1.

1 Stress Testing
Stress Testing is a risk management tool that helps identify the potential impact of extreme ye
tplausible events or movements on the value of a portfolio. Stress tests help identify and analyze
the risks which might be latent under benign conditions but, if triggered, could have serious
implications for the very existence of a financial institution
1.2 Stress Testing Methodologies
In term of methodologies, stress tests can be broadly classified into following two types:
1.2.1 Sensitivity Analysis
Sensitivity Analysis typically examines the short term impact of change in some
variable interest rate, equity prices or a combination of both on the value of a
portfolio/financial position.
For instance, sensitivity tests may include (i) a parallel shift in the yield curve by
200 basis points (ii) depreciation of domestic currency by 15% and (iii) increase in
consumer loan defaults by 30%.
While the simplicity of sensitivity analysis makes it easier to use and understand, at
best ,it provides an approximation of the impact of a risk factor on a portfolio. Such
analysis does not take into account the reason behind the movement of a selected
risk factor or the probability of occurrence of any such movement.
Potentially, a number of variables can be collectively stressed or different sensitivity
test can be combined to form a multifactor stress test. For instance, the worst ever
movement in equity price ,interest rates over the past 10 years can be combined to
form a multifactor shock.
However, this approach still ignores the correlation between risk factors and should
be interpreted accordingly. The time horizon for sensitivity analysis is often shorter,
usually instantaneous. These tests can be designed on the basis of historical or
hypothetical movements in risk factors.
1.2.2 Scenario Analysis
Scenario Analysis assesses impact of extreme but plausible scenarios on a given portfolio/
financial position of an institution, using sophisticated modeling techniques and typically
incorporating macroeconomic variables. Scenarios could be historical (events experienced in
the past like stock market crashes, currency depreciations or natural disasters) or
hypothetical (plausible events that are extreme but not improbable). At the supervisory level,
scenario analysis has been extended to contagion analysis with the objective of examining the
transmission of shocks from individual institutions to the system as a whole. Macro stress
testing in particular has become very popular among supervisors as a tool to assess
vulnerabilities of the overall financial system. Moreover, leading financial institutions use macro
stress testing mostly in conjunction with their internal risk models of credit risk. Scenario analysis
takes into account correlations between risk factors, including macroeconomic variables.
Shocks assumed are closer to real life as other factors are not supposed to be held constant ‐
a big assumption under simple sensitivity test. However, the complexity of various techniques
based on statistical/macroeconomic modeling has somewhat restricted its usage to banks with
sophisticated risk management systems.
Stress Testing as a Risk Management Tool
Stress Testing is an integral part of an institution’s risk management framework and helps
risk managers in variety of ways. Specifically, stress testing:

Provides a useful base for communication of key risks across the organization;
Supplements other risk measures by providing a complementary perspective on various
risks;

 Indicates how much capital might be needed to absorb losses if worst‐case scenarios
materialize

 Provides forward looking assessment of risks and facilitates capital allocation and
liquidity management.

Helps development of risk mitigation or contingency plans across a range of stress

conditions;

Enables management to set limits for risk tolerance and redesign their risk strategies if REQ
Adds value to the risk analysis when combined with other statistical measures like value‐at‐
risk models by particularly focusing on tail events;

Highlights the limitations of models and historical data by exhibiting the impact of extreme y
et plausible shocks which models using normal conditions fail to capture; and

Helps in Internal Capital Adequacy Assessment Program (ICAAP), by providing information on

how much capital, in addition to the minimum capital requirement under Pillar‐I of the Basel‐
II regime, is adequate for an institution.

Roles and Responsibility of Board and BOD:

The governance of stress testing framework at banks/DFIs shall, at the minimum, comprise
of the following:
 The Board shall take the responsibility of establishing a robust stress testing program
while the senior management shall design and implement the program;
The senior management shall actively engage in the entire stress testing process
ensure appropriate designing, effective implementation, and its contribution into risk
mitigation strategies of the institution;
Senior management should ensure the documentation of policies and procedures
governing the stress testing framework and its periodic review to ensure its continuo
us relevance for the institution;
 The stress testing program shall not only comply with regulatory stress testing
requirements but also be capable of conducting additional tests covering various risk
types and severities for internal consumption;
 The banks/DFIs should establish an appropriate stress testing infrastructure with
adequate IT systems and resources in place, which should be periodically updated for its
continued effectiveness;
The key responsibility of implementing a sound stress testing program rests with the
head of risk management;
 Senior management should take suitable action based on stress results and incorporate
stress testing outputs into the institution’s strategic and business decision-making process and
capital allocation.
Where
Liquidity Coverage Ratio= A /max (B , C)

