Risk Management (Project)

8/12/2019 Risk Management (Project)

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EXECUTIVE SUMMARY

While financial institutions have faced difficulties over the years for a multitude of

reasons, the major cause of serious banking problems continues to be directly

related to lax credit standards for borrowers and counter parties, poor portfolio riskmanagement, or a lack of attention to changes in economic or other circumstances

that can lead to a deterioration in the credit standing of a banks counter parties.

Credit risk in most simply defined as the potential that a bank borrowers or counter

party will fail to meet its obligations in accordance with agreed terms. The goal of

credit risk management is to maximize a banks risk-adjusted rate of return by

maintaining credit risk exposure within acceptable parameters. Banks need to

manage the credit risk inherent in the entries portfolio as well as the risk in

individual credits or transactions. Banks should also consider the relationshipsbetween credit risk and other risks. The effective management of credit risk is a

critical component of a comprehensive approach to risk management and essential

to the long term success of any banking organization.

For most banks, loans are the largest and most obvious source of credit risk;

however, other sources of credit risk exist throughout the activities of a bank,

including in the banking book and in the trading book, and both on and off the

balance sheet. Banks are increasingly facing credit risk (or counter party risk) in

various financial instruments other than loans including acceptances, interbank

transactions, trade financing, foreign exchange transactions, financial futures,

swaps, bonds, equities, options, and in the extension of commitments and

guarantees, and the settlement of transactions.

Since exposure to credit risk continues to be the leading source of problems in

banks world-wide, banks and their supervisors should be able to draw useful

lessons from past experiences.

Banks should now have a keen awareness of the need to identify measure, monitorand control credit risk as well as to determine that they hold adequate capital

against these risks and they are adequately compensated for risks incurred.

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Although the principles contained in this paper are most clearly applicable to the

business of lending, they should be applied to all activities where credit risk is

present.

The sound practices set out in this documents specifically address the followingarea: (a) establishing an appropriate credit risk environment , (b) operating under a

sound credit granting process, (c) maintaining an appropriate credit administration,

measurement and monitoring process, and (d) ensuring adequate controls over

credit risk. Although specific credit risk management practices may differ among

banks depending upon the nature and complexity of their credit activities, a

compressive credit risk management program will address these four areas. These

practices should also be applied in conjunction with sound practices related to the

assessment of asset quality, the adequacy of provision and reserves And the

disclosure of credit risk.

A further particular instance of credit risk relates to the process of settling financial

transactions. If one side of a transaction is settled but the other fails, a loss may be

incurred that is equal to the principal amount of the transactions. Even if one party

is simply late in settling, then the other party may incur a loss relating to missed

investment opportunities. Settlement risk (i.e. the risk that the completion or

settlement of a financial transaction will fail to take place as expected) thus

includes elements of liquidity, market, operational and reputational risk as well ascredit risk. The level of risk is determined by the particular arrangements for

settlement. Factors in such arrangements that have a bearing on credit risk include:

the timing of the exchange of value: payment/settlement finality; and the role of

intermediaries and clearing houses and reserves, and the disclosure of credit risk.

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CHAPTER-1

INTRODUCTION:

Background of the study:

Globalization is a buzzword and became widely use since 1990s. it has created two

trends in the financial sector that are the increasing of globalization of economic

and financial activity and the promotion of financial stability in all countries, both

developed and developing countries.

The globalization of markets for final goods, financial &non-financial services,

and even factors of production has been one of the most striking development of at

least the past two decades.

The other key trend, the increased focus on the promotion of financial stability, our

concern to promote financial stability involves not only the promotion of price

stability, but also support for deep and robust financial markets, for sound financial

institutions and for a stable overall infrastructure for the financial industry.

Why worry about these elements of a stable financial system in a modern market

economy? As we have seen, over the long term, economic and financial based on

open competition& global market forces can achieve out comes that are far

superior to those possible in a highly regulated and controlled environment.

But they said, such market- based system can, and do, display elements of

vulnerability. Markets can be dysfunctional and they can be subject to failure and

break downs. Investor and borrower

Behavior does not always produce sufficiently deep and liquid markets, or prices

that consistently reflect economic fundamentals.

When financial stability is lost, the costs can be grave not only for the financial

sector itself but also for the country economy as a whole.

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So, the challenge is to promote sound risk management practices in financial

institution in a way that ensures that they are adequately capitalized and prudently

managedwhile not hindering a their ability to pursue opportunities and profits

responsibly. Well capitalized and well managed financial institutions can serve as

efficient intermediaries of credit, not only in good times, but also in periods ofstrain.

Content and Objectives.

This section of the guideline describes risk management as a part of lending

business of banks. This is done by outlining the basic elements of risk management

in the context of bank wide capital allocation and defining the central

requirements on effective risk management. As some of these issues discussed in

this context cannot be dealt with exclusively in terms of credit risk, there areoccasional switches between a bankwide perspective and a narrower look at the

credit sector, with this change of perspective not always being made explicit to

allow for smooth reading?

Starting from the requirements on risk management in banks, the first subchapter

provides an overview of the functions of risk management and shows the basic

prerequisites in terms of organization and processes. This is used as a basis to

derive the strategic and operational core elements of credit risk management.

The second subchapter explains the importance risk management has for bank-

wide capital allocation and shows how the content of the following subchapters

can be regarded as parts of an integrated system to combine value and risk

management at all organizational levels.

The third and fourth subchapters show how banks determine their risk bearing

capacity and build their credit risk strategy on that basis.

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Subchapters five then deals with the question of capital allocation, while the

subchapter six and seven outline the ways in which banks can limit their credit risk

by setting risk limits and

Control these risks by means of active portfolio management. The eighthsubchapter finally deals with works out the main requirements for risk controlling

systems that banks use to manage their risks.

Credit Risk Management:

All organizations including nonprofits government entities and business need to

establish sound and functional credit risk management procedures to prevent

operating losses. Due to the nature of their operations, financial institutions

generally monitor credit risks more closely than other organizations.

Definition:

Credit risk is the loss expectation arising from a business partners default or

inability to fulfill other financial commitments on time. A business partner- also

called a counterpartydefaults because of bankruptcy or temporary financial

distress. Credit risk management helps a firm mitigate credit losses in operating

activities.

Significance:

Credit risk management is an integral component of an organizations profit

management mechanisms. Without adequate and functional credit risk control

procedures, the organization may incur significant losses if counterparties are out

of business, according to financial information portal investopedia.

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Considerations:

Credit risk management techniques typically demand analytical acumen, financial

dexterity and level of mathematical sophistications that corporate personnel often

do not possess.

Accordingly, a company may hire a specialist, such as a chartered financial

analyst, to help implement adequate credit risk management tools.

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CHAPTER-2

REVIEW OF LITERATURE

CREDIT RISK:

Probability of loss from a debtors default. In banking, credit risk is a major factor

in determination of interest rate on a loan, longer the term of loan, usually higher

the interest rate also called credit exposure.

Credit risk is an investors risk of loss arising from a borrower who does not make

payments promised. Such an event is called a default. Another term for credit risk

is default risk.

Credit risk is a significant element of the galaxy of risks facing the derivativesdealer and the derivatives end users. There are different grades of credit risk. The

most obvious one is the risk of default. Default means that the counter party to

which one is exposed will cease to make payments on obligations into which it has

entered because it is unable to make such payments.

This is the worst case credit event that can take place. An intermediate credit risk

occurs when the counterpartys creditworthiness is downgraded by the credit

agencies causing the value of obligations it has issued to decline in value. One can

see immediately that market risk and credit risk interact in that the contracts intowhich we entre with counterparties will fluctuate in value with changes in markets

prices, thus affecting the size of our Credit exposure. Note also that we are only

exposed to credit risk on contracts in which we are owned some form of payment.

