A BRIEF INTRODUCTION: Traditionally, Banks have been using the 5C’s approach while making assessment of a borrower. The 5C’s represent Character of borrower, Capital, Capacity, Collateral and Condition. The same may be further expanded to represent willingness to pay, borrower’s risk bearing commitment, ability to pay/cash flow adequacy, value of security offered vis-à-vis loan component and the position/condition of the business of the borrower/industry trend respectively. Though the basic norm of any credit risk rating continues to rest on the backbone of the above principles, the traditional assessment suffered for want of consistency and subjectivity. In the traditional approach, there is no separation in organization structure between risk taking and risk management.
WHY MEASURE RISK ?
Credit Risk is inherent in all of bank’s activities like lending, trading, off-balance sheet activities.
Nine out of ten banking failures can be attributed to poor credit risk management.
Corporates able to access markets at cheaper rates leaving banks with next best.
Due to liberalization, new forms of financial transactions like securitisation and credit derivatives are emerging.
BENEFITS OF CREDIT RISK MEASUREMENT:
It facilitates informed credit decision consistent with the bank’s risk appetite.
It provides ability to price products on the basis of risk.
It facilitates dynamic provisioning and minimizes impact of losses.
CREDIT RATING FRAMEWORK (CRF): A Credit Risk Framework is necessary to avoid the limitations associated with a simplistic and broad classification of loans into a “good” and “bad” category. CRF tries to capture all the probable risks faced by an entity or units and tries to measure such risks in a scientific manner.
The basic difference between a normal credit appraisal undertaken on a borrowing unit and a credit risk rating of a borrowing unit is that the latter measures the risk involved in financing the concerned borrower unit. CRF calibrates and communicates the risk associated with an exposure. CRF employs a number/alphabet/symbol as a primary summary indicator of risk. A CRF enables the bank in the following:
Pricing. (Higher the risk, higher the premium)
Terms and Conditions. (Higher the risk, stringent the conditions)
Quantum of exposure. (Restricting the exposure for higher risk category depending on the bank’s risk appetite)
Frequency of review. (Higher the risk, the more frequent the review)
Provisioning requirements. (Higher the risk, higher the provisioning)
CRF IN OUR BANK: The concept of Credit risk rating was introduced in our Bank vide HO cir 168/99 in respect of HO Power accounts (Under manufacturing activity only) and later on extended to exposures of lesser value. As of now the following risk rating models are in use in our Bank.
DETAILS OF EXPOSURES
COVERED
RATING MODEL
Typically large value exposures. (i.e. above Rs. 200 lacs)
CRISIL’S Risk Assessment Model (RAM)
Typically medium sized Exposures. (i.e. above Rs.30 lacs)
Manual Rating Model.
Typically small value Exposures.
Portfolio Model Approach
DRAFT GUIDELINES ON ELIGIBILITY, PERIODICITY ETC., APPLICABLE TO MANUAL RATING MODEL FOR CM/DM & AGM POWER ACCOUNTS
The Manual Model developed by the Bank is applicable in respect of all accounts falling under the CM/DM and AGM powers excepting the following categories:
Loans under Retail lending schemes, excepting loans under Traders Scheme, but including educational loans.
Individual non priority loans for non productive purpose.
Agricultural loans including gold loans.
Any other schematic loans.
Staff loans.
Valuable Security loans and other loans against the prime security of approved securities.
Premises loans
The models are designed for 3 categories viz., Industrial accounts, Trading accounts and New accounts. This is based on the premise that any activity undertaken for productive purpose can be classified under these broad categories. Activities such as Construction contractors, Real Estate, Commission Agents etc may not strictly fall into either industrial or trading activity. However, for the limited purpose of risk rating a borrower coming under the above categories, the following may be taken note of:
Construction contractors, Real Estate may be brought under industrial accounts model.
Commission agents or any intermediary activity may be brought under trading model.
If manufacturing activity is not there, major portion of the sales is by trading, then it may be taken under Trading model.
“New accounts” for the limited purpose of risk rating may include accounts which have dealings with our bank up to a period of 2 years.
In respect of Term loans, wherever project appraisal is required to be undertaken, rating exercise of such accounts may be undertaken after receipt of PFD’s report duly taking into account the risk factors as perceived by PFD/PFC.
In respect of term loans to traders, there is no specific provision for TL parameters in the proposed model. However, any term loan for a trader would likely to involve only purchase of items such as office equipments, construction of office space etc and as such the existing model itself can be made use of.
In respect of parties enjoying/seeking only non fund based limits also, the rating exercise has to be undertaken excepting in instances where 100% margin is available.
In respect of Consortium accounts/MBA accounts, where our Bank’s share falls within CM/DM & AGM powers, rating shall be done using this model.
PERIODICITY: Risk Rating of a borrowal account shall be done before sanction of a fresh loan/limits and renewal of limits with a periodicity not exceeding one year.
In respect of accounts, where the tenability of limits have been extended, risk rating shall be carried out on the expiry date of limits, even though renewal of limits have not taken place.
In respect of single transaction Term Loans (where the party is not enjoying any WC limits) rating shall be done annually. Risk rating shall be done based on audited balance sheet only. In case of non-availability of ABS as at the time of renewal, rating shall be done based on the previous year’s ABS, if not done already. If it is done already, the same shall be continued. In such cases, rating shall be done immediately on receipt of ABS without waiting for renewal.
AUTHORITY FOR RATING: The recommending Authority for the Credit Risk rating shall be the Manager (Credit), in respect of VLB/ELBs and the Manager in-charge, RO in respect of RO power accounts.
Sanctioning authority will be vested with the power for confirming the rating of an account. In respect of ELB/VLBs, the rating will be done at the branch level itself and the rating will be confirmed by the respective AGM/CM of the branch. In respect of RO power accounts, branches shall ensure to furnish all the required particulars to the concerned RO while submitting the credit report at the time of renewal (as per the Annexure).
There may be instances of borrowal accounts falling under higher authority’s powers, than AGM/DM for reasons such as current ratio less than 1, group concept, takeover of borrowal accounts etc. In such cases, ROs after obtaining relevant particulars from the branch risk rate the account and the same shall form a part of the proposal. In short, for the purpose of risk rating an account under Manual model, the quantum of limit proposed shall be the guiding factor and not the sanctioning authority wherever the sanctioning authority happens to be above the rank of AGM.
There may also be cases, where an account which is falling under normal branch powers but comes under RO powers for any of the reason such as current ratio is less than 1, group concept etc. In such accounts, risk rating as per manual model need not be undertaken since for branch power accounts separate portfolio model approach will be put in place in due course.
Normally, risk rating exercise is applicable only in case of Standard assets. However, there may be accounts which may fall into substandard category, where the unit is running and the bank may be contemplating revival/rehabilitation. Hence, risk rating exercise may have to be carried out in such cases also where operations are permitted(either holding on operation or regular renewal/extension) in the account till such time, a final decision is taken on the account to initiate recovery steps or otherwise.
In respect of accounts which are classified Doubtful/Loss assets and also accounts which are marked for recovery, all such accounts may be classified under ‘Highest Risk category’.(Risk rating of such accounts may not be possible for want of required particulars) However, if rehabilitation is taken up after the account is transferred to Doubtful/Loss or LPD category, then the same shall be risk rated before any rehabilitation is taken up.
Due to enhancement in limits in between two renewals and/or due to single transaction/adhoc limits, an account may come under the purview of CM/DM or AGM power.(previously, the account would have been under branch powers and might not have been risk rated ) In such cases, the risk rating exercise has to be undertaken and the branch shall furnish necessary particulars along with the proposal.
Though ‘TRADERS SCHEME’ is brought under the purview of Retail lending schemes, accounts under Traders scheme falling under CM/DM &AGM powers will have to be risk rated.
The grade allotted to an account during the risk rating shall be mentioned in the Mid Term Review of the account and the major risk factors, if any, may be commented upon.(applicable only in respect of AGM power accounts)
For any borrowal account to be graded above Grade V (i.e. III, IV, V) the borrower has to necessarily obtain a minimum score of 29 under Financial Risk.
