Role and Importance of CIBIL for banks

Credit Information Bureau India Limited (CIBIL) is the first credit information
company founded in India. It records and maintains credit details of individuals.
These include details such as payment records of loans and credit card bills
received from member banks and financial institutions. This information is then
used to create Credit Information Records (CIR) and credit scores. This is shared
with all the banks and financial institutions for evaluation and sanctioning of
different types of loans.

CIBIL score and its calculation

In the last five years or so, the Indian financial market has become quite stringent.
Therefore, it is essential to maintain a healthy CIBIL credit score. Your CIBIL
credit score is generated basis the CIR created and is used for evaluating your
eligibility for any kind of borrowing. A CIR is an individual's credit payment
history across loan types and credit institutions over a period of time.

A CIBIL credit score can be explained as a 3 digit numeric outline of your credit
history. It is calculated on the basis of your complete borrowing details such as
repayment record, repayment pattern, the number and type of loan accounts and
outstanding debts and default instances (if any). It ranges between 300 and 900
points. A healthy or a high credit score is important to get loans effortlessly. The
higher the points i.e. close to 900, higher are the chances of getting loans from a
lender (bank of other financial institutions in India). A low score (close to 300)
indicates defaults in the repayment pattern or other discrepancies pertaining to
borrowings in the past.
However, each bank or financial institution has its own benchmark for home loan
eligibility and approvals. Your CIBIL score is the first thing banks refer to when
you apply for a loan or a credit card. It is one of the most important criteria to
decide your eligibility for a loan or a credit card

How to improve your CIBIL score?

A low CIBIL credit score can not only weaken your chances of getting credit at a
modest interest rate but can also make it extremely difficult and cumbersome to get
loans sanctioned. However, if you follow the simple tips mentioned below, you
might be able to maintain and improve your credit score immensely.

Make payments on time: You must be very punctual about paying off your credit
card bills and other utility bills in order to maintain and further improve your
CIBIL score. If you have any outstanding bills, ensure that they are fully paid off,
in time. Use methods such as online payments or automatic deduction from your
account to avoid missing on any payments.

Do not take too much credit: It is a common notion that having multiple credit
cards is an easy way to get credit. However, what home buyers fail to realize is that
owning multiple credit cards sends out a signal that you are desperate for credit
and this might reduce your chances of getting credit or a home loan when you
actually need it.

Use your credit card wisely: It is essential to use your credit cards wisely. Do not
exceed your card limit. In fact, try and use only up to 75 per cent of the limit. This
indicates calculated spending, which is a positive point from a lender’s perspective.
Avoid applying for too many loans: When you apply or enquire about loans with
banks, an enquiry from the bank is sent to CIBIL. The higher the number of such
enquires with CIBIL, the more pressure it puts on your credit score.

Keep a check on your credit report: You must get a copy of your credit report
periodically to ensure that all details are correct. In case you find any mistakes that
might hamper your credit score, you must immediately report it to CIBIL. You can
get your credit report on the CIBIL website.
Importance of CIBIL score

 Easy Credit from Lenders: A good CIBIL score helps you in getting loans
and credits from lenders quite easily as your good CIBIL score raises hopes
of lenders that you will easily pay back your loans on time.
 Quick Approval of Loans: A good CIBIL score states that you a good
prospect to lend money. Thus banks try to give you the loan as early as
possible. People having lower credit score have to furnish a number of
documents and find guarantors making the loan disbursal process a bit time-
taking.
 Low interest rate credits: People with high CIBIL score get loans at
relatively lower rate of interests. Those having a lower credit score are
granted loans and credits at higher rates of interest.
 More Negotiation Authority: People having a good CIBIL score get loans
easily and at a lower rate of interest. Banks grant them loans very quickly. If
you know your CIBIL score is very high, you have the negotiation authority
to bring down your interest rate.
  Higher Approval Limits: If your CIBIL score is high, you not only get
loans at a lower rate of interest but also have chances of getting the upper
limit of loans.
 Easy Approval for Leased/Rented Properties: People having a good credit
score get easy approval for loans even for rented or leased properties like
homes, commercial complexes or apartments.
 Exciting Credit Card Offers: People having a good CIBIL score, get
exciting credit card offers from all banks. These cards have higher limits,
more privileges and amazing offers and cashbacks.

