A

Project Report
On
Risk Management
IN Banks

In Partial Fulfillment Of The Requirement

For The Degree of Master Of Business Administration (M.B.A)
(Session 2009-2011)

SUBMITTED TO:
University school of management , kurukshetra university , kurukshetra

Submitted by
Vinod kumar
Roll no . - 109

PREFACE
Master of Business Administration is a course, which combines both theory and its applications
as its contents of study in the field of management. As part and parcel of this course, every
aspirant has to cover the research project report. The purpose of this research project report is
to expose the student of management sciences real life situations and to provide an insight into
the various functions who can visualize things what they have been taught in classrooms.
Actually, it is the life force of management.
I was fortunate enough to get this opportunity of to prepare project report on Risk
Management Banks. This is related to my specialization Finance.
This report is an attempt to present an account of practical knowledge and observations
gathered. This research report includes the general information about Basel Capital Accord
1988-Accord and June 1999 Proposals, and the impact of its implementation in Indian Banks.

Vinod Kumar
109, MBA FINAL

ACKNOWLEDGEMENT
Inspiration and hard work always played a key role in the success of any venture. At the level
of practice, it is often difficult to get knowledge without guidance. Project is like a bridge
between theoretical and practical. With this willing, I joined this project.
There is always a sense of gratitude which one expresses to other for the helpful and needy
services that render during all phases of life. I would like to do so as I readily wish to express
my gratitude towards all those who have been helpful to me in getting this mighty task of
training to a successful end.
It often happens that one is at loss of words when one is really thankful and sincerely wants to
express ones feeling of gratitude towards other.
I am deeply indebted to Dr. Sanjiv Marwah (Director) and my worthy thanks to my teacher Dr.
Bateshwer Singh (Guide) for their valuable contribution during the academic session &
guidance in preparation of this project report.
Finally, it is efforts of my parents and friends and the Almighty GOD who have been a source
of strength and confidence for me in this endeavor.

Vinod Kumar
109, MBA final

DECLARATION

This is to certify that I Pardeep Grewal, the student of Maharishi Markandeshwar Institute of
Management studying in M.B.A. (4th Sem.). Roll no. 109 have submitted a project/
Dissertation report on the title Risk Management in Banks" for the partial fulfillment of
Degree of Master of Business Administration (M.B.A) to KURUKSHETRA UNIVERSITY.
I solemnly declared that the work done by me is original and no copy of it has been submitted
to any other Universities for award of any other degree/diploma/fellowship or on similar title
and topic.

Signature of Student
(VINOD KUMAR )

EXECUTIVE SUMMARY
Risk is inherent in all aspects of a commercial operation and covers areas such as customer
services, reputation, technology, security, human resources, market price, funding, legal, and
regulatory, fraud and strategy. However, for banks and financial institutions, credit risk is the
most important factor to be managed. Credit risk is defined as the possibility that a borrower or
counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk,
therefore, arises from the banks' dealings with or lending to a corporate, individual, another
bank, financial institution or a country. Credit risk may take various forms, such as:

In the case of direct lending, that funds will not be repaid;

In the case of guarantees or letters of credit, that funds will not be forthcoming from the
customer upon crystallization of the liability under the contract;

In the case of treasury products, that the payment or series of payments due from the
counterparty under the respective contracts is not forthcoming or ceases;

In the case of securities trading businesses, that settlement will not be effected;

In the case of cross-border exposure, that the availability and free transfer of currency
is restricted or ceases.

Globalisation and financial innovation have over the last two decades or more multiplied and
diversified the risks carried by the banking system. In response, the regulation of banking in
the developed industrial countries has increasingly focused on ensuring financial stability, at
the expense of regulation geared to realising growth and equity objectives. The appropriateness
of this move is being debated even in the developed countries, which in any case are at a
completely different level of development of their economies and of the extent of financial
deepening and intermediation as compared to the developing world.
Despite this and the fact that in principle the adoption of the core principles for effective
banking supervision issued by the Basel Committee on Banking Supervision is voluntary, India
like many other emerging market countries adopted the Basel I guidelines and has now decided
to implement Basel II.
India had adopted Basel I guidelines in 1999. Subsequently, based on the recommendations of
a Steering Committee established in February 2005 for the purpose, the Reserve Bank of India
had issued draft guidelines for implementing a New Capital Adequacy Framework, in line with
Basel II.
At the centre of these guidelines is an effort to estimate how much of capital assets of specified
kinds should banks hold to absorb losses. This requires some assessment of likely losses that
may be incurred and deciding on a proportion of liquid assets that banks must have at hand to
meet those losses in case they are incurred. This required regulatory capital is defined in terms
"tiers" of capital that are characterized by differing degrees of liquidity and capacity to absorb
losses. The highest, Tier I, consists principally of the equity and recorded reserves of the bank.
The higher the risk of loss associated with an investment the more of it must be covered in this
manner, requiring assets to be risk-weighted. A 100 per cent risk loss implies that the whole of
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an investment can be lost under certain contingencies and a zero per cent risk-weight implies
that the asset concerned is riskless.