If we owe the counterparty payment and the counterparty defaults, we are not at

risk of losing ant future cash flows.

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Different aspects of credit risk: market risk, default rates and recovery rates

The two aspects of credit risk of the contracts into which we have entered with

counterparty and potential for some pejorative credit events such as default or

downgrade.

The difficult thing is to try and calculate the probability of default or of a negative

credit event.

Another difficulty in accessing credit risk is estimating the recovery rate. Debts as

that ABC bank defaults and those we have an outstanding swap with ABC, the

market value of which is $10 million in our favor. It is not automatically true that

we are not going to see any of that $ 10million once the smoke clears from the

bankruptcy negotiations. We may be able to receive a partial payment. The

recovery rate is the rate at which are paid in the event of a negative credit event. If

we are paid $ 2 million at the end of the day, then the recovery rate here is 20%.

What was the expected value of the swap to us the day before ABC defaulted?

Lets say that we had estimated an ex ante default probability of 5% and a recovery

rate of 20%. Then, the expected value condition is straight forward.

Expected value swap= 0.95($10 million) +0.05($10 million *0.20) =$9.6 million.

The expected value of the swap is less than its current market value because of the

possibility of default and less than total recovery of the value of the swap in the

event of default.

There are two steps in calculating credit risk: estimating the credit exposure and

calculating the probability of default. Once we have calculated these two statistics,

we can quantify the credit risk.

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The credit exposure is equal to the greater of the current replacement values of the

outstanding contracts plus the expected maximum increase in value of the contract

over the remaining life of the contract for a given confidence interval or zero. This

potential exposure can be calculated using the value at risk techniques we

discussed in an earlier article.

If the sum of the current replacement value and the potential increase in the value

of the contract is negative, then we have no exposure to the counter party from a

credit perspective because we are obligated to make payments to them.

Credit risk is simply the product of this calculated credit exposure and the

estimated probability of default.

Credit risk is a significant element of any derivatives transaction. Because of the

significance of credit risk, dealers must account for it when they conduct swaps

transactions with their counter parties.

This may mean that they charge a greater swap spread when pricing the swap

curve for a particular counter party or it may mean that they place greater

conditions on the transaction

Credit Risk- Internal Ratings Based Approach

This section describes the RBI approach to credit risk. Subject to certain minimumconditions and disclosure requirements, banks that have received supervisory

approval to use the RBI approach may relay on their own internal estimates of risk

components include measures of the probability of default(PD), loss given

default(LGD), the exposure at default (EAD), and effective maturity(M). In some

cases banks may be required to use supervisory values as opposed to an internal

estimate for one or more of the risk components.

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The IRB approach is based on measures of unexpected losses (UL) and expected

losses (EL). The risk weight functions produce capital requirements for the UL

portion.

Adoption of the IRB approach across all assets classes is discussed early in thissection, as are transitional arrangements.

The risk components , each of which is defined later in this section serve as inputs

to the risk weight function that have been developed for separate assets classes. For

example, there is a risk weight for corporate exposures and another one for

qualifying revolving retail exposures. The treatment of each asset class begins with

a presentation of the relevant risk weight functions followed by the risk

components and other relevant factors such as the treatment of credit risk

mitigates.

1. Categorization of exposures.

Under the IRB approach banks must categorize banking book exposures into broad

classes of assets with different underlying risk

Characteristics, subject to the definition set out below.

-Corporate

-Sovereign

-Bank

-Retail

-Equity

The classification of exposure in this way is broadly consistent with established

bank practice. However, some banks may use different definitions in their internal

risk management and measurement system.

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While it is not the intention of the committee to require banks to change the way in

which they manage their business and risks banks are required to apply the

appropriate treatment to each exposure for the purpose of deriving their minimum

capital requirement. Banks must demonstrate to supervisors that their methodology

for assigning exposures to different classes is appropriate and consistent over time.

Definition of corporate exposures

In general, a corporate exposure is defined as a debt obligation of a corporation.

Partnership or Proprietorship banks are permitted to distinguish separately

exposures to small and medium sized entities (SME). Within the corporate asset

class, five subclasses of specialized lending (SL) are identified. Such lending

possesses all the following characteristics, either in legal form or economic

substance.

- The exposure is typically to an entity (often a special purpose entity (SPE) which

was created specifically to finance and or operate physical assets;

- The borrowing entity has little or no other material assets or activities, and

therefore little or no independent capacity to repay the obligation, apart from the

income that if receives from the assets being financed;

- The term of the obligation given the lender a substantial degree of control over

the assets and the income that it generates; and

- As a result of the preceding factors, the primary source of repayment of the

obligation is the income generated by the assets rather than the independent

capacity of a broader commercial enterprise.

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The five sub classes of specialized lending are project finance, object finance,

commodities finance, income producing real estate, and high volatility commercial

real estate. Each of these sub classes is defined below.

Project finance

Project finance (PF) is a method of funding in which the lender looks primarily to

the revenues generated by a single project, both as the source of repayment and as

security for the exposure. This type of financing is usually for large, complex and

expensive installations that might include, for example power plants, chemical

processing plants, mines, transportation infrastructure, environment, and

telecommunication infrastructure.

Project finance may take the form of financing of the construction of a new capital

installation, or refinancing of an existing installation, with or without

improvements. In such transactions, the lender is usually paid solely or almost

exclusively out of the money generated by the contracts for the facilitys output,

such as the electricity sold by a power plant. The borrower is usually an SPE that is

not permitted to perform any function other than developing, owning, and

operating the installation. The consequence is that repayment depends primarily on

the project cash flow and on the collateral value of the projects assets. In contrast

if repayment of the exposure depends primarily on a well-established, diversified,

credit worthy, contractually obligated end users for repayment it is considered a

secured exposure to those end users.

Object finance

Object finance (OF) refers to a method of funding the acquisition of physical assets

(e.g. ships, aircraft, satellite, railcars, fleets) where the repayment of the exposure

is independent on the cash flow generated by the specific assets that have been

financed and pledged or assigned to the lender. A primary source of these cash

flows might be rental or lease contracts with one or several third parties.

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In contrast if the exposure is to a borrower whose financial condition and debt

servicing capacity enables it to repay the debt without undue reliance on the

specifically pledged assets, the exposure should be treated as a collateralized

corporate exposure.

Commodities finance.

Commodities finance (CF) refers to structured short term lending to finance

reserves, inventors, or receivables of exchange traded commodities(e.g. crude oil,

metals, or crops), where the exposure will be repaid from the proceeds of the sale

of the commodity and the borrower has no independent capacity to repay the

exposure. This is the case when the borrower has no other activities and no other

material assets on its balance sheet. The structured nature of the financing is

designed to compensate for the weak credit quality of the borrower. Theexposures rating reflects its self- liquidating nature and the lenders skill in

structuring the transaction rather than the credit quality of the borrower.

The committee believes that such lending can be distinguished from exposures

financing the reserves, inventors, or receivables of other more diversified corporate

borrowers. Banks are able to rate the credit quality of the latter type of borrowers

based on their broader ongoing operations. In such cases, the value of the

commodity serves as a risk mitigate rather than as the primary source of

repayment.

Incomeproducing real estate

Income producing real estate (IPRE) refers to method of providing funding to

real estate (such as, office buildings to let, retail space, multifamily residential

buildings, industrial or warehouse space, and hotels) where the prospects for

repayment and recovery on the exposure depend primarily on the cash flows

generated by the asset. The primary source of these cash flows would generally be

lease or Rental payments or the sale of the asset.

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The borrower may be, but is not required to be, an SPE, an operating company

focused on real estate construction or holdings, or an operating company with

source of revenue other than real estate.

