credit risk mitigation

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Instruction Circular No. 9716/CP&RMD/2007-2008/08 Date : 04.08.2007

BANKSPolicy on Credit Risk Mitigation and Collateral

Management under New CapitalAdequacy Framework

ALLAHABAD BANK

CREDIT POLICY & RISK MANAGEMENT DEPARTMENT


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ALLAHABAD BANKCREDIT POLICY & RISK MANAGEMENT DEPARTMENT

Head Office : 2, Netaji Subhas Road, Kolkata 700 001

Instruction Circular No. 9716/CP&RMD/2007-08/08 Date : 04.08.2007

To All Offices and Branches

POLICY ON CREDIT RISK MITIGATION AND COLLATERAL MANAGEMENT UNDER NEWCAPITAL ADEQUACY FRAMEWORK

1. INTRODUCTION:

1.1. Credit Risk Mitigationimplies to reduction of C redit Risk in an exposure by a safety

net tangible and realizable securities including third party guarantee / insurance i.e.

exposure may be collateralizedin whole or in part.

1.2. In the Final Guidelines on Implementation of the New Capital Adequacy

Frameworkunder Basel-II Framework, RBI has prescribed certain norms for Credit

Risk Mitigation.

1.3. RBI guidelines on Credit Risk Mitigation are with reference to Standardised

Approach, which the Bank is adopting for calculation of capital requirement underCredit Risk.

1.4 RBI in its guidelines has stipulated to put in place Board Approved Policy on

Utilisation of the Credit Risk Mitigation Techniques and Collateral Management.

2. SALIENT FEATURES OF RBI GUIDELINES:

2.1. Banks are allowed for a wider range of credit risk mitigants.

2.2. Under Financial Collaterals,the permissible items are as under (withconditionalties)

tobe recognized for regulatory capital purposes :

2.2.1. Cash (As well as Certificate of Deposit or comparable instruments including

Fixed Deposit Receipts issued by the Lending Bank).

2.2.2. Gold

2.2.3. Securities issued by Central/State Govt.

2.2.4. KVPs/NSCs

2.2.5. Life Insurance Policies with a declared surrender value.

2.2.6. Debt Securities rated / un-rated by a chosen credit Rating Agency in

respect of which the Banks should be sufficiently confident about the

market liquidity.


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2.2.7. Equities (including Convertible Bonds) that are listed on a recognized Stock

Exchange and are included in prescribed indices.

2.2.8. Units of Mutual Funds.

2.3. Eligibility / Permissible Guaranteesare :

2.3.1. Guarantee offered by Sovereigns (State & Central Govt.)

2.3.2. Guarantee offered by Sovereign Entities (including BIS, IMF, ECB, EC, MDBs

etc.)

2.3.3 Guarantee offered by CGTSI & ECGC

2.3.4. Guarantee offered by Banks and Primary Dealers with lower risk weight

than counter party.

2.3.5. Guarantee offered by other entities having rated AA(-) or better as per

rating agencies.

2.4. Credit Risk Mitigation approach will be applicable to the Banking Book Exposures.

This will also be applicable for calculation of the counterparty risk charges for OTC

derivatives and repo-style transactions booked in the trading book.

2.5. No 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.

2.6. The effects of CRM willnotbe double counted. Therefore, no additional supervisory

recognition of CRM for regulatory capital purposes will be granted on c laims for

which an issue-specific rating used that already reflec ts that CRM.

2.7. Principal-only ratings will not be allowed within the CRM framework.

2.8. In order for Banks to obtain capital relief for any use of CRM techniques, the

minimum prescribed standards for legal documentationmust be met.

2.9. A Collateral transaction is one in which :

2.9.1. banks have a credit exposure and that credit exposure is hedged in whole

or in part by collateral posted by a counterparty or by a third party on

behalf of the counterparty. Here, counterparty is used to denote a party

to whom a bank has an on-or off-balance sheet credit exposure.

2.9.2. banks have a specific lien on the collateral and the requirements of legal

certainty are met.

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2.10. Banks in India shall adopt the Comprehensive Approach, which allows fuller offset

of collateral against exposure, by effectively reducing the exposure amount by

the value ascribed to the collateral subject to haircutsthat will provide volatility

adjusted amounts for both exposure and collateral.

