouraging all banks to operate safely
and soundly. And today, central bank governors – and bank regulators – are working hard
to reform one of the most important tools that they have to encourage banks to operate
safely. This challenge is known in financial circles as the Basel II process. What exactly
is this about?

The challenge is to promote sound risk management practices in banks in a way that
ensures that they are adequately capitalised and prudently managed – while not hindering
a bank’s ability to pursue opportunities and profits responsibly. Well capitalised and well
managed banks can serve as efficient intermediaries of credit, not only in good times, but
also in periods of strain.

Currently, banks are subject to rules regarding their capitalisation that were first adopted
by the Basel Committee in 1988. The rules are quite simple. The 1988 Basel Accord
stipulated that internationally active banks should hold an amount of capital that is
roughly in line with simple measures of the riskiness of their assets, and that all banks
should be subject to the same capital charges – the aim being to create a level playing
field. The Accord was originally designed for the internationally active banks of the most
advanced financial systems, but its appeal has been such that more than 100 countries
have adopted it to date.

Unfortunately, the simplicity of the 1988 Accord has also proved to be a weakness.
Advances in methodology, technology and telecommunications have changed the way in
which banks measure and manage their risks. Financial innovations have introduced new
banking products, many of which the 1988 Accord had not anticipated or did not address.

Over the past five years, the Basel Committee has been working to develop a New
Capital Accord, or “Basel II”. The New Accord is intended to reflect the improvements in
banks’ abilities to measure risk. It is also intended to align regulatory capital
requirements more closely with the actual degree of risk that banks face. But equally
important, the New Accord will provide incentives to banks to improve their
management of risk.

The Basel II process has not been easy. The Basel Committee has tackled some
extremely complex issues. It has consulted widely and openly with banks, with industry
associations and with other stakeholders, to improve the proposals and build the
necessary support for them.

But the efforts have already proved worthwhile. Both commercial bankers and central
bankers have acknowledged the need for a New Accord and have offered strong support
to the Committee’s efforts. Currently, the Committee expects to resolve the outstanding
issues by mid-2004, which will allow banks and countries to continue to prepare for its
implementation.

In closing, let me leave you with this thought: in a world of change and innovation,
promoting financial stability must be seen not only as a continuous process, but also as a
multifaceted challenge that calls for strong commitment to open and honest international
cooperation. The BIS remains committed to this mission, which has evolved and gained
importance since we first opened our doors in 1930. And this is likely to keep us in Basel
for a long time to come

Challenges the Indian banks face

February 17, 2005

It is by now well recognised that India is one of the fastest growing economies in the
world.

Evidence from across the world suggests that a sound and evolved banking system is
required for sustained economic development. India has a better banking system in place
vis a vis other developing countries, but there are several issues that need to be ironed
out.

In this article, we try and look into the challenges that the banking sector in India faces.

Interest rate risk

Interest rate risk can be defined as exposure of bank's net interest income to adverse
movements in interest rates. A bank's balance sheet consists mainly of rupee assets and
liabilities. Any movement in domestic interest rate is the main source of interest rate risk.

Over the last few years the treasury departments of banks have been responsible for a
substantial part of profits made by banks. Between July 1997 and Oct 2003, as interest
rates fell, the yield on 10-year government bonds (a barometer for domestic interest rates)
fell, from 13 per cent to 4.9 per cent. With yields falling the banks made huge profits on
their bond portfolios.

Now as yields go up (with the rise in inflation, bond yields go up and bond prices fall as
the debt market starts factoring a possible interest rate hike), the banks will have to set
aside funds to mark to market their investment.

This will make it difficult to show huge profits from treasury operations. This concern
becomes much stronger because a substantial percentage of bank deposits remain
invested in government bonds.

Banking in the recent years had been reduced to a trading operation in government
securities. Recent months have shown a rise in the bond yields has led to the profit from
treasury operations falling. The latest quarterly reports of banks clearly show several
banks making losses on their treasury operations. If the rise in yields continues the banks
might end up posting huge losses on their trading books. Given these facts, banks will
have to look at alternative sources of investment.

Interest rates and non-performing assets

The best indicator of the health of the banking industry in a country is its level of NPAs.
Given this fact, Indian banks seem to be better placed than they were in the past. A few
banks have even managed to reduce their net NPAs to less than one percent (before the
merger of Global Trust Bank into Oriental Bank of Commerce, OBC was a zero NPA
bank). But as the bond yields start to rise the chances are the net NPAs will also start to
go up. This will happen because the banks have been making huge provisions against the
money they made on their bond portfolios in a scenario where bond yields were falling.

