RISK MANAGEMENT & CAPITAL

MEASUREMENT

Asit Mohanty

1. Management of Financial Institutions

with Emphasis on Bank and risk management By Meera Sharma

(PH India Publication)

2. Risk Management and Financial Institutions: J.C.Hull

3. Risk Management and Capital Adequacy…….Reto Gallati

INTRODUCTION TO CREDIT RISK

BUILDING BLOCKS FOR CREDIT RISK

INTRODUCTION TO CREDIT RISK

BUILDING BLOCKS FOR CREDIT RISK

WHAT IS RISK

Risk is possibility/probability of loss. It arises as deviation between what happens and what was expected to happen.

As Risk arises due to uncertainty of future, Risk is always in the future.If there is no tomorrow, there is no Risk.

Uncertainty and Risk

Uncertainty: At least TWO outcomes

B G B

B G G

Risk: Possibility that at least one outcome isUNFAVOURABLE

Measuring Risk

What is UNFAVOURABLE?

Short of a BENCHMARK

RISK Degree of Unfavourablity

DOWNSIDE Risk: Probability that the actual return may be at variance with expected returns

RISK MANAGEMENT

BUSINESS IS INHERENTLY RISKY

RISKS CANNOT BE AVOIDED COMPLETELY

RISKS DEFY CONVENTIONAL THINKING

IMPORTANCE OF RISKS CHANGES WITH TIME

WHAT IS RISK MANAGEMENT

Risk Management involves Five Silos / Steps : -

1. Identification of Risk..Factor/Parameter/Category

2. Identification of Risk

3. Measurement/ Quantification of Risk

4. Mitigation of Risk

5. Controlling/Managing/Monitoring Risk

Objectives of Risk Management….Minimisation of Risk Associtiated with Claims…… Efficient Use Capital

What constitutes Credit What constitutes Credit Risk Management?Risk Management?

IDENTIFICATION QUANTIFICATION

POLICY/OBJECTIVES

IMPLEMENTATIONMONITORING

MitigationControlling Managing

Banking and Risk Management

Banks are trustees of public money.

Banks are facing certain kinds of Risk while discharging their role as financial intermediaries…while utilizing the funds of the depositors

Risk faced by the Banks are of broadly three types : - Credit Risk- Market Risk- Operational Risk

Earnings variability is induced by the underlying risk factors

Types of Risk

Credit Risk Variability in earnings to the bank

caused by cash flow from the project, business environment, Industry scenario, management decisions…

Variability in earnings caused by changes in the interest rate, forex rate, Equity Prices, commodity prices….

Variability in earnings caused by Process, people, technology,…….

Operational

Market Risk

What is Credit Risk?

At t=T,

Actual Payment < Required Payment

Pre-specified Amount

WHY? Inability or Unwillingness

What is Credit Risk

Credit Risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending.

It is defined by the losses in case of default of a borrower(Crystalised Default) or in the event of a deterioration of the borrower’s credit quality.

Traditionally Credit Risk is having two components viz. –

Solvency aspect of Credit Risk – the risk that the borrower is unable to repay in full the sum outstanding.

Liquidity aspect of Credit Risk – the risk that arises due to delay in repayment by the borrower leading to cash flow problems for the lender.

However, solvency and liquidity aspects are closely related. Perpetual/Continuous iIliqidity leads to Insolvency

What is Credit Risk

Objectives of Credit Risk Management

Minimising losses Remaining competitive despite various risks and

stringent regulatory limits Risk based pricing (for profit/capital

optimisation) Developing quality loan products Developing sound lending policies and a

rigorous appraisal system Developing effective post sanction

processes..Monitoring

WHAT IS COUNTER PARTY CREDIT RISK

Another variant of Credit Risk is counter party risk. The counter party risk arises from the non-performance of the trading

partners. Counter party risk in a derivative transaction is different from the

Credit Risk on a loan. In a loan transaction only the creditor is at risk. On the other hand,

both the parties to the contract may be at risk in a derivative transaction. The counter party risk can be categorized into :

1. Pre-settlement Risk – Credit loss suffered by a Bank due to default by counter party prior to the settlement.

2. Settlement Risk .. fails to deliver the contract on settlement date.. Settlement risk is sometimes called "Herstatt Risk", named after the well-known failure of the German bank Herstatt. On Jun 26, 1974, the bank had taken in its foreign-currency receipts in Europe, but had not made any of its U.S. dollar payments when German banking regulators closed the bank down, leaving counter parties with substantial losses

Credit Risk Management and NPA Management

Credit Risk Management is not NPA management. NPAs are a legacy of past in the present…therefore

backward looking Credit Risk Management is action in present for the

future occurrence……forward looking In a NPA account the credit risk is already

materialised. Credit Risk Management enables the Bank to take

timely action to stem deterioration in credit portfolio quality much before actual default.

Portfolio Level Credit Risk

Fortunes of the firms are correlated

Say -

(a) Real Estate, Steel, (b) Cement

Positive Correlation

Fortunes of the firms are not correlated

Say -

Real Estate - Food

No Correlation

Correlation

BROAD PARAMETERS/BUILDING BLOCKS OF RISK MANAGEMENT FUNCTION

Risk Management Organization

Policy & Strategy

Operations / System…Implementation

1. Structure Risk Management Organisation

Board of Directors

Integrated Risk Management Committee (IRMC)

CRMC ALCO

OP Risk Management Function

Market Risk Management Function

Credit Risk Management

Function

OP Risk Mgmnt Committee

HEAD, RMD

Head CR Head MR Head OR

Risk Management Organisation

PROCESS FLOW The Board of Directors will have the overall responsibility for approval

of Risk management Policies. The Board should approve the Risk Management Policy of the bank

The Integrated Risk Management Committee frames the policy which includes….CEO and heads of Credit, Market and Operational Risk Management Committee. It will devise/design the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit , market and operational risk. They take the feed from the respective departments.

For designing the appropriate policy, this Committee should effectively coordinate between the Credit Risk Management Committee (CRMC), the Asset Liability Management Committee (ALCO) and Operational Risk Committees(ORC) of the bank.

Risk Management Organisation

It is imperative that the independence of this Committee is preserved. The Board should, therefore, ensure that this is not compromised at any cost.

In the event of the Board not accepting any recommendation of this Committee, systems should be put in place to spell out the rationale for such an action and should be properly documented.

This document should be made available to the internal and external auditors for their scrutiny and comments.

2.Policy & Strategy

Every bank should have a credit risk/market risk/operational risk policy document approved by the Board. The document should include risk identification, risk measurement, risk grading/ aggregation techniques, reporting and risk control/ mitigation techniques, documentation, legal issues and management of problem loans.

The Board of Directors of each bank shall be responsible for approving and periodically reviewing the credit/market/operational risk strategy and significant credit risk policies.

The credit/market/operational risk policies approved by the Board should be communicated to branches/controlling offices. All dealing officials should clearly understand the bank's approach for credit sanction and should be held accountable for complying with established policies and procedures.

Policy & Strategy

The strategy would, therefore, include a statement of the bank's willingness to grant loans based on the type of economic activity, geographical location, currency, market, maturity and anticipated profitability.

This would necessarily translate into the identification of target markets and business sectors, preferred levels of diversification and concentration, the cost of capital in granting credit and the cost of bad debts.

The credit risk strategy should provide continuity in approach as also take into account the cyclical aspects of the economy and the resulting shifts in the composition/ quality of the overall credit portfolio. This strategy should be viable in the long run and through various credit cycles.

Senior management of a bank shall be responsible for implementing the credit risk strategy approved by the Board.

3. Operations / System

Banks should have in place an appropriate credit administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases:

1. Relationship management phase i.e. business development.

2. Transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, on going monitoring and risk measurement.

3. Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans

4. Banks should establish proactive credit risk management practices like annual / half yearly industry studies and individual obligor reviews, periodic credit calls that are documented, periodic visits of plant and business site, and at least quarterly management reviews of troubled exposures/weak credits

Jurisdiction (Country-wise) wise Implementation of Basel Guidelines

  REGULATOR DIRECTIVES JURISDICTION

1 Bank of International Settlement(BIS)

International Convergence of Capital Measurement and Capital Standards Global (Generic)

2

Committee of European Banking Supervisors (CEBS) Capital Requirement Directives(CRD) EU

3 Financial Services Authority (FSA) Capital Requirement Directives(CRD) UK

4

Australian Prudential Regulatory Authority(APRA) Basel II Implementation Australia

5 Reserve Bank of India (RBI)New Capital adequacy

Framework(NCAF) India

6 Hong Kong Monetary Authority Capital Rules Hong Kong

7 Financial Service Agency (FSA) Capital Guidelines for Banks (CGB) Japan

8

Office of the Comptroller of the Currency & Office of Thrift SupervisionFederal Reserve SystemFederal Deposit InsuranceCorporation National proposed Rule Making (NPR) USA

9 Ministry of Finance Capital Requirement Directives(CRD) France

CREDIT RISK MODEL

CREDIT RISK RATING

Risks in Business can be defined as any uncertainty about a future event…..

Broadly, risk refers to any factor that could cause variability in the cash flow of a company.

Credit Risk is the risk of loss to the Bank in the event of Default of Borrower

Default arises due to Borrower’s inability and/or unwillingness to meet commitments in relation to lending.

The Model Evaluates the Credit Risk of a Corporate Borrower by identifying different Risk Factors

& Building them up logically in order to arrive at Overall Credit Risk

Score

Which is then maps to a Risk Rating and Corresponding RW.

CREDIT RISK RATING

THE NEED FOR CREDIT RISK RATING. The need for Credit Rating has arisen due to the following:

With dismantling of State control and deregulation and globalisation and allowing things to shape on the basis of market conditions, Indian Industry and Indian Banking face new risks and challenges. Competition results in the survival of the fittest. It is therefore necessary to identify these risks, measure them, monitor and control them.

It provides a basis for Credit Risk Pricing and fixation of rate of interest on lending to different borrowers based on their credit rating thereby balancing Risk & Reward for the Bank.

The Basel Accord and consequent RBI guidelines requires that the level of capital required to be maintained by the Bank will be in proportion to the riskiness of the loan in Bank’s Books for measurement of which proper Credit Risk Rating system is necessary.

The credit risk rating can be a Risk Management tool for prospecting fresh borrowers in addition to monitoring the weaker parameters and taking remedial action.

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. 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.

CREDIT RISK RATING

OVERVIEW OF THE CREDIT RISK RATING MODEL Credit Risk Factors…..which could cause variability in the cash

flow of a company. Credit Risk Parameters Risk Categories Overall Credit Risk Score Credit Risk Rating: Risk Weight

This is known as as Bottom – Up Approach.

Bottom Up Approach…Rating Model

Number of Risk Factors makes Risk a parameter

Numbers of Risk parameter makes a Risk Category

Numbers of Risk category makes over all Risk….Risk Rating

Rating Model

Every risk factor identified has a bearing, whether direct or indirect, on the default probability of the company.

