ABSTRACT

The Economic Development of any country depends upon the strong based

financial system. It is like a backbone to the economic development of any

country. The year 2007-08 was characterized by several developments in the

global domestic economies and financial markets. These financial markets have

been growing recently at a faster pace influenced by financial innovations in

terms of Products & services, modern technologies, and market to the global

economy. Similarly many innovative financial products are introduced to meet

the varied requirements of both corporate and individual customers. The new

pace of technological advances has accelerated to greater heights.

The sub prime crisis in the USA and increasing inflationary expectations

around the major economies coupled with a slow down in growth rates. the

banks' practice of giving loans to borrowers with sub-prime rating (below the

bench-mark, having little or no repayment capacities) is called as sub prime

lending. As per statistics between 2004-06 years American banks issued 21% of

their loans as sub prime lending.

The Lehman Brothers an investment bank in USA which is having more than

158 years of history in banking sector, now has became insolvent. In fact it also

influenced Indian economic system. These types of economic fluctuations will

have an impact in Indian stock market. Some banks has declared that they came

to an insolvency (bankruptcy) stage, some of such banks are Merill Lynch bank

etc. The Federal Reserve Bank in US agree to give financial support to these

banks.

These sub prime lending practice of banks leads to banks insolvency, so the

quality of lending to public (individuals, group borrowers, Corporates etc) is

very important in lending process of banks. Since the bank involved in lending

activity then would raise default risk, this default risk turns into potential risk.

The banks should take necessary steps to manage the exposure effectively and

efficiently even before beginning the lending process. Bank should put in place a

comprehensive ‘risk management policy’ for the management of credit risk,

market risk and operational risk. Bank should have a detailed analysis in every

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exposure, Study various parameters in issuing the loans, and loan policy of bank

should be well defined. Banks should investigate the borrower’s credit

worthiness and repayment capability based on RBI guidelines.

The banks can also mitigate the credit risk through credit risk mitigation

techniques as per Basel II norms. Bank have to formulate policies on rating

system, loan review mechanism, risk concentrations, risk monitoring and

evaluation, legal compliance, etc.

The present study concentrated on this important issue of credit risk

management with the following objectives.

1. To understand the concept of risk, risk management, credit risk

management and related conceptual framework

2. To study the various follow-ups / supervisions followed by the Bank

3. To examine the credit risk mitigation techniques followed by the Bank.

4. To present about implementation of BASEL-II risk management system.

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Contents pg.no’s

Chapter-I Introduction including profile of Andhra Bank 9-13

Chapter-II Risk Management a conceptual frame work 14-27

Chapter –III Credit negotiation and loan monitoring 29-47

Techniques

Chapter-IV Risk management a study of Basel-1 and Basel-2 48-58

Management systems

Chapter-V Conclusions and Summary 59-60

Bibliography 61

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CHAPTER I

1.0 Introduction The past decade has witnessed significant changes in the structure,

characteristics and types of products and servives provided by the financial

services industry.Now the structure and characteristics of banks and banking

organizations are changing from traditional banking to universal banking and

internet banking. A bank is a financial institution its primary activity is to

accept deposits from the public and lend to the individuals, traders, medium &

small scale industries and Large – scale industries.

The economic development of any country depends up on the existence of a

well organized financial system. This system supplies the necessary financial

inputs for the production of goods and services which in turn promote the well

being and standard of living of the people in the country. And this financial

system is a broader term which brings under its fold the financial markets and

financial institutions which support the system. The money and monetary assets

are major assets in this financial system. The responsibility of the financial

system or institution is to mobilise the savings in the form of money and

monetary assets and invest them to productive ventures. An efficient functioning

of the financial system facilitates the free flow of funds to more productive

activities and thus promotes investment. It also provides the intermediation

between savers and investors, and that promotes faster economic development.

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With the liberalization in the Indian financial markets over the past decade and

growing integration of domestic markets with foreign markets, the risk

associated with the operations of banks have become complex and made

necessity for strategic management. The management of banks are based on

their business decisions, dynamic and integrated risk management system and

process driven by corporate strategy.In Indian banking sector is divided a public

and private sectors, co-operative banks, and foreign banks under the supervision

of the RBI.

ROLE OF BANKS

According to the Banking Regulation act 1949 Banking means “the

accepting for the purpose of lending or investment, of deposit of money from

the public, repayable on demand or otherwise and withdrawals by cheques,

drafts order or otherwise.”

Deriving from the definition in the view of Customers, Banks

essentially perform the following functions;

1. Accepting deposits from public / others (Deposits)

2. Lending money to public (Loans)

3. Transferring money from one place to another (Remittances)

4. Acting as trustees.

5. Keeping valuables in safe custody.

6. Government business etc.

The Banking institution having the following features:

It deals with money; it accepts deposits and advances loans.

It also deals with credit; it has the ability to create credit.

It is a commercial institution with the aim of making profit.

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It is a unique financial system that manages the payment system of the

country.

Importance of the Banks

Bankers play very important role in the economic development of any nation.

The health of the economy is closely related to the soundness of its banking

system. Although banks create no new wealth but their borrowing, lending,

and related activities facilitate the process of production, distribution,

exchange and consumption of wealth. In this way they become very effective

partners in the process of economic development. Today modern banks are

very useful for the utilization of the resources of the country. The banks are

mobilizing the savings of the people for the investment purposes.

A bank as a matter of fact is just like a heart in the economic structure and

the capital provided by it is like blood in it. As long as blood is in circulation

the organs will remain sound and healthy. Many difficulties in the

international payments have been overcome and volume of transactions has

been increased. Cheques, drafts, bills of exchange and Letter of credit are

important instruments of the banks.

Banking is collectively defined as a profession or industry in which the

professionals (known as bankers) are engaged in the business of keeping

money. The money deposited by each of its customers is kept in their

individual accounts.

Banking is also defined as the transactions of business done with a bank by

its customers. These include depositing funds, withdrawing funds, applying

for a loan, etc. One of the main functions of a bank is to provide various types

of financial services. These services are related to the keeping the deposits

and granting of credit. Credit is extended to a person only after checking his

or her credit-worthiness (in other words, the financial credibility of a person,

or simply, the ability of the person to pay).

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1.2 ANDHRA BANK-PROFILE

Andhra Bank” was founded by the eminent freedom fighter and a multifaceted

genius, Dr.Bhogaraju Pattabhi Sitaramayya. The Bank was registered on 20th

November 1923 and commenced business on 28th November 1923 with a paid

up capital of Rs 1.00 lakh and an authorized capital of Rs 10.00 lakhs. It was

nationalized in 1980. The Bank crossed many milestones and the Bank’s Total

Business as on 31.03.2008 stood at Rs.83, 993 Crores with a Clientele base over

1.71 crores.

Founder:

 Dr Bhogaraju Pattabhi Sitaramayya was born on 24th November 1880 in Gundugolanu village, West Godavari District in Andhra Pradesh. He was a renowned Freedom Fighter and a very illustrious personality.

Corporate Identity:

(‘Togetherness ‘) is the theme of this logo where the world of banking services

meets the realm of ever changing customer needs and establishes a link that is

like a chain, and inseparable.

The logo also denotes a bank that’s prepared to do anything, to go to any

lengths, for the customer. The blue pointer on the top represents the philosophy

of a bank that’s always looking for growth and newer, and challenging, more

promising directions. The keyhole indicates safety and security. The colours red

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and blue represent fusion of dynamism and solidity. At a time when the

performance of the bank, the prospects of the bank, and even the perceptions of

the bank are vibrantly, and poised as we are at the threshold of a new

millennium, this modernized logo is a tribute to the Andhra Bankers who are the

true creators of the image of the Bank. It making a difference with People, Ideas

and Solutions commitments to values fulfilled.

Vision and Mission:

Vision: Andhra Bank is commited to create a customer centric organization

with a deep sense of social responsibility and to continuously leverage

technology to attain world class standards of performance.

Mission:

Besides the core activity of banking. Andhra Bank will venture in to a spectrum

of financial services. Utmost concern will be accorded to customer satisfaction

by offering and innovative and need-based financial products and services using

state-of-the art technology.

1.3 Services /schemes from Andhra Bank:

Andhra Bank has providing many schemes and services to the customer. They

are as follows…

1. Andhra Bank Saving Accounts;

Andhra Bank kiddy Bank

Andhra Bank Abhaya plus.