Reduced NPAs generally gives the impression that banks have strengthened their credit
appraisal processes over the years. This does not seem to be the case. With increasing
bond yields, treasury income will come down and if the banks wish to make large
provisions, the money will have to come from their interest income, and this in turn, shall
bring down the profitability of banks.

Competition in retail banking

The entry of new generation private sector banks has changed the entire scenario. Earlier
the household savings went into banks and the banks then lent out money to corporates.
Now they need to sell banking. The retail segment, which was earlier ignored, is now the
most important of the lot, with the banks jumping over one another to give out loans. The
consumer has never been so lucky with so many banks offering so many products to
choose from. With supply far exceeding demand it has been a race to the bottom, with the
banks undercutting one another. A lot of foreign banks have already burnt their fingers in
the retail game and have now decided to get out of a few retail segments completely.

The nimble footed new generation private sector banks have taken a lead on this front
and the public sector banks are trying to play catch up.

The PSBs have been losing business to the private sector banks in this segment. PSBs
need to figure out the means to generate profitable business from this segment in the days
to come.

The urge to merge

In the recent past there has been a lot of talk about Indian Banks lacking in scale and size.
The State Bank of India is the only bank from India to make it to the list of Top 100
banks, globally. Most of the PSBs are either looking to pick up a smaller bank or waiting
to be picked up by a larger bank.

The central government also seems to be game about the issue and is seen to be
encouraging PSBs to merge or acquire other banks. Global evidence seems to suggest
that even though there is great enthusiasm when companies merge or get acquired,
majority of the mergers/acquisitions do not really work.

So in the zeal to merge with or acquire another bank the PSBs should not let their
common sense take a back seat. Before a merger is carried out cultural issues should be
looked into. A bank based primarily out of North India might want to acquire a bank
based primarily out of South India to increase its geographical presence but their cultures
might be very different. So the integration process might become very difficult.
Technological compatibility is another issue that needs to be looked into in details before
any merger or acquisition is carried out.

The banks must not just merge because everybody around them is merging. As Keynes
wrote, "Worldly wisdom teaches us that it's better for reputation to fail conventionally
than succeed unconventionally". Banks should avoid falling into this trap.

Impact of BASEL-II norms

Banking is a commodity business. The margins on the products that banks offer to its
customers are extremely thin vis a vis other businesses. As a result, for banks to earn an
adequate return of equity and compete for capital along with other industries, they need
to be highly leveraged.

The primary function of the bank's capital is to absorb any losses a bank suffers (which
can be written off against bank's capital).
Norms set in the Swiss town of Basel determine the ground rules for the way banks
around the world account for loans they give out. These rules were formulated by the
Bank for International Settlements in 1988.

Essentially, these rules tell the banks how much capital the banks should have to cover up
for the risk that their loans might go bad. The rules set in 1988 led the banks to
differentiate among the customers it lent out money to. Different weightage was given to
various forms of assets, with zero per centage weightings being given to cash, deposits
with the central bank/govt etc, and 100 per cent weighting to claims on private sector,
fixed assets, real estate etc.

The summation of these assets gave us the risk-weighted assets. Against these risk
weighted assets the banks had to maintain a (Tier I + Tier II) capital of 9 per cent i.e.
every Rs100 of risk assets had to be backed by Rs 9 of Tier I + Tier II capital. To put it
simply the banks had to maintain a capital adequacy ratio of 9 per cent.

The problem with these rules is that they do not distinguish within a category i.e. all
lending to private sector is assigned a 100 per cent risk weighting, be it a company with
the best credit rating or company which is in the doldrums and has a very low credit
rating.

This is not an efficient use of capital. The company with the best credit rating is more
likely to repay the loan vis a vis the company with a low credit rating. So the bank should
be setting aside a far lesser amount of capital against the risk of a company with the best
credit rating defaulting vis a vis the company with a low credit rating. With the BASEL-
II norms the bank can decide on the amount of capital to set aside depending on the credit
rating of the company.

Credit risk is not the only type of risk that banks face. These days the operational risks
that banks face are huge. The various risks that come under operational risk are
competition risk, technology risk, casualty risk, crime risk etc. The original BASEL rules
did not take into account the operational risks. As per the BASEL-II norms, banks will
have to set aside 15 per cent of net income to protect themselves against operational risks.
So to be ready for the new BASEL rules the banks will have to set aside more capital
because the new rules could lead to capital adequacy ratios of the banks falling. How the
banks plan to go about meeting these requirements is something that remains to be seen.
A few banks are planning initial public offerings to have enough capital on their books to
meet these new norms.

