BANKING RISK MANAGEMENT : -2021-22

Dr. Asit Mohanty

Professor in Finance
XIM University

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 Schedules to the Balance sheet…
Capital &Liabilities Schedule Number

Capital 1
Reserves and Surplus 2

Deposits 3

Borrowings 4

Other Liabilities &Provisions 5

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 Schedules to the Balance Sheet
Assets Schedule Number
Cash and balances with 6
RBI
Balances with banks and 7
Money at Call & Short
Notice

Investments 8

Advances/Loans 9

Fixed Assets 10
Other Assets 11
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 Schedules to the Balance sheet
Contingent liability…OBS 12
Interest Income 13
Non Interest Income 14
Interest Expenses 15
Operating Expenses 16
Significant Accounting 17
Policies

Notes on accounts 18
Disclosure of Important Items

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 Overview of Bank Balance Sheet
• Capital & Liabilities
 1. Capital ….0.10%
 2.Reserves & Surplus…4.87%
 3.Deposits …81.35%
 4.Borrowings …11.13%
 5.Other Liabilities & Provisions
…2.5%
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• Assets
• 6.Cash & Bank Balances…5.67%
&
7.Money at Call & Short Notices …
1.57%
• 8.Investments…30.28%
• 9.Advances ..60.52%
• 10. Fixed Assets…0.23%
• 11.Other Assets…1.73%
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 PROFIT AND LOSS ACCOUNT

• 15.Expenses
 Income  Interest Expenses (68.50%)
(borrowings & deposits)
 13.Interest Income(87.34%)
 Advances
 Investment  16. Non Interest Expenses -
 Inter Bank lending 18.15% (Operating Expenses)
 Interest on balances with RBI • Expenses on
Employee,Premises,Printing &
 14.Non Interest Income Stationery etc
(12.66%)
 Income earned from in form  Provisions & Contingencies –
of Commission and brokerage
13.37%
 Profit & sale of Investment
 Profit on Forex Transaction
 Profit on Sale of assets

Net Profit is Income net of expenses is apportioned to Reserves &

asit
Surplus, Dividend & Tax on Dividend
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 Risk
1. Risk Factor….Growth in Sales
2. Risk Identification…Credit Risk..
3. Risk Measurement/Quantification…..RW
4. Risk Mitigation………collateral….Mitigants
5. Risk Management…..Live With it….Tail Risk

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 Types
Banking Risk
1. Credit Risk
2. Market Risk
3. Operational risk

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• Credit risk is most simply defined as the potential
that a borrower or counterparty will fail to meet
its obligations in accordance with agreed terms.

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 Market Risk
• Market risk - Risk of losses in on and off-
balance sheet positions arising from
movements in market variables

• Market variables are

– Interest rates
– Equity prices
– Forex rates

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• Operational risk is defined as the risk of loss
resulting from inadequate or failed processes,
people and systems or from external events.

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 Risk Tool
• https://www.palisade.com/

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 Broad Course Outline
• Introduction to Balance Sheet
• Expected vs Unexpected Loss
• Loss Given Default Modeling
• PD Modeling
• Credit Rating
• Exposure at Default Modeling
• Validation Techniques

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• Standardized Approach to Credit Risk
• Internal Rating Model Approach to Credit Risk
• Economic Capital Modeling
• Basel II
• Basel III
– Market Risk ( Foundation & Advanced Approach)
– Operational Risk ( Basic Indicator & Advanced Measurement
Approach)
• Capital Structure
• Capital Allocation
• Credit Risk Mitigation
• Hands On……..
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• Major Features of Basel III
• Recent Discussion on Basel III…..COVID

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 Exam Pattern
• Mid Term – 20
• End Term –40
• Quiz – 25
• CP - 15
• 100 Marks

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 https://www.bis.org/bcbs/index.htm
https://www.apra.gov.au/capital-adequacy-internal-ratin
gs-based-approach-to-credit-risk
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EL Vs. UL

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 Tail Risk

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 Risk Parameters
1. Probability of Default
2. Loss Given Default
3. Exposure at Default

