EXECUTIVE SUMMARY

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 counter parties, 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 banks counter parties.
Credit risk in most simply defined as the potential that a bank borrowers or counter
party will fail to meet its obligations in accordance with agreed terms. The goal of
credit risk management is to maximize a banks risk-adjusted rate of return by
maintaining credit risk exposure within acceptable parameters. Banks need to
manage the credit risk inherent in the entries 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 organization.
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 counter party 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 they are adequately compensated for risks incurred.
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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 documents specifically address the following
area: (a) establishing an appropriate credit risk environment , (b) operating under a
sound credit granting process, (c) maintaining an appropriate credit administration,
measurement and monitoring process, and (d) 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
compressive 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 transactions. 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.




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CHAPTER-1
INTRODUCTION:
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 globalization of markets for final goods, financial &non-financial services,
and even factors of production has been one of the most striking development 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 based on
open competition& global market forces can achieve out comes that are far
superior to those possible in a highly regulated and controlled environment.
But they said, such market- based system can, and do, display elements of
vulnerability. Markets can be dysfunctional and they can be subject to failure and
break downs. Investor and borrower
Behavior 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.

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So, the challenge is to promote sound risk management practices in financial
institution in a way that ensures that they are adequately capitalized and prudently
managed while not hindering a their ability to pursue opportunities and profits
responsibly. Well capitalized and well managed financial institutions can serve as
efficient intermediaries of credit, not only in good times, but also in periods of
strain.
Content and Objectives.
This section of the guideline describes risk management as a part of lending
business of banks. This is done by outlining the basic elements of risk management
in the context of bank wide capital allocation and defining the central
requirements on effective risk management. As some of these issues discussed in
this context cannot be dealt with exclusively in terms of credit risk, there are
occasional switches between a bank wide perspective and a narrower look at the
credit sector, with this change of perspective not always being made explicit to
allow for smooth reading?
Starting from the requirements on risk management in banks, the first subchapter
provides an overview of the functions of risk management and shows the basic
prerequisites in terms of organization and processes. This is used as a basis to
derive the strategic and operational core elements of credit risk management.
The second subchapter explains the importance risk management has for bank-
wide capital allocation and shows how the content of the following subchapters
can be regarded as parts of an integrated system to combine value and risk
management at all organizational levels.
The third and fourth subchapters show how banks determine their risk bearing
capacity and build their credit risk strategy on that basis.

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Subchapters five then deals with the question of capital allocation, while the
subchapter six and seven outline the ways in which banks can limit their credit risk
by setting risk limits and
Control these risks by means of active portfolio management. The eighth
subchapter finally deals with works out the main requirements for risk controlling
systems that banks use to manage their risks.
Credit Risk Management:
All organizations including nonprofits government entities and business need to
establish sound and functional credit risk management procedures to prevent
operating losses. Due to the nature of their operations, financial institutions
generally monitor credit risks more closely than other organizations.
Definition:
Credit risk is the loss expectation arising from a business partners default or
inability to fulfill other financial commitments on time. A business partner- also
called a counterpartydefaults because of bankruptcy or temporary financial
distress. Credit risk management helps a firm mitigate credit losses in operating
activities.
Significance:
Credit risk management is an integral component of an organizations profit
management mechanisms. Without adequate and functional credit risk control
procedures, the organization may incur significant losses if counterparties are out
of business, according to financial information portal investopedia.




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Considerations:
Credit risk management techniques typically demand analytical acumen, financial
dexterity and level of mathematical sophistications that corporate personnel often
do not possess.
Accordingly, a company may hire a specialist, such as a chartered financial
analyst, to help implement adequate credit risk management tools.
















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CHAPTER-2
REVIEW OF LITERATURE
CREDIT RISK:
Probability of loss from a debtors default. In banking, credit risk is a major factor
in determination of interest rate on a loan, longer the term of loan, usually higher
the interest rate also called credit exposure.
Credit risk is an investors risk of loss arising from a borrower who does not make
payments promised. Such an event is called a default. Another term for credit risk
is default risk.
Credit risk is a significant element of the galaxy of risks facing the derivatives
dealer and the derivatives end users. There are different grades of credit risk. The
most obvious one is the risk of default. Default means that the counter party 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 counterpartys 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 entre with counterparties will fluctuate in value with changes in markets
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 owned some form of payment.
If we owe the counterparty payment and the counterparty defaults, we are not at
risk of losing ant future cash flows.