A. Total Liquid Assets (as defined under Section 2.3)

B. Liabilities maturing within 1 month minus Assets maturing within 1 month (based on

the behavioral study

C. 25% of Liabilities maturing within 1 month

Banks should calculate after-shock LCR by using each of the following three scenarios:

(i) Applying 20% haircut to the value of Investments in Government Securities while

calculating component “A” of the ratio.

(ii) Assuming C = 70% of liabilities maturing within1 month

(iii) Applying 20% haircut to the value of Investments in Government Securities while

calculating “A” component of the ratio and increasing the denominator “max (B, C)”

by 20%.

Stress Tests for Operational Risk

Banks should aim to develop a framework for operational risk management particularly for col
lecting operational loss data. In respect of designing operational risk stress tests, key indicator
like human errors, frauds, or failure to perform in timely manner, breaching limits, failure of
information technology systems or events such as major fires or disasters that may be
identified against the business lines. Shocks may be given to these risk events, their
frequency and severity of losses. Once the operational loss events are identified, the level of
shocks may be designed by looking into both the historical as well as hypothetical level of losses
under those risk events.

Reverse Stress Tests

Specifically, a reverse test may start with an assumed result (stress scenario) like (i) failure of
the firm’s business model, (ii) significant breach of a certain regulatory ratio/requirement like
capital adequacy ratio, liquidity reserve requirements, etc. (iii) materialization of an assumed
amount of loss that is commensurate with the risk appetite of the bank. Once the outcome
has been assumed, risk managers can proceed to identify and evaluate the circumstances/
changes in risk factors that would turn the assumed outcome into a reality
Scenario CR-4:
Calculation of Default Rate:
Credit Risk Scenario‐4 (CR‐4) stresses the default rate of a corporat e portfolio and gauges its
impact on capital adequacy ratio of a bank. For this shock, the Default Rate shall be defined
as follows:

Definition of default: An exposure is categorized under default if;

i. classified under substandard category or below and/or claims are overdue by 90 days or more or
ii. has undergone restructuring/rescheduling .

For the shock C4, the default rate is defined as a ratio of amount of outstanding ex
posure that defaulted (as per definition above) to the total amount of exposure that
could potentially default during a specified period of time.
Formula to Calculate Quarterly Default Rate:
Following formula should be used to calculate quarterly default rate using outstanding
exposures of the borrowers:

Default Rate of a Quarter = DRqi = Dqi / (Lpi - Ri)

Here
 Lpi = Outstanding amount of performing loans at the beginning of the quarter
 Dqi = Amount of defaults at the end of the quarter out of the total Lpi.
Ri =Repayments i.e. Amount of loans repaid during the quarter out of the total Lpi.
Following example describes default rate calculation:
Example:
First Quarter (Assume its Jan-Mar Quarter)
Assume that the outstanding exposure of performing borrowers of a bank on January
the start of the quarter was Rs105 billion. By the end of the quarter i.e. March 31
out of these Rs105 billion, Rs5 billion of loans were repaid, which means they are no
more on books, and additional Rs3 billion loans defaulted (as per definition above). T
he default rate for the March quarter shall be calculated as follows:
Lpi = Outstanding amount of performing loans on January 1st= Rs105 billion
Dpi = Amount of defaults at the end of the quarter out of the total Lpi= Rs3 billion
R
Amount of loans repaid during the quarter = Rs5 billion
Default Rate for March quarter shall be calculated as follows:
DRqi = 3/(105-5) = 3%
Second Quarter (Mar-Jun)
Now, on April 1st, outstanding exposure of the performing loans may have increased
to Rs104 billion due to new loans booked during the last quarter. During the June
quarter, out of this Rs104 billions, Rs 4billion were repaid and Rs 5 billion stand
defaulted by June 30. The default rate for the June quarter shall be calculated using the
above formula.
Lp2 = Outstanding amount of performing loans on April 1st= Rs104 billion
Dq2 = Amount of defaults at the end of the quarter out of the total Lp2= Rs5 billion
Lp2 = Amount of loans repaid during the quarter = Rs4 billion
Default Rate for June quarter shall be calculated as follows:
DRq2 = 5/(104-4) = 5%
The same method shall be used to calculate default rate for the other two quarters.
Once default rate for the last four quarters is calculated, the benchmark default rate
for the shock C-4 shall be taken as the maximum of the last four quarters’
default rate or the 2%, which ever is higher. This can also be calculated using the following
formula:
Benchmark Default Rate for Shock C-4 = MAX(MAX(DRq1,DRq2,DRq3,DRq4), 2%)
This 2% has been set as the minimum benchmark default rate.