Expected Loss Unexpected Loss

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03/19/2022
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22

Evolution of Capital Calculations

 UL < Cap…..Shortfall Cap

EL = Provision + shortfall Cap

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 Analytical Measure of Expected Loss
• Individual exposure wise and Portfolio Expected Loss (EL)
• ELi = PDi x LGDi x EADi
• ELP = ∑ PDi x LGDi x EADi

24
 Portfolio Credit Risk (Correlation Effect)
• Practice is to group risks by facility type

• Then calculate correlation (i for facility i) between the default

rates of each facility group and that of the portfolio as a whole

• Then calculate for the portfolio:

ULP  i ULi  i
 MARGINAL RISK CONTRIBUTION
1. ULP = SQRT[(UL1 + UL2 )^2]
= SQRT(UL1^2 + UL^2 + 2.r12.UL1.UL2)
2. ULP = ULP^2 / ULP = (UL1 + UL2 )^2 / ULP
= (UL1^2 + UL^2 + 2.r12.UL1.UL2 )/ (ULP)
= UL1^2 + r12.UL1.UL2 + UL^2 + r12.UL1.UL2
/(ULP)
= (UL1^2 + r12.UL1.UL2 )/ (ULP )…….MRC1
+ (UL^2 + r12.UL1.UL2) /(ULP)….MRC2

=> ULP = MRC1 + MRC2

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 Marginal Risk Contribution
• ULp = MRC1 + MRC2
• MRC1 = (UL1^2 + r*UL1*UL2)/ ULp
• MRC2 = (UL2^2 + r*UL1*UL2)/ Ulp
• MRC1 +M RC2 = (UL1^2+ UL2^2 +
2r*UL1*UL2)/ Ulp
= ULp^2/ULp
= ULp
 Default Correlation

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 Loss Measures for Credit Risk
• Expected Loss
– Losses anticipated on a credit exposure / credit portfolio due to
defaults expected to occur during the normal course of business
– Measured as Average Loss using analytical formulae
• Unexpected Loss
– Volatility in credit portfolio losses due to larger than expected and
correlated defaults
– Measured as Standard Deviation of Loss using analytical formulae
• Credit Value at Risk (C-VaR)
– The maximum credit portfolio loss that can occur with a pre-defined
probability (confidence level) over pre-defined future time horizon
– Measured as Percentile Loss of the Credit Portfolio Loss Distribution
by analytical or simulation methods
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 Inputs in Estimation of Expected(Unexpected)
Loss
• Probability of Default (PD): estimate of the
likelihood of default over a given time horizon.

• Exposure at Default (EAD): estimate of the

exposure at a future default date, taking into
account expected changes in the exposure after
the reporting date, including repayments of
principal and interest and expected drawdowns on
committed facilities.
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 LGD
• Loss given Default (LGD): estimate of the
percentage loss arising on default. It is based on
the difference between the contractual cash flows
due and those that the lender would expect to
receive, including from any collateral. It is usually
expressed as a percentage of EAD.

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 Expected Vs. Unexpected Loss

• While it is never possible to know in advance the losses a bank will

suffer in a particular year, a bank can forecast the average level of credit
losses (EL) it can reasonably expect to experience.
• Losses above the expected levels are usually referred to as unexpected
losses (UL).
• Institutions know that these losses will occur now and then, but they
cannot know in advance the time of their arrival and their severity.
• Banks are in general expected to cover their EL on an ongoing basis, e.g.
by pricing and provisions because it represents just another cost
component of the lending business.
• According to this concept, capital is only needed for covering unexpected
losses. Hence (in Basel II & III ) the banks are only required to hold
capital against UL.
• Capital is the cushion for unexpected loss.

