Bm Reading Raroc

8/9/2019 Bm Reading Raroc

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Pramod [email protected]

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RISK CAPITAL REQUIREMENT & RAROC FRAMEWORK

FOR CORPORATE BANKING RELATIONSHIPS

Confidential for Private circulation only


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CONTENTS

1. INTRODUCTION ......................... .......................... ........................... .......................... ........3

2. ECONOMIC CAPITAL .......................... .......................... ........................... ......................... 4

3. RAROC .......................... .......................... .......................... ........................... .....................5

4. INPUTS TO RISK MEASURE.............................................................................................6

i. Internal Risk Rating ......................................................................................................6 ii . Rating Mig ration and Probabil ity of Default (PD) ........................................................7 iii. Estimated Exposure at Default (EAD)........................................................................11

iv . Estimated Loss Given Default (LGD) .........................................................................12 v. Spread ........................... ........................... .......................... .......................... ...............13 vi . Fees ........................... .......................... ........................... .......................... ................... 13 vii. Operat ing Cost........................................................................................................13

5. EXPECTED LOSS (RISK PREMIUM)...............................................................................14

6. ECONOMIC CAPITAL MEASUREMENT..........................................................................15

7. APPLICATION OF THE RAROC MODEL: .......................... ........................... .................. 17

ANNEXURE : COMPARISON OF RATING MIGRATIONS.............................. .......................... 19

ANNEXURE : REGULATORY VERSUS IRB CAPITAL ............................. .......................... .....21

ANNEXURE : RAROC VERSUS RETURN ON REGULATORY CAPITAL ............................ ....22


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1. INTRODUCTION

In a risk-return setting, borrowers placed in a high credit risk category should be priced higher

than those in a low risk category. Thus, risk rating and therefore, expected probability of default is

a key determinant of pricing. As in the case of pricing, risk rating has a bearing also on economic

capital allocation in preference to merely regulatory capital allocation for the underlying asset. A

standard risk adjusted measure of return is a tool for both pricing and making better lending

decisions. The Risk-Adjusted Return on Capital (RAROC) framework, which is already put in

place worldwide by large sized banks, is one such measure. The lender begins by charging an

interest mark-up to cover the expected loss – expected default rate of the rating category of the

borrower. The lender then allocates enough capital to the prospective loan to cover the

unexpected loss – variability of default rates. The primary focus of RAROC is to provide an

apples-to-apples comparison of capital usage and return across business lines and risk types.

Bankers Trust in the 1970s first introduced the RAROC concept. Their original interest was to

measure the risk of the bank’s portfolio, as well as the amount of equity capital necessary to limit

the exposure of the bank’s depositors and other debt holders to a specified probability of loss.

The recent surge among banks to adopt the RAROC approach is attributed to two forces: (i) the

demand by shareholders for improved performance, especially the maximization of shareholder

value and (ii) growth of conglomerates around profit centres. This has forced banks to develop a

measurement of performance, especially when the capital of the bank is both costly and limited.

RAROC is an integrated approach for measuring risk. It is a decision support tool, which enables

the Bank to:

Calculate how much capital is needed to support all risks taken by the enterprise.

Understand where the shareholders’ capital is invested.

Compare risk-adjusted returns earned on that capital across dissimilar business lines and

activities.

Identify opportunities for risk transfer.

The purpose of this document is to lay down the framework and mechanism for computation of

economic capital and Risk-adjusted pricing using internal ratings and internal default and loss

data. The computation of economic capital in this manner will lead us further on the road to

adoption of the Internal Ratings Based (IRB) approach for arriving at capital requirement for credit

risk under the proposed New Basel Accord, when permitted by the regulator. The Risk-adjusted

pricing approach will serve the dual purpose of ensuring that returns generated from a credit


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exposure is truly commensurate with the extent of risk assumed (capital at stake) and assessing

the profit performance of individual business units relative to the assets booked by them,

effectively a risk-based performance measurement tool.

2. ECONOMIC CAPITAL

Economic Capital is the amount of capital that an activity or business requires to support the

economic risk it faces to a specified solvency standard or default probability. It protects the lender

against unexpected volatility in the economic earnings of the firm. It is calculated from the

aggregated risk distribution at the target solvency standard. Effectively, Economic Capital is a

measure of the unexpected loss or economic capital at risk (VaR) as a result of the lending.

Generally, international banks allocate enough capital so that the expected loan loss reserve or

provision plus allocated capital covers over 99% of the loan loss outcomes.