For assessing the risk under a parameter, the rater has therefore to first identify the most relevant risk factors for the company within that parameter and then assign the score after considering the position of the company vis-à-vis the position of other players.

Rating Model for Large Corporate Sector

Projected for data for Current FY

Past data for last five Financial Years..from audited balance sheet

Types of Risk categories

Overall Risk Score/Risk Rating Financial Risk…….30 Score Industry Risk……..6 Score Business Risk…….16 Score Management Risk…..23 Score Facility Risk/Conduct of Account…..25

Score

Maximum Score…….100

Meaning of the Rating

AAA….Extremely Favorable Position and Minimum Risk….Very High Degree of Sustainability

AA….. Indicates Favorable Position and have only Marginal risk A…….Indicated Stable Position with Modest Risk BBB…..Implies average Position and the outlook is Stable….investment

Grade BB…….Though not maximum degree of Risk but 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

Important Points for Credit Risk Rating

Whether Audited Balance Sheet is a must for purpose of rating? The latest Audited Balance Sheet should be obtained as far as

possible for the purpose of rating. Which years Audited Balance Sheet should be taken?

The Audited Balance Sheet of the borrower for last five years required for assessment and sanction as per guidelines issued by Credit Department should be taken into account for rating.

Which projections of the Financial Data of the borrower are to be taken into account for purpose of Credit Risk Rating?

The projections on realistic basis accepted by the bank for purpose of assessment is to be taken into account for purpose of rating. In case the projections submitted by the borrower are revised, all corresponding financial ratios of projections must also be revised and the borrower rated accordingly.

Risk Parameters in Financial Risk Category category…Total Score 30

Profitability… Gross Profit margin ( Before Interest, Dep., & Taxes) , Return on Capital Employed (ROCE)

Leverage…(TOL TNW)

Liquidity……. Current Ratio

Efficiency of working Capital management Inventory Holding Level Debtors Holding Level Creditors Holding Level

Estimated Cash Flows vs Repayment Due Auditors Qualification of Balance sheet

Risk factors in Financial risk Parameter (Contd.)

Net Estimated Cash Flow/ Net RepaymentEstimated Cash Profit during the current year (1+2+3) :1.Estimated Profit ( as per projections) after Tax and

Dividend for the current year.2.Estimated Interest receivable on Short Term Debt and

Long Term Debt for the current year.3.Estimated Depreciation for the Current year.Repayment Due during the current year (1+2) :1.Repayment of instalments/principal of long term debt due

during the current year2.Interest Payable on short-term debt and Long term debt

during the current year.

------------------------------------------------------------------------------------------- Total weight is 30………Financial Risk Category

2. Industry Risk ( Risk Category)…Max Score- 6 Industry Characteristics (Risk Parameter)

Risk Factor Importance to the Economy (Risk Factor) Cyclical fluctuation Sensitivity to the Govt. policies Growth potential of the IndustryCompetitive Forces (Risk Parameter)

Risk Factor Threat from ImportersExternal CompetitionTechnology RiskBarriers to EntryDemand & supply GapBargaining Power of the Industry

Industry FinancialsRisk Factor

ROCEOperating MarginsEarning Stability

3. Business Risk ( Risk Category)…Maximum Score 16

Business Growth (Risk Parameter)….Max Score 8Risk Factors

• Growth in sales or Growth in income

• Percentage increase in Nett Profit Margin (Before Tax) Over the Previous year’s margin

Operating Efficiency (Risk Parameter) Max Score 8Risk Factors

• Availability of infrastructural facilities and utilities • Availability of raw materials/labour at reasonable cost • Availability of arrangements for marketing, distribution, selling, storage at

reasonable cost • Advantage available in product/service range and quality

4. Management Risk ( Risk Category)…Max Score 23

Risk Factors Achievement during last year of targeted Net Sales/Income/Receipts

as the case may be…………………04 Achievement during last year of targeted Net Profits……………….05 Capability of the Principal Promoters/Management run the business

……04 No. of years of experience of the Principal Promoters in the line of

business …………03 Financial support to the borrowing firm from the

Promoters/Group…..03 Succession plan for the running of the borrower's business in

future…..02 Retention of funds (in the borrowing firm )generated from the

borrower's business profits………..02

Total……………………23

5. Conduct of Accounts ( Risk Category)…Max scores 25

Risk Factors Realizable value of Tangible Collateral Security …..04 Availability of Personal Guarantees to secure proposed

exposure ….02 Conduct and Operations of accounts …..16 Compliance of terms & conditions of sanction including

the charging of securities, timely submission of stock

statements and renewal papers etc. ……03

Total score……..25

Types of Risk / Risk categories

Financial Risk…….17 Score….30 Industry Risk……..6 Score….6 Business Risk…….14 Score….16 Management Risk…..18 Score…..23 Conduct of Accounts…..20 Score…..25

Total 75 out of100...A Moderate Risk

Utility of Credit Rating models…..Pricing

S. No.

Range of scores obtained by borrower

Credit ratingGrade

Description of risk

Interest Slab

1 80% AAA Minimum risk

Base Rate +200 bps

2 70% and 80% AA Marginal risk Base Rate +300 bps

3 60% and 70% A Modest risk Base Rate +400 bps

4 50% and 60% BBB Average risk Base Rate +500 bps

5 40% and 50% BB Acceptable risk

Base Rate +600 bps

6 30% and 40% B High Risk Base Rate +700 bps

7 20% and 30% C Caution Not acceptable

8 20% D Default

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

Transition Matrix……(gupton et al 1997_)

AAA AAA AA A BBB BB B C D  total

AAA 87.74 10.93 0.45 0.63 0.12 0.10 0.02 0.01 100

AA 0.84 88.23 7.47 2.16 1.11 0.13 0.02 0.04 100

A 0.27 1.59 89.05 7.4 1.48 0.13 0.02 0.06 100

BBB 1.84 1.89 5.00 84.21 6.51 0.32 0.07 0.16 100

BB 0.08 2.91 3.29 5.53 74.68 8.05 4.14 1.32 100

B 0.21 0.36 9.25 8.29 2.31 63.89 10.13 5.56 100

C 0.06 0.25 1.85 2.06 12.34 24.86 39.97 18.67 100

Sample credit rating transition matrix(Probability of migrating to another rating within one year as a percentage)

Credit rating one year in the future

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 BBB-rated loan migrating to single-B within one year would be 0.32%.

Rating Model – II…..Weighted Rating Model

Each risk factor relatively has a different level of importance.

This difference in importance is differentiated by assignment of higher weight to more important factor and lower weight to a factor which is not so important.

Assignment of weights to Risk factors

The higher the weight assigned to a factor, the larger the influence of the factor on the score of the Risk Parameter.

Assignment of weights to a Parameter

Weights are assigned to each Risk Parameter, again based on the relative importance of the parameter in overall assessment.

Process Flow of Rating Model Assignment of weights to a Parameter

Weights are assigned to each Risk Parameter, again based on the relative importance of the parameter in overall assessment.

WEIGHTED SCORE

The score allotted to a factor and/or a Parameter is multiplied by the weight to arrive at the weighted score.

Weighted Score of a factor = Score of the factor X Weight allotted to the factor

Weighted Score of Parameter = Score of the Parameter X Weight allotted to the Parameter

Process Flow of Rating Model

WEIGHTED AVERAGE SCORE Weighted average score is the average of weighted scores arrived at by dividing the

total weighted scores by the total of weights.

Weighted Average of a Parameter=Total of weighted scores of the factors / Total of Weights assigned to the factors

Weighted Average of a Risk Category=Total of weighted scores of the Parameters / Total of Weights assigned to the Parameters under the category

Overall Risk Score of the Borrower = Total of weighted scores of the Risk Categories / Total of Weights assigned to the Risk Categories

The score for each Risk Parameter and Risk Category is mapped to a 6-point scale.

The Weights assigned to Risk Factors, Risk Parameters and Risk Categories to

arrive at the Overall score have been made transparent in the Model itself.

Overall Rating includes all 7 Risk Categories

Weighted Score

Risk Parameter X

Risk Factor XMaximum

weight Score Awarded Weight Weighted Sccore

A 6 4 1.5 6

B 6 5 1 5

C 6 5 1 5

D 6 6 1.5 9

Total     5 25

Weighted Average Score of Risk Parameter (25/5) = 5

Weighted Score

Risk Category F

Risk Parameter X

Maximum Score

Score Awarded Weight Weighted Score

X 6 5 2.5 12.5

Y 6 4 1.5 6

Z 6 3 1 3

Total     5 21.5

Weighted Average Score of Risk Category (21.5/5) = 4.3

Overall Score for ABC Ltd.

Overall Score

Risk CategoryMaximum

Score Score Awarded Weight Weighted Sccore

Financial 6 4.22 5 21.1

Industry 6 3.2 1 3.2

Business 6 4.8 2 9.6

Management 6 5 2 7.5

Total 6   10 41.4

Weighted Average Score of Risk Category (41.4/10) = 4.14

FINAL OVERALL RATING OF BORROWER S. No.

Weighted Average Score Credit ratingGrade

Description of risk

Interest Slab

1 6.00 – 5.40 AAA Minimum risk BR

2 5.39 – 5.10 AA Marginal risk BR +2.00

3 5.09 – 4.20 A Modest risk BR +2.50

4 4.19 – 3.30 BBB Average risk BR+ 3.00

5 3.29 – 2.40 BB Acceptable risk

BR+ 3.50

6 2.39 – 1.00 B High Risk BR+4.00

7 0.9 – > 0.00 C Caution Not acceptable

8 < 0.00 D Default

BENCH MARK

PRIME LENDING RATE

Option I (IBA Approach) …..for Determination of BPLR

Components of PLR

Average cost of funds Reserve Adjusted Cost of funds Operating Cost Cost of Provisions Margin Cost of NPA Cost of Capital

Computation…..PLR Cost of Deposits = Interest Expenses on Deposits / Total Liabilities

Reserve Adjusted Cost of Funds ……Direct Cost

CR = (Cost of Deposit - ic* ci) / 1 – cRR

where, CR is the reserve-adjusted cost of funds

ci is the interest bearing component of CRR

ic is the interest rate on CRR

cRR is CRR Requirement

Computation…..PLR Operating Cost = Operating Expenses \ Total Liabilities

Cost of provisions = Provisioning Expenses / Total Liabilities

Indirect Cost = Operating Cost + Cost of Provisions

Direct Cost + Indirect Cost = Effective Cost of Funds

Margin = Net Profit \ Total Asset

Effective Cost of Funds + Margin = Base PLR

Computation…..PLR

Cost of NPA = Gross NPA Ratio * (Interest Income/Total Assets)

Cost of Capital = CRAR * RWA * Dividend Rate

PLR = Base PLR + Cost of NPA + Cost of Capital

PRIME LENDING RATE Advanced Approach

PLR…..Prime Lending Rate

Reference Rate Reserve Adjusted Cost of Funds Cost of Operation Effective Cost of Funds Margin (profit margin and cost of capital) Base PLR Default Premium PLR

Components

Step 1 :PLR……..Reference rate Banks can link their PLR to any of the reference rates or

base rates as determined by the Average Cost of Funds or theMarginal Cost of Funds.