2.11. Credit Risk Mitigation is allowed only on account-by-accountbasis, even within

regulatory retail portfolio.

2.12. While the use of CRM techniques reduces or transfers credit risk, it simultaneously

may increase other risks (residual risks). Residual risks include legal, operational,

liquidity and marketrisks.

2.13. Prescribed disclosure requirementsmust always be observed for Banks to obtain

capital relief in respect of any CRM techniques.

3. POLICY FRAMEWORK OF THE BANK

3.1. Objective of the Policy:

3.1.1. Under Final Guidelines of New Capital Adequacy Framework (Basel-II)released by Reserve Bank Of India (RBI) in April, 2007, the Bank can use awide range of prescribed Credit Risk Mitigants (CRMs) covering financialcollaterals/ guarantees to be recognised for regulatory capitalcalculation purposes.

3.1.2. Use of such permissible CRMs will enable the Bank to:(a). pursue credit risk mitigation by insisting for eligible collaterals.(b). reduce the volume of risk weighted assets reducing thereby the

quantum of minimum capital requirement.

3.2. Coverage of Risk Mitigants under the Policy:

3.2.1. All securitieswhich are obtained by the Bank against credit exposure inthe normal course of businessare not eligible for mitigation purposes.

3.2.2. Only eligible collaterals prescribed in this policy are allowed to be

recognised for computation of regulatory capital charge for credit risk.

3.2.3. This policy, therefore, does not prohibitobtention of securities out side thepurview of eligible collaterals which however will not be eligible formitigation purposes.

3.3 Applicability / General Principles

3.3.1 Credit Risk Mitigation (CRM) approach/techniques as detailed in thispolicy are applicable to the Banking Book exposures.

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3.3.2 This will also be applicable for calculation of the counterparty riskcharges for OTC derivatives and repo style transactions booked in theTrading Book.

3.3.3 The general principles applicable to use of credit risk mitigationtechniques are as under:

(i) No transac tion in which Credit Risk Mitigation (CRM) techniques areused should receive a higher capital requirement than an otherwiseidentical transaction where such techniques are not used.

(ii) The effects of CRM will not be double counted. Therefore, noadditional supervisory recognition of CRM for regulatory capitalpurposes will be granted on claims for which an issue-spec ific ratingis used that already reflects that CRM.

(Note: The above stipulation implies that if mitigating factors arealready built into issue-specific rating, the benefit of mitigation can

not be again counted for capital requirement.)

(iii) Principal-only ratings will not be allowed within the CRM framework.

(iv) While the use of CRM techniques reduces or transfers credit risk, itsimultaneously may increase other risks (residual risks). Residual risksinclude legal, operational, liquidity and market risks.Therefore, it isimperative that Banks laid down procedures and processes arestrictly adhered to control these risks, including strategy;consideration of the underlying credit; valuation; policies and

procedures; systems; control of roll-off risks; and management ofconc entration risk arising from the Banks use of CRM techniquesand its interaction with the Banks overall credit risk profile.

3.4 Collateralised transactions

3.4.1 A collateralised transaction is one in which:

(i) Bank has a credit exposure and that credit exposure is hedged inwhole or in part by collateral posted by a counterparty or by athird party on behalf of the counterparty. Here, counterparty isused to denote a party to whom a bank has an on- or off-balance

sheet credit exposure.

(ii) Bank has a spec ific lien on the collateral and the requirements oflegal certainty are met.

3.5 Minimum Conditions

3.5.1. Credit risk mitigation is allowed only on an account-by-account basis,even withinregulatory retail portfolio.

3.5.2. However, before capital relief is considered the standards set out belowmust be met.

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:: 5 ::(i) In addition to the general requirements for legal certainty, the legal

mechanism by which collateral is pledged or transferred must ensurethat the bank has the right to liquidate or take legal possession of it,in a timely manner, in the event of the default, insolvency orbankruptcy (or one or more otherwise-defined credit events set out

in the transaction documentation) of the counterparty (and, whereapplicable, of the custodian holding the collateral). Furthermore,Bank must take all steps necessary to fulfil those requirements underthe law applicable to the Banks interest in the collateral forobtaining and maintaining an enforceable security interest, e.g. byregistering it with a registrar.