Historically, two approaches have emerged to measure economic capital at risk. The first

approach, following Bankers Trust, develops a market-based measure - maximum adverse

change in the market value of a loan over the next year, as given in the block below:

Capital At RiskMcCauley Loan Duration x Loan Exposure x Expected Discounted

Change in Credit Risk Premium

The second, following Bank of America among others, develops an experiential or historicallybased measure, as follows:

Economic Capital3.4 to 6.0 times Standard Deviation of PD (x Loss Given

Default x Exposure

.


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3. RAROC

RAROC is the ratio of risk-adjusted income over a period, past or present, to the economic capital

at risk for a business unit as a result of an activity (lending). Thus,

RAROC = Adjusted Income

Economic Capital

Spread It is the direct income earned on the loan, i.e. Loan Rate – Bank’s

Cost of Funds.

Fees Non-interest income directly attributable to the loan over the relevant

period (such as processing charges, commitment fees, LC / BG

charges, fee from ancillary business, etc.).

Expected Loss Probability of Default (PD) x Loss Given Default (LGD)

x Exposure At

Default (EAD)

PD is the default probability over a given horizon for a particular

rating class

LGD is the estimated loss value of the loan or 1 minus recovery

value of a loan on default.

EAD is the estimated exposure at the time of default as a

percentage of commitment

Operating Costs It is the cost of executive time, effort, and resources in originating

and monitoring a loan.

RAROC adjusts the profitability of each lending activity based on the cost of the capital that it

requires. The RAROC calculated for a loan should be compared with the Bank’s expected Return

on Equity (ROE). The ROE will be the Hurdle Rate. Where RAROC exceeds this Hurdle Rate, the

loan will be considered as adding value to Bank’s capital and therefore, eligible for allocation of

capital.

Adjusted Income = Spread + Fees – Expected Loss – Operating Costs


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4. INPUTS TO RISK MEASURE

For computation of Risk Capital and RAROC, the following will be the fundamental inputs:

i. Internal Risk Rating

ii. Rating Migration and Probability of Default (PD)

iii. Estimated Exposure at Default (EAD)

iv. Estimated Loss Given Default (LGD)

v. Spread

vi. Fees

vii. Operating Cost

We propose to compute Risk Capital and RAROC on a corporate relationship basis, using the

following mechanism for arriving at each of the above inputs:

i. Internal Risk Rating

The Bank has in March 2001, sourced, customized and adopted a corporate credit risk-rating

model from CRISIL, christened by us as the XY-risk Rating System. The model delivers a quick

assessment of a borrower’s credit quality, structured analysis and grading of risk parameters and

key parameters for tracking and controlling asset quality. The model in its basic form is designedto assess credit risk in a structured and comprehensive manner. XY-risk has 10 ratings, not

including the modifiers, to match international best practices. The 10 ratings are as follows (the

first 5 being “pass” grades and the last 5 “problem loan” grades):

Rating Meaning Score Band

XY-AAA Very Strong credit quality 5.50 6.00

XY-AA+ Strong credit quality 4.75 5.50

XY-AA Good credit quality 4.25 4.75

XY-A Above average credit quality 3.75 4.25XY-BBB Average credit quality 3.25 3.75

XY-BB+ Moderate credit quality 2.75 3.25

XY-BB Weak credit quality 2.25 2.75

XY-B Near Default credit 1.75 2.25

XY-CC Default credit 1.50 1.75


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XY-C Loss credit 1.00 1.50

The above rating is based on an assessment of the borrower only without considering transaction

characteristics and in that respect is uni-dimensional. By default, assets classified as ‘Sub-

Standard’ will be accorded a rating of XY-CC and ‘Doubtful’ assets accorded a rating of XY-C. All

exposures to the same corporate are assigned the same borrower rating, irrespective of any

differences in the nature of each individual transaction.

To introduce the second dimension – transaction characteristics – the Bank to begin with permits

rating of the corporate guarantor to be superimposed on the borrower rating. Further, 100% cash

collateralized exposures (for the individual transaction) are accorded a rating of XY-AAA, while

bank guaranteed exposures are accorded a rating equivalent to the rating of the bank. As and

when sufficient reference data points are generated, the Bank will work towards adopting

transaction characteristic Loss Given Default (LGD) estimates as the second dimension for the

rating system. The transaction characteristics will be security, product type, tenor, etc.

The structure of the rating model, the parameters and risk factors assessed and the process to be

followed for rating a corporate and reviewing the rating is documented separately (copy

appended).

ii. Rating Migration and Probabili ty of Default (PD)

Using the internal risk-rating model, the bank will arrive at a credit rating for each exposure in itsportfolio, every year. The model will be consistently used across the portfolio and over the years.