Average Cost of Funds is based upon the historical cost of funds, ……..hence irrelevant to current pricing for new credit. In a falling interest rate scenario, the average cost of funds is higher than the marginal cost of funds.

Hence, Constructing the PLR based on average cost of funds would trigger a a higher PLR to even its current borrowers.

PLR……..Reference rate

The more logical option ……… marginal cost of borrowed funds.

This may be represented either as the marginal cost of deposits or the marginal cost of borrowing funds from the market.

To calculate the marginal cost of borrowed funds for PLR, one approach is for the bank to develop a funding strategy to finance prime borrowers and allocate the cost of this pool of funds to the prime portfolio.

This approach is however, may be difficult to adopt due to the requirement of identifying prime borrowers of the bank and developing a funding strategy especially for this pool.

What will be the reference Rate……………….

PLR……..Reference rate Empirical Analysis ……of the PLR of Indian Banks has a high & significant

positive correlation with the Bank Rate….recently Repo Rate

The Bank Rate represents the marginal rate at which banks may borrow funds from the RBI…..Repo Rate is borrowing from Central Bank

Changes in the Bank Rate get transmitted to changes in PLR for most banks.

However, in recent years the correlation Repo rate and PLR has gone up…

This implies that the Repo Rate may be the best reference rate for the computation of PLR.

Repo Rate… is a Proxy for Marginal Cost… Repo rate 4.75%

Step 2 :Reserve Adjusted Cost (CR) of Funds

Banks have to meet the Cash Reserve Ratio (CRR) of 5.% .

Thus, for every 100 rupees deposits raised by the banks, Rs. 5 has to be held as CRR.

The reference rate is adjusted for the CRR to arrive at the reserve adjusted cost of funds.

CR = (Reference Rate - ic* ci) / 1 – cRR

where, CR is the reserve-adjusted cost of funds

ci is the interest bearing component of CRR

ic is the interest rate on CRR

cRR is CRR Requirement

CR = 5.00%

Step 3:Estimating the Cost of Operations

In providing credit to borrowers, banks have to incur various operational costs.

It varies widely between banks based on the efficiency of their lending function.

Operational costs……..employee cost

Cost of Operation …3%

Operating Cost/ Total Liabilities

The Bank must estimate its own cost of operations to use in this analysis.

Step 4 : Effective Cost of Funds

The Cost of Operations (O) has to be loaded on to the reserve-adjusted cost (CR) of funds to determine the Effective Cost of Funds (EC).

EC = CR + O

EC = 5.00% + 3.00% = 8.0%

Step 5: Margin…. How to Compute…Hurdle Rate

Margin is arrived from Expected Rate of Return …from Shareholder’s point of view

Expected Rate of Return is also called Hurdle Rate

Hurdle Rate……is the Reflection of the Investors’/Shareholder’s Risk tolerance

Hurdle Rate…..is derived from the cost of equity …..

……Measured from the Expected Pre-Tax Return on Equity (ROE)

Step 5: Margin…. How to Compute…Hurdle Rate

The Hurdle Rate is calculated as

HR = { ROE/ (1- t)- EC} * Lwhere

ROE…….Return on EquityEC…..Effective cost of Funds

t is the corporate tax rate.L is Capital Adequacy Ratio

The bank’s leverage (L) is expressed in terms of capital adequacy……is used to assign the weight

To arrive at the Margin , the Hurdle Rate derived as

above has to be adjusted for Non Performing Assets since they represent the non-earning category.

Step 5: Margin

The Hurdle Rate is thus scaled up by the factor A/A* where A is the Gross Advances

A* is the total Performing …..Standard advances (A-Gross NPA).

Margin = { ROE/ (1- t)- EC} * L * A/A*

Hurdle Rate 2.74%......is scaled up by factor 1..11

………. Margin is 3.10%

Base PLR is EC (of funds) + Margin = 8% + 3.10% = 11.10%

Step 6 : Default Premium

Estimation of the Default Premium is calculated based on the Expected Loss…… average losses

The Expected Loss Rate (EL) is computed as the product of Expected Default Probability (PD), post default Recovery Rate (LGD) & EAD

EL = PD * (1-Recovery Rate)* Exposure amount PD…….Number of defaulting borrowers as a percentage of all borrowers in

a particular Rating Category…….Transition Matrix

The Recovery Rate is defined as the percentage of exposure at the time of default that is subsequently recovered…….Recovered on Present Value Basis

The Loss Given Default (LGD) is defined as 1-Recovery Rate.

Step 6 : Default Premium

In the absence of historical data on rating wise number of defaulters, the Probability of Default can be estimated using a proxy method.

By this method, the PD for a year is given by the ratio of incremental Gross NPA for a particular year to Gross Advances for the previous year. …..Default Ratio /

PD = Incremental Gross NPA at time t / Gross Advances at time (t-1)

This ratio is calculated for as previous years for which data on Gross NPA

and Gross Advances is available for the bank. The simple average of the ratio for the all the years gives the One Year Expected Default Probability.

Step 6 : Default Premium

The Recovery Rate should be estimated based on the bank’s past recovery experience on defaulted loans.

In the absence of relevant recovery data, the bank may, as a starting exercise, assume an overall Recovery Rate.

A Recovery Rate …….discounted value of future recoveries from Incremental Gross NPAs.

In this case, the discount Rate is RAC and the denominator is last year outstanding NPA.

Average Default Probability * (1-Recovery Rate) = Default Premium = 0.72%

Base PLR + Default Premium = PLR ( 11.10% + 0.72%) = 11.82%

BASE RATE…W..E.F JULY,2010

PLR…..Extract from Live Mint in 2010

RBI said that there is a perception that banks are charging lower rates for corporates and higher rates to farmers and SMEs. “There is a public perception that banks’ risk assessment processes are less than appropriate and that there is unde rpricing of credit for corporates, while there could be overpricing of lending to agriculture and SMEs

Competition has turned the pricing of a significant proportion of loans far out of alignment with the BPLR and in a non-transparent manner,” RBI said in its report on currency and finance. The report adds that the BPLR has ceased to be a reference rate(Benchmark Rate), thereby hindering an assessment of the efficacy of monetary transmission.

RIP….BPLR There is a structural problem . Even though the industry is by and large

deregulated, a few lending rates are still mandated and linked to banks’ BPLR.

For example, loans to exporters are given at 2.5 percentage points below BPLR. Similarly, all loans to small farmers are priced cheaper than BPLR.

This has prevented banks from lowering their BPLR as the moment this benchmark rate is cut, automatically the loan rate for exporters and small farmers declines.

So banks preferred to keep their BPLR at an artificially high level and charge most of their borrowers a rate much below the benchmark rate.

This is the only way they could prevent loan rates for exporters and small farmers from declining to a level that does not even cover their cost of

funds. In particular, the fixation of BPLR continues to be more arbitrary than rule-

based. Therefore, the concept of arriving at the BPLR needs to be looked into

with a view to making it more transparent.

RIP….BPLR Despite that, most of the banks ended up having their BPLRs in the

same range even though their cost of funds, overheads and level of non-performing assets were not alike.

Typically, State Bank of India, the largest lender, takes the lead in setting the rate and others follow.

Some Facts Sub PLR Lending (PSU) constitutes 67% of Total Lending as March

2009. Sub PLR Lending (Pvt. Sec) constitutes 84% of Total Lending as

March 2009. Sub PLR Lending (Foreign banks) constitutes 81% of Total Lending

as March 2009.

Why Base Rate…. The BPLR system, introduced in 2003, fell short of its original

objective of bringing transparency to lending rates…. mainly because under the BPLR system, banks could lend below BPLR.

For the same reason, it was also difficult to assess the transmission of policy rates of the Reserve Bank to lending rates of banks.

Hence, the Base Rate system is aimed at enhancing transparency in lending rates of banks and efficiency in transmission of monetary policy

The Base Rate system will replace the BPLR system with effect from July 1, 2010.

Why Base Rate…. Issues In Transparency

Disclosure of Important info on Loan pricing…on all the components those are built into

No Hidden additional costs

Everything should be clear to the Borrower at the Beginning

Floating Rate Loans Downward Stickiness of BPLR

Banks used to raise the lending Rate in upturn..while during the down turn …they are very slow in reducing the loan rate

Components of Base Rate 1.Cost of Deposits

CA….SB….TD… 2.Negative Carry on CRR and SLR

Negative carry on CRR and SLR balances arises because the return on CRR balances is nil, while the return on SLR balances (proxied using the 364-day Treasury Bill rate) is lower than the cost of deposits .

Negative carry cost on SLR and CRR was arrived at by taking the difference between RACOF and the Cost of Deposits

ROI on CRR is 0% and ROI on SLR is 364 T bill

3. Overhead Cost Employee Cost wrt. Deployable Deposits Total deposits less share of deposits locked as CRR and SLR balances (1-6%-

24%)…70% of Total Outstanding Deposits

Components of Base Rate

4. Weighted Return on Net Worth WRONW is computed as the product of net profit to net worth ratio and

net worth to deployable deposits ratio expressed as a percentage.

The weight is net worth to deployable deposits (Net Profit/Net Worth)* (Net worth/Deployable Deposits)

Base rate = 1+2+3+4

Loan pricing = Base rate + Product Specific Operating cost(139)

+ Default Premium + Maturity Premium

Transition Matrix

Yield Curve

Applicability of Base Rate All categories of loans should henceforth be priced only

with reference to the Base Rate. The Base Rate could also serve as the reference

benchmark rate for floating rate loan products.

…….However Two other categories of loans will not need to adhere to

the base rate formula—1. loans to banks’ own employees 2. loans against deposits.

Misuse of Base Rate A bank can offer loan to a top-rated firm at its base rate

and pay 2 percentage points higher than the market rate on the deposit that the firm keeps with the bank.

International Comparison In the US, the Prime rate—normally 3 percentage points higher that

the Federal Reserve rate—is the benchmark rate for all consumer commercial and retail loans,

Similarly, in the UK, the Bank of England’s base rate is the benchmark rate for consumer and retail loans, while Libor is the benchmark for commercial loans.

Libor’s Indian counterpart is Mibor, or the Mumbai interbank offered rate—the rate at which banks can borrow funds from each other in the interbank market.

But this is an overnight rate and the efforts to develop one-month and three-month Mibor have not yet met with success.

RATING MODEL OF BANKS

Bottom Up Approach…Rating Model

Number of Risk Factors makes Risk a parameter… Components of CAMELS

Numbers of Risk parameter makes a Risk Category…..CAMEL

Numbers of Risk category makes over all Risk…. Financial and Non Financial Risk…..Risk Rating

CAMELS

CAMELS ratings are commonly viewed as summary measures of the private supervisory information gathered by examiners regarding banks' overall financial conditions

C…Capital adequacy Tier 1 & Tier 2 Capital Asset Quality….NPA and Provisions M……Management Earnings….Profitability Liquidity…Total Liquid Assets

Credit Risk Index of Banks

CRIB is the inherent Credit Risk identified and captured under various financial and non-financial risk areas of the Bank and indexed in a scale of 100.

