ASSET QUALITY MANAGEMNENT Introduction Asset quality is one of the most critical areas in determining the overall condition

of a bank. The primary factor effecting overall asset quality is the quality of the loan portfolio and the credit administration program. Loans are usually the largest of the asset items and can also carry the greatest amount of potential risk to the bank's capital account. Securities can often be a large portion of the assets and also have identifiable risks. Other items which impact a comprehensive review of asset quality are other real estate, other assets, offbalance sheet items and, to a lesser extent, cash and due from accounts, and premises and fixed assets. Management often expends significant time, energy, and resources on their asset portfolio, particularly the loan portfolio. Problems within this portfolio can detract from their ability to successfully and profitably manage other areas of the institution. Examiners need to be diligent and focused in their review of the various asset quality areas, as they have an important impact on all other facets of bank operations. Evaluation of Asset Quality The asset quality rating reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, other real estate owned, and other assets, as well as off-balance sheet transactions. The ability of management to identify, measure, monitor, and control credit risk is also reflected here. The evaluation of asset quality should consider the adequacy of the Allowance for Loan and Lease Losses (ALLL) and weigh the exposure to counterparty, issuer, or borrower default under actual or implied contractual agreements. All other risks that may affect the value or marketability of an institution's assets, including, but not limited to, operating, market, reputation, strategic, or compliance risks, should also be considered. Prior to assigning an asset quality rating, several factors should be considered. The factors should be reviewed within the context of any local and regional conditions that might impact bank performance. Also, any systemic weaknesses, as opposed to isolated problems, should be given appropriate consideration. The following is not a complete list of all possible factors that may influence an examiner's assessment; however, all assessments should consider the following: • The adequacy of underwriting standards, soundness of credit administration practices, and appropriateness of risk identification practices. • The level, distribution, severity, and trend of problem, classified, nonaccrual, restructured, delinquent, and nonperforming assets for both on- and off-balance sheet transactions. • The adequacy of the allowance for loan and lease losses and other asset valuation reserves. • The credit risk arising from or reduced by off-balance sheet transactions, such as unfunded commitments, credit derivatives, commercial and standby letters of credit, and lines of credit. • The diversification and quality of the loan and investment portfolios. • The extent of securities underwriting activities and exposure to counterparties in trading activities. • The existence of asset concentrations. • The adequacy of loan and investment policies, procedures, and practices. • The ability of management to properly administer its assets, including the timely identification and collection of problem assets. • The adequacy of internal controls and management information systems. • The volume and nature of credit documentation exceptions. As with the evaluation of other component ratings, the above factors, among others, should be evaluated not only according to the current level but also considering any ongoing trends. The same level might be looked on more or less

favorably depending on any improving or deteriorating trends in one or more factors. The examiner should never look at things in a vacuum, instead, noting how the current level or status of each factor relates to previous and expected future performance and the performance of other similar institutions. Asset quality in banks improve considerably Gross NPAs (non-performing assets) in Indian banking sector have declined sharply to close to 3.0 per cent in 2006 (15.7 per cent at end-March 1997). Net NPAs of the banking sector are now at close to one per cent and the gap between the gross and net NPAs has narrowed over the years. Recovery of dues is also more than the fresh slippages. The decline in NPAs is particularly significant as income recognition, asset classification and provisioning norms were tightened over the years. For instance, banks now follow 90-day delinquency norm as against 180-day earlier. An asset is now treated as doubtful if it remains unpaid for more than 120 days instead of 180 days earlier. Banks are also required to make general provisioning (0.40 per cent) for standard advances, barring banks direct advances to agricultural and SME sector. The general provisioning requirement is 1.0 per cent for certain sensitive sectors. According to Reserve Bank of India, improved profitability, underpinned by robust macroeconomic environment and upturn in interest rate cycle, has enabled banks to reduce the backlog of NPAs. Improvement in the credit appraisal process and new institutional mechanisms created by the Government and the Reserve Bank for resolution of NPAs (including enactment of the Securitizations and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002; Lok Adalats; debt recovery tribunals; and corporate debt restructuring mechanism) have also played a significant role. Although asset quality in the banking system has improved considerably over the years, ,banks need to guard against any deterioration of credit quality, particularly in the wake of significant expansion of credit. RBI feels that Banks need to have a comprehensive system in which the process of risk monitoring is combined with proper risk assessment. This would entail creation and maintenance of an appropriate data base on risk assessment and credit extended, which would be required to be updated periodically. The enactment of the Credit Information Companies (Regulation) Act is an important development in this regard. As the Reserve Bank issues guidelines for such companies to be formed, the availability of credit information to banks can be expected to increase over time. This should help significantly in risk assessment and monitoring, thereby leading to lower transaction costs. NPAs of the Indian banking system are now comparable to several advanced economies and significantly lower than several economies in the Asian region. RBI rates reduction in non-performing assets (NPAs) as one of the major achievements of the Indian banking sector in recent years. Overview of asset quality In evaluating asset quality, examiners will look at the existing and potential loss exposure, primarily in your loan portfolio, but also in the investment portfolio and other assets as well. As with every CAMELS component, we put a lot of weight on management’s ability to recognize and control portfolio risk. Even if your bank has very few adversely classified assets, asset quality could still be rated less than satisfactory because management is not adequately controlling the potential credit risks. Keep in mind, our conclusions about asset quality will directly impact the other component areas, such as capital, earnings, and especially management. Evaluation Factors The assessment of asset quality involves much more than simply calculating past due and adverse classification ratios. In addition to assessing trends in classified assets, delinquent loans, and credit concentrations, the asset quality component rating takes into account management’s ability to underwrite and