The distinguishing characteristic of IPRE versus other corporate exposures that arecollateralized by real estate is the strong positive correlation between the prospects

for repayment of the exposure and the prospects for recovery in the event of

default, with both depending primarily on the cash flows generated by a property.

High volatility commercial real estate

High volatility commercial real estate (HVCRE) lending is the financing of

commercial real estate that exhibits higher loss rate volatility (i.e. higher asset

correlation) compared to other types of SL. HVCRE includes:

- commercial real estate exposures secured by prosperities of types those are

categorized by the national supervisor as sharing higher volatilities in portfolio

default rates;

- Loans financing any of the land acquisition, development and construction

(ADC) phases for properties of those types in such jurisdictions; and

Loans financing ADC of any other properties where the source of repayment at

organization of the exposure is either the future uncertain sale of the property orcash flows whose source of repayment is substantially uncertain ( e.g. the property

has not yet been leased to the occupancy rate prevailing in that geographic market

for that type of commercial real estate). Unless the borrower has substantial equity

at risk. Commercial ADC loans exempted from treatment as HVCRE loans on the

basis of certainty of repayment of borrower equity are, however, ineligible for the

additional reductions for SL exposures described in paragraph.

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Where supervisor categorize certain types of commercial real estate exposures as

HVCRE in their jurisdictions, they are required to make public such

determinations. Other supervisors need to ensure that such treatment is then

applied equally to banks under their supervision when making such HVCRE loans

in that jurisdiction.

Definition of sovereign exposures

This asset class covers all exposures to counterparties treated as sovereigns under

the standardized approach. This include sovereigns (and their central banks),

certain PSEs identified as sovereigns in the standardized approach, MDBs that

meet the criteria for a 0% risk weight under the standardized approach.

Definition of bank exposures

Bank exposures also include claims on domestic PSEs that are traded like claims

on banks under the standardized approach, and MDBs that do not meet the criteria

for a 0% risk weight under the standardized approach.

Definition of retail exposures

An exposure is categorized as a retail exposure if it meets all of the following

criteria:

Nature of borrower or low value of individual exposures

-Exposures to individualssuch as revolving credits and lines of credit (e.g. credit

cards, overdrafts, and retail facilities secured by financial instruments) as well as

personal term loans and leases (e.g. installment loans, auto loans and leases,

student and educational loans, personal finance, and other exposures with similar

characteristics) - are generally eligible for retail treatment regardless of exposure

size, Although supervisor may wish to establish exposure thresholds to distinguish

between retail and corporate exposures.

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-Residential mortgage loans (including first and subsequent liens, term loans and

revolving home equity lines of credit) are eligible for retail treatment regardless of

exposure sizes so long as the credit is extended to an individual that is an owner

occupier of the property

(With the understanding that supervisors exercise reasonable flexibility regarding

building containing only a few rental units otherwise they are treated as corporate).

Loans secured by a single or small number of condominium or cooperative

residential housing units in a single building or complex also fall within the scope

of the residential mortgage category. National supervisors may set limits on the

maximum number of housing units per exposure.

-loans extended to small business and managed as retail exposures are eligible for

retail treatment provided the total exposure of the banking group to a smallbusiness borrower( on a consolidated basis where applicable) is less than a million.

Small business loans extended through or guaranteed by an individual are subject

to the same exposure threshold.

-it is expected that supervisors provide flexibility in the practical application of

such threshold such that banks are not forced to develop extensive new information

systems simply for the purpose of ensure that such flexibility( and the implied

acceptance of exposure amounts in excess of the threshold that are not treated as

violations) is not being abused.

Definition of equity exposures

In general, equity exposures are defined on the basis of the economic substance of

the instrument. An instrument is considered to be equity if it meets all of the

following requirements:

-It is irredeemable in the sense that the return of invested funds can be achieved

only by the sales of the investment or sale of the rights to the investment or by theliquidation of the issuer.

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-It does not embody an obligation on the part of the issuer, and

-It conveys a residual claim on the assets or income of the issuer.

2. Foundation and advanced approaches

For each of the asset classes covered under the IRB framework, there are three key

elements:

-Risk components- estimates of parameters provided by banks some of which are

supervisory estimates that are probability of default (PD). Loss given default

(LGD), exposure at default (EAD) and effective maturity (EM)

-Risk-weight functions- themselves by which risk components are transformed into

risk-weighted asset and therefore capital requirements.-Minimum requirement the minim understands that must be met in order for a

bank to use the IRB approach for a given asset class.

For many of the asset classes, the committee has made available two broad

approaches: a foundation and an advanced. Under the foundation approach, as a

general rule, banks provide their own estimates of PD and rely on supervisory

estimates for other risk components.

Under the advanced approach, banks provide more of their own estimates of PD,LGD, and EAD, and their own calculation of M, subject to meeting minimum

standards.

For both the foundation and advanced approaches, banks must always use the risk

weight functions provided in this frame work for the purpose of deriving capital

requirements.

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The full suite of approaches is described below.

(I) Corporate, sovereign, and bank exposures

-Under the foundation approach, banks must provide their own estimates of PD

associated with each of their borrower grades, but must use supervisory estimates

for the other relevant risk components. The other risk components are LGD, EAD

and M.

-Under the advanced approach, banks must calculate the effective maturity (M)

and provide their own estimates of PD, LGD and EAD.

Banks that meet the requirements for the estimation of PD is able to use the

foundation approach to corporate exposure of derive risk weights for all classes of

SL exposures except HVCRE. At national discretion, banks meeting therequirements for HVCRE exposure are able to use a foundation approach that is

similar in all respects to the corporate approach, with the exception of a separate

risk weight function. Banks that meet the requirements for the estimation of PD,

LGD and EAD are able to use the advanced approach to corporate exposures to

derive risk weights for all classes of SL exposures except HVCRE. At national

discretion, banks meeting these requirements for HVCRE exposure are able to use

an advanced approach that is similar in all respects to the corporate approach, with

the exception of a separate riskweight function.

Banks that meet the requirement for the estimation of PD, LGD and EAD are able

to use the advanced approach to corporate exposures to derive risk weights for all

classes of SL exposures except HVCRE. At national discretion, banks meeting

these requirements for HVDRE exposure are able to use an advanced approach that

is similar in all respects to the corporate approach, with the exception of a separate

risk weight function.

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(ii) Retail exposures

For retail exposures, banks must provide their own estimates of PD, LGD and

EAD.

There is no distinction between a foundation and advanced approach for this asset

class.

(iii)Equity exposures

There are two broad approaches to calculate risk weighted assets for equity

exposures not held in the trading book: a market- based approach and a PD/LGD

approach.

The PD/LGD approach to equity exposures remains available for banks that adoptthe advanced approach for the other exposure types.

(iv)Eligible purchased receivables

The treatment potentially straddles two asset classes. For eligible corporate

receivables, both a foundation and advanced approach are available subject to

certain operational requirements being met. For eligible retail receivables, as with

retail asset class, there is no distinction between a foundation and advanced

approach.

3. Adoption of the IRB approach across asset classes

Once a bank adopts an IRB approach for part of its holdings, it is expected to

extend it across the entire banking group. As we recognize however, that, for many

banks, it may not be PRACTICABLE for various reasons to implement the IRB

approach across all material asset classes and business units at the same time.

Furthermore, once on IRB, data limitations may mean that banks can meet the

standards for the use of own estimates of LGD and EAD for some but not all of

their asset classes/business units at the same time.

