A

AProject ReportOnRisk Management IN BanksIn Partial Fulfillment Of The RequirementFor The Degree of Master Of Business Administration (M.B.A)(Session 2009-2011) SUBMITTED TO:

University school of management , kurukshetra university , kurukshetra

Submitted by

Vinod kumar

Roll no . - 109

PREFACEMaster of Business Administration is a course, which combines both theory and its applications as its contents of study in the field of management. As part and parcel of this course, every aspirant has to cover the research project report. The purpose of this research project report is to expose the student of management sciences real life situations and to provide an insight into the various functions who can visualize things what they have been taught in classrooms. Actually, it is the life force of management.

I was fortunate enough to get this opportunity of to prepare project report on Risk Management Banks. This is related to my specialization Finance.

This report is an attempt to present an account of practical knowledge and observations gathered. This research report includes the general information about Basel Capital Accord 1988-Accord and June 1999 Proposals, and the impact of its implementation in Indian Banks.

Vinod Kumar

109, MBA FINAL ACKNOWLEDGEMENT

Inspiration and hard work always played a key role in the success of any venture. At the level of practice, it is often difficult to get knowledge without guidance. Project is like a bridge between theoretical and practical. With this willing, I joined this project.

There is always a sense of gratitude which one expresses to other for the helpful and needy services that render during all phases of life. I would like to do so as I readily wish to express my gratitude towards all those who have been helpful to me in getting this mighty task of training to a successful end.

It often happens that one is at loss of words when one is really thankful and sincerely wants to express ones feeling of gratitude towards other.

I am deeply indebted to Dr. Sanjiv Marwah (Director) and my worthy thanks to my teacher Dr. Bateshwer Singh (Guide) for their valuable contribution during the academic session & guidance in preparation of this project report.

Finally, it is efforts of my parents and friends and the Almighty GOD who have been a source of strength and confidence for me in this endeavor.

Vinod Kumar 109, MBA finalDECLARATION

This is to certify that I Pardeep Grewal, the student of Maharishi Markandeshwar Institute of Management studying in M.B.A. (4th Sem.). Roll no. 109 have submitted a project/ Dissertation report on the title Risk Management in Banks" for the partial fulfillment of Degree of Master of Business Administration (M.B.A) to KURUKSHETRA UNIVERSITY.I solemnly declared that the work done by me is original and no copy of it has been submitted to any other Universities for award of any other degree/diploma/fellowship or on similar title and topic.

Signature of Student (VINOD KUMAR ) EXECUTIVE SUMMARYRisk is inherent in all aspects of a commercial operation and covers areas such as customer services, reputation, technology, security, human resources, market price, funding, legal, and regulatory, fraud and strategy. However, for banks and financial institutions, credit risk is the most important factor to be managed. Credit risk is defined as the possibility that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual, another bank, financial institution or a country. Credit risk may take various forms, such as:

In the case of direct lending, that funds will not be repaid;

In the case of guarantees or letters of credit, that funds will not be forthcoming from the customer upon crystallization of the liability under the contract;

In the case of treasury products, that the payment or series of payments due from the counterparty under the respective contracts is not forthcoming or ceases;

In the case of securities trading businesses, that settlement will not be effected;

In the case of cross-border exposure, that the availability and free transfer of currency is restricted or ceases.

Globalisation and financial innovation have over the last two decades or more multiplied and diversified the risks carried by the banking system. In response, the regulation of banking in the developed industrial countries has increasingly focused on ensuring financial stability, at the expense of regulation geared to realising growth and equity objectives. The appropriateness of this move is being debated even in the developed countries, which in any case are at a completely different level of development of their economies and of the extent of financial deepening and intermediation as compared to the developing world.

Despite this and the fact that in principle the adoption of the core principles for effective banking supervision issued by the Basel Committee on Banking Supervision is voluntary, India like many other emerging market countries adopted the Basel I guidelines and has now decided to implement Basel II.

India had adopted Basel I guidelines in 1999. Subsequently, based on the recommendations of a Steering Committee established in February 2005 for the purpose, the Reserve Bank of India had issued draft guidelines for implementing a New Capital Adequacy Framework, in line with Basel II.

At the centre of these guidelines is an effort to estimate how much of capital assets of specified kinds should banks hold to absorb losses. This requires some assessment of likely losses that may be incurred and deciding on a proportion of liquid assets that banks must have at hand to meet those losses in case they are incurred. This required regulatory capital is defined in terms "tiers" of capital that are characterized by differing degrees of liquidity and capacity to absorb losses. The highest, Tier I, consists principally of the equity and recorded reserves of the bank.

The higher the risk of loss associated with an investment the more of it must be covered in this manner, requiring assets to be risk-weighted. A 100 per cent risk loss implies that the whole of an investment can be lost under certain contingencies and a zero per cent risk-weight implies that the asset concerned is riskless.

INDEX OF CONTENTS1Preface22Acknowledgement33Declaration44Executive Summary5-6CHAPTER-1 Introduction to Topic.

1.1 The nature of risk management.101.2 risk management process...10-12 1.3 About Credit Risk.1.4 Credit risk Policy and strategy ...................................................................13.CHAPTER-2 Introduction to Basel Committee Accord2.1 About the Basel Committee.152.2 History of the Basel Committee.15-17

2.3 Basel Accord, 1988.17-20

2.4 The New Basel Capital Accord - An Explanatory NoteNeed for Revising/Improving the 1988-Accord - June 1999 Proposals.20-232.5 Pillar 1: Minimum capital requirements...232.5(1) Standardized Approach to Credit Risk..242.5(2) Internal Ratings-based (IRB) Approaches25

2.6 Pillar 2: Supervisory Review...26

2.7 Pillar 3: Market Discipline27CHAPTER-3 RBI guidelines on risk management in banks3.1 Credit Rating Framework.29-32

3.2 Credit Risk Models...333.3 Techniques for Measuring Credit Risk33-343.4 Managing Credit Risk in Inter-bank Exposure34-38

3.5 New Capital Accord: Implications for Credit Risk Management38-403.6 Comments of the Reserve Bank of India on New Capital Adequacy Framework...40-41 3.7 Risk management in ICICI Bank3.8 Risk Management in SBI Bank CHAPTER-5 Literature Review

CHAPTER-6 Research Methodology

6.1 Objective of the Study

6.2 Research Design.

6.3 Methods of Data Collection

6.4 Steps of Methodology

CHAPTER-7 Findings

CHAPTER-9 Analysis and Interpretation.

CHAPTER-10 ConclusionCHAPTER-11 Suggestions Bibliography

INTRODUCTION TO TOPICRisk management is the process of measuring, or assessing risk and then developing strategies to manage the risk. In general, the strategies employed include transferring the risk to another party, avoiding the risk, reducing the negative affect of the risk, and accepting some or all of the consequences of a particular risk. Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments. Regardless of the type of risk management, all large corporations have risk management teams and small groups and corporations practice informal, if not formal, risk management.

In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled later. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss vs. a risk with high loss but lower probability of occurrence can often be mishandled.

Risk management also faces a difficulty in allocating resources properly. This is the idea of opportunity cost. Resources spent on risk management could be instead spent on more profitable activities. Again, ideal risk management spends the least amount of resources in the process while reducing the negative effects of risks as much as possible.