administer credits in a prudent and sound manner. What Should a Director Do? As directors, you have four primary responsibilities in the asset quality area: 1. Adopt effective policies before loans are made 2. Enforce those policies as the loans are made 3. Monitor the portfolio after the loans are made 4. Maintain an adequate Allowance for Loan and Lease Losses (ALLL)

1. Adopt Effective Loan Policies In today’s environment, the need for effective policies is more critical than ever before. New products, new regulations, merger activity, etc. require that the board effectively convey their risk tolerance to the loan officers. Make sure it is your credit culture that the loan officers are adhering to, not their previous employer. Listed below are other items to keep in mind as you annually revise your loan policy. • Send a clear message - Don’t confuse your loan officers with a loan policy that sounds conservative when management stresses growth. Whatever your plan is, use your policies as a guide to achieve that plan. • Customize your policies to suit your institution - There is no “one size fits all” loan policy just like there is no “one size fits all” for an audit program or business resumption plan. While examiners don’t expect boards to reinvent the wheel, you will still need to take a generic policy and tailor it to your own size, products, risk tolerance, etc. 2. Enforce Adherence to the Loan Policies The two largest aspects of enforcing policy adherence are (1) requiring loan officers to provide comprehensive credit memos/write-ups to the loan committee during the approval process that identify exceptions to the loan policy, and (2) ensuring that an effective loan review function is in place to review the loans after they are approved (discussed below). Loan officers should be required to address exceptions to the loan policy in their credit approval memos/write-ups. The loan officers should explain why the exceptions are necessary and how the exposure is mitigated. This gives you and/or other approving officials the ability to track exceptions in monthly reports and ensures that the loan officers are familiar with the policy. Keep in mind that loan officers have been known to deliberately structure loans to avoid bringing them to loan committee. This exposure can be mitigated by requiring your bank’s loan review process to review smaller loans, under the loan committee threshold, for exceptions to the loan policy. 3. Monitor the Loan Portfolio After loans are made, directors should be monitoring the portfolio to determine if the credits are being administered properly and what the overall condition of the portfolio is. At a minimum, directors should provide for an effective credit review program and review a variety of management reports on the loan portfolio during the board meetings. • Management Reports - The monthly board packages should include a variety of loan reports, including a watch list detailing all problem or potentially problem credits. The package should also contain a delinquency report, a listing of new and renewed credits, the results of the internal or external loan reviews, and asset concentration reports. The board should require management to explain changes or trends and should require accuracy and objectivity in the reports. For example, an examiner should rarely be the one to convey bad news regarding a credit. If your loan officers and management teams are truly monitoring their portfolios, then they should be the first to downgrade credits. Having a lot of downgrades at an examination indicates an internal control weakness that will impact not just the asset quality rating but also the management component rating.