CAMEL approach

The CAMELS Rating System was developed in the United States as a supervisory
rating system to assess a bank’s overall condition. CAMELS is an acronym that
represents the six factors that are considered for the rating. Unlike other regulatory
ratios or ratings, the CAMELS rating is not released to the public. It is only used
by top management to understand and regulate possible risks.

Supervisory authorities use scores on a scale of 1 to 5 to rate each bank. The

strength of the CAMEL lies in its ability to identify financial institutions that will
survive and those that will fail. The concept was initially adopted in 1979 by the
Federal Financial Institutions Examination Council (FFIEC) under the name
Uniform Financial Institutions Rating System (UFIRS). CAMELS was later
modified to add a sixth component – sensitivity – to the acronym.

 (C)apital adequacy
 (A)ssets
 (M)anagement capability
 (E)arnings
  (L)iquidity
 (S)ensitivity

Capital Adequacy

Capital adequacy assesses an institution’s compliance with regulations on the

minimum capital reserve amount. Regulators establish the rating by assessing the
financial institution’s capital position currently and over several years.

Future capital position is predicted based on the institution’s plans for the future,
such as whether they are planning to give out dividends or acquire another
company. The CAMELS examiner would also look at trend analysis, the
composition of capital, and liquidity of the capital.

Assets

This category assesses the quality of a bank’s assets. Asset quality is important, as
the value of assets can decrease rapidly if they are high risk. For example, loans are
a type of asset that can become impaired if money is lent to a high-risk individual.

The examiner looks at the bank’s investment policies and loan practices, along
with credit risks such as interest rate risk and liquidity risk. The quality and trends
of major assets are considered. If a financial institution has a trend of major assets
losing value due to credit risk, then they would receive a lower rating.

Management Capability
Management capability measures the ability of an institution’s management team
to identify and then react to financial stress. The category depends on the quality of
a bank’s business strategy, financial performance, and internal controls. In the
business strategy and financial performance area, the CAMELS examiner looks at
the institution’s plans for the next few years. It includes the capital accumulation
rate, growth rate, and identification of the major risks.

For internal controls, the exam tests the institution’s ability to track and identify
potential risks. Areas within internal controls include information systems, audit
programs, and recordkeeping. Information systems ensure the integrity of
computer systems to protect customer’s personal information. Audit programs
check if the company’s policies are being followed. Lastly, record keeping should
follow sound accounting principles and include documentation for ease of audits.

Earnings

Earnings help to evaluate an institution’s long term viability. A bank needs an

appropriate return to be able to grow its operations and maintain its
competitiveness. The examiner specifically looks at the stability of earnings, return
on assets (ROA), net interest margin (NIM), and future earning prospects under
harsh economic conditions. While assessing earnings, the core earnings are the
most important. The core earnings are the long term and stable earnings of an
institution that is affected by the expense of one-time items.

Liquidity
For banks, liquidity is especially important, as the lack of liquid capital can lead to
a bank run. This category of CAMELS examines the interest rate risk and liquidity
risk. Interest rates affect the earnings from a bank’s capital markets business
segment. If the exposure to interest rate risk is large, then the institution’s
investment and loan portfolio value will be volatile. Liquidity risk is defined as the
risk of not being able to meet present or future cash flow needs without affecting
day-to-day operations.

Sensitivity

Sensitivity is the last category and measures an institution’s sensitivity to market

risks. For example, assessment can be made on energy sector lending, medical
lending, and agricultural lending. Sensitivity reflects the degree to which earnings
are affected by interest rates, exchange rates, and commodity prices, all of which
can be expressed by Beta.

How does the CAMELS Rating System Work?

For each category, a score is given from one to five. One is the best score and
indicates strong performance and risk management practices within the institution.
On the other hand, five is the poorest rating. It indicates a high probability of bank
failure and the need for immediate action to ratify the situation. If an institution’s
current financial condition falls between 1 and 5, it is called a composite rating.