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As such, supervisors may allow banks to adopt a phased rollout of the IRB

approach across the banking group. The phased rollout includes (I) adoption of

IRB across asset classes within the same business unit (or in the case of retail

exposures across individual sub classes); (ii) adoption of IRB across business units

in the same banking group; and (iii) move from the foundation approach to theadvanced approach for certain risk components. However, when a bank adopts an

IRB approach for an asset class within a particular business unit (or in the case of

retail exposures for an individual sub class), it must apply the IRB approach to all

exposures within that asset class (or sub class) in that unit.

A bank must produce an implementation plan, specifying to what extent and when

it intends to roll out IRB approaches across significant asset classes (or sub classes

in the case of retail) and business units over time. The plan should be exacting, yet

realistic, and must be agreed with the supervisor. It should be driven by the

practically and feasibility of moving to the more advanced approaches. During the

roll out period, supervisor will ensure that no capital relief is granted for intra

group transaction which is designed to reduce a banking groups aggregate capital

charge by transferring credit risk among entities on the standardized approach,

foundation and advanced IRB approaches. This includes, but is not limited to, asset

sales or cross guarantees.

Some exposures in no significant business units as well as asset classes (orsubclasses in the case of retail) that are immaterial in terms of size and perceived

risk profile may be exempt from the requirements in the previous two paragraphs,

subject to supervisory approval.

Notwithstanding the above, once a bank has adopted the IRB approach for all or

part of any of the corporate, bank, sovereign, or retail asset classes, it will be

required to adopt the IRB approach for its equity exposures at the same time,

subject to materiality. Supervisor may require a bank to employ one of the IRB

equity approaches if its equity exposures are a significant part of the banksbusiness, even though the bank may not employ an IRB approach in other business

lines.

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Further, once a bank has adopted the general IRB approach for corporate

exposures, it will be required to adopt the IRB approach for the SL sub classes

within the corporate exposure class.

Banks adopting an IRB approach are expected to continue to employ an IRBapproach. A voluntary return to the standardized or foundation approach is

permitted only in 57 extraordinary circumstances, such as divestiture of a large

fraction of the banks credit related business, and must be approved by the

supervisor.

Given the data limitations associated with SL exposures, a bank may remain on the

supervisory slotting criteria approach for one or more of the PF, OF, CF, IPRE or

HVCRE sub classes, and move to the foundation or advanced approach for other

subclasses, within the corporate asset class. However, a bank should not move tothe advanced approach for the HVCRE sub class without also doing so for material

IPRE exposures at the same time.

Credit Risk- The standardized Approach

The following section sets out revisions to the 1988 Accord of BIS committee for

risk weighting banking book exposures.

A. External Credit Assessment

1. The recognition process

National supervisor are responsible for determining whether an external credit

assessment institution (ECAI) meets the criteria listed in the paragraph below. The

assessment of ECAI s may be recognized on a limited basis, e. g. by type of claims

or by jurisdiction. The supervisory process for recognizing ECAIs should be made

public to avoid unnecessary barriers to entry.

2. Eligibility criteria

An ECAI must satisfy each of the following six criteria.

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Objectivity:The methodology for assigning credit assessments must be rigorous,

systematic, and subject to some form of validation based on historical experience.

Moreover, assessment must be subject to ongoing review and responsive to

changes in financial condition. Before being recognized by supervisors, anassessment methodology for each market segment, including rigorous back testing,

must have been established for at least one year and preferably three years.

Independence: An ECAI should be independent and should be independent and

should not be subject to political or economic pressures that may influence the

rating. The assessment process should be as free as possible from any constraints

that could arise in situations where the composition of the board of directors or the

shareholders structure of the assessment institution may be seen as creating a

conflict of interest.

International access/ Transparency: The individual assessments should be

available to both domestic and foreign institutions with legitimate interests and at

equivalent terms. In addition, the general methodology used by the ECAI should

be publicly available.

Disclosure: An ECAI should disclose the following information its assessment

methodologies, including the definition of default, the time horizon, and the

meaning of each rating; the actual default rates experienced in each assessmentcategory; and the transitions of the assessment e.g. the likelihood of AA ratings

becoming an over time.

Resources: An ECAI should have sufficient resources to carry out high quality

credit assessment. These resources should allow for substantial ongoing contact

with senior and operational levels within the entities assessed in order to add value

to the credit assessment. Such assessments should be based on methodologies

combining qualitative and quantitative approaches.

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Credibility: To some extent, credibility is derived from the criteria above. In

addition the reliance on an ECAIs external credit assessment by independent

parties (investors, insurers, trading partners) is evidence of the credibility of the

assessment of an ECAI. The credibility of an ECAI is also underpinned by the

existence of internal procedures to prevent the misuse of confidential information.In order to be eligible for recognition, an ECAI does not have to assess firms in

more than one country.

B. Implementing Consideration

1. The mapping process

Supervisors will be responsible for assigning eligible ECAIs assessment to the

risk weights available under the standardized risk weighting frame work, i.e.

deciding which assessment categories correspond to which risk weights.

The mapping process should be objective and should result in a risk weight

assignment consistent with that of the level of credit risk reflected in the tables

above. It should cover the full spectrum of risk weights.

When conducting such a mapping process, factors that supervisor should assess

include, among other, the size and scope of the pool of issuers that each ECAI

covers, the range and meaning of the assessment that it assigns, and the definition

of default used by the ECAI.

In order to promote a more consistent mapping of assessments into the available

risk weights and help supervisors in conducting such a process.Banks must use the

chosen ECAIs and their ratings consistently for each type of claim, for both risk

weighting and risk management purposes. Banks will not be allowed to cherry

pick the assessment provided by different ECAIs.

Banks must disclose ECAIs that they use for the risk weighting of their assets by

type of claims,

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The risk weights associated with the particular rating grades as determined by

supervisor through the mapping process as well as the aggregated risk Weighted

assets for each risk weight based on the assessments of each eligible ECAI.

2. Multiple assessments

If there is only one assessment by an ECAI chosen by a bank for a particular claim

that assessment should be used to determine the Risk weight of the claim. If there

are two assessments by ECAIs chosen by a bank which map into different risk

weights, the higher risk weight will be applied. If there are three or more

assessments with different risk weights, the assessments corresponding to the two

lowest risk weights should be referred to and the higher of those two risk weights

will be applied.

3. Domestic currency and foreign currency assessment

Where unrated exposures are risk weighted based on the rating of an equivalent

exposure to that borrower, the general rule is that foreign currency ratings would

be used for exposures in foreign currency. Domestic currency ratings, if separate,

would only be used to risk weight claims denominated in the domestic currency.

4. Short term/long term assessment

For risk-weighting purposes, short term assessments are deemed to be issuespecific. They can only be used to derive risk weights for claims arising from the

rated facility in on event can a short term rating can be used to support a risk

weight for an unrated long term claim. Short term assessments may only be used

for short term claims against banks and corporate.

The table below provides a frame work for bank exposure to specific short term

facility, such as a particular issuance of commercial paper.

Creditassessment

A1-P1 A2-P2 A3-P3 Others

Risk weight 20% 50% 100% 150%

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The credit rating follows the methodology used by standard and poors and by

Moodys investorsservice.

If a short term rated facility attract a 50% risk weight, unrated short term claims

cannot attract a risk weight lower than 100%. If an issuer has a short term facilitywith an assessment that warrants a risk weights of 150%, all unrated claims,

whether long term or short term, should also receive a 150% risk weight, unless the

bank users recognized credit risk mitigation techniques for such claims.

In cases where national supervisors have decided to apply option 2 under the

standardized approach to short term interbank claims to banks in their jurisdiction,

the interaction with specific short term assessments is expected to be the following

The general preferential treatment for short term claims, applies to all banks of up

to three months original maturity when there is no specific short term claim

assessment.

MEASURING THE CREDIT RISK

There are various types of measuring credit risks, in the limitation of the research;

we are going to discuss the following techniques for measuring the credit risk.