Andhra Bank Easy savings.

Andhra Bank Abhaya Gold SB account. And etc.

2. Andhra Bank current Deposit account.

3. Andhra Bank term deposits;

Andhra Bank Excel

Andhra Bank money time

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Andhra Bank tax saver.

Andhra Bank fixed deposits, Kalpatarvu deposits, Recurring deposits

and etc.

4. Andhra Bank other schemes;

Andhra Bank Arogyadaan scheme.

Life and General Insurance Schemes and etc.

5. Agriculture loans;

Andhra Bank mahila soubhagya.

Andhra Bank Kissan Rakshak, kissan vikas, kissan chakra, kissan

samptai, surya Shakti and etc

Awards and Rewards to Andhra Bank:

Andhra Bank is a best leading public sector bank in banking services

institutions. Andhra Bank has received many awards and rewards from different

organizations,

It has received “Best presented accounts award 2005” from ‘south

asian federation of accounts’ on 16.01.2007

“Best Banker Award” from IDRBT. (Institute for development and

research in banking technology) on 2.9.2006 for the use of IT for

Customer Service in semi-urban and rural areas.

The prestigious- ‘The banker’ published by financial times (july-

2005)

‘Best Bank’ Rating from ‘Business Today’ Magazine.

“Fintech Asia 2006” Award for ‘Any Branch Banking’ initiatives.

And etc.

1.1 OBJECTIVES:

The present study concentrated on this important issue of credit risk

management with the following objectives.

1. To understand the concept of risk, risk management, credit risk

management and related conceptual framework

2. To study the various follow-ups / supervisions followed by the Bank

9

3. To examine the credit risk mitigation techniques followed by the Bank.

4. To present about implementation of BASEL-II risk management system.

1.2 PLAN OF THE STUDY

CHAPTER-I Introduction including profile of Andhra Bank

CHAPTER-II Risk management a conceptual framework

CHAPTER-III Credit negotiation and loan monitoring techniques

CHAPTER-IV Risk management a study of Basel-1 and Basel-2

Management systems

CHAPTER-V Conclusions and summary

1.3 SOURCES OF DATA

To fulfill the above said objectives, information was collected from

annual reports, RBI website and various books on Risk management practices

etc. Information was also obtained from various internet sites as a source of

information to my project.

1.4 Limitations of the study:

The study is the limited to the preparation of with in the organization only.

The study is on credit risk management and how it is managed in banks

effectively though RBI guidelines to the bank.

The study is conducted in short period due to which the study may not be

detailed in all aspects, such data is in banks inaccessible because data being

confidential.

CHAPTER-II

2.0 RISK MANAGEMENT

Definition of Risk : 10

Risk usually arises out of uncertainty and is usually interpreted in layman’s

terms as the probability of failure.

In banking parlance risk can be defined as:

The probability of loss due to default of a customer or a counter-party.

The probability of loss due to occurrence of unexpected events.

The general dictionary meaning of risk is “the possibility of loss or some

thing unpleasant will happen”.

Risk can be financial or non-financial. It can also be expected or unexpected

loss.

Risk Management is a Good Management:

Every business, in every stage of its operation, is exposed to risks. How well a

firm manages its risk without effecting performance depends on the risk

management system put in place. Only when the firm knows the various types of

risks it faces and the impact of each risk on its business, can it evaluate ways of

protecting itself from the losses arising. Thus, as identifying, evaluating and

monitoring risk not only helps an organization also avoid costly mishaps but

contributes to the quality of its management as well, it is rewarding to focus on

this aspect of management.

Identifying risk:

By isolating specific risks, defining them and determining how to deal with

them effectively, we can put each risk in its place. The process of identifying

and defining risk contributes to the sound management of our business. It

may also prevent us from various risks. The source of the potential loss gives

us another way to identify risk and determine how to protect ourselves

against it.

Questionnaires distributed to key personnel throughout the organization

can help to identify risks. But are also other ways to identify and define risk

as well ,

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Reviewing loss histories of your own and similar organizations:

Suppose if we have to put up with an accident, we might as well learn

something from it. By reviewing our company’s accidents record from that we

may identify a risk that we weren’t aware of.

Analyzing financial statements & accounting records:

By referring to balance sheets, profit&loss statements from a past series of

years, from them we can detect exposures to potential losses that may merit

further analysis.

Reviewing records and files:

In addition to financial records, we can also review contracts,

correspondence; minutes of meetings are to identify potential losses.

Consulting experts:

Experts within and outside the organization can help us understand the

potential losses facing our business.

Analyze organizational objectives:

The significance of a particular loss exposure depends on how much it

interferes with our ability to achieve. And analyze the organizational

objectives.

What is risk management?

Risk 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 that

a) The individuals who take or manage risks clearly understand it.

b) The organization’s Risk exposure is within the limits approved by Board

Of Directors.

c) Risk taking Decisions are on line with the business strategy and objectives12

Set by Board.

d) The expected payoffs should compensate for the risks taken

e) Risk taking decisions are explicit and clear.

f) Sufficient capital should be available to take risk.

After identifying the risk, we have to manage risk by estimating the chances

that an event will occur that will lead to loss or injury, then taking steps to

minimize those chances. Ultimately, we want to

Minimize the occurrence the of risk,

Recover from the event if it occurs,

Rebuild our business after the event and

Prevent, reduce or eliminate the chance of second occurrence.

There are five steps to manage the risk:

There are five steps in developing a risk management system.

1. Identifying exposures: Identifying exposures to accidental loss that may

interfere with an organization’s basic objectives. Until we identify an

exposure to loss, we can’t manage it effectively. By identifying and

defining the exposure, we can usually determine how to manage it. The

greater the threat that a risk presents to our business, the more

seriously we should think about it. Then we can figure out how to

manage the risk. Identifying various courses of action and examine their

advantages and disadvantages in view of achieving organizational

objectives and available resources.

2. Assessing techniques for dealing with risk: We should examine the

feasible techniques for dealing with these exposures. A good risk-

management program allows us to undertake activities which are cost-

effective, and to adopt measures to control risk. We can choose a number

of techniques like. Exposure avoidance, loss prevention, loss reduction.

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3. Selecting the best technique: Here select the most appropriate

techniques to minimize the risk. The selection process is plays a crucial

role for the implementing the technique. It implies a real opportunity for

choice.

4. Putting the techniques into effect: After implementing techniques based

on detailed planning. It involves putting the risk management plan in to

action. And

5. Monitoring the risk management program: ones a risk management plan

has been implemented, it has to be monitored. It helps to evaluate the

risk plan.

Risk management has become an important area in banking sector. It

needs to be looked into with great concern and care. In view of this growing

complexity of Banks business and the dynamic operating environment, risk

management has become very significant in the financial sector. RBI has

already issued guidelines to all Banks for formulating and implementing risk

management system in their organizations.

2.1 Risk management in Andhra Bank:

The Bank has put in place a comprehensive Risk management policy, loan

policy, ALM policy, Investment policy etc. The Bank has put in place

effective systems and procedures to constantly monitor and mitigate the

risk.

ORGANIZATIONAL STRUCTURE:

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Risk management is a continuous process, the success of which depends on

the awareness and willingness to perceive, measure and mitigate risk. While

facing the challenges to mitigate risk, we have to bear in mind that risk

management is about optimizing the risk-reward trade-off and not minimizing

the absolute level of risk.

The banking sector reforms introduced in India as part of the economic

reforms led to increased sophistication in banking operations like online

electronic banking, electronic fund transfers, reduced regulatory control,

improvements in information technology etc. these developments along with

the attendant advantages have lead to increased diversity and complexity of

risks being encountered by banks. These risks are independent and events that

affect one area of risk can have ramifications for a range of other risk

categories. All these risks faced by banks can be broadly grouped into three

main risks, viz., Credit Risk, Market Risk, and Operational Risk.

Why do organizations take risks? The answer would be – to make some

handsome gains. Banks, the world over, because they live with money, are said

to be financial risk takers. Generally, it is said that “No Risk-No Gain”, but

RISK MANAGEMENT DEPARTMENT (Board Level Committee)

Integrated Risk Management Department

(IRMD)

Credit Risk Management

Asset Liability Management

Operational Risk Management

15

sometimes, taking high risk becomes disastrous for the organization. Banks in

the process of financial intermediation are dealt with various kinds of financial

and non-financial risks. The major categories of risks are viz.