Risk Management in Banks

With growing competition and fast changes in the operating environment impacting the business potentials, banks are compelled to constantly monitor and review their approach to ``credit'', the main earning asset in the balance sheet. With compulsions at peer level in the international standards, the Reserve Bank of India as the central bank has been emphasizing, in the recent years, on risk management and recently, issued a timely warning to bank managements to focus on the efforts for installing effective systems for control of risks, through calling for certification regarding compliance on these aspects.

The first circular of RBI introducing ALM (Asset Liability Management) for banks as mandatory, was issued in September 1998; given the history of banking in India and the comfort of insulated economy, awareness on the relative implications is yet to perceive while the RBI itself is administering the relative regulatory measures in phases. It is not simply the banking industry but change in the environment, like the legal structure, market imperfections including the depth of the market and tax structure, need to keep pace for the requirements. However, bank managements are yet to grapple with what is before them while towards the exercise, the first step namely establishing a data base is being initiated.

Pertaining to risk management in credit portfolio, it is not as though banks are not conscious of the various risk elements - in fact, all these phraseologies are repeated all over from time to time in different context. Such comprehension requires to be translated into practice by evolving systems for control/administration.

So, this project comprises understanding the procedure of the risk management carried by the banks in order to maintain their assets and liability position and also to compete well in the market in lieu of guidelines provided by the RBI .In this study we would do study various risks such as credit risk, market risk, liquidity risk and operational risk as well. This project would describe how banks work against these risks and try to minimize it in order to maximize the profit margin. Also the banks management and various departments in regard to manage these kinds of risks. We would also study the guidelines provided by RBI in regard to Risk Management procedure that to be followed by Nationalized and Private Banks also NBFCs.

In the project we would describe the risk management process that been carried by banks and also ALM structure in order to control upon assets liability position in the banks in order to keep eye on liquidity position of banks and also we would see which tools or methods are being used by banks in order to control risk and maximize profitability.

DEFINING RISKFor the purpose of these guidelines financial risk in banking organization is possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on banks ability to meet its business objectives. Such constraints pose a risk as these could hinder a bank's ability to conduct its ongoing business or to take benefit of opportunities to enhance its business.

Regardless of the sophistication of the measures, banks often distinguish between expected and unexpected losses. Expected losses are those that the bank knows with reasonable certainty will occur (e.g., the expected default rate of corporate loan portfolio or credit card portfolio) and are typically reserved for in some manner. Unexpected losses are those associated with unforeseen events (e.g. losses experienced by banks in the aftermath of nuclear tests, Losses due to a sudden down turn in economy or falling interest rates). Banks rely on their capital as a buffer to absorb such losses.

Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc, it is believed that generally the banks face Credit, Market, Liquidity, Operational, Compliance / legal /regulatory and reputation risks. Before overarching these risk categories, given below are some basics about risk Management and some guiding principles to manage risks in banking organization.

RISK MANAGEMENTRisk Management is a discipline at the core of every financial institution and encompasses all the activities that affect its risk profile. It involves identification, measurement, monitoring and controlling risks to ensure thata) The individuals who take or manage risks clearly understand it.b) The organizations Risk exposure is within the limits established by Board of Directors.c) Risk taking Decisions are in line with the business strategy and objectives set by BOD.d) The expected payoffs compensate for the risks takene) Risk taking decisions are explicit and clear.f) Sufficient capital as a buffer is available to take risk

The acceptance and management of financial risk is inherent to the business of banking and banks roles as financial intermediaries. Risk management as commonly perceived does not mean minimizing risk; rather the goal of risk management is to optimize risk-reward trade -off. Notwithstanding the fact that banks are in the business of taking risk, it should be recognized that an institution need not engage in business in a manner that unnecessarily imposes risk upon it: nor it should absorb risk that can be transferred to other participants. Rather it should accept those risks that are uniquely part of the array of banks services.

In every financial institution, risk management activities broadly take place simultaneously at following different hierarchy levels.

A) Strategic level: It encompasses risk management functions performed by senior management and BOD. For instance definition of risks, ascertaining institutions risk appetite, formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken.B) Macro Level: It encompasses risk management within a business area or across business lines. Generally the risk management activities performed by middle management or units devoted to risk reviews fall into this category.C) Micro Level: It involves On-the-line risk management where risks are actually created. This is the risk management activities performed by individuals who take risk on organizations behalf such as front office and loan origination functions. The risk management in those areas is confined to following operational procedures and guidelines set by management.

Expanding business arenas, deregulation and globalization of financial activities emergence of new financial products and increased level of competition has necessitated a need for an effective and structured risk management in financial institutions. A banks ability to measure, monitor, and steer risks comprehensively is becoming a decisive parameter for its strategic positioning.The risk management framework and sophistication of the process, and internal controls, used to manage risks, depends on the nature, size and complexity of institutions activities. Nevertheless, there are some basic principles that apply to all financial institutions irrespective of their size and complexity of business and are reflective of the strength of an individual bank's risk management practices.

Risk Management ProcessSteps in the Risk Management Process

A first step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, will cause problems. Hence, risk identification can start with the source of problems, or with the problem itself. Source analysis Risk sources may be internal or external to the system that is the target of risk management. Examples of risk sources are: stakeholders of a project, employees of a company or the weather over an airport.

Problem analysis Risks are related to fear. For example: the fear of losing money, the fear of abuse of privacy information or the fear of accidents and casualties. The fear may exist with various entities, most important with shareholder, customers and legislative bodies such as the government.

When either source or problem is known, the events that a source may trigger or the events that can lead to a problem can be investigated. For example: stakeholders withdrawing during a project may endanger funding of the project; privacy information may be stolen by employees even within a closed network; lightning striking a B747 during takeoff may make all people onboard immediate casualties.

The chosen method of identifying risks may depend on culture, industry practice and compliance. The identification methods are formed by templates or the development of templates for identifying source, problem or event. Common risk identification methods are:

Objectives-based Risk Identification - Organizations and project teams have objectives. Any event that may endanger achieving an objective partly or completely is identified as risk. Objective-based risk identification is at the basis of COSO's. Scenario-based Risk Identification - In scenario analysis different scenarios is created. The scenarios may be the alternative ways to achieve an objective, or an analysis of the interaction of forces in, for example, a market or battle. Any event that triggers an undesired scenario alternative is identified as risk. Taxonomy-based Risk Identification - The taxonomy in taxonomy-based risk identification is a breakdown of possible risk sources. Based on the taxonomy and knowledge of best practices, a questionnaire is compiled. The answers to the questions reveal risks. Common-risk checking - In several industries lists with known risks are available. Each risk in the list can be checked for application to a particular situation.

Assessment

Once risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring. Therefore, in the assessment process it is critical to make the best educated guesses possible in order to properly prioritize the implementation of the risk management plan.

Risk avoidance

Includes not performing an activity that could carry risk. An example would be not buying a property or business in order to not take on the liability that comes with it. Another would be not flying in order to not take the risk that the airplane was to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning the profits.

Risk reduction

Involves methods that reduce the severity of the loss. Examples include sprinklers designed to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not be suitable. Halon fire suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.

Modern software development methodologies reduce risk by developing and delivering software incrementally. Early methodologies suffered from the fact that they only delivered software in the final phase of development; any problems encountered in earlier phases meant costly rework and often jeopardized the whole project. By developing in increments, software projects can limit effort wasted to a single increment. A current trend in software development, spearheaded by the Extreme Programming community, is to reduce the size of increments to the smallest size possible, sometimes as little as one week is allocated to an increment.