• Loan Review Systems – Every bank should have a loan review system that, among other things, accurately assigns risk ratings and promptly identifies loans or industries that are developing credit weaknesses. This allows senior management and the board to take appropriate action to mitigate risks and provides them with the information needed to assess the adequacy of the ALLL. The complexity of the loan review process will vary based upon a bank’s size and type of operations and could be performed internally or externally. Directors should ensure that the scope of the loan review covers all significant credits or pools of credits. Besides large loans and known problem credits, you might want your credit review to target loans from a specific branch, department, or officer - especially if they have generated an unusually large amount of business. The review could also focus on concentrations to a particular industry or collateral type, or areas that the board has deemed to be a higher risk. Expect management to address all of the concerns identified in the loan review reports and expect status reports and timelines for correction in an audit tracking report. 4. Maintain an Adequate ALLL The board and management are responsible for maintaining an allowance for loan and lease losses that is adequate relative to the estimated credit losses in the loan portfolio.The adequacy of the ALLL should be evaluated at least quarterly based on a comprehensive analysis of the portfolio, including the loan review process that we discussed above. The ALLL analysis should include all significant, classified, and past due credits, with the remaining portfolio segmented into separate components based on similar characteristics, such as grade, loan type, etc. While historical loss experience provides a reasonable starting point for the analysis, this is not a sufficient basis for determining an appropriate ALLL. The ALLL analysis should also consider factors such as: • Changes in lending procedures and/or staff • Changes in the nature and volume of loans • Trends in past due and adversely classified credits • The existence of credit concentrations • Changes in local and national economic conditions Concentrations We’ve mentioned concentrations several times throughout this exercise. This is certainly an area that regulators are concerned with and is an area that is starting to receive more attention. A concentration is a large volume of economically related assets by borrower, industry, or collateral type. Concentrations are not necessarily a reflection of inadequate management; they are oftentimes created by factors such as location, economic environment, or a given bank’s market niche. However, the additional risk requires higher levels of capital and oversight. The board should consider these concentrations when formulating growth plans and policies, including establishing prudent limitations as a percentage of capital. All concentrations should be monitored closely by management and receive a more in-depth review than the more diversified portions of the institution's assets - the greater the concentration, the greater the need for monitoring. The board needs to monitor the exposure via management reports detailing the dollar volume of the exposure, industry status, supply and demand trends for that type of property, or changes in underwriting standards. You should be getting enough information so that you can feel comfortable that management is controlling the risk. This is one of the more critical responsibilities of a director, since credit concentrations have been a factor in a very high percentage of bank failures. UBPR Analysis of Asset Quality Now that you are armed with some information on how regulators evaluate and rate asset quality , as well as some suggestions on where you should focus your attention, let’s apply this knowledge to First State Bank. The UBPR is a good starting point to begin extracting asset quality information. It is a very useful tool for identifying trends or outlying performance issues relative to a group of

similar banks. Examiners use the UBPR to plan for examinations by identifying areas with potential credit exposure. Nonetheless, the UPBR will only take you so far in painting a picture of asset quality. The onsite portion of the examination will build upon the UBPR analysis and so should your board reviews. Several financial ratios relating to asset quality are available in the UBPR. These ratios provide detail on balance sheet composition, off-balance sheet commitments, delinquencies, charge-offs, and portfolio mix. We are only going to focus on four ratios in our brief exercise, the significant amount of information that we have compiled on your bank. Four ratios to focus on when assessing asset quality include: 1. Asset Growth Rate - This ratio details the change in total assets over the past 12 months. 2. Non-current Loans and Leases to Gross Loans and Leases - This ratio reflects the percentage of loans that are 90 days or more past due, or are no longer accruing interest. 3. Net Losses to Average Total Loans and Leases - This ratio presents the level of net losses, on an annualized basis, as a percentage of the total portfolio. It takes into consideration any recoveries on prior period losses. 4. Loan and Lease Allowance to Total Loans - This ratio measures the allowance available to absorb loan losses relative to total loans outstanding. Let’s review the UBPR for First State Bank and analyze these four ratios. They are detailed on the Summary Ratios page (page 1) and, as always, we will assess level andtrend. OK, now let’s talk about what you discovered. Consider the following: 1. Asset Growth Rate – What is the rate of asset growth and how would you characterize this growth? The asset growth rate for the past year is 33.60%. This is a significant increase from the two prior years of 1.63% and 2.77%, and significantly higher than peer. This is clearly something the directors should be aware of and monitoring. 2. What category dominated asset growth? Growth was centered in loans at 62.56% at the expense of short term investments, which declined by more than 50%. 3. Non-current Loans to Gross Loans – The ratio of non-current loans to gross loans is 3.11%. How would characterize the level of delinquencies? The ratio has risen dramatically and is high relative to peer. 4. Net Losses to Average Total Loans – This ratio is 0.22%. What has the trend been? The ratio has not increased dramatically but it is higher than peer and trending upwards. Potential problems are not yet impacting the portfolio. 5. Loan and Lease Allowance to Total Loans and Leases – This ratio is 1.13%. What conclusions can you draw about the adequacy of the allowance? Nothing definite, this is almost a trick question! There is NO benchmark or acceptable range for the ALLL. An assessment of ALLL adequacy will consider past loss history, changes in underwriting standards, economics, etc. We can see, however, that the provision expenses have not kept pace with portfolio growth resulting in a deteriorating allowance as a percent of total loans. Additionally, examination findings will suggest that the risk profile is rising, which will necessitate a higher rather than lower ALLL. (Requirements for ALLL calculation methodologies are fully detailed in the July 2001 Interagency Policy Statement on the ALLL) Of course, UBPR analysis is a starting point. Let’s move on in our examination exercise and see what else we can learn about asset quality at First State Bank. Examination Exercise – Report of Examination The Report of Examination provides several useful pages for assessing asset quality. As with all of the other CAMELS components, the Examination Conclusions and Comments page provides a summary of the examination findings, along with support for the examiner's rating. The Examination Data and Ratios page will present the volume and severity of adversely classified assets and the Items Subject to Adverse Classification page will have detailed write-ups for the larger classified loans and those that examiners are grading more harshly than management. These write-ups are worth reading because they may contain information that your management team may not have given you previously. Finally, the