Credit risk

Operational risk

Market risk

A) Credit Risk:

“Credit risk is the risk that arises due to the inability or unwillingness of

a borrower or counter party to meet the commitments relating to

payment of loan or interest or both, is called credit risk of the bank.

B) Market Risk:

It is defined as “possibility of loss on account of changes in the market

variables”. The Bank for International Settlements (BIS) defined Market

Risk as “the risk that the value of on and off balance sheet positions will

be adversely affected by movements in equity and interest rate markets,

currency exchange rates and commodity prices”. Besides it is equally

concerned about the banks ability to meets its obligations.

C) Operational Risk:

Operational Risk defined as “the risk of loss resulting from inadequate or

failed internal processes, people and systems or from external events”.

This risk arises mainly due to breakdowns in internal controls, systems

and procedures, rules and regulations laid down by an organization / due

to such external factors(changes in the industry, technological factors

etc) could adversely affect in achievement of the banks objectives. Such

breakdowns can lead to financial loss through error, fraud, or failure to

perform in timely manner.

These risks are highly interdependent and events that affect one area of risk

can have ramifications for a range of other risk categories. Thus, top

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management of banks should improve their ability to identify measure,

monitor and control such risks.

2.2 Credit Risk Management

What is Credit?

Credit is defined as confidence in a borrower's ability and intention to

repay. People use the credit they have with financial institutions,

businesses, and individuals to obtain loans. And they use the loans to buy

goods and services.

The credit for a person typically determines how much he will be

permitted to borrow, for what purpose, for how long, and at what interest

rates.

The level of "confidence" lenders have in potential borrowers depends on

many factors. A person's income is an indicator of a person's ability to

repay, particularly when compared to the amount of debt they already have.

The amount of borrowing a person has already done and how well they

handled repayment is an indicator of their intention to repay.

Why to use credit?

The reasons people borrow are varied and personal. Loans allows you to

obtain goods and services today, construction of houses etc. This credit is

used for various purposes by the people for Business development,

Agriculture, and personal etc.

Credit Risk:

Lending involves a number of risks. In addition to the risks related to

creditworthiness of the counterparty, the banks are also exposed to various

risks like credit, market, operational risks etc.

Credit 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

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Resulting in economic loss to the bank.

“Understanding, measuring and managing credit risk is the key to success

and profitability for Bank. ”

Credit risk is defined as “the possibility of losses associated with

diminution (reduction/reducing) in the credit quality of borrowers or

counter parties”.

The risk that is associated with the possibility that a borrower will

fail to meet his obligations on any money that are owed.

Credit risk or default risk involves inability or unwillingness of a

customer or counterparty to meet commitments in relation to

lending, trading, hedging, settlement and other financial

transactions.

Objectives of credit risk management:

To ensure firm sound credit portfolio.

To maximize profits of financial institution.

To overcome loan losses.

To ensure proper margin.

To overcome inherent risks.

Upgrading the credit risk data base system for migration to the

various approaches.

Quantifying a credit risk or measuring credit risk:

The measurement of credit risk is of vital importance in credit risk

management.

A number of qualitative and quantitative techniques to measure risk inherent

in credit portfolio are evolving. To start with, banks should establish a credit

risk rating framework across all type of credit activities. Among other things,

the risk rating framework may, incorporate:

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o Business Risk

o Industry Characteristics

o Competitive Position (e.g. marketing/technological edge)

o Management

o Financial Risk

o Financial condition

o Profitability

o Capital Structure

o Present and future Cash flows

The assessed aggregate value of credit risk for an applicant is the sum of

subjective value of credit and objective value of credit risk. The assessment of

credit risk is usually spilt into the willingness of the company to repay and

the other one is its ability to repay the loan. Here again the willingness of the

company to repay is an objective assessment.

A complicated and interrelated set of variables must be reduced to one

single indicator of credit risk as the probability default. This can be

attempted by models like Discriminanant factor modeling and more efficient

Decision.

2.3 Management of credit risk:

The management of credit risk should receive the top management’s

attention and the process should encompass: 

a. Measurement of  risk through credit rating/scoring;

b. Quantifying the risk through estimating expected loan losses.

c. Design and development of support systems for risk assessment

&monitoring.

d. Assisting CRMC and carrying out its directions.

e. Risk pricing on a scientific basis; and

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f. Controlling the risk through effective Loan Review Mechanism and

portfolio management.

The credit risk management process should be articulated in the bank’s

Loan Policy, duly approved by the Board. Each bank should constitute a

high level Credit Policy Committee, also called Credit Risk Management

Committee or Credit Control Committee etc. to deal with issues relating to

credit policy and procedures and to analyze, manage and control credit risk

on a bank wide basis. Each bank should also set up Credit Risk Management

Department (CRMD), independent of the Credit Administration Department.

The CRMD should enforce and monitor compliance of the risk parameters

and prudential limits set by the CPC. The CRMD should also lay down risk

assessment systems, monitor quality of loan portfolio, identify problems and

correct deficiencies, develop MIS and undertake loan review/audit. Large

banks may consider separate set up for loan review/audit. The CRMD should

also be made accountable for protecting the quality of the entire loan

portfolio.  The Department should undertake portfolio evaluations and

conduct comprehensive studies on the environment to test the resilience of

the loan portfolio.

Components of credit risk management:

A typical Credit risk management framework in a financial institution may be

broadly categorized into following main components.

a) Board and senior Management’s Oversight

b) Organizational structure

c) Systems and procedures for identification, acceptance, measurement,

Monitoring and control the risks.

a) Board and senior Management’s Oversight:

It is the overall responsibility of bank’s Board to approve bank’s credit risk

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Strategy and significant policies relating to credit risk and its management

which is based on the bank’s 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

include:

Ensure that bank’s overall credit risk exposure is maintained at prudent

managing credit risk

Ensure that top management as well as individuals responsible for credit

risk management

Ensure that appropriate plans and procedures for credit risk management

are in place

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. Such policies and procedures shall provide

guidance to the staff on various types of lending including corporate, SME,

consumer, agriculture, etc.

b) Organizational structure:

The sound risk management structure of the organization should be perfect.

The banks may choose different structures depending upon the institution’s

size, complexity and diversification of its activities... It must facilitate

effective management control process.

The ‘CRMC’ (Credit Risk Management Committee) should be mainly

responsible for,

The implementation of the credit risk policy / strategy approved by the

Board.

Recommend to the Board, for its approval, clear policies on standards for

presentation of credit proposals, financial covenants, rating standards and

benchmarks.

Establish systems and procedures relating to risk identification,

management Information System, monitoring of loan / investment portfolio

21

quality and early warning. The department would work out remedial

measure when deficiencies/problems are identified.

c) Systems and procedures..:

Systems and procedures are for identification, acceptance, measurement,

monitoring and control risks. Banks must operate within a sound and well-

defined criteria for new credits as well as the expansion of existing credits.

Credits should be extended within the target markets and lending strategy

of the institution.

Before allowing a credit facility, the bank must make an assessment of risk

profile of the customer/borrower transaction. This may include;

Credit assessment of the borrower’s industry, and macro economic factors.

The purpose of the credit and source of repayment.

The track record / repayment history of borrower.

Assess/evaluate the repayment capacity of the borrower.

Adequacy and enforceability of collaterals.

Approval from appropriate authority.

While structuring the credit facilities, institutions should appraise their

amount and timing of the cash flows as well as their financial position.

Management Information System (MIS):

The MIS has vital role in the every organization. Information flow is a key

to successful credit risk process. Collecting accurate data in a timely

manner is the biggest challenge. Since the bank has achieved 100%

computerization in spite of large network of branches. It is easy to receive

data from all the branches on a fortnightly basis. Information flow in Andhra

bank is available, adequate and expedient

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Andhra Bank has constituted “Credit Risk Management Committee” for

analyzing all issues relating to credit matters and for recommending to the

Board.

The BASEL committee set up by BIS (Banks for International Statements)

has been urging banks to set up internal systems to measure & manage

credit risk objectively. BASEL II recommendations, has become regulatory

requirements for tight risk management practices and reporting by banks.