The identified risk category, the risk parameters and risk factors under which the risks are captured, their relative importance (risk weights) and the structure of the model to measure the overall Credit Risk Index of a Bank (CRIB) are as under: Risk Category

Marks …A. Objective or the Quantitative Financial Risk Category….75

B. Subjective or the Non-financial Qualitative Category …..25

Total 100 Out of 'CAMEL(Risk Parameter) ', the risk under 'M(RP)' i.e. Management is

captured under B. The remaining risk areas are covered under A.

CRIB Score = 0.75 of the Score under A+0.25 of the Score under B.

FINAL OVERALL RATING OF BANK

S. No.

Weighted Average Score Credit ratingGrade

Description of risk

1 85 A++ Minimum risk

2 85 75 A+ Marginal risk

3 75 70 A Modest risk

4 70 60 B+ Average risk

5 60 50 B Acceptable risk

6 50 C Caution

Utility of RatingBank Exposure Limit

Call/Money Forex Dealings Investment in Bond Issued by other Banks Investment in Shares of others Bank Credit Lines offered to other Banks Discounting of Bills Bank Guarantee____________________________________________________ At present bank's exposure limits are being fixed by by the Treasury

Department of the Bank

-------------------------------------------------------------------------- Bank Condition & Performance of Banks Indicator For Bank Failures Public Monitoring of Banks Pricing Bank Securities/Bonds/instruments issued by the Bank

Utility of Rating 

Reserve Bank of India in its risk management guidelines has envisaged following action points in this regard:

Put in place a Centralised mechanism for evaluating exposure on other individual Banks.

Set up Bank wise Exposure Limits on the basis of assessment of Financial Performance, Management Quality, Experience and Operational Efficiency.

Allocate inter-bank limits to various types of Transaction Review BEL and its allocation annually

Utility of Rating

Reserve Bank of India has also, in the ‘Guidance Note on Credit Risk Management’ issued in October 2002, issued detailed guidelines for fixing such Bank-wise Exposure Limits (BEL) which is on the lines of "CAMEL" ratings of banks

Structure of the BEL Model

Overall Exposure Limit with Banks for the purposes indicated earlier shall be a function of:

Net worth of the Bank (NW) Ownership status (OS) Credit Risk Index of Bank (CRIB)

BEL =Min (50%NW1, NW2 ) X OS X CRIB/100, where: NW (Target Bank) =Equity + Reserves – Revaluation of Reserves

(As per the latest published balance sheet). NW Considered as the outer limit for exposure (Maximum limit) for

inter bank even when the threat from OS and CRIB is minimal.

Structure of the BEL Model (contd.)

OS Ownership status is factored to reflect the intensity of the owner's

intention to pay back by drawing on its capacity to raise resources.

Ownership status has been indexed in the following manner:

All Public Sector Banks…..100% New Private Sector Banks with Institutional sponsorship & listing

arrangements …….. 80% Foreign Banks……..75% Other Pvt. Sector Banks with listing arrangements ….60% All other Banks…(not listed)……..50%

Risk Management Practices(International Convergence) - Basel II & III

Basic Structure

Standard isedApproach

InternalR atings-based

Approach

C redit risk

BasicInd icatorApproach

S tandard isedApproach

AdvancedM easurem entApproaches

O perationalrisk

S tandard isedApproach

M odelsApproach

M arketrisks

R isk w eightedassets

C oreC apita l

Supplem entaryC apita l

D efin ition ofcapita l

M in im um capita lrequirem ents

Supervisory revie wprocess

M arketd iscip line

ThreeBasic P illars

Pillar 1: Minimum Capital Requirements

Credit Risk – Standardised Approach (SA) Internal Rating Based (IRB) Approach

Foundation (FIRB) Advanced (AIRB)

Market Risk Modified Duration Approach Internal Model Approach

Operational Risk Basic Indicator Approach Standardised Approach Advanced Measurement Approach (AMA)

Actual Capital & RWA Requirementvs

Actual RWA & Capital Requirement

1. Actual Capital Eligible Capital Required RWA Required RWA = Exposure (Claims) Amount X Risk Weight

(RW) (Given)

Exposure Amount Credit Planning Business Planning Capital Planning …..Outcome of Budgeted Business\Credit

If bank has Rs100 cr of Capital, then it can generate Rs.1250 cr of RWA

Standardised Approach

Steps FollowedI. Calculation of Exposure/ Claims Amount

II. Exposure-----Asset Class

Mapping of exposures into Asset class based on

Product type & customer type

Computation of RW – Given by the Regulator & Rating Agency Risk Weighted Assets = Exposure (Claims) Amount X Risk Weight (RW) Capital Requirement = 9%(8%) X RWA

If bank has Rs100 cr of Capital, then it can generate Rs.1250 crores of RWA------- 12.5% is capital charge (assuming 8% CRAR)

Actual Capital & RWA Requirementvs

Actual RWA & Capital Requirement

Computation of RW –Based on external rating or Given by the Regulator Computed Risk Weighted Assets = Actual Exposure (Claims) Amount X

Risk Weight (RW) Capital Requirement = 9%(8%) X RWA If bank has Rs.1250 crores of RWA, Rs100 cr is capital requirement

Compare Capital Requirement with Eligible Capital

Capital Planning

Credit Planning / Business Planning VS. Capital Planning

How to calculate Capital Requirement

For all direct exposures (on-balance sheet exposures) a risk weight (RW) is multiplied to arrive at Risk Weighted Asset (RWA).

For all indirect exposures (off- balance sheet exposures) a Credit Conversion Factor (CCF) is multiplied to find out the equivalent direct exposure and then RW is multiplied with this equivalent direct exposure to arrive at RWA.

Capital requirement on Credit Risk under Standardized approach is RWA*8%...(9%).

External Credit Assessment Institutions (ECAI)

ECAIs are eligible Credit Rating Agencies identified by the Regulator, whose ratings may be used by banks for assigning risk weights for credit risk

Reserve Bank of India has decided that banks may use the ratings of the following domestic credit rating agencies

1.Credit Analysis and Research Limited (CARE)2. CRISIL Limited3. FITCH India4. ICRA Limited.

The Reserve Bank of India has decided that banks may use the ratings of the following international credit rating agencies

1. Fitch;2. Moodys 3. Standard & Poor’s

International Rating Agency basicaly assess the issuer’s capability to meet the commitment for foreign currency as well as local currency.

Asset Classes - Basel

The broad classifications are as under : 12 Asset Classes Claims on Sovereign Claims on PSEs Claims on MDBs Claims on Banks Claims on Securities firms Claims on Corporates Regulatory Retail Portfolio Secured by Residential Property Secured by Commercial Real Estate Other Assets Past due Loans

Off Balance Sheet exposures.

1. Claims on Domestic Sovereigns - India

All claims on the Central government will attract a zero risk weight including Central Government guaranteed claims.

All claims to State Government will attract zero risk weight……Direct Loan / Over Draft

However, State government guaranteed claims, will attract 20 per cent risk weight.

2.Claims on Foreign Sovereigns

Claims on foreign sovereigns will attract risk weights as per the rating assigned by international rating agencies

S & P /Fitch AAA to AA A BBB BB to B Below B Unrated

             

Moody Aaa to Aa A Baa Ba to B Below B Unrated

             

RW 0% 20% 50% 100% 150% 100%

If funding currency is same as the lending currency for this claim, then risk weight of zero percent (No Currency Mismatch)

3 . Claims on Banks - Domestic - India

  Risk Weight (%)

CRAR of the Investee Bank Investee Bank

 

Investments in Instrument Eligible for Capital Status

All otherclaims

1 2 3

>9%max(100%, RW of the

Instrument ) 206% to < 9% 150 50

3% to < 6% 250 100

0% to < 3% 350 150

Negative 625 625

Claims on Banks – Foreign Banks - India

S & PFitch

AAA to AA A BBB BB to B Below BB Unrated

MoodyAaa to

Aa A Baa Ba to B Below B Unrated

RW 20% 50% 50% 100% 150% 50%

The claims on foreign banks will be risk weighted as under as per the ratings assigned by international rating agencies

If funding currency and lending currency are same in the foreign country, then risk weighted of 20% will be applied provided the bank complies with theminimum CRAR prescribed by the concerned regulator of that foreign country.

Claims on Banks - Basel

Based on rating of the sovereign. All banks incorporated in a given country

will be assigned a risk weight one category

below the sovereign rating. However, for claims rated BB+ to B- on banks will attract the same weight as Sovereign Rating and, unrated claims will attract 100% RW.

Claims on Banks - Basel

CreditAssessment

AAA toAA- A+ to A- BBB+ to BBB- BB+ to B-

Below B- Unrated

Sovereigns 0% 20% 50% 100% 150% 100%

Bank 20% 50% 100% 100% 150% 100%

4.Claims on Regulatory Retail Portfolios (RRP) – RBI

Product type + Customer Type + Exposure type

Orientation criterion

Product criterion

Granularity criterion

Claims on Regulatory Retail Portfolios (RRP) - RBI

Orientation criterion….customer Type small business (includes)

individual, partnership firm, trust, private limited companies, public limited companies, and co-operative societies

Total average annual turnover is less than Rs. 50 crore The average of the last three years in the case of existing

entities projected turnover in the case of new entities both actual and projected turnover for entities which are yet

to complete three years

Claims on Regulatory Retail Portfolios (RRP) - RBI

Product criterion…Product type revolving credits and lines of credit (including

overdrafts) Term loans Including Educational loan (exclude

Consumer Credit) Small business facilities i.e. demand loan ,WCL

Claims on Regulatory Retail Portfolios (RRP) - RBI Granularity criterion….exposure type

• Aggregate exposure to one counterparty should not exceed 0.2 per cent of the overall RRP. GNPA to be netted out from RRP.

• Aggregate exposure…Gross amount of exposure ( Fund Based & Non Fund Based)

• Counterparty….. Single Beneficiary/Group Exposure Concept

The maximum aggregated retail exposure to one Counterpart should not exceed of Rs. 5 crore …..(Small Ticket & Large no. of Exposures)

Max (Actual outstanding, Sanctioned Limit )

Risk Weight of 75 % is assigned to RRP

5.Claims secured by Residential Property – RBI(Product Type + Customer Type + Exposure type)

If LTV (Loan to Value Ratio) is more than 75%, then RW is 100%

If LTV is less than 75% Amount of loan is up to Rs 30 lakh, then RW is

50% Amount of loan is above Rs 30 lakh, then RW is

75%.Restructured housing Loan will attract additional RW of

25%

6.Claims on Corporate Product type + Customer Type

Resident Corporate - India Long Term Claims on corporate shall be risk weighted as

per the ratings assigned by the rating agencies.

