Chapter-5 CREDIT RISK

Banks are primarily indulging into accepting deposits for the purpose of lending to earn profit. While
banks are statutorily required to place a certain amount of fund mobilized in highly liquid assets in the
form of CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio), remaining surplus is deployed in
various financial assets, loans and advances and other money market instruments/ investments.
Whereas, the Banks are under obligation to repay the amount mobilized from depositors either on
demand or on maturity, the Banks run a risk of failure by the borrower to repay the dues on due dates
or on demand as originally envisaged.

Credit Risk is defined as a potential risk that a bank borrower or counterparty will fail to meet its
obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank's
risk-adjusted rate of return by maintaining credit risk exposure within the acceptable levels. In the
total Risk Weighted Assets, lion’s share is that of credit portfolio (about 85%). Thus, selection of
borrowers and nature of lending assumes importance.

Credit Risk Mitigation :

Credit risk mitigation is an essential part of credit risk management. This refers to the process through
which credit risk is reduced or it is transferred to a counterparty. Strategies for risk reduction at
transaction level differ from that at portfolio level.

At transaction level banks use a number of techniques to mitigate the credit risks to which they are
exposed. They are mostly traditional techniques and need no elaboration. They are, for example,
exposure collateralised by first party claims, either in whole or in part, with cash or securities, or an
exposure guaranteed by third party. Recent techniques include buying a credit derivative to offset credit
risk at transaction level.

At portfolio level, asset securitization, credit derivative, etc., are used to mitigate risks in the portfolio.
They are used to achieve desired diversification in the portfolio as also to develop a portfolio with
desired characteristics. It must be noted that while the use of CRM techniques reduces or transfers
credit risk, it simultaneously may increase other risks such as legal, operational, liquidity and market
risks. Therefore, it is imperative that banks employ robust procedures and processes to control these
risks as well. In fact, advantages of risk mitigation must be weighed against the risk acquired and its
interaction with the bank’s overall risk profile.

BASEL has provided guidelines for specifying the instruments that are eligible as financial collateral.
Further, certain collaterals are subject to haircut for which BASEL provides the guidelines as to how
much haircut should be applied to calculate the final exposure. BASEL also provides guidelines for other
mitigation techniques to reduce the exposure for the capital requirement. Following are the eligible
financial collateral used for calculating Credit risk weighted assets as per Standardised Approach.
I. Cash: Cash (as well as certificates of deposit or comparable instruments, including fixed deposit
receipts, issued by the lending bank) deposit with the bank which is incurring the counterparty
exposure.
II. Gold: Gold would include both bullion and Jewellery.
III. Securities issued by Central and State Governments
IV. Kisan Vikas Patra and National Savings Certificates provided no lock-in period is operational
and if they can be encashed within the holding period .
V. Life insurance policies with a declared surrender value of an insurance company which is
regulated by an insurance sector regulator.
Common mistakes by Branches:
 Security Codes are not assigned properly
 Security amount are not entered in actual rupees (Sometimes entered in lakhs of rupees)

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 Instead of creating securities in CORE and linking to the respective loan accounts, branches are only
marking lien on the securities and keep with the loan records.
 Not properly apportioning securities among various facilities, should there be common/ multiple
security/ ies linked/ continued to more than one facility.
 Not updating recent values as and when revalued.

Capital Charge for Credit Risk

The Basel II Framework presents two approaches for calculating credit risk capital charge in a continuum
of increasing sophistication and risk sensitivity:

1. Standardised Approach and

2. Internal Rating Based (IRB) Approach:
 Foundation Internal Rating Based (FIRB) Approach,
 Advanced Internal Rating Based (AIRB) Approach.

I. Standardised Approach

In the standardized approach, the risk weights for different exposures are specified by the BASEL
committee. To determine the risk weights for the standardized approach, the bank can take the help
of external credit rating agencies that are recognised as eligible by Reserve Bank of India.

The Bank is using the ratings assigned by the following accredited rating agencies, approved by the RBI,
for calculating risk weights:

1. CRISIL
2. CARE
3. ICRA
4. Fitch/India Rating
5. Brickworks
6. SMERA/Acute Rating
7. Informerics

The loans and advances portfolio is segregated into eight major segments as per RBI guidelines on BASEL-
III as given below :

1. Corporates (CORP): These include borrowers whose exposure is Rs. 5 Crore and above
(irrespective of nature of facility). The risk weight applied to these borrowers is based
on external rating as given below:

External Rating Applicable Risk

Long Term Short Term Weight
AAA A1+ 20%
AA A1 30%
A A2 50%
BBB A3 100%
BB & Below A4 150%
Externally unrated -- 100%

2. Regulatory Retail (RR): These include Corp Schemes (excluding Home loan, Personal
loan, Jewel loan) and commercial loans to borrowers whose exposure is less than Rs. 5
Crore. RW for exposure to RR is 75%.