RISK GRADATION SCALE FOR MANUAL RATING MODEL IS AS UNDER :
Overall Risk Score Range
(OUT OF 150)
Risk
Grade
*
DEFINITION OF RISK
GRADE DEFINITION
>100
III
Low Risk - LR 3
GOOD
>85 but <100
IV
Normal Risk
Average with relatively higher standing
>70 but < 85
V
Moderate Risk
Average with relatively lower standing
>55 but < 70
VI
High Risk – HR 1
Below average with relatively higher standing
>40 but < 55
VII
High Risk – HR 2
Below average with relatively lower standing
< than 40
VIII
High Risk - HR 3
Poor
* There will be no grade under I & II in Manual Model Rating as the rating is capped at Grade III as suggested by IBM – BCS
Thursday, May 1, 2008
CREDIT RATING FRAMEWORKS
GENERAL PRINCIPLES OF CREDIT RATING
ü Credit rating is primarily intended to systematically measure credit risk arising from transactions between Lender and Borrower.
ü Credit risk is the risk of a financial loss arising from the inability of the borrower to meet the financial obligations towards its creditor
ü The ability of a borrower to meet its obligations fluctuates according to the behavior of risk factors.
ü Risk factors are both Internal and External
ü Risk factors impact the performance of a business enterprise
ü Most lenders have to incur costs of analyzing the Risk Factors before a lending decision is made.
ü Lenders are also required to create a monitoring mechanism that enables evaluation of such ratings, when the borrowers’ obligations are outstanding
ü One of the many ways of standardizing the credit quality of borrowers, through a formal examination of risk factors, which enables classification of credit risk into defined categories.
ü Such categorisation standardises credit risk, in ways that enable measurement and management of Credit Risk
Thus, Credit Rating enables :
Ø Pricing of debt products
Ø Their valuation in a balance sheet, over the period they are outstanding.
Ø Credit rating is a well established enterprise in most economies, where specialized agencies have evolved to create extensive methods of analysis of information, and provide ratings to borrowers.
Ø The acceptance of these ratings by lenders crucially hinges on the independence of the rating agency, and the expertise it brings to bear on the process of credit rating.
Ø Credit rating agencies assess the credit quality of debt issuers, on the basis of a number of quantitative and qualitative factors
Ø Rating essentially involves the translation of information variables into a ranking, which places the company in a slot that describes the ability and willingness of the company to service the instrument proposed to be issued.
Rating Grades are classified into the following three grades:
Ø High Investment Grades
Ø Investment Grades
Ø Speculative Grades
High Investment Grades
AAA – (Triple A) Highest Safety : Debentures rated ‘AAA’ are judged to offer highest safety of timely payment of interest and principal. Though the circumstances providing this degree of safety are likely to change, such changes as can be envisaged are most unlikely to affect adversely the fundamentally strong position of such issues.
AA – (Double A) High Safety : Debentures rated ‘AA’ are judged to offer high safety of timely payment of interest and principal. They differ in safety from ‘AAA’ issues only marginally
Investment Grades
A – Adequate Safety : Debentures rated ‘A’ are judged to offer adequate safety of timely payment of interest and principal. However, changes in circumstances can adversely affect such issues more than those in the higher rated categories.
BBB (Triple B) Moderate Safety : Debentures rated ‘BBB’ are judged to offer moderate safety of timely payment of interest and principal for the present; however, changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for debentures in higher rated categories.
Speculative Grades
BB (Double B) Inadequate Safety : Debentures rated ‘BB’ are judged to carry inadequate safety and principal, while they are less susceptible to default than other speculative grade debentures in the immediate future; the uncertainties that the issuer faces could lead to inadequate capacity to make timely interest and principal payments.
B - High Risk : Debentures rated ‘B’ are judged to have greater susceptibility to default; while currently interest and principal payments are met, adverse business of economic conditions would lead to lack of ability or willingness to pay, interest or principal.
C – Substantial Risk : Debentures rated ‘C’ are judged to have factors present that make them vulnerable to default; timely payment of interest and principal is possible only if favourable circumstances continue.
D – Default : Debentures rated ‘D’ are in default and in arrears of interest or principal payments or are expected to default on maturity. Such debentures are extremely speculative and return from these debentures may be realized only on reorganization or liquidation.
· Rating agencies may apply ‘+’ (plus) or ‘¾’ (minus) signs for ratings from AA to C to reflect comparative standing within the categories.
APPROACHES OF CREDIT RISK
Standardized Approach, Foundation Internal Rating Based Approach, Advanced Internal Rating Based Approach
Reserve Bank of India instructed all Banks in India to follow the Standardized Approach for the beginning and over a period of time, some of the strong banks are expected to move over to higher approaches. The approaches developed by BCBS are in an increasing order of sophistication and risk sensitivity
Standardized Approach : Standardized approach is the basic approach which banks at a minimum have to use for moving to Basel II implementation. It is an extension of the existing method of calculation of capital charge for credit risk. The standardized approach follows the existing method of calculating credit risk in our loan and investment portfolio through assignment of risk weights. The existing method is refined and made more risk sensitive by :
Introducing more number of risk weights thus aiding finer differentiation in risk assessment between asset groups
Linking risk weights to risk rating grade in respect of corporates and high value exposures (above Rs 5 crores).
Recognizing wide range of collaterals (securities) as risk mitigants and netting them off while determining the exposure amount on which risk weights are to be applied.
Introducing Retail regulatory portfolio as a separate asset group with clear cut definition and criteria
Assignment of Risk weight for NPA accounts
Assignment of Risk Weights : Under Standardized approach risk weights are assigned to various asset groups both in the Loan and Investment portfolio in the following broad ways:
Assignment of Standard Risk Weights straight away based on the type of Asset Group.
Assignment of Risk Weights based on the ratings assigned by External Credit Rating Agencies recognized by RBI.
Treatment of off-Balance Sheet Exposures.
Assignment of risk weights straight away : The asset groups for which standard risk weights prescribed by Basel II Framework can be straight away applied are given below
Asset Group Standard
risk weight
1. Direct exposure to domestic
a. State Government
b. Central Government
0%
0%
2. Guarantee exposures to domestic
a. State Government
b. Central Government
20%
0%
3. Exposures denominated in Indian rupees to
a. Scheduled banks
b. Other Banks
20%
100%
4. Retail Regulatory Portfolio 75%
5. Loans secured by Residential property
a. With substantial margin
b. Others
75%
100%
6. Investment in mortgage backed securities issued by Housing Finance Companies 75%
7. Loans secured by commercial real estate 100%
8. NPAs ( unsecured portion ) where
a. Specific provisions are less than 20% of outstanding NPA amount.
b. Specific provisions are at least 20% of outstanding NPA amount
c. Specific provisions are at least 50% of outstanding NPA amount
d. Secured by Land & Building &/ or Plant & Machinery & where specific provisions are at least 15% of outstanding NPA amount
e. Loans secured by residential mortgage
i. Specific provisions are at least 20% of outstanding NPA amount
ii. others
150%
100%
50%
100%
75%
100%
9. Exposures defined as High Risk Category by RBI 150%
10. Other Assets 100%
Retail Regulatory Portfolio: One noteworthy provision of the new framework is the introduction of Retail Regulatory portfolio. Basel II framework has stipulated the following four criteria for qualifying an exposure as retail
1. Orientation Criteria : This defines the types of borrowers who can be brought under the Retail definition. According to the new accord a loan to be categorised under Retail exposure should be to an individual person or persons or to a small business. Here the meaning of the word person means any legal entity capable of entering into contracts and includes individual, HUF, Partnership firm, trust, Pvt/Public Limited Companies, Cooperative Societies etc. Small Business is defined as one where the total annual turnover is less than Rs 50 crore.
2. Product Criteria : This defines the type credit facilities that can be brought under the Retail segment. The exposures, which take any of the following forms, can be categorized as Retail
o Revolving Credit ( Credit Card)
o Lines of Credit ( Overdrafts)
o Personal Term loans and Leases( eg Instalment loans, auto loans, Student educational loans, Personal loans etc)
o Small business facilities and commitments
3. Granularity Criteria : This is stipulated to ensure that loans under the retail portfolio are well dispersed thus ensuring that concentration risk is adequately addressed. To ensure this the accord stipulates that aggregate exposure to one borrower should not exceed 0.2% of overall Retail Regulatory portfolio. Here Aggregate exposure refers to the gross amount i.e. exposure amount before effecting any deduction for the collateral held. Borrower means one or several entities that may be considered as a single beneficiary ( For eg In case of small business that is affiliated to another small business the ceiling of 0.2% would apply to the Bank’s aggregated exposure on both the businesses). For determining the amount outstanding under the overall Retail Regulatory portfolio for granularity purpose, NPAs are excluded.
