Why Rating?

• Marketing Tool for canvassing new proposals

• Acceptance of Proposals based on cut-off score (Investment grade)
• Regulatory requirement (Basel III) to arrive at Expected Loss
• Risk based Pricing
• Discretionary Lending Power/ Review
• Sanction of Adhoc/ Excess
• Periodicity of Inspection of Securities
• Rating Based Exposure Ceiling
• Early detection of Warning Signals
• RAROC Computation
Expected Loss: It is the average credit loss expected from an exposure over a given period
of time
EL = (EAD) X (PD) X (LGD)
EAD = Exposure * CCF
Credit Conversion Factor (CCF) It convert the exposure of a free credit lines and other off
balance sheet items (excluding derivatives) to EAD.
CCF is different for different credit facilities. Example: Term loan facility of Rs. 20 lacs and
letter of credit (working capital) facility of Rs. 10 lacs was disbursed to ABC Ltd. The CCF for
term loan is 100% and short term LC facility is 20%
Probability of Default: It is the probability that, the borrower will default on its contractual obligations
over a period.

The probability that a borrower will default on Credit obligation.

PD is calculated on the basis of historical data and hence, more the historical information, better the
PD estimate.
Historical data should be at least 5 years as mandated by RBI and should necessarily include a period
of high financial duress.
Probability of Default is of 2 types:
Through the Cycle PD (TTC): is essentially a long run average default rate covering a
time horizon of minimum 5 years and including at least one period(s) of high stress.

Point in Time PD (PIT) is a default rate that is responsive to the current economic
scenario as in at a particular point of time

Loss Given Default (LGD): The amount of money a bank or other financial institution loses
when a borrower defaults on a loan.
repayment towards contractual dues coupled with liquidation of collateral security is to be
considered and thus the Recovery Rate is found out.
LGD = 1 – RR
The facility rating (FR) under internal rating model provides different LGD estimates
Credit Risk: The risk of an obligor defaulting on his obligation towards the bank
It exists even in continuous repayment. i.e deterioration of credit worthiness of borrower.
Components of Credit Risk: Obligor Risk & Facility Risk
Maturity: Risk related to the length or maturity of the credit exposure.
EAD: Bank’s exposure on the borrower. Exposure x Credit Conversion Factor
Expected Loss = PD x LGD x EAD
Factors that drive in Credit Risk:
 RATING MATRIX
FR1 FR2 FR3 FR4 FR5 FR6 FR7 FR8
BOB1 CR1 CR1 CR1 CR1 CR1 CR1 CR2 CR2

BOB2 CR1 CR1 CR2 CR2 CR2 CR2 CR2 CR3

BOB3 CR2 CR3 CR3 CR3 CR4 CR4 CR4 CR4

BOB4 CR3 CR3 CR4 CR4 CR5 CR5 CR5 CR5

BOB5 CR3 CR4 CR4 CR5 CR5 CR6 CR6 CR6

BOB6 CR3 CR5 CR6 CR6 CR7 CR7 CR7 CR7

BOB7 CR5 CR6 CR7 CR7 CR8 CR8 CR8 CR8

BOB8 CR6 CR7 CR8 CR8 CR9 CR9 CR9 CR9

BOB9 CR6 CR8 CR9 CR9 CR9 CR10 CR10 CR10

BOB10 CR7 CR8 CR9 CR10 CR10 CR10 CR10 CR10

 RAROC
 For exposure above Rs.5 Crores only
 RAROC is defined as the ratio of risk adjusted return to capital employed
 RAROC = Risk Adjusted Net Income/ Economic Capital
 Where, the numerator: Risk Adjusted Net Income = Revenues (Gross Interest
Income + Other fees, commission etc.) - Total Cost - Expected Losses + Ancillary
business.
 Economic Capital: Economic Capital is the cushion, bank is desirous to set
aside considering the internal risk climate. EC helps absorb the unexpected
losses.
 (EC = Quantum of loan amount that carries risk x Capital rate according
to Credit rating of A/c)
 Quantum of loan amount that carries risk = Loan limit x RWA%
 RAROC= (Revenues - Costs - Expected Losses)/ Economic Capital
Revenue = Interest Income + Non Interest Income (Like Fee, commission, Processing charges etc) + Ancillary Income
Ancillary Income = Income incidental to the sanction of the parent loan
Costs = Cost of Funds + Operating Expenses + Expected Loss
Cost of Funds = (Interest Expended /Avg Working Funds) +Negative Carry on CRR.
Avg Working Funds = Daily average of all assets less cash and fixed assets
Operating Expenses in % = Operating Expenses /Total Deployable Deposits
EL = PD x LGD X EAD
Hurdle rate = 15%
Limit = 10.00 Cr; ROI = 9%, Process chrgs = 0.25%, PD = 2% & LGD= 55%, AAA rated @ capital rate 10.5%, COF
& OpE are 5.41% & 1.55%
Revenue = 0.9 + 0.025 = 0.925
Cost = 0.541 + 0.155 + 0.11 = 0.806
EC = Rate on Regulatory capital on RWA
RWA = 20% = 2.00  2 x 10.5% = 0.21 Now RAROC=(0.925-0.806)/0.21=56%  56% -15% = 41%
Credit Concentration Monitoring: Herfindahl-Hirschman Index (HHI) is used to assess
concentration risk.

Portfolio type HHI Risk type

Monopoly 10000 Extreme High Concentration
Oligopolistic (less) 1800-10000 High concentration
more number of Industries/ 1000-1800 Moderate concentration
borrowers
Up to 1000 Low concentration
e
Capital requirement under Basel III: RWA – 11.50%. Of which 2% should be Common Equity.
Common equity = Tier I capital + Tier II capital
Tier I: Bank’s pure capital = Common Equity Tier I (Core capital)+ Additional Tier I (Perpetual non-cumulative
preference share + Perpetual Debt Instruments)
Tier II: General Provision Reserves + Subordinate debt issued by Bank + Revaluation Reserves.
Capital Conversion Buffer (CCB): A capital that built up in normal time (outside period of stress) which backs
on losses during stress period.
Counter Cyclical Capital Buffer (CCCB): A capital that built up in good times to maintain the flow to real
sector in stress period.
Basel III norms:
Item % Required
1. Minimum Common Equity Tier1 (CET1) 5.50
2. Additional Tier 1 1.50
3. Minimum Tier 1 Capital Ratio (1+2) 7.00
4. Tier2 Capital Ratio 2.00
5. Min Total capital ratio (3+4) 9.00
6. Capital Conversion Buffer (CCB) 2.50
7. Min CET1 + CCB (1+6) 8.00
8. Minimum Total capital Ratio + CCB (5+6) 11.50