WHAT SHOULD BE AN IDEAL RISK MANAGEMENT POLICY?

(WITH SPECIAL REFERENCE TO CREDIT RISK MANAGEMENT POLICY)

RESEARCH WORK TOWARDS PARTIAL FULFILLMENT OF THE ASSESSMENT IN THE SUBJECT
OF PRINCIPLES AND PRACTICES OF BANK MANAGEMENT

NATIONAL LAW UNIVERSITY, JODHPUR

Submitted to:
DR. RITUPARNA DAS
ASSOCIATE PROFESSOR,
FACULTY OF MANAGEMENT
WORD COUNT: 10,000

Submitted by:
NEHA SHARMA
ROLL NO. 960
SIXTH SEMESTER
B.B.A., LL.B. (hons.)

CONTENTS
1.

INTRODUCTION....................................................................................................................3

2.

CREDIT RISK: BACKGROUND..............................................................................................5

3.

TOOLS OF CREDIT RISK MANAGEMENT...........................................................................7

4.

CREDIT RISK MANAGEMENT: POLICIES............................................................................8

5.

CREDIT RISK MANAGEMENT: PROCESS............................................................................9

6.

CREDIT RISK MANAGEMENT: PRUDENTIAL LIMITS.......................................................11

7.

CREDIT RISK: RATING......................................................................................................12

8.

CREDIT RISK: PORTFOLIO MANAGEMENT......................................................................13

9.

CREDIT RISK AND INVESTMENT BANKING......................................................................16

10. CREDIT RISK MANAGEMENT IN OFF-BALANCE SHEET EXPOSURE...............................16

11. PRINCIPLES FOR THE ASSESSMENT OF BANKS MANAGEMENT OF CREDIT RISK.........17
12. CREDIT RISK MANAGEMENT IN INDIA.............................................................................20
13. COMPARATIVE ANALYSIS: ADVANCED AND EMERGING MARKETS................................26
13. A. United Kingdom....26
13. B. The United States of America....................................................................................28
13. C. Korea:.........................................................................................................................29
13. D. Baltic States:..............................................................................................................29
14. CREDIT RISK MANAGEMENT: ANALYTICAL FRAMEWORK............................................32
15. CONCLUSION......................................................................................................................33
16. REFERENCES......................................................................................................................34

1. INTRODUCTION
Credit risk is the likelihood that a debtor or financial instrument issuer is unwilling or unable to
pay interest or repay the principal according to the terms specified in a credit agreement resulting
in economic loss to the banking institution.

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International institutions, analysts and rating agencies tend to regard emerging markets (EM)
banks as high risk. Advanced country banks are thought to be robust and well regulated. But the
global financial crisis (GFC) and the continuing European sovereign debt crisis demonstrated
just the opposite. After the East Asian crises, Emerging Markets have strengthened, with better
macro stabilisation and other reforms. However, the IMF (2011) has again warned about dangers
to Emerging Market banks. In October 2011, Moody downgraded the Indian SBI from C- to D+,
and in November, revised its outlook on Indias banking sector from stable to negative, although
S&P gave a stable assessment. This is part of a general assessment of higher risks for banks
around the globe.
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 counterparties, poor portfolio risk management, 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 counterparties. The worldwide credit crunch, which started in 2006 with sub-prime
mortgages in the United States, has highlighted the fundamental importance of the credit
decision. As the problems in these mortgages have unfolded, it has demonstrated that unsound
credit decisions were made and lessons as to how to effectively manage credit risk were either
ignored or never learned. It shows that poor lending decisions, whether by a financial institution
or a corporate, can lead to significant losses. What the incredible losses sustained by banks and
others caught up in the credit crunch have underlined is the major impact of credit risk and by
implication credit risk management on the wellbeing and profitability of businesses. Being able
to manage this risk is a key requirement for any lending decision.
Risk Management is a measure that is used for identifying, analyzing and then responding to a
particular risk. It is a process that is continuous in nature and a helpful tool in decision making
process. Credit risk is most simply defined as the potential that a bank borrower or counterparty
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
entire portfolio as well as the risk in individual credits or transactions. Banks should also
consider the relationships between credit risk and other risks. The effective management of credit
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risk is a critical component of a comprehensive approach to risk management and essential to the
long-term success of any banking organisation.
Structural risks are found to have fallen for Indian banks but cyclical risks are rising. The paper
outlines the implications of the risk-assessment for macroeconomic policy and for the structure
of international regulation. A loan-based banking system suffers if there are sharp changes in
interest rates. Large fluctuations in exchange rates, due to capital flows driven by external
shocks, also create risk. Policy needs to smooth such fluctuations and international institutions
need to design instruments to mitigate these risks.

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2. CREDIT RISK: BACKGROUND

Credit risk can be defined as the potential that a contractual party will fail to meet its obligations
in accordance with the agreed terms. Credit risk is also variously referred to as default risk,
performance risk or counterparty risk. These all fundamentally refer to the same thing: the
impact of credit effects on a firms transactions.
2. A. There are three characteristics that define credit risk:
i.

exposure (to a party that may possibly default or suffer an adverse change in its ability to

ii.
iii.

perform)
the likelihood that this party will default (or the default probability) on its obligations
the recovery rate (that is, how much can be retrieved if a default takes place). Note that the
larger the first two elements, the greater the exposure. On the other hand the higher the
amount that can be recovered, the lower the risk.

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 counterparty 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, monitor and control credit
risk as well as to determine that they hold adequate capital against these risks and that they are
adequately compensated for risks incurred. While the credit decision is relatively straightforward
in principle: a lender must decide whether to give credit or refuse credit to a potential client; in
practice, it involves experience, judgement and a range of analytic and evaluative techniques that
are designed to determine the likelihood that money will be repaid or equally, that the money
will be lost by the credit not being able to repay.

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2. B. Common sources of Credit problems are:

i.

Credit concentrations: these are viewed as any exposure where the potential losses are large
relative to the banking institutions capital, its total assets or, where adequate measures exist,
the banks overall risk level. This may be in the form of single borrowers or counterparties,
a group of connected counterparties, and sectors or industries, such as trade, agriculture, etc.
or in the form of common or correlated factors. The Asian crisis demonstrated how close
linkages among emerging markets under stress situations and correlation between market
and credit risks as well as between those risks and liquidity risk, can produce widespread

ii.

losses.
Credit process issues: Many credit problems reveal basic weaknesses in the credit granting
and monitoring processes. While shortcomings in underwriting and management of credit
exposures represent important sources of losses at banking institutions, many credit
problems would have been avoided or mitigated by a strong internal credit process.