(ii) In order for collateral to provide protection, the credit quality of thecounterparty and the value of the collateral must not have amaterial positive correlation. For example, securities issued by thecounterparty or by any related group entity would provide littleprotection and so would be ineligible.

(iii) Banks laid down procedures for the timely liquidation of collateraldeclaring the default of the counterparty and liquidating thecollateral are observed, and that collateral shall be liquidatedpromptly.

(iv) Where the collateral is held by a custodian, Bank must takereasonable steps to ensure that the custodian segregates thecollateral from its own assets.

3.5.3 A capital requirement will be applied on either side of the collateralisedtransaction: for example, both repos and reverse repos will be subject tocapital requirements. Likewise, both sides of securities lending and

borrowing transactions will be subject to explicit capital charges, as willthe posting of securities in connection with a derivative exposure or otherborrowing.

3.6 Approach

3.6.1. Under this policy, Bank will adopt the Comprehensive Approach, whichallows fuller offset of collateral aga inst exposures, by effectivelyreducing the exposure amount by the value ascribed to the collateral.Under this approach, bank when take eligible Financial Collateral (e.g.cash or securities, more specifically defined herein after), is allowed toreduce Banks credit exposure to a counterparty when calculating itscapital requirements to take account of the risk mitigating effect of the

collateral.3.6.2. In the comprehensive approach, when taking collateral, Bank will

calculate its adjusted exposureto a counterparty for capital adequacypurposes in order to take account of the effects of that collateral. Bank isrequired to adjust both the amount of the exposureto the counterpartyand the value of any collateralreceived in support of that counterpartyto take account of possible future fluctuations in the value of either,occasioned by market movements. These adjustments are referred to ashaircuts. The application of haircuts will produce volatility-adjustedamounts for both exposure and collateral. The volatility-adjusted amountfor the exposure will be higher than the exposure and the volatilityadjusted amount for the collateral will be lower than the collateral,

unless either side of the transaction is cash. In other words, the haircutfor the exposure will be a premium factor and the haircut for thecollateral will be a discount factor.


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3.6.3. Additionally where the exposure and collateral are held in different

currencies an additional downwards adjustment must be made to thevolatility adjusted collateral amount to take account of possible futurefluctuations in exchange rates. (Also refer to Paragraph-3.9 herein after).

3.6.4. Where the volatility-adjusted exposure amount is greater than thevolatility-adjusted collateral amount (including any further adjustment forforeign exchange risk), Bank shall calculate the risk-weighted assets asthe difference between the two multiplied by the risk weight of thecounterparty. The framework for performing calculations of capitalrequirement is indicated in Paragraph3.8hereinafter.

3.7 Eligible Financial Collateral

3.7.1. The following collateral instruments are eligible for recognition in theComprehensive Approach:

Type of FinancialCollateral

Eligibility/ Stipulations/ Restrictions

1.Cash and Depositswith Bank

Cash (as well as Certificates of Deposits like DDP,FDR,RD etc issued by our Bank ) on deposit withthe Bank which is incurring the counterpartyexposure

2. Gold & J ewellery Gold would include both bullion and jewellery.However, the value of the collateralized jewellery

should be arrived at after notionally convertingthese to 99.99 purity

3. Govt Securities Securities issued by Central and StateGovernments

4. KVP/NSC Kisan Vikas Patra and National SavingsCertificates provided no lock-in period isoperational and if they can be encashed withinthe holding period.

5. LIC Policies Life insurance policies with a declared surrendervalue of an insurance company which isregulated by IRDA (Insurance Regulatory &

Development Authority).

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6. Debt Securities (Rated) Debt securities rated by a chosen C redit RatingAgency in respect of which the bank should besufficiently confident about the market liquidity@where these are either:a. Attracting 100% or lesser risk weight i.e., rated

at least BBB(-)when issued by public sectorentities and other entities (including bank andPrimary Dealers); or

b. Attracting 100% or lesser risk weight i.e., ratedat least PR3/P3/F3/A3 for short-term debtinstruments.