The bank will capture ratings year-wise for each corporate in a database and track the upward

and downward migration in rating for each exposure over the years. To compute the transition

rate, each corporate’s rating at the end of a year (or the end of a horizon) is compared with its

rating at the beginning of the year (or the beginning of the horizon). From these individual

transitions, the bank will build a ‘ten by ten’ transition matrix (frequency distribution) for a given

horizon (e.g. 1 year, 2 years, etc.) on a portfolio level. As an illustration, the transition matrix for a

given horizon will look as follows (transition year 1998-1999):

AAA AA+ AA A BBB BB+ BB B CC C Total

AAA 1 - - - - - - - - - 1

AA+ - 6 0 - - - - - - - 6

AA - 1 23 10 - - - - - - 34

A - - 6 69 16 1 - - - - 92

BBB - - - 13 66 17 1 - - - 97

BB+ - - - 1 10 18 10 - 1 - 40

BB - - - - - 2 8 1 2 - 13

B - - - - - - - 1 - - 1

CC - - - - - - - - 0 1 1

C - - - - - - - - - 1 1

1 7 29 93 92 38 19 2 3 2 286


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As per the above matrix, of 34 exposures (100%), which were rated AA in Year 1998, 23 (68%)

retained their rating in Year 1999 (1 year horizon) while 10 (29%) slipped to A rating and 1 (3%)

moved up to AA+ rating. Similarly of 40 exposures (100%) rated BB+ in Year 1998, 18 (45%)

remained at BB+ in Year 1999, whereas 10 (25%) upgraded to BBB and 1 (3%) to A while 10

(25%) slipped to BB and 1 (3%) defaulted (CC & C).

The bank will build transition matrixes as above for every year (where the horizon is one year).

From these matrixes, a mean (probability) transition matrix and a standard deviation matrix will be

generated. The mean transition matrix will throw up the probability of an exposure with a given

rating migrating upward or downward, including to a default stage (called Probability o f Default

– PD - in the latter case) over a given horizon. For example, assuming the above matrix to be a

mean transition matrix, the Probability of Default (PD) of a corporate rated BB over a one-year

period is 15% (slippage to CC and C), while for a AA rated corporate rate the PD is estimated as

nil. A default will be considered to have occurred with regard to a particular borrower when one or

more of the following events has taken place (in accordance with BIS guidelines):

i. It is determined that the borrower is unlikely to pay its debt obligations (principal, interest,fees) in full.

ii. A credit loss event associated with an obligation of the borrower, such as a charge-off,

specific provision or distressed restructuring involving the forgiveness or postponement of

principal, interest or fees

iii. The borrower is past due more than 90 days on any credit obligation

iv. The borrower has filed for bankruptcy or similar protection from creditors

% AAA AA+ AA A BBB BB+ BB B CC C Total

AAA 100% 0% 0% 0% 0% 0% 0% 0% 0% 0% 100%

AA+ 0% 100% 0% 0% 0% 0% 0% 0% 0% 0% 100%

AA 0% 3% 68% 29% 0% 0% 0% 0% 0% 0% 100%

A 0% 0% 7% 75% 17% 1% 0% 0% 0% 0% 100%

BBB 0% 0% 0% 13% 68% 18% 1% 0% 0% 0% 100%

BB+ 0% 0% 0% 3% 25% 45% 25% 0% 3% 0% 100%

BB 0% 0% 0% 0% 0% 15% 62% 8% 15% 0% 100%

B 0% 0% 0% 0% 0% 0% 0% 100% 0% 0% 100%

CC 0% 0% 0% 0% 0% 0% 0% 0% 0% 100% 100%

C 0% 0% 0% 0% 0% 0% 0% 0% 0% 100% 100%


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The last column (PD) gives the Probability of Default over a one-year horizon for each rating. The

PDs will dynamically be revised as further data flows into the transition matrix. A comparison of

CRISIL’s and ICRA’s average one-year transition rates versus our transition rates is given in the

Annexure to this document. For the purpose of the RAROC framework, to begin with, the

following PDs for each performing grade will be used (percentage converted into decimal terms,

i.e. 0.50% stated as 0.0050 and an upward differential correction given to PDs of AA+ and AA

ratings):

Rating PD

AAA 0.0000

AA+ 0.0005

AA 0.0010

A 0.0040

BBB 0.0144

BB+ 0.0634

BB 0.1536

B 0.2500

In order that the ratings migration matrix and the probability of default is upto-date, it is extremely

essential that branches are prompt in annually re-rating their exposures using the XY-risk Rating

model immediately on receipt of the previous year end financials (without waiting for the

periodical review / renewal of the account). Branches should obtain the financials as soon as

these are ready with the company. Delays in populating the ratings afresh could result in the

following:

The Bank may over-price a good credit and end up losing the business to competition

A risky credit could get under-priced and the Bank’s earnings would not be

commensurate with the risk assumed

The risk measure of the individual exposure or portfolio could get under or over-stated

due to which the Bank’s capital could get sub-optimally utilized.