Concentrations page will detail concentrations identified by examiners. Hopefully, your management team has been providing you with this information for as long as the concentrations have existed; however, this is a good secondary check for directors. Examination Conclusions and Comments Asset quality has deteriorated. Adversely classified items to Tier 1 Leverage Capital and the Allowance for Loan and Lease Losses (ALLL) now total 37%, up from 23% at the prior examination. The severity of adversely classified items has also increased as assets classified Doubtful and Loss total $1.2 million, or 26% of total adverse classifications - up from $177,000 at the prior examination. The increase in classifications is a direct result of more liberal credit practices and lax loan documentation, particularly within the commercial real estate and construction loan portfolios. Management has aggressively pursued these loans despite the economic downturn in its trade area. The bank now has significant concentrations of credit in commercial real estate and construction loans, aggregating 480% and 530% of Tier 1 Capital, respectively. These figures exceed policy maximums, and rather than control these risks, the board opted to increase policy risk limits. Furthermore, management has exceeded the loan-to-value guidelines contained in Part 365 of the FDIC’s Rules and Regulations on many loans, and an excessive 62% of loans reviewed contained documentation exceptions. Management’s monitoring of loan concentrations is deficient. Concentration reports show only the bank’s aggregate exposure to commercial real estate and construction loans rather than segmenting the portfolios by loan type/collateral, etc. These reports do not allow management to adequately identify, manage, and monitor concentration risk. Loan Policy The Loan Policy does not establish prudent guidelines for loan concentrations and provides inadequate guidance for commercial real estate and construction lending. As a result, loan concentrations are excessive and are not being properly monitored or controlled. Additionally, asset quality has deteriorated due to weak loan underwriting and credit administration practices. The Loan Policy is again criticized for its lack of sufficient guidance for underwriting commercial real estate and construction loans. The policy does not: • Establish prudent credit concentration guidelines • Establish effective concentration monitoring and reporting procedures • Require comprehensive analysis of cash flow and repayment ability • Specify the type of financial information and other documentation necessary for each loan type • Require property inspections on commercial real estate and construction loans Loan Underwriting Weaknesses • Credit memos do not provide a clear assessment of repayment capacity - many real estate credits are approved based olely on collateral values with no cash flow analysis performed • Loan documentation weaknesses are again noted at this examination – an excessive 62% of the credits reviewed contained documentation exceptions • Property inspections are not being prepared for all commercial properties Credit Administration Weaknesses • Ongoing loan documentation is poor as updated financial statements are not being acquired • Management’s internal credit review is based solely on delinquency • The watch list is inadequate - many of the credits classified in this examination were not classified internally Allowance for Loan and Lease Losses (ALLL) The ALLL methodology is inadequate and a provision of at least $500M is needed to replenish the ALLL following the credit losses identified during the examination. The methodology needs to be revised to include the following items from the Interagency Policy Statement on ALLL Methodologies and Documentation:

• The performing portion of the loan portfolio should be stratified into groups with similar characteristics • Reserves should be assigned based on the risk present in each group • Factors such as changes in economic trends, underwriting standards, and portfolio growth should be considered in determining an adequate reserve level. Discussion Points – Asset Quality The examination identified a number of significant weaknesses with regard to the bank’s rapid expansion. Some of the more significant concerns related to asset quality include the following: • The volume and severity of adversely classified items rose substantially to 37% of Tier 1 Capital and the ALLL • Deterioration in asset quality is a result of more liberal credit practices and lax loan documentation • Credit approval memos do not provide a clear assessment of the borrowers’ repayment ability • Loan documentation exceptions were noted in 62% of the loans reviewed • The internal loan review and watch list process are inadequate • The methodology for determining an appropriate Allowance for Loan and Lease Losses is insufficient • Management and the board are not adequately monitoring significant concentrations of credit • The loan policy is inadequate with regard to concentrations, commercial real estate lending, and construction lending the problems cited above signify failures with regard to management and board oversight. As a board member, what are some of the actions that you would take to address these concerns? We have detailed potential solutions below, and in a normal . • Revise the Loan Policy to require more stringent credit practices and loan documentation standards • Revise the Loan Policy to provide more guidance over commercial real estate and construction lending • Revise the Loan Policy to establish more prudent limits for concentrations and require more rigid monitoring and reporting processes for concentrations • Enforce the Loan Policy and require exceptions to be reported to, and approved by, the board • Require more detailed credit approval memos from the loan officers • Stop/slow loan growth until management has properly addressed underwriting and administration weaknesses • Determine if the experience and abilities of the lending staff are sufficient relative to the portfolio and portfolio growth • Improve the internal loan review and grading function

Loan Lending Criteria Agriculture loan To meet entire agricultural credit requirements such as crop production, investment credit, including consumption credit through single loan product. To provide a simple, comprehensive and flexible credit package to farmers. Salient feature: Both crop production and investment credit met. Consumption / house hold / miscellaneous agricultural expenditure / working capital needs for allied activities also considered. Repetitive documentation avoided. Stamped receipts not needed for purchase of manure, fertilisers, animal feeds and other inputs. Advances recoveries could be withdrawn to meet unforeseen expenditure. Cardholders eligible for personal accident insurance scheme upto Rs.50000; annual premium of

Rs.15/= per cardholder is shared by the bank and the borrower at 2:1 ratio. Builtin incentive for prompt repayers. On credit balance in the short term / crop loans, SB interest rates paid. Eligibility: All farmers, such as owner / tenant cultivators and share croppers are eligible. Farmers cultivating on authorized leased lands are also eligible. Should not be a defaulter to any financial institution. Assessment of crop loan / short term limits / term loan limits Crop loan limits based on scale of finance and area under cultivation. Consumption / household expenses, post harvest and miscellaneous agricultural expenditure considered. Working capital requirement for dairy and poultry for one month’s feed cost met. Total limits as mentioned above are the operational limit. 20% contingency is added on to the operational limit to fix the overall card limit. Overall card limit is meant to avoid repetitive documentation and to take care of increase in scale of finance in future. Term loan projects with a repayment period of upto 5 years only are considered under VKV. Term loan limit is assessed based on Unit Cost and the Activity undertaken based on viability of the project.

Lending norms: Margin No margin for crop loans. For term loans and other short term loans, margin is as follows For loans upto Rs.50000 : No margin For loans above Rs.50000 : 15 to 25% margin Security For loans upto Rs.50000: only hypothecation of crops / assets purchased out of bank loan For loans above Rs.50000: hypothecation of crops / assets created and mortgage of land / third party guarantee at bank’s discretion Interest rate As applicable for agricultural loans from time to time