1 .VALUEATRISK

Financial institutions and corporate treasuries require a method for reporting their

risk that is really understandable by non-financial executives, regulators and the

investment public and they also require that this mechanism be scientifically

rigorous.

The answer to this problem is Value- at- risk (VAR) analysis. VAR is a number

that expresses the maximum expected loss for a given time horizon and for a given

confidence interval and for a given position or portfolio of instruments, under

normal market conditions, attributable to changes in the market price of financialinstrument.

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Suppose that we are investment managers with positions in foreign exchange, fixed

income and equities.

We need an assessment of what we can expect the worst case to be for the position

overnight with a 95% degree of confidence. The VaR number gives us thismeasurement. For example, the portfolio manager might have 100 million dollars

under management and an overnight 95% confidence interval VaR of 4 million

dollars.

This means that 19 times out of 20 his biggest loss should be less than 4 million

dollars. Hopefully, he is making money instead of losing money. You can also

express VaR as a percentage of assets, in this case 4%.

VaR is also useful when we want to compare the riskiness of different portfolios.

Let us now consider two portfolio managers. Each of them starts the years with

100 million dollars under management. Bob makes a return of 30% handily beating

his target of 20%.

Jerry makes a return of 20%, coming in on target. Who is the better fund

manager? The answer is, as economists always say, it depends. To make an

accurate judgment, many people believe that we need to compare the risk involved.

Lets say that As average overnight 95% VaR was 7 million dollars and Bs

average overnight 95% VaR was 2 million dollars. One day of calculating Bobs

return on risk capital is a follows: 30 million dollars/7 million dollars= 428.6%

using the same method, Bs return on risk capital is: 20 million dollars/2 million

dollars=1000.

It could be reasonably argued that B is a better fund manager in that he used his

risk capital more efficiently. How many people when they invest in mutual funds

know anything about the risk that their portfolio managers take in generating a

return? Most mutual funds do not report this kind of risk adjusted number,although some of them could use it to justify or explain their actions This is

especially important when evaluation how closely a portfolio manager conformed

to the stated risk tolerance of his fund.

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This is especially important when evaluation how closely a portfolio manager

conformed to the stated risk tolerance of his fund. If the funds is advertising itself

as a very low-risk investment vehicle suitable for windows &orphans, the average

daily VAR as percentage of assets is an interesting number, especially, when

compared to investments. Corporate treasuries & banks use VAR for the samepurposes.

CALCULATING VALUE-AT-RISK

Value-at-Risk is scientifically rigorous in that it utilizes statistical techniques that

have evolved in physics and engineering. VaR is questionable in that it makes

assumptions in order to use these statistical techniques. Chief among these

assumptions is that the return of financial prices is normally distributed with a

mean of zero. The return of a financial price may be thought of as the capitalgain/loss that one might expect to accrue from holding the financial asset for one

day.

For example, in the case of foreign exchange, if I own one Canadian dollar against

being short 1 US dollar, I will earn a return overnight if the Canadian dollar

appreciates against the US dollar. One way of expressing the return is the

difference between the current price and the previous period's price, divided by the

previous period's pen. CJP Morgan has developed a methodology for calculating

components) called Risk Metrics.

Risk Metrics forecasts the volatility of financial instruments and their various

correlations. It is this calculation that enables us to calculate the VaR in a simple

fashion. Volatility comes into play because if the underlying markets are volatile,

investments of a given size are more likely to lose money than they would if

markets were less volatile.

Volatility here refers to the distribution of the return around the mean. A volatile

market is one in which the returns can vary greatly around the mean while a calmmarket is one in which the returns vary little around the mean.

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Correlation is important, too. Modern portfolio theory is familiar to many people

who intentionally diversify their investments.

If we invest all of our money in a set of financial instruments that move in the

same direction and with the same relative speed, that is a riskier portfolio than ifwe invest in a portfolio of financial instruments that move in different directions at

different speeds. If the instruments in the former portfolio all move down, we will

lose money on each of these instruments whereas we would expect to make money

on some instruments and lose money on the remaining instruments in the latter

portfolio. Hopefully, in the case of the latter portfolio, we make more money than

we lose, on average. Earlier, we stated that volatility was both dynamic and

persistent. That is to say, volatility changes over time but it moves in a trending

fashion. Correlation is dynamic, too. Correlations move with less persistence than

volatilities. It is easy to see how complex the management of financial price risk

can be with a portfolio containing more than two or three instruments. For more

information, visit the Risk Metrics web site at http://www.riskrnetrics.com. Once

optionality is involved, it becomes computationally difficult to calculate the VaR,

in some cases requiring statistical simulation of the portfolio. The reason for this is

because of the convexity of option products. Straightforward VaR calculation

underestimates or overestimates the VaR, depending on whether or not one is long

or short convexity (i.e. whether one owns or has sold options).

SCNARIO ANALYSIS:

In describing VAR, we have emphasized the fact that VAR is only good for

calculation an expected maximum loss under normal market conditions. Because

of generally idiosyncratic nature of financial prices we must have a way of

understanding the implications for our portfolio of abnormal market conditions.

Scenario analysis is the tool we use for this purpose. Consider this portfolio

manager.

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Scenario analysis is the tool we use for this purpose. Consider this portfolio

manager from our original example in this article who has an overnight 95%

VaR of 4 million dollars on underlying assets of 100 million dollars. The VaR

number that our calculator generates describes his expected loss under normal

market conditions. An important critical adjunct procedure to VaR measurement isscenario analysis. In scenario analysis, the portfolio manager will simulate various

hypothetical evolutions of events in order to determine their effect on the value of

the portfolio

Any portfolio manager must understand what the weak spot is in his portfolio.

Naturally this is the first set of scenarios to simulate. By determining the change in

value of his portfolio under stressful conditions (called "stress-testing"), the

portfolio manager has a better perception of where the risks in his portfolio lie. At

that point, he can make trades that reduce this risk to levels with which he is

comfortable. At the very least, he has an appreciation of what will happen so that if

the worst-case does take place unexpectedly,he can act more decisively and more

quickly to manage his portfolio. Without this kind of stress-testing, he will be

forced to react in a moving market, a situation that can exacerbate his market

losses. In a complex derivatives portfolio, stress-testing that reveals excessively

risky exposures either to movements in the underlying cash rate or shifts in implied

volatility or interest rates (or combinations of these factors) is said to identify "risk

holes."

For example, an options portfolio that is short a great deal of short-dated options

around a particular strike is said to have a "gamma hole" around that strike and

date (analogous to space and time, in a physical sense).

If the underlying rate were to move to the same level as the strike price around the

same time as the options were maturing or just before, the portfolio would become

very difficult to manage and the profitability of the portfolio could become

intolerably volatile. The bottom line here is that all of these ways of measuring riskmust he interpreted in terms of the preferences of the investor or the institution

managing the risk

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3. Expected and Unexpected Loss Measurement

Once current and potential credit exposures are calculated, expected and

unexpected losses may be determined using estimated default probabilities and

recovery rates. Expected credit losses are defined as the mean of the credit lossdistribution based on the distribution of credit exposures, the default probability of

the counterparty, and the expected recovery rate if counterparty were to default.

Unexpected credit losses are defined as an extreme (e.g., 99 percent confidence

interval) level of loss derived from the credit loss distribution determined.

Expected credit loss calculations are used to determine expected net returns to the

portfolio, and unexpected credit losses are used to determine extreme potential

credit losses to the portfolio, similar to the market risk losses estimated by value at

risk.

Expected and unexpected loss measurement requires even more data about the

counterpartyspecifically default probabilities and recovery rates. Historic default

probabilities are available from public rating. agencies, such as Standard & Poor's

and Moody' s. Default probabilities may also be determined using vendor

methodologies, such as KMV's Credit Monitor, the Risk Metrics Group's Credit

Manager, Credit Suisse First Boston's Credit Risk +, and Moody's Risk Calc.