The successful management of credit risk requires a clear understanding

about risks involved in lending and managing the risk. The thing is only how

we managing the risk. The good management of risk will improve efficiency

of banks portfolio.

PRUDENTIAL NORMS OR LOAN POLICY OF

BANK

The effective credit risk management framework will influence in framing of

loan policy guidelines of the Bank. Loan Policy Guidelines of the bank facilitate

the dealing officials at controlling offices and branches to clearly understand

bank's approach for credit sanction and credit risk policies approved by Board to

comply themselves with established policies and procedures. The Bank should

frame well defined loan policy guidelines to the credit structure. These

guidelines should be reviewed at regular intervals by the credit departments at

head office.

Loan policy:

For a long time “Loan & credit policy of the banking industry” was determined

by Reserve Bank of India. Consequent to the financial reforms initiated by the

Govt. of India, Reserve Bank of India has started extending freedom to all banks

23

to decide their own loan policy. RBI has issued broad guidelines on few

parameters which are to be observed by the banks while formulating their own

loan policy

Objectives of Loan Policy:

The underlying objective of drafting the loan policy is to:-

Improve the credit off take of the Bank and maximize profits.

Ensure that there is a balanced growth of credit. Lopsided growth of

credit to any particular sector of economy/segment of borrower is not

desirable and needs to be avoided.

Ensure that the loan policy of the Bank is competitive and flexible in

relation to other banks so as to attract and bring good corporate/non-

corporate borrowers into our fold.

continue to maintain thrust to priority sector advances in consonance /

agreement with Govt. of India /Reserve Bank of India guidelines, and

Ensure that the quality of credit is sound and the Bank is not exposed to

avoidable and unwarranted risks.

Statutory & Regulatory Exposure Norms of RBI:

Reserve Bank of India advised that each bank should fix its own prudential

exposure limits within the overall exposure limits fixed by them. Fixing of

exposure limits to different industries/sectors has been left to the discretion of

individual banks. Each bank has to fix its own exposure limit, basing on its

experience and risk perception. Thus, fixing of exposure limits, to limit the

concentration of risk has become an important aspect of credit risk

management.

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CHAPTER-III

3.0 CREDIT INVESTIGATION

Introduction:

When ever credit requests are to be considered, it is necessary to conduct a

credit investigation before taking up such case for evaluation. This process of

preliminary study needs to be undertaken invariably before detailed

evaluation.

Importance of Credit Investigation:

25

Sanction of credit limits to a new borrowing entity involves thorough

investigation of management, industry & unit, Financial and operational risk

factors. In this direction the first step is pre sanction unit inspection, which

brings to light several adverse features like poor industrial relations,

interrupted production, poor maintenance of plant & machinery etc. it will help

to assessing the credit worthiness of the prospective borrower and credit risk

involved in the proposal.

The new emerging concept, being followed by few banks is “Credit

Investigation and Compilation of Credit Report” as a preliminary study, which

unfolds valuable information on integrity / truthfulness, honesty, reliability,

creditworthiness, financial status , capacity, experience, of prospective

borrower, associate concerns and guarantors, Market reports, details of the

project and performance of the industry etc. The reports serve as preliminary

information about the prospective borrower before detailed evaluation is

undertaken.

Purpose:

The Credit Investigation report serve as the basis for taking a decision for

entertaining the proposal for detailed evaluation, appraisal and approval by

the sanctioning authority.

Reporting: Credit Investigation Officers shall submit Credit Investigation

Reports directly to Credit Monitoring & Review Dept (CM & RD) at HO.

Credit investigation shall be conducted by the Credit Investigation Officers.

3.1 CREDIT APPRAISAL / EVALUATION

Introduction:

The appraisal/evaluation stage begins after the Bank has undertaken a

thorough credit investigation on the constituent and is satisfied about his

integrity, reputation and creditworthiness. The credit investigation process shall

give comfort/confidence to the Bank to go ahead with the Appraisal/evaluation

process. Here bank should analyze ‘ownership and management’ of the

organization.

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The appraisal / evaluation process involves evaluating the various parameters

like background of promoters, purpose of the credit, financial position,

requirement of credit , repayment of capacity, security, guarantee etc.,

Security/Guarantee standards:

Repayment capacity of the borrower shall be the prime consideration while

evaluating the proposal. Security and guarantee offered by the borrower shall

be considered as secondary source of repayment. The assets acquired out of

Bank finance shall regularly be taken as primary security for the entire

exposure. Credit facilities extended to limited companies shall normally be

supported by the personal guarantee of promoter-directors.

Management and Organizational set up:

The Bank shall assess the quality of Management/Board and ensure that

Directors having good knowledge and experience in different spheres of

business activity represent the Board. The organizational set up shall be in tune

with the business needs and facilitate smooth and efficient working and the

management of key functions may rest with professionals.

Production facilities, market prospects and selling arrangements:

The Bank shall review the performance of the industry/sector, study the

demand-supply position of the product/service and take into account the scope

for creation of additional capacities. The Bank shall also ascertain the names of

major players in the industry/the borrower’s position/market share/advantages

enjoyed, in relation to other players in the industry etc. The Bank shall look into

the availability of all infrastructure facilities, forward and backward linkages for

ensuring efficient operations.

Exposure norms:

While appraising a proposal, the Bank shall ensure that all exposure norms

relating to individual/group, industry, sector, maturity, rating etc. are complied

with.

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Risk rating and pricing of the exposure:

The Bank shall undertake a SWOT analysis of the proposal and identify major

strengths, weaknesses, opportunities, threats / risk factors that may affect the

performance of the borrower leading to decline of the quality of the exposure.

The borrower’s capabilities to mitigate these risks shall be assessed.

The Bank shall gradually cover the entire portfolio under rating framework to

adopt RAROC methodology for pricing and allocation of capital for each credit

exposure.

Recommendations:The appraisal memorandum shall contain specific recommendations as whether

to approve / not to approve the credit facilities. The recommendations for approval

of credit exposure shall include the extent of credit facilities proposed, purpose, security,

margin, rate of interest, commission, repayment, tenor of bills, guarantors etc.

Other general guidelines:

The approval note for new credit proposals, review existing credits / previously

approved credits / prepared formats by the bank.

3.3 RISK RATING:

Risk rating also known as credit risk rating system. This is the account and

assessment of borrower exposure. The ratings are based on the current

information provided by the issuer. And it involves in various risk factors that

influence the credit worthiness of the entity.

Banks should have a comprehensive risk scoring / rating system that serves as

a single point indicator of diverse risk factors of counterparty and for taking

credit decisions in a consistent manner.  To facilitate this, a substantial degree

of standardization is required in ratings across borrowers.  The risk rating

system should be designed to reveal the overall risk factor of lending, critical 28

input for setting pricing and non-price terms of loans as also present

meaningful information for review and management of loan portfolio.  The risk

rating, in short, should reflect the underlying credit risk of the loan book. The

rating exercise should also facilitate the credit granting authorities some

comfort in its knowledge of loan quality at any moment of time. 

 The risk rating system should be drawn up in a structured manner,

incorporating, inter alia, financial analysis, projections and sensitivity,

industrial and management risks.  The banks may use any number of financial

ratios and operational parameters and collaterals as also qualitative aspects of

management and industry characteristics that have bearings on the

creditworthiness of borrowers. Within the rating framework, banks can also

prescribe certain level of standards or critical parameters, beyond which no

proposals should be entertained. Banks may also consider separate rating

framework for large corporate / small borrowers, traders, etc. The overall

score for risk is to be placed on a numerical scale ranging between 1-6, 1-8,

etc. on the basis of credit quality.  For each numerical category, a quantitative

definition of the borrower, the loan’s underlying quality, and an analytic

representation of the underlying financials of the borrower should be

presented. Further, as a prudent risk management policy, each bank should

prescribe the minimum rating below which no exposures would be undertaken.

Any flexibility in the minimum standards and conditions for relaxation and

authority for that reason should be clearly articulated in the Loan Policy.

External risk rating:

Based on the Basel committee guidelines, RBI prescribed that the loan

exposure above 5 crores, such exposure is rated by any of the recognized

credit rating agencies, the risk weights applicable varies with ratings of the

exposures. RBI has recognized domestic rating agencies such as CRISIL,

CARE, ICRA, and FITCH as the eligible rating agencies whose ratings can be

used by the banks. CRISIL is the first rating agency in India. Here a better

rated (low risk) borrower exposure shall attract lower capital and a poorly

rated (high risk) borrower exposure shall attract higher capital to be

maintained by the banks. And unrated borrowel exposure accounts shall 29

attract higher capital. For the purpose of risk weighting of credit under the

Basel II norms for capital adequacy, the external rating proves to be crucial.