Repayment Repayment for crop loans based on the crop period and reasonable period for harvesting / marketing of produce For term loans, as per the repayment period suggested by NABARD or on the basis of income generation of the project; need based gestation period also considered Educational loan driven by banks: HIGHER studies are increasingly assuming importance. More and more students aspire to pursue a professional course and dream of high-flying careers. New courses attract students to a variety of areas and to various parts of the world. But the exorbitant cost of education is, as has been, a hurdle for many an aspiring student. For those students aspiring to pursue higher studies without straining the finances of their parents, educational loans come as a boon. Most banks, in private and public sector, offer educational loans for bright and needy students. Considering the necessity and importance of such financing, the norms for granting loans to students for higher studies have been eased. The prevailing low interest rates have made these loans cheaper and all the more attractive. So you can always approach a bank to finance your education and repay it yourself, after you start earning. How do you go shopping for an educational loan? What are the facts you should know and how do you apply for a loan? Here is a brief guide on the

procedure for obtaining an educational loan. Eligibility If you are an Indian citizen and have obtained admission to a reputed university or course either in India or abroad, you can approach the nearest bank — of course, go to your bank first — and apply for a loan. Most banks give preference to existing customers, as that would limit the procedures, and thus reduce the time taken to sanction the loan. The amount sanctioned and the collateral are often decided on a case-to-case basis, after evaluation of your credentials. Work out your need You must first ascertain the total cost of education including, usually, the tuition fees, the library charges, boarding and lodging, books, hostel and exam fees, equipment, project costs and so on. In the case of studies abroad, the airfare can be included in the loan. Once you have estimated the cost, decide on what you can put together and the loan amount you would require. Margin The margin money (your contribution towards the total cost) depends on the quantum of loan and on the location of the institution. If the loan sought is below Rs 4 lakh, banks usually finance the full cost of education; that is, you do not put up any margin money. But if the loan amount exceeds Rs 4 lakh, only 95 per cent would be financed in case of studies in India. If you are going abroad, the bank will finance up to 85 per cent of the loan. Once decide on the loan amount, you should approach the bank with all the necessary certificates and documents. You will be asked to come for a discussion so that the bank can ascertain your capability and the financial back ground. The documents required could include certificates of examination cleared, proof of address, income statement of the co-applicant, and where some collateral security is required, the asset document. For loans below Rs 4 lakh, you may not have to offer any collateral security. These loans are granted based on the financial soundness of the borrower, future earning capacity and personal guarantee. Canara Bank for instance, insist on a guarantor and also ask for his financial details. If the bank is satisfied with the documents, it may take 15-20 days to sanction the loan. Facts you should know The terms and conditions of most banks are similar. The maximum amount of loan granted is Rs 7.50 lakh for studies in India and Rs 15 lakh for studies abroad and the repayment period could be up to seven years after completion of the course. The amount is disbursed as and when required, and directly to the university or institute. During the period of the study, only simple interest on the outstanding loan is charged at quarterly rests. The loan repayment usually commences one year after completion of the course or immediately after you get a job, whichever is earlier. You have the flexibility to choose the repayment period and the size of the equated monthly instalment. The EMI is the total loan amount and the interest thereon (compounded quarterly after commencement of repayment) divided by the repayment period (in months). You can also accelerate your repayment. No penalty is charged for pre-payments. Cost of the loan The interest rate is by and large the only parameter for deciding which bank to take the loan from. Interest rates again depend on the quantum of loan. Up to Rs 4 lakh, interest is charged at the prime lending rate (PLR) or medium term lending rate (MTLR). For loans above Rs 4 lakh, interest is one per cent higher. At present, the interest rates vary between 11.75 per cent and 14 per cent. Canara Bank offers the best deal at 11.75 per cent for loans up to Rs 4 lakh. HDFC's loan is much more expensive at around 14 per cent. Interest rate is subject to change from time to time. There is usually no processing fee, or maximum of 1 per cent of the loan amount. An educational loan appears to be a convenient and cost effective means of making your dreams come true. But the success of the scheme depends on how many people genuinely make the effort to repay the loans. If all borrowers repay promptly, more students would benefit.