4. Low value of Individual exposures : The Basel II framework has fixed the maximum limit up to which retail exposure to one borrower can be permitted taking into account the extent of Capital funds held by a bank. This criteria has been set to ensure that high value accounts do not get categorised under Retail segment and straight away enjoy concessionary risk weight of 75% without proper assessment through the process of risk rating. We are furnishing below the various threshold limits fixed based on the Capital Funds held.
Banks Capital funds Threshold limit Banks Capital funds Threshold limit
Up to Rs 300 Cr Rs 1 Cr More than Rs 500 Cr Rs 5 Cr
> Rs 300 Cr & up to Rs 500 Cr Rs 3 Cr
Substantial relief is extended in the new framework by prescribing concessionary risk weight (75%) for Retail Regulatory Portfolio.
However one stipulation that may affect the Banks considerably is the concept of exposure particularly in respect of running/revolving facilities like OCC where limit concept is used. As per the new guidelines in respect of running accounts the limit sanctioned is taken as the exposure for assigning risk weights. Thus unavailed portion of the limits too attracts capital. Hence ensuring full availment of limits becomes crucial in managing judiciously the Capital Adequacy requirements.
Exposure types under standardized approach: Exposures are classified into the following categories. The Details of risk weights given to each category of exposure are
• SOVEREIGN EXPOSURE
• PUBLIC SECTOR ENTITIES
• EXPOSURE TO MULTILATERAL DEVELOPMENT BANKS
• EXPOSURE TO BANKS
• EXPOSURE TO SECURITY FIRMS
• CLAIMS ON CORPORATES
• RETAIL PORTFOLIO
• MBS - RETAIL PROPERTY
• MBS - COMMERCIAL REAL ESTATE
• LOANS PAST DUE (BEYOND 90 DAYS NORM)
• HIGHER RISK CATEGORY LOANS
• OTHER ASSETS
• OFF-BALANCE SHEET ITEMS
Credit Risk Mitigation: Risk mitigation is a general term and engulfs in its meaning every step or initiative taken by a Bank to protect itself against losses arising out of doing business. Banks use a number of techniques to reduce or mitigate the risks to which they are exposed to while taking credit exposures. Basel II accord recognises a wide range of Collateral (securities) and Guarantees as credit risk mitigants. It allows Banks to adjust the credit exposures against the values of recognised collateral and or guarantees for capital calculation purposes.
Definition of a collateral : The context in which we use the term collateral in our day to day banking is different from what is referred to by the Basel II document. According to the accord ‘collateral’ is a security –
• Offered by the counter-party or by a third party on behalf of the counter-party to secure the credit exposure. Here counter party refers to the person/s on whom the bank has taken an on or off balance sheet exposure i.e all obligors to the loan transaction like borrower, coobligant, guarantor etc.
• On which Bank has a specific lien and the legal certainty aspects like binding all the parties and being legally enforceable are met.
Eligible Financial Collateral types : Basel II accord does not recognise all the types of securities that Banks take to secure their loans. It recognises only the following securities as Credit risk mitigants and permits setting them off against the exposure amount for obtaining capital relief.
1. Cash on deposit with the Bank. ( also includes certificates of deposit and similar instruments issued by the lending Bank).
2. Gold – includes both bullion and jewellery. The value of the jewellery should be benchmarked to 99.99 purity.
3. Securities issued by Central and State Governements
4. Indira Vikas Patra, Kisan Vikas Patra and National Savings Certificates.
5. Life Insurance Policies with a declared surrender value of an insurance company that is regulated by an insurance sector regulator.
6. Debt securities rated by a recognised credit rating agency where these are either At least BB when issued by Public Sector entities/At least A when issued by other entities ( including banks and Primary dealers) or At least P2+/A3/PL3/F3 for short - term debt instruments.
7. Debt securities not rated by a recognised credit rating agency but are Issued by a Bank / Listed on a stock exchange / Classified as senior debt
8. Equities that are listed on a recognised stock exchange in respect of which Banks are sufficiently confident about the market liquidity.
9. Undertakings for collective investments in transferable securities (UCITS) and mutual funds where Price for the units is publicly quoted daily i.e., where the daily Net Asset Value is available in public domain.
Approaches for using collateral as Credit risk mitigants : Basel II accord prescribes the following two approaches for obtaining capital relief through offset of collateral against exposures
Simple approach & Comprehensive approach
Simple approach : Reserve Bank of India does not recommend use of this approach for the Banks in India.
Comprehensive approach : Comprehensive approach allows a fuller offset of the recognised collateral against the exposures. Under this approach the value of the recognised collateral effectively reduces the exposure value.
The risk weights for the purpose of computing capital requirements are applied on the net exposure value obtained after set off. Reserve Bank of India has prescribed use of comprehensive approach for the Banks in India for calculating their capital requirements.
Example : If a credit exposure of Rs 1 lac is secured by a recognised collateral say cash by Rs 50000/- then the net exposure after risk mitigation would be Rs 50000/-( Rs 100000 – Rs 50000). In the instant case the risk weight for CAR calculation will be applied on the net exposure of Rs 50000/ and not on Rs 1 lakh.
Haircuts : The collateral or securities that we take for our loans and advances may not carry the same value through out the tenure of the loan. That is to say some of them may be subject to variations in their value over the tenure of the loan depending on the movement of market prices. In certain types of loan transactions the loan exposure may also be subjected to variations in value. Hence we have two types of variations or volatilities that may cause changes in the value. One relates to the securities or collaterals taken for the loan and the other to the loan exposure itself. These variations are referred to as volatilities or Haircuts.
Basel Committee on Banking Supervision factors the risks arising out of these two volatilities or Haircuts while arriving at the exact exposure on which the risk weights have to be applied for calculating capital requirements.
Types of haircuts : In principle Banks have two ways of calculating the haircuts viz Standard supervisory haircuts & Own estimate haircuts
Standard haircuts : These are prescribed by the supervisor (RBI). They are expressed as a percentage and assume the following
• Daily mark to market of the securities
• That the securities will be held for a minimum period of 10 days.
The standard haircuts as prescribed by Basel II are given below
Issue rating for debt securities Residual maturity Sovereigns* Other issues**
AAA to AA-/A-1 > 1 year 0.5 1.0
> 1 year, <> 5 years 4.0 8.0
A+ to BB-/A-2/A-3 /P-3 and unrated Bank securities. <> 1 year, <> 5 years 6.0 12.0
BB+ to BB- All 15.0
Main index equities (including convertible Bonds) and Gold 15.0
Other equities ( including convertible bonds) listed on a recognized exchange 25.0
Mutual Funds Highest haircut to any security in which the fund can invest
Cash in the same currency 0
Example: Let us take a loan of Rs 10 lakhs which is secured by following securities
a. A+ debt securities with less than 1 year residual maturity - Rs 3 lakhs
b. Securities issued by central govt with 3 year residual maturity – Rs 5 lakhs
c. Equities - Rs 2 lakhs
Weight of asset a in the basket of securities = Value of the asset a
Value of the basket of securities
= 3/10 = 0.3
Weight of asset b in the basket = 5/10 = 0.5
Weight of asset c in the basket = 2/10 = 0.2
Standard haircut applicable to asset a as per the table given above = 2%
Standard haircut applicable to asset b as per the table given above = 2%
Standard haircut applicable to asset c as per the table given above = 15%
Applying the formula
Haircut for the Basket=0.3*2% +0.5*2% +0.2*15% =0.6% +1% +3% = 4.6%
In the example the value of the security basket after applying the haircut is worked out as under:
Total value of the security Basket = Rs 10 Lakhs
Haircut applicable on the basket of securities = 4.6%
Value of security after haircut = 10,00,000 – 1000000 x 4.6 % = 10,00,000 – 46000 = 9,54,000/-
Own estimate haircuts : Under Basel II accord National supervisors are given discretion to permit Banks to use their own internal estimates of market price volatility and exchange rate volatility. Banks must estimate the volatility of the collateral instrument or the foreign exchange mismatch individually. The supervisor will be permitting banks to use their own estimates of volatility or haircuts only when the qualitative and quantitative criteria set by the Basel II Accord are met.
Calculation of Capital requirement: In the Capital Adequacy ratio calculations under the standardized approach, the risk-weighted assets are arrived at by multiplying the credit exposure amount with the standard risk weight applicable to it as per the constitution type. Hence in order to give effect to the credit risk mitigation effect on account of holding collaterals or securities it is necessary that the exposure amount be reduced to the extent of the value of the security arrived at after accounting for the price volatility or haircut. The resultant exposure amount should then be multiplied with the standardized applicable risk weight as per the customer type to arrive at the risk weighted assets.