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 What is LGD?
 In the event of default, only a fraction of the risky debt
can be recovered  Recovery Rate
 The Recovery Rate depends upon:
 industry, economic cycle, seniority of borrowing,
collateral value
 The Recovery Rate is specific to the Loan
 It may calculated based on historical experience of the
bank in recovery in the event of default

Accounting Loss Given Default (LGD) = 1 - Recovery Rate

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 Estimation of Economic LGD

• To estimate Economic LGDs, each bank has to rely on

its internal data on defaulted loans and the positive
(recovery against principal and interest) and negative
(recovery costs-legal procedure etc.) cash flows
associated with these defaulted loans.
• Recovery Rate is defined as the present value of
recoveries post default as a fraction of the EAD
• The Present Value of Recoveries post default are
arrived at by discounting these cash flows using the
appropriate discount rate (risk free rate/average rate
charged on the loan)

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 LGD
• Loss given Default (LGD): estimate of the percentage loss
arising on default. It is based on the difference between
the contractual cash flows due and those that the lender
would expect to receive, including from any collateral. It
is usually expressed as a percentage of EAD.

 ELGD

• Discount Rate: rate used to discount the future expected

losses to present value at reporting date

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 Economic LGD Computation

A basic equation might be:

Recov𝑒𝑟𝑖𝑒𝑠𝑡 −𝐶𝑜𝑠𝑡 𝑠𝑡
𝐸𝐿𝐺𝐷=1−∑ ¿
¿¿
This is 1-all the recoveries (workout cost deducted) discounted back at the
time of default by the EAD.

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 LGD
LGD = 1- ∑Tt=1 (FRt – ACt )/ EAD
(1+r)t
• FRt face value of recovery including accrued rate of interest at
time ‘t’
• ACt cost associated with recovery(legal, administrative cost)
• r is the discount rate
• t is the time of default & T date of recovery

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 Numerical Example of Calculating Economic LGD
• At the time of default (Year. 2001), the facility is used for Rs. 1 Cr.
• There is a cost of legal procedure of Rs. 20,000 one year after the default
(up to 2015).
• In the first year (2015), bank recovers additional Rs. 20 Lacs from the
selling of collateral.
• After 2 years (2016), bankruptcy is pronounced and the default borrower
has paid additional Rs. 20 Lacs
• Say the discount rate is 10.5% (1 year MCLR of the bank)
• The economic (ELGD) LGD would be:

 20,000 20,00,000 20,00,000

  2
1 1 .105 1.105 1. 105  65.7%
1,00,00,000
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 Asian Historical LGDs Vary a Lot by Country,
but are High Relative to the US (45%)

Country Est.
LGD (%)
Hong Kong 50
India 70
Indonesia 85
Malaysia 55
Philippines 75
Singapore 25
Taiwan 60
Thailand 70

Source: S & P

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 Secured and Unsecured LGD

• Source: The Global Credit Data Consortium (2020)

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 Source: The Global Credit Data Consortium (2020)

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 Expected vs Unexpected Loss
• Although credit losses naturally fluctuate over time and with economic conditions, there
is (ceteris paribus) a statistically measured, long-run average loss level.
• Assume for example that, based on historical performance, a bank has come to expect
around 1% of its borrowers to default every year.
• Average recovery rate ( considering the impact of Cost of Recovery & PV) at
50%.....ELGD 50%
• Credit portfolio of $1 billion
• In that case, the bank’s expected loss (EL) for this a credit portfolio is $5 million (i.e. $1
billion x 1% x 50%).
• EL is based on three parameters:
• The likelihood that default will take place over a specified time horizon
(probability of default or PD)
• The fraction of the exposure, net of any recoveries, which will be lost following
a default event (loss given default or LGD).
• The amount borrowed by the counterparty at the moment of default (exposure
at default or EAD)
• Since estimation is on one-year basis , the product of these three factors is the one-year
EL as follows:

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EL = PD x EAD
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x ELGD 43
 Parameters for ELGD Modeling

 It is possible to estimate LGD using econometric models for corporate

exposures from the loss data on doubtful and loss accounts across
various lines of business.
 Parameters
 Type of collateral
 Net Value of Collateral
 Type of loan ( senior/junior)
 Industry (Asset Intensive)
 GDP / IIP
 age of the firm
 size of the firm etc. can be used to predict recovery and hence
LGD.