 Internal risk rating:

Credit risk rating is summary indicator of a bank’s individual credit exposure.

An internal rating system categorizes all credits into various classes on the

basis of underlying credit quality. A well-structured credit rating framework is

an important tool for monitoring and controlling risk inherent in individual

credits as well as in credit portfolios of a bank or a business line. The

importance of internal credit rating framework becomes more eminent due to

the fact that historically major losses to banks stemmed from default in loan

portfolios. While a number of banks already have a system for rating individual

credits in addition to the risk categories prescribed by SBP, all banks are

encouraged to devise an internal rating framework.

An internal rating framework would facilitate banks in a number of ways such

as

a) Credit selection

b) Amount of exposure

c) Tenure and price of facility

d) Frequency or intensity of monitoring

e) Analysis of migration of deteriorating credits and more accurate

Computation of future loan loss provision

f) Deciding the level of Approving authority of loan.

Managing credit risk

3.4 Credit Risk 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

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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 standardize and uniformly communicate the “judgment” in credit

selection procedures and are not a substitute to the vast lending experience

accumulated by the bank’s professional staff. 

Broadly, CRF can be used for the following purposes:

a. Individual credit selection, wherein a borrower or a particular exposure /

facility is rated on the CRF.

b. Pricing (credit spread) and specific features of the loan facility. This would

largely constitute transaction-level analysis.

c. Portfolio-level analysis.

d. Surveillance, monitoring and internal MIS

Sample / Model for Credit risk-Rating Framework:

The credit risk-rating framework evaluates the various risk factors as

follows...

Credit risk for counterparty arises from an aggregation of the following

categories:

a) External risk

sector risk (including government policies)

b) Internal risk with respect to counterparty

Management Risk

Industry or Business Risk

Financial Risk

Project Risk

Above any risk rating model would need to evaluate each of the above

risks individually and aggregate the same to arrive at an overall rating

measure.

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1. Evaluation of management risk factors:

Evaluation of management risk would involve in Assessment of

management capability in terms of

Track record of the management

Quality of the management personnel

Payment record with banks

Market standing/credibility

Support from group companies

Management reputation, talent, plan and succession

The overall score on management would be arrived at by aggregation of

the individual scores on these parameters selected.

2. Evaluation of Industry and business risk factors:

The business position of a company is a function of its relative positioning

within the industry/sector. It would be determined by its market position

and operating efficiencies in terms of

Industry cycle

Competition to the industry

Using the technology by the industry

Regulatory position

Suitable parameters, relevant to the industry/sector in which the company

is operating may be selected for evaluation of the same.  The parameters

may be suitably scored based on the relative strength of the company being

rated in relation to competitors in the industry. The scores may be

aggregated to arrive at an overall business score.

3. Evaluation of financial risk factors:

Evaluation of financial risks could typically involve in

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Analysis of past financials

Operating margins, interest cover, contingent liabilities, and auditor

comments on companies balance sheet etc

Profit after tax before tax and net sales

Analysis of future cash flows including projected profitability

Flexibility to raise required resources

Strength of sponsor group

Projected or predictable leverage

Past financial reports

The parameters may be suitably scored and aggregated to arrive at the

financial risk score.

4. Evaluation of project risk factors:

Projects of significant size impact the risk profile of a company (even if

existing operations are satisfactory). Analysis of project risks would

involve

Determination of size of project in relation to existing net worth

Assessment of implementation risk

Technology / stabilization risks

Risks related to statutory clearances

Assessment of funding risks

Assessment of post-implementation risks such as market, company’s

business position etc.

The overall score on project would be arrived by aggregation of the

individual scores on final score.

The rating will also enable you to understand the risk inherent in your

business and take suitable steps to mitigate those risks

Advantages of risk rating:

33

Risk rating is a source of variable information to the investors. Those are

briefly…

Independent evaluation:

The rating of financial institutions is done by an independent

institution. No need depend on financial intermediaries for information

on their investment.

Low cost information:

The investors receive rating information with out any extra cost. The

expenses of rating are accepted by the company whose securities are

being rated.

Quick investment decisions:

The investors can take quick investment decisions as the rating is done

by assigning easily understandable symbols.

Benefits to companies:

It improves its image in the eyes of the investors. Credit rating also

encourages financial discipline in the company.

Also companies can use rating as marketing tool to improve their

image investors, lenders, customers and creditors.

3.5 Rating guide:

The risk rating guide shows score and risk rating symbols for applicable rate

of interest getting the marks secured from the overall risk parameters. This

rating guide used by banks prepared by their individual rating guide of bank.

The Rating Guide in Andhra Bank:

Risk Rating Guide:

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SCORES DESCRIPTION

5.4 & above

A++ Indicates an exceptionally high position of strength. Very high degree of sustainability.

4.9-5.39 A+ Indicates a high degree of strength among the peer group. High sustainability.

4.2-4.89 A Indicates a moderate degree of strength with positive outlook.

3.6-4.19 B++ Indicates a moderate degree of strength with stable outlook.

3.0-3.59 B+ Indicates a moderate degree of strength with marginally negative outlook.

2.4-2.99 B Indicates a weakness in comparison to peers. Unstable outlook.

< 2.4 C Indicates a fundamental weakness. Unlikely to improve under normal circumstances.

0 D Defaulter.

CREDIT RISK MITIGATION TECHNIQUES

Banks use number of techniques to mitigate the credit risks to which they are

exposed. While banks use credit risk mitigation techniques (CRM) to reduce

their credit risk. These techniques give rise to risks that control the overall risks

less effective. Various measures will influence involved in minimize the risk for

bank like study about credit worthiness of the counter party, track record,

35

dealing with other banks, credit quality, and market demand for the business

etc. the new capital adequacy provide to banks new rules on credit risk

mitigation and to examine techniques which may serve to reduce a bank's

capital requirements.

1988 accord was (Basel-1) relatively limited in its scope and application. Then

the Basel II offers a stark contrast and adopts a radically different approach. In

line with its overall purpose, the document takes account of the techniques open

to banks to secure their exposures and is thus much more "risk-sensitive" in that

respect. On the other hand, it imposes detailed requirements designed to ensure

that the use of such techniques is soundly based in each case.

Number of techniques are used by banks to mitigate the credit risks to which

they are exposed. For example, exposures may be collateralized in whole or in

part by cash or securities, deposits from the counterparty, guarantee of third

party, etc.

Legal Certainty: In order to obtain/gain capital relief for any use of CRM

techniques, the minimum standards for legal documentation must be met. All

documentation used in collateralized transactions and guarantees must be

binding on all parties and legally enforceable in all relevant jurisdictions. Banks

must have conducted sufficient legal review, which should be well documented,

to verify this.

The security must be legally effective and enforceable in all relevant

jurisdictions. Also, the financial undertaking must take any and all measures

required to ensure the effectiveness of its credit risk mitigation and to limit the

risks inherent in it.

Mitigation Techniques:

Collateralized transactions; this is the main technique to mitigate the credit

risk exposure in the mitigation techniques. It gives something more secure than

primary security. For example primary security for a manufacturing company

like hypothecation of stocks of raw materials, work in progress, finished goods,

36

stores spares, and other current assets etc. but collateral security is more than

that charge on the fixed assets, guarantees of borrowers etc.

i. Banks have a credit exposure and that credit exposure is hedged in whole or in

part by collateral posted by counterparty or by a third party on behalf of the

counterparty. Here, banks have a credit exposure or a potential exposure, and

ii. Banks have a specific lien on the collateral and the requirements of legal

assurance are met.

The revised frame work allows banks to adopt either the simple approach, which

related to the 1988 Accord, substitutes the risk weighting of the collateral for

the weighting of the counterparty for the collateralized portion of the exposure.

(Generally subject to a 20% floor), or   for  the comprehensive  approach,  which

allows  fuller  offset  of  collateral  against  exposures,  by effectively reducing

the exposure amount by the value approved to the collateral. Banks in India

shall adopt the comprehensive approach, which allows fuller equalize of

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

value approved to the collateral.