Risk retention

Involves accepting the loss when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amount of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much.

Risk transfer

Means causing another party to accept the risk, typically by contract or by hedging. Insurance is one type of risk transfer that uses contracts. Other times it may involve contract language that transfers a risk to another party without the payment of an insurance premium. Liability among construction or other contractors is very often transferred this way. On the other hand, taking offsetting positions in derivative securities is typically how firms use hedging to financial risk management: financially manage risk.

Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group.

Create the plan

Decide on the combination of methods to be used for each risk

Implementation

Follow all of the planned methods for mitigating the effect of the risks. Purchase insurance policies for the risks that have been decided to be transferred to an insurer, avoid all risks that can be avoided without sacrificing the entity's goals, reduce others, and retain the rest.

Review and evaluation of the plan

Initial risk management plans will never be perfect. Practice, experience, and actual loss results, will necessitate changes in the plan and contribute information to allow possible different decisions to be made in dealing with the risks being faced.

1.3 About Credit RiskCredit risk arises from the potential that an obligor is either unwilling to perform on an obligation or its ability to perform such obligation is impaired resulting in economic loss to the bank.In a banks portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively losses may result from reduction in portfolio value due to actual or perceived deterioration in credit quality. Credit risk emanates from a banks dealing with individuals, corporate, financial institutions or a sovereign. For most banks, loans are the largest and most obvious source of credit risk; however, credit risk could stem from activities both on and off balance sheet.

In addition to direct accounting loss, credit risk should be viewed in the context of economic exposures. This encompasses opportunity costs, transaction costs and expenses associated with a non-performing asset over and above the accounting loss.

Credit risk can be further sub-categorized on the basis of reasons of default. For instance the default could be due to country in which there is exposure or problems in settlement of a transaction.

Credit risk not necessarily occurs in isolation. The same source that endangers credit risk for the institution may also expose it to other risk. For instance a bad portfolio may attract liquidity problem.

Components of credit risk managementA typical Credit risk management framework in a financial institution may be broadly categorized into following main components. Board and senior Managements Oversight Organizational structure Systems and procedures for identification, acceptance, measurement, monitoring and control risks.

Board and Senior Managements OversightIt is the overall responsibility of banks Board to approve banks credit risk strategy and significant policies relating to credit risk and its management which should be based on the banks overall business strategy. To keep it current, the overall strategy has to be reviewed by the board, preferably annually. The responsibilities of the Board with regard to credit risk management shall, interalia, include: Delineate banks overall risk tolerance in relation to credit risk.

Ensure that banks overall credit risk exposure is maintained at prudent levels and consistent with the available capital

Ensure that top management as well as individuals responsible for credit risk management possess sound expertise and knowledge to accomplish the risk management function

Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of credit risk.

Ensure that appropriate plans and procedures for credit risk management are in place.

The very first purpose of banks credit strategy is to determine the risk appetite of the bank. Once it is determined the bank could develop a plan to optimize return while keeping credit risk within predetermined limits. The banks credit risk strategy thus should spell out

The institutions plan to grant credit based on various client segments and products, economic sectors, geographical location, currency and maturity Target market within each lending segment, preferred level of diversification. Pricing strategy.It is essential that banks give due consideration to their target market while devising credit risk strategy. The credit procedures should aim to obtain an in depth understanding of the banks clients, their credentials & their businesses in order to fully know their customers.

The strategy should provide continuity in approach and take into account cyclic aspect of countrys economy and the resulting shifts in composition and quality of overall credit portfolio. While the strategy would be reviewed periodically and amended, as deemed necessary, it should be viable in long term and through various economic cycles.

The senior management of the bank should develop and establish credit policies and credit administration procedures as a part of overall credit risk management framework and get those approved from board. Such policies and procedures shall provide guidance to the staff on various types of lending including corporate, SME, consumer, agriculture, etc. At minimum the policy should include

Detailed and formalized credit evaluation/ appraisal process. Credit approval authority at various hierarchy levels including authority for approving exceptions. Risk identification, measurement, monitoring and control Risk acceptance criteria Credit origination and credit administration and loan documentation procedures Roles and responsibilities of units/staff involved in origination and management of credit. Guidelines on management of problem loans.In order to be effective these policies must be clear and communicated down the line. Further any significant deviation/exception to these policies must be communicated to the top management/board and corrective measures should be taken. It is the responsibility of senior management to ensure effective implementation of these policies.1.5 CREDIT RISK POLICY AND STRATEGYPolicy and StrategyThe Board of Directors of each bank shall be responsible for approving and periodically reviewing the credit risk strategy and significant credit risk policies.

Credit Risk Policy1. Every bank should have a credit 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.

2. Credit risk policies should also define target markets, risk acceptance criteria, credit approval authority, credit origination/ maintenance procedures and guidelines for portfolio management.

3. The credit 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.

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

Credit Risk Strategy1. Each bank should develop, with the approval of its Board, its own credit risk strategy or plan that establishes the objectives guiding the bank's credit-granting activities and adopt necessary policies/ procedures for conducting such activities. This strategy should spell out clearly the organizations credit appetite and the acceptable level of risk-reward trade-off for its activities.

2. 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.

3. 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.

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

INTRODUCTION TO BASEL COMMITTEE ACCORD2.1 ABOUT THE BASEL COMMITTEEThe Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.

The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. The present Chairman of the Committee is Mr Nout Wellink, President of the Netherlands Bank.

The Committee encourages contacts and cooperation among its members and other banking supervisory authorities. It circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. Contacts have been further strengthened by an International Conference of Banking Supervisors (ICBS) which takes place every two years.

The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland, and is staffed mainly by professional supervisors on temporary secondment from member institutions. In addition to undertaking the secretarial work for the Committee and its many expert sub-committees, it stands ready to give advice to supervisory authorities in all countries. Mr Stefan Walter is the Secretary General of the Basel Committee.

2.2 History of the Basel Committee

The Basel Committee, established by the central-bank Governors of the Group of Ten countries at the end of 1974, meets regularly four times a year. It has four main working groups which also meet regularly.

The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. The present Chairman of the Committee is Mr Nout Wellink, President of the Netherlands Bank, who succeeded Mr Jaime Caruana on 1 July 2006.

The Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements - statutory or otherwise - which are best suited to their own national systems. In this way, the Committee encourages convergence towards common approaches and common standards without attempting detailed harmonisation of member countries' supervisory techniques.

The Committee reports to the central bank Governors of the Group of Ten countries and to the heads of supervisory authorities of these countries where the central bank does not have formal responsibility. It seeks their endorsement for its major initiatives.These decisions cover a very wide range of financial issues. One important objective of the Committee's work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be adequate. To achieve this, the Committee has issued a long series of documents since 1975.

In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by end-1992. Since 1988, this framework has been progressively introduced not only in member countries but also in virtually all other countries with internationally activebanks. In June 1999, the Committee issued a proposal for arevised Capital Adequacy Framework. The proposed capital framework consists of three pillars: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. Following extensive interaction with banks, industry groups and supervisory authorities that are not members of the Committee, the revised framework was issued on 26 June 2004. This text serves as a basis for national rule-making and for banks to complete their preparations for the new framework's implementation.