2. C. The credit risk management practices set out in this document specifically address the
following areas:
(i)
(ii)
(iii)

establishing an appropriate credit risk environment;

operating under a sound credit granting process;
maintaining an appropriate credit administration, measurement and monitoring

(iv)

process; and
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 comprehensive credit risk management
program should address these four areas.1
The exact approach chosen by individual supervisors for credit risk will depend on a host of
factors, including their on-site and off-site supervisory techniques and the degree to which
external auditors are also used in the supervisory function. Supervisory expectations for the
credit risk management approach used by individual banks should be commensurate with the
1 Sound Practices for Loan Accounting and Disclosure (July 1999) and Best Practices for Credit
Risk Disclosure (September 2000).
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scope and sophistication of the banks activities. For smaller or less sophisticated banks,
supervisors need to determine that the credit risk management approach used is sufficient for
their activities and that they have instilled sufficient risk-return discipline in their credit risk
management processes.
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 transaction. 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 as credit
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.2

3. TOOLS OF CREDIT RISK MANAGEMENT

The instruments and tools, through which credit risk management is carried out, are detailed
below:
3. A. Exposure Ceilings: Prudential Limit is linked to Capital Funds say 15% for individual
borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by
the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial
Exposure, which is the sum total of the exposures beyond threshold limit should not exceed
600% to 800% of the Capital Funds of the bank (i.e. six to eight times).
3. B. Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of
powers, Higher delegated powers for better-rated customers; discriminatory time schedule for
review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal
based on risk rating, etc. are formulated.
2 Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions
(September 2000).
7|Page

3. C. Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale.
Clearly define rating thresholds and review the ratings periodically preferably at half yearly
intervals. Rating migration is to be mapped to estimate the expected loss.
3. D. Risk based scientific pricing: Link loan pricing to expected loss. High-risk category
borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb
the unexpected loss. Adopt the RAROC framework.
3. E. Portfolio Management: The need for credit portfolio management emanates from the
necessity to optimize the benefits associated with diversification and to reduce the potential
adverse impact of concentration of exposures to a particular borrower, sector or industry.
Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of
borrowers in various industry, business group and conduct rapid portfolio reviews.
3. F. Loan Review Mechanism: This should be done independent of credit operations. It is also
referred as Credit Audit covering review of sanction process, compliance status, review of risk
rating, pickup of warning signals and recommendation of corrective action with the objective of
improving credit quality. It should target all loans above certain cut-off limit ensuring that at least
30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit
risks embedded in the balance sheet have been tracked.

4. CREDIT RISK MANAGEMENT: POLICIES

Credit policies establish framework for making investment and lending decisions and reflect an
institutions tolerance for credit risk. To be effective, policies should be communicated in a
timely fashion, and should be implemented through all levels of the institution by appropriate
procedures. Any significant deviation/exception to these policies must be communicated to the
Senior Management/Board and corrective measures should be taken.
At a minimum, credit policies should include:
a) General areas of credit in which the institution is prepared to engage or is restricted from
engaging such as type of credit facilities, type of collateral security, types of borrowers, or
geographic sectors on which the institution may focus;
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b) Detailed and formalized credit evaluation/ appraisal process, administration and

documentation;
c) Credit approval authority at various hierarchy levels including authority for approving
exceptions;
d) Clear guidelines for each of the various types of credits, such as loans, overdrafts,
mortgages, leases, etc.
e) Concentration limits on single counterparties and groups of connected counterparties,
particular industries or economic sectors, geographic regions and specific products. Banking
institutions should ensure that their own internal exposure limits comply with any prudential
f)
g)
h)
i)
j)

limits or restrictions set by the Reserve Bank of Malawi;

Authority for approval of allowance for probable losses and write-offs;
Credit pricing;
Roles and responsibilities of units/staff involved in origination and management of credit;
Guidelines on management of problem loans; and
Clear guidance for internal rating systems including definition of each risk grade; criteria to
be fulfilled while assigning a particular grade, as well as the circumstances under which
deviations from criteria can take place.

In order to be effective, credit policies must be communicated throughout the institution,

implemented through appropriate procedures, and periodically revised to take into account
changing internal and external circumstances.

5. CREDIT RISK MANAGEMENT: PROCESS

The credit risk management process should be articulated in the banks Loan Policy, duly
approved by the Board. Each bank should constitute a high level Credit Policy Committee, also
called Credit Risk Management Committee or Credit Control Committee etc. to deal with issues
relating to credit policy and procedures and to analyse, manage and control credit risk on a bank
wide basis. The Committee should be headed by the Chairman/CEO/ED, and should
comprise heads of Credit Department, Treasury, Credit Risk Management Department
(CRMD) and the Chief Economist. The Committee should, inter alia, formulate clear policies
on standards for presentation of credit proposals, financial covenants, rating standards and
benchmarks, delegation of credit approving powers, prudential limits on large credit exposures,
asset concentrations, standards for loan collateral, portfolio management, loan review
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mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning,
regulatory/legal compliance, etc. Concurrently, each bank should also set up Credit Risk
Management Department (CRMD), independent of the Credit Administration Department.
The CRMD should enforce and monitor compliance of the risk parameters and prudential limits
set by the CPC. The CRMD should also lay down risk assessment systems, monitor quality of
loan portfolio, identify problems and correct deficiencies, develop MIS and undertake loan
review/audit. Large banks may consider separate set up for loan review/audit. The CRMD should
also be made accountable for protecting the quality of the entire loan portfolio. The Department
should undertake portfolio evaluations and conduct comprehensive studies on the environment to
test the resilience of the loan portfolio.3
Each bank should have a carefully formulated scheme of delegation of powers. The banks should
also evolve multi-tier credit approving system where the loan proposals are approved by an
Approval Grid or a Committee. The credit facilities above a specified limit may be approved
by the Grid or Committee, comprising at least 3 or 4 officers and invariably one officer
should represent the CRMD, who has no volume and profit targets. Banks can also consider
credit approving committees at various operating levels i.e. large branches (where considered
necessary), Regional Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating
powers for sanction of higher limits to the Approval Grid or the Committee for better rated /
quality customers. The spirit of the credit approving system may be that no credit proposals
should be approved or recommended to higher authorities, if majority members of the Approval
Grid or Committee do not agree on the creditworthiness of the borrower. In case of
disagreement, the specific views of the dissenting member/s should be recorded.4