In closing

Over the last few years, the falling interest rates, gave banks very little incentive to lend
to projects, as the return did not compensaTe them for the risk involved. This led to the
banks getting into the retail segment big time. It also led to a lot of banks playing it safe
and putting in most of the deposits they collected into government bonds. Now with the
bond party over and the bond yields starting to go up, the banks will have to concentrate
on their core function of lending.

The banking sector in India needs to tackle these challenges successfully to keep growing
and strengthen the Indian financial system.

Furthermore, the interference of the central government with the functioning of PSBs
should stop. A fresh autonomy package for public sector banks is in offing. The package
seeks to provide a high degree of freedom to PSBs on operational matters. This seems to
be the right way to go for PSBs.

The growth of the banking sector will be one of the most important inputs that shall go
into making sure that India progresses and becomes a global economic super power.

The author is Resear#h Schol!r, ICFAI University

PART B. SURVEY AND FINDINGS

1. Percentage of credit compared to other risks in ICICI Bank

 10%
5% Credit Risk

Market Risk
10%
Liquidity Risk

60% Operational
15% Risk
Other Risk

Interpretation:

From the table it is clear that the credit risk is the main risk being faced by ICICI Bank. It
is accounted of 60% compared to the other risk

2. Frame work of risk weighting.

ASSESSMENT

Claim AAA to A+ to A- BBB+ to BB+ to B- Below B- Unrated

AA- BBB-

Sovereign 0% 20% 50% 100% 150% 100%

Bank 20% 50% 100% 100% 150% 100%

Corporate 20% 100% 100% 100% 150% 100%

Interpretation:

From the table, we can see that under the lowest risk rating ( AAA to AA) the bank and
corporate are riskier than sovereign. Come to next rating the corporate exposure
accounted for the highest risk weighting which is 100% compared to 50% and 20% for
Bank and Sovereign respectively. However under the rating from BB+ to unrated, all the
claims are facing the same risk weighted. The highest risk weighted comes under the
rating of below B-.

3.Instrument type with respected to information required.

Instrument types Information required

Bonds Credit spreads by ratings categories

Loans Credit Spreads

Receivable Credit Spreads

Letter of Credits Credit Spreads

Loans of commitments Credit Spreads, commission fees,

Market Driven Instruments ( swap, future, Credit Spreads, exposures based volatility
etc..) of underlying market rates

Interpretation

The revaluation of those instruments with respected to its information required allows us
to treat a variety of product type

4. Transition Matrix
 Next Year’s Rating

AAA AA A BBB BB B CCC Default

%
AAA 90.81 8.33 0.68 0.06 0.12 0.00 0.00 0.00

AA 0.70 90.65 7.79 0.64 0.06 0.14 0.02 0.00

Today’
s
A 0.09 2.27 91.05 5.52 0.74 0.26 0.02 0.06
Rating
BBB 0.02 0.33 5.95 86.93 5.30 1.17 0.12 0.18

BB 0.03 0.14 0.67 7.73 80.53 8.84 1.00 1.06

B 0.00 0.11 0.24 0.43 6.48 83.46 4.07 5.20

CCC 0.22 0.00 0.22 1.30 2.38 11.24 64.86 19.79

Defaul 0.00 0.00 0.00 0.00 0.00 0.00 0.00 100.00

t

Interpretation

From the number given in the above table, we will know change in the percentage of
credit rating from the current to the future time. Most of the rating will change except
the default category.
90,81 % of chance to be remain the same in case of AAA while 90.65%, 91.05%,
86.93%, 80.53%, 83.46%, 64.86%, in case of AA, A, BBB, BB, B, CCC respectively
and 100% for the default.

A transition matrix tells us how likely is an issuer to change credit rating over a give
time horizon based on historical ratings data.

Top 5 Concern for credit risk management

Implementing risk-based pricing

Meeting local regulatory guidance

on loan grading/internal ratings

Integration of credit risk into

business processes

Methodology for internal ratings

model development

Data gathering for internal ratings

model development

0 20 40 60 80
Interpretation.

From the above charts, we can see that the highest percentage 59% of credit risk
management based on the data gathering for internal ratings model development and only
around 35% of using implementing risk based pricing. The methodology for internal
ratings model developments accounted of 48% and 39% using integration of credit risk in
business processes.

6.