Over the past few years, the Committee has moved more aggressively to promote sound supervisory standards worldwide. In close collaboration with many non-G10 supervisory authorities, the Committee in 1997 developed a set of "Core Principles for Effective Banking Supervision", which provides a comprehensive blueprint for an effective supervisory system. To facilitate implementation and assessment, the Committee in October 1999 developed the "Core Principles Methodology". The Core Principles and the Methodology were revised recently and released in October 2006.

In order to enable a wider group of countries to be associated with the work being pursued in Basel, the Committee has always encouraged contacts and cooperation between its members and other banking supervisory authorities. It circulates to supervisors throughout the world published and unpublished papers. In many cases, supervisory authorities in non-G10 countries have seen fit publicly to associate themselves with the Committee's initiatives. Contacts have been further strengthened byInternational Conferences of Banking Supervisors (ICBS) which take place every two years. The last ICBS was held in Mexico in the autumn of 2006.

The Committee's Secretariat is provided by the Bank for International Settlements in Basel. Thefifteen person Secretariat is mainly staffed by professional supervisors on temporary secondment from member institutions. In addition to undertaking the secretarial work for the Committee and its many expert sub-committees, it stands ready to give advice to supervisory authorities in all countries.

2.3 Basel Accord,1988

Credit management is the challenging functional area in a commercial bank. It calls for expert handling, assessing risk exposure at every stage and securing adequately the safety of funds exposed. In spite of best efforts there can be no full-proof safety standards, resulting in the unpreventable emergence of sticky or overdue credit periodically. Credit management is therefore a continuous search for more secure de-risking (effective risk-management) standards, and Asset-Liability Management strategies. Such risk-management expertise built and implemented helps at not eliminating risk altogether, but minimising the same.

Risk management is a subject for advanced study in the western countries. The subject has also attracted the attention of our business managers recently. In the coming years risk-management and Asset-Liability Management strategies will receive increasing attention in India, as a consequence of deregulation measures implemented in Indian Banking by RBI and the Government of India. While banks face a variety of risks, the effect of "Credit-Risk" is being severely felt in India. In fact the 1988 Basle Accord exclusively addresses at handling effectively credit-risks. However the proposed New accord to be implemented from 2004 hopes to cover other risks also. Relevant extract from the Consultative Paper issued by Basel Committee on Banking Supervision covering the New Capital Adequacy Framework speaks as under.

"While the original Accord focused mainly on credit risk, it has since been amended to address market risk. Interest rate risk in the banking book and other risks, such as operational, liquidity, legal and reputational risks, are not explicitly addressed. Implicitly, however, the present Accord takes account of such risks by setting a minimum ratio that has an acknowledged buffer to cover unquantified risks."

In India the first effort for standardisation of credit-assets for a better understanding of the inherent risk-component was made in the Eighties, when RBI introduced categorisation of bank-advances termed "Health Code" graded as per risk-content in each type of advance. The object of any coding system is standardization. RBI introduced the Health code system of commercial bank credit to bring industry level uniformity and intended for better transparency. All bank advances are categorized under eight health codes as under-

While Health Code provided for the categorisation of Bank-credit based on risk-exposure, it did not provide for risk-coverage on account of Credit-Assets turning non-productive or sticky . It is in this background that Prudential norms of Income recognition and provisioning for sticky accounts were introduced in 1992 when RBI considered it essential to accept Basel Committee Recommendations for Capital Adequacy. Brief description of measures implemented as per guidelines of RBI is given hereunder. Asset Classification

The banks should classify their assets based on weaknesses and dependency on collateral securities into four categories:

1. Standard Assets- It carries not more than the normal risk attached to the business and is not an NPA

2. Sub-standard Asset - An asset which remains as NPA for a period not exceeding 24 months, where the current net worth of the borrower, guarantor or the current market value of the security charged to the bank is not enough to ensure recovery of the debt due to the bank in full.

3. Doubtful Assets- An NPA which continued to be so for a period exceeding two years (18 months, with effect from March, 2001).

4. Loss Assets - An asset identified by the bank or internal/ external auditors or RBI inspection as loss asset, but the amount has not yet been written off wholly or partly

Capital Adequacy Ratio - Basle Accord 1988The growing concern of commercial banks regarding international competitiveness and capital ratios led to the Basle Capital Accord 1988. The accord sets down the agreement among the G-10 central banks to apply common minimum capital standards to their banking industries. The standards are almost entirely addressed to credit risk, the main risk incurred by banks. The document consists of two main sections, which cover

a. The definition of capital and

b. The structure of risk weights.

Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian banks. According to these guidelines, the banks will have to identify their Tier-I and Tier-II capital and assign risk weights to the assets. Having done this they will have to assess the Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR which the Indian banks are required to meet is set at 9 percent.

Tier-I Capital Paid-up capital

Statutory Reserves

Disclosed free reserves

Capital reserves representing surplus arising out of sale proceeds of assets

Equity investments in subsidiaries, intangible assets and losses in the current period and those brought forward from previous periods will be deducted from Tier I capital.

Tier-II Capital Undisclosed Reserves and Cumulative Perpetual Preference Shares

Revaluation Reserves

General Provisions and Loss Reserves

Background of the Basel Accord of 1988The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of the G10 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition. Capital is necessary for banks as a cushion against losses and it provides an incentive for the owners of the business to manage it in a prudent manner.

The Existing FrameworkThe 1988 Accord requires internationally active banks in the G10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their riskiness. The definition of capital is set (broadly) in two tiers, Tier 1 being shareholders' equity and retained earnings and Tier 2 being additional internal and external resources available to the bank. The bank has to hold at least half of its measured capital in Tier 1 form.

A portfolio approach is taken to the measure of risk, with assets classified into four buckets (0%, 20%, 50% and 100%) according to the debtor category. This means that some assets (essentially bank holdings of government assets such as Treasury Bills and bonds) have no capital requirement, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claim. However, virtually all claims on the non-bank private sector receive the standard 8% capital requirement.

There is also a scale of charges for off-balance sheet exposures through guarantees, commitments, forward claims, etc. This is the only complex section of the 1988 Accord and requires a two-step approach whereby banks convert their off-balance-sheet positions into a credit equivalent amount through a scale of conversion factors, which then are weighted according to the counterparty's risk weighting.

The 1988 Accord has been supplemented a number of times, with most changes dealing with the treatment of off-balance-sheet activities. A significant amendment was enacted in 1996, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities were removed from the credit risk framework and given explicit capital charges related to the bank's open position in each instrument.

Impact of the 1988 AccordThe two principal purposes of the Accord were to ensure an adequate level of capital in the international banking system and to create a "more level playing field" in competitive terms so that banks could no longer build business volume without adequate capital backing. These two objectives have been achieved. The merits of the Accord were widely recognized and during the 1990s the Accord became an accepted world standard, with well over 100 countries applying the Basel framework to their banking system. However, there also have been some less positive features. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. The simple bucket approach with a flat 8% charge for claims on the private sector has given banks an incentive to move high quality assets off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the 1988 Accord does not sufficiently recognise credit risk mitigation techniques, such as collateral and guarantees. These are the principal reasons why the Basel Committee decided to propose a more risk-sensitive framework in June 1999.