3 Reserve Bank of India, Risk Management Systems in Banks

4 Id
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FIGURE 1: CREDIT PROCESS OF BANKS

(Source: Through Internet from Danske Banks Credit Process)

6. CREDIT RISK MANAGEMENT: PRUDENTIAL LIMITS

In order to limit the magnitude of credit risk, prudential limits should be laid down on various
aspects of credit:
a) stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio
or other ratios, with flexibility for deviations. The conditions subject to which deviations are
permitted and the authority therefor should also be clearly spelt out in the Loan Policy;
b) single/group borrower limits, which may be lower than the limits prescribed by Reserve
Bank to provide a filtering mechanism;
c) substantial exposure limit i.e. sum total of exposures assumed in respect of those single
borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15% of capital
funds. The substantial exposure limit may be fixed at 600% or 800% of capital funds,
depending upon the degree of concentration risk the bank is exposed;
d) maximum exposure limits to industry, sector, etc. should be set up. There must also be
systems in place to evaluate the exposures at reasonable intervals and the limits should be
11 | P a g e

adjusted especially when a particular sector or industry faces slowdown or other

sector/industry specific problems. The exposure limits to sensitive sectors, such as, advances
against equity shares, real estate, etc., which are subject to a high degree of asset price
volatility and to specific industries, which are subject to frequent business cycles, may
necessarily be restricted. Similarly, high-risk industries, as perceived by the bank, should
also be placed under lower portfolio limit. Any excess exposure should be fully backed by
adequate collaterals or strategic considerations; and
e) banks may consider maturity profile of the loan book, keeping in view the market risks
inherent in the balance sheet, risk evaluation capability, liquidity, etc.
7. CREDIT RISK: RATING
Banks should have a comprehensive risk scoring / rating system that serves as a single point
indicator of diverse risk factors of a counterparty and for taking credit decisions in a consistent
manner.
7. A. To facilitate this, a substantial degree of standardization is required in ratings across
borrowers. The risk rating system should be designed to reveal the overall risk of lending, critical
input for setting pricing and non-price terms of loans as also present meaningful information for
review and management of loan portfolio. The risk rating, in short, should reflect the underlying
credit risk of the loan book. The rating exercise should also facilitate the credit granting
authorities some comfort in its knowledge of loan quality at any moment of time.
7. B. The risk rating system should be drawn up in a structured manner, incorporating, inter
alia, financial analysis, projections and sensitivity, industrial and management risks. The banks
may use any number of financial ratios and operational parameters and collaterals as also
qualitative aspects of management and industry characteristics that have bearings on the
creditworthiness of borrowers. Banks can also weigh the ratios on the basis of the years to which
they represent for giving importance to near term developments. Within the rating framework,
banks can also prescribe certain level of standards or critical parameters, beyond which no
proposals should be entertained. Banks may also consider separate rating framework for large
corporate / small borrowers, traders, etc. that exhibit varying nature and degree of risk.
7. C. Forex exposures assumed by corporates who have no natural hedges have significantly
altered the risk profile of banks. Banks should, therefore, factor the unhedged market risk
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exposures of borrowers also in the rating framework. The overall score for risk is to be placed
on a numerical scale ranging between 1-6, 1-8, etc. on the basis of credit quality. For each
numerical category, a quantitative definition of the borrower, the loans underlying quality, and
an analytic representation of the underlying financials of the borrower should be presented.
7. D. Further, as a prudent risk management policy, each bank should prescribe the minimum
rating below which no exposures would be undertaken. Any flexibility in the minimum
standards and conditions for relaxation and authority therefor should be clearly articulated in the
Loan Policy.
7. E. The credit risk assessment exercise should be repeated biannually (or even at shorter
intervals for low quality customers) and should be delinked invariably from the regular renewal
exercise. The updating of the credit ratings should be undertaken normally at quarterly intervals
or at least at half-yearly intervals, in order to gauge the quality of the portfolio at periodic
intervals. Variations in the ratings of borrowers over time indicate changes in credit quality and
expected loan losses from the credit portfolio. Thus, if the rating system is to be meaningful, the
credit quality reports should signal changes in expected loan losses.
7. F. In order to ensure the consistency and accuracy of internal ratings, the responsibility for
setting or confirming such ratings should vest with the Loan Review function and examined by
an independent Loan Review Group. The banks should undertake comprehensive study on
migration (upward lower to higher and downward higher to lower) of borrowers in the
ratings to add accuracy in expected loan loss calculations.

8. CREDIT RISK: PORTFOLIO MANAGEMENT

The existing framework of tracking the Non-Performing Loans around the balance sheet date
does not signal the quality of the entire Loan Book. Banks should evolve proper systems for
identification of credit weaknesses well in advance. Most of international banks have adopted
various portfolio management techniques for gauging asset quality. The CRMD, set up at Head
Office should be assigned the responsibility of periodic monitoring of the portfolio. The
portfolio quality could be evaluated by tracking the migration (upward or downward) of
borrowers from one rating scale to another. This process would be meaningful only if the
borrower-wise ratings are updated at quarterly / half-yearly intervals. Data on movements
within grading categories provide a useful insight into the nature and composition of loan book.
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The banks could also consider the following measures to maintain the portfolio quality:
i.

stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e.

certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3, 2 to

ii.