Risks borne by banks: • Liquidity Risk Liquidity risk is the potential inability of a bank to generate sufficient cash to meet its normal operating requirements (cash expenses and repayment of liabilities). A mismatch in the assets and liabilities causes a bank to have a liquidity risk. A bank often promises greater liquidity in its liabilities than its assets can provide directly. To deal with such contingencies, a bank must have sources of liquidity - ways it can lay its hands on cash whenever it needs it. However, excess liquidity is also costly for the bank because idle cash carries a cost as the bank pays interest on its deposits. So, banks seek to achieve a reasonable trade-off between overtly liquid and relatively illiquid. • Interest Rate Risk Interest rate risk is the risk of an adverse effect of interest rate movements on a bank's profits or balance sheet. Interest rates affect a bank in two ways - by affecting the profits and by affecting the value of its assets or liabilities. If the money borrowed is on floating rate basis the bank faces the risk of lower profits in an increasing interest rate scenario. Similarly fixed rate assets face the risk of lower value of investments in an increasing interest rate scenario. Interest rate risk becomes prominent when the assets and liabilities of the bank do not match in their exposure to interest rate movements. • Foreign Exchange Risk Foreign Exchange Risk is the chance that a fluctuation in the exchange rate will change the profitability of a transaction from its expected value. It is the risk that arises due to unanticipated changes in exchange rates, which arises due to the presence of multi-currency assets and liabilities in a bank’s balance sheet. Fluctuations occur over the medium and long-term and also during a dealing session on a moment-to-moment basis. Foreign exchange exposure in a bank might arise due to the operations of the treasury (the dealing room) or due to unmatched assets and liabilities (in terms of currency and maturity) on the balance sheet. In addition, banks making markets and dealing in currency forwards, swaps and options take on foreign exchange exposure and relevant risks. Foreign exchange operations of a bank can function properly only if the risks associated with such operations are correctly identified and measures are taken to manage / limit those risks.

Rating Asset Quality The findings are substantial and will clearly have a negative impact on the asset quality rating. Click on the link below to review the regulatory rating guidelines and determine which rating best fits this bank. Keep in mind that the asset quality rating incorporates both the quantity of adverse classifications and quality of underwriting/administration practices. The following is an excerpt from the Uniform Financial Institutions Ratings System. Read the ratings guide and rate the asset quality component for First

State Bank. Uniform Financial Institution Ratings System The asset quality rating reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, other real estate owned, other assets, and off-balance sheet items. The ability of management to identify, measure, monitor, and control credit risk is also reflected here. The evaluation of asset quality should consider the adequacy of the allowance for loan and lease losses. The asset quality of a financial institution is rated based upon, but not limited to, an assessment of the following evaluation factors: • The adequacy of underwriting standards, credit administration, and risk identification practices • The level, distribution, severity, and trend of problem assets • The adequacy of the Allowance for Loan and Lease Losses • The credit risk arising from off-balance sheet transactions such as unfunded commitments and commercial or standby letters of credit • The existence of asset concentrations • The adequacy of loan and investment policies, procedures, and practices • The ability of management to properly administer its assets, including the timely identification and collection of problem assets • The adequacy of internal controls and management information systems • The volume and nature of credit documentation exceptions Ratings A rating of “1” indicates strong asset quality and credit administration practices. Identified weaknesses are minor in nature and risk exposure is modest in relation to capital protection and management's abilities. Asset quality in such institutions is of minimal supervisory concern. A rating of “2” indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and management's abilities. A rating of “3” is assigned when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate deterioration in asset quality or an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require an elevated level of supervisory concern. There is generally a need to improve credit administration and risk management practices. A rating of “4” is assigned to financial institutions with deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability. A rating of “5” represents critically deficient asset quality or credit administration practices that present an imminent threat to the institution's viability. What should the Asset quality component be rated? Consider the ratings definitions above and compare them to the circumstances described in the Report of Examination for First State Bank. What should the Asset quality component be rated? 1. Strong. 2. Satisfactory. 3. Less than satisfactory. 4. Unsatisfactory. 5. Critically deficient. Examiners rated asset quality a “3”. While the level of classifications may not be high enough to justify a “3” rating on its own, poor underwriting and credit administration practices suggest future losses may be significant. Additionally, the risk profile is heightened by a weak loan policy, increasing and unmonitored loan concentrations, and generally weak risk management practices. If you assigned a “4” rating, then you weren’t very far off; however, what you haven’t been able