(@ A debenture would meet the test of liquidity if it istraded on a recognised stock exchange(s) on atleast 90% of the trading days during the preceding365 days. Further, liquidity can be evidenced in thetrading during the previous one month in therecognised stock exchange if there are a minimum of25 trades of marketable lots in securities of eachissuer.)

7. Debt Securities (Un-Rated)

Debt securities not rated by a chosen C reditRating Agency in respect of which the bankshould be sufficiently confident about the marketliquidity where these are:a) Issued by a bank; andb) Listed on a recognised exchange; andc) Classified as senior debt; andd) All rated issues of the same seniority by the

issuing bank are rated at least BBB(-) or

PR3/P3/F3/A3 by a chosen Credit RatingAgency; and

e) The bank has no information to suggest thatthe issue justifies a rating below BBB(-) orPR3/P3/F3/A3 (as applicable) and;

f) Bank should be sufficiently confident about themarket liquidity of the security.

8. Equities Equities (including convertible bonds) that arelisted on a recognised stock exchange and areincluded in the following indices: BSE- SENSEXand BSE-200 of the Bombay Stock Exchange;S&P CNX NIFTY and J unior NIFTY of the NationalStock Exchange and the main index of any otherrecognised stock exchange, in the jurisdiction ofbanks operation

9. Units of Mutual Funds Units of Mutual Funds regulated by the securitiesregulator of the jurisdiction of the Banksoperation mutual funds where:a). a price for the units is publicly quoted daily

i.e., where the daily NAV is available in publicdomain; and

b). Mutual fund is limited to investing in theinstruments listed in recognised stockexchanges specified under Equity head asabove.

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3.8 Calculation of Capital Requirement

3.8.1. For a collateralised transaction, the exposure amount after risk

mitigation will be calculated as follows:

E*= max {0, [E x(1 + H e) - C x(1 - Hc - Hfx)]}where:

E*= the exposure value after risk mitigationE = current value of the exposure for which the collateral qualifies

as a risk mitigantHe= haircut appropriate to the exposureC = the current value of the collateral receivedHc= haircut appropriate to the collateralHfx= haircut appropriate for currency mismatch between the

collateral andexposure.

3.8.2. The exposure amount after risk mitigation (i.e., E*) will be multipliedby the risk weight of the counterparty to obtain the risk-weightedasset amount for the collateralised transaction. Illustrative examplescalculating the effect of Credit Risk Mitigation is furnished inAppendix-B

3.9. Haircuts

3.9.1. Bank will use the Standard Supervisory Haircutsunder this policy forboth the exposure as well as the collateral. (Alternative way ofcalculating haircuts i.e.own-estimate haircutis not permissible inthis policy).

3.9.2. The Standard Supervisory Haircuts (assuming daily mark-to-market,daily re-margining and a 10 business day holding period*)expressed as percentages are given in Appendix-A, (Table-1).(* Holding period will be the time normally required by the Bank torealise the value of collateral.)

(ii) A

3.9.3. The standard supervisory haircuts applicable to exposure/ eligibleunrated securities issued by the C entral or State Governments, willbe the same as applicable to AAA rated debt securities.

3.9.4. Sovereign will include Reserve Bank of India, DICGC, and CGTSI,which are eligible for zero per cent risk weight.

3.9.5. Haircuts (He) will apply to exposures to all counterparties where thebank desires to avail of credit risk mitigation benefits and will bedetermined by the maturity of the exposure, external ratingassigned to the exposure and the counterparty category. (A few

illustrations for determining the applicable Hair Cuts for exposures)Heis indicated in (Appendix-A, Table-2)).

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3.9.6. Bank will apply a zero haircut for eligible collateral where it isNational Savings Certificates, Kisan Vikas Patras, surrender value ofInsurance Policies, and Banks own deposits.

3.9.7. The standard supervisory haircut for currency risk where exposureand collateral are denominated in different currencies is 8% (alsobased on a 10-business day holding period and daily mark-to-market)

3.9.8. The standard supervisory haircuts prescribed above would apply tothe security (Hc) with reference to the rating of the issuer and to theexposure (He) with reference to the rating of counterparty.