DomesticRatingAgency AAA AA A BBB

BB & Below Unrated

             

RW 20% 30% 50% 100% 150% 100%

Includes the exposures on Asset Finance Companies (AFC)……To be Rated by ECAI….100% RW instead of 150% RW

Rating Agency is registered with SEBI & Accredited by RBINBFC – AFC & IFC…

Four categories of NBFCs — asset finance companies loan finance companies investment companies Infrastructure Finance Companies

NBFC….AFC & IFC AFC would be defined as any company which is a financial institution

carrying on as its principal business the financing of physical assets supporting productive / economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines. Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising there from is not less than 60% of its total assets and total

income respectively. IFC….. a minimum of 75 per cent of these institutions’ assets should be

deployed in infrastructure and their net owned funds should be Rs 300 crore or above.

FINAL OVERALL RATING OF BORROWER S. No.

Weighted Average Score Credit ratingGrade

Description of risk

Interest Slab

1 6.00 – 5.40 AAA Minimum risk BR

2 5.39 – 5.10 AA Marginal risk BR +2.00

3 5.09 – 4.20 A Modest risk BR +2.50

4 4.19 – 3.30 BBB Average risk BR+ 3.00

5 3.29 – 2.40 BB Acceptable risk

BR+ 3.50

6 2.39 – 1.00 B High Risk BR+4.00

7 0.9 – > 0.00 C Caution Not acceptable

8 < 0.00 D Default

Un Rated Exposure

Regulator may increase the standard risk weight for unrated claims where a higher risk weight is warranted by the overall default experience. As part of the supervisory review process(SREP Pillar II), the Reserve Bank would also consider whether the credit quality of unrated corporate claims held by individual banks should warrant a standard risk weight higher than 100 per cent.

With a view to reflect a higher element of inherent risk which may be latent in these asset class whose obligations have been subjected to re-structuring / re-scheduling by banks, the unrated standard / performing claims should be assigned a higher risk weight until satisfactory performance under the revised payment schedule has been established for one year from the date when the first payment of interest / principal falls due under the revised schedule.

The applicable risk weights will be 125 per cent.

Claims on CorporateResident Corporate - India

Short Term Ratings

CARE CRISIL FITCH ICRA   RW

PR1+ P1+ F1+ A1+ 20%

PR1 P1 F1 A1 30%

PR2 P2 F2 A2 50%

PR3 P3 F3 A3 100%

PR4 &PR5 P4 & P5 F4/F5 A4 / A5 150%

UnratedUnrated Unrated Unrated 100%

Claims on Corporate Resident Corporate - India

Definition of Corporate Asset Class………The Value of Exposure is more than Rs. 5

Crore / (and ) Average turnover is more than Rs. 50 crore. I

7.Claims on Corporate Non Resident Corporate - India

S &PFitch

AAA to AA A BBB to BB Below BB Unrated

Moody Aaa to Aa A Baa to Ba Below Ba Unrated

RW 20% 50% 100% 150% 100%

No claim on an unrated corporate may be given a risk weight preferential to that assigned to its sovereign of incorporation

8. Claims on Public Sector Entities (PSE) - India

Customer Type

Claims on Domestic public sector entities Claims

on Resident Corporate …… short tem/long term claim….unrated claim with

125% Claims on foreign public sector entities Claims on

Non Resident Corporate

9.Claims on Primary Dealers - India Customer Type

Treatment for Claims on Primary Dealers is similar to claims on Resident Corporate

The role of Primary Dealers is to

(i) commit participation as Principals in Government of India issues through bidding in auctions

(ii) provide underwriting services

(iii) offer firm buy - sell / bid - ask quotes for T-Bills & dated securities

(v) Development of Secondary Debt Market

10. Claims on Multilateral Development Banks -

India (MDB)…..Customer Type

The List of MDBs are : World Bank Group: IBRD and IFC, Asian Development Bank, African Development Bank, European Bank for Reconstruction & Development, Inter-American Development Bank, European Investment Bank, European Investment Fund, Nordic Investment Bank, Caribbean Development Bank, Islamic Development Bank and Council of Europe Development Bank International Finance Facility for Immunisation (IFFIm)

& BIS,IMF

20% RW will be assigned

11.Claims on Specified Categories – RBIProduct Type

Venture Capital Funds……150% RW Consumer Credit Loans (Excluding Educational Loan) & Credit Card Receivables….125% RW Capital Market Exposures…… RW =max(125%,Rating) Investment/loan finance NBFC….100%

Investment up 30% of paid up Equity of financial entities (Investee financial entities)….. RW =max(125%,Rating)

12.Claims secured by Commercial Real Estate – RBI (Product Type)

Income-producing real estate (IPRE) refers to a method of providing funding to real estate (such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, and hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset.

The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. 

The distinguishing characteristic of IPRE versus other corporate exposures that are collateralised by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property

The primary source of cash flow (i.e. more than 50% of cash flows) for repayment would generally be lease or rental payments or the sale of the assets as also for recovery in the event of default where such asset is taken as security.

12.Claims secured by Commercial Real Estate – RBI (Product Type)

Commercial Real Estates (CRE) are: Office buildings, retail space, Multi-purpose commercial premises, Industrial or warehouse space, hotels, land acquisition,

development and construction etc.) Exposures to entities for setting up Special Economic Zones

(SEZs)

Claims secured by commercial real estate as defined above will attract a risk weight of 100 per cent

13.Claims secured by Commercial Real Estate – RBI (Product Type)

Loans extended to builders towards construction of any property which is intended to be sold or given on lease ( e.g. loans extended to builders for housing buildings, hotels, restaurants, gymnasiums, hospitals, condominiums, shopping malls, office blocks, theatres, amusement parks, cold storages, warehouses, educational institutions , industrial parks)

In such cases, the source of repayment in normal course would be the cash flows generated by the sale/lease rentals of the property. In case of default of the loan, the recovery will also be made from sale of the property if the exposure is secured by these assets as would generally be the case.

14. Other Assets - RBI

Loans & Advances to Bank’s own staff which are fully covered by superannuation will attract a 20% risk weight.

Other loans and advances to bank’s own staff will be eligible for inclusion under regulatory retail portfolio and will therefore attract a 75% risk weight.

All other assets will attract a uniform risk weight of 100%.

15.Other Assets - Basel All other assets which do not fall under the asset classes

specifically mentioned, will attract a risk weight of 100%.

At national discretion, the supervisor may prescribe higher risk to some category of exposures

16.Claims (NPA) secured by residential property - RBI

The outstanding value of NPA net of specific provisions will be risk-weighted as follows:

Risk weighted at 100% when specific provisions are less than 20% of the outstanding amount of the NPA (Provision coverage Ratio)

If the specific provisions in such loans are at least 20% but less than

50% of the outstanding amount, the risk weight applicable to the loan net of specific provisions will be 75% (Provision coverage Ratio)

If the specific provisions are 50% or more the applicable risk weight will be 50% (Provision coverage Ratio)

Accounting Treatment of Non Performing Assets

Secured Portion

Un Secured Portion

10% Provisions

20% Provisions

STA

DA

Secured Portion

Un Secured Portion

LASecured Portion

Un Secured Portion

100% Provisions

20% up to one year30% -1Y to 3Y

100% > 3Y

100% Provisions

100% Provisions

Non Performing Assets (NPA)Product Type

NPAs are a legacy of past where the credit risk is already materialisedConcepts

Gross vs Net NPA Gross NPA Ratio vs Net NPA Ratio Secured portion of NPA ( Collateral) Unsecured portion of NPA (NPA) Provision Coverage Ratio

17.Non Performing Assets (NPA) - RBI The unsecured portion of NPA net of specific provisions will be risk-weighted as follows

150% risk weight when specific provisions are less than 20% of the outstanding amount of the NPA (Provision coverage Ratio)

100% risk weight when specific provisions are 20%-(less than)50% of the outstanding amount of the NPA (Provision coverage Ratio)

50% risk weight when specific provisions are more than or equal to 50% of the outstanding amount of the NPA (Provision coverage Ratio)

For the purpose of defining the secured portion of the NPA, eligible collateral ( in SA) will be considered.

Other forms of collateral like land, buildings, plant, machinery, current assets, etc. will not be reckoned while computing the secured portion of NPAs for capital adequacy purposes.

Normal treatment for the secured part (Net of SP.Provisions)

This excludes NPA on account of residential property

Non Performing Assets (NPA) - RBI

NPA is fully secured by the following forms of collateral that are not eligible collateral in SA,

(i) Land and building which are valued by an expert valuer and where the valuation is not more than three years old, and

(ii) Plant and machinery in good working condition at a value not higher than the depreciated value as reflected in the audited balance sheet of the borrower, which is not older than eighteen months.

100 per cent risk weight may apply, net of specific provisions, when provisions reach 15 per cent of the outstanding amount.

Here, The above collaterals will be recognized only where the bank is having clear title to realize the sale proceeds thereof and can appropriate the same towards the amounts due to the bank.

Non Performing Assets (NPA) - BIS

Same Treatment as in RBI

Separate Treatment for NPA on Account of Residential property Claims

Risk weighted at 100% net of specific provisions when specific provisions are less than 20% of the outstanding amount of the NPA

If the specific provisions in such loans are at least 20% of the

outstanding amount, the risk weight applicable to the loan net of specific provisions will be 50%

Classification & RW Computation - Basel IIClassification of Claim AAA to

AA- A+ to A-

BBB+ to BBB- BB+ to BB- B+ to B-

Below B-

Unrated

1.Claims on Sovereigns 0% 20% 50% 100% 150% 100%

2.Claims on Banks -

Option 1 20% 50% 100% 100% 150% 100%

Option 2 –Short Term Claims 20% 20% 20% 50% 150% 20%

3. Claims on Corporates 20% 50% 100% 150% 100% Exception: Short term claims on Banks & Corporates with specific rating

A-1/P-1 A-2/P-2 A-3/P-3 Others 20% 50% 100% 150%

4. Claims on public sector entities

According to claims on banks.

5. Claims on MDBs 0% RW for Claims on IBRD, IFC, ADB, AfDB, EBRD, IADB, EIB, EIF, NOB, CDB, IDB & CEDB; FOR OTHERS AS PER OPTION 2 OF CLAIMS ON BANKS

6. Claims on Securities Firms When these firms are subject to comparable capital requirements - Treat as Banks otherwise treat as Claims on Corporates

7.Claims included in the regulatory retail portfolio (RRF)

75% or higher as required by National Supervisor

8.Claims secured by Residential Property

35% or higher as required by National Supervisor if LTV is less than 75%

9.Claims secured by Commercial Real Estate

100%

10. Past Due Loans Category % of Sp. Prov. Additional

Condition RW

>=20% If Supervisor Allows 50% 1. Qualifying Residential Mortgage Loans <20% 100%

>=50% If Supervisor Permits 50% >=20% If Supervisor Permits 100% >=15% to <20% If Supervisor Permits 100%

2. Other Past Due Loans

Others Fully secured by ineligible collateral

150%

11. Higher Risk Categories 150% or Higher as required by National Supervisor

ISSUES IN CREDIT RISK RATING

Rating Structure in IndiaExternal Credit Assessment Institutions (ECAI)

ECAIs are eligible Credit Rating Agencies identified by the Regulator, whose ratings may be used by banks for assigning risk weights for credit risk

Reserve Bank of India has decided that banks may use the ratings of the following domestic credit rating agencies

1.Credit Analysis and Research Limited (CARE)2. CRISIL Limited3. FITCH India4. ICRA Limited.