to read are management’s responses. It is possible that the rising classifications in a very new portfolio were enough to make management agree to curtail future expansion until these weaknesses are corrected. Additionally, the bank has historically been rated a “2” overall, leading us to believe that they may have the ability to correct these deficiencies before the level of adversely classified items threatens the bank’s viability. Now let’s move on to the capital module. S&P cautions Indian banks against poor asset quality MUMBAI, DEC 8: International credit rating agency Standard & Poor's (S&P) has assigned BB ratings to Bank of India, Canara Bank, Union Bank of India and Central Bank of India. However, S&P has cautioned the banking industry saying that the asset quality of banks is poor. All the four banks will be challenged to maintain profitability and asset quality at current levels, given a weaker economic environment and the implementation of more stringent prudential standards, an S&P release said on Tuesday. "Rising impaired loans, a weak industrial sector and an economy that is less robust than in the past, could be problematic for the industry in the near term. These pressures are expected to have a negative impact on the profitability and internal capital-generating capacity of all Indian financial intermediaries, at a time when the Reserve bank of India has announced that it will progressively strengthen capital requirements and asset classification and provisioning standards, in the next two years," said S&P. Implementation of these guidelines may necessitate additional capital infusions by government or possibly a reassessment of the government required minimum shareholding of 51 per cent in the state-owned banks that dominate the sector. The ratings on all the four state-run banks are supported by their sound market positions as key depository institutions, with each bank enjoying a strong funding base. Creditworthness is also supported by majority government ownership and the significant role the banks play in fulfilling social policy objectives. These strengths are, however, moderated by asset quality that is poor by international standards, weak underlying profitability and the challenging and somewhat volatile and deregulating operating environment. Central Bank's capital base is impaired by accumulated losses that are carried onbalance sheet. Accordingly, the bank has relatively less financial flexibility than other banks in the same category. S&P has noted that the Indian financial sectorhas progressively reformed since 1991 and while the risk profile of the industry has improved significantly following the introduction of tighter prudential controls on asset classification, provisioning and capitalisation, the sector remains highly regulated and relatively inefficient by international standards. The almost complete deregulation of interest rates and the dismantling of the standardised bank lending guidelines have introduced a range of new risks and challenges and have necessitated the development of improved credit disciplines and more sophisticated techniques for the management of liquidity and interest rate risks. These are areas that have previously received little management attention. CRISIL rates HDFC BANK's CRISIL has assigned a rating of AAA / Stable to HDFC Bank Limited's (HDFC Bank's) Upper Tier II bonds issue. The rating reflects the bank's strong asset quality, good capitalisation levels, and a healthy earnings profile. HDFC Bank's good resource profile and strong market position across segments in the financial services sector also support the rating. HDFC Bank's strong asset quality is reflected in its low gross non-performing assets (NPA) of 1.43 per cent (as a proportion of gross advances) as on March 31, 2006; the bank has a strong presence in the retail finance space, which has traditionally been a low-risk business. A strong asset quality, along with a healthy net worth base of Rs53 billion (as on March 31, 2006), has resulted in strong coverage levels; as on March 31, 2006, the bank's net worth coverage for

net NPAs stood at a high of 34.2 times. HDFC Bank's good capitalisation levels also reflect in its high Tier I capital adequacy ratio and overall capacity adequacy ratio, each as a proportion of riskweighted assets, at 8.55 per cent and 11.41 per cent respectively. CRISIL expects the bank's capitalisation levels to remain strong over the medium term, backed by its healthy asset quality. CRISIL's rating on HDFC Bank's debt instrument also derives strength from its strong and stable earnings profile. This is reflected in the bank's high return on assets of 1.4 per cent over the last four years. A high core fee income also supports the bank's profitability levels: in 2005-06 (refers to financial year, April 1 to March 31), HDFC Bank reported a core fee income of 1.9 per cent (as a proportion of average funds deployed), as against the system average around 1 per cent. A high proportion of current and savings accounts - 55.4 per cent of the bank's deposits as on March 31, 2006 - has also shored up its resource profile. This has translated into low cost of deposits (3.38 per cent in 2005-06), supporting the bank's profitability levels. The rating is also supported by HDFC Bank's strong market position in the retail finance space; the bank is among the top three banks in India, with disbursements of Rs. 142 billion in 2005-06. Outlook: CRISIL expects HFDC Bank to maintain its healthy capital position, supported by its strong asset quality levels in its fast-growing retail portfolio. These factors will enable the bank to maintain its good earnings profile. The rating is also based on CRISIL's expectation that HDFC Bank will maintain capital adequacy at levels higher than the regulatory requirement throughout the tenure of the instrument. About the bank: HDFC Bank commenced operations in January 1995. The bank offers a wide range of banking services, covering both commercial and investment banking on the wholesale side and transactional and branch banking on the retail side. HDFC Bank is India's largest private sector bank, active in the retail finance business with a thrust on car finance, personal loans, commercial vehicle finance, twowheeler finance, and credit cards. The bank's retail advances, as a proportion of total advances, stood at 61 per cent as on March 31, 2006. HDFC Bank had an asset base of Rs735.06 billion as on March 31, 2006. It reported a profit after tax (PAT) of Rs8.71 billion in 2005-06 (Rs6.66 billion in 2004-05).

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