Basel II accord prescribes the use of the following formula for arriving at the exposure after risk mitigation
E* = max { E x (1+He) – Cx ( 1-Hc – H fx)]}, Where
E* = the exposure value after risk mitigation
E = Current value of the exposure for which the collateral(security) qualifies as a risk Mitigant
He = Haircut appropriate to the exposure
C = The current value of the collateral
Hc = Haircut appropriate to the collateral
Hfx = Haircut appropriate for the currency mismatch between the collateral and the exposure.
Guarantees : Banks can avail of capital relief under Basel II accord by securing their credit exposures with guarantees. Basel II recognizes wide range of guarantees as credit risk mitigants than envisaged under Basel I for providing capital relief. Risk mitigation effect in the form of capital relief obtained through a collateral and from a guarantee vary in their treatment under Basel II accord. In respect of collateral, Capital relief is obtained by reducing the collateral value (after adjustment for haircut) from the exposure and on the net exposure so obtained risk weights are applied. On the other hand, in respect of guarantees the capital relief is obtained through substitution approach.
Substitution approach: Substitution approach means replacing the risk weight applicable to the Borrower with that of the Guarantor. But substitution will result in risk mitigation and consequently provide capital relief only when the risk weight that the guarantor attracts is less than that of the borrower. In cases where the guarantor attracts higher risk weight than the borrower, credit risk mitigation effect cannot be given. In such cases the risk weight that the borrower attracts will alone be reckoned for capital calculation purpose and the guarantor’s risk weight will be ignored. Hence the first rule in using Guarantee as a credit risk mitigant is that the Guarantor should attract a lower risk weight than the borrower.
Illustration : Bank has sanctioned a loan to a corporate rated as AA and obtained State Government guarantee for the loan. As per Basel II norms AA rated corporate exposures attract a risk weight of 50% and the State Government guaranteed exposures attract a risk weight of 20%. The capital relief in the instant case is obtained by substituting the lower risk weight (20%) that the guarantor (state govt.) is eligible for with the higher risk weight (50%) that the borrower attracts.
Eligible guarantors: The credit protection or guarantee against default of the borrower provided by the following types of customers are recognized by Basel II for providing capital relief
1. Sovereigns , Sovereign entities ( includes BIS,IMF,ECGC,CGTSI and Multi lateral Development Banks)
2. Public Sector Entities ( Enterprises wholly or partly(more than 51%) by Central or State Governments)
3. Primary dealers
4. Other entities rated AA or better
Currency mismatches : In cases where the cover or protection provided by the guarantor is in a currency that is different from the currency in which the loan is denominated a currency mismatch will occur. In such cases the extent of exposure covered or protected by the guarantee is calculated by applying the following formula
GA = G x ( 1-HFX) Where
GA = Exposure amount protected by the guarantee
G = Nominal amount of credit protection
HFX = Haircut appropriate for the currency mismatch between the credit protection and underlying obligation
For Indian Banks RBI has prescribed a haircut of 8% for currency mismatch.
Foundation IRB Approach: Depending upon the robustness of the risk rating system adopted & with regulator’s permission, a bank can switch over to this Approach. Under the this approach, the asset classes are divided into:
Coporate exposure, Sovereign exposure, Bank exposure, Retail exposure, Equity exposure.
In this approach, Capital charge for credit risk is calculated by estimating Expected Loss and Unexpected Loss. To arrive at EL & UL, banks have to calculated Probability of Default, Loss Given Default and Exposure at default.
In respect of Corporate, Sovereign and Bank exposures individual banks can calculate their own estimation of Probability of Default from their own internal data. LGD & EAD shall be given by the national regulator. Whereas in case of Retail & Eq1uity Exposure, all the three (PD, LGD, EAD) shall be estimated by individual banks.
Advanced IRB Approach: In this approach, the asset classifications remains the same as in Foundation IRB approach. Here freedom is given to individual banks to estimate their own PD, LGD & EAD and calculate capital charges accordingly.
RISK RATING CONCEPTS
The main objectives of the Credit Risk Rating /Risk Assessment exercise is to measure the losses that we are likely to incur from the exposure and ensure whether the capital we hold is adequate to absorb these losses. Capital Adequacy Ratio (CAR) that we are calculating every September and March is the measure that indicates the adequacy of capital held by us vis a vis the risks we perceive in our assets.
The risks perceived are measured through risk weights. Risk weights are nothing but factors expressed in percentage that indicate the extent of risk inherent in the exposure. The risk weights that we are presently applying to our assets are given by RBI and range from 0% to 100%. Multiplying the risk weight assigned to a particular risk asset type with the total exposure under that asset type gives the Risk weighted asset for that Asset type. Aggregating the Risk Weighted Asset of all asset types in our balance sheet gives the Total Risk Weighted Assets, which forms the denominator of CAR. CAR or simply called capital ratio has capital on the numerator and total Risk Weighted Assets as the denominator.
In respect of off balance sheet exposures (Guarantees and LCs) the exposure is multiplied with a credit conversion factor and the resultant figure is multiplied with the supervisor prescribed risk weightage to get the Risk Weighted Asset. The CAR prescribed by RBI for maintenance by Indian Banks is 9%.
Effect of Asset Quality on Capital:: To study the impact of Asset quality on Capital let us take three scenarios having the same total asset exposure of Rs 100 crores but with different asset quality. For the purpose of simplicity in assessing asset quality we have taken the assets as falling under three risk categories namely Low, Medium and High risk.
Low composition of low risk exposures and high composition of high-risk exposures in the asset portfolio in Bank A indicate a poor asset quality and warrant a capital of Rs 8.46 crores.
Equal composition of Low, Medium and High-risk exposures in Asset portfolio in Bank B indicate a Medium Asset quality warranting a capital of Rs 6.70 crores.
High composition of low risk Assets and low composition of High risk assets in credit portfolio in Bank C indicate high quality assets and require capital of Rs 4.95 crores.
Therefore it is concluded from the above example that ::1. Better the Asset Quality, Lower is the Capital required to be held.
2. Hence improving the Asset Quality helps us in managing the credit risk in loan book by holding less Capital. Alternately improved asset quality requiring Lesser Capital, can result in increasing the overall asset base of the Bank with the same level of Capital.
3. While quantitative tools help in knowing the asset quality of our credit portfolio qualitative tools help in improving the asset quality.
4. Hence both qualitative and quantitative tools are required for effectively managing our credit risks and thereby the capital to be held.
STRUCTURES OF CREDIT RISK
Introduction : The main risk associated with lending is that the various parties (borrower/coobligant/Guarantor) who have to repay interest and or installments may fail to meet their commitments on the due dates. This is called as default risk. The default may occur either due to decline in the credit worthiness of the borrower or due to external factors like the exposure to adverse interest rate and foreign exchange rate movements. Trade restrictions imposed by the country where exposures are taken may also have adverse impact on the borrowers and consequently the banks, which have lent them. The credit risk of Bank’s loan portfolio depends both on external and internal factors
External factors:
o State of economy
o Wide swings in commodity /equity prices
o Interest rates
o Foreign exchange rates
o Trade restrictions
o Economic sanctions
o Government policies
Internal factors
o Deficient loan policies
o Inadequately defined powers for sanction of loans
o Absence of prudential credit concentration limits
o Deficiency in credit appraisal systems
o Excessive dependence on collaterals
o Inadequate/lack of risk pricing
o Absence of loan review mechanism and post sanction surveillance
Credit management as is conventionally understood is confined to selection, limitation and diversification and overall management of credit.
At time of selection, the obligor’s or borrowers financial condition, profitability and cash flows etc. are assessed with a view to decide whether or not the borrower has a repaying capacity. The nature of the industry in which the borrower is operating, the quality of management, the presence of collaterals etc. is an essential part of the appraisal process as all these can affect the prospect of recovery. In short , the six Cs viz., Character, Capacity, Cash, Collateral, Conditions and Control relating to borrower are examined.
Credit Risk Management is not merely Credit Management. Credit Management focuses on probability of repayment, whereas Credit Risk Management focuses on probability of default. Limitation is based on the premise that the borrower concentrations should not be too large. There are regulatory norms on individual or group exposure limits but bank may prescribe a lower per borrower/group of borrower exposure limits in its loan policies. Diversification is related to limitation and is based on the age-old principle, which says that does not put all your eggs in one basket. The banks credit policy normally indicates the exposure limits to various sectors of the
Credit Management
It is based on Asset-by-Asset or Stand alone approach to credit management. The risk in the portfolio as a whole are not captured
Expected loss and unexpected loss are not measured. Losses are recognised in the accounting sense or as per the regulatory guidelines
The concentration risks are identified on the basis of owned funds/ industry/ geographical area etc.