The Reserve Bank of India has decided that banks may use the ratings of the following international credit rating agencies

1. Fitch;2. Moodys 3. Standard & Poor’s

Scope of Application of External Rating

Banks should use the ratings of particular ECAI consistentently for each type of claim.

Banks shall not use one agency’s rating for one corporate bond, while using another agency’s rating for another exposure to the same counterparty

If a bank has decided to use the ratings of some of the chosen credit rating agencies for a given type of claim, it can use only the ratings of those credit rating agencies, despite the fact that some of these claims may be rated by other chosen credit rating agencies whose ratings the bank has decided not to use.

Banks will not be allowed to “cherry pick” the assessments provided by different credit rating agencies…..stick to single rating agency

Scope of Application of External Rating (Contd.) External assessments for one entity within a corporate group cannot

be used to risk weight other entities within the same group….No Change in Rating agency within the Group

Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets…corporate asset class

The external credit assessment must take into account and reflect the entire amount of credit risk exposure the bank has with regard to all payments owed to it. For example, if a bank is owed both principal and interest, the assessment must fully take into account and reflect the credit risk associated with timely repayment of both principal and interest….Repaying capacity both in terms repayment of principal and interest

The rating agency should have reviewed the rating at least once during the previous 15 months.

Mapping Process…Rating Notation to RW

Mapping process is to assign the ratings issued by ECAI to the risk weights which is consistent with that of the level of credit risk

Long Term Ratings RW

AAA 20%

AA 30%

A 50%

BBB 100%

BB & below 150%

Unrated 100%

Where “+” or “-” notation is attached to the rating, the corresponding mainrating category risk weight should be used. For example, A+ or A- would beconsidered to be in the A rating category and assigned 50% risk weightIf an issuer has a long-term exposure with an external long term rating thatwarrants a risk weight of 150%, all unrated claims on the same counterparty,whether short-term or long-term, should also receive a 150% riskweight.

Six Categories

An eligible credit assessment must be publicly available. In other words, a rating must be published in an accessible form and included in the external credit rating agency’s transition matrix.

Consequently, ratings that are made available only to the parties to a transaction do not satisfy this requirement.

Scope of Application of External Rating (Contd.)

For assets in the bank’s portfolio that have contractual maturity less than or equal to one year, short term ratings will be accorded…more weight on Liquidity

For other assets which have a contractual maturity of more than one year, long term ratings will be accorded

Cash credit exposures tend to be generally rolled over and also tend to be drawn on an average for a major portion of the sanctioned limits.

Therefore, Cash Credit exposures should be reckoned as long term exposures and accordingly the long term ratings will be accorded

Mapping Process (Short Term Rating)

Short-term ratings are deemed to be issue specific to derive risk weights for that particular claim.

They cannot be generalized to other short-term claims

The unrated short term claim on borrower will attract a risk weight of at least one level higher than the risk weight applicable to the rated short term claim on that borrower

If a short-term rated facility to borrower attracts a 20% risk-weight, unrated short-term claims to the same borrower cannot attract a risk weight …lower than 30%

Exception

Similarly, if an issuer has a short-term exposure with an external short term rating that warrants a risk weight of 150%, all unrated claims on the same counter-party, whether long-term or short-term, should also receive a 150%risk weight

If an issuer has a long-term exposure with an external long term rating that warrants a risk weight of 150%, all unrated claims on the same counterparty, whether short-term or long-term, should also receive a 150% risk weight.

Mapping Process (Short Term Rating contd.)

In respect of the issue specific short term ratings the following risk weight mapping shall be adopted by banks

Short Term Ratings RW

CARE CRISIL FITCH ICRA  

PR1+ P1+ F1+ A1+ 20%

PR1 P1 F1 A1 30%

PR2 P2 F2 A2 50%

PR3 P3 F3 A3 100%

PR4 &PR5 P4 & P5 B,C,D A4 / A5 150%

Unrated Unrated Unrated Unrated 100%

Where “+” or “-” notation is attached to the rating, the corresponding mainrating category risk weight should be used for PR2/ P2/ F2/ A2. For example, P2+ or P2- would be considered to be in the P2 rating category and assigned 50% risk weight.

Seven Categories

Solicited Ratings

A rating would be treated as solicited only if the issuer of the instrument has requested the credit rating agency for the rating and has accepted the rating assigned by the agency

Banks should use only solicited rating from the chosen credit rating agencies

No ratings issued by the credit rating agencies on an unsolicited basis should be considered for risk weight calculation

Multiple Rating Assessments…At the Beginning

If there is only one rating by a chosen credit rating agency for a particular claim, that rating would be used to determine the risk weight of the claim.

If there are two ratings accorded by chosen credit rating agencies which map into different risk weights, the higher risk weight should be applied

If there are three or more ratings accorded by chosen credit rating agencies with different risk weights, the ratings corresponding to the two lowest risk weights should be referred to and the higher of those two risk weights should be applied

For example if 20%, 30% and 50% are the RW applied to the same exposure, then 30% RW will be applied.

Techniques of Credit Risk Mitigation

Techniques of Credit Risk Mitigation

Techniques of Credit Risk Mitigation

j

N

i

M

jjii CwLwRWA

1 1

*

On-balance sheet items: principal times risk weight

Off-balance sheet items: credit equivalent amount times risk weight

For a derivative Cj = max(Vj,0)+ajLj where Vj is value, Lj is principal and aj is add-on factor

Types of Mitigants

Financial Collateral (FC) On-balance sheet Netting Guarantee Credit Derivative

Use of Mitigants is to i) either Reduce RW or ii) the Exposure Amount of the Existing Asset Class Reduce the RWA

CRM techniques reduces or transfers credit risk

Principles for Credit Risk Mitigation (CRM) Techniques 1.No (Exposures) transaction in which Credit Risk

Mitigation (CRM) techniques are used should receive a higher capital requirement than an otherwise identical transaction where such techniques are not used.

2.The effects of CRM will not be double counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on claims for which an issue-specific

rating is used that already reflects that CRM

Eligible Financial Collateral

Cash, Fixed Deposits (issued by lending Bank), CDs also issued by lending Bank (Cash Equivalent)

Gold (Cash Equivalent) Sovereign Securities (Central & State Govt.) KVP, NSC certificate Life Insurance Policies with declared surrender value Rated Debt securities with 100% or lesser Risk weight with

sufficient liquidity (discretion of the bank)

Equities listed on a recognized Stock Exchange(BSE/NSE/NYSE/LSE/TSE/ASE/MICEX)

Units of Mutual Fund where daily NAV is available (publicly Quoted)

Basics….. If the Bank is in SA Mode, the secured lending/Loan implies that

the Exposure is backed Collateral given by the borrower. Here the collateral includes the financial collateral (eligible) only.

If the Bank is in IRB Mode, the secured lending implies that the Exposure is backed financial collateral (eligible) & IRB Collaterals given by the borrower.. Here the IRB collateral includes

Financial Receivables CRE & RRE Other Physical collateral (Plant, machinery, land

etc…)

Hence, collateral is defined on the basis of SA or IRB Method

Basics….. The effect of Financial collaterals are not be

reflected in the Rating( issue/issuer) by the Rating Agency in SA Approach.

The effect of IRB collaterals are not be reflected in the PD by the Bank in IRB Approach

In both SA & IRB, the collaterals will be part of Credit Risk Mitigation.

Basics….Mortgage Loan vs Secured Loan

In Mortgage Loan ( Claims secured by Housing Loan, Claims Secured by CRE ), the effect of mortgages (CRE,RRE) are already reflected in the Rating / PD of the borrower ….therefore, CRE & RRE are not treated as collateral.

Hence, the impact will not be captured in Credit risk Mitigation (CRM) as it has already reduced the RW/PD.

In secured Loan, the financial Collaterals (given by the borrower)

do not impact the rating/ PD of the borrower. Impact is captured in the Credit risk Mitigation (CRM) by reducing the value of exposures SA or LGD in IRB Approach.

What is Guaranteed Loan?

Approaches for Credit Risk Mitigation

Simple Approach Comprehensive Approach

Comprehensive ApproachComprehensive Approach

Comprehensive ApproachComprehensive Approach allows fuller offset of allows fuller offset of collateral value against collateral value against exposuresexposures after applying haircut to capture volatility in the collateral value. This is done on an account-by-account basis, even within regulatory retail This is done on an account-by-account basis, even within regulatory retail portfolioportfolio

The legal mechanism by which collateral is pledged or transferred must ensure timely liquidation/ possession of the collateral by the bank in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral).

The banks must take all steps for obtaining and maintaining an enforceable security interest in the collateral, e.g. by registering it with a registrar.

Collateralised transactionCollateralised transaction…contd…contdWhere the collateral is held by a custodian, the custodian must segregate the collateral from its own assets.

No positive co-relation between the credit quality of No positive co-relation between the credit quality of the counterparty and value of the collateralthe counterparty and value of the collateral. e.g., . e.g., securities issued by the counterparty ─ or by any related group entity ─ would provide little protection and so would be ineligible.

There could be standard supervisory haircuts (set by the Basel Committee) or bank's own estimate of the volatility of the collateral. The bank will have to meet a set of quantitative and qualitative criteria in the latter case.

RBI has accepted the comprehensive approach and prescribed standard supervisory haircuts.

162

Comprehensive Approach for Credit Risk Mitigation It reduces the existing RWA of the Asset Class by reducing the value

of Exposure / Asset.

The reduced value is arrived by offsetting the value of Exposure / Asset against the value of Financial Collateral.

Concept : Hc = Haircut appropriate to the Financial collateral (FC) Haircut is the price volatility of the appropriate financial collateral

It adjusts the value of collateral C x (1 – Hc)……where C is the Value of FC

For Example, if the value of FC is Rs. 50,000 & Hc is 10%, then adjusted value of collateral will be Rs. 45,000. In this case if the value of exposure is Rs. 1,00,000, then the off-setted value of Exposure will be Rs.55,000(1,00,000 – 45,000). If the RW of the asset class is pegged at 100%, then RWA will be Rs.55,000 as against original RWA of Rs.1,00,000 ( RW 100% * 1,00,000).

Pre Mitigated RWA is Rs. 1,00,000 & Post Mitigated CRM is Rs. 55,000.Hence, there is a benefit in terms of reduced RWA to the tune of Rs.45,000& Capital Req…………….?

Volatility Haircut – Financial Collateral

The application of haircuts will produce volatility adjusted amounts for both exposure and collateral.

The volatility adjusted amount for the exposure will be higher than the exposure and the volatility adjusted amount for the collateral will be lower than the collateral, unless either side of the transaction is cash.