4 or 4 to 5, etc.;
evaluate the rating-wise distribution of borrowers in various industry, business segments,

iii.

etc.;
exposure to one industry/sector should be evaluated on the basis of overall rating
distribution of borrowers in the sector/group. In this context, banks should weigh the pros
and cons of specialisation and concentration by industry group. In cases where portfolio
exposure to a single industry is badly performing, the banks may increase the quality

iv.

standards for that specific industry;

target rating-wise volume of loans, probable defaults and provisioning requirements as a
prudent planning exercise. For any deviation/s from the expected parameters, an exercise for
restructuring of the portfolio should immediately be undertaken and if necessary, the entry

v.

level criteria could be enhanced to insulate the portfolio from further deterioration;
undertake rapid portfolio reviews, stress tests and scenario analysis when external
environment undergoes rapid changes (e.g. volatility in the forex market, economic
sanctions, changes in the fiscal/monetary policies, general slowdown of the economy,
market risk events, extreme liquidity conditions, etc.). The stress tests would reveal
undetected areas of potential credit risk exposure and linkages between different categories
of risk. In adverse circumstances, there may be substantial correlation of various risks,
especially credit and market risks. Stress testing can range from relatively simple alterations
in assumptions about one or more financial, structural or economic variables to the use of
highly sophisticated models. The output of such portfolio-wide stress tests should be
reviewed by the Board and suitable changes may be made in prudential risk limits for
protecting the quality. Stress tests could also include contingency plans, detailing

vi.

management responses to stressful situations.

introduce discriminatory time schedules for renewal of borrower limits. Lower rated
borrowers whose financials show signs of problems should be subjected to renewal control

vii.

twice/thrice a year.
Banks should evolve suitable framework for monitoring the market risks especially forex
risk exposure of corporates who have no natural hedges on a regular basis.

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viii.

Banks should also appoint Portfolio Managers to watch the loan portfolios degree of

ix.

concentrations and exposure to counterparties.

For comprehensive evaluation of customer exposure, banks may consider appointing
Relationship Managers to ensure that overall exposure to a single borrower is monitored,
captured and controlled. The Relationship Managers have to work in coordination with the
Treasury and Forex Departments. The Relationship Managers may service mainly high
value loans so that a substantial share of the loan portfolio, which can alter the risk profile,
would be under constant surveillance.
Further, transactions with affiliated companies/groups need to be aggregated and

x.

maintained close to real time. The banks should also put in place formalised systems for
identification of accounts showing pronounced credit weaknesses well in advance and also
prepare internal guidelines for such an exercise and set time frame for deciding courses of
action.
Credit Risk Models:
Many of the international banks have adopted credit risk models for evaluation of credit
portfolio. The credit risk models offer banks framework for examining credit risk exposures,
across geographical locations and product lines in a timely manner, centralising data and
analysing marginal and absolute contributions to risk. The models also provide estimates of
credit risk (unexpected loss) which reflect individual portfolio composition.
i.

The Altmans Z Score forecasts the probability of a company entering bankruptcy within
a 12-month period. The model combines five financial ratios using reported accounting
information and equity values to produce an objective measure of borrowers financial

ii.

health.
J. P. Morgan has developed a portfolio model Credit Metrics for evaluating credit risk.

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9. CREDIT RISK AND INVESTMENT BANKING

Significant magnitude of credit risk, in addition to market risk, is inherent in investment banking.
The proposals for investments should also be subjected to the same degree of credit risk analysis,
as any loan proposals. The proposals should be subjected to detailed appraisal and rating
framework that factors in financial and non-financial parameters of issuers, sensitivity to external
developments, etc. The maximum exposure to a customer should be bank-wide and include all
exposures assumed by the Credit and Treasury Departments. The coupon on non-sovereign
papers should be commensurate with their risk profile. The banks should exercise due caution,
particularly in investment proposals, which are not rated and should ensure comprehensive risk
evaluation. There should be greater interaction between Credit and Treasury Departments and the
portfolio analysis should also cover the total exposures, including investments. The rating
migration of the issuers and the consequent diminution in the portfolio quality should also be
tracked at periodic intervals.
As a matter of prudence, banks should stipulate entry level minimum ratings/quality standards,
industry, maturity, duration, issuer-wise, etc. limits in investment proposals as well to mitigate
the adverse impacts of concentration and the risk of illiquidity.

10. CREDIT RISK MANAGEMENT IN OFF-BALANCE SHEET EXPOSURE

Banks should evolve adequate framework for managing their exposure in off-balance sheet
products like forex forward contracts, swaps, options, etc. as a part of overall credit to individual
customer relationship and subject to the same credit appraisal, limits and monitoring procedures.
Banks should classify their off-balance sheet exposures into three broad categories - full risk
(credit substitutes) - standby letters of credit, money guarantees, etc, medium risk (not direct
credit substitutes, which do not support existing financial obligations) - bid bonds, letters of
credit, indemnities and warranties and low risk - reverse repos, currency swaps, options, futures,
etc.
The trading credit exposure to counterparties can be measured on static (constant percentage of
the notional principal over the life of the transaction) and on a dynamic basis.

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The total exposures to the counterparties on a dynamic basis should be the sum total of:
i.
ii.

the current replacement cost (unrealised loss to the counterparty); and

the potential increase in replacement cost (estimated with the help of VaR or other methods
to capture future volatilities in the value of the outstanding contracts/ obligations).
The current and potential credit exposures may be measured on a daily basis to evaluate the
impact of potential changes in market conditions on the value of counterparty positions. The
potential exposures also may be quantified by subjecting the position to market movements
involving normal and abnormal movements in interest rates, foreign exchange rates, equity
prices, liquidity conditions, etc.

11. PRINCIPLES FOR THE ASSESSMENT OF BANKS MANAGEMENT OF CREDIT RISK

A. ESTABLISHING AN APPROPRIATE CREDIT RISK ENVIRONMENT
Principle 1: The board of directors should have responsibility for approving and periodically
(at least annually) reviewing the credit risk strategy and significant credit risk policies of the
bank. The strategy should reflect the banks tolerance for risk and the level of profitability the
bank expects to achieve for incurring various credit risks.
Principle 2: Senior management should have responsibility for implementing the credit risk
strategy approved by the board of directors and for developing policies and procedures for
identifying, measuring, monitoring and controlling credit risk. Such policies and procedures
should address credit risk in all of the banks activities and at both the individual credit and
portfolio levels.
Principle 3: Banks should identify and manage credit risk inherent in all products and
activities. Banks should ensure that the risks of products and activities new to them are subject to
adequate risk management procedures and controls before being introduced or undertaken, and
approved in advance by the board of directors or its appropriate committee.
B. OPERATING UNDER A SOUND CREDIT GRANTING PROCESS
Principle 4: Banks must operate within sound, well-defined credit-granting criteria. These
criteria should include a clear indication of the banks target market and a thorough
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understanding of the borrower or counterparty, as well as the purpose and structure of the credit,
and its source of repayment.
Principle 5: Banks should establish overall credit limits at the level of individual borrowers
and counterparties, and groups of connected counterparties that aggregate in comparable and
meaningful manner different types of exposures, both in the banking and trading book and on
and off the balance sheet.
Principle 6: Banks should have a clearly-established process in place for approving new credits
as well as the amendment, renewal and re-financing of existing credits.
Principle 7: All extensions of credit must be made on an arms-length basis. In particular,
credits to related companies and individuals must be authorised on an exception basis, monitored
with particular care and other appropriate steps taken to control or mitigate the risks of non-arms
length lending.
C. MAINTAINING