The June 1999 ProposalThe initial consultative proposal had a strong conceptual content and was deliberately rather vague on some details in order to solicit comment at a relatively early stage of the Basel Committee's thinking. It contained three fundamental innovations, each designed to introduce greater risk sensitivity into the Accord. One was to supplement the current quantitative standard with two additional "Pillars" dealing with supervisory review and market discipline. These were intended to reduce the stress on the quantitative Pillar 1 by providing a more balanced approach to the capital assessment process. The second innovation was that banks with advanced risk management capabilities would be permitted to use their own internal systems for evaluating credit risk, known as "internal ratings", instead of standardized risk weights for each class of asset. The third principal innovation was to allow banks to use the gradings provided by approved external credit assessment institutions (in most cases private rating agencies) to classify their sovereign claims into five risk buckets and their claims on corporates and banks into three risk buckets. In addition, there were a number of other proposals to refine the risk weightings and introduce a capital charge for other risks. The basic definition of capital stayed the same.

The comments on the June 1999 paper were numerous and can be said to reflect the important impact the 1988 Accord has had. Nearly all commentaries welcomed the intention to refine the Accord and supported the three Pillar approach, but there were many comments on the details of the proposal. A widely-expressed comment from banks in particular was that the threshold for the use of the IRB approach should not be set so high as to prevent well-managed banks from using their internal ratings.

Intensive work has taken place in the eighteen months since June 1999. Much of this has leveraged off work undertaken in parallel with industry representatives, whose cooperation has been greatly appreciated by the Basel Committee and its Secretariat.

2.4 The New Basel Capital Accord - An Explanatory Note) Need for Revising/Improving the 1988-Accord - June 1999 Proposals)

More than a decade has passed since the Basel Committee on Banking Supervision (the Committee) introduced its 1988 Capital Accord (the Accord). The business of banking, risk-management practices, supervisory approaches, and financial markets each have undergone significant transformation since then. In June 1999 the Committee released a proposal to replace the 1988 Accord with a more risk-sensitive framework. Rationale for a New Accord: Need for more flexibility and Risk

THE EXISTING ACCORDTHE PROPOSED NEW ACCORDFocus on a single risk measure

More emphasis on banks' own internal methodologies, supervisory review, and market discipline

One size fits all

Flexibility, menu of approaches, incentives for better risk management

Broad brush structure

More risk sensitivity

Safety and soundness in today's dynamic and complex financial system can be attained only by the combination of effective bank-level management, market discipline, and supervision.

The 1988 Accord focussed on the total amount of bank capital, which is vital in reducing the risk of bank insolvency and the potential cost of a bank's failure for depositors.

Building on this, the new framework intends to improve safety and soundness in the financial system by placing more emphasis on banks' own internal control and management, the supervisory review process, and market discipline.

Although the new framework's focus is primarily on internationally active banks, its underlying principles are intended to be suitable for application to banks of varying levels of complexity and sophistication. The Committee has consulted with supervisors worldwide in developing the new framework and expects the New Accord to be adhered to by all significant banks within a certain period of time.

The 1988 Accord provided essentially only one option for measuring the appropriate capital of internationally active banks. The best way to measure, manage and mitigate risks, however, differs from bank to bank. An Amendment was introduced in 1996 which focussed on trading risks and allowed some banks for the first time to use their own systems to measure their market risks. The new framework provides a spectrum of approaches from simple to advanced methodologies for the measurement of both credit risk and operational risk in determining capital levels. It provides a flexible structure in which banks, subject to supervisory review, will adopt approaches which best fit their level of sophistication and their risk profile. The framework also deliberately builds in rewards for stronger and more accurate risk measurement.

The new framework intends to provide approaches which are both more comprehensive and more sensitive to risks than the 1988 Accord, while maintaining the overall level of regulatory capital. Capital requirements that are more in line with underlying risks will allow banks to manage their businesses more efficiently.

The new framework is less prescriptive than the original Accord. At its simplest, the framework is somewhat more complex than the old, but it offers a range of approaches for banks capable of using more risk-sensitive analytical methodologies. These inevitably require more detail in their application and hence a thicker rule book. The Committee believes the benefits of a regime in which capital is aligned more closely to risk significantly exceed the costs, with the result that the banking system should be safer, sounder, and more efficient.

Structure of the New Accord - Three pillars of the New Accord First pillar: minimum capital requirement

Second pillar: supervisory review process

Third pillar: market discipline

The new Accord consists of three mutually reinforcing pillars, which together should contribute to safety and soundness in the financial system. The Committee stresses the need for rigorous application of all three pillars and plans to work actively with fellow supervisors to achieve the effective implementation of all aspects of the Accord.

The First Pillar: Minimum Capital RequirementThe first pillar sets out minimum capital requirements. The new Accord maintains both the current definition of capital and the minimum requirement of 8% of capital to risk-weighted assets. To ensure that risks within the entire banking group are considered, the revised Accord will be extended on a consolidated basis to holding companies of banking groups. The revision focuses on improvements in the measurement of risks, i.e., the calculation of the denominator of the capital ratio. The credit risk measurement methods are more elaborate than those in the current Accord. The new framework proposes for the first time a measure for operational risk, while the market risk measure remains unchanged.

For the measurement of credit risk, two principal options are being proposed. The first is the standardised approach, and the second the internal rating based (IRB) approach. There are two variants of the IRB approach, foundation and advanced. The use of the IRB approach will be subject to approval by the supervisor, based on the standards established by the Committee.

The Second Pillar: Supervisory Review ProcessThe supervisory review process requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks. The new framework stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's particular risk profile and control environment. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. This internal process would then be subject to supervisory review and intervention, where appropriate.

The implementation of these proposals will in many cases require a much more detailed dialogue between supervisors and banks. This in turn has implications for the training and expertise of bank supervisors, an area in which the Committee and the BIS's Financial Stability Institute will be providing assistance.

The Third Pillar: Market DisciplineThe third pillar of the new framework aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can better understand banks' risk profiles and the adequacy of their capital positions. The new framework sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods.

The core set of disclosure recommendations applies to all banks, with more detailed requirements for supervisory recognition of internal methodologies for credit risk, credit risk mitigation techniques and asset securitization

2.5 Pillar 1: Minimum capital requirementsWhile the proposed New Accord differs from the current Accord along a number of dimensions, it is important to begin with a description of elements that have not changed. The current Accord is based on the concept of a capital ratio where the numerator represents the amount of capital a bank has available and the denominator is a measure of the risks faced by the bank and is referred to as risk-weighted assets. The resulting capital ratio may be no less than 8%.

Under the proposed New Accord, the regulations that define the numerator of the capital ratio (i.e. the definition of regulatory capital) remain unchanged. Similarly, the minimum required ratio of 8% is not changing. The modifications, therefore, are occurring in the definition of risk-weighted assets, which is in the methods used to measure the risks faced by banks. The new approaches for calculating risk-weighted assets are intended to provide improved bank assessments of risk and thus to make the resulting capital ratios more meaningful.

The current Accord explicitly covers only two types of risks in the definition of risk weighted assets: (1) credit risk and (2) market risk. Other risks are presumed to be covered implicitly through the treatments of these two major risks. The treatment of market risk arising from trading activities was the subject of the Basel Committee's 1996 Amendment to the Capital Accord. The proposed New Accord envisions this treatment remaining unchanged.

The pillar one proposals to modify the definition of risk-weighted assets in the New Accord have two primary elements:

1. Substantive changes to the treatment of credit risk relative to the current Accord;

2. The introduction of an explicit treatment of operational risk that will result in a measure of operational risk being included in the denominator of a bank's capital ratio. The discussions below will focus on these two elements in turn.