3.9.9. For transactions in which the Banks exposures are unrated or bank

lends non eligible instruments e.g. non investment grade corporatesecurities, the haircut to be appliedon the exposure should be thesame as the one for equity traded on a recognised stock exchangewhich is not part of main index i.e, 25%.

3.9.10. Where the collateral is a basket of assets, the haircut on the basketwill be,H = aiHi , whereai is the weight of the asset (as measured by units

of Currency) in the basket; and Hi the haircut applicable to thatasset.

3.9.11. For using the Standard Supervisory Haircuts, the 10- business dayhaircuts provided above will be the basis and this haircut will bescaled up or down depending on the type of transaction and thefrequency of remargining or revaluation using the formula below:

___________H=H10NR+iTM1j

10Where:

H= haircut ; H10 = 10-business day standard supervisory haircut forinstrument

NR = actual number of business days between remargining forcapital market transactions or revalidation for secured transactions.

TM=minimum holding period for the type of transaction.

3.10. Credit Risk Mitigation Techniques On-Balance Sheet Netting

3.10.1. On-balance sheet netting is confined to loans/advances anddeposits, where Bank has legally enforceable nettingarrangements, involving specific lien with proof ofdocumentation. Bank will calculate capital requirements on thebasis of net credit exposures subject to the following conditions

where the Bank:

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a) has a well-founded legal basis for concluding that the nettingor offsetting agreement is enforceable in each relevantjurisdiction regardless of whether the counterparty is insolvent

or bankrupt;b) is able at any time to determine the loans/advances and

deposits with the same counterparty that are subject to thenetting agreement; and

c) monitors and controls the relevant exposures on a net basis.

3.10.2. On fulfilment of aforesaid conditions, Bank may use the netexposure of loans/advances and deposits as the basis for itscapital adequacy calculation in accordance with the formula inParagraph 3.8. Loans/Advances are treated as exposure anddeposits as collateral. The haircuts will be zero except when a

currency mismatch exists. All the requirements contained inParagraph 3.8 and 3.12 will also apply.

3.11 Credit Risk Mitigation Techniques - Guarantees

3.11.1. Where guarantees are direct, explicit, irrevocable andunconditional Bank may take account of such creditprotection in calculating capital requirements.

3.11.2. A range of guarantors are recognised and a substitutionapproachwill be applied. Thus, only guarantees issued by entities

with a lower risk weight than the counterparty will lead toreduced capital charges since the protected portion of thecounterparty exposure is assigned the risk weight of theguarantor, whereas the uncovered portion retains the risk weightof the underlying counterparty.

3.11.3. Detailed operational requirements for guarantees eligible forbeing treated as a CRM are as under:

1.Operationalrequirements

for guarantees

(i) A guarantee (counter-guarantee) mustrepresent a direct claim on the protection

provider.(ii) The guarantee must be explicitlyreferenced

to specific exposures or a pool of exposures,so that the extent of the cover is clearlydefined and incontrovertible.

(iii) The guarantee must be irrevocable; theremust be no clause in the contract thatwould allow the protection providerunilaterally to cancel the cover or thatwould increase the effective cost of coveras a result of deteriorating credit quality in

the guaranteed exposure.

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(iv) The guarantee must also be unconditional;there should be no clause in the guaranteeoutside the direct control of the Bank thatcould prevent the protection provider frombeing obliged to pay out in a timely mannerin the event that the original counterpartyfails to make the payment(s) due.

(v) All exposures will be risk weighted aftertaking into account risk mitigation availablein the form of guarantees. When aguaranteed exposure is classified as non-

performing, the guarantee will cease to be acredit risk mitigant and no adjustment wouldbe permissible on account of credit riskmitigation in the form of guarantees. Theentire outstanding, net of specific provisionand net of realisable value of eligiblecollaterals / credit risk mitigants, will attractthe appropriate risk weight.