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For the Bank to benefit from the Internal Ratings Based approach for capital measurement, it is

all the more necessary that the ratings are reviewed promptly every year and the ratings

migration maintained real-time.

Rating initiators should be balanced in their assessment of the risk factors underlying a credit.

Any attempt to play down a risk unreasonably pull down a rating will impact the stability of the

rating system on one hand and on the other distort the migration statistics and the expected

distribution and trend of the portfolio. To illustrate, assume that a i-BBB rated corporate is

“pushed” up to a rating of i-A. In the unfortunate event that this borrower defaults during the year,

this transition from ‘A’ to default grade will resultantly increase the default probability of ‘A’ rating

category. In the process, all assets rated ‘A’ might have to thereafter bear a higher price (risk

premium) and capital requirement compared to existing, thanks to the mis-classification. Level 2

and Level 3 confirmers in the rating system are, therefore, expected to play the balancing role to

ensure that inconsistencies do not occur.

ii i. Estimated Exposure at Default (EAD)

EAD is the estimated exposure at the time of default as a percentage of commitment. The bank

will need to capture data on every exposure, which defaulted in the history of the bank (ideally) or

minimum over one economic cycle. The types of data that the bank will capture for each

exposure are:

a. Nature and size of committed exposures on and off balance sheet at the time of default

b. Actual exposure at the time of default

c. Activity / industry

Principally, (a) and (b) above, for all defaulted credits, will be used for computing the estimated

Exposure At Default (EAD) in percentage terms.

We have captured data on every exposure, which has defaulted (to NPA category) in the history

of the bank. The data captured for each exposure are:

a. Name of Account in default

b. Nature of committed exposures on and off balance sheet at the time of default

c. Quantum of committed exposures on and off balance sheet at the time of default

d. Actual exposure at the time of default

e. Activity / industry


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From (c) and (d) above for all defaulted credits, the estimated Exposure At Default (EAD) was

computed in percentage terms. As per data as on 31st March 2002, the EAD estimate works out

to 76%. This estimated EAD will be periodically recomputed in the event of fresh defaults.

iv. Estimated Loss Given Default (LGD)

LGD is the estimated loss value of the loan or 1 minus recovery value of a loan on default. For

each of the defaulted exposures in (iii) above, the Bank will additionally capture the following

information:

a. Date of default

b. Amount and date of each recovery made in the credit after default

c. Expenses incurred on the credit after default for legal proceedings, maintenance of security,

recoveries, etc.

d. Nature, seniority, share and value of security

The bank will discount the cash flows and work out the Present Value of the net recovery in the

credit as at the time of default. The net recovery as a percentage of the actual exposure at the

time of default will give the recovery rate (%). 100 minus the recovery rate (%) will yield the Loss

Given Default (LGD), expressed in percentage terms. This will be computed for each exposure

to arrive at an overall estimated LGD.

Besides an overall LGD, it would be also advisable that the bank captures LGD specific to each

industry. This of course provided there is adequate representation of defaults in each industry.

The objective of such fragmentation is that each industry depending on the stage of its economic

cycle, contribution to GDP, phase of technology, etc., will have a different recovery potential out

of the operations of the company or the assets of the defaulting corporate in such an industry. To

illustrate, under current economic conditions, the prospects of recovery in a credit related to a

dyes & pigments industry would be very low compared to recovery in a credit related to a FMCG

industry. LGDs could also be captured by seniority of charge on security and by type of exposure.

For each of the defaulted exposures (NPAs), we have captured the following information:

a. Date of default

b. Amount and date of each recovery made in the credit after default


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c. Expenses incurred on the credit after default for legal proceedings, maintenance of security,

recoveries, etc.

The LGD was computed for each exposure to arrive at an overall estimated LGD, which as on

31st March 2002 worked out to 88%. This estimated LGD would be periodically computed to

factor in fresh recoveries, costs, defaults, if any.

v. Spread

The difference between the stipulated interest rate on the credit and the cost of funding it is the

spread. Cost of funding used for the RAROC framework will be the prevailing FTP for the

particular exposure horizon.

vi. Fees

On a relationship basis, will include processing charges, non-interest income from non-fund

based credit facilities, forex income, fee income from ancillary services, etc, as per rates

stipulated.

vii. Operating Cost

This will be computed on a look-back basis or budgets for the current year. The annual operating

expenses as a percentage of aggregate of deposits, advances, investments and off-balance

sheet exposure, will be multiplied by the total exposure to arrive at the overheads for the related

account. For corporate banking relationships, the operating cost per Rs 100 of business

(advances + contingent + deposits) has been computed at Rs 0.23 (i.e. 0.23%) using the

following data:

Budget as on

Average Advances Rs 3538 crore

Average Contingent Rs 1669 crore Average Deposits Rs 3750 crore

Operating Expenses Rs 20.79 crore


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5. EXPECTED LOSS (Risk Premium)

The Expected Loss (EL) corresponding to each rating will be the product of the Probability of

Default (PD) for that rating, the estimated Exposure at Default (EAD) and the estimated Loss

Given Default (LGD). Based on the information for each of these variables given earlier in this

paper, the rating-wise EL is as follows:

Rating PD Expected Loss (Risk Premium)

AAA 0.0000 0.00%

AA+ 0.0005 0.03%

AA 0.0010 0.07%

A 0.0040 0.27%BBB 0.0144 0.96%

BB+ 0.0634 4.24%

BB 0.1536 10.27%

B 0.2500 16.72%

The Expected Loss should be recovered from pricing as a risk premium. Alternatively,

suitable specific provisioning should cover this. The Bank could consider carving out the risk

premium from each exposure’s pricing and building up the provision cover.


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6. ECONOMIC CAPITAL MEASUREMENT

To arrive at the Economic Capital, the risk related capital requirement formula as proposed in the

Basel Capital Accord II under Internal Ratings Based approach, will be used. However, as this

factor includes Expected Loss component, the Expected Loss as worked out above separately for

each rating will be deducted from the capital requirement computed using the IRB formula to give

the Economic Capital for the RAROC framework. The formula in the Accord is as follows (the

confidence level used in 99.90%)

Capital Requirement (K) = LGD x M x N[(1-R)^-0.5xG(PD)+(R/(1-R))^0.5xG(0.999)]

LGD = Loss Given Default

M = Maturity Factor = 1+0.047x((1-PD)/PD^0.44)

PD = Probability of Default

N ( ) = Standard Normal Cumulative Distribution Function, with mean 0 and standard

deviation 1.

G ( ) = Inverse Standard Normal Cumulative Distribution Function, with mean 0 and

standard deviation 1.

R = Correlation = 0.10 x (1-EXP(-50xPD))/(1-EXP(-50))+0.20x[1-(1-EXP(-50xPD))/(1-

EXP(-50))]

EXP ( ) = Natural Exponential Function

Using the above formula, the rating wise Capital Requirement and the Economic Capital after

netting off Expected Loss is as follows:

Rating Expected Loss IRB Capital Req. Economic Capital(IRB Cap – Exp Loss)

AAA 0.00% 0.56% 1.40% @

AA+ 0.03% 2.52% 2.49%

AA 0.07% 3.61% 3.54%

A 0.27% 7.15% 6.88%

BBB 0.96% 12.22% 11.26%

BB+ 4.24% 22.12% 17.88%

BB 10.27% 35.13% 24.86%

B 16.72% 44.52% 27.80%

@ Minimum requirement


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A comparison of capital requirement as per the above capital measures versus current regulatory

requirement of 9% for the corporate banking portfolio as on 31st March 2002 is given in the

Annexure.


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7. APPLICATION OF THE RAROC MODEL:

Using the above inputs, RAROC will be computed as follows for each relationship:

Spread + Fees – Operating Costs – Risk Premium (Expected Loss)RAROC = --------------------------------------------------------------------------------

Economic Capital

The targeted RAROC will be 25% (hurdle rate). To achieve this target, and considering the

Economic Capital, Risk Premium, Operating Cost worked out above, Corporate Banking will need

to leverage a minimum Spread plus Fees, rating-wise as follows, from the relationship:

Rating Spread + Fees

(as percentage of exposure) AAA 0.58%

AA+ 0.93%

AA 1.23%

A 2.23%

BBB 3.98%

BB+ 8.98%

BB 16.73%

B 23.98%

(Exposure for the above purpose, will be: Fund Based : 100% of limit sanctioned, Non-fund

Based : 50% of limit sanctioned till March 2003, 100% thereafter and Forex Limit : 100% of limit

sanctioned)

To illustrate, as per the RAROC framework devised above, the rating-wise pricing structure will

be as follows, considering 29th July 2002 FTPs, for fund based facilities:

FTP 6.58% 6.65% 6.75% 6.70% 6.78% 6.84% 7.57% 7.90% 8.66% 8.82%

RATING 7-14 days 15-30 31-45 46-90 91-180 181-270 271-3651 yr 1 day-

1.5 1.5 yr 1 day-22yrs 1 day- 3

yrs

AAA 7.16% 7.23% 7.34% 7.28% 7.36% 7.42% 8.15% 8.48% 9.25% 9.40%

AA+ 7.51% 7.58% 7.69% 7.63% 7.71% 7.77% 8.50% 8.83% 9.60% 9.75%

AA 7.81% 7.88% 7.99% 7.93% 8.01% 8.07% 8.80% 9.13% 9.90% 10.05%

A 8.81% 8.88% 8.99% 8.93% 9.01% 9.07% 9.80% 10.13% 10.90% 11.05%

BBB 10.56% 10.63% 10.74% 10.68% 10.76% 10.82% 11.55% 11.88% 12.65% 12.80%

BB+ 15.56% 15.63% 15.74% 15.68% 15.76% 15.82% 16.55% 16.88% 17.65% 17.80%

BB 23.31% 23.38% 23.49% 23.43% 23.51% 23.57% 24.30% 24.63% 25.40% 25.55%

B 30.56% 30.63% 30.74% 30.68% 30.76% 30.82% 31.55% 31.88% 32.65% 32.80%


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Returns based on the above pricing on Current Regulatory Capital are given in the Annexure

(RAROC versus Return on Regulatory Capital). Based on the comparison, it is suggested that till

a Risk Based Capital framework (such as the Internal Ratings Based Approach) is accepted by

the Regulator, pricing based on Scenario III in the annexure is accepted, i.e. pricing where both

RAROC and Risk Adjusted Return on Regulatory Capital is 25% minimum.

Risk premiums are normally based on Default Probabilities over a 1-year horizon. Therefore, in

the case of exposures with a tenor of over one year, the Bank needs to stipulate a pricing-reset

clause linked to either the internal rating of the borrower or certain Events of Default (EODs),

which have a direct bearing on the rating, so that at the end of each year the pricing can be

revised to factor in the changed risk premium corresponding to the fresh rating of the corporate.

Credit proposals will henceforth use this model for fixing risk related pricing and determining

account profitability both actual and projected, to understand the value of the relationship. Value

of collateral, market forces, perceived value of accounts, future business potential, portfolio /

industry exposure and strategic reasons may play an important role in pricing. However, any

attempt at price-cutting for market share would result in mispricing of risk, adverse selection, and

sub-optimal capital utilization.

Ideally, the RAROC model should be applied across the portfolio of the loan assets and

aggregated. It should also be aggregated for the various business activities of the Bank, to arrive

at the enterprise-wide risk-adjusted return on economic capital. To begin with the same shall be

applied to individual corporate credit relationships. Branches can then work out the RAROC for

the branch portfolio by extending the framework to the entire portfolio on an aggregate, to

benchmark it against the targeted RAROC – in the process it will ensure that higher earnings in

another asset duly compensate any shortfall in earnings in an otherwise preferred low yield asset,so that targeted RAROC is achieved at branch level. The same principle should be followed at

the Region Level and at the Country Level.

*******


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Annexure : COMPARISON OF RATING MIGRATIONS

Bank’s Average One-Year Transi tion Rates (1997-2001)

Crisi l Average One-Year Transit ion Rates (1993 – 2000)

Rating DataPoints

AAA AA A BBB BB B C & Below

AAA 154 96.8% 3.2%

AA 500 2.8% 85.2% 10.0% 1.0% 0.4% 0.4% 0.2%

A 759 3.3% 82.3% 8.8% 3.2% 0.3% 2.1%

BBB 317 0.3% 5.7% 73.2% 11.0% 1.9% 7.9%

BB 117 2.6% 58.1% 2.6% 36.7%

B 16 62.5% 37.5%

C & Below 32 100%

ICRA’s Average One-Year Transit ion Rates (1992 – 2001)

Rating Data Points AAA AA A BBB NI

AAA 142 92.3% 7.0% 0.7%

AA 287 1.7% 86.4% 10.1 0.3% 1.4%

A 279 1.4% 83.5% 7.5% 7.5%

BBB 133 0.8% 85.7% 13.5%

NI 2.6% 58.1%

NI – Non-Investment (BB+ to D)

Remarks:

The long-run stability of our rating model is yet to be proved given its short history.

% AAA AA+ AA A BBB BB+ BB B CC C PD

AAA 100.00% 0.00%

AA+ 58.33% 30.21% 11.46% 0.00%

AA 7.90% 59.60% 31.10% 1.39% 0.00%

A 0.26% 14.05% 66.33% 18.29% 0.67% 0.40% 0.40%

BBB 0.26% 30.34% 55.30% 11.44% 1.22% 1.44% 1.44%

BB+ 4.68% 26.16% 44.52% 18.29% 6.34% 6.34%

BB 14.37% 55.85% 14.42% 15.36% 15.36%

B 75.00% 25.00% 25.00%

CC 61.06% 38.94% 100.00% C 100.00% 100.00%


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CRISIL’s and ICRA’s transition matrix cover almost a decade, which could be considered

as one economic cycle. This rating model is yet to go through a full economic cycle.