In both cases, a major innovation of the proposed New Accord is the introduction of three distinct options for the calculation of credit risk and three others for operational risk. The Committee believes that it is not feasible or desirable to insist upon a one-size-fits-all approach to the measurement of either risk. Instead, for both credit and operational risk, there are three approaches of increasing risk sensitivity to allow banks and supervisors to select the approach or approaches that they believe are most appropriate to the stage of development of banks' operations and of the financial market infrastructure.

2.5(1) Standardised Approach to Credit Risk

The standardised approach is similar to the current Accord in that banks are required to slot their credit exposures into supervisory categories based on observable characteristics of the exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The standardised approach establishes fixed risk weights corresponding to each supervisory category and makes use of external credit assessments to enhance risk sensitivity compared to the current Accord. The risk weights for sovereign, interbank, and corporate exposures are differentiated based on external credit assessments. For sovereign exposures, these credit assessments may include those developed by OECD export credit agencies, as well as those published by private rating agencies.

The standardised approach contains guidance for use by national supervisors in determining whether a particular source of external ratings should be eligible for banks to use. The use of external ratings for the evaluation of corporate exposures, however, is considered to be an optional element of the framework. Where no external rating is applied to an exposure, the standardised approach mandates that in most cases a risk weighting of 100% be used, implying a capital requirement of 8% as in the current Accord. In such instances, supervisors are to ensure that the capital requirement is adequate given the default experience of the exposure type in question. An important innovation of the standardised approach is the requirement that loans considered past-due be risk weighted at 150%, unless a threshold amount of specific provisions has already been set aside by the bank against that loan.

Another important development is the expanded range of collateral, guarantees, and credit derivatives that banks using the standardised approach may recognise. Collectively, Basel II refers to these instruments as credit risk mitigants. The standardised approach expands the range of eligible collateral beyond OECD sovereign issues to include most types of financial instruments, while setting out several approaches for assessing the degree of capital reduction based on the market risk of the collateral instrument. Similarly, the standardised approach expands the range of recognised guarantors to include all firms that meet a threshold external credit rating.

The standardised approach also includes a specific treatment for retail exposures. The risk weights for residential mortgage exposures are being reduced relative to the current Accord, as are those for other retail exposures, which will now receive a lower risk weight than that for unrated corporate exposures. In addition, some loans to small- and mediumsized enterprises (SMEs) may be included within the retail treatment, subject to meeting various criteria.

By design the standardised approach draws a number of distinctions between exposures and transactions in an effort to improve the risk sensitivity of the resulting capital ratios. The same can also be said of the IRB approaches to credit risk and those for assessing the capital requirement for operational risk where capital requirements are more closely linked to risk. In order to assist banks and national supervisors where circumstances may not warrant a broad range of options, the Committee has developed the 'simplified standardised approach' outlined in Annex 9 of CP3. The annex collects in one place the simplest options for calculating risk weighted assets. Banks intending to adopt the simplified standardised methods are also expected to comply with the corresponding supervisory review and market discipline requirements of the New Accord.

2.5(2) Internal Ratings-based (IRB) Approaches

One of the most innovative aspects of the New Accord is the IRB approach to credit risk, which includes two variants: a foundation version and an advanced version. The IRB approach differs substantially from the standardised approach in that banks' internal assessments of key risk drivers serve as primary inputs to the capital calculation. Because the approach is based on banks' internal assessments, the potential for more risk sensitive capital requirements is substantial. However, the IRB approach does not allow banks themselves to determine all of the elements needed to calculate their own capital requirements. Instead, the risk weights and thus capital charges are determined through the combination of quantitative inputs provided by banks and formulas specified by the Committee.

Corporate, Bank and Sovereign ExposuresThe IRB calculation of risk-weighted assets for exposures to sovereigns, banks, or corporate entities uses the same basic approach. It relies on four quantitative inputs:

1. Probability of default (PD), which measures the likelihood that the borrower will default over a given time horizon;

2. Loss given default (LGD), which measures the proportion of the exposure that will be lost if a default occurs;

3. Exposure at default (EAD), which for loan commitments measures the amount of the facility that is likely to be drawn if a default occurs; and

4. Maturity (M), which measures the remaining economic maturity of the exposure.

Implementation of IRBBy relying on internally generated inputs to the Basel II risk weight functions, there is bound to be some variation in the way in which the IRB approach is carried out. To ensure significant comparability across banks, the Committee has established minimum qualifying criteria for use of the IRB approaches that cover the comprehensiveness and integrity of banks' internal credit risk assessment capabilities. While banks using the advanced IRB approach will have greater flexibility relative to those relying on the foundation IRB approach, at the same time they must also satisfy a more stringent set of minimum standards.

The Committee believes that banks' internal rating systems should accurately and consistently differentiate between different degrees of risk. The challenge is for banks to define clearly and objectively the criteria for their rating categories in order to provide meaningful assessments of both individual credit exposures and ultimately an overall risk profile. A strong control environment is another important factor for ensuring that banks' rating systems perform as intended and the resulting ratings are accurate. An independent ratings process, internal review and transparency are control concepts addressed in the minimum IRB standards.

Clearly, an internal rating system is only as good as its inputs. Accordingly, banks using the IRB approach will need to be able to measure the key statistical drivers of credit risk. The minimum Basel II standards provide banks with the flexibility to rely on data derived from their own experience, or from external sources as long as the bank can demonstrate the relevance of such data to its own exposures. In practical terms, banks will be expected to have in place a process that enables them to collect, to store and to utilise loss statistics over time in a reliable manner.

2.6 Pillar 2: Supervisory Review

The second pillar of the New Accord is based on a series of guiding principles, all of which point to the need for banks to assess their capital adequacy positions relative to their overall risks, and for supervisors to review and take appropriate actions in response to those assessments. These elements are increasingly seen as necessary for effective management of banking organisations and for effective banking supervision, respectively.

Feedback received from the industry and the Committee's own work has emphasised the importance of the supervisory review process. Judgements of risk and capital adequacy must be based on more than an assessment of whether a bank complies with minimum capital requirements. The inclusion of a supervisory review element in the New Accord, therefore, provides benefits through its emphasis on the need for strong risk assessment capabilities by banks and supervisors alike. Further, it is inevitable that a capital adequacy framework, even the more forward looking New Accord, will lag to some extent behind the changing risk profiles of complex banking organisations, particularly as they take advantage of newly available business opportunities. Accordingly, this heightens the importance of, and attention supervisors must pay to pillar two.

The Committee has been working to update the pillar two guidance as it finalises other aspects of the new capital adequacy framework. One update is in relation to stress testing. The Committee believes it is important for banks adopting the IRB approach to credit risk to hold adequate capital to protect against adverse or uncertain economic conditions. Such banks will be required to perform a meaningfully conservative stress test of their own design with the aim of estimating the extent to which their IRB capital requirements could increase during a stress scenario. Banks and supervisors are to use the results of such tests as a means of ensuring that banks hold a sufficient capital buffer. To the extent there is a capital shortfall, supervisors may, for example, require a bank to reduce its risks so that existing capital resources are available to cover its minimum capital requirements plus the results of a recalculated stress test.