Where default probability methodologies rely on historic data, questions about

applicability exist due to the small number of data points available.

Other methodologies that do not rely on historic default data rely on certain

assumptions about firms and markets that must be considered. Historic recovery

rates on senior securities are available from Standard & Poor's and Moody's.

MANAGING CREDIT RISK

WHY MANAGING THE RISK?

- Increase shareholders value Value creation

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Value preservation

Capital optimization

- Instill confidence in the market place

- Alleviate regulatory constraint and distortions there of

CREDIT DERIVATIVES

A credit derivative is a financial instrument used to mitigate or to assume specific

forms of credit risk by hedgers and speculators. These new products are

particularly useful for institutions with widespread credit exposures. Some

observers suggest that credit derivatives may herald a new form of international

banking in which banks resemble portfolios of globally diversified credit risk morethan purely domestic lenders.

CREDIT SWAPS

Corporate bonds trade at a premium to the risk-free yield curve in the same

currency. US Corporate Bonds trade at a premium (called a credit spread) to the

US Treasury curve. The credit spread is volatile in and of itself and it may be

correlated with the level of interest rates.

For example, in a declining, low interest rate environment combined with strongdomestic growth, we might expect corporate bond spreads to be smaller than their

historical average.

The corporate who has issued the bond will find it easier to service the cash flows

of the corporate bond and investors will be hungry for any kind of premium they

can add to the risk-free rate.

Imagine the fund manager who specializes in corporate bonds who has a view on

the direction of credit spreads on which he would like to act without taking aspecific position in an individual corporate bond or a corporate bond index.

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One way for the fund manager to take advantage of this view is to enter into a

credit swap.

Let's say that the fund manager believes that credit spreads are going to tighten and

that interest rates are going to continue to decline.

He would then want to enter into a swap in which he paid the corporate yield at six

month intervals against receiving a fixed yield equal to the inception Treasury

yield plus the corporate credit spread. That is to say, at the six-month reset for the

tenor of the swap, the fund manager agrees to pay a cash flow determined to be

equal to the current annual yield on some benchmark corporate bond or corporate

bond index in consideration for receiving a fixed cash flow.

This is an off-balance sheet transaction and the swap will typically have zero value

at inception .If corporate yield, continue to fall (i.e. through a combination of a

lower risk-free rate and a lower corporate credit spread than the one he locked in

with the swap), he will make money.

If corporate yields rise, he will lose money.1998 was a dynamic year for corporate

bond spreads with the backup in interest rates in the aftermath of the Russian

devaluation-inspired liquidity crisis concentrated mainly in corporate yields. The

volatility of these spreads was extreme when compared to their historical

movement. Credit swaps would have been an excellent way to play this spreadvolatility.

Moreover, credit swaps (particularly ones based on a spread index) are clean

structures without the messy difficulty of finding individual corporate bond supply,

etc.

Another example of a credit swap might be the exchange of fixed flows

(determined by the yield on a corporate bond at inception) against paying floating

rate flows tied to the risk-free Treasury rate for the corresponding maturity.

Naturally, swaps are flexible in their design. If you can imagine a cash flow

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Exchange, you can structure the swap. There might be a cost associated with it but

you can certainly put it on the books.

CREDIT DEFAULT SWAPS

A credit default swap is a swap in which one counterparty receives a premium at

pre-set intervals in consideration for guaranteeing to make a specific payment

should a negative credit event take place.

One possible type of credit event for a credit default swap is a downgrade in the

credit- status of some preset entity.

Consider two banks: First Chilliwack Bank and Basque de Bas.

Chilliwack has made extensive loans in its corporate credit portfolio to a propertydeveloper called Churchill Developments.

It is looking for some kind of insurance against a downgrade of Churchill by the

major ratings agency, a real possibility since the main project

Churchill has taken on is running into unforeseen delays. Chilliwack Banquet de

Bas with the concept of a credit default swap. They pay Basque deal premium

every six months for the next five years in exchange for which de Baste make

payments to Chilliwack of a pre-set amount should Churchill betas now has

exposure to Churchill, a position they could not take directly because are not part

of Churchill's lending syndicate.

Chilliwack has some degree of protection against a Churchill credit downgrade.

This reduction in their overall credit profile means that they do not need to hold as

much ital. in reserve, freeing Chilliwack up to take other business opportunities as

they present themselves.

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OPTIONS ON CREDIT RISKY BONDS

Finally, our fund manager from the first example could use an options position to

take of advantage of his view on the level of the corporate yield.

If he believed that corporate yields were set to fall through some combination of

lower risk free interest rates and tighter corporate bond spreads, then he could just

buy a call on a corporate bond of the appropriate maturity.

These are just a few of the examples of credit derivatives. Institutional investors

often use credit derivatives when positioning themselves in emerging markets for

the ease of transaction in the same way that they might use equity swaps. Fund

managers can use derivatives to hedge themselves against adverse movements in

credit spreads.

Corporation can use credit swaps to hedge near-term issues of corporate bonds.

Banks & other financial institution

Corporation can use credit swaps to hedge near-term issues of corporate bonds.

Banks and other financial institutions can use credit derivatives to optimize the

employment of their capital by diversifying their portfolio-wide credit risk.

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CHAPTER-3

COMPANY PROFILE

Company Overview:

SBM ., is an entity formed with the coming together of erstwhile, SBM Ltd, a

premier bank in the Indian Private Sector and a global financial powerhouse, 1MG

of Dutch origin, during Oct 2002.

The origin of the erstwhile SBM was pretty humble. It was in the year 1930 that a

team of visionaries came together to form a bank that would extend a helping hand

to those who weren't privileged enough to enjoy banking services.

It's been a long journey since then and the Bank has grown in size and stature to

encompass every area of present-day banking activity and has carved a distinct

identity of being India's Premier Private Sector Bank.

In 1980, the Bank completed fifty years of service to the nation and post 1985; the

Bank made rapid strides to reach the coveted position of being the number one

private sector bank. In 1990, the bank completed its Diamond Jubilee year. At the

Diamond Jubilee Celebrations, the then Finance Minister Prof. Madhu Dandavate,

had termed the performance of the bank 'Stupendous'. The 75th anniversary, the

Platinum Jubilee of the bank was celebrated during 2005.

The origin of SBM

On the other hand, SBM originated in 1990 from the merger between National -

Nederland NV the largest Dutch Insurance Company and NMB Post Bank Grope

NV. Combining roots & ambitions, the newly formed company called

International Nederland Group

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Market circles soon abbreviated the name to I-N-G. The company followed suit by

changing the statutory name to "1MG Group N.V.".

Profile

SBM has gained recognition for its integrated approach of banking, insurance andasset management.

Furthermore, the company differentiates itself from other financial service

providers by successfully establishing life insurance companies in countries with

emerging economies, such as Korea, Taiwan, Hungary, Poland, Mexico and Chile.

Another specialization is 1SBM Direct, an Internet and direct marketing concept

with which SBM is rapidly winning retail market share in mature markets. Finally,

SBM distinguishes itself internationally as a provider of 'employee benefits', i.e.

arrangements of nonwage benefits, such as pension plans for companies and their

employees.

Mission

SBM's mission is to be a leading, global, client-focused, innovative and low-cost

provider of financial services through the distribution channels of the client's

preference in markets where SBM can create value.

The new identity

The immediate benefit to the bank, SBM, has been the pride of having become a

Member of the global financial giant SBM As at the end of the year December

2009, SBMs total assets exceeded 1164 billion Euros, employed around 110000

people, served over 85 million customers, across 40 countries.