 A scale of 1 implies that a bank exhibits a robust performance, is sound, and

complies with risk management practices.
  A scale of 2 means that an institution is financially sound with moderate
weaknesses present.
 A scale of 3 suggests that the institution shows a supervisory concern in
several dimensions.
 A scale of 4 indicates that an institution has unsound practices, thus is unsafe
due to serious financial problems.
 A rating of 5 shows that an institution is fundamentally unsound with
inadequate risk management practices.

Sources of Liquidity Risk

To put it simply, liquidity risk is the risk that a business will not have sufficient
cash to meet its financial commitments in a timely manner. Without proper cash
flow management and sound liquidity risk management, a business will face a
liquidity crisis and ultimately become insolvent.

As businesses go about the process of measuring and managing liquidity risk, they
need to be on alert for common sources of that risk. Those sources include:

1. Lack of Cash Flow Management

Cash flow management gives a business good visibility into potential liquidity
challenges and opportunities. Cash is king, and cash flow is the bloodline of all
businesses. Without proper management of cash flow, a business will increase its
exposure to unnecessary liquidity risks. Moreover, a business without healthy and
well-managed cash flow will face an uphill battle to remain profitable, secure
favorable financing terms, attract potential inventors, and be viable in the long run.

2. Inability to Obtain Financing

A history of late debt repayment and/or non-compliance with loan covenant
requirements may translate into additional challenges when attempting to secure
financing. Therefore, it is imperative that businesses have good capital structure
management, match debt maturity profiles to assets, and maintain a good
relationship and regular communication with lenders. The inability to obtain
funding at all or to obtain it at competitive rates and acceptable terms increases
liquidity risk.

3. Unexpected Economic Disruption

At the start of 2020, the stock market was at its all-time high and few people
expected the world would be so hard hit by COVID-19. The adverse economic
impact of this global pandemic was swift and relentless. Lockdowns created an
unexpected economic disruption, and many businesses saw sales dwindle to a
catastrophically low level and liquidity risk drastically increase.

4. Unplanned Capital Expenditures

Having proper fixed asset management is extremely important, particularly for a

business that operates in a capital-intensive industry such as energy,
telecommunications, or transportation. A capital-intensive business is often highly
leveraged with a high fixed to variable costs ratio. For businesses like these, a
single unplanned capital expenditure, such as a new purchase or major equipment
repairs, may exacerbate existing budget constraints. This, in turn, further increases
operating leverage and heightens liquidity risk.

5. Profit Crisis
A business in a profit crisis will not only see a decline in its profitability margins
but also a decline in its top-line revenue. Consequently, to combat negative
profitability margins and remain in operation, it will need to start dipping into cash
reserves. Failure to stop a continuous cash burn will eventually deplete cash
reserves, with the business inevitably facing a liquidity crisis.

Principles of Liquidity Management

Introduction to Liquidity Management:

Liquidity means an immediate capacity to meet one’s financial commitments. The
degree of liquidity depends upon the relationship between a company’s cash assets
plus those assets which can be quickly turned into cash, and the liabilities awaiting
payments could be met immediately. The liquidity and the Investments are two
corners opposite to each other.

If more earning is required more and more investment is to be made which may
result into less degree of liquidity, which may result ,on account of not fulfilling
the commitments, into penalties/high rate of interests or other type of losses.

1. Identify Liquidity Risks Early

A liquidity deficit at even a single branch or institution has system-wide

repercussions, so it’s paramount that your bank be prepared before a shortfall
occurs. This means your bank needs to have a rigorous process for IDENTIFYING
AND MEASURING LIQUIDITY RISK.

Your liquidity management process should include a forward-looking framework

to project future cash flows from assets, liabilities and items not on your balance
sheet. This framework should include:

 The ability to conduct risk analysis on extreme, hypothetical situations

 The maintenance of liquid assets to serve as a cushion in case of a possible
shortfall

2. Monitor & Control Liquidity Regularly

Once you’ve identified and forecasted your bank’s liquidity risk, you need to
actively MONITOR AND CONTROL ANY RISK EXPOSURES OR FUNDING
NEEDS. Depending on the size and scope of your bank, this monitoring needs to
account for multiple legal entities, business lines and international currencies. Of
course, you must also remember to account for any banking compliance
regulations that might limit the transferability of your liquid assets.