In order for collateral to provide protection, the credit quality of the

counterparty and the  value  of  the  collateral  must  not  have  a  material

positive  correlation.  For example, securities issued by the counterparty? Or by

any related group entity? Would provide little protection and so would be

ineligible.

Banks must have clear and robust procedures for the timely liquidation of

collateral to ensure that any legal conditions required for declaring the default

of the counterparty and liquidating the collateral are observed, and that

collateral can be liquidated promptly.

Where the collateral is held by a custodian, banks must take reasonable steps to

ensure that the custodian segregates the collateral from its own assets.

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The following have been identified by Reserve Bank of India as Eligible

Financial Collateral in the New Capital Adequacy Framework:

Eligible financial collateral:

The following collateral instruments are eligible for recognition in the

comprehensive approach.

i. Cash (as well as certificates of deposits or comparable instruments,

including fixed deposit receipts, issued by the bank) on deposit with the

bank.

ii. Gold: gold would include both bullion and jewelry.

iii. Securities issued by central and state Govt’s.

iv. Life insurance polices with a declared surrender value of an insurance

company.

v. Equities (including convertible bonds) that are listed on a recognized stock

exchange and are included following indices: BSE of the Bombay Stock

Exchange, NIFTY of the National Stock Exchange and the main index of

any other recognized stock exchange, in the jurisdiction of banks

operation.

vi. Units of Mutual Funds regulated by the securities.

vii. Debt securities rated and not rated by a chosen Credit Rating Agency in

respect of which the banks should be sufficiently confident about the

market liquidity.

Though physical collaterals such as land, buildings etc also act as effective credit risk mitigants, they

do not qualify for capital adequacy computation under Basel II framework.

Guarantees:

Where guarantees are direct, explicit, irrevocable and unconditional banks

may take account relating to risk management processes of such credit

protection in calculating capital requirements.

A range of guarantors are recognized. As under the 1988 Accord, a

substitution approach will be applied. Thus only guarantees issued by

entitles with a lower risk weight than the counterparty will lead to reduced

38

capital charges since the protected portion of the counterparty exposure is

assigned the risk weight of the guarantor, where as the uncovered portion

retains the risk weight of the underlying counterparty.

The brief details about operational requirements for guarantees eligible for

being treated as a CRM are

Operational requirements for guarantees

A guarantee must represent a direct claim on the protection provider and

must be explicitly referenced to specific exposures or a pool of exposures,

so that the extent of the cover clearly defined and incontrovertible or not

disputed or unclear. The guarantee must be irrevocable (not able to be

changed); the guarantee must also be unconditional; there should be no

clause in the guarantee outside the direct control of the bank.

All exposures will be risk weighted after taking into account risk

mitigation available in the form guarantees. When a guaranteed exposure

is classified as non-performing, the guarantee will cease to be a credit risk

mitigant and no adjustment would be permissible on account of credit risk

mitigation in the form of guarantees. The realizable value of eligible

collateral / credit risk mitigants will attract the appropriate risk weight.

LOAN MONITORING AND REVIEW MECHANISM

Loan monitoring review mechanism is an effective tool for constantly evaluating

the quality of loan book and to bring about qualitative improvements in credit

administration. Banks should, therefore, put in place proper Loan Review

Mechanism for large value accounts with responsibilities assigned in various

areas such as, evaluating the effectiveness of loan administration, maintaining

the integrity of credit grading process, assessing the loan loss provision,

portfolio quality, etc.  The complexity and scope of LRM normally vary based on

banks’ size, type of operations and management practices.  It may be

independent of the CRMD or even separate Department in large banks. 

The main objectives of LRM or credit audit could be:

39

To identify promptly loans which develop credit weaknesses and initiate

timely corrective action

To evaluate portfolio quality and isolate potential problem areas

To provide information for determining adequacy of loan loss provision

Improvement in the quality of credit portfolio

Review sanction process & compliance status of large loans

Pick-up early warning signals and suggest remedial measures

Recommend corrective action to improve credit quality, credit

administration and credit skills of staff

To provide top management with information on credit administration,

including credit sanction process, risk evaluation and post-sanction

follow-up.

Accurate and timely credit grading is one of the basic components of an

effective LRM.  Credit grading involves assessment of credit quality,

identification of problem loans, and assignment of risk ratings.  A proper Credit

Grading System should support evaluating the portfolio quality and establishing

loan loss provisions. Given the importance and subjective nature of credit rating,

the credit ratings awarded by Credit Administration Department should be

subjected to review by the Loan Review Officers who are independent of loan

administration. 

Banks should formulate Loan Review Policy and it should be reviewed annually

by the Board.  The Policy should, inter alia, address:

Qualification and Independence:

The Loan Review Officers should have sound knowledge in credit appraisal,

lending practices and loan policies of the bank.  They should also be well versed

in the relevant laws/regulations that affect lending activities.  The independence

of Loan Review Officers should be ensured and the findings of the reviews

should also be reported directly to the Board or Committee of the Board.

Frequency and scope of reviews:

40

The frequency of review should vary depending on the magnitude of risk (say,

for the high risk accts – 3 months, for the average risk accts – 6 months, for

the low risk accts – 1 year

Examine adequacy of polices, procedures and practices

Review the credit risk assessment methodology

Examine reporting system

Recommend corrective action for credit administration and credit skills

of staff

Forecast likely happenings in the near future

The Loan Reviews are designed to provide feedback on effectiveness of credit

sanction and to identify incipient deterioration in portfolio quality.  Each

account required to be audited is subjected to audit within a period of 3 to 6

months of its sanction/enhancement/renewal.

Depth of Reviews:

The loan reviews should focus on:

Appraisal

Approval process

Accuracy and timeliness of credit ratings  assigned by loan officers

Post-sanction follow-up;

Portfolio quality

Supervision

Monitoring & Control

Early warning signals and

Recommendations for improving portfolio quality

The findings of Reviews should be discussed with line Managers and the

corrective actions should be elicited for all deficiencies.  Deficiencies that

remain unresolved should be reported to top management

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CAPITAL TO RISK- WEIGHTED ASSETS RATIO’: (CRAR)

The concept of CRAR (Capital to Risk Weighted Assets Ratio) it also called as

CAR ‘Capital Adequacy Ratio’ in Basel-II guidelines. This is played important

role in the banking system. CAR is indirectly protects the banks Depositors and

other lenders.

It is a ratio of a bank's capital to its risk weighted assets. It is a measure of the

amount of a bank's capital expressed as a percentage of its risk weighted credit

exposures.

‘This ratio is used to protect depositors and promote the stability and efficiency

of financial system around the world.’

Why do financial institutions need to hold capital?

Here lenders are financial intermediaries, taking funds from savers and lending

them on to borrowers. Given the risk that some borrowers will be unable to

repay their loans, so lenders need capital of their own to protect their depositors

(the savers) from the risk of losing money. Thus capital acts as a cushion to

absorb unexpected losses.

Risk weighting:

Different assets on a banks balance sheet carry different risks. Non risky items

are such as cash, gold, and government bonds have 0% risk weight. Riskier

items carry a higher risk, for e.g. mortgages are weighted at 50%, lending to

companies is 100%

A minimum 9% of risk weighted assets must be met by Tier -1 and Tier -2

capital. Capital adequacy ratio is the ratio which determines the capacity of the

bank in terms of meeting the time liabilities and other risk such as credit risk,

operational risk, etc. In the simplest formulation, a bank's capital is the "cushion

/ buffer" for potential losses, which protect the bank's depositors or other

lenders. Banking regulators in most countries define and monitor CAR to protect

depositors, thereby maintaining confidence in the banking system.

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Banks are also generally concerned with their own ‘economic capital’. This is

the banks own assessment of the capital required to support the business which

may be affected by a number of factors. Traditionally this is said to provide

insurance against unexpected losses ( that may arise from difficulties)

Types of capital:

The calculation of capital (for use in capital adequacy ratios) requires some

adjustments to be made to the amount of capital shown on the balance sheet.

There are two types capital to measure

1. Tier I Capital: which is available to absorb losses from actual contributed

equity plus retained earnings, and from undisributed amounts to share

holders.

2. Tier II Capital: This generally absorbs losses from only in the event of

winding–up of a bank. And so provides a lesser degree of protection for

depositors and other creditors.