The strategy under this approach is to originate the loan and hold the loan till maturity.
Credit Risk Management
It is based on portfolio approach to risk.
Measurement of EL and UL is carried out as an integral credit risk management process.
The concentration risks are measured in terms of additional portfolio risk arising on account of increased exposure to a borrower/group of correlated borrowers. The correlation among constituent assets are captured to arrive at a measure of portfolio risk.
Credit risk management techniques allow active management of the credit portfolio by trading credit risk through securitization/ Credit derivatives.
Credit risk management is not NPA management. It is much more than that. NPA management is largely recovery management. A NPA account represents a situation when credit risk has crystallized – i.e, the situation when default has already taken place. Credit risk management is concerned more with the quality of credit portfolio before default rather than in the post default situation when the recovery proceedings begin. The credit risk approach gives indications of worsening credit quality of portfolio by tracking credit migration of constituent assets in the credit/investment portfolio much before the actual defaults occur so that management action can be initiated in to stem the deterioration in the credit portfolio quality.
Credit risk management process : The credit risk management in any Bank should be addressed both qualitatively and quantitatively. Qualitative credit risk management aims at improving the assets quality while quantitative credit risk management aims at measuring credit risk and providing required capital in tune with the credit risk. Qualitative & Quantitative Risk Management address the following issues respectively. Qualitative Credit Risk Management
Well drawn Loan Policy
Having a proper organizational structure.
Well formulated Delegation of Powers for sanction of loans.
Prudential Limits to contain the Concentration Risk.
Portfolio Management
Loan Review Mechanism
Quantitative Credit Risk Management
Measuring the extent of risk in the Bank’s Credit Portfolio.
Making Provisions as per the Expected Loss estimated.
Holding Capital for the Unexpected Loss.
Assessing the asset quality in term of risks involved and loading the risk premium while pricing the loans so as to realize optimum returns.
For achieving the twin objectives of qualitative & quantitative credit risk management the following tools are used::
ü Measurement of risk through credit rating/scoring
ü Estimation of the probable default and loss occurrence and calculation of capital required for credit risk through assignment of either supervisor determined or internally generated risk weights.
ü Risk pricing of loan products.
Organization structure:: Every Bank should have a Credit Policy Committee (CPC) headed by the Chairman and with heads of Credit, Treasury and the chief Economist as its members.
They should also set up a Credit Risk Management Department (CRMD)to enforce and ensure compliance of the practices and prudential limits set by CPC through loan policy. The CRMD should be accountable for protecting the quality of the entire loan portfolio.
Qualitative Credit Risk Management can be achieved by various parameters like Loan Policy, Delegation of powers, Prudential limits, Loan Review Mechanism (LRM). Some of the Techniques adopted by some banks in Qualitative Credit Risk Management are::
1. Credit policy duly approved by the Board .
2. Proper Delegation of Powers for sanction of loans.
3. Separation of relationship function ( loan disbursement and follow up) from appraisal function. This practice will not only enhance the quality of appraisal, but helps the relationship manager to concentrate on disbursement and review of loans.
4. Fixing of prudential limits to contain the concentration risk
v Stipulation of benchmark current, debt equity, debt service coverage, profitability ratios with flexibility for deviations under certain conditions
v Fixation of single/group borrower limits
v Fixation of substantial exposure limits
v Maximum exposure limits to industry/sector.
v Exposure limits to sensitive sectors like loans against equity shares, real estate etc which are subject to high degree of asset price volatility.
v Fixing lower portfolio limit for High-risk industries.
5. Some of the Loan Review mechanisms which are like, Review of sanctions of each authority by the next higher authority. Mid term review system to review the asset quality at the time of renewals and in between two renewals.
v Preventing slippage of accounts NPA through follow up.
v Close follow up of accounts suffering mortality within 1 year.
Risk Rating :: Risk rating helps the banks in understanding the various dimensions of risks in different credit transactions. The aggregation of such ratings borrower-wise, activity-wise and region-wise gives a broad assessment of the quality of the credit portfolio. Rating can be undertaken both at the pre-sanction and the post-sanction stage.
At the pre sanction stage, it helps the sanctioning authority to take a decision on whether or not to lend. At the post sanction stage it helps the banks in deciding on the periodicity and depth of review and on the precautions to be taken to maintain the asset quality. Features of risk rating system
v It should serve as a single point indicator of the diverse risk factors of the borrower
v It should incorporate the following risks
Industrial risks
Financial risks
Business risks
Management risks
Separate rating models may be used for Large corporate, SMEs, Traders and NBFCs. The overall score for risk should be on a numerical scale between 1-6 or 1-8. For each numerical category a quantitative description of the borrower, the loans underlying quality should be presented.
Bank has to prescribe in its Risk Management Policy, the minimum rating below which no exposures would be undertaken. Any relaxations in deviating from the minimum standards and the authority vested with permitting such deviations should be clearly spelt out in the loan policy.
Rating Parameters: These are various areas relating to the activity financed that are separately assessed and awarded scores. The four common areas of assessment are Industrial, Management, Business and Financial risks. Depending on the line of business of the borrower the score composition for the above four areas will undergo a change.
Financial Parameters:: Under this, the Balance sheet and other financial statements of the borrower are studied and important ratios are worked out. Based on the ratios appropriate risk weights are assigned.
Industry related parameters:: This includes comparison of the industry being rated with its peers, studying of aspects such as growth of net sales, operating profit before depreciation, interest and tax, working capital etc. The track record of the industry over the years is also studied. Here again depending on the type of industry the risk weights assigned for various sub-parameters may vary.
Management Parameters:: This includes aspects like promoter’s details, their stake in the business, their experience in running the business, their ability to face challenges and capacity to meet difficult situations. For example the unit may be doing well when the industry in general is not doing that well.
Business risks:: This includes aspects like the type of creditors, the availability of infrastructure, marketing arrangements, the debtors and their turnover ratio etc. Apart from the above the party’s proposal is studied in depth and the key issues unique to the borrower being rated are listed out and studied before assigning/ approving the final rating.
CONCEPTS OF CREDIT RISK
Definition of Credit Risk: Credit Risk is defined as ” The inability or unwilling ness of the customer or counter party to meet commitments in relation to lending, hedging, settlement and other financial transactions.”
Hence credit risk emanates when the counter party is unwilling or unable to meet or fulfill the contractual obligations/ commitments thereby leading to defaults. Credit Risk of a Bank depends upon several External and Internal factors. These External or Internal factors are related both to the borrower & the bank.
Internal factors (Applicable to Banks):: Deficient loan policies, Inadequately defined powers for sanction of loans, Absence of prudential credit concentration limits, Absence of credit committees, Deficiency in credit appraisal systems, Excessive dependence on collaterals, Inadequate/lack of risk pricing, Absence of loan review mechanism and post sanction surveillance
External factors (Applicable to Borrowers) :: Inadequate technical know-how, Locational disadvantages, Outdated production process, High input costs, Break Even Point being very high, Uneconomic size of plant, Large investment in Fixed Assets, Over estimation of demand, wide swings in commodity or equity prices.
External Factors (Applicable both to the Borrower and Banks): Credit worthiness of the counter party, default risk, interest rate risk, forex risk, country risk, concentration risk, portfolio risk, transaction risk, Economic scenario, Government policies and Trade restrictions etc.
Effects of External factors on Credit Risk:
1. Creditworthiness of the counter party: Failure of the counter party to meet the commitments agreed upon either on account of unwillingness to pay despite adequate cash generation or incapacitated to pay for reasons beyond the control of the country party leads to default there by leading to Credit Risk. Failure to meet the commitments agreed upon can occur on account of either intentional default or bona-fide reasons. However at the same time situations can not be ruled out where despite low or no cash generation the counter parties may still honor their commitments. Hence proper assessment of credit worthiness of the counter party is crucial.
2. Default risk: This kind risk can arise
i. on account of failure of the counter party who is our borrower to meet the commitments agreed upon.
ii. Also on account of defaults committed by other parties connected to the counter party.
3. Interest Rate Risk: Lending rates that are stipulated for any activity should be reasonable, acceptable besides being affordable to the borrower based on his cash generation as well as repaying capacity. Fixation of unreasonable interest rates which are not matched by adequate cash generation may lead to defaults in meeting the commitments. Hence interest rates shall be linked to creditworthiness & default risk of the borrower.