Other refinements focus on banks' review of concentration risks, and on the treatment of residual risks that arise from the use of collateral, guarantees and credit derivatives. Further to the pillar one treatment of securitisation, a supervisory review component has been developed, which is intended to provide banks with some insight into supervisory expectations for specific securitisation exposures. Some of the concepts addressed include significant risk transfer and considerations related to the use of call provisions and early amortisation features. Further, possible supervisory responses are outlined to address instances when it is determined that a bank has provided implicit (non-contractual) support to a securitisation structure.

2.7 Pillar 3: Market DisciplineThe purpose of pillar three is to complement the minimum capital requirements of pillar one and the supervisory review process addressed in pillar two. The Committee has sought to encourage market discipline by developing a set of disclosure requirements that allow market participants to assess key information about a bank's risk profile and level of capitalisation. The Committee believes that public disclosure is particularly important with respect to the New Accord where reliance on internal methodologies will provide banks with greater discretion in determining their capital needs. By bringing greater market discipline to bear through enhanced disclosures, pillar three of the new capital framework can produce significant benefits in helping banks and supervisors to manage risk and improve stability.

Over the past year, the Committee has engaged various market participants and supervisors in a dialogue regarding the extent and type of bank disclosures that would be most useful. The aim has been to avoid potentially flooding the market with information that would be hard to interpret or to use in understanding a bank's actual risk profile. After taking a hard look at the disclosures proposed in its second consultative package on the New Accord, the Committee has since scaled back considerably the requirements, particularly those relating to the IRB approaches and securitizations. The Committee is aware that supervisors may have different legal avenues available in having banks satisfy the disclosure requirements. The various means may include public disclosures deemed necessary on safety and supervision grounds or information that must be disclosed in regulatory reports. The Committee recognises that the means by which banks will be expected to share information publicly will depend on the legal authority of supervisors. Another important consideration has been the need for the Basel II disclosure framework to align with national accounting standards. Considerable efforts have been made to ensure that the disclosure requirements of the New Accord focus on bank capital adequacy and do not conflict with broader accounting disclosure standards with which banks must comply. This has been accomplished through a strong and co-operative dialogue with accounting authorities. Going forward, the Committee will look to strengthen these relationships given that the continuing work of accounting authorities may have implications for the disclosures required in the New Accord. With respect to potential future modifications to the capital framework itself, the Committee intends to also consider the impact of such changes on the amount of information a bank should be required to disclose.

RBI GUIDELINES ON CREDIT RISK MANAGEMENT

3.1 Credit Rating Framework

A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations associated with a simplistic and broad classification of loans/exposures into a "good" or a "bad" category. The CRF deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated with a credit exposure. Such a rating framework is the basic module for developing a credit risk management system and all advanced models/approaches are based on this structure. In spite of the advancement in risk management techniques, CRF is continued to be used to a great extent. These frameworks have been primarily driven by a need to standardise and uniformly communicate the "judgement" in credit selection procedures and are not a substitute to the vast lending experience accumulated by the banks' professional staff.

Basic Architecture of CRFsThe following elements outline the basic architecture and the operating principles of any CRF.

Grading system for calibration of credit risk

Operating design of CRF

GRADING SYSTEM FOR CALIBRATION OF CREDIT RISKThe grades (symbols, numbers, alphabets, descriptive terms) used in the internal credit-risk grading system should represent, without any ambiguity, the default risks associated with an exposure. The grading system should enable comparisons of risks for purposes of analysis and top management decision-making. It should also reflect regulatory requirements of the supervisor on asset classification (e.g. the RBI asset classification). It is anticipated that, over a period of time, the process of risk identification and risk assessment will be further refined. The grading system should, therefore, be flexible and should accommodate the refinements in risk categorisation.

Nature of Grading System for the CRFThe grading system adopted in a CRF could be an alphabetic or numeric or an alpha-numeric scale. Since rating agencies follow a particular scale (AAA, AA+, BBB etc.), it would be prudent to adopt a different rating scale to avoid confusion in internal communications. Besides, adoption of a different rating scale would permit comparable benchmarking between the two mechanisms. Several banks utilise a numeric rating scale. The number of grades for the "acceptable" and the "unacceptable" credit risk categories would depend on the finesse of risk gradation. Normally, numeric scales developed for CRFs are such that the lower the credit-risk, the lower is the calibration on the scale.

IllustrationA rating scale could consist of 9 levels, of which levels 1 to 5 represent various grades of acceptable credit risk and levels 6 to 9 represent various grades of unacceptable credit risk associated with an exposure.

The scale, starting from "1" (which would represent lowest level credit risk and highest level of safety/ comfort) and ending at "9" (which would represent the highest level of credit risk and lowest level of safety/ comfort), could be deployed to calibrate, benchmark, compare and monitor credit risk associated with the bank's exposures and give indicative guidelines for credit risk management activities. Each bank may consider adopting suitable alphabetic prefix to their rating scales, which would make their individual ratings scale distinct and unique.

OPERATING DESIGN OF THE CRFWhich Exposures are Rated?The first element of the operating design is to determine which exposures are required to be rated through the CRF. There may be a case for size-based classification of exposures and linking the risk-rating process to these size-based categories. The shortcoming of this arrangement is that though significant credit migration/deterioration/erosion occurs in the smaller sized exposures, these are not captured by the CRF. In addition, the size-criteria are also linked with the tenure-criteria for an exposure. In several instances, large-sized exposures over a short tenure may not require the extent of surveillance and credit monitoring that is required for a smaller sized long-tenure exposure. Given this apparent lack of clarity, a policy of 'all exposures are to be rated' should be followed.

The Risk-Rating ProcessThe credit approval process within the bank is expected to replicate the flow of analysis/ appraisal of credit-risk calibration on the CRF. As indicated above the CRF may be designed in such a way that the risk rating has certain linkages with the amount, tenure and pricing of exposure. These default linkages may be either specified upfront or may be developed with empirical details over a period of time. The risk rating assigned to each credit proposal would thus directly lead into the related decisions of acceptance (or rejection), amount, tenure and pricing of the (accepted) proposal.

For each proposal, the credit/ risk staff would assign a rating and forward the recommendation to the higher level of credit selection process. The proposed risk rating is either reaffirmed or re-calibrated at the time of final credit approval and sanction. Any revisions that may become necessary in the risk-ratings are utilised to upgrade the CRF system and the operating guidelines. In this manner, the CRF maintains its "incremental up gradation" feature and changes in the lending environment are captured by the system. The risk-rating process would be equally relevant in the credit-monitoring/ surveillance stage. All changes in the underlying credit-quality are calibrated on the risk-scale and corresponding remedial actions are initiated.

Assigning & Monitoring Risk-RatingsIn conventional banks, the practice of segregating the "relationship management" and the "credit appraisal" functions is quite prevalent. One of the variants of this arrangement is that responsibilities for calibration on the risk-rating scale are divided between the "relationship" and the "credit" groups. All large sized exposures (above a limit) are appraised independently by the "credit" group. Generally, the activities of assigning and approving risk-ratings need to be segregated. Though the front-office or conventional relationship staff can assign the risk-ratings, the responsibilities of final approval and monitoring should be vested with a separate credit staff.

Mechanism of Arriving at Risk-RatingsThe risk ratings, as specified above, are collective readings on the pre-specified scale and reflect the underlying credit-risk for a prospective exposure. The CRF could be separate for relatively peculiar businesses like banking, finance companies, real-estate developers, etc. For all industries (manufacturing sector), a common CRF may be used. The peculiarity of a particular industry can be captured by assigning different weights to aspects like entry barriers, access to technology, ability of new entrants to access raw materials, etc. The following step-wise activities outline the indicative process for arriving at risk-ratings.