CRISIL’s and ICRA’s reports on the transition acknowledge that deteriorating general

economic conditions have resulted in greater volatility / lesser stability in the ratings in the

recent years – this is reflected in our matrix which covers the recent years only.

Our ratings transition rates may not be truly comparable with that of CRISIL and ICRA

due to possible differences in the underlying characteristics of the statistical population

(number of data points, geographical spread of exposures, size of corporate entities, etc).


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Annexure : REGULATORY VERSUS IRB CAPITAL

Corporate Banking Exposure (Performing Assets) as on 31st March

Remarks

Aggregate Risk Capital requirement is lower than Regulatory Capital requirement as on 31st

March

Aggregate Risk Capital requirement relative to Regulatory Capital requirement will change

with change in the composition of the portfolio.

Rs in Crore

Rating Risk Capital FB O/S NFB O/S

Regulatory

Capital (9%) Risk Capital

i-AAA 1.40% 11.38 86.06 4.90 0.76

i-AA+ 2.49% 112.95 15.10 10.84 3.00

i-AA 3.54% 530.12 278.12 60.23 23.70

i-A 6.89% 1360.98 544.17 146.98 112.48

i-BBB 11.25% 400.32 224.48 46.13 57.68

i-BB+ 17.88% 65.19 39.01 7.62 15.14

i-BB 24.86% 11.18 6.13 1.28 3.54

i-B 27.80% 0.00 0.00 0.00 0.00

Total 2492.12 1193.44 277.98 216.31


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Annexure : RAROC VERSUS RETURN ON REGULATORY CAPITAL

Portfolio Return on Regulatory Capital will change depending on the portfolio mix. Since the

pricing is higher at the higher risk end, the Returns will expectedly increase as Risk

increases. The Returns steeply increase in view of the risk premium required to be earned

from the exposure, reflective of the propensity to default.

As the Risk Premium (Expected Loss) is netted from Returns, the Risk Adjusted Return on

Regulatory Capital increases gradually as risk increases.

Related to targeted RAROC of 25%, the Risk Adjusted Return on Regulatory Capital

obviously is much lower than the RAROC figure in the lower risk categories and then

surpasses the RAROC figure as one moves up the risk band.

The pricing scenarios for RAROC target 25% (scenario I), Risk Adjusted Return on

Regulatory Capital (Scenario II) target 25% and Minimum of Scenario I and Scenario II

(Scenario III) are given below rating-wise. This is followed by the tenure-wise pricing structure

for each Scenario. The Bank is required to maintain Capital as per current regulatory

requirement till permission is acceded by the Regulator to move into a Risk-based Capital

(Internal Ratings Based Approach, etc) framework. In order that the Bank generates the

Rs in Crore

Rating Risk Capital FB O/S NFB O/S

Regulatory

Capital (9%) Risk Capital

Pricing

Proposed

Return on

Regulatory

Capital

Risk Adjusted

Return on

Regulatory

Capital RAROC

i-AAA 1.40% 11.38 86.06 4.90 0.76 0.58% 6% 4% 25%

i-AA+ 2.49% 112.95 15.10 10.84 3.00 0.93% 10% 7% 27%

i-AA 3.54% 530.12 278.12 60.23 23.70 1.23% 14% 10% 26%

i-A 6.89% 1360.98 544.17 146.98 112.48 2.23% 25% 19% 25%

i-BBB 11.25% 400.32 224.48 46.13 57.68 3.98% 44% 31% 25%

i-BB+ 17.88% 65.19 39.01 7.62 15.14 8.98% 100% 50% 25%

i-BB 24.86% 11.18 6.13 1.28 3.54 16.73% 186% 69% 25%

i-B 27.80% 0.00 0.00 0.00 0.00 23.98%

Total 2492.12 1193.44 277.98 216.31 28% 20% 25%


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Pramod Vaidyapramodvaidya@gmail com

targeted minimum Return of 25% on Capital (satisfying both Current Regulatory Capital and

Risk Capital), Scenario III pricing structure is recommended:

Rating Risk Premium

Note : (1) Pricing = Spread + Fees from the exposure (2) Overheads = 0.23%

i-AAA 0.00%

i-AA+ 0.03%

i-AA 0.07%

i-A 0.27%

i-BBB 0.96%

i-BB+ 4.24%

i-BB 10.27%

i-B 16.72%

3.98%

8.98%

16.73%

23.98%

0.58%

0.93%

1.23%

2.23%

Scenario IIScenario I

2.75%

2.77%

2.80%

3.00%

3.70%

7.00%

13.05%

23.98%

16.73%

Scenario III

19.50%

Mark up for RAR on

Regulatory Cap 25%

Mark up for RAR onRegulatory Capital AND

RAROC 25%

2.75%

2.77%

2.80%

3.00%

3.98%

8.98%

Mark-up for RAROC 25%

ExposureTenure 7-14 days 15-30 31-45 46-90 91-180 181-270 271-365 1 yr 1 day-1.5 1.5 yr 1 day-2