In other words, the Haircut for the exposure will be a premium factor and the Haircut for the collateral will be a discount factor.

Besides, if the exposure and collateral are held in different currencies an additional downwards adjustment must be made to the volatility adjusted collateral amount to take account of possible future fluctuations in exchange rates.

Collateralised transactionCollateralised transaction…contd…contd

Why `haircut’?For exposure - it is a premium factor.For exposure - it is a premium factor.For collateral – it is a discount factor. For collateral – it is a discount factor. No haircut if the exposure/ collateral is No haircut if the exposure/ collateral is

cash.cash.Std. sup. haircuts are prescribed by RBI Std. sup. haircuts are prescribed by RBI

assuming daily mark-to-market, daily assuming daily mark-to-market, daily revaluation and a 10-business revaluation and a 10-business day holding period. day holding period.

165

Volatility Haircut – Financial Collateral

Banks have two ways of calculating the haircuts: (i) Standard Supervisory haircuts, using parameters set by the

Basel Committee, (ii) Own Haircuts using banks’ own internal estimates of market

price volatility.

Banks in India shall use only the Standard Supervisory haircuts

The Standard Supervisory Haircuts assumes daily revaluation and a 10 business-day holding period.

Holding period will be the time normally required by the bank to realise the value of collateral.

Eligible financial Collateral

The following collateral instruments are eligible for recognition in the comprehensive approach: (i) Cash (as well as certificates of deposit or comparable instruments, including fixed deposit receipts, issued by the lending bank) on deposit with the bank which is incurring the counterparty exposure. (ii) Gold: Gold would include both bullion and jewellery. However, the value of the collateralised jewellery should be arrived at after notionally converting these to 99.99 purity. (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.

Eligible financial collateral

(vi) Debt securities rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity and these securities will attract 100 per cent or lesser risk weight vii) Debt securities not rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity where these are:

a) issued by a bank; and

b) listed on a recognised exchange; and

c) classified as senior debt; and

Banks should be sufficiently confident about the market liquidity of the security.

How the liquidity of the Instrument is defined?

Eligible financial collateral A debenture would meet the test of liquidity if it is traded on a recognised stock

exchange on at least 90 per cent of the trading days during the last 250 Trading days.

Further, liquidity can be evidenced in the trading during the previous one month in the recognized stock exchange if there are a minimum of 25 trades of marketable lots in securities of each issuer.

Units of debt oriented Mutual Funds regulated by the securities regulator of the jurisdiction of the bank‘s operation mutual funds where price for the units is publicly quoted daily i.e., where the daily NAV is available in public domain

As per Basel II framework, are accepted as collaterals…listed in Stock exchange…..listed in national stock exchange ….Cost of transaction (impact cost) of less than 0.75% for more than 90% of trades, over six months

Supervisory Volatility Haircut – Financial Collateral

0% Haircut is applied to NSC,KVP, Insurance Policies (surrender) and Bank Fixed Deposits, Certificate of Deposits issued by the lending Bank ( Treated as Cash Equivalent).

15% Haircut is applied to Gold & Equities….Equity Oriented MF

Non investment Grade Debt Securities will attract 25% haircut. (Below BBB or Baa)

Where the collateral is a basket of instruments, the haircut on the basket will be,

H = ΣaiHi where ‘ai’ is the weight of the collateral (as measured by the amount/value of the collateral in units of currency) in the basket and Hi, the haircut applicable to that collateral .

Example

Supervisory Volatility Haircut – Financial Collateral

 

Issue RatingFor Debt Securities

Residual Maturity(Years)

Haircut(Percentage)

A Sovereign Securities

 

Rating is not applicable for Sovereign

< =1 year 0.5

i > 1 year to up to 5 Years 2

  more than five years 4

B Debt Securities

 

AAA to AAPR1/PP1/F1/A1

<= 1 year 1

ii >1 year to up to 5 Years 4

  more than five years 8

   

 A to BBB PR2 / P2 / F2 /

A2 /PR3 /P3 / F3 / A3 and Unrated Bank securities

<= 1 year 2

ii 1 year to up to 5 Years 6

  more than five years12

iv

Highest haircut applicable to any of the above securities, in which the eligiblemutual fund can Invest

 

Units of Mutual Funds/ Equities/Gold

15

 

C Cash In same Currency 0

Supervisory Volatility Haircut – Financial Collateral –Foreign Sovereign & Corporate

Issue rating fordebt securities asassigned by International Rating Agency

Residual Maturity Sovereigns Other Issues

AAA to AA / A-1(0% RW for sov)

20% corporate& Bank

<= 1 Year 0.5 1

> 1 Year & <(=) 5 Years 2 4

> 5 Years 4 8

A to BBB/BaaPR2\P2\F2\A2PR3\P3\F3\A3

Unrated Bank Securities(20% to 50% for Sov )

= 1 Year 1 2

> 1 Year & <(=) 5 Years 3 6

> 5 Years 6 12

If the securities issued by foreign Central Governments & by foreign Corporate is pledged as Fin. Coll……… Hc will be

These are the hair Cut for 10 Business Days Holding Period

&

Daily Revaluation

Unrated Corporate Debt Securities as Fin Col…Hc is 25%

Apr 7, 2023

Sr. No

Rating of Securities Residual Maturity Haircut (%)

A.

Securities issued/ gteed by GoI and issued by State Govts.

Rating not applicable, as Govt securities are not currently rated in India

< or = 1 year 0.5

> 1 year, < or = 5 years 2

> 5 years 4

B

Securities other than at A including State Govt guaranteed securities.AAA to AAPR1/P1/F1/A1

< or = 1 year 1

> 1 year, < or = 5 years 4

> 5 years8

A to BBB-PR2/P2/F2/A2PR3/P3/F3/A3 & Unrated bank securities

< or = 1 year 2

> 1 year, < or = 5 years 6

> 5 years 12

Mutual Funds Highest haircut applicable to any security in which the fund can invest.

C Cash in the same currency (including Deposits of the Bank) 0

D Gold 15

Standardized Supervisory Haircuts for Basel II Collaterals

Adjustment of Holding period / Revaluation Frequency

Secured Lending : The secured lending/Loan implies that the Exposure is backed Fin. Collateral (in Standardized Approach)

For Secured Lending, the average holding period is 20 Business Days and Daily Revaluation…..recommended by the Regulator

In order to capture the 20 business holding period, the supervisory haircuts are to be scaled up by the factor 1.414….SQRT(20/10)

Haircuts…contd

Formula for adjustments in haircut on a/c of Formula for adjustments in haircut on a/c of changes in holding periods/ changes in changes in holding periods/ changes in remargining scheduleremargining schedule

H = HH = H10 10 √ {N√ {NR R + (T+ (TM M - 1)}/ 10, Where: - 1)}/ 10, Where:H = Adjusted haircutH = Adjusted haircutHH1010 = 10-business day standard supervisory = 10-business day standard supervisory

haircut for instrumenthaircut for instrumentNNRR = actual number of business days of = actual number of business days of

revaluation for secured transactions.revaluation for secured transactions.TTM M = minimum holding period for the type of = minimum holding period for the type of

transactiontransaction

176

Adjustments to Std. Sup. Haircuts – A case Adjustments to Std. Sup. Haircuts – A case studystudy

HH10 10 for AAA rated securities with residual for AAA rated securities with residual

maturity of 1 year is 1%. Holding period maturity of 1 year is 1%. Holding period estimated (Testimated (TM M ) is 20 days. N) is 20 days. NRR assumed as assumed as

one considering daily revaluation. one considering daily revaluation. HH2020 = H = H10 10 √ {N√ {NR R + (T+ (TM M - 1)}/ 10 - 1)}/ 10

HH2020 = 1% = 1% √ {1√ {1 + (20+ (20 - 1)}/ 10 - 1)}/ 10

HH2020 = 0.01√ {20}/ 10 = 0.01√ {20}/ 10

HH2020 = 0.01 x √ 2(= = 0.01 x √ 2(=1.414)

HH2020 =0.014 =0.014177

Proof of Concept (POC)

Borrower ‘B’ had requested for a loan of Rs.100 cr for a multiplex project to Bank ‘A’. Bank ‘A’ has sanctioned entire Rs.100 cr loan. However, as on today ‘A’ has disbursed only Rs.10 cr for the first 1st phase of project.

Asset Class…Claim on CER At this point in time, Banks will have claim on the asset created in

the first phase of implementation of worth Rs.10 crore Since the exposure is being mapped to ‘Claims Secured by CRE’

with RW of 100%. The Value of the ‘CRE’ i.e Multiplex (Mortgage Value) is already reflected in the RW.

RWA is 100%* Rs.10 Cr = Rs.10 cr

If the borrower ‘B’ has pledged non investment grade debt instrument of worth Rs.12 crore during the first phase of implementation.

Proof of Concept (POC) contd…

This CRE Claim will be treated as Secured Lending as it is backed financial Collateral.

Since it is an non-investment grade, it will attract 25% Haircut for 10days holding period. The volatility has to be scaled up to 20 days holding period.

Hc = 25% *sqrt(20/10) = 35.36% Adjusts the value of collateral C x (1 – Hc) =12*(1-0.3536)

= Rs. 7.76 cr. The off-setted value of Exposure is Rs.10 cr – Rs.7.76

cr = Rs. 2.24 cr. The Post CRM RWA is 100%* 2.24 = Rs.2.24 cr. The benefit in terms of RWA is Rs.10cr. – Rs.2.24 =

Rs.7.76 cr. At 9% CRAR….CC will be reduced by 2.24*9% Post CRM CC is 7.76*9%

Internal Estimates

If the Bank has internal estimate of the volatility…. For secured borrowing … minimum holding period is to be decided by the bank (has to take a view)…based on the holding period, the daily volatility has to be scaled up or down….

Besides, all the secured lending will revalued on daily basis.

If the financial Coll.is not revalued daily basis and volatility is not calculated for holding period as decided by the bank, then the volatility will further adjusted by

HC = HT *SQRT [(NR + TM -1)/ T]

Where, TM = Holding Period as decided by bank

NR = revaluation ( days) for secured transactions.

T = Time period for which volatility HT is calculated

Example

HC = HT *SQRT [(NR + TM -1)/ T]Where, TM = Holding Period as decided by bank

NR = Actual Revaluation period HT = Volatility for the time period ‘T’ T = Time period for which volatility is

calculated Bank has a secured lending & calculated annualized volatility (260

Trading days) at 30% where the frequency of revaluation is 10 days. 15 days is Holding Period

In this case, the volatility is to be adjusted for 15 days holding period (as decided by bank) and daily revaluation

HC = 30%* SQRT [(10 + 15 -1)/ 260] = 33%

Concept – Currency Mismatch (Hfx)

If Exposure & Collateral are denominated in different currencies. Example…..if Bank has lent in Rupee and fin. Coll.

pledged by the borrower is FED 364 T - Bill…. denominated in USD

The supervisory Haircut (volatility) for currency mismatch is placed at 8%...based on 10 Business Days …..has to be scaled up by 20 Days for secured lending….