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Different aspects of credit risk: market risk, default rates and recovery rates
The two aspects of credit risk of the contracts into which we have entered with
counterparty and potential for some pejorative credit events 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 accessing credit risk is estimating the recovery rate. Debts as
that ABC bank defaults and those 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 $ 10million 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 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?
Lets say that we had estimated an ex ante default probability of 5% and a recovery
rate of 20%. Then, the expected value condition is straight forward.
Expected value swap= 0.95($10 million) +0.05($10 million *0.20) =$9.6 million.
The 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.




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The credit exposure is equal to the greater of the current replacement values 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 the value
of the contract is negative, then we have no exposure to the counter party 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 counter parties.
This may mean that they charge a greater swap spread when pricing the swap
curve for a particular counter party or it may mean that they place greater
conditions on the transaction
Credit Risk- Internal Ratings Based Approach
This section describes the RBI approach to credit risk. Subject to certain minimum
conditions and disclosure requirements, banks that have received supervisory
approval to use the RBI approach may relay on their own internal estimates of 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 supervisory values as opposed to an internal
estimate for one or more of the risk components.



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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 assets classes is 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 function that have been developed for separate assets classes. For
example, there is a risk weight 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 functions followed by the risk
components and other relevant factors such as the treatment of credit risk
mitigates.
1. Categorization of exposures.
Under the IRB approach banks must categorize banking book exposures into broad
classes of assets with different underlying risk
Characteristics, subject to the definition set out below.
-Corporate
-Sovereign
-Bank
-Retail
-Equity
The classification of exposure in this way is broadly consistent with established
bank practice. However, some banks may use different definitions in their internal
risk management and measurement system.

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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 purpose 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 subclasses of specialized 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 if receives from the assets being financed;
- The term of the obligation given the lender a substantial degree of control over
the assets 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 assets rather than the independent
capacity of a broader commercial enterprise.



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The five sub classes of specialized 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
telecommunication 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 facilitys 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 cash flow and on the collateral value of the projects assets. In contrast
if repayment of the exposure depends primarily on a well-established, diversified,
credit worthy, contractually obligated end users for repayment it is considered a
secured exposure to those end users.
Object finance
Object finance (OF) refers to a method of funding the acquisition of physical assets
(e.g. ships, aircraft, satellite, railcars, fleets) where the repayment of the exposure
is independent on the cash flow 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.

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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 collateralized
corporate exposure.
Commodities finance.
Commodities finance (CF) refers to structured short term lending to finance
reserves, inventors, 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
exposures rating reflects its self- liquidating nature and the lenders skill in
structuring the transaction rather than the credit quality of the borrower.
The committee believes that such lending can be distinguished from exposures
financing the reserves, inventors, 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 mitigate rather than as the primary source of
repayment.
Income producing real estate
Income producing real estate (IPRE) refers to 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.
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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
source of revenue other than real estate.
The distinguishing characteristic of IPRE versus other corporate exposures that are
collateralized 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 prosperities of types those are
categorized 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
organization 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.



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Where supervisor categorize 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 standardized approach. This include sovereigns (and their central banks),
certain PSEs identified as sovereigns in the standardized approach, MDBs that
meet the criteria for a 0% risk weight under the standardized approach.
Definition of bank exposures
Bank exposures also include claims on domestic PSEs that are traded like claims
on banks under the standardized approach, and MDBs that do not meet the criteria
for a 0% risk weight under the standardized approach.
Definition of retail exposures
An exposure is categorized 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 supervisor may wish to establish exposure thresholds to distinguish
between retail and corporate exposures.

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-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 sizes 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
building containing only a few rental units otherwise they are treated as corporate).
Loans secured by a single or small number of condominium or cooperative
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 business 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 a million.
Small business loans extended through or guaranteed by an individual are subject
to the same exposure threshold.
-it is expected that supervisors provide flexibility in the practical application of
such threshold such that banks are not forced to develop extensive new information
systems simply for the purpose of ensure that such flexibility( and the implied
acceptance of exposure amounts in excess of the threshold 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 equity 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 sales of the investment or sale of the rights to the investment or by the
liquidation of the issuer.

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-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- estimates of parameters provided by banks some of which are
supervisory estimates that are probability of default (PD). Loss given default
(LGD), exposure at default (EAD) and effective maturity (EM)
-Risk-weight functions- themselves by which risk components are transformed into
risk-weighted asset and therefore capital requirements.
-Minimum requirement the minim understands that must be met in order for a
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 frame work for the purpose of deriving capital
requirements.