Formula for capital Adequacy Ratio is as follows:

Capital (Tier I + Tier II)

RWA of Credit risk + RWA of Market risk + RWA of Operational risk

RWA: Risk Weighted Assets

Under Basel II, the banking institutions must hold total capital equal to atleast 9% of risk-weighted

assests.

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CHAPTER-IV

4.0 BASEL COMMITTEE

The Basel Committee on Banking Supervision, a group of banking supervisors

whose secretariat is based at the Bank for international settlements in Basel, at

Switzerland.

The New Basel Accord forces banks to adopt sophisticated risk management

techniques especially with regard to credit risk. Credit risk competition is now

based on the certain statistical models. Banks need to manage the credit risk

inherent in the entire credit portfolio as well as risk in individual credit and

transaction.

While risk management is very important tool for banks in view of the

multiplicity of the risks they faced and their interdependence. Will the banks

become less procyclical if risk management improves? The answer is yes. Basel-

44

II requires banks to increase capital if loans get riskier. But banking system

overall will be better capitalized and hence, less vulnerable to cyclical shocks.

However, badly capitalized banks that have not assessed their risk properly will

certainly face problems.

Basel-2 therefore, provides an incentive for better risk management. It also

contains excellent tools for risk management and measurement as well.

About the Basel Committee:

Basel-I was released by the Basel committee in July 1988. These guidelines are

adopted in India as part of the financial sector and implemented in a phased

manner starting from the year 1992-93. Basel-2 was released in 2004.

The 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 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-

45

committees, it stands ready to give advice to supervisory authorities in all

countries. Mr. Stefan Walter is the Secretary General of the Basel Committee.

4.1 Main Expert Sub-Committees

The Committee's work is organized under four main sub-committees (organization chart):

The Accord Implementation Group

The Policy Development Group The Accounting Task Force The International Liaison Group ( This is newly established group)

4.2 Basel-I:

Basel-I was released by the Basel committee in July 1988. This frame work

implemented in India in 1992 in a phased manner, pursuance to the

recommendations of ‘Narasimham Committee’. Basel I covered only ‘Credit

Risk’ in the Bank’s operations.

The basic differences between Basel-I & Basel-II

Basel-I:

1) Banks are required to maintain capital only for credit risk.

2) Uniform risk weights are prescribed for various types of exposures.

Banks are required to use the same risk weights irrespective of the quality

of the portfolios. This made the accord risk non-sensitive.

3) No capital charge for Operational Risk.

4.3 Basel-II:

1) Banks have to maintain capital for Credit Risk, Market Risk, &

Operational Risk also.

2) Risk weights depend on the quality or the portfolios. Risk weights are to

be decided based on the credit rating by approved External Credit Rating

agencies such as CARE, CRISIL, FITCH or ICRA .

3) Banks have to maintain capital charge for operational risk too. And it is

revised frame work on banking supervision.

46

4.4 Limitations of Basel-I:

There is a historical backdrop in Basel-1 committee’s capital measurement

system frame work. And the banking industry has changed in many ways,

since Basel-1 was implemented in 1988. Two specific changes in the

expanded use of securitization and derivatives in secondary markets and

vastly improved risk-management systems in banks. Basel-1 has become

outdated. Basel-1 limitations are like...

In assessing ‘Credit Risk’ no distinction between ‘AAA’ rated borrower or

‘C’ grade borrower i.e., Risk weights are uniformly assigned without any

link to grading of the borrower;

Only ‘Credit Risk and Market Risk’ are addressed, whereas all other types

of risks inherent in Banking Operations ignored. (Examples of risks

ignored – Operational Risk, Liquidity Risk, Credit concentration risk,

interest rate risk etc.)

Since 1988, the emergence of innovative financial products such as

‘Securitization, ‘Credit derivates’ etc. did not find place in capturing risks

involved in them.

4.5 Why is Basel-II necessary?

Why the need for Basel-II? For the purpose of …

Assignment of credit risk weights under Basel-I is crude- Basel-II aims

to make capital requirements more risk sensitive.

Basel-I only acts for credit risk and market risk, but Basel-II includes

operational risk and other risks also.

Many of the banking supervisors around the world believed that the current

capital regime must be replaced by a more risk sensitive regime due to

emergence of complex banking institutions, newer financial products and

globalization of the financial institutions. In view of the limited number of the

risk weight buckets under the current accord, there is every possibility that

banks may not be keeping adequate capital commensurate with the risk ness

of their balance sheet. Besides, the risk measurement and management

systems in banks have improved significantly since implementation of Basel-I

47

and the banking industry, the world over, has developed newer techniques to

improve risk assessment and risk management.

Basel-II builds on the current Accord to align regulatory capital requirements

more closely with underlying risks and to provide banks and their supervisors

with several options for assessment of capital adequacy. It attempts to educe

the gap between economic capital and regulatory capital. Basel-II is based on

three mutually reinforcing pillars- minimum capital requirements,

supervisory review, and market discipline. When implemented, Basel-II would

go a long way in making the capital allocation in banks more risk-sensitive

with market discipline would reinforce the supervisory framework and ensure

financial stability.

The RBI is fully committed to implement the best international practices.

India’s policy approach is that external perception about India conforms to

best international standards is positive and is in India’s favor. It is this

background that the Reserve Bank has decided to implement Basel-2 in India.

4.6 Basel- II :

In January 2006 the ‘Basel Committee on Banking Supervision’ issued for a

proposal for a New Basel Capital Accord (better to known as Basel-II)

Basel II is the second of the Basel Accords, which are recommendations on

banking laws and regulations issued by the Basel Committee on Banking

Supervision. The purpose of Basel II, which was initially published in June

2004, is to create an international standard that banking regulators can use

when creating regulations about how much capital banks need to put aside to

guard against the types of financial and operational risks banks face. This

Revised Framework ("Basel II") Basel II is designed to replace the Basel

Capital Accord of 1988 (the "1988 Accord").

Basel- II has been designing a much more risk sensitive regulatory frame work

that takes into account the recent developments in risk management

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techniques. This frame work, which currently under development is known as

the second Basel Accord or more commonly as Basel- II frame work. 1988

Accord have been retained. For example, the definition of eligible capital and

the requirement for banks to hold own funds equivalent to at least eight per

cent of their risk-weighted assets are notable survivors of the 1988 Accord. It

was nevertheless necessary radically to revise the 1988 Accord, partly because

of rapid developments in the financial markets themselves and partly because

the risks faced by banks have become more clearly understood. Thus, for

example, whilst the composition of capital and the eight per cent figure remain

essentially intact, the risk-weighting of assets will become a much more

sophisticated process. Furthermore, whilst the 1988 Accord focused essentially

on credit risk, Basel II adopts a much broader approach to a variety of other

potential threats to a bank's capital base. Generally speaking, these rules mean

that the greater risk to which the bank is exposed, the greater the amount of

capital the bank needs to hold to safeguard its solvency and overall economic

stability.

The main Objectives of New Basel Capital Accord or Basel-II:

A. Ensuring that capital allocation is more risk sensitive

B. Separating operational risk from credit risk, and quantifying both

C. To provide an overview of the new capital adequacy system

D. Establishing an appropriate credit risk environment.

E. Operating under a sound credit-granting process.

F. Maintaining an appropriate credit risk administration, measurement and

monitoring process.

G. Ensuring adequate controls over credit.

H. To provide an explanation of the new rules on credit risk mitigation and to

examine techniques serve to reduce a bank's capital requirements.

I. Attempting to in correct economic and regulatory capital more closely to

reduce the scope for regulatory arbitrage, and

J. To introduce greater risk sensitivity into the calculation of the amount of

capital that a bank needs to hold.

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4..7 BASEL II FRAME WORK :

Basel committee on banking supervision issued new proposal for a new Basel

Capital Accord (Basel-2) will replace the current 1988 Capital Accord. It was

announced in June, 2004.

The New Capital Accord of frame work is based on three (3) reinforcing pillars

that allow banks and supervisors to evaluate properly the various risks that

banks face.

Basel- II rests on three "pillars" are:

1. Minimum capital requirement (addressing risk)

2. Supervisory review process, and

3. Market discipline (To promote greater stability in the financial system.)

Pillar I - Minimum capital requirement:

This pillar relates to, to maintain capital requirement allocation not only for

credit risk, also operational risk, and market risk. Operational risk was not

covered in the previous accord.