Scenario IR-1:
Change in Net Interest Income (NII) using Repricing Gap:
Annexure -B
Scenario IR‐1:
Change in Net Interest Income (NII) using Repricing Gap:
Annexure ‐B
The repricing gap is the difference between the rate sensitive assets (RSA) and rate
sensitive liabilities (RSL) for a particular time band. The change in net interest income
(NII) can be estimated using the repricing gaps.
A bank with more rate sensitive assets than rate sensitive liabilities would have
positive repricing gap thus with any increase in interest rates there will be an increase
in net interest income. Accordingly, a financial institution with more rate sensitive liabilities
than rate sensitive assets would be negatively gapped, and in case, of increase in the
interest rates there will be a decrease in net interest income.
Change in NII of a bank/DFI due to changes in interest rates can be calculated by
using the following formula:

∆NII = GAP * ∆R
where GAP= (RSA – RSL)

Interest Rate Risk Management

2. Sources of interest rate risk
2.1 The main components of interest rate risk are repricing or maturity mismatch risk,
yield curve risk, basis risk, options risk and price risk. The brief description of each
type is given as under:
2.2 Repricing risk
Repricing or maturity mismatch risk occurs when the repricing schedules of assets,
liabilities and off-balance sheet items are not identical. For example, if a bank sells a
three year car financing which it funds with a one year deposit, the bank is exposed to
a risk because both products do not re-price at the same time.
2.3 Yield curve risk
Yield curve risk is the risk of non-parallel shifts in the yield curve, thus causing a
flatter or steeper curve. Yield curve risk emanates from unanticipated shifts, change in
slope or shape of the yield curve.
2.4 Basis risk
Basis risk arises when two yield curves which normally act together suddenly follow
different paths. This is simply from the imperfect correlation in the adjustment of
rates earned and paid on different instruments or products. For example, one year loan
that reprices quarterly based on three month T-bill rate is funded by one year liability
that also reprices quarterly based on three month KIBOR may expose the bank to the
risk that the spread between the two rates (T-bill and KIBOR) may change
unexpectedly.
2.5 Options risk
Options risk results from the options embedded in the bank’s assets, liabilities, and
off-balance sheet instruments or products. Examples of embedded options are;
withdrawal or early redemption option, prepayment option, embedded caps and/or
floors, choice option etc.
2.6 Price risk
Price risk results from changes in the value of marked-to-market financial instruments
which occur when interest rates change. It is closely associated with trading book. For
example, trading portfolios and held-for-sale portfolios declines in value when
interest rate increases.

3. Effects of interest rate risk movements

3.1 Variations in interest rates can have adverse effects both on a bank's earnings and its
economic value. There are two different perspectives i.e. earnings and economic
value, for assessing a bank's interest rate risk exposure.
3.2 Earnings perspective focuses on the impact of changes in interest rates on accounting
earnings in the near term, typically one or two years. Net interest income, difference
between total interest income and total interest expense, is the most important
component of the bank’s overall earnings and has direct link to changes in interest
rates. Net interest income will vary due to different interest rate risk sources like
repricing, shift and movement in yield curve and underlying options in the products.
Traditionally, net interest income was the only focal point, however recently net
income incorporating both interest and non-interest income and expenses is
considered better indicator of earnings.
3.3 Economic value perspective provides a more comprehensive outlook of the potential
longer-term effects of changes in interest rates on the market value of a portfolio. The
economic value of a bank can be viewed as the present value of the bank's expected
net cash flows, defined as the expected cash flows on assets minus the expected cash
flows on liabilities plus the expected net cash flows on off-balance sheet positions.
The changes in interest rates directly affect the economic value of a bank’s assets,
liabilities and off-balance sheet positions. In essence, the economic value perspective
explains the impact of interest rate fluctuations on the banks’ net worth.
3.4 Notably, earnings and economic value sensitivities may give different perspective of
risk. A bank may show improved earnings in a rising interest rate environment but the
economic value may deteriorate under the same scenario. While fundamentally
different, these two measures are interrelated and there exists a trade-off between
them. Therefore, having both the short-term earnings perspective and the long-term
economic value perspective of risk, add value to bank’s risk management framework.
However, the State Bank will focus mainly on measuring interest rate risk in relation
to economic value while risk in relation to earnings would serve as a supplementary
measure.