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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 meet the requirements for the estimation of PD is able to use the
foundation approach to corporate exposure of 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 requirement 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 HVDRE 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.



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(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 the 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
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.

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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
practically and feasibility of moving to the more advanced approaches. During the
roll out period, supervisor will ensure that no capital relief is granted for intra
group transaction which is designed to reduce a banking groups aggregate capital
charge by transferring credit risk among entities on the standardized approach,
foundation and advanced IRB approaches. This includes, but is not limited to, asset
sales or cross guarantees.
Some exposures in no 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. Supervisor may require a bank to employ one of the IRB
equity approaches if its equity exposures are a significant part of the banks
business, even though the bank may not employ an IRB approach in other business
lines.
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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 standardized or foundation approach is
permitted only in 57 extraordinary circumstances, such as divestiture of a large
fraction of the banks credit related 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
subclasses, 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 standardized 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 supervisor are responsible for determining whether an external credit
assessment institution (ECAI) meets the criteria listed in the paragraph below. The
assessment of ECAI s may be recognized on a limited basis, e. g. by type of claims
or by jurisdiction. The supervisory process for recognizing ECAIs should be made
public to avoid unnecessary barriers to entry.
2. Eligibility criteria
An ECAI must satisfy each of the following six criteria.

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Objectivity: The methodology for assigning credit assessments must be rigorous,
systematic, and subject to some form of validation based on historical experience.
Moreover, assessment must be subject to ongoing review and responsive to
changes in financial condition. Before being recognized 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 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
shareholders 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 assessment e.g. the likelihood of AA ratings
becoming an over time.
Resources: An ECAI should have sufficient resources to carry out high quality
credit assessment. 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 assessment. Such assessments should be based on methodologies
combining qualitative and quantitative approaches.


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Credibility: To some extent, credibility is derived from the criteria above. In
addition the reliance on an ECAIs external credit assessment by independent
parties (investors, insurers, trading partners) is evidence of the credibility of the
assessment 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 assessment to the
risk weights available under the standardized risk weighting frame work, 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 supervisor should assess
include, among other, the size and scope of the pool of issuers that each ECAI
covers, the range and meaning of the assessment 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 assessment provided by different ECAIs.
Banks must disclose ECAIs that they use for the risk weighting of their assets by
type of claims,
Page no: 23


The risk weights associated with the particular rating grades as determined by
supervisor 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 issue
specific. They can only be used to derive risk weights for claims arising from the
rated facility in on event can a short term rating can 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 corporate.
The table below provides a frame work for bank exposure to specific short term
facility, such as a particular issuance of commercial paper.
Credit
assessment
A1-P1 A2-P2 A3-P3 Others
Risk weight 20% 50% 100% 150%
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The credit rating follows the methodology used by standard and poors and by
Moodys investors service.
If a short term rated facility attract 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 weights of 150%, all unrated claims,
whether long term or short term, should also receive a 150% risk weight, unless the
bank users recognized credit risk mitigation techniques for such claims.
In cases where national supervisors have decided to apply option 2 under the
standardized approach to short term interbank claims to banks in their jurisdiction,
the interaction with specific short term assessments is expected to be the following
The general preferential treatment for short term claims, applies to all banks of up
to three months original maturity when there is no specific short term claim
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 really 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
instrument.
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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 years 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.
Lets say that As average overnight 95% VaR was 7 million dollars and Bs
average overnight 95% VaR was 2 million dollars. One day of calculating Bobs
return on risk capital is a follows: 30 million dollars/7 million dollars= 428.6%
using the same method, Bs return on risk capital is: 20 million dollars/2 million
dollars=1000.
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 evaluation how closely a portfolio manager conformed
to the stated risk tolerance of his fund.
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This is especially important when evaluation how closely a portfolio manager
conformed to the stated risk tolerance of his fund. If the funds is advertising itself
as a very low-risk investment vehicle suitable for windows &orphans, the average
daily VAR as percentage of assets is an interesting number, especially, when
compared to investments. Corporate treasuries & banks use VAR for the same
purposes.
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 pen. CJP Morgan has developed a methodology for calculating
components) called Risk Metrics.
Risk Metrics 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.
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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 Risk Metrics web site at http://www.riskrnetrics.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).
SCNARIO ANALYSIS:
In describing VAR, we have emphasized the fact that VAR is only good for
calculation an expected maximum loss under normal market conditions. Because
of 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 this portfolio
manager.