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 Dependent Variable: LGD
Method: DOLS RR
Included obs ervations : 340

Variable Coefficient Actual Prob.  

C 0.07801 0.0001
VCOL 1.727767 30 51.83301 0.0057
TLOAN 5.121546 1 5.121546 0.0435
GDP 10.24575 5% 0.51228735 0.0236
AGE 0.675861 12 8.110332 0.0032
SD1 0.223359 1 0.223359 0.034
65.8005344

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 ELGD in India..

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 FED RSEVE MODEL
• The Federal Reserve System, has suggested..
banks in the US use a simple formula to
specify downturn LGD --:
ELGD = 0.08 + 0.92 LGD

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 The Collapse of Barings

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 Background of Barings
• Founded in 1762.( 233 year old)

• Rapid growth during

Napoleonic Wars (1798 – 1814)

• Concurred as the sixth great European power at the

Congress of Vienna in 1815

• During the years of 1830s and 1840s, Barings

became the most influential financial house in U.S.
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 Background of Barings

• A Financial Crisis in 1890

– Provided loans to Argentina in 1824

– Debt crisis in Argentina in 1888

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 Background of Barings

– Success in consulting the royal family asset

management

– Success in giving advice for stock and bonds for

small British firms

– Moved back into American finance scene in 1980s

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 Background of Barings
• Leeson Crisis in 1995

– Nick Leeson, a lone manager in the company’s Singapore office made

speculative trades on future market, which broke the company

– Losses on account of unauthorised trading was accumulated to account no.

“88888” created by Leeson which was not disclosed to the management: Loss
of £830 million by 1995.

– fraudulent investments, primarily in futures contracts

– ING, Dutch financial service company, bought Barings at the fire sale price of
just £1 in June 1995.

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 Nicholas Leeson
• The son of a plasterer from
the London suburb of Watford

• Described as a loner by the people that he

worked with

• Competent soccer player

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 Nicholas Leeson
• 28-year-old trader who never graduated from
college

• Gained knowledge through numerous

investment establishment positions

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 Nicholas Leeson
• An investment officer at
Barings L.P.C.

• Working at the Singapore International

Monetary Exchange

• In charge of both making deals and overseeing

the paperwork on these deals
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 Nicholas Leeson
• Accused of losing the P.S1.3
billion

• Charged with forgery and cheating on

December 1, 1995

• Sentenced to six and a half years

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 How Leeson Broke Barings?
• Arrived in Singapore in 1992

• Arbitrage opportunities of Nikkei 225 futures

between SIMEX and OSE

• Leeson’s Singapore office is terribly understaffed –

errors frequently occurred

Operational Risk --Market Risk

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 CASE STUDY
THE BANK OF CREDIT AND COMMERCE
INTERNATIONAL (BCCI)

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 BCCI was shut down in 1991 after Bank of England
audits revealed that fraud, improper loans and
deceptive accounting practices had been discovered

Investigations in both the USA and the UK revealed

that BCCI was involved in money laundering, tax
evasion, bribery, smuggling, arms trafficking, and
the illegal purchases of banks and real estate. It was
accused of catering to drug dealers, arms merchants
and third world dictators

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The fraud required a highly compartmentalized organizational
structure, designed to foster deception and avoid centralized
regulatory review

BCCI’s annual auditing system was designed to

be non-transparent, with complexity built in to
avoid the detection of illegal accounting
practices

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 1993
Syed Ziauddin Ali Akbar, the Head of BCCI’s treasury
division in London until 1986, was the first to face BCCI-
related charges in Britain. Akbar pleaded guilty to false
accounting practice involving $765 million. Authorities
estimated that Akbar had personally gained or misused
$61 million. Akbar was sentenced to six years in prison
(a light sentence resulting from a plea bargain for his
guilty plea)

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 1988
In the United States investigations began when the
Bank was implicated in Panamanian dictator General
Noriega’s drug trafficking and money laundering
activities. The investigations revealed BCCI’s
connections with the Central Intelligence Agency and
various members of the American political elite.
Indictments on multiple fraud and larceny were drawn
up in 1991 against Swaleh Naqvi, the former BCCI chief
operating officer.