Ensure that your liquidity risk MONITORING AND CONTROL TOOLS include
the following indicators and metrics (via ACCENTURE):

 Global liquidity indicators

 Business-specific liquidity indicators
 Advanced cash flow forecasting
 All relevant regulatory ratios

3. Conduct Scheduled Stress Tests

Just like any professional facility must practice for fire drills or emergency
procedures, your bank needs to conduct regular financial stress tests to anticipate
 different potential liquidity shortfalls. Your stress tests should include both short-
term and long-term scenarios that identify sources of liquidity strain and that
ensure all exposures align with your established liquidity risk tolerance.

Confirm that your regularly scheduled stress tests include the following scenarios:

 Institution-specific strains
 Market-wide stress scenarios of individual variables
 Market-wide stress scenarios of multiple, combined variables

4. Create A Contingency Plan

Using the results of your stress tests, adjust your liquidity risk management
strategies accordingly. Then, use these new policies and positions to develop a
formal contingency funding plan (CFP) that clearly articulates your bank’s plan for
overcoming liquidity shortfalls in various emergency situations.

A robust CFP should (via BASEL COMMITTEE):

 Outline policies for managing various stress environments

 Delegate clear lines of responsibility
 Establish escalation procedures
 Be regularly tested and updated

Approaches of Liquidity Management

1. Fundamental Approach.
2. Technical Approach.
 These two methods distinguish from each other in their strategically approach to
eliminate liquidity risk. While the fundamental approach aims to ensure the
liquidity for long run sustenance of the bank, the technical approach targets the
liquidity in the short run. Due to these features, the two approaches supplement
each other in eliminating the liquidity risk and ensuring profitability.

1. Fundamental Approach

Since long run sustenance is driving factor in this approach, the bank tries to tackle
/eliminate the liquidity risk in the long run by basically controlling its assets-
liability position. A prudent way of tackling this situation can be by adjusting the
maturity of assets and liabilities or by diversifying and broadening the sources of
funds.

The two alternatives available to control the liquidity exposure under this approach
are Asset Management and Liability Management. This implies that liquidity
can be imparted into the system either by liability creation or by asset liquidation,
which eve suite the situation.

1. Asset Management: Asset management is to eliminate liquidity risk by holding

near cash assets i.e. those assets, which can be turned into cash whenever required.
For instance, sale of securities from the investment portfolio can enhance liquidity.
When asset management is resorted to, the liquidity requirements are generally met
from primary and secondary reserves. Primary reserves refer to cash assets held to
meet the statutory cash reserve requirements (CRR) and other operating purposes.
Though primary reserves do not serve the purpose of liquidity management for
long period, they can be held as second line of defense against daily demand for
cash. This is possible mainly due to the flexibility in the cash reserve balances
 (statutory cash reserves are required to be maintained only on a daily average basis
for a reserve maintenance period). However, most of the liquidity is generally
attained from the secondary reserves, which include those assets held primarily for
liquidity purposes. These secondary reserves are highly liquid assets, which when
converted into cash carry little risk of loss in their value. Further, they can also be
converted into cash prior to their maturity at the discretion of the management.
When asset management is resorted to for liquidity, it will be through liquidation
of secondary reserves. Assets that fall under this category generally take the form
of unsecured marketable securities. The bank can dispose these secondary reserves
to honor demands for deposit withdrawals, adverse clearing balances or any other
reasons.

2. Liability Management: Converse to the asset management strategy is liability

management, which focuses on the sources of funds. Here the bank is not
maintaining any surplus funds, but tries to achieve the required liquidity by
borrowing funds when the need arises. The underlying implications of this process
will be that the bank mostly will be investing in long-term securities /loans (since
the short-term surplus balance will mostly be in a deficit position) and further, it
will not depend on its liquidity position/surplus balance for credit
accommodation/business proposals. Thus in liability management a proposal may
be passed even when there is no surplus balance since the bank intends to raise the
required funds from external sources. Though it involves a greater risk for the
bank, it will also fetch higher yields due to the long-term investments. However,
sustenance of such high spreads will depend on the cost of borrowing. Thus, the
cost and the maturity of the instrument used for borrowing funds play a vital role in
liability management. The bank should on the one hand be able to raise funds at
low cost and on the other hand ensure that the maturity profile of the instrument
does not lead to or enhance the liquidity risk and the interest rate risk. Of the two
strategies available in fundamental approach, it is understood that while asset
management tries to answer the basic question of how to deploy the surplus to
eliminate liquidity risk, liability management tries to achieve the same by
mobilizing additional funds.