Page no: 28


Scenario analysis is the tool we use for this purpose. Consider this 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 he interpreted in terms of the preferences of the investor or the institution
managing the risk
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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 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
counterpartyspecifically 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 Risk Metrics Group's Credit
Manager, Credit Suisse First Boston's Credit Risk +, and Moody's Risk Calc.
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 shareholders value
Value creation
Page no: 30



Value preservation
Capital 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.
Page no: 31


One way for the fund manager to take advantage of this view is to enter into a
credit swap.
Let's say that the fund 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 yield, 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
Page no: 32


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 Basque 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 Banquet de
Bas with the concept of a credit default swap. They pay Basque deal premium
every six months for the next five years in exchange for which de Baste make
payments to Chilliwack of a pre-set amount should Churchill betas now has
exposure to Churchill, a position they could not take directly because 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 ital. in reserve, freeing Chilliwack up to take other business opportunities as
they present themselves.



Page no: 33


OPTIONS ON CREDIT RISKY BONDS
Finally, our fund manager from the first example could use an options position to
take of 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 derivatives to hedge themselves against adverse movements in
credit spreads.
Corporation can use credit swaps to hedge near-term issues of corporate bonds.
Banks & other financial institution
Corporation 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.








Page no: 34



CHAPTER-3
COMPANY PROFILE
Company Overview:
SBM ., is an entity formed with the coming together of erstwhile, SBM Ltd, a
premier bank in the Indian Private Sector and a global financial powerhouse, 1MG
of Dutch origin, during Oct 2002.
The origin of the erstwhile SBM was pretty humble. It was in the year 1930 that a
team of visionaries came together to form a bank that would extend a helping hand
to those who weren't privileged enough to enjoy banking services.
It's been a long journey since then and the Bank has grown in size and stature to
encompass every area of present-day banking activity and has carved a distinct
identity of being India's Premier Private Sector Bank.
In 1980, the Bank completed fifty years of service to the nation and post 1985; the
Bank made rapid strides to reach the coveted position of being the number one
private sector bank. In 1990, the bank completed its Diamond Jubilee year. At the
Diamond Jubilee Celebrations, the then Finance Minister Prof. Madhu Dandavate,
had termed the performance of the bank 'Stupendous'. The 75th anniversary, the
Platinum Jubilee of the bank was celebrated during 2005.
The origin of SBM
On the other hand, SBM originated in 1990 from the merger between National -
Nederland NV the largest Dutch Insurance Company and NMB Post Bank Grope
NV. Combining roots & ambitions, the newly formed company called
International Nederland Group

Page no: 35


Market circles soon abbreviated the name to I-N-G. The company followed suit by
changing the statutory name to "1MG Group N.V.".
Profile
SBM has gained recognition for its integrated approach of banking, insurance and
asset management.
Furthermore, the company differentiates itself from other financial service
providers by successfully establishing life insurance companies in countries with
emerging economies, such as Korea, Taiwan, Hungary, Poland, Mexico and Chile.
Another specialization is 1SBM Direct, an Internet and direct marketing concept
with which SBM is rapidly winning retail market share in mature markets. Finally,
SBM distinguishes itself internationally as a provider of 'employee benefits', i.e.
arrangements of nonwage benefits, such as pension plans for companies and their
employees.
Mission
SBM's mission is to be a leading, global, client-focused, innovative and low-cost
provider of financial services through the distribution channels of the client's
preference in markets where SBM can create value.
The new identity
The immediate benefit to the bank, SBM, has been the pride of having become a
Member of the global financial giant SBM As at the end of the year December
2009, SBMs total assets exceeded 1164 billion Euros, employed around 110000
people, served over 85 million customers, across 40 countries.
This global identity coupled with the back-up of a financial power house and the
status of being the first Indian International Bank, would also help to enhance
productivity, profitability, to result in improved performance of the bank, for the
benefit of all the stake holders.