Interest rate risk measurement techniques

A. Repricing schedules
The simplest techniques for measuring a bank's interest rate risk exposure begin with a
maturity/repricing schedule that distributes interest-sensitive assets, liabilities, and OBS
positions into a certain number of predefined time bands according to their maturity (if
fixed-rate) or time remaining to their next repricing (if floating-rate). Those assets and
liabilities lacking definitive repricing intervals (e.g. sight deposits or savings accounts) or
actual maturities that could vary from contractual maturities (e.g. mortgages with an option
for early repayment) are assigned to repricing time bands according to the judgment and
past experience of the bank.

1. Gap analysis
Simple maturity/repricing schedules can be used to generate simple indicators of the
interest rate risk sensitivity of both earnings and economic value to changing interest rates.
When thisapproach is used to assess the interest rate risk of current earnings, it is typically
referred to asgap analysis. Gap analysis was one of the first methods developed to measure
a bank's interest rate risk exposure, and continues to be widely used by banks. To evaluate
earnings exposure,interest rate-sensitive liabilities in each time band are subtracted from
the corresponding interest rate-sensitive assets to produce a repricing “gap” for that time
band. This gap can be multiplied by an assumed change in interest rates to yield an
approximation of the change in net interest income that would result from such an interest
rate movement. The size of the interest rate movement used in the analysis can be based on
a variety of factors, including historical experience, simulation of potential future interest
rate movements, and the judgment of bankmanagement.
A negative, or liability-sensitive, gap occurs when liabilities exceed assets (including OBS
positions) in a given time band. This means that an increase in market interest rates could
cause a decline in net interest income. Conversely, a positive, or asset-sensitive, gap implies
that the bank's net interest income could decline as a result of a decrease in the level of
interest rates. These simple gap calculations can be augmented by information on the
average coupon on assetsand liabilities in each time band. This information can be used to
place the results of the gapcalculations in context. For instance, information on the average
coupon rate could be used tocalculate estimates of the level of net interest income arising
from positions maturing or repricingwithin a given time band, which would then provide a
“scale” to assess the changes in incomeimplied by the gap analysis.
Although gap analysis is a very commonly used approach to assessing interest rate risk
exposure,it has a number of shortcomings. First, gap analysis does not take account of
variation in the characteristics of different positions within a time band. In particular, all
positions within a given time band are assumed to mature or reprice simultaneously, a
simplification that is likely to have greater impact on the precision of the estimates as the
degree of aggregation within a time band increases. Moreover, gap analysis ignores
differences in spreads between interest rates that could arise as the level of market interest
rates changes (basis risk). In addition, it does not take into account any changes in the
timing of payments that might occur as a result of changes in the interest rate environment.
Thus, it fails to account for differences in the sensitivity of income that may arise from
option-related positions. For these reasons, gap analysis provides only a rough
approximation of the actual change in net interest income which would result from the
chosen change in the pattern of interest rates. Finally, most gap analyses fail to capture
variability in noninterest revenue and expenses,a potentially important source of risk
to current income.