8% * SQRT(20/10) = 11.31%

Bank may have own estimate of currency volatility In Case the Holding period is 15 days, then Hfx will be estimated for 15

days Volatility period for forex = Holding/Liquidation Period of Fin. Coll If Bank has the volatility of Foex for 260 Trading days…then

accordingly Hfx for 15 days will be estimated….SQRT(15/260)

Proof of Concept – Currency Mismatch

Pre CRM Bank ‘Trust Ltd’ has given a term loan (senior) to

Corporate Borrower ‘Wall Mart’ amounting Rs.50 cr. This Term Loan is not Rated. (Unrated)

This exposure is mapped to ‘ Claims on Corporate’ This Issue/loan/exposure is not rated

However, another term loan taken by ‘Wall Mart’ is rated at ‘AAA’. Also, the rating of the ‘Wall Mart’ is available & it is ‘AA’ .

AAA 20% & AA 30%.......ICRA Rating Agency RW = max ( AAA,AA) = 30%

RWA (Pre CRM) = 30% * 50 = Rs.15 cr

Proof of Concept – Currency MismatchPost CRM ‘Wall Mart’ owns debt securities issued by company ‘FORD’ in Aug,2009 with

original maturity of 6 years. It is ‘A’ rated by S&P. This was issued in US and dollar denominated. The value of the debt issued is pegged at Rs.40 cr as on today ( using the current spot rate of USD/Rs ). ‘Wall Mart’ has pledged this as collateral to Bank ‘Trust Ltd’ for this term loan.

This will be treated as eligible financial collateral issued by foreign corporate with Rating of ‘A with residual maturity of 10 years

Appropriate Supervisory Haircut will be HC = 12% for 10 Days Holding Period…..for 20

days….. HC = 12% *SQRT(20/10) = 17% supervisory Haircut (volatility) for currency mismatch

Hfx = 8% * SQRT(20/10) = 11.31% Adjusts the value of collateral

C x (1 – Hc- Hfx) =40*(1-0.17-0.11) = Rs. 28.80 cr.

The off-setted value of Exposure is Rs. 50 cr – Rs.28.80 cr = Rs. 21.20 cr.

The Post CRM RWA is 30%* 21.20 = Rs. 6.36 cr. The benefit in terms of RWA is Rs.15cr. – Rs.6.36 = Rs.8.64 cr. CC is reduced to 28.80*9% The reduced Capital charge stands at is 8.64*9% = Rs. 0.78 Cr

Comprehensive Approach

E* Calculation

E* = max {0, [E – C x (1 – Hc - Hfx)]}

Where

E* = Exposure Value after Risk Mitigation

E = Current Value of the Exposure

C = The current value of the collateral received (Financial Collateral)

Hc = Volatility haircut appropriate to the collateral

Hfx = Forex haircut appropriate for currency mismatch

RWA is calculated as RW ( of the Asset Class) x E*

http://www.youtube.com/watch?v=pofLLw5LqVw

Concept – Maturity Mismatch

Maturity Mismatch Maturity Mismatch is due to difference between Residual Maturity of

Exposure and Residual Maturity of collateral& Residual Maturity of collateral is less than the Residual Maturity of

Exposure (Loan) Example

Residual Maturity of Exposure = 4 Yrs and Residual Maturity of Collateral = 5 Yrs, then there is No Maturity Mismatch as Collateral is valid till the maturity of Exposure

Residual Maturity of Exposure =4 Yrs and Residual Collateral Maturity = 3Yrs, then there is Maturity Mismatch as Collateral Matures before Exposure Matures

Maturity Mismatch is applied only to Collateral and it further reduces

the value of Collateral .

Concept – Maturity Mismatch ..contd

Ca = C x (t-0.25) ÷ (T-0.25)Where:

C = Current Collateral Value after capturing the effect of Price & Forex Volatility ( volatility haircut and currency mismatch)

T = min (5, residual maturity of the exposure), expressed in years t = min (T, residual maturity of the Collateral), expressed in years Ca = value of the collateral adjusted for maturity mismatch

Example Residual maturity of the exposure = 8 yrs

T = min (5, 8) = 5 yrs Residual maturity of the Collateral = 4 yrs………Maturity Mismatch

t = min [ (T = 5), 4) ] = 4 yrs, Ca = C x (4-0.25) / (5-0.25) = C x 3.75/4.75 = C x 0.79

If there is Maturity Mismatch , Maturity Mismatch Factor will be less than one …….maximum value is ‘1’………indicates that there is no maturity mismatch

Maturity Mismatch Factor

Concept – Maturity Mismatch ..contd

Conditions Collaterals with Residual Maturity less than

one year are not recognized. C =0

If there is embedded option in the Collateral, & the residual time period for this option is less than the residual maturity of the Collateral, then residual maturity will be equal to residual time period for this option to be exercised.

M = min (Mc, Rm )

Proof of Concept - Maturity Mismatch

Previous ExampleExisting Inputs1. Wall Mart with RW-30% & Value of Exposure ( Term Loan) is Rs.100cr2. Adjusts the value of collateral (debt securities issued by ‘FORD’)

C x (1 – Hc- Hfx) =40*(1-0.17-0.11) = Rs. 28.80 cr

Additional Inputs

3.Residual Maturity of the loan -7 yrs & Residual Maturity of the Collateral - 4 yrs

4. The Call option embedded in the Collateral (debt securities) is due after 3 yrs

Residual Maturity of the Collateral - 3 yrs There is maturity mismatch…. Residual Maturity of Collateral (3 yrs) is less than

Residual Maturity of Loan (7 yrs) T = min (5, 7) = 5 yrs & t = min (T = 5, 3) = 3 yrs, Ca = 28.80 x (3-0.25) / (5-0.25) = 28.80 x 2.75/4.75

= 28.80 x 0.58 = Rs. 16.70 Cr

Proof of Concept - Maturity Mismatch

Now the off-setted value of Exposure will be Rs.50 cr – Rs.16.70cr = Rs. 33.30 cr

The Post CRM RWA is 30%* 33.30 = Rs. 10 cr.

The Pre CRM RWA is calculated at :

RWA (Pre CRM) = 30% * 50 = Rs.15 cr

The benefit in terms of RWA is Rs. 15cr. – Rs. 10 cr = Rs. 5 cr.

The( benefit) ….CC is reduced by….. is 5*9% = Rs.0.45 Cr

The reduced Capital charge stands before capturing Maturity Mismatch was at 8.64*9% = Rs. 0.78 Cr

Hence because of Maturity Mismatch benefit in terms of CC gas declined.

Comprehensive Approach

Even if the RW of the securities which are pledged as Fin. Coll, is more than RW of the borrower, Bank can still avail the benefit of lower RWA……

Since the value of the Fin Coll is considred not the RW

M = (t-0.25)/(T-0.25)…why 0.25? C = 0 when their original maturities of CM< 1 Year If , maturity of collateral for exposures with original

maturities of < 1 year It will be recognised. Residual maturity of the exposure = 9 Months

T = min (5, 0.75) = 0.75 yrs Residual maturity of the Collateral = 6 months………Maturity

Mismatch t = min [ (T = 0.75), 0.6) ] = 0.6, Ca = C x (0.60-0.25) / (0.75-0.25) =

C x 0.35/0.50 = C x 0.70

M = (t-0.25)/(T-0.25)…why 0.25? Residual maturity of the exposure = 9 Months

T = min (5, 0.75) = 0.75 yrs Residual maturity of the Collateral = 3 months………Maturity Mismatch

t = min [ (T = 0.25), 0.6) ] = 0.25, Ca = C x (0.25-0.25) / (0.75-0.25) = 0

In all cases, collateral with MM are ignored when they have a residual maturity of three months or less…C =0

Collateral with OM/CM <1Y or RM<0.25Y, C = 0 Hence, (t-0.25)/(T-0.25)…Hence… 0.25 Exception In above case, if RM of Coll is 3 months, then CRM is recognised. Therefore, Coll with lesser maturity(< 0.25Y) is recognised, if there Coll with lesser maturity(< 0.25Y) is recognised, if there

is no MM….is no MM…. RM of Exposure should be less than or equal to RM FIN . Coll RM of Exposure should be less than or equal to RM FIN . Coll

POC1 - Calculation of Capital Charge POC1 - Calculation of Capital Charge A bond exposure of INR 100 with maturity of 3-yr to a AA A bond exposure of INR 100 with maturity of 3-yr to a AA

rated corporate is collateralised by a FD of INR 50 of rated corporate is collateralised by a FD of INR 50 of equivalent maturity. Assuming all conditions are met, the equivalent maturity. Assuming all conditions are met, the exposure after the risk mitigation is as follows. exposure after the risk mitigation is as follows.

E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]} E* = max {0, [100 x (1 +0.04) – 50 x (1 – 0 – 0)]} E* = max {0, [100 x (1.04) – 50 x 1]} E* = max {0, [104 – 50 ]} E* = max {0, 54} E* = 54 Risk-weighted assets = INR 16.20 [INR 54 * 30%, i.e. the risk Risk-weighted assets = INR 16.20 [INR 54 * 30%, i.e. the risk

weight for the long term claims on AA rated corporate]weight for the long term claims on AA rated corporate] 9% Capital Charge on the risk-weighted assets = INR 1.458 9% Capital Charge on the risk-weighted assets = INR 1.458

[16.20 * 9%][16.20 * 9%] Without CRM benefits, capital charge would be INR 2.70 [100 Without CRM benefits, capital charge would be INR 2.70 [100

* 30% * 9%]* 30% * 9%]195

POC 2 - Calculation of Capital Charge POC 2 - Calculation of Capital Charge

A FC exposure (INR 100 equivalent) with 6-yr maturity to A FC exposure (INR 100 equivalent) with 6-yr maturity to a corporate rated A+ is collateralised by debt security a corporate rated A+ is collateralised by debt security (rated AA) of equivalent maturity. Current Value of the (rated AA) of equivalent maturity. Current Value of the collateral =INR 100. Assuming all conditions are met, the collateral =INR 100. Assuming all conditions are met, the exposure after the risk mitigation is as follows. exposure after the risk mitigation is as follows.

E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]} E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]} E* = max {0, [100 x (1 + 0.12) – 100 x (1 – 0.08 – 0.08)]} E* = max {0, [100 x (1 + 0.12) – 100 x (1 – 0.08 – 0.08)]} E* = max {0, [100 x (1.12) – 100 x (1 – 0.16)]} E* = max {0, [100 x (1.12) – 100 x (1 – 0.16)]} E* = max {0, [112 – 100 x (0.84)]}E* = max {0, [112 – 100 x (0.84)]} E* = max {0, [112 – 84]}E* = max {0, [112 – 84]} E* = max {0, 28}E* = max {0, 28} The exposure value after risk mitigation is INR 28.  The exposure value after risk mitigation is INR 28.  Capital charge may be calculated as indicated earlier.Capital charge may be calculated as indicated earlier.

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