Approaches to all risks, 50

Standardized Approach for ‘Credit Risk’

Standardized Duration Approach for ‘Market Risk’ and

Basic Indicator Approach for ‘Operational Risk’

Approaches to study capital requirements of credit risk in new accord as follows

briefly…

Standardized Approach and Internal Ratings Based Approach (IRB). This

IRB approach is classified into Foundation and Advanced Approaches.

Under Standardized Approach, preferential risk weights in the range of 0%,

20%, 50%, 100%, and 150% would be assigned on the basis of rating given by

external credit assessment institutions banks have to calculate the Risk Weight

Assets based on the assessment given by external credit assessment institutions

(ECAIs) for claims authority. The External Credit Rating Agencies like:

Domestic credit rating agencies identified by RBI

a. Credit Analysis and Research Limited (care)

b. CRISIL Ltd.c. FITCH India.d. ICRA Ltd.

International credit rating agencies identified by RBI

a. Fitch

b. Moody’sc. Standard and poor

In this Standardized Approach weights would be prescribed by Central Bank

(RBI in India) and would be adopted by the Banks without any discretion to

modify. This approach is based on ratings from ‘External Credit Rating

Institution’ (ECRI) for Sovereigns Bank and ‘Corporates’. This approach is very

suitable to credit risk. For the approach preferential risk weights in the range of

0%, 20%, 50%, 100% and 150% would be assigned on the basis of ratings given

by external credit assessment institutions.

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Under IRB Approach Committee proposes two approaches – foundation and

advanced - as an alternative to standardized approach for assigning preferential

risk weights.

Under the foundation approach, banks, which comply with certain minimum

requirements viz. comprehensive credit rating system with capability to quantify

Probability of Default (PD) could assign preferential risk weights, with the data

on Loss Given Default (LGD) and Exposure at Default (EAD) provided by the

national supervisors.

In order to qualify for adopting the foundation approach, the internal credit

rating system should have the following parameters/conditions are briefly…

Each borrower within a portfolio must be assigned the rating before a loan

is originated.

Each individual rating assignment must be subject to an independent review or approval by the Loan Review Department

Rating must be updated at least on annual basis.

The Board of Directors must approve all material aspects of the rating and PD estimation.

Internal and External audit must review annually, the banks’ rating system including the quantification of internal ratings.

Banks should have individual credit risk control units that are responsible for the design, implementation and performance of internal rating systems. These units should be functionally independent.

Members of staff responsible for rating process should be adequately qualified and trained.

Banks must have a credible track record in the use of internal ratings at least for the last 3 years.

Under the advanced approach, banks would be allowed to use their own

estimates of PD, LGD and EAD, which could be validated by the supervisors.

Pillar II- ‘Supervisory Review Process’:

Supervisory Review Process also known as ‘Supervisory Regulatory Review

Process’ under pillar-2. This necessitates Banks to develop or makes certain

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that each bank has an Internal Capital Adequacy Assessment Process (ICAAP)

to effectively assess the adequacy of its capital and evaluate risks.

Under ‘Supervisory Review Process’, the Supervisors (say RBI) would conduct

a detailed examination of the ICAAP of the Bank and if warranted could

prescribe a higher capital requirement over and above the minimum Capital

Adequacy Ratio envisaged in Pillar – I.

Pillar III- ‘Market Discipline’:

‘Market Discipline’ focuses on the effective Public disclosures to be made by the

Banks and is a critical component to the other two pillars. It recognizes the fact

that the discipline exerted by the markets can be as powerful as the same

imposed by the Regulator. This pillar facilitates enhanced disclosure

requirements and facilitating market discipline to the banks.

Market discipline through effective disclosure to encourage safe and sound

banking practices. And the purpose of pillar III- market discipline is to

compliment the minimum capital requirements (pillar I) and the supervisory

review process (pillar II).

The committee aims to encourage market discipline by developing a set of

disclosure requirements which will allow market participants to assess key

pieces of information on the scope of application, capital, risk exposures, risk

assessment process, and hence the capital adequacy of the institution. The

committee believes that such disclosures have particular relevance under the

frame work, where reliance on internal methodologies gives banks more

discretion in assessing capital requirements.

Effective Date of Implementation (Basel-II):

RBI has issued final guidelines on Capital Adequacy and Market Discipline

notification on 27th April, 2007.

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Foreign banks operating in India and Indian banks having operational presence

outside India should migrate to the selected approaches under the Revised

Framework with effect from 31st March, 2008.

All other commercial banks (except Local Area Banks and Regional Rural banks)

are should migrate these approaches under the revised frame work inn

alignment with them, but in any case not later than 31st March,2009

The BASEL committee set up by BIS has been urging or influence banks to set

up internal system to measure & manage credit risk objectively. BASEL II

recommendations, which become regulatory requirements for tight risk

management practices & reporting by banks.

Basel-II is the new Accord now implemented across most of the developed

world, presents challenges and opportunities to banks technical and complex it

is important to understand how it works. Its impact on how a loan is priced and

what the financial consequences of any change in its application might be.

It furnishes key issues involved in the Basel-2 Accord in order to identify and

minimize the inherent risks and liabilities.

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CHAPTER-V

SUMMARY AND CONCULSIONS

Finally, though the final decision of granting a loan is judgmental, but there is a

strong evidence of usage of qualitative & quantitative tools by the lending

institutions. Any how the lending decision is a complex process involving a vast

set of decision variables- intrinsic or extrinsic.

The global economy witnessed a marked slowdown, with greatest impact on

advanced economies, particularly in the United States where the sub-prime

crisis continues to deepen the financial stress. Similar is the situation according

international monetary fund the financial market crisis that erupted in August

2007 has developed in to the largest financial shock since the great depression,

inflicting heavy damage on markets and institutions at the core of the financial

system.

However, emerging and developing countries, including India, have been less

affected so far although economic activities in these countries are coming off the

peak.

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Inflation has increased around the world, lead mainly food and energy prices.

Indian economy could contain the inflationary pressures despite global rise in

commodity and energy prices. In addition to RBI raised the Cash Reserve Ratio

(CRR), RBI has also introduced several new measures aimed at development of

the financial system.

Business environment of any bank could post healthy financials while

maintaining high asset quality and strong capital base. The soundness of the

banking system is one of the most important issues for the regulatory authorities

and for the financial system stability.

Instead of Basel-I all banking institutions would have had to implement the new

capital accord or Basel-II for the current ‘2008-09’ i.e by 31.03.2009.

The new accord Basel II introduce a new approaches to capital adequacy that

are appropriately / suitably to the degree of risk involved in a banks positions

and activities and better measure the insolvency probability.

Banking business and banking risks have become much more complicated with

globalization and the revolution in information technology. There is a need for

banking supervisory tools to keep up with changes in the market, to track the

risks and ensure that they are prudently and carefully managed.

Institutions should not over rely on collaterals / covenant. Although the

importance of collaterals held against loan is beyond any doubt yet these

should be considered as a buffer providing protection in case of default.

The main and primary focus should be on borrower’s debt servicing ability

and reputation in the market, and market for the business.

Banks should start the preparation process for the implementation of the

new accord by reviewing the requirements it satisfy, the requirements need

to attain based on the chosen approaches.

One important part of the banks preparation process is to assess the

availability of information required for each approach.

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FINDINGS AND SUGGESTIONS

Banks conducts credit investigation and credit evaluation in the lending

process of borrower.

Banks also considers the risk rating given to the borrower by the external

credit rating agencies.

Banks may face certain risk incase of borrower’s default, so the banks

certain follow certain mitigation techniques to minimize these risks.

Banks should continuously adopt the loan monitoring and review

mechanism, which is an effective tool for constant evaluation of quality

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loan book and to bring about qualitative improvements in credit

administration.

Banks should follow New Capital Accord Basel II Framework

BIBILOGRAPHYSites Browsed:

www.andhrabank.com

www.bis.org

www.riskglossary.com

www.gtnews.com

www.cml.org.uk

Books Referred: Author &

Publication

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Various reference books Andhra

Bank

by bank for related topics

Risk Management Andhra

bank

Staff College

Hyderabad

Financial Institutions and Services Tata McGraw-Hill Company

Guidance Note on Credit Risk Reserve Bank

Management. Of India

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