. Duration
A maturity/repricing schedule can also be used to evaluate the effects of changing interest
rates on a bank's economic value by applying sensitivity weights to each time band.
Typically, suchweights are based on estimates of the duration of the assets and liabilities
that fall into each time band. Duration is a measure of the percentage change in the
economic value of a position thatwill occur given a small change in the level of interest
rates.
It reflects the timing and size of cash flows that occur before the instrument's contractual
maturity. Generally, the longer the maturity or next repricing date of the instrument and the
smaller the payments that occur before maturity (e.g. coupon payments), the higher the
duration (in absolute value). Higher duration implies that a given change in the level of
interest rates will have a larger impact on economic value.
Duration-based weights can be used in combination with a maturity/repricing schedule to
provide a rough approximation of the change in a bank's economic value that would occur
given a particular change in the level of market interest rates. Specifically, an “average”
duration is assumed for the positions that fall into each time band. The average durations
are then multiplied by an assumed change in interest rates to construct a weight for each
time band. In some cases, different weights are used for different positions that fall within a
time band, reflecting broad differences in the coupon rates and maturities (for instance, one
weight for assets, and another for liabilities). In addition, different interest rate changes are
sometimes used for different time bands, generally to reflect differences in the volatility of
interest rates along the yield curve. The weighted gaps are aggregated across time bands to
produce an estimate of the change in economic value of the bank that would result from the
assumed changes in interest rates. Alternatively, an institution could estimate the effect of
changing market rates by calculating the precise duration of each asset, liability, and OBS
position and then deriving the net position for the bank based on these more accurate
measures, rather than by applying an estimated average duration weight to all positions in a
given time band. This would eliminate potential errors occurring when aggregating
positions/cash flows. As another variation, risk weights could also be designed for each time
band on the basis of actual percentage changes in market values of hypothetical
instruments that would result from a specific scenario of changing market rates. That
approach - which is sometimes referred to as effective duration - would better capture the
nonlinearity of price movements arising from significant changes in market interest rates
and, thereby, would avoid an important limitation of duration.
Estimates derived from a standard duration approach may provide an acceptable
approximation of a bank's exposure to changes in economic value for relatively non-
complex banks. Such estimates, however, generally focus on just one form of interest rate
risk exposure - repricing risk. As a result, they may not reflect interest rate risk arising, for
instance, from changes in the relationship among interest rates within a time band (basis
risk). In addition, because such approaches typically use an average duration for each time
band, the estimates will not reflect differences in the actual sensitivity of positions that can
arise from differences in coupon rates and the timing of payments. Finally, the simplifying
assumptions that underlie the calculation of standard duration means that the risk of
options may not be adequately captured.

B. Simulation approaches
Many banks (especially those using complex financial instruments or otherwise having complex risk
profiles) employ more sophisticated interest rate risk measurement systems than those basedon
simple maturity/repricing schedules. These simulation techniques typically involve detailed
assessments of the potential effects of changes in interest rates on earnings and economic value

by simulating the future path of interest rates and their impact on cash flows.

2. Dynamic simulation

In a dynamic simulation approach, the simulation builds in more detailed assumptions about the
future course of interest rates and the expected changes in a bank's business activity over that time.
For instance, the simulation could involve assumptions about a bank's strategy for changing
administered interest rates (on savings deposits, for example), about the behaviour of the bank's
customers (e.g. withdrawals from sight and savings deposits), and/or about the future stream of
business (new loans or other transactions) that the bank will encounter. Such simulations use these
assumptions about future activities and reinvestment strategies to project expected cash flows and
estimate dynamic earnings and economic value outcomes. These more sophisticated techniques
allow for dynamic interaction of payments streams and interest rates, and better capture the effect
of embedded or explicit options. As with other approaches, the usefulness of simulation-based
interest rate risk measurement techniques depends on the validity of the underlying assumptions
and the accuracy of the basic methodology. The output of sophisticated simulations must be
assessed largely in the light of the validity of the simulation's assumptions about future interest rates
and the behaviour of the bank and its customers. One of the primary concerns that arises is that
such simulations do not become “black boxes” that lead to false confidence in the precision of the
estimates.