This global identity coupled with the back-up of a financial power house and the

status of being the first Indian International Bank, would also help to enhance

productivity, profitability, to result in improved performance of the bank, for thebenefit of all the stake holders.

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In terms of pure numbers, the performance over the decades can better be

appreciated from the following table:

Rs. In millions

Year Net worth Deposits Advances Profits Outlets

1998 0.001 0.400 0.400 0.001 4

1999 1.40 5.30 3.80 0.09 16

2000 1.60 20.10 13.50 0.13 19

2001 3.00 91.50 62.80 0.74 39

2002 11.50 1414.30 813.70 1.13 228

2003 162.10 8509.40 4584.80 50.35 319

2004 5900.00 74240.00 39380.00 443.10 481

2005 6527.00 81411.10 43163.10 371.90 484

2006 6863.24 80680.00 44180.00 687.50 483

2007 7067.90 91870.00 56120.00 863.50 456

2008 7473.20 104780.00 69367.30 590.01 523

2009 7094.00 125693.10 90805.90 (381.80) 536

2010 10196.70 133352.50 102315.20 90.6 562

2011 11101.90 154185.70 119761.70 889.0 626

2012 14260.00 204980.00 146500.00 1569.00 677

2013 15940.00 248900.00 167510.00 1888.00 857*

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* Outlets comprises of 441 branches, 37 ECs, 28 Satellite Offices and 351 ATMs

as of March 31st 2013. Additionally the bank also has Internet Banking, mi-bank

and Customer Service Line for Phone Banking Service

INDUSTRY OVERVIEW:

A commercial bank is a type of financial intermediary and a type of ban.

Commercial banking is also known as business banking. It is a bank that provides

checking accounts, savings accounts, and money market accounts and that accepts

time deposits [1] After the implementation of the Glass-Seagull Act, the U.S.

Congress required that banks engage only in banking activities, whereas

investment banks were limited to capital market activities. As the two no longer

have to be under separate ownership under U.S. law, some use the term

"commercial bank" to refer to a bank or a division of a bank primarily dealing withdeposits and loans from corporations or large businesses. In some other

jurisdictions, the strict separation of investment and commercial banking never

applied. Commercial banking may also be seen as distinct from retail banking,

which involves the provision of financial services direct to consumers. Many banks

offer both commercial and retail banking services.

Commercial banks engage in the following activities:

* processing of payments by way of telegraphic transfer, EFTPOS, internetbanking, or other means

issuing bank drafts and bank cheques

accepting money on term deposit

* lending money by overdraft, installment loan, or other means

* providing documentary and standby letter of credit, guarantees, performance

bonds, securities underwriting commitments and other forms of off balance sheetexposures .

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* Safekeeping of documents and other items in safe deposit boxes

* Sale, distribution or brokerage, with or without advice, of insurance, unit trusts

and similar financial products as a "financial supermarket"

* Cash management and treasury services

* Merchant banking and private equity financing

* Traditionally, large commercial banks also underwrite bonds, and make markets

in currency, interest rates, and credit-related securities, but today large commercial

banks usually have an investment bank arm that is involved in the mentioned

activities.

Profile of SBM Credit Risk Management

Credit risk, the most significant risk faced by SBM, is managed by the Credit Risk

Compliance & Audit Department (CRC & AD), which evaluates risk at the

transaction level as well as in the portfolio context. The industry analysts of the

department monitor all major scoots aid evolve a sartorial outlook, which as an

important input to the portfolio planning process. The department has done

detailed studies on default patterns of loans and prediction of defaults in the Indian

context. Risk-based pricing of loans has been introduced.

The functions of this department include:

Review of Credit Origination & Monitoring

o Credit rating of companies/structures Default risk & loan pricing

o Review of industry sectors

o Review of large exposures in industries/ corporate groups/ companies

o Ensure Monitoring and follow-up by building appropriate systems such as CASE

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Design appropriate credit processes, operating policies & procedures

Portfolio monitoring

Methodology to measure portfolio risk

Credit Risk Information System (CRIS)

Focused attention to structured financing deals

Pricing, New Product Approval Policy, Monitoring

Monitor adherence to credit policies of RBI

During the year, the department has been instrumental in reorienting the credit

processes, including delegation of powers and creation of suitable control points inthe credit delivery process with the objective of improving customer response time

and enhancing the effectiveness of the asset creation and monitoring activities.

Availability of information on a real time basis is an important requisite for sound

risk management. To aid its interaction with the strategic business units, and

provide real time information on credit risk, the CRC & AD has implemented a

sophisticated information system, namely the Credit Risk Information System

In addition, the CRC & AD has designed a web-based.

Risk Management Structure:

Centralized risk management with integrated treasury operations Board: Set risk

limits

- Risk management committee:

Identity, monitor and measure risk profile o Develop policies and procedures

Verifying pricing model

Reviewing Risk Models

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Identify New Risks

Risk Limits in terms of CARVAR

RISK MANAGEMENT STRUCTUR

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Risk Management Committee

Asset Liability ManagementCommittee

Credit Policy Committee


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CHAPTER-4

RISK LENDING

RISK IN LENDING:

INTRINSIC RISK:

- Deficiencies in Loan policies and procedures

- Absence of Prudential Credit conc. Limits

- Inadequately defined lending limits

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- Deficiency in appraisal

Risk in lending

Interest Rate

Risk

Forex Risk Counter Party

Risk

Credit Risk Country Risk

Default Risk Portfolio Risk

Intrinsic Risk

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- Excessive dependence collateral

- Inadequate risk pricing

- Absence of post sanction surveillance

CONCENTRATION RISK

- State of Economy - Volatility in

Equity market Commodity Market

Foreign Exchange Market

Interest Rate - Trade restriction

- Economic Sanction

- Government Policies

Instrument of Credit Risk Management

- Credit Approving Authority

- Prudential limits

- Risk rating

- Risk pricing

- Portfolio Management

- Loan review mechanism

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RISK RATING:

- Rating reflects underlying credit risk of loan book

- Encompass industry risk, business risk, financial risk, risk management - Specify

cutoff standards/ critical parameters

- Separate rating framework for large corporate, small borrowers, traders etc.. -

Account for UN hedged market risk exposure of borrowers

Research Design

a. Research Objectives

The ultimate objective of this research is to critically evaluate the effect of the

credit risk on the financial institution especially in the banking sector and howthese organizations manage and control such risks. In the process of such

evaluation, this research will try to get an insight as to how the credit risk works,

what their effects on financial institution, and which tools and methods the

financial institution use to measure and control those risks. To sum up, the research

objectives are enlisted below:

1. To understand the specific types of credit risk and how to measure credit risk.

2. To identify the tools and methods which are used by financial institution andhow they safe guard financial institution against unexpected losses arising from

credit risk.

b. Statement of the problem

In managing risk, financial institution must decide which risks to take, which to

transfer, and which to avoid altogether.

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Accepting credit risk, though, is fundamentally the business of banking and other

institutions and is the activity which most banks see as their principal competitive

advantage.

In recent years, leading banks have devoted increased attention to measuring creditrisk and have made important gains, both by employing innovative and

sophisticated risk modeling techniques and also by strengthening their more

traditional practices. From the above point of view, my research will focus on 1

basic question: How does financial institution manages credit risk? To get a clear

idea for the research question, it will come up with extra questions such as: What is

the type and role of credit risk in financial institution? How are they measured?

And what are methods and tools does the financial use to manage and control the

risk?

c. Needs and importance of the study

Because taking risk is an integral part of the financial institution system, it is not

surprising that banks have been practicing risk management ever since there have

been banks--the industry could not have survived without it. The only real change

is the degree of sophistication now required to reflect the more complex and fast-

paced environment.