1. Step I: Identify all the principal business and financial risk elements

2. Step II: Allocate weights to principal risk components

3. Step III: Compare with weights given in similar sectors and check for consistency

4. Step IV: Establish the key parameters (sub-components of the principal risk elements)

5. Step V: Assign weights to each of the key parameters

6. Step VI: Rank the key parameters on the specified scale

7. Step VII: Arrive at the credit-risk rating on the CRF

8. Step VIII: Compare with previous risk-ratings of similar exposures and check for consistency

9. Step IX: Conclude the credit-risk calibration on the CRF

The risk-rating process would represent collective decision making principles and as indicated above, would involve some in-built arrangements for ensuring the consistency of the output. The rankings would be largely comparative. As a bank's perception of the exposure improves/changes during the course of the appraisal, it may be necessary to adjust the weights and the rankings given to specific risk-parameters in the CRF. Such changes would be deliberated and the arguments for substantiating these adjustments would be clearly communicated in the appraisal documents. 2.5.5 Standardisation and Benchmarks for Risk-Ratings

In a lending environment dominated by industrial and corporate credits, the assignors of risk-ratings utilise benchmarks or pre-specified standards for assessing the risk profile of a potential borrower. These standards usually consist of financial ratios and credit-migration statistics, which capture the financial risks faced by the potential borrower (e.g. operating and financial leverage, profitability, liquidity, debt-servicing ability, etc.). The business risks associated with an exposure (e.g. cyclicality of industry, threats of product or technology substitution etc.) are also addressed in the CRF. The output of the credit-appraisal process, specifically the financial ratios, is directly compared with the specified benchmarks for a particular risk category. In these cases, the risk rating is fairly standardised and CRF allocates a grade or a numeric value for the overall risk profile of the proposed exposure.

IllustrationThe CRF may specify that for the risk-rating exercise:

i. If Gross Revenues are between Rs.800 to Rs.1000 crore - assign a score of 2

ii. If Operating Margin is 20% or more - assign a score of 2

iii. If Return on Capital Employed (ROCE) is 25% or more - assign a score of 1

iv. If Debt : Equity is between 0.60 and 0.80 - assign a score of 2

v. If interest cover is 3.50 or more - assign a score of 1

vi. If Debt Service Coverage Ratio (DSCR) is 1.80 or more - assign a score of 1

The next step would be to assign weights to these risk-parameters. In an industrial credit environment, the CRF may place higher weights on size (as captured in gross revenues), profitability of operations (operating margins), financial leverage (debt: equity) and debt-servicing ability (interest cover). Assume that the CRF assigns a 20% weightage to each of these four parameters and the ROCE and DSCR are given a 10% weightage each. The weighted-average score for the financial risk of the proposed exposure is 1.40, which would correspond with the extremely low risk/highest safety level-category of the CRF (category 1). Similarly, the business and the management risk of the proposed exposure are assessed and an overall/ comprehensive risk rating is assigned.

The industrial credit environment permits a significantly higher level of benchmarking and standardisation, specifically in reference to calibration of financial risks associated with credit exposures. For all prominent industry-categories, any lender can compile profitability, leverage and debt-servicing details and utilise these to develop internal benchmarks for the CRF. As evident, developing such benchmarks and risk-standards for a portfolio of project finance exposures, as in the case of the bank, would be an altogether diverse exercise.

The CRF may also use qualitative/ subjective factors in the credit decisions. Such factors are both internal and external to the company. Internal factors could include integrity and quality of management of the borrower, quality of inventories/ receivables and the ability of borrowers to raise finance from other sources. External factors would include views on the economy and industry such as growth prospects, technological change and options.

3.2 Credit Risk Models

A credit risk model seeks to determine, directly or indirectly, the answer to the following question: Given our past experience and our assumptions about the future, what is the present value of a given loan or fixed income security? A credit risk model would also seek to determine the (quantifiable) risk that the promised cash flows will not be forthcoming. The techniques for measuring credit risk that have evolved over the last twenty years are prompted by these questions and dynamic changes in the loan market.

The increasing importance of credit risk modelling should be seen as the consequence of the following three factors:

1. Banks are becoming increasingly quantitative in their treatment of credit risk.

2. New markets are emerging in credit derivatives and the marketability of existing loans is increasing through securitization/ loan sales market."

3. Regulators are concerned to improve the current system of bank capital requirements especially as it relates to credit risk.

Importance of Credit Risk ModelsCredit Risk Models have assumed importance because they provide the decision maker with insight or knowledge that would not otherwise be readily available or that could be marshalled at prohibitive cost. In a marketplace where margins are fast disappearing and the pressure to lower pricing is unrelenting, models give their users a competitive edge. The credit risk models are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines. The outputs of these models also play increasingly important roles in banks' risk management and performance measurement processes, customer profitability analysis, risk-based pricing, active portfolio management and capital structure decisions. Credit risk modeling may result in better internal risk management and may have the potential to be used in the supervisory oversight of banking organisations.

3.3 Techniques for Measuring Credit RiskThe following are the more commonly used techniques:

1. Econometric Techniques such as linear and multiple discriminant analysis, multiple regression, logic analysis and probability of default, etc.

2. Neural networks are computer-based systems that use the same data employed in the econometric techniques but arrive at the decision model using alternative implementations of a trial and error method.

3. Optimisation models are mathematical programming techniques that discover the optimum weights for borrower and loan attributes that minimize lender error and maximise profits.

4. Rule-based or expert are characterised by a set of decision rules, a knowledge base consisting of data such as industry financial ratios, and a structured inquiry process to be used by the analyst in obtaining the data on a particular borrower.

5. Hybrid Systems In these systems simulation are driven in part by a direct causal relationship, the parameters of which are determined through estimation techniques.

Domain of application: These models are used in a variety of domains:

Credit approval: - Models are used on a stand alone basis or in conjunction with a judgemental override system for approving credit in the consumer lending business. The use of such models has expanded to include small business lending. They are generally not used in approving large corporate loans, but they may be one of the inputs to a decision.

Credit rating determination: - Quantitative models are used in deriving 'shadow bond rating' for unrated securities and commercial loans. These ratings in turn influence portfolio limits and other lending limits used by the institution. In some instances, the credit rating predicted by the model is used within an institution to challenge the rating assigned by the traditional credit analysis process. Credit risk models may be used to suggest the risk premia that should be charged in view of the probability of loss and the size of the loss given default. Using a mark-to-market model, an institution may evaluate the costs and benefits of holding a financial asset. Unexpected losses implied by a credit model may be used to set the capital charge in pricing.

Early warning: - Credit models are used to flag potential problems in the portfolio to facilitate early corrective action.

Common credit language: - Credit models may be used to select assets from a pool to construct a portfolio acceptable to investors at the time of asset securitisation or to achieve the minimum credit quality needed to obtain the desired credit rating. Underwriters may use such models for due diligence on the portfolio (such as a collateralized pool of commercial loans).

Collection strategies: - Credit models may be used in deciding on the best collection or workout strategy to pursue. If, for example, a credit model indicates that a borrower is experiencing short-term liquidity problems rather than a decline in credit fundamentals, then an appropriate workout may be devised.

3.4 Managing Credit Risk in Inter-bank Exposure

During the course of its business, a bank may assume exposures on other banks, arising fro