4. Forex Risk: Volatility in foreign exchange rates may also impair the repaying ability of the counter party. When rupee depreciates, the counter may have to bring more Indian currency to meet the obligations/ commitments denominated in foreign currency (import bills).
However when the Rupee appreciates against the foreign currency, the counter party’s foreign currency earnings gets reduced resulting in erosion of profits & there by making him unable to meet his commitments.
Therefore counter parties importers are likely to suffer when the Rupee value depreciates and Counter parties Exporters are likely to suffer when the Rupee appreciates.
5. Country Risk: Prevailing economic conditions in different countries determine the risk which the bank is exposed to. If the importer’s country has imposed an embargo on repatriation, our exporter will not be in a position to receive the exports proceeds which may lead to defaults.
6. Concentration Risk: This is the single largest cause for major credit problems. This includes concentration in a single borrower, a group of connected counter parties, sectors or industries and the concentration based on common or correlated risk factors.
7. Portfolio Risk: This is similar to Concentration risk. When the Bank takes credit or investment exposure on certain sectoral activities like, Housing, Textile Industry etc, the success or failure of these sectors has direct bearing on the performance of the credit or investment. In the event of all or some of them not performing well may cause hardships to parties engaged in these business which in turn may result in default of payments agreed upon.
8. Transaction Risk: The very nature of transaction some times has an intrinsic risk like:
ü Granting of clean or unsecured loan
ü Discounting of a supply bill
ü Book debt finance to individuals & proprietary concerns
9. Economic Scenario /Government Policies/ Trade Restrictions: The changes in economic scenario or the Government policies or the trade restrictions imposed by different countries which are beyond the control of either the Bank or the Borrower may adversely affect the business or activity which might cause default leading to Credit Risk.
Credit risk is having two components. The first is the solvency aspect of credit risk, which relates to the risk that the borrower is unable to repay in full the sum outstanding. The second is the liquidity aspect of credit risk that arises when the payment due from the borrower are delayed leading to cash flow problems for the lender. The liquidity and solvency risks are closely related.
In order to meet the short liquidity needs, a firm may have to undertake fire-sale of assets which might fetch a lower amount for the assets sold as compared to the sale of assets under normal circumstances. This could lead to a situation of technical insolvency where the realizable value of assets may be less than the value of liabilities.
This problem is more pronounced in case of banks as their balance sheet contains assets ( like loans and investment etc ) which fluctuate in value where as the value of deposits remains constant and in fact might grow on account of interest element. Thus what may appear to be liquidity risk in the beginning may turn in to solvency risk over a period of time.
Capital Charge for Credit Risk: In the earlier chapters we have seen how the equation for capital adequacy ratio has changed after the advent of Basel II. But capital charge for credit risk is totally different from provisioning for NPAs. In the environment of risk management, NPA is defined as a situation in which the default has already occurred and the credit risk thereof has crystallized. But Credit Risk is more concerned with quality of credit portfolio before default. Therefore adequate cover by appropriate allocation of Capital for unexpected losses in future is the objective Credit risk Management. As per RBI requirement, the CAR remains at 9 %, but the risk weights assigned to various credit assets depends upon the credit quality, area of operation, consistency of operation etc of that credit asset.
Measurement of Credit Risk: Basel II proposes two methods for measurement of Credit Risk. They are
1. Standardized Approach
2. Internal Ratings Based (IRB) Approach.
Standardized Approach:: Under this approach, the Basel II accord proposes differential capital requirements depending upon the credit quality of the borrower. The differential risk weights range from 0 %, 20%, 50%, 100 % and 150% would be assigned on the basis of ratings of the borrower. Therefore to adopt this approach Risk Rating of the borrowers is pre requisite.
Internal Ratings Based Approach: A further option of 2 methods exist in this. They are Foundations Approach & Advanced Approach. This approach is based calculation of Expected Losses and Unexpected Losses. In turn these are calculated by Probability of Default (PD), Loss Given Default(LGD) and Exposure at Default (EAD)
Banks which comply with certain minimum requirements like Comprehensive Credit rating system shall be permitted to adopt the Foundation Approach. Under this approach, the rating system adopted by the banks shall be capable of quantifying the Probability of Default, whereas the LGD and EAD are provided by RBI.
Under Advanced Measurement Approach, banks will be allowed to use the internal for calculation of PD, EAD, LGD for assigning the risk weights and they will be validated by RBI.
However for adopting the IRB Approach, banks should build up historical data base on the Portfolio quality/Provisioning/Write offs etc.
STRUCTURES OF RISK MANAGEMENT
a) credit risk b) market risk and c) operational risk.
With progressive de-regulation, cross border dealings, globalization, introduction of wide range of products & services, improvement in technology & communications, significant changes have occurred in the balance sheets of banks. Risks faced by banks have now increased manifold posing significant challenges to both banks & supervisors. To respond to these challenges there have been various supervisory initiatives to introduce better operating standards in banks, greater transparency & sensitivity towards risk management by banks.
The risks faced by banks can be categorized under two risk groups:
1) Business risks which are inherent in the activities that banks undertake.
2) Control risks that arise out of inadequacy, break down or absence of various controls that are used to mitigate business risks.
Inherent business risks include credit risk, market risk, liquidity risk, operational risk, strategy & business environment risk, group risk etc.
Control risks include breakdown of internal controls & risk related to organization structure & management.
The impact of losses on account of various risks get reflected in a bank’s earnings & capital. As such, while earnings & capital do not represent risk per se, since they bear the impact of various risks their assessment in relation to risk management is important. Hence capital & earnings have been included under business risks.
i) CREDIT RISK:: Credit risk represents the major risk faced by banks
on account of nature of their business activity, which includes dealing with or lending to a corporate, another bank, financial institution or a country. Credit risk may be carried in banking book or the trading book or in the off balance sheet items. Credit risk includes:
a) COUNTER PARTY RISK- the possibility that a borrower or counter party will
fail to meet obligations in accordance with agreed terms. It may also be reflected in the down grading of the standing of the counter party making him more vulnerable to possibility of defaults.
b) PORTFOLIO RISK – due to adverse credit distribution, credit Concentration / investment concentration .
c) COUNTRY RISK – the possibility that a country will be unable to service or repay its debts to foreign lenders in a timely manner.
ii) MARKET RISK:: Market risk is the potential of erosion of income or
market value of an asset arising due to changes in market variables such as interest rate, foreign exchange rate, equity prices & commodity prices.
a) Interest rate risk – the risk in the erosion of earnings due to variation in
the interest rate with in a given time zone. Interest rate risk may arise on account of gap or mismatch risk, basis risk, embedded options risk, yield curve risk etc.
b) Foreign exchange risk – the holdings of foreign exchange assets or
liabilities, not been hedged against movement in exchange rates. This position is referred to as open position. Forex risk affects both spot & forward positions of the bank. Forex risk includes settlement risk, time zone risk & translation risk.
c) Equity price risk- potential of an institution to suffer losses on its exposure to capital markets, from adverse movements in the prices of equity.
d) Commodity price risk – the potential of adverse movements in prices of physical products, which are or can be traded in the secondary markets like agricultural products, minerals & oils, precious metal.
iii). LIQUIDITY RISK – possibility that a bank may be unable to meet its liabilities as they become due for payment or may be able to fund the liabilities at a cost much higher than the normal cost. The risk arises due to mismatch in the timing if inflows & outflows of funds, and from funding of long term assets from short term liabilities. Surplus liquidity could also represent a loss to the bank in terms of earnings missed & hence an earning risk.
iv). STRATEGY & BUSINESS ENVIRONMENT RISK – may arise due to inappropriate or non-viable business strategy adopted by the bank/ its absence altogether & the business environment that the bank operates in, including the business cycle that the economy may be passing through. A dynamic & viable medium term strategy formulated on the basis of proper research & planning, identifying target areas, markets, products, customer base etc is necessary for effective risk management. Lack of the same may pose a significant risk to the earnings & viability of the bank.
v). OPERATIONAL RISK – may arise due to inadequate or failed internal processes, people & systems or from external events. It includes People risk ( incompetence, frauds, work environment, motivation ), Operational control risk ( failure of operational controls, volumes ),Model risk ( model application error, methodology error ). Apart from the above the following are also covered under operational risk.