INDEX OF CONTENTS
1

Preface...............................................................................................................................2

Acknowledgement.............................................................................................................3

Declaration........................................................................................................................4

Executive Summary.......................................................................................................5-6

CHAPTER-1 Introduction to Topic.

1.1

The nature of risk management.10

1.2 risk management process...10-12

1.3 About Credit Risk.
1.4

Credit risk Policy and strategy ...................................................................13.

CHAPTER-2 Introduction to Basel Committee Accord

2.1 About the Basel Committee.15
2.2 History of the Basel Committee.15-17
2.3 Basel Accord, 1988.17-20
2.4 The New Basel Capital Accord - An Explanatory Note
Need for Revising/Improving the 1988-Accord - June 1999 Proposals.20-23
2.5 Pillar 1: Minimum capital requirements...23
2.5(1) Standardized Approach to Credit Risk..24
2.5(2) Internal Ratings-based (IRB) Approaches25
2.6 Pillar 2: Supervisory Review...26
2.7 Pillar 3: Market Discipline27

CHAPTER-3 RBI guidelines on risk management in banks

3.1 Credit Rating Framework.29-32
3.2 Credit Risk Models...33
3.3 Techniques for Measuring Credit Risk33-34
3.4 Managing Credit Risk in Inter-bank Exposure34-38
3.5 New Capital Accord: Implications for Credit Risk Management38-40

3.6CommentsoftheReserveBankofIndiaonNewCapitalAdequacyFramework...4041

3.7 Risk management in ICICI Bank

3.8 Risk Management in SBI Bank
CHAPTER-5 Literature Review
CHAPTER-6 Research Methodology
6.1

Objective of the Study

6.2

Research Design.

6.3

Methods of Data Collection

6.4

Steps of Methodology

CHAPTER-7 Findings
CHAPTER-9 Analysis and Interpretation.
CHAPTER-10 Conclusion
CHAPTER-11 Suggestions
Bibliography

INTRODUCTION TO TOPIC
Risk management is the process of measuring, or assessing risk and then developing
strategies to manage the risk. In general, the strategies employed include transferring the risk to
another party, avoiding the risk, reducing the negative affect of the risk, and accepting some or
all of the consequences of a particular risk. Financial risk management, on the other hand,
focuses on risks that can be managed using traded financial instruments. Regardless of the type
of risk management, all large corporations have risk management teams and small groups and
corporations practice informal, if not formal, risk management.
In ideal risk management, a prioritization process is followed whereby the risks with the
greatest loss and the greatest probability of occurring are handled first, and risks with lower
probability of occurrence and lower loss are handled later. In practice the process can be very
difficult, and balancing between risks with a high probability of occurrence but lower loss vs. a
risk with high loss but lower probability of occurrence can often be mishandled.
Risk management also faces a difficulty in allocating resources properly. This is the idea of
opportunity cost. Resources spent on risk management could be instead spent on more
profitable activities. Again, ideal risk management spends the least amount of resources in the
process while reducing the negative effects of risks as much as possible.

Risk Management in Banks

With growing competition and fast changes in the operating environment impacting the
business potentials, banks are compelled to constantly monitor and review their approach to
``credit'', the main earning asset in the balance sheet. With compulsions at peer level in the
international standards, the Reserve Bank of India as the central bank has been emphasizing, in
the recent years, on risk management and recently, issued a timely warning to bank
managements to focus on the efforts for installing effective systems for control of risks,
through calling for certification regarding compliance on these aspects.
The first circular of RBI introducing ALM (Asset Liability Management) for banks as
mandatory, was issued in September 1998; given the history of banking in India and the
comfort of insulated economy, awareness on the relative implications is yet to perceive while
the RBI itself is administering the relative regulatory measures in phases. It is not simply the
banking industry but change in the environment, like the legal structure, market imperfections
including the depth of the market and tax structure, need to keep pace for the requirements.
However, bank managements are yet to grapple with what is before them while towards the
exercise, the first step namely establishing a data base is being initiated.
Pertaining to risk management in credit portfolio, it is not as though banks are not conscious of
the various risk elements - in fact, all these phraseologies are repeated all over from time to
time in different context. Such comprehension requires to be translated into practice by
evolving systems for control/administration.
So, this project comprises understanding the procedure of the risk management carried by the
banks in order to maintain their assets and liability position and also to compete well in the
market in lieu of guidelines provided by the RBI .In this study we would do study various risks
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such as credit risk, market risk, liquidity risk and operational risk as well. This project would
describe how banks work against these risks and try to minimize it in order to maximize the
profit margin. Also the banks management and various departments in regard to manage these
kinds of risks. We would also study the guidelines provided by RBI in regard to Risk
Management procedure that to be followed by Nationalized and Private Banks also NBFCs.
In the project we would describe the risk management process that been carried by banks and
also ALM structure in order to control upon assets liability position in the banks in order to
keep eye on liquidity position of banks and also we would see which tools or methods are
being used by banks in order to control risk and maximize profitability.