2.Additionaloperational

requirementsfor guarantees

In addition to the legal certainty requirements, inorder for a guarantee to be recognised, the

following conditions must be satisfied:

(i) On the qualifying default/non-payment of thecounterparty, the bank is able in a timelymanner to pursue the guarantor for anymonies outstanding under thedocumentation governing the transaction.The guarantor may make one lump sumpayment of all monies under suchdocumentation to the bank, or the guarantormay assume the future payment obligations

of the counterparty covered by theguarantee. The Bank must have the right toreceive any such payments from the

guarantor without first having to take legal

actions in order to pursue the counterparty for

payment.

(ii) The guarantee is an explicitly documentedobligation assumed by the guarantor.

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(iii) The guarantee covers all types of payments

the underlying obligor is expected to makeunder the documentation governing thetransaction, for example notional amount,margin payments etc. However, where aguarantee coverspayment of principal only,interests and other uncovered paymentsshould be treated as an unsecured amountin accordance with Point No.5 herein belowunder Proportional Cover.

3.Range ofeligible

guarantors(counter-guarantors

Credit protection given by the following entitieswill berecognised:

(I) Sovereigns, Sovereign Entities (including BIS,IMF, European Central Bank and EuropeanCommunity as well as various MDBs* ,ECGC and C GTSI) (* List enclosed asAppendix-3)

(ii). Banks and Primary Dealers with a lower riskweightthan the counterparty;

(iii) Other entities rated AA(-) or better. Thiswould include guarantee cover provided byparent, subsidiary and affiliate companies

when they have a lower risk weight than theobligor. The rating of the guarantor shouldbe an entity rating which has factored in allthe liabilities and commitments (includingguarantees) of the entity.

4.Risk weights The protected portion will be assigned the riskweight of the protection provider. Exposurescovered by State Government guarantees willattract a risk weight of 20%. The uncoveredportion of the exposure will be assigned the riskweight of the underlying counterparty

5.Proportionalcover

Where the amount guaranteed, or againstwhich credit protection is held, is less than theamount of the exposure, and the secured andunsecured portions are of equal seniority, i.e. thebank and the guarantor share losses on a pro-rata basis, capital relief will be afforded on aproportional basis: i.e. the protected portion ofthe exposure will receive the treatmentapplicable to eligible guarantees, with theremainder treated as unsecured.

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6.Currency

mismatches

Where the credit protection is denominated in acurrency different from that in which the

exposure is denominated i.e. there is acurrency mismatch, the amount of the exposuredeemed to be protected will be reduced by theapplication of a haircut ( HFX) , i.e.

GA = G x (1- H FX)

where:

G = nominal amount of the credit protectionHFX =haircut appropriate for currency

mismatch between the credit

protection and underlying obligation. (AHaircut of 8% for currency mismatch willbe applicable as permissible under theSupervisory Haircut Approach)

7.Sovereignguaranteesand counter-

guarantees

A claim may be covered by a guarantee that isindirectly counter-guaranteed by a sovereign.Such a claim may be treated as covered by asovereign guarantee provided that:

(i). the sovereign counter-guarantee covers allcredit risk elements of the claim;

(ii). both the original guarantee and the counter-guarantee meet all operational requirementsfor guarantees, except that the counter-guarantee need not be direct and explicit tothe original claim; and

(iii). the cover should be robust and no historicalevidence suggests that the coverage of thecounter-guarantee is less than effectivelyequivalent to that of a direct sovereignguarantee.

3.12. Maturity Mismatch

3.12.1. For the purposes of calculating risk-weighted assets, a maturitymismatch occurs when the residual maturity of collateral is lessthan that of the underlying exposure. Where there is a maturitymismatch and the CRM has an original maturity of less than oneyear, the CRM will not be recognised for capital purposes. In othercases where there is a maturity mismatch, partial recognition isgiven to the CRM for regulatory capital purposes as detailedbelowin Paragraphs 3.13 to 3.15

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3.13 Definition of Maturity

3.13.1. The maturity of the underlying exposure and the maturity of thecollateral should both be defined conservatively. The effectivematurity of the underlying should be gauged as the longestpossible remaining time before the counterparty is scheduled tofulfil its obligation, taking into account any applicable graceperiod. For the collateral, embedded optionswhich may reducethe term of the collateral should be taken into account so that theshortest possible effective maturity is used. The maturity relevanthere is the residual maturity.