a) Legal risk – may arise due to the possibility of actions of a bank not being in conformity with the laws of a country or being in violation thereof. The bank can also experience legal risk when customers approach court of law for redressal of their grievances where transactions with its counter parties are not supported by proper documents or the terms of the contract are unclear or even due to lack of well established legal pronouncements in cases where issues involved are nebulous.
b) Reputational risk – the financial implications of a moral obligation cast on a bank in the environment it is functioning or by virtue of its association with another organization is called reputational risk. Reputational risk is the potential of suffering loss due to significant negative public opinion, bad or wrong publicity.
c) Technological risk – arising out of IT related factors like validity of IT systems, back up & disaster recovery systems, failure of systems, security of systems, programming errors etc. It can also arise due to obsolescence of technology being used, technology not being in alignment with business needs or adoption of untried & untested technology, inability of the staff to respond to new technology etc.
vi). GROUP RISK – arising on account of financial implications being cast on the bank due to its obligations to other entities in the group or due to contagion effect. A bank may have various domestic/over seas subsidiaries dealing in mutual funds, merchant banking services, housing finance, gilt securities, banking services etc. Since there are, as yet, no rigorous capital adequacy norms & prudential regulations governing subsidiaries, the parent bank is exposed to the risk of rescue operations whenever a subsidiary runs in to losses/ needs fresh injection of funds.
vii). EARNINGS RISK – it can be assessed through assessment of fund cost & return, assessment of earnings & expenses and assessment of earnings quality & stability.
viii). CAPITAL INADEQUACY RISK – capital of bank is a cushion against unexpected losses. The volume of capital determines the direction & magnitude of future growth of business of a bank. Though capital does not represent business risk, since it bears the impact of other risks its adequacy or inadequacy is a material in the risk assessment of a bank.
CONTROL RISKS.
i) Internal control risk – arising on account of failure of internal control system of the bank. Weakness in internal controls have been historically recognized as a high risk factor. It requires special attention due to its high potential to inflict heavy losses on a bank on account of failure of various control systems.
ii) Organization risk – arising on account of organizational bottlenecks in the form of inadequate or inappropriate structure in relation to its business and the quality of its external & internal relationships. The organization structure needs to be clear and in tune with the legal & business requirements of the bank .The organization should be flexible to meet the challenges.
iii) Management risk – arising out of poor quality and lack of integrity of management. It is reflected in quality of senior management personnel, their leadership, competence, integrity and their effectiveness in strategizing, delivering & dealing with the problems.
iv) Compliance risk – arising out of non-compliance with various requirements on account of authorisation, statutory requirements, prudential operations & supervisory directives/guidance.
RISK MANAGEMENT ARCHITECTURE: The effectiveness of risk management systems depends to a large extent on having in place appropriate and effective risk management architecture. It should at the minimum include the following:
i) Risk management policies.
ii) Board of directors & Senior management commitment.
iii) Effective organization structure for risk management.
iv) Effective risk management processes & systems.
v) Human resources & training.
vi) In-house monitoring.
RISK MANAGEMENT POLICIES: Bank should have appropriate risk management policies in place. The risk management policy document should broadly cover the followings:
a) Identify the risks that are to be measured & monitored.
b) Define risk tolerance level for the bank.
c) Specify the methodology for measuring the various risks and specifically approve the methodology or models to be used.
d) Provide for exception reporting to top management when the allocated limits are breached.
e) Indicate the process to be adopted for immediate corrective action.
f) Set up an organizational structure for risk management including delegation of powers & responsibilities for risk monitoring & control.
g) Provide detailed guidelines for proper data collection, collation & updating.
h) Specify a separate organizational unit for validation & review of the risk monitoring techniques used.
i) Specify system for comprehensive review of risk management & risk control & report to the board.
BOARD OF DIRECTORS AND SENIOR MANAGEMENT COMMITMENT: The Board should set various risk limits by assessing the bank’s risk appetite, skills available & risk bearing capacity represented by capital. It should also set up appropriate procedures for management of the risks. This calls for clear lines of responsibility for managing risk, adequate systems for measuring risk, appropriately structured limits on risk taking, effective internal controls & a comprehensive risk reporting process.
The Board should ensure that senior management attends to its responsibilities concerning risk management & internal control and frequently reviews the effectiveness of the system. It also needs to make a periodical review of risk management policies, control systems in place, clarity of various reporting lines, adequacy of monitoring mechanisms, adherence to policies, procedures & limits by operational departments and adequacy of management responses on identified weaknesses.
RISK MANAGEMENT ORGANIZATION : At the apex of the risk management organization of a bank should be the Risk Management Committee, which generally comprises the Managing Director, Heads of business units of the bank and Head of Risk Management. It can also include some members of the Board. The RMC is responsible for supervising the activities & operations of all committees entrusted with risk management functions with in the bank. These committees include Credit Risk Management Committee, Asset Liability Management Committee and the Operational Risk Control Function.
The Risk Management Department supports the activities of Risk Management Committee through research on & analysis of risks, reporting risk positions & making recommendations as to the level & degree of risk to be assumed. RMD has the responsibility to identify, measure & monitor the risks faced by the bank, develop & issue policies and procedures, verify the models that are to be used for risk measurement & pricing complex products and identify new risks as a result of emerging markets & new products.
Under RMD, there may be independent groups/departments for supporting the committees for specific risks ie. Credit risk, Market risk and Operational risk.
The Credit Risk Management Department may be supported by Risk Planning Cell, Risk Assessment & Monitoring Cell, Risk Analytic Cell & Credit Risk Systems Cell.
RISK MANAGEMENT PROCESSES & SYSTEMS:
a) Risk Identification: The first step for risk management process is to identify all risks to which the bank is exposed. The activities undertaken by the bank as well as the new activities that the bank proposes to enter in to as observed from the balance sheet & other records should be systematically examined to identify all kinds of risks faced by the bank. The bank will have to proceed in systematic manner across all its activities both on assets and liabilities, including off balance-sheet items to ensure that there is no activity of the bank omitted from risk management.
b) Risk measurement: Banks should have proper systems in place to measure the risks identified as arising from various activities. For this, banks may develop risk management techniques that are appropriate to the size & complexities of their portfolios, resources & data availability. The methodologies of risk measurement may range from a simple assessment on the basis of certain qualitative & quantitative criteria compared with certain pre-set standards/bench marks to sophisticated statistical/mathematical models.
c) For measuring credit risk traditional methods involve financial analysis in conjunction with credit rating framework to arrive at risk aggregation, pricing & other decisions. On the other hand there are several other new techniques in the nature of quantitative models using econometric, mathematical programming or simulation methodologies for decision making.
d) For interest rate/forex/market risk measurement, some of the standard techniques used are maturity gap analysis, duration gap analysis, value-at-risk approach etc.
e) Risk monitoring & control: Controlling the risk with in the parameters & limits set by the Competent Authority is the ultimate objective of the risk management exercise. Risk monitoring & control involves
i) Limit setting – each bank should determine for itself what is the maximum level of risk it can face given the level of its capital. Fixation of risk level has a great significance since capital is subject to erosion if risks actually materialise. The limits could be fixed in terms portfolio standards for credit risk or setting limit for value at risk in respect of credit risk, earning risk & market risk.
ii).Monitoring – once limits are fixed, the actual performance/utilization needs to be compared against the limits for risk monitoring. The results of such comparisons will reveal the exceptions, which may be investigated for reasons of material deviations and reported to the proper authority for remedial action. Tracking of risk migrations upward or downward is another aspect of risk mitigation.
iii).Reporting & MIS – the existence of strong MIS that captures relevant information and data is an important pre-requisite for effective risk control. However, the accuracy of data, the frequency of revision of data/information and its timely availability are important factors that determine the efficacy of the risk monitoring & control process.
iv). Risk mitigation – the essential aspect of risk monitoring & control is to take corrective action for bringing down risk to manageable levels if it is considered high. The various ways of risk mitigation are reduction in exposure to a particular industry, stepping up of recoveries to bring down NPAs, acceptance of collateral’s, reducing open positions in foreign currencies .etc.
HUMAN RESOURCES & TRAINING:: with banks gradually refining their risk management systems & the impending introduction of risk based supervision of banks by RBI, the need of understanding the risks m the process of their management & control and the increasing use of sophisticated tools for measuring & managing the risks, bank should have specialised staff adequately trained to discharged various risk management functions.
Since specialization develops over time, identification and positioning core staff for risk management as well as availability of second line of support are crucial for effective risk management. IN-HOUSE MONITORING:: The risk management process needs to be reviewed periodically by an independent group of executives to ensure that all important elements of risk management process are functioning effectively/efficiently and the risk as measure through the process is the actual risk/close to the actual risks faced by Bank.