Page no: 36


In terms of pure numbers, the performance over the decades can better be
appreciated from the following table:
Rs. In millions
Year Net worth Deposits Advances Profits Outlets
1998 0.001 0.400 0.400 0.001 4
1999 1.40 5.30 3.80 0.09 16
2000 1.60 20.10 13.50 0.13 19
2001 3.00 91.50 62.80 0.74 39
2002 11.50 1414.30 813.70 1.13 228
2003 162.10 8509.40 4584.80 50.35 319
2004 5900.00 74240.00 39380.00 443.10 481
2005 6527.00 81411.10 43163.10 371.90 484
2006 6863.24 80680.00 44180.00 687.50 483
2007 7067.90 91870.00 56120.00 863.50 456
2008 7473.20 104780.00 69367.30 590.01 523
2009 7094.00 125693.10 90805.90 (381.80) 536
2010 10196.70 133352.50 102315.20 90.6 562
2011 11101.90 154185.70 119761.70 889.0 626
2012 14260.00 204980.00 146500.00 1569.00 677
2013 15940.00 248900.00 167510.00 1888.00 857*
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* Outlets comprises of 441 branches, 37 ECs, 28 Satellite Offices and 351 ATMs
as of March 31st 2013. Additionally the bank also has Internet Banking, mi-bank
and Customer Service Line for Phone Banking Service
INDUSTRY OVERVIEW:
A commercial bank is a type of financial intermediary and a type of ban.
Commercial banking is also known as business banking. It is a bank that provides
checking accounts, savings accounts, and money market accounts and that accepts
time deposits [1] After the implementation of the Glass-Seagull Act, the U.S.
Congress required that banks engage only in banking activities, whereas
investment banks were limited to capital market activities. As the two no longer
have to be under separate ownership under U.S. law, some use the term
"commercial bank" to refer to a bank or a division of a bank primarily dealing with
deposits and loans from corporations or large businesses. In some other
jurisdictions, the strict separation of investment and commercial banking never
applied. Commercial banking may also be seen as distinct from retail banking,
which involves the provision of financial services direct to consumers. Many banks
offer both commercial and retail banking services.
Commercial banks engage in the following activities:
* processing of payments by way of telegraphic transfer, EFTPOS, internet
banking, or other means
issuing bank drafts and bank cheques
accepting money on term deposit
* lending money by overdraft, installment loan, or other means
* providing documentary and standby letter of credit, guarantees, performance
bonds, securities underwriting commitments and other forms of off balance sheet
exposures .

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* Safekeeping of documents and other items in safe deposit boxes
* Sale, distribution or brokerage, with or without advice, of insurance, unit trusts
and similar financial products as a "financial supermarket"
* Cash management and treasury services
* Merchant banking and private equity financing
* Traditionally, large commercial banks also underwrite bonds, and make markets
in currency, interest rates, and credit-related securities, but today large commercial
banks usually have an investment bank arm that is involved in the mentioned
activities.
Profile of SBM Credit Risk Management
Credit risk, the most significant risk faced by SBM, 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 scoots aid evolve a sartorial outlook, which 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 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 CASE
Page no: 39



Design appropriate credit processes, operating policies & procedures
Portfolio monitoring
Methodology to measure portfolio risk
Credit Risk Information System (CRIS)
Focused attention to structured financing deals
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:
Identity, monitor and measure risk profile o Develop policies and procedures
Verifying pricing model
Reviewing Risk Models
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Identify New Risks
Risk Limits in terms of CAR VAR

RISK MANAGEMENT STRUCTUR


















Page no: 41

Risk Management Committee
Asset Liability Management
Committee
Credit Policy Committee


CHAPTER-4
RISK LENDING
RISK IN LENDING:













INTRINSIC RISK:
- Deficiencies in Loan policies and procedures
- Absence of Prudential Credit conc. Limits
- Inadequately defined lending limits
Page no: 42
- Deficiency in appraisal
Risk in lending
Interest Rate
Risk
Forex Risk Counter Party
Risk
Credit Risk Country Risk
Default Risk Portfolio Risk
Intrinsic Risk
Concentration Risk


- Excessive dependence collateral
- Inadequate risk pricing
- Absence of post sanction surveillance
CONCENTRATION RISK
- State of Economy - Volatility in
Equity market Commodity Market
Foreign Exchange Market
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



Page no: 43



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
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 organizations 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.


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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.



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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.


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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.
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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.

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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 off take 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 emits.

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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 or 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 behavior 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 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.

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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 worths 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
liberalization 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 mug'
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."
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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 totaling $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 transferthe
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 armored 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
nonbank financial institutions, such as pension funds, mutual funds and life-
insurance companies. Unfortunately, rather than recognize this danger, the Finance
Ministry is keen on ensuring changes of the kind described above through a State-
directed process of financial engineering.
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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 Base! British Swiss Chamber of Commerce, Base! 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 finalize 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 mission
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 CFIF 290
billion.
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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-!
970s 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 Delores 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.
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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 finalizing the so-called
Basel It 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
globalization 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 globalization 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 globalization. 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 centers 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.