2. Technical Approach

As mentioned earlier, technical approach focuses on the liquidity position of the

bank in the short run. Liquidity in the short run is primarily linked to the cash
flows arising due to the operational transactions. Thus, when technical approach is
adopted to eliminate liquidity risk, it is the cash flows position that needs to be
tackled. The bank should know its cash requirements and the cash inflows and
adjust these two to ensure a safe level for its liquidity position.

Working Funds Approach and the Cash Flows Approach are the two methods
to assess the liquidity position in the short run. Of these two approaches, the
former concentrates on the actual cash position and depending on the factual data,
it forecasts the liquidity requirements. The latter approach goes a step forward and
forecasts the cash flows i.e. estimates any change in the deposits withdrawals
credit accommodation etc. Thus apart from assessing the liquidity requirements, it
also advises the bank on its investments and borrowing requirements well in
advance.

Interest rate risk management

What is Interest Rate Risk :

Interest rate risk is the risk where changes in market interest rates might adversely
affect a bank’s financial condition. The management of Interest Rate Risk should
be one of the critical components of market risk management in banks. The
regulatory restrictions in the past had greatly reduced many of the risks in the
banking system. Deregulation of interest rates has, however, exposed them to the
adverse impacts of interest rate risk. T

What is the Impact of IRR:

The immediate impact of changes in interest rates is on the Net Interest Income
(NII). A long term impact of changing interest rates is on the bank’s networth since
the economic value of a bank’s assets, liabilities and off-balance sheet positions get
affected due to variation in market interest rates.
The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent
on the movements of interest rates. Any mismatches in the cash flows (fixed assets
or liabilities) or repricing dates (floating assets or liabilities), expose bank’s NII or
NIM to variations. The earning of assets and the cost of liabilities are closely
related to market interest rate volatility.
The interest rate risk when viewed from these two perspectives is known as
‘earnings perspective’ and ‘economic value’ perspective, respectively.
Management of interest rate risk aims at capturing the risks arising from the
maturity and repricing mismatches and is measured both from the earnings and
economic value perspective.
(a) Earnings perspective involves analysing the impact of changes in
interest rates on accrual or reported earnings in the near term. This is
measured by measuring the changes in the Net Interest Income (NII) or Net
Interest Margin (NIM) i.e. the difference between the total interest income
and the total interest expense.
 (b) Economic Value perspective involves analysing the changes of impact
on interest on the expected cash flows on assets minus the expected cash
flows on liabilities plus the net cash flows on off-balance sheet items. It
focuses on the risk to networth arising from all repricing mismatches and
other interest rate sensitive positions. The economic value perspective
identifies risk arising from long-term interest rate gaps.
Functions

 Board and Senior Management Oversight

A bank’s board of directors is expected to have working knowledge of the
different types of interest rate risk, understand how business activities could
create or change the bank’s exposure, and understand how risk measurement
reports can be used to identify exposures. Therefore, training and education
in this area is critical.

 Risk Limits
Risk limits define how much exposure is acceptable before action should be
taken. Limits must be understood by management and the board,
measureable using existing tools and stated relative to meaningful values,
such as earnings or capital.

 Risk Measurement and Reporting

A bank’s interest rate risk measurements should quantify the bank’s risk
exposure and the potential reduction in earnings that might result in
changing interest rates for two time periods: short-term (12-24 months) and
long-term (up to five years). While simple static gap reporting may be
acceptable for some small banks, regulators expect that management and
 directors of banks with more complex risk profiles evaluate and actively
manage earnings at risk and economic value exposures.

 Internal Controls and Audit

With the increased use of interest rate risk models, examiners expect
management teams to take greater steps to ensure that data, assumptions and
output are both reasonable and accurate.