RISK MANAGEMENT CONCEPTS
The first step towards an organized Risk Management arose through Basel initiatives. The advent of Basel II has certainly brought to focus the pressure on Capital through differential risk weights
Risk is imminent in every activity and more so in the case of financial sector where we deal with money day in and day out. In every successful enterprise diligent risk management is seen as a distinct and integral part of their functioning and for Banks the capital Accord of 1988 or Basel I reinforced this diligence. It, in a sense, homogenized the independent efforts of each Bank in managing their risks into a standard framework.
The inadequacies of Basel I, like in its failure to recognize operational risk, its broad-brush approach with regard to credit risk apparently encouraged banks to go in for riskier assets in search of higher returns on capital. A dire need was felt at the global level to introduce a more rigorous framework of standards and practices, which would lead banks into firmer grounds of Risk Management. The series of setbacks witnessed in the financial sector like the fall of Barings Bank, Incurring of huge losses by Daiwa and Sumitomo also added to the need for more rigorous risk management practices.
I. What is Risk ?
The word ‘risk’ is derived from an Italian word ‘risicare’ which means, "to dare". This means that risk is more a ‘choice’ than a ‘fate’. Extending this analogy further we can say that risk is not something to be ‘faced’ but a set of opportunities open to ‘choice’. There is no single definition that captures the entire spectra of what constitutes risk. The Bank for International Settlement (BIS) definition, which is widely accepted, reads thus
"Risk is the threat that an event or action will adversely affect an organization’s ability to achieve its objectives and successfully execute its strategies".
A very wider definition of risk is “ Risk is nothing but the certainty of an exposure to uncertainty.”
II. What is Risk Management ?
Managing the risks commences with the task of identifying all the possible risks in our activities. The next task would be to list out the controls in place against each of the identified risks. Making an assessment of the controls in place versus the identified risks for adequacy follows this.
The risk identification and assessment is a dynamic exercise and must be carried out at regular intervals aiming at continuous refinement of our procedures in tune with the risks perceived. Risks also need to be measured to not only ascertain their financial impact on our resources but also to aid in pricing our products. Finally a system should be in place to monitor/review the above processes.
III. Classification of risks in Banks: Risk is an integral part of the banking business. Banks are exposed to various types of risks depending on the activities pursued by them. Broadly speaking they are exposed to three major categories of risks namely
Credit risk, Market risk, Operational risk
Credit Risk:: It is defined as "the inability or unwillingness of the customer or counter-party to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions."
Credit risk emanates from a bank’s dealings with an individual, corporate, bank, financial institution or a sovereign. Credit risk may take the following forms
In the case of direct lending : Principal/and or interest amount may not be repaid
In the case Guarantees and Letters of credit: Funds may not be forthcoming from the constituents upon crystallization of liability.
In the case of Treasury operations : The series of payments due from counter-parties under the respective contracts may not be forthcoming or ceases
In the case of securities trading businesses: Funds/securities settlement may not be effected.
In the case of cross-border exposure : The availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the country where exposure is taken.
Market Risk: It is defined as" the possibility of loss to a bank caused by changes in the market variables such as interest rate, foreign exchange rate, equity price and commodity price." To put it in simple terms it is the risk to the Bank’s earnings and capital due to changes in the Market level of interest rates or prices of securities, foreign exchange and equities. Market risk also addresses the issue of bank’s ability to meet its obligations as and when due( Liquidity risk).
Operational risk: It is defined as " the risk of loss arising from failed or inadequate internal processes, systems, people or from external events." In short, it includes all risks the bank faces other than Credit and Market risk. All losses from human and technical failures fall under this category. These are highly probabilistic in nature and are not easy to quantify. It has shot into prominence because of the series of catastrophes observed in the financial sector in the 1990s owing to failures in internal controls.
History of Risk Management in Banks: The origin and development of risk management in Banks in a chronological order. For this purpose the subject is divided into the following periods,
1970s and BCBS, Basel Accord I, Events of 1990s, Basel Accord II
1970s and BCBS:: The first major Bank event that opened the eyes of financial sector was that of Bank Herstatt of Germany, which was forced by German regulators into liquidation. The G-10 countries and Luxembourg formed a committee under the auspices of Bank for International Settlements (BIS), called Basel Committee on Banking Supervision (BCBS) to promote stability in the global banking system. The committee meets regularly four times a year. It has about thirty technical working groups and task forces, which also meet regularly. The two main objectives of the committee at the time of its formation were
No foreign Banking system should escape supervision
Supervision must be adequate for all Banks operating internationally
BCBS engaged itself in formulating standards, guidelines and best practices with the expectation that respective central banks will implement them to best suit their national systems.
Basel Accord I:: Pursuing the goal of creating a level competitive field for all Banks, BCBS published a credit risk framework to guide the allocation of capital reserves for all internationally active Banks. This popularly came to be known as Basel I accord. The Basle I framework defined two minimum standards for acceptable Capital adequacy requirements.
Risk based capital ratio & Asset to capital multiple
Risk based capital ratio is defined as the ratio of capital to risk weighted assets. Assets means both on balance sheet items(Loans, advances and investments etc) and off balance sheet exposures(Guarantees and Letters of credit etc).As per the accord Banks had to hold a minimum capital of 8% over the risk weighted assets. Out of the minimum capital to be held at least 4% of it should be in the form of Tier I capital. The asset to capital multiple was set at 12.5.Tier II capital is limited to 100% of Tier I capital
Capital Adequacy Ratio(CAR) = Capital divided by Credit risk
Capital = Tier I Capital + Tier II Capital
Credit risk = Sum of Risk Weighted Assets (RWA)
Risk Weighted assets = Exposure X Supervisor determined risk weights.
Capital ratio Minimum 8% as per Basel. and 9% as per RBI
In India Basel I accord, was implemented through the Narasimham Committee Recommendations introducing Prudential Norms such as Asset Classification, Income Recognition & Capital Adequacy Ratio. CAR of 9 % was stipulated by Reserve Bank of India. Basel I met the following objectives:
o Strengthened the capital base of Banks
o Created clear and uniform guidelines for all Banks world over
o Reduced competitive distortion among banks
Capital brought in by the above formula is known as Regulated Capital as risk weights are prescribed by the regulator of the respective countries ( In India RBI)
Events of 1990s:: In the 1990s many loss incidents were witnessed in the financial sector. Failure of Barings Bank, BCCI, Sumitomo Bank and Daiwa Bank are some of the examples. BCBS continued its efforts to suggest measures and remedies to strengthen the Banking system world over. In January 1996 BCBS came out with amendment to the 1988 accord to incorporate Market risks.
Accordingly RBI introduced Asset Liability Management for Banks in India to address Liquidity and Interest rate risks with effect from 1.04.1999.
Basel New Accord:: Towards the end of 20th century banking operations witnessed significant changes like::
Deregulated environment
Liberalization, Privatization and Globalization
Technology boost leading to introduction of sophisticated and complex products
Expansion and foray into new types of activities
Basel I though a revolutionary move of earlier times, it suffered from many shortcomings which have ignored the above changes. The short comings of Basel I are:
Non-recognition of Operational risk
Ignoring of the Risk management advancements
Capital reserve inaccuracies
In 1999 BCBS came out with fresh proposals to align the capital held by banks more closely with the risks faced by them. This is popularly known as Basel New Accord. The proposals had three stages of consultation and have finally found approval on 26.06.2004.The proposals of the new accord have to be implemented by 01 04 2007. These proposals stand on three reinforcing pillars namely
Minimum Capital Requirements
Supervisory Review
Market Discipline
Pillar I Minimum Capital Requirements:: Prescribes the various approaches in the order of risk sensitivity for measuring credit and operational risk, thus enabling banks to move from Regulated Capital to Economic Capital.
Pillar II Supervisory Review:: This pillar of the Accord aims at not only ensuring that Banks are capital adequate in terms of risks faced but also encourages them to use better risk management techniques in monitoring and managing their risks. Another important aspect of pillar II is the assessment of compliance with the minimum standards and disclosure requirements for pursuing advanced measurement approaches as mentioned above. National supervisor i.e., Reserve Bank of India will ensure that these requirements are met both as qualifying criteria and on a continuous basis.
Pillar III Market Discipline:: This pillar of the accord while complementing Pillar I and II proposals aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on
Scope of application
Capital
Risk exposures
Risk assessment processes