Page no: 55


The other key trend, the increased focus on the promotion of financial stability, is
closely tied to the first issue of globalization, 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 modem 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 him dysfunctional and they can be subject to failures
and breakdowns.
Investor and borrower behavior 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, Parma at, 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.


Page no: 56


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 organize, 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?
Page no: 57


The challenge is to promote sound risk management practices in banks in a way
that ensures that they are adequately capitalized and prudently managed - while not
hindering a bank's ability to pursue opportunities and profits responsibly. Well
capitalized 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 capitalization that were first
adopted by the Basel Committee in 1988. The rules are quite simple. The 1988
Base! 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 Base! Committee has
been working to develop a New Capital Accord, or 'Basel [I". 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 Base! II process has not been easy. The Base! 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.
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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 recognized 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 vise avian 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,



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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
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
corporate. 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.
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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
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 weight
age 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 Rs 100 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 percent.
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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 visa 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 visa a visa the company with a low
credit rating. With the BASELII 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-11
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.
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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 Research # h Scholar ICFAI University.














Page no: 63


CHAPTER-5
SURVEY AND FINDINGS
SURVEY AND FINDINGS.
Frame work of risk weighting:
ASSESSMENT:

Claim
AAA TO
AA
A+ TO
A-
BBB+ to
BBB-
BB+ to
B-
Below B- Unrated
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 so reign 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-.


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1. 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 etc.,)
Credit Spreads, exposures based
volatility 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





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4. Transition Matrix:
Next Years 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
A 0.09 2.27 91.05 0.52 0.74 0.26 0.02 0.06
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 0.00 0.22 1.30 2.38 11.24 64.86 19.79
Default 0.00 0.00 0.00 0.00 0.00 0.00 0.00 100.00

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
given time horizon based on historical ratings data.
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Top S 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.
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.






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CHAPTER-6
SUGGESTIONS & CONCLUSION:
Overall, the components of effective credit risk management comprise active board
and senior management oversight; sufficient policies, Procedures and limits;
adequate risk measurement, monitoring and management information systems; and
comprehensive internal controls. Lupus, a U.K.-based investment banking
management consultancy, sought the opinions of industry participants on the key
components of effective credit risk management. The responses of the eight banks
interviewed are summarized in the graph below:
Robust Technology & business
Robust Technology as a critical component of effective credit risk management by
38% of interviewees It is thoughts to help banks identify, measure, manage &
validate counter party risk, although it is of little value without effective credit risk
policies & business processes in place.
Policies
In 25% of the banks, having a comprehensive & strategic vision for credit policy is
vital as it sets guidelines for businesses, giving risk to effective credit risk
management. These guidelines include a set of general principle that apply to all
credit risk situations, as well as specific principle applicable to some countries &
type of counter parties & or transactions.
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Exposures
In 25 percent of the interviewed banks, the ability to measure, monitor and forecast
potential credit risk exposures across the entire firm on both counterparty level and
portfolio level is vital.
Robust analytics
A key component of an effective credit risk management strategy as suggested by
13 percentages of the banks is having robust risk analytics. Efficient & accurate
credit analytics enable risk managers in banks to make better & more informed
decisions. The availability of better information, combined with timeliness in its
delivery, leads to more effective balancing of risk & reward, and the possibility of
higher long-term profitability.
Role of technology in credit risk management:
As mentioned, technology is widely acknowledged to be a key component of
effective credit risk management. Lupus thus sought industry opinions on how
important IT is for achieving best practice in credit risk management. Thirty-eight
percent of the interviewees stated that technology plays a significant role in
enabling active portfolio management and assessment. This is followed by data
transparency (25 percent) and facilitation of global credit risk function (25
percent). Subsequently, technology facilitates elimination of manual processes and
allows information to be managed in an efficient and effective way.

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Today, the focus for many banks is to adopt an enterprise credit risk management
approach to achieve an integrated view of risk. Best practice in credit risk
management should demonstrate centralization, standardization, timeliness, active
portfolio management and efficient tools for managing exposures.
Robust analytics:
This is encouraged by the pressure from regulatory requirement such as Basel 11.
By constantly existing tools & method, banks are able to work toward achieving
best practices further more. Consistent, accurate & reliable data is required to
achieve beat practice in credit risk management.