AN

APPROPRIATE

CREDIT

ADMINISTRATION,

MEASUREMENT

AND

MONITORING PROCESS

Principle 8: Banks should have in place a system for the ongoing administration of their
various credit risk-bearing portfolios.
Principle 9: Banks must have in place a system for monitoring the condition of individual
credits, including determining the adequacy of provisions and reserves.
Principle 10: Banks are encouraged to develop and utilise an internal risk rating system in
managing credit risk. The rating system should be consistent with the nature, size and complexity
of a banks activities.
Principle 11: Banks must have information systems and analytical techniques that enable
management to measure the credit risk inherent in all on- and off-balance sheet activities. The
management information system should provide adequate information on the composition of the
credit portfolio, including identification of any concentrations of risk.

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Principle 12: Banks must have in place a system for monitoring the overall composition and
quality of the credit portfolio.
Principle 13: Banks should take into consideration potential future changes in economic
conditions when assessing individual credits and their credit portfolios, and should assess their
credit risk exposures under stressful conditions.
D. ENSURING ADEQUATE CONTROLS OVER CREDIT RISK
Principle 14: Banks must establish a system of independent, ongoing assessment of the banks
credit risk management processes and the results of such reviews should be communicated
directly to the board of directors and senior management.
Principle 15: Banks must ensure that the credit-granting function is being properly managed
and that credit exposures are within levels consistent with prudential standards and internal
limits. Banks should establish and enforce internal controls and other practices to ensure that
exceptions to policies, procedures and limits are reported in a timely manner to the appropriate
level of management for action.
Principle 16: Banks must have a system in place for early remedial action on deteriorating
credits, managing problem credits and similar workout situations.
E. THE ROLE OF SUPERVISORS
Principle 17: Supervisors should require that banks have an effective system in place to
identify, measure, monitor and control credit risk as part of an overall approach to risk
management. Supervisors should conduct an independent evaluation of a banks strategies,
policies, procedures and practices related to the granting of credit and the ongoing management
of the portfolio. Supervisors should consider setting prudential limits to restrict bank exposures
to single borrowers or groups of connected counterparties.

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12. CREDIT RISK MANAGEMENT IN INDIA

12. A. REGULATION OF INDIAN BANKS
The post-reform shift from micro intervention to a strategy of macro management included
strengthening prudential (safety) norms and the supervisory framework. The Basel I Accord
capital standards were implemented fully by March 1996. Guidelines on income recognition,
asset classification, provisioning, and capital adequacy were tightened. Indian banks with foreign
business were required to implement the standardized version of Basel II by March 2008 and
others by 2009, although capital adequacy already exceeds Basel III in some cases.
A major challenge in implementing risk-based capital charges is to collect accurate and detailed
additional data. Lack of historical data for wholesale and retail, together with the absence of
industry benchmarks to be used in calculation of internal parameters, was feared to distort riskbased pricing. Data for many years would have to be collected and processed, implications of
legal changes such as the SARFAESI Act that facilitates credit recovery, etc. would have to be
built in.
These lacunae were part of the reason Basel-type prudential norms were supplemented with
broad pattern regulation. This turned out to have incentive features that played a role in keeping
markets safe. The argument that continued controls limiting market development were the reason
the sub-prime crisis bypassed the Indian financial sector is not correct since steady market
development took place.
Incentive-based regulation included loan to value and countercyclical provisioning ratios. When
Indian real estate prices rose, provisioning for bank housing and commercial real estate loans
was raised as a countercyclical measure. A provisioning coverage ratio for banks of 70 per cent
of gross non-performing assets augments provisioning buffers in good times. Changing sectoral
provisioning requirements, which directly affect the profit and loss account of banks, were found
to be more effective than varying risk weights. With the latter, there was scope for arbitrage for
example, since average capital adequacy ratios were above the minimum (Sinha, 2011).5

5 Goyal, A., (2012). Banks, Policy and Risks. IGIDR Policy Series No. 12 (January, 2012).
20 | P a g e

Relatively conservative accounting standards without full mark-to-market requirements do not

permit recognition of unrealised gains in equity or the profit and loss account, but unrealised
losses have to be accounted. Banks are required to periodically mark-to-market their
investments, but only those held in trading categories. They have to provide for net losses while
ignoring net gains. This reduces pro-cyclical incentives. Under guidelines on securitisation,
issued in February 2006, exposures have conservative capital adequacy requirements. Any
profits on sale of assets to a special purpose vehicle can be recognised only over the life of the
pass through certificates issued, not immediately on sale. These features, while differing from
modern fair value accounting standards, again reduce pro-cyclicality (Goyal, 2009). There are
ongoing discussions to adjust international accounting norms to take care of some of these
issues.6
Indian banks do continue to have position and sectoral exposure limits. Certain activities, for
example financing domestic acquisitions, are not allowed. In 2011, Indian banks had reached the
exposure limit in financing infrastructure. The new philosophy of regulation, together with high
growth and legal reform that made debt recovery easier, led to non-performing assets falling to
historic lows (Figure 2) even as systemic failures were avoided. There were structural
improvements in the health of Indian banks. Indian financial institutions were thought to be
behind their global peers in modern risk management practices, but it should be now recognised
that a traditional does not implement. Hence, the problem of excess primary liquidity will not be
resolved, and neither will its endogenous amplification.7