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 When proceedings commenced, Naqvi
admitted responsibility for $255 million in
losses in the United States, and pled guilty to
charges of fraud, racketeering and conspiracy.
He was ordered to pay restitution and
sentenced to eight years in prison

Operational Risk(PPS)…..>Credit Risk

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 Case Study: Chokio State Bank
• Agricultural region
• Agricultural boom of the 70’s led to increased
land value
• Agricultural recession of the 80’s led to
decreased land value.
• Loan to Value Ratio ?

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 Rural Bank

• Bank relied on agricultural community

• Decrease in land and equipment value left
little means of insuring the value of loans
• The bank was in trouble!!

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 Bank closes and FDIC takes over
• Bank was sold simultaneous to its
closure
• FDIC takes over $8.5 million of the
$9.5 million loans
• Majority of loans under FDIC
control
• Led to widespread hardship

Credit Risk

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 Convergence trade 

• Convergence trade is a trading strategy

consisting of two positions: buying one asset
forward—i.e., for delivery in future
(going long the asset)—and selling a similar
asset forward (going short the asset) for a higher
price, in the expectation that by the time the
assets must be delivered, the prices will have
become closer to equal (will have converged),
and thus one profits by the amount  of
convergence

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 LTCM
• Long Term Capital Management…

• This fund was set-up by some very famous people, namely,

John Meriwether from Salomon Brothers, Myron Scholes
and Robert C Merton among other important names.
( academicians + bond traders)
• Into Convergence Trade(Investment in Bonds)..Algo Trading
• At the beginning of 1998, the firm had equity of $5 billion
and had borrowed over $125 billion with assets of around
$130 billion, for a debit to equity ratio of over 25 to 1
• However, RONW was 40%
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 LTCM
• On Monday, October 27,,1987the DOW dropped 554 points(23% drop).
This termed as black Monday and the New York Stock Exchange shut
down twice in an attempt to calm the market(spill over to other Euro
counties)
• The Russian Financial Crisis of August and September 1998 which was
caused due to the default of the Russian Government bonds further
contributed to these losses.
• This was called the “Ruble” crisis and it resulted in the Russian
Government devaluing the ruble and defaulting on its debt
• The asset value came down to be $4.6 billion( Buffett offered 250
mio USD)
• The LTCM was frozen.
• Market Risk, Liquidity Risk, Model Risk
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 The Story of Washington Mutual--The
Biggest Bank Failure in American History
• Through a case study of Washington Mutual Bank
(WaMu), the Report found that in 2006, WaMu began
pursuing high risk loans to pursue higher profits
• The Office of Thrift Supervision (OTS) was cited in the
Report as a major culprit in financial collapse, for their
“failure to stop the unsafe and unsound practices that
led to the demise of Washington Mutual
• Inflated Credit Ratings
Operational Risk….Credit Risk

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 Orange County…
• Was declared bankrupt in 1994 with a loss of
$1.6 billion
• Largest financial failure of local Govt in US
history
Interest Rate Risk & Operational Risk

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 CRB Crash in India
• Incorporated on 16 May '85, CRB Capital Market (CRB Caps) (formerly CRB
Consultants) was promoted by the Bhansali group.
• The company is active in areas like credit syndication, project advisory
services, corporation counselling, capital market operations, leasing, hire
purchase, and issue management.
• It is also a category-I merchant banker
• Bhansali is alleged to have lost about US$337 million of investors' money when
his group of finance companies collapsed
• The CRB debacle is the second biggest scandal to hit the Indian capital market;
the worst being the 1992 bank securities scam, masterminded by Harshad
Mehta - the 'Big Bull' - and some other stockbrokers. Many leading Indian and
foreign banks were defrauded then of around 40 billion rupees.
• The worst hit are his companies' depositors
Operational Risk