3.14. Risk Weights for Maturity Mismatches

3.14.1. As outlined in Paragraph 3.13.1 collateral with maturitymismatches are only recognised when their original maturities aregreater than or equal to one year. As a result, the maturity ofcollateral for exposures with original maturities of less than oneyear must be matched to be recognised. In all cases, collateralwith maturity mismatches will no longer be recognised when theyhave a residual maturity of three months or less.

3.14.2. When there is a maturity mismatch with recognised credit riskmitigants (collateral, on-balance sheet netting and guarantees)

the following adjustment will be applied:

Pa = P x (t-0.25) (T-0.25)Where:

Pa = value of the credit protection adjusted for maturity mismatchP = credit protection (e.g. collateral amount, guarantee amount)

adjusted for any haircutst = min (T, residual maturity of the credit protec tionarrangement)

expressed in yearsT = min (5, residual maturity of the exposure) expressed in years

3.15. Treatment of Pools of CRM Techniques

3.15.1. In the case where Bank has multiple CRM techniques covering asingle exposure (e.g. Bank has both collateral and guaranteepartially covering an exposure), the bank will be required tosubdivide the exposure into portions covered by each type ofCRM technique (e.g. portion covered by collateral, portioncovered by guarantee) and the risk-weighted assets of eachportion must be calculated separately.

3.15.2. When credit protection provided by a single protection provider

has differing maturities, they must be subdivided into separateprotection as well.

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3.16. Commencement of Implementation of the Policy:

3.16.1. The implementation of the policy would commence withimmediate effect consequent upon approval of the Board.

4. LEGAL CERTAINTY

4.1 In order for Banks to obtain capital relief for any use of CRM technique,the following minimum standardsfor legal documentation must be met.

a) Documentation used in collaterised transactions and guaranteesmust be binding on all parties and legally enforceable in all relevant

jurisdictions.

b) The legal mechanism by which collateral is pledged or transferredmust ensure that the Bank has the right to liquidate or take legalpossession of it, in a timely manner, in the event of default, insolvencyor bankruptcy (or one or more otherwise defined credit events setout in the transaction documentation) of the counter-party (and,where applicable, of the custodian holding the collateral).

c) Banks must take all steps necessary to fulfill those requirements underthe law applicable to the Banks interest in the collateral for obtaining

and maintaining an enforceable security interest e.g., by registering itwith a registrar.

d) Banks must have clear and robust procedures for the timelyliquidation of collateral to ensure that any legal condition required fordeclaring the default of the counter-party and liquidating thecollateral are observed, and the collateral can be liquidatedpromptly.

e) Banks have legally enforceable on balance-sheet nettingarrangement confined to loans /advances and deposits involving

specific lien with proof of documentation in each relevant jurisdictionregardless of whether the counter-party is insolvent or bankrupt. Bankis able at any time to determine the loan/advances and deposits withthe same counter-party that are subjec t to the netting arrangement.

f) In order for a guarantee to be recognized, the following conditions

must be satisfied:

i). A guarantee (counter-guarantee) must represent a direc t claimon the protection provider and must be explicitly referenced tospecific or pool of exposures, so that the extent of the cover isclearly defined and incontrovertible.

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ii). The guarantee must be clearly defined, irrevocable andunconditional; there must be no clause in the contract thatwould allow the protection provider unilaterally to cancel the

cover or that would increase the effective cost of cover as aresult of deteriorating credit quality in the guaranteed exposure.Further the guarantee should not contain an erroneous clausewherein the guarantee will be outside the direct control of theBank and thus prevent the protection from timely pay out in theevent that the original counter party fails to make payment.

g) In order for a guarantee to be recognized, the following conditionsmust be satisfied.

I). The guarantee should be explicitly documented and obligation

must be amended by the guarantor.

h). Sovereign Guarantees and counter-guarantees:A c laim may becovered by a G uarantee that is indirectly counter-guaranteed by aSovereign. Such a claim may be treated as covered by a SovereignGuarantee provided that:

(i) the sovereign counter-guarantee covers all credit risk elementsof the c laim;

(ii) both the original guarantee and the counter-guarantee meet alloperational requirements for guarantees, except that the

counter guarantee need not be direct and explicit to the originalclaim; and(iii) The cover should be robust and no historical evidence suggests

that the coverage of the counter-guarantee is less thaneffectively equivalent to that of a direct sovereign guarantee.