2yrs 1 day- 3yrs

FTP 6.58% 6.65% 6.75% 6.70% 6.78% 6.84% 7.57% 7.90% 8.66% 8.82%

i-AAA 7.16% 7.23% 7.34% 7.28% 7.36% 7.42% 8.15% 8.48% 9.25% 9.40%

i-AA+ 7.51% 7.58% 7.69% 7.63% 7.71% 7.77% 8.50% 8.83% 9.60% 9.75%

i-AA 7 .81% 7.88% 7.99% 7.93% 8.01% 8.07% 8.80% 9.13% 9.90% 10.05%

i-A 8.81% 8.88% 8.99% 8.93% 9.01% 9.07% 9.80% 10.13% 10.90% 11.05%

i-BBB 1 0.56% 10.63% 10.74% 10.68% 10.76% 10.82% 11.55% 11.88% 12.65% 12.80%

i-BB+ 15.56% 15.63% 15.74% 15.68% 15.76% 15.82% 16.55% 16.88% 17.65% 17.80%

i-BB 23.31% 23.38% 23.49% 23.43% 23.51% 23.57% 24.30% 24.63% 25.40% 25.55%

i-B 30.56% 30.63% 30.74% 30.68% 30.76% 30.82% 31.55% 31.88% 32.65% 32.80%

Scenario I Effect - Overall pricing on Fund Based exposure

ExposureTenure 7-14 days 15-30 31-45 46-90 91-180 181-270 271-365 1 yr 1 day-1.5 1.5 yr 1 day-2

2yrs 1 day- 3yrs

FTP 6.58% 6.65% 6.75% 6.70% 6.78% 6.84% 7.57% 7.90% 8.66% 8.82%

i-AAA 9.33% 9.40% 9.50% 9.45% 9.53% 9.59% 10.32% 10.65% 11.41% 11.57%

i-AA+ 9.35% 9.42% 9.52% 9.47% 9.55% 9.61% 10.34% 10.67% 11.43% 11.59%

i-AA 9.38% 9.45% 9.55% 9.50% 9.58% 9.64% 10.37% 10.70% 11.46% 11.62%

i-A 9.58% 9.65% 9.75% 9.70% 9.78% 9.84% 10.57% 10.90% 11.66% 11.82%

i-BBB 10.28% 10.35% 10.45% 10.40% 10.48% 10.54% 11.27% 11.60% 12.36% 12.52%

i-BB+ 13.58% 13.65% 13.75% 13.70% 13.78% 13.84% 14.57% 14.90% 15.66% 15.82%

i-BB 19.63% 19.70% 19.80% 19.75% 19.83% 19.89% 20.62% 20.95% 21.71% 21.87%

i-B 26.08% 26.15% 26.25% 26.20% 26.28% 26.34% 27.07% 27.40% 28.16% 28.32%

Scenario II Effect - Overall pricing on Fund Based exposure

Exposure

Tenure 7-14 days 15-30 31-45 46-90 91-180 181-270 271-365 1 yr 1 day-1.5 1.5 yr 1 day-2

2yrs 1 day- 3

yrs

FTP 6.58% 6.65% 6.75% 6.70% 6.78% 6.84% 7.57% 7.90% 8.66% 8.82%

i-AAA 9.33% 9.40% 9.50% 9.45% 9.53% 9.59% 10.32% 10.65% 11.41% 11.57%

i-AA+ 9.35% 9.42% 9.52% 9.47% 9.55% 9.61% 10.34% 10.67% 11.43% 11.59%

i-AA 9.38% 9.45% 9.55% 9.50% 9.58% 9.64% 10.37% 10.70% 11.46% 11.62%

i-A 9.58% 9.65% 9.75% 9.70% 9.78% 9.84% 10.57% 10.90% 11.66% 11.82%

i-BBB 10.56% 10.63% 10.74% 10.68% 10.76% 10.82% 11.55% 11.88% 12.65% 12.80%

i-BB+ 15.56% 15.63% 15.74% 15.68% 15.76% 15.82% 16.55% 16.88% 17.65% 17.80%

i-BB 23.31% 23.38% 23.49% 23.43% 23.51% 23.57% 24.30% 24.63% 25.40% 25.55%

Scenario III Effect - Overall pricing on Fund Based exposure

Documents

Bm Reading Raroc