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 GTB
• Started by banking genius Ramesh Gelli, a banker who
captured the imagination of Indians with his banking
pyrotechnics, GTB appeared to have a bright future.
• NW became negative with huge NPA
• No prudent lending Norms
• Concentration Risk on account of huge capital market
exposure
• Bank was merged (No NPA Bank)……GTB
Operational Risk +Credit risk + Credit Concentration Risk

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 To name a few……
• Merrill Lynch(BOFA)…..Credit Risk…2008
• Bear Stearns(JPMC)……. Credit risk..2008
• Lehman Brothers (Nomura Holdings )…..Market Risk…2008
• Northern Rock (Virgin Money)….Credit Risk…2008/12
• Wachovia (Wells Fargo)…Credit Risk 2008
• National City Bank(PNC Financial Services)…Credit Risk..2008
• Bank of Antigua(Eastern Caribbean Central Bank) Operational Risk…2009
• Alliance Bank(Government of Kazakhstan)…Credit Risk..2009
• Lloyds TSB (HBOS)….Operational risk….2012
• Royal Bank of Scotland Group…Bailed out…..Operational Risk
The FSA admits that its own supervision was "flawed”

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 June 2018: IL&FS defaults for the first time on repayment of
commercial paper (short-term borrowing) and inter-corporate deposit
(unsecured borrowing) worth Rs450 crore ($60 million).

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 Managing Operational Risk
Expected Unexpected Catastrophic
Loss Loss Loss
Likelihood
Of
Loss

Magnitude of loss
Loss Prov. Op. Risk Risk financing using
Absorbed Capital Tier I Capital

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 CREDIT RISK RATING MODEL
&
Estimation of PD

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 Mapping Process (Borrower Rating )
“Standardisation of Rating Symbols and Definitions

Long Term Ratings

CARE CRISIL BRICK WORK ICRA

AAA AAA AAA AAA

AA AA AA AA
Seven
A A A A Categories
BBB BBB BBB BBB
BB BB BB BB
B B B B
C C C C
D D D D

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 Meaning of the Rating
• AAA….Extremely Favorable Position and Minimum Risk….Highest Degree of
Safety …regarding timely servicing of financial obligations
• AA….. Indicates Favorable Position and have only Marginal risk …. High Degree of
Safety
• A…….Indicated Stable Position with Modest Risk …Adequate degree of
• safety
• BBB…..Implies average Position and the outlook is Stable….investment Grade
…..Moderate degree of safety
• BB…….Though not Acceptable Risk Tending towards negative outlook…..Below
Investment Grade
• B…………Very High Risk Category
• C……..Indicates Maximum Degree of Risk and Highly unfavorable Position that
could affect the Borrower in a detrimental Way

• D……Default Category
81

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 Rating at End of Year
AAA AA A BBB BB B CCC D
AAA 78.93% 7.02% 5.62% 2.81% 2.25% 1.40% 1.12% 0.84%
AA 0.63% 77.10% 5.88% 5.25% 4.20% 3.15% 2.10% 1.68%
A 0.00% 2.69% 72.58% 6.45% 5.38% 5.91% 4.30% 2.69%
BBB 0.00% 0.22% 10.04% 71.43% 5.58% 4.46% 3.79% 4.46%
BB 0.00% 0.00% 3.67% 11.56% 67.89% 6.79% 5.50% 4.59%
B 0.00% 0.00% 0.26% 0.53% 11.90% 66.14% 13.23% 7.94%
CCC 0.00% 0.00% 0.27% 1.08% 1.97% 10.76% 63.95% 21.97%
D 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 100.00%

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 Average Transition Matrix of 5 Years
AAA AA A BBB BB B CCC D
AAA 82.65% 14.41% 2.37% 0.42% 0.11% 0.03% 0.01% 0.01%
AA 1.65% 78.39% 16.81% 2.34% 0.36% 0.29% 0.05% 0.08%
A 0.23% 5.48% 79.19% 12.27% 1.81% 0.73% 0.09% 0.24%
BBB 0.10% 0.96% 11.42% 73.76% 9.48% 2.75% 0.48% 1.06%
BB 0.08% 0.28% 2.04% 14.12% 61.88% 14.94% 2.25% 4.45%
B 0.03% 0.26% 0.97% 2.23% 11.44% 63.64% 5.90% 15.53%
CCC 0.28% 0.09% 0.78% 2.09% 4.50% 16.36% 32.56% 43.40%
D 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 100.00%
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 Transition Matrix