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 3. Public Sector Enterprises (PSE): All central government guaranteed advances attract 0%
risk weight. All state government guaranteed advances attract 20% risk weight. The RW for
any other exposure to PSE is computed based upon the external rating, as in case of
Corporate.

4. Residential Real Estate (RRE): The RW for RRE is based upon LTV ratio as given below:

LTV ratio and Risk Weight

Loan amount Outstanding LTV ratio Risk Weight
Up to Rs.30 lacs <=80% 35%
>80% and <=90% 50%
Above Rs.30 lacs and up to Rs.75 lacs <=75% 35%
(Loan Sanctioned before 07.06.2017) >75% and <=80% 50%
Above Rs.30 lacs and up to Rs.75 lacs <=80% 35%
(Loan Sanctioned on or after 07.06.2017)
Above Rs.75 lacs <=75% 75%
(Loan Sanctioned before 07.06.2017)
Above Rs.75 lacs <=7% 50%
(Loan Sanctioned on or after 07.06.2017)

5. Commercial Real Estate (CRE): Exposure to CRE attracts a risk weight of 100%. Exposure to
Commercial Real Estate – Residential Housing (CRE-RH) attracts 75% risk weight.
6. Consumer Credit (CC): Consumer Credit, including credit card receivables, personal loans
attract Risk Weight of 125%.
7. Staff: Loans and advances to Banks own Staff carry Risk Weight at 20%.
8.Bank: All scheduled Banks with CRAR of 9% & above attracts 20% Risk Weight. All non-
scheduled Banks with CRAR of 9% and above attracts 100% Risk Weight.

Note: 1. The Bank maintains 0% risk weight for any exposure secured by Cash or Cash equivalent
(Gold, NSC, KVP, MF, Banks own deposits etc) collateral.

2. For un-utilized portion of exposure (both Fund based and Non Fund based), 20% Credit
Conversion Factor (CCF) is applied and RW is computed as above.

3. For non-fund exposures, the RW is computed as detailed above on the exposure (based on CCF
i.e. 20% of LC < 1 Yr, 50% for LC > 1 Yr & PBG and 100% for FBG).

4. Non-performing Assets: In respect of Non-performing assets, risk weight will be net of

specific provisions, as follows:

150% risk weight when specific provisions are less than 20 per cent of the outstanding amount of
the NPA ;

i. 100% risk weight when specific provisions are at least 20 per cent of the outstanding amount of
the NPA ;
ii. 50% risk weight when specific provisions are at least 50 per cent of the outstanding amount of
the NPA

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Non Fund Based Exposure:

For non-funded exposures like BGs/LCs, the Credit Conversion Factor (CCF) ranges from 20% to 100%
and is applied to arrive at the exposure for credit risk computation. The non-fund exposures are
converted to fund based exposures after applying CCF and applicable risk weight will be applied along
with the risk weight of funded exposure of the borrower to arrive at the total RWA.

Non-funded exposure Credit Conversion Factor

(CCF)
Financial Bank Guarantee 100%
Performance Bank Guarantee 50%
Short Term LC (Upto 1 Year) 20%
Long Term LC (More than 1 Year) 50%

Precautions to be taken by Branches:

 The guarantees issued are to be properly classified as per the sanction terms.
 Expired BGs are to be eliminated from Core as these lead to increase in RWA.
 Security for BG, LC and other exposures need to be properly entered in CORE and linked to
respective accounts.
 Security should be created for cash margins (deposits) obtained for non-funded exposures in Core
and are to be linked to the respective BG’s/LC’s.
 If a single security is taken for multiple non-funded exposures, it can be allotted to the different
exposures proportionately (as per sanction terms).
 Security amount has to be entered in actual rupees.

II Internal rating Based (IRB) Approach

The IRB Approach allows banks, subject to the approval of RBI, to use their own internal estimates for
some or all of the credit risk components [Probability of Default (PD), Loss Given Default (LGD), Exposure
at Default (EAD) and Effective Maturity (M)] in determining the capital requirement for a given credit
exposure.

The IRB approach allows it to use internal models to calculate credit capital, enabling more sensitivity
to the credit risk in the bank’s portfolio. Furthermore, incorporating better risk management techniques
on its portfolio will show its effect on minimizing the regulatory capital required. Another incentive to
move to the IRB approach is that the IRB-based regulatory capital is “lower than” the standardized
approach for higher credit rated banks and “higher than” for lower credit rated banks, thus providing a
better alternative for investment grade banks.