6 Id

7 Id
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FIGURE 2: BANKS NON-PERFORMING LOANS TOTAL GROSS LOANS (%)

Since the Global Financial Crisis also demonstrated regulatory failure, simple robust reforms that
change market incentives and are less vulnerable to regulatory discretion and delays are required.
Prudential regulation does align incentives by putting the entitys own capital at risk and
providing a buffer to absorb shocks. But loss-absorbing buffers tend to be procyclical buffers
may have to be built up in bad times. Since this is not feasible, delays will be negotiated, as in
the current Basel III, where full capital adequacy does not kick in until 2018. In the meantime,
fear of spillovers from a crisis, such as the Euro sovereign debt, force bailouts creating further
moral hazard. The systemic effects from financial crises make ex-post discipline difficult to
impose. So the deadline for Basel III may be further postponed. Shin (2011) argues the focus
should be on preventing risky behaviour rather than on the loss-absorbing or shock-insulating
role of buffers.8
12. B. THE INDIAN EXPERIENCE: REFORMS
In 1967, a policy of social control over banks aimed to change commercial banks management
and distribution of credit. After successive waves of nationalisation, the public sector's share of
deposits was 92 per cent in 1980. The share of directed lending to priority sectors stood at 40 per
cent. The statutory liquidity ratio (SLR) and the cash reserve ratio (CRR) were at 15 per cent and
38.5 per cent respectively in 1991, compared to 2 and 25 per cent in 1960. The average return on
assets was only about 0.15 per cent and capital and reserves a paltry 1.5 per cent of assets.
Inefficiencies created by these severe restrictions on the use and the price of funds prompted
liberalisation, as part of the opening out of the economy. The shift from controls to markets
8 Supra Note 5
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sought to reverse financial repression. But the change was gradual. Therefore, banks dependence
on short-term or overnight wholesale funding is limited. Most of the banks follow a retail
business model. Loans dominate market investments in balance sheets, reducing market risk.
The second half of the 1980s saw the introduction of treasury bills, the creation of money
markets, and a partial deregulation of interest rates hitherto used as a tool for cross-subsidisation.
Further reforms included a reduction in statutory pre-emptions and entry deregulation for both
private domestic and foreign banks, improved prudential norms and the development of interbank and other markets. Legal changes such as the SARFAESI Act made it easier for banks to
recover loans. Another proposed reform was to reduce priority sector advances from 40 per cent
to 10 per cent. Although this was not implemented, expanding the definition of priority sectors to
include sunrise sectors such as information technology has reduced the effective burden of
priority sector advances. The CRR reached a low of 4.5 per cent in June 2003 and the SLR
touched its statutory minimum of 25 per cent in October 1997. The long-term aim remains to
reduce the CRR to 3 per cent. Outcomes were positive. In 2004, the return on assets improved to
1.01 per cent and CRAR to 12.8 per cent. Gross non-performing assets, as a ratio to gross
advances, fell to 2.4 per cent in 2009-10 from 12.8 per cent in 1991.
In October 1994, banks were asked to announce a bank prime lending rate (BPLR), based on the
cost of funds. For advances of up to Rs.2 lakh, interest rates could not exceed the BPLR. For
loans exceeding this amount, which accounted for over 90 per cent of total advances, interest
rates were freed. Interest rates on all term deposits, accounting for 70 per cent of total deposits,
were freed gradually. They were liberalised fully by 1997. Interest rates on savings deposits of
over Rs. 1 lakh, were also freed in 2011.
12. C. INDIAN REGULATORY EVOLUTION AND BASEL III
Except for a few banks, aggregate capital to risk weighted asset ratio (CRAR), was above the
Basel III requirement in 2011. But as a developing country with low credit ratios undergoing
structural transformation, India can except to see the ratios rise. New rules should not inhibit a
sustainable expansion of banks balance sheets as credit grows faster than GDP (Subbarao,
2011). Expanding the capital base, as required to finance high growth, may also conflict with
public sector ownership of some banks. Strong broad pattern regulation such as caps on credit to
23 | P a g e

some sectors, position limits and limits on exposure to different types of risk, high statutory
liquidity ratios to finance government debt, and other types of taxation, contribute to financial
stability. There is a case, therefore, for reducing required capital buffers in view of these other
types of regulation. Since they could fill gaps in global regulatory regimes, any exemptions or
tradeoffs should be part of global regulations, not just for India as a special case. Indian
regulators will implement whatever Basel III criteria are agreed to. The RBI points out that
holdings of liquid, low-risk, statutory liquidity ratio (SLR) G-secs should not be counted as
leverage in calculating the leverage ratio. They should also be regarded as contributing to
liquidity. These are government bonds against which the central bank provides liquidity under
stressed conditions, since the RBI Act does not allow the central bank (CB) to provide liquidity
except against acceptable collateral. But the BCBS regards the SLR as a statutory requirement
that cannot be reduced. Asking Indian banks to maintain liquid assets over and above the already
high SLR would reduce their competitiveness. Although the BCBS is a comply or explain
framework, markets may regard any deviation unfavourably, even though the leverage ratio of
Indian banks is low (Sinha, 2011). Therefore, awareness has to be created on these issues.
12. D. SOURCES OF CREDIT RISK FOR INDIAN BANKS
We examine below how thin markets and monetary policy affect credit risks facing Indian banks,
before pulling together these, international factors, and regulatory issues to make a final
assessment.
12. D. (i). Thin markets
If a market is thin, there is a large impact of a demand or supply shock. An initial evaluation
suggests critical markets remain thin.
The difference between the interest rates on interbank loans and on risk-free, short-term
government debt (T-bills) is an indicator of rising counterparty risk, or of tightening liquidity in
the interbank market. The TED spread remains generally within the range of 10 and 50 bps,
except in times of financial crisis. A rising TED spread often precedes a downturn in the US
stock market.
In India, however, these spreads are large even in non-crisis times. That they narrowed during the
years of large inflows in the mid-2000s suggests that they are partly due to tight liquidity or the
24 | P a g e