One of the most difficult tasks when measuring interest rate risk is how to deal with those positions
where behavioural maturity differs from contractual maturity (or where there is no stated
contractual maturity). On the asset side of the balance sheet, such positions may include mortgages
and mortgage-related securities, which can be subject to prepayment. In some countries, borrowers
have the discretion to prepay their mortgages with little or no penalty, which creates uncertainty
about the timing of the cash flows associated with these instruments. Although there is always some
volatility in prepayments resulting from demographic factors (such as death, divorce, or job
transfers) and macroeconomic conditions, most of the uncertainty surrounding prepayments arises
from the response of borrowers to movements in interest rates. In general, declines in interest rates
result in increasing levels of prepayments as borrowers refinance their loans at lower yields. In
contrast, when interest rates rise unexpectedly, prepayment rates tend to slow, leaving the bank
with a larger than anticipated volume of mortgages paying below current market rates. On the
liability side, such positions include so-called non-maturity deposits such as sight deposits and
savings deposits, which can be withdrawn, often without penalty, at the discretion of the depositor.
The treatment of such deposits is further complicated by the fact that the rates received by
depositors tend not to move in close correlation with changes in the general level of market interest
rates. In fact, banks can and do administer the rates on the accounts with the specific intention of
managing the volume of deposits retained. The treatment of positions with embedded options is an
issue of special concern in measuring the exposure of both current earnings and economic value to
interest rate changes. In addition, the issue arises across the full spectrum of approaches to interest
rate measurement, from simple gap analysis to the most sophisticated simulation techniques. In the
maturity/repricing schedule framework, banks typically make assumptions about the likely timing of
payments and withdrawals on these positions and “spread” the balances across time bands
accordingly. For instance, it might be assumed that certain percentages of a pool of 30-year
mortgages prepay in given years during the life of the mortgages. As a result, a large share of the
mortgage balances that would have been assigned to the time band containing 30-year instruments
would be spread among nearer-term time bands. In a simulation framework, more sophisticated
behavioural assumptions could be employed, such as the use of option-adjusted pricing models to
better estimate the timing and magnitude of cash flows under different interest rate environments.
In addition, simulations can incorporate the bank's assumptions about its likely future treatment of
administered interest rates on non-maturity deposits. As with other elements of interest rate risk
measurement, the quality of the estimates of interest rate risk exposure depends on the quality of
the assumptions about the future cash flows on the positions with uncertain maturities. Banks
typically look to the past behaviour of such positions for guidance about these assumptions. For
instance, econometric or statistical analysis can be used to analyse the behaviour of a bank's
holdings in response to past interest rate movements.Such analysis is particularly useful to assess
the likely behaviour of non-maturity deposits, which can be influenced by bank-specific factors such
as the nature of the bank's customers and local or regional market conditions. In the same vein,
banks may use statistical prepayment models -either models developed internally by the bank or
models purchased from outside developers – to generate expectations about mortgage-related cash
flows. Finally, input from managerial and business units within the bank could have an important
influence, since these areas may be aware of planned changes to business or repricing strategies
that could affect the behaviour of the future cash flows of positions with uncertain maturities.

Internal Credit Risk Rating Systems

3. Scope of Ratings:
3.1 All banks/DFIs are required to assign internal risk ratings across all their credit
activities including consumer portfolio.
3.2 The internal risk ratings should be based on a two tier rating system.
1. An obligor rating, based on the risk of borrower default and representing theprobability of
default by a borrower or group in repaying its obligation in the normal course of business and that
can be easily mapped to a default probability bucket.
2. A facility rating, taking into account transaction specific factors, and
determining the loss parameters in case of default and representing loss
severity of principal and/or interest on any business credit facility.
5.2 In order to assign obligor ratings the banks are required to consider, but not

limited to, the following aspects of the borrower:

A. Financial Condition including:

a. Economic and financial situation

b. Leverage

c. Profitability

d. Cash flows

B. Management and ownership structure

a. Ownership structure

b. Management and quality of internal controls

c. Promptness/ assessment of the willingness to pay

d. Strength of Sponsors

C. Qualitative factors:

a. CIB report

b. Sector of business

c. Industry properties and its future prospects

D. Others:

a. Country risk

b. Comparison to external ratings.

c. Credit information from other sources

5.3 In order to assign the facility ratings, the bank should consider the relevant and material
information including :

A. Facility

a. Nature and purpose of loan

b. Loan structure

c. Product type

d. Priority of rights in case of bankruptcy

e. Degree of collateralization

f. Composition of collateral

B. Collateral

a. Nature
b. Quality

c. Liquidity

d. Market value

e. Exposure of the collateral to different risks

f. Quality of the charge

g. Legal status of rights

h. Legal enforceability

i. Time required to dispose off

5.4 In the case of credits to individuals, factors such as personal income, wealth, debt burden and
other relevant personal information should also be considered.

11. Reporting requirements:

11.1 All banks and DFIs are required to develop their internal risk rating policy duly approved by
their Board of Directors and formulate their internal risk rating systems based on the two tier rating
system as mentioned earlier. The policy should provide for objective criteria for grading of the
exposures on the rating scales for both borrower and facility ratings. The criteria should be clear and
well documented.

11.2 In order to effectively manage their credit portfolios, banks may have as many credit grades as
they wish. However, for reporting purpose to the State Bank, banks are required to map their
borrower ratings in nine performing categories i.e. 1 to 9 and three default categories i.e. 10 to 12.