The IRB approach is again classified into:

a) Foundation IRB (FIRB) approach: Banks estimate Probability of default (PD) using internal
models, while the other parameters take supervisory estimates.
b) Advanced IRB (AIRB) approach: Banks provide their own estimate of PD, Loss Given Default LGD,
and Exposure at default (EAD) and their calculation for Maturity (M) is subject to the supervisory
requirements.

Under the IRB approach, banks are required to categorize their banking book exposures into the
following asset classes:
 Corporate
 Sovereign
 Bank
 Retail
 Equity

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Probability of Default (PD): The probability that the obligator or counterparty will default on its
contractual obligations to repay its debt.

Loss Given Default (LGD): The percentage of exposure the bank might lose in case the borrower
defaults.
Usually it is taken as: 1-recovery rate

Exposure At Default (EAD): In the event of default, how large will be the outstanding obligations if the
default takes place.

Effective Maturity (M): Effective maturity of the underlying should be gauged as the longest possible
remaining time before the borrower is scheduled to fulfill its obligation.

Mapping of Internal Rating Grades with External Rating Grades:

 HO-Integrated Risk Management Division is the authority to validate/Confirm Internal rating

assigned to the borrower before sanction of credit facility by various committees.

 As per the extant guidelines of the Bank, all the borrowers enjoying Credit limits of Rs.5 crore
and above should be rated externally by one of the accredited External Rating agencies, viz.
CRISIL, CARE, ICRA, India Ratings, SMERA, Brickworks or Informerics. Similarly, all commercial
proposals above Rs.25 lakh are rated internally by processing in the Risk Assessment Module
(RAM).

 The credit proposals which are internally rated have to be mapped to the external ratings,
wherever the borrowers are externally rated.

 The mapping of Internal Rating Grades with External Rating Grades (short term as well as long
term) is as follows:

Short Term Rating Long Term Rating Corresponding

Internal
Rating
A1+ AAA CB1
A1 AA CB2
A2 A CB3
A3 BBB CB4/CB5
A4 BB CB6
A4 B CB7
A4 C CB8
A4 D CB8

 In the case of proposals for Fresh Sanction / Renewal, where the borrower is not externally rated
i.e. Unrated, Internal Rating should not be assigned better than CB4, except for PSEs.

 While mapping Internal Rating grades with External Rating grades, following Scoring in RAM need
to be assessed:

a) Business Score
b) Financial Score
c) Management Score
d) Industry Score

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  While mapping Internal Rating grades with External Rating Grades, 2 Notch and above difference
is permitted by competent authority only on justifiable grounds like:

a) Key financial parameters are within benchmark level like TOL/TNW is not exceeding 4:1 ,
Debt/Equity Ratio is within 3:1, DSCR is at least 1.5:1, Current Ratio is above 1.33:1,
Promoters’ Contribution is above 25% , NOF/TFD is above 25% etc.,
b) Satisfactory dealings of the borrowers with our Bank i.e. no past overdues.
c) Long standing relationship of the borrowers with our Bank and borrower is maintaining
Deposits with Our Bank.
d) Adequate Security coverage, cash margin etc.,

Risk Weight vs Amount deployed:

RWA oriented decision making: Implementing RWA oriented decision making is the need of the hour.
For example, for deployment of Rs. 100 crore for "AAA" rated customer, RW is just Rs.20 crore, whereas
same amount deployed in non- corporate advances will have a RW of Rs.25 to Rs 75 crore (other than
CRE and Personal Loans) and Rs 150 crore for "BB" and below rated corporate customer.

This can be better appreciated by the following table:

Rs 100 Cr capital may be used for deploying of credit as follows:

(Amounts in Rs Crore)
Amount of Credit
that can be
Risk Available Credit deployed for the
External Rating Weight Capital RWA* rating Grade

AAA/A1+ 20% 4,348

AA/A1 30% 2,899

A/A2 50% 100 870 1,739

BBB/Unrated/A3 100% 870

BB & below/A4 150% 580

*Calculated @ 11.50%, the regulatory requirement of CRAR as on 31.03.2019

Interpretation: For available capital of Rs. 100 Crore, Bank can extend the credit exposure of Rs. 4348
Crore to AAA/A1+ rated borrower, whereas, the Bank can deploy only Rs. 580 Crore if the rating of
borrower is BB & below/A4.

Risk Adjusted Return on Capital (RAROC):

RAROC is a tool to compute the risk adjusted return on capital employed. It is but natural that higher
risk should be compensated by higher return of capital. It is arrived at by computing tax adjusted return
net of interest expense, operating expense and expected loss vis-à-vis capital deployed. Higher the
RAROC, better is the return on capital employed and value to investors.

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