inability to fine tune liquidity in response to shocks that include global shocks. Curdia and
Woodford (2009) suggest that, in advanced countries, only a change in spreads has implications
for optimal monetary policy. To that extent, a larger, persistent spread in EMs may not have
much impact for policy, but the changes in the spread due to liquidity shocks have to be reduced
or compensated for through lower rates.
Spreads in bank interest rates are also high. For India, it is the difference between the RBI endof-period bank rate and the BPLR before July 2010, but after that, it uses the base lending rate
charged by India's five largest commercial banks. The spread is much higher for India, but falls
to below that of the US in 2010, the time of the definitional shift. The latter approximated a shift
from one of the highest bank lending rates to the lowest. That a simple reform such as a shift
from BPLR to BR reduced Indias measured loan spread suggests high spreads may partly be an
illusion created by problems of definition and measurement in heterogeneous markets. But
different types of borrowers do face very different rates. So the average bank lending rate in
India would continue to be much above US rates.
12. D. (ii). Assessment of Credit Risks for Indian banks
According to market perception, credit risk is high for Indian banks because of public sector
ownership and directions for lending. Market risk is high because of the tightening cycle of
monetary policy. Spillovers from the Euro debt crisis add to exchange rate risk, as slowing
foreign inflows cause sharp depreciation. The drying up of dollar inflows can also affect
liquidity.
However, strong oversight, the successful past use of countercyclical prudential regulation, the
legacy of deposits so that banks are not so dependent on borrowed funds, limits on open FX
positions to reduce cross-border exposures, all lower systemic risk. The Indian banking system
will escape any blow up of the European debt crisis, just as it escaped the Global Financial
Crisis. There is no exposure to exotic derivatives or to foreign sovereign debt; more than a
quarter of deposits are invested in high quality government securities, interest rates are not so
low as to provoke a risky search for yield. A sharp rise in credit growth is an indicator of risk
build-up, but credit growth in the post-Lehman crash period has been low. Mark to market,
which is procyclical, is limited.
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13. COMPARATIVE ANALYSIS: ADVANCED AND EMERGING MARKETS

SCALE AND CROSS-BORDER EXPOSURES
Advanced European Banks and Emerging Indian Banks differ in both quantity and quality. Table
1, Figure 3 and 4 show the countries whose banks (Table 1), and the countries in which banks
(Figure 1) had the largest international positions in 2010. The totals given in the charts show the
positions of banks in developed countries were nearly nine times larger than in EMs. These
countries US, UK, Euro Area, France and Germany also had the greatest impact on the
financial crisis and bore the major brunt of it. The same countries dominate international debt,
money markets, and domestic debt, and therefore, are most at risk from the sovereign debt crisis.
Most MNC banks originate from these countries. In comparison, emerging market positions, and
even those of Australia and Canada, are tiny.
13. A. United Kingdom:
In 2010, UK had 318 banks of which 241 were foreign banks with branches or subsidiaries in
UK, compared to 81 banks (of which 32 were foreign) in India. The aggregate UK bank balance
sheet exceeded 6 trillion, or more than four times the annual UK output. Total Indian bank
assets constituted only 92 per cent of Indian GDP.9 Even after shrinking following the Global
Financial Crisis, leverage in advanced country banks remains at 25:1 compared to 10:1 for
Indian banks.
During the Global Financial Crisis, cross-border borrowing was a major source of risk as money
markets froze. As the European debt crisis plays out, cross-border exposures are a continuing
source of risks for banks.

9 Source press reports and http://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=999.

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FIGURE 3: EXTERNAL POSITIONS OF REPORTING BANKS IN DEVELOPED COUNTRIES: LIABILITIES

(TOTAL-19307.35 USS B)

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FIGURE 4: EXTERNAL POSITIONS OF REPORTING BANKS IN EMERGING MARKETS- LIABILITIES

(TOTAL- 2151.18 USS B)
13. B. The United States of America
The U.S. dollar as the reserve currency is the funding currency for global banks. Shin (2011)
reports around 160 foreign banks raise about $1 trillion of wholesale dollar funding in US capital
markets to send $600 billion to head office. These interoffice assets of foreign bank branches in
the US increased steeply since the nineties. They did fall sharply in 2008, but rose again the next
year. Cross-currency maturity mismatches compound problems created by dependence on shortterm funding. For example, European banks typically hold long-dated, less liquid, US dollardenominated assets funded by short-dated US dollar borrowings and FX swaps.
In a decentralised funding model, intra-group funding has a low share and the role of the central
treasury in allocating and distributing funds is limited. Local assets are largely funded locally.
But multinational banks either borrow cross-border in various financial centres (Swiss and US
banks) or source extensive local funding abroad (Canadian and Spanish banks have expanded in
Latin America and in the United Kingdom) (BIS 2010b).
Since deposit-taking banks are no longer the only financial intermediaries, their deposit liabilities
(which are equivalent to broad money) underestimate the aggregate size of leveraged balance
sheets. Even for banks mainly funded by deposits, banks liabilities to foreign creditors are not
counted as money, but they expand balance sheets (Shin and Shin, 2010). Deposits are now not
28 | P a g e

the most volatile component of aggregate financial liabilities. In the U.S. itself, securitisation and
capital markets dominate traditional banking. In other economies, even if banking is mostly
traditional, US liquidity creation affects balance sheets through portfolio flows, foreign liabilities
of the banking sector and other types of dollar carry trade.
13. C. Korea:
While Emerging Markets may not contribute to these risks, they are often at the receiving end.
Banks are the largest source of volatile capital flows to emerging markets. Shin and Shin (2010)
document the working of the dollar carry trade in Korea. Foreign bank branches borrowed
dollars from headquarters using their inter-office account or unsecured borrowing in the
interbank market. These were sold to buy the Korean Won on the spot market and simultaneously
buy dollars in the forward market, thus creating an FX swap. In the period before the swap
matured, the foreign banks held Korean fixed income instruments denominated in Won, thus
lending at the higher Korean interest rate.
Local banks held long-term dollar assets that were claims on Korean firms, arising from the
hedging of long-term dollar receivables by shipbuilders. The banking sector then had to borrow
short in dollars for maturity transformation. Thus, although there was no currency mismatch,
there was still a maturity mismatch, since assets were not usable to meet maturing dollar
liabilities. As a result, there were sharp depreciations of the Won in 2008 and 2010.
13. D. Baltic States:
The Baltic States are small countries with open economies that depend substantially on export
transactions and foreign investments. The banking sectors of the Baltic States hold the dominant
position of the financial system of the countries, which are substantially integrated into the
European financial markets. Estonia has joined the Euro area in the beginning of 2011.
The real GDP per capita presents additional information regarding the Baltic States economies'
development. The calculated increase of the real GDP per capita for the period 1998-2009 for
Estonia was 1.63 times, for Latvia 1.61 and for Lithuania 2.22 times. At the same time the
biggest real GDP per capita measured in EUR was achieved by the Estonian economy (6 573
EUR). The respective numbers for Latvian economy is 4 287 EUR and Lithuanian economy 5
969 EUR respectfully. The insufficient analysis of credit risk by all banks in the Baltic States and
29 | P a g e

strong dependence of current consumption on short-term foreign investments caused more

substantial recession of the economies than in other European countries and a substantial
decrease of the real estate market (see figure 5).