Risk exists and banks as well as financial institutions must accept risk if they are tothrive and meet an economy's needs. But they must manage the risks and recognize

them as real. Risk matters. Whether or not it is temporarily ignored, it will

eventually come out. Recognizing that fact and dealing with it will benefit lending

institutions and the economies in which they operate. Indeed, given globalization,

we must all adopt increasingly sophisticated risk management practices in the

years ahead.

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d. Methodology of data collection

The universe of the study was financial institutions, with respect to focus on

banking sector and credit department. Methodology is based on Primary Data and

Secondary information.

Primary Data:

The procedure followed in collection of primary data is through personal interview

with those who have knowledge in the credit risk control sector.

Secondary Data:

Secondary Data for credit risk management will be mainly collected from the

available press and issues of Bank for International Settlements, magazines, books,and internet.

Statistical tools and techniques for analysis:

- The data which is collected though both primary and secondary sources will be

tabulated on the datasheet.

- Various diagrams will be used with the help of appropriate statistical techniques

such as averages, percentages, regression, standard deviation etc

e. Limitations of the study

- The study is subject to the views and statistics as expressed by the concerned

officials of the financial institution, especially the banking sector.

- The primary data collected for the research is limited to the few public financial

institutions only.

- The actual identity of financial institution is kept confidential due to the sensitive

nature of the topic.

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5. Literature review

a. Purpose of review of literature.

The purpose of review of literature was to identify the problem statement,

understand the secondary data that has been gathered in this field of study and to

make new findings on the problem statement.

b. Methodology of the review of literature.

Methodology of literature review encompasses different facets of information

sources concerning credit risk management.

Sources of information for the literature review are as follows:

- Banking magazines

- Internet

- Newspaper publications and articles

Whatever is happening to Indian Banking?

By C.P. Chandrasekhar (Financial News)Currently, banks seem to be the prime targets of the government's reforming zeal.

Having encouraged foreign acquisition, consolidation and universalization in the

banking system, the Finance Ministry's current thrust seems to be to find a host of

new areas of activity for these institutions. According to unconfirmed reports, the

Reserve Bank of India (RBI) has approved a proposal from the government to

amend the Banking Regulation Act to permit banks to trade in commodities and

commodity derivatives. This offer to banks, of one more new avenue of

speculative investment by removal of a prohibition on commodity trading that hasbeen in existence for long, merely furthers the fundamental changes that have been

under way in India's banking sector.

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In developing countries, the interventionist framework also had developmental

objectives and involved measures to direct credit to what were "priority" sectors in

the government's view.

In recent years liberalization and denationalization" have changed all that andforced a change in banking practices in two ways. First, private players are

unsatisfied with returns that are available within a regulated framework, so that the

government and the central bank have had to dilute or dismantle regulatory

measures as is happening in the case of priority lending as well as restrictions on

banking activities in India.

Second, even public sector banks find that as private domestic and foreign banks,

particularly the latter, lure away the most lucrative banking clients because of the

special services and terms they are able to offer, they have to seek new sources offinance, new activities and new avenues for investments, so that they can shore up

their interest incomes as well as revenues from various fee-based activities.

In sum, the processes of liberalization noted above fundamentally alter the terrain

of operation of the banks. Their immediate impact is a visible shift in the focus of

bank activities away from facilitating commodity production and investment to

lubricating trade and promoting personal consumption. Interest rates in these areas

are much higher than that which could be charged to investments in commodity

production. According to a study (Consumer Outlook 2004), conducted by market

research firm KSA Technopak, Indian consumers are increasingly financing

purchases of their dream products with credit that is now on offer, even without

collateral. 'Personal credit off take has increased from about Rs 50,000 crore in

2000 to Rs 1,60,000 crore in 2003, giving an unprecedented boom to high-ticket

item purchases such as housing and automobiles,' the study reportedly found.

But there are changes also in the areas of operation of the banks, with banking

entities not only creating or linking up with insurance companies, say, but also

entering into other "sensitive markets like the stock and real estate emits.

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It should be expected that this growing exposure to non-collateralized personal

debt and entry into sensitive sectors would increase bank vulnerability to default or

failure. The effects on bank fragility became clear after the stock scam of the late

1990s. The RBI's Monetary and Credit Policy Statement for the year 2001-2002

had noted that: "The recent experience in equity markets, and its aftermath, havethrown up new challenges for the regulatory system as well as for the conduct of

monetary policy.

It has become evident that certain banks in the cooperative sector did not adhere to

their prudential norms or to the well-defined regulatory guidelines for asset-

liability management nor even to the requirement of meeting their inter-bank

payment obligations. Even though such behavior was confined to a few relatively

small banks by national standards, in two or three locations, it caused losses to

some correspondent banks in addition to severe problems for depositors."

Interestingly, this increase in financial fragility has been accompanied by the

emergence of new instruments in the banking sector. Derivatives of different kinds

are now traded in the Indian financial system, including crucially, credit

derivatives. Most derivatives, financial instruments whose value is based on or

derived from the value of something else, are linked to interest rates or currencies.

Credit derivatives are based on the value of loans, bonds or other lending

instruments.

A working of the Reserve Bank of India had recommended in 2003 that scheduled

commercial banks may initially be permitted to use credit derivatives only for

managing their credit risks. But banks were not permitted to take long or short

credit derivative positions with a trading intent.

Credit derivatives were seen as helping banks manage the risk arising from adverse

movements in the quality of their loans, advances, and investments by transferring

that risk to a protection seller.

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Using credit derivatives banks can: (1) transfer credit risk and, hence, free up

capital, which can be used in other opportunities; (2) diversify credit risk; (3)

maintain client relationships, and (4) construct and manage a credit risk portfolio

as per their risk preference.

Banks in India have quickly responded to this opportunity. For example, soon after

the introduction of interest rate futures in India, Citigroup concluded three

securitization deals worths 570 crore ($126.6 million), where yields on

government securities or the call money rate, were used as the benchmark for

pricing floating rate payments for investors.

The underlying receivables arise from a large number of fixed rate loan contracts

made for financing commercial vehicles and construction equipment. The risk here

is being shared with mutual funds, who are reportedly the major investors.

Even the conservative State Bank of India (SBI) has taken a plunge into the credit

derivatives market to cope with the risk arising from its growing loan portfolio.

The bank had recorded a growth of almost Rs 36,000 crore or 25 per cent in its

loan portfolio on a year-on-year basis till September 2004, staring from a total loan

assets position of Rs 1, 35,000 crore in the corresponding period of the previous

year. Of this credit growth recorded by the bank, more than 40 per cent had been

contributed by retail assets. Credit derivatives offered an opportunity to hedge

against the risks being accumulated in this manner.

It should be clear that credit derivatives are an industry response to the increasing

fragility which comes with the changed nature of banking practices.

Derivatives of this kind permit the socialization of the risks associated with the

liberalization induced transformation of banking. These trends are in keeping with

changes in the international banking industry as well. As The Economist, London

put it: 'The world's leading banks decided some years ago that lending is a mug'

game. They began to get rid of their loans, repackaging them and selling them offas securities, or getting others to re-insure their risk."

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From the point of view of the banks this effort has been extremely fruitful. Thus,

when there was a major melt down in corporate America, as a result of financial

fraud and accounting malpractice, leading to the closure of giants like Enron and

WorldCom, leading banks that had lent large sums to them appeared unaffected.

According to one estimate, loans totaling $34 billion were wiped out through thesebankruptcies. But far less amounts showed up as losses in the bank's accounts and,

in the second quarter of 2003, Citigroup reported a 12 per cent increase in profits

and J.P. Morgan Chase a 78 per cent increase.

It should be clear that these losses have to show up so

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Risk Management (Project)