5. RESIDUAL RISKS

5.1 While the use of CRM techniques reduces or transfers Credit Risk, it maysimultaneously increase other risks (Residua l Risks). Therefore, it isimperative that Banks employ robust procedures to address mitigation

of such risks.

6. Branches/Offices should take note of the policy framework and comply withthe requirements on receipt of various instructions thereof.

Hindi Version of the Circular follows.

(PRABIR MOULIK)GENERAL MANAGER (CP&RMD)


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Appendix-A

Table-1: Standard Supervisory Haircuts

Issue rating for debtsecurities

Residual Maturity Sovereigns Other Issues

< 1 year 0.51

>1 year, < 5 years 2 4

AAA to AAPR1/P1/F1/A1

> 5 years 4 8

< 1 year 1 2

>1 year, < 5 years 3 6

A+ to BBB-PR2/P2/F2/A2;

PR3/P3/F3/A3 andUnrated Bank Securities

(as specified below)

> 5 years 6 12

Main Index equities @( including convertible bonds)

and Gold15

Other Equities ( including convertible bonds)listed on a recognised stock exchange

25

Mutual FundsHighest Haircut applicable to any

security in which the fund can invest

Cash in the same currency 0

@This would be equities included in the BSE Sensex and the NSE NIFTY.

Table-2; Haircut for exposures Illustration

Counterparty Maturity

(years)

External

rating

Haircut for

Exposure (%)

Sovereign 5 years A+ 6.0

Bank < 1 year AAA- 1.0

Bank >5 years A+ 12

Corporate 1 to 5 years AAA- 4Corporate Irrespective of

Maturity

Unrated 25

Individuals Irrespective of

Maturity

Unrated 25


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Appendix B

Illustrations on Credit Risk Mitigation

E* = Max {0, [E x (1+He) C x (1-Hc-Hfx)]}

Where,E* = Exposure value after risk mitigationE = Current value of the exposureHe = Haircut appropriate to the exposureC = Current value of the collateral receivedHc = Haircut appropriate to the collateralHfx = Haircut appropriate for currency mismatch between collateral & exposure

Case 1 Case 2 Case 3 Case 4 Case 5 Case 6 Case 7*

Exposure 100 100 100 100 100 100 100

Maturity of

Exposure (Yrs)

2 3 6 2 3 3 3

Nature ofExposure

Corporate Corpo-rate

Corporate Corporate Corporate Corporate Corporate

Currency INR INR USD INR INR INR INR

Rating ofExposure

BB A BBB Unrated AAA B- B-

Haircut forExposure

0.15 0.06 0.12 0.25 0.04 0.25 0.25

Collateral 100 100 100 100 125 100 100

Maturity of

Collateral (Yrs)

2 3 6 3 3 0.5

Nature ofCollateral

Sovereign BankBonds

CorporateBonds

Equityoutside mainindex

Equity inmain index

CorporateBonds

CorporateBonds.

Currency INR INR INR INR INR INR INR

Rating ofCollateral

A Un-rated

AA AAA BB

Haircut forCollateral

0.03 0.06 0.12 0.25 0.12 0.04 0.06

Haircut forurrencyMismatch

0.08

Exposure afterHaircut

115 106 112 125 104 125

Collateralafter Haircut

97 94 80 75 110 96

Net Exposure 18 12 32 50 0 29 100

Risk Weight 150 50 100 100 20 150 150

RWA 27 6 32 50 0 43.5 150

CASE 4,6 & 7 : The Haircut for the Exposure is the highest as applicable to other equities

CASE 5 : As value of the Collateral is higher than the exposure a fter haircuts, the exposure isZero.

CASE 7 : Ineligible for CRM since the maturity of the collateral is less than one year & Rating isBelow A-.


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Appendix-C

List of Eligible Multilateral Development Banks (MBDs)

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 Fund,

Caribbean Development Bank,

Islamic Development Bank and

Council of Europe Development Bank

credit risk mitigation

Documents