For facility ratings banks are required to map their ratings to six facility rating grades i.e. A to F
showing expected zero loss to full exposure loss.

11.3 These regulatory grades are broadly defined in the Annexure A. The mapping should be based
on the given definitions and the bank’s internal definitions of credit ratings.

11.4 All banks DFIs are advised to submit the borrower’s ratings in the field IBRATING and facility
rating in the field (to be informed later) in their credit information reports submitted in eCIB.
Annexure A

Regulatory Definitions of Rating Grades:

The banks are required to establish criteria to map their internal obligor ratings according to the
broad definitions provided below:

The rating grade 1 means that the credit exposure is of the highest quality and has minimum credit
risk. This rating should be assigned only when the creditor’s capacity and willingness to meet its
financial obligations in time is extremely strong and is unlikely to be adversely affected by the
economic or foreseeable events.

The rating grade 2 should be assigned to very good quality creditors that are lower than grade 1 in
only small degree and denotes somewhat larger credit risk than grade 1creditors. This distinction
may be based on the facts which lead to show that the margins of protections may not be as large as
in the highest quality grade or there are other elements present which make the long term risk
appear somewhat larger. The obligor’s capacity to meet its financial commitment on the obligation is
very strong and is not significantly vulnerable to foreseeable events.

The rating scale 3 should be assigned to good quality creditors, whose capacity to meet their
financial commitment to the obligation is still strong, however there are elements present, however
minor, which may suggest a susceptibility to impairment some time in the future. This category is
more susceptible to adverse effects of changes in circumstances and economic conditions than
obligations in higher rated categories.

The rating grade of 4 should be assigned to medium quality obligor and bears average security and
certainty of timely fulfillment of financial obligations. Although capability and willingness of the
obligor are adequate however, certain protective elements may be lacking or may be
characteristically unreliable over any greater length of time. Although adequate protection
parameters are present yet, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its financial commitment to the obligation.

The rating grade of 5 should be assigned to the lower medium quality obligor, whose future cannot
be considered as well assured. Such customers bear high risk associated with their capability or
willingness to fulfill their financial obligations in a timely manner and face major uncertainties or
exposure to adverse business, financial or economic variations which could lead to their inadequate
capacity to meet financial commitment.

The rating grade of 6 means poor quality creditors. Fulfillment of financial obligations over any
longer period of time may be uncertain. Although the obligor currently has the capacity and
willingness to meet its financial obligations, yet is more vulnerable to non payment than obligations
rated 5. Capacity for continued payment is contingent on a sustained, favorable business, financial
and economic conditions. Even non-distinct variations in the business, financial or economic
conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on
the obligation.

The obligors graded 7 are of poor standing and there may be elements of danger with respect to
fulfillment of their financial obligations. They are currently vulnerable to nonpayment, and their
capability to meet financial obligations is dependent upon favorable business, financial, and
economic conditions. Very high risk factors are present and negative variations of business, financial
and economic conditions of any scope mean real risk of default.

The rating grade of 8 means that the capacity of the obligor to meet its financial commitments is
currently highly vulnerable and at any time may discontinue its payments. Its capability to meet its
financial obligations depends on distinctively positive development of the sector and industry of the
operation of the obligor.

The obligor bears the highest default risk exposure and is virtually in default but payments on the
obligations are still continued. Even the positive development of the business, financial and
economic conditions need not mean its capability to meet its financial obligations.

Facility Grades

Facility grades should be assigned according to the severity of the expected losses in case of default,
keeping in view the factors listed above. For reporting purposes the definitions of the facility grades
would be:

Facility grade A would represent the facilities where severity of loss would be minimal
and close to zero in case of default. In other words the bank is expected to recover almost whole of
the principal and interest and other outstanding charges.

Facility grade B would represent that the severity of loss in case of default is mild and bank would be
able to recover most of its principal and interest in case obligor defaults.

Facility grade C would represent the facilities where the severity of loss is medium.

Facility grade D would be assigned to the facilities where the expected loss of principal and interest
would be high.

Facility grade E means that the expected loss would be very high.

Facility grade F shows that the loss severity would be highest in case of default and bank may not
recover all the principal or interest.

Broadly the facility grades listed above would represent the following expected recovery rates as a
percentage of outstanding exposure.

Grade Expected loss of

exposure
A 0%
B UPTO 20%
C 20% TO 40%
D 40% TO 60%
E 60% TO 80%
F 80% TO 100%