• An element of a transition matrix gives the

probability that an obligor with a certain initial
rating slab migrates to another rating slab by
the risk horizon…..time period

84

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 Interpretation of Transition Matrix
• The likelihood of a customer migrating from its current risk rating category
to any other category from the beginning of year t-1 to year t is frequently
expressed in terms of a rating transition matrix

• Therefore, for the Transition Matrix to be generated, at least two years

rating data should be available

• Thus, in the exhibit, the likelihood of a B rated borrower migrating to “ D”

Category within one year would be 10.98%....Probability of Default
(Crisil)
85

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Transition Matrix

Grade at T+1
AAA AA ... B CCC D
AAA

Downgrade
AA

Grade at T .
.
.
.

B
Upgrade

CCC

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 Interpretation
• Stability of Ratings
Stability rate for each rating category indicates
Percentage of ratings remaining in the same
category at the end of one year.

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 CRISIL’s Corporate Ratings :
Average Annual Transition Rates: FY10-FY20

Source : CRISIL Ratings

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 CRISIL’s Corporate Ratings :
Average Annual Transition Rates: FY 2008-FY2018

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 Objectives in Modeling Default Risk

• Measure credit risk in terms of default

probabilities

• Provide the most accurate forward-looking,

approach..(Key Word)

• Provide frequent updates and early warning of

changes in credit quality
• Credit-Rating model captures both credit worthiness
and also the potential default.
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 Rating - Rationale
• The primary focus of the rating exercise is to assess
future cash generation capability of the company
and its adequacy to meet debt obligations, even in
adverse conditions. The analysis attempts to
determine the long-term fundamentals and the
probabilities of change in these fundamentals.  

• Debt Service Coverage Ratio (DSCR)

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 BIS Requirements…Rating Structure…
International Best Practices

• A bank must have specific rating definitions,

processes and criteria for assigning exposures to
grades within a rating system.
• The rating definitions must result in a meaningful
differentiation of risk.
• A bank must have a meaningful distribution of
exposures across grades with no excessive
concentrations.
• To meet this objective, a bank must have a minimum
of seven borrower grades for non-defaulted
borrowers and one for those that have defaulted.
•
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 BIS Requirements…Rating Structure…
International Best Practices

• This is to avoid undue concentrations of borrowers

in particular grades
• Banks with lending activities may satisfy this
requirement with the minimum number of grades;
• However, supervisors may require banks, which lend
to borrowers of diverse credit quality, to have a
greater number of borrower grades.
• A borrower grade is defined as an assessment of
borrower risk on the basis of a specified and distinct
set of rating criteria, from which estimates of PD are
derived.

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 Monotonic Relationship between Default Rates and Rating
Classes

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 Evolution of Capital Calculations
1988 Basel Capital Accord (Basel I) :

Capital Ratio = Total Capital

Credit Risk (RWAs of Banking Book)

1996 Market Risk Amendment:

Capital Ratio = Total Capital

Credit Risk + Market Risk (Market

Risk equivalent of Trading Book)
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 Basel Capital Accord – Brief History

Basel 1 Basel 1.5 Basel 2

Proposed: 1986 Proposed: 1993 Proposed: 1999
Effective: 1988 Effective: 1998 Effective: 2007
Credit Credit Credit
Risk Risk Risk
+ (Enhanced)

Market +
Risk Market
Risk
(No change)
Key sources of required work +
for affected banks. Op Risk
(New)

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 Evolution of Capital Calculations
Revised Capital Accord (Basel III):

Capital Ratio = Total Eligible Capital

Credit Risk + Market Risk + Operational Risk

Minimum 8% remain No Change

unchanged

RWA Calculations New Risk Capital

Revised Charge
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 Validation of Credit Risk Models

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 PD and GDP Growth Rate

• Negative Correlation

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