FIGURE 5: THE QUANTITY OF DEALS CONCLUDED ON REAL ESTATE MARKET

(Source: Data obtained through the internet from Statistics Estonia (http://www. Stat.ee/), the
Land Register of Latvia (http://www.zemesgramata.lv) and the Land Register of Lithuania
(http://www.registrucentras.lt/ntr/stat/))
Since 1990 the banking systems of the three Baltic States have faced several financial crises.
During last financial crises the rapid growth of real GDP was substantially supported by rapid
loan portfolio growth in every Baltic State. During the period 1997 to 2009 the Latvian banking
sector experienced the most considerable growth in their loan portfolios, i.e. +2975%. This
growth was 2.84 times higher than the growth of the loan portfolio granted by the Estonian
banking system (i.e. 1049.27% respectfully) and 2.12 times higher than the growth of the loan
portfolio granted by the Lithuanian banking system (i.e. 1402.34% respectfully). As a result, the
significant growth of nonperforming loans and instability followed. Therefore the general level
of indebtedness in the Baltic States, measured as aggregated loan portfolio divided by the real
GDP, has grown rapidly and substantially during the period 1998 - 2009: for the Estonian
economy 6.53 times, for the Latvian economy 13.31 times and for the Lithuanian economy 7.49
times. The general level of indebtedness for the mentioned period for Estonian economy changed

30 | P a g e

from 27.19% up to 177.53%, for the Latvian economy from 17.02% up to 226.45%, for the
Lithuanian economy from 12.54% up to 93.93%.10

FIGURE 6: THE LEVEL OF NON-PERFORMING LOANS IN BALTIC STATES AS A PERCENTAGE OF

AGGREGATE LOAN PORTFOLIOS

(Source: Data obtained through the internet from the Bank of Estonia (http://www.
eestipank.info), the Financial and Capital Commission of Latvia (http://www.fktk.lv) and the
Bank of Lithuania (http://www.lb.lt))

FIGURE 7: BALANCE OF CURRENT ACCOUNT OF BALTIC STATES FOR THE PERIOD 1998-2009, AS
% OF GDP
(Source: Obtained through Internet from Eurostat (http://epp. eurostat.ec.europa.eu))
10 Grigori Fainstein, The Comparative Analysis of Credit Risk Determinants In the Banking
Sector of the Baltic States, REVIEW OF ECONOMICS & FINANCE (14/Mar./2011).
31 | P a g e

The insufficient and timely inadequate analysis of credit risk of financed projects can be treated
as the initial reason for the rapid development of the financial crises started in the Baltic States in
years 2007 2008. This caused the substantial growth of the level of problem loans, as Figure 2
presented.

14. CREDIT RISK MANAGEMENT: ANALYTICAL FRAMEWORK

Generally, there can be identified two types of credit risk analysis models depending on the
required inputs:
(i)
(ii)

models, which are presented as a simple function, and

models, which are presented as a composite function. Exogenous variables used in the
first type of models are presented as percentage change of different parameters treated as
credit risk determinants.

Blaschke, Jones, Majonni and Peria (2001) researched the sensitivity of unexpected loan losses
to negative external shocks. They used exogenous variables such as: nominal interest rate,
inflation rate, percentage changes of real GDP and percentage change in terms of trade.
Shanazarian and Asberg-Sommar (2008) analyzed distance to default or the ratio of value of
company equity to the standard deviation of assets market value, where a company equity value
is based on future cash flows. They used as exogenous variables the 3-month state bonds interest
rate, the interstate index of industrial production and the interstate index of consumption prices.
These models prove the proposition that loan portfolio quality depends on the economy cycle.
The second type of models use composite exogenous variables; where one parameter is
multiplied by a ratio of two other variables, for example: Pesola (2001, 2005). It should be noted
that endogenous variables in both types of models are presented as a ratio of two different
parameters and can be interpreted as default rate, probability of default, default frequency
measure, expected default frequency etc.., for example: Bonfim (2009), Gasha and Morales
(2004), Jimenez and Saurina (2006), Marcucci and Quagliariello (2008, 2009), Meyer and
Yeager (2001), Pesola (2001, 2007). Due to a strong bias of the mentioned models to one type of

32 | P a g e

variables, and in order to better understand links between credit risk and macroeconomics,
banking sector and microeconomic level variables, the new model is constructed.

15. CONCLUSION
To conclude, structural risks are low in Indian banks. The path of steady market development and
regulatory evolution has helped reduce these risks. Cyclical risks are rising but they are not of a
very large magnitude, as long as policy makers moderate large fluctuations in asset prices. This
is required since markets remain thin.
Much more nuanced assessments of risks in alternative banking systems, complementary
macroeconomic policies and regulatory structure, and evolution of regulation are required.
Moreover, the goal posts of banking structure and regulation cannot remain the same after the
GFC. EM banks have to continue to modernise but an ideal regulatory system should adopt some
current EM practices. Regulation based on broad ratios is a way of reducing risk for banks
without the disincentives for activity that full or no liability involves. Awareness has to be
created about these issues since markets tend to punish any deviation from advanced country
norms without understanding the contextual differences.
A lesson needs to be learnt from many Emerging Markets, including India, where simpler
regulations have successfully restricted leverage and have acted counter cyclically. IMF (2011)
notes these successes but does not build on them, preferring to merely continue advocating
deepening markets for Emerging Markets. With such broad-pattern regulations, risk-taking can
be reduced without forcing too much risk on risk aggregators through large buffers. Financial
stability is then compatible with financial innovation.
The highly bank-based regulatory stance of the BCBS is a problem for Emerging Markets since
their financial systems are bank-dominated, already have strong regulation and taxes but are yet
have to reach scale. The impact of additional requirements under Basel III may be onerous,
especially since the shadow banking system that plays a large part in volatile flows to the region
escapes regulation. Ideally, the regulatory package should be redesigned and lightened for banks,
yet be spread more widely to cover shadow banks too.

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