DEFINING RISK
For the purpose of these guidelines financial risk in banking organization is possibility that the
outcome of an action or event could bring up adverse impacts. Such outcomes could either
result in a direct loss of earnings / capital or may result in imposition of constraints on banks
ability to meet its business objectives. Such constraints pose a risk as these could hinder a
bank's ability to conduct its ongoing business or to take benefit of opportunities to enhance its
business.
Regardless of the sophistication of the measures, banks often distinguish between expected and
unexpected losses. Expected losses are those that the bank knows with reasonable certainty
will occur (e.g., the expected default rate of corporate loan portfolio or credit card portfolio)
and are typically reserved for in some manner. Unexpected losses are those associated with
unforeseen events (e.g. losses experienced by banks in the aftermath of nuclear tests, Losses
due to a sudden down turn in economy or falling interest rates). Banks rely on their capital as a
buffer to absorb such losses.
Risks are usually defined by the adverse impact on profitability of several distinct sources of
uncertainty. While the types and degree of risks an organization may be exposed to depend
upon a number of factors such as its size, complexity business activities, volume etc, it is
believed that generally the banks face Credit, Market, Liquidity, Operational, Compliance /
legal /regulatory and reputation risks. Before overarching these risk categories, given below are
some basics about risk Management and some guiding principles to manage risks in banking
organization.

RISK MANAGEMENT
Risk Management is a discipline at the core of every financial institution and encompasses all
the activities that affect its risk profile. It involves identification, measurement, monitoring and
controlling risks to ensure that
a) The individuals who take or manage risks clearly understand it.
b) The organizations Risk exposure is within the limits established by Board of Directors.
c) Risk taking Decisions are in line with the business strategy and objectives set by BOD.
d) The expected payoffs compensate for the risks taken
e) Risk taking decisions are explicit and clear.
f) Sufficient capital as a buffer is available to take risk

The acceptance and management of financial risk is inherent to the business of banking and
banks roles as financial intermediaries. Risk management as commonly perceived does not
mean minimizing risk; rather the goal of risk management is to optimize risk-reward trade -off.
Notwithstanding the fact that banks are in the business of taking risk, it should be recognized
that an institution need not engage in business in a manner that unnecessarily imposes risk
upon it: nor it should absorb risk that can be transferred to other participants. Rather it should
accept those risks that are uniquely part of the array of banks services.
In every financial institution, risk management activities broadly take place simultaneously at
following different hierarchy levels.
Strategic level: It encompasses risk management functions performed by senior
management and BOD. For instance definition of risks, ascertaining institutions risk appetite,
formulating strategy and policies for managing risks and establish adequate systems and
controls to ensure that overall risk remain within acceptable level and the reward compensate
for the risk taken.
A)

B) Macro Level: It encompasses risk management within a business area or across business
lines. Generally the risk management activities performed by middle management or units
devoted to risk reviews fall into this category.
C) Micro Level: It involves On-the-line risk management where risks are actually created.
This is the risk management activities performed by individuals who take risk on
organizations behalf such as front office and loan origination functions. The risk management
in those areas is confined to following operational procedures and guidelines set by
management.
Expanding business arenas, deregulation and globalization of financial activities emergence of
new financial products and increased level of competition has necessitated a need for an
effective and structured risk management in financial institutions. A banks ability to measure,
monitor, and steer risks comprehensively is becoming a decisive parameter for its strategic
positioning.
The risk management framework and sophistication of the process, and internal controls, used
to manage risks, depends on the nature, size and complexity of institutions activities.
Nevertheless, there are some basic principles that apply to all financial institutions irrespective
of their size and complexity of business and are reflective of the strength of an individual
bank's risk management practices.

Risk Management Process

Steps in the Risk Management Process
A first step in the process of managing risk is to identify potential risks. Risks are about events
that, when triggered, will cause problems. Hence, risk identification can start with the source of
problems, or with the problem itself.

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Source analysis Risk sources may be internal or external to the system that is the target
of risk management. Examples of risk sources are: stakeholders of a project, employees
of a company or the weather over an airport.
Problem analysis Risks are related to fear. For example: the fear of losing money, the
fear of abuse of privacy information or the fear of accidents and casualties. The fear
may exist with various entities, most important with shareholder, customers and
legislative bodies such as the government.

When either source or problem is known, the events that a source may trigger or the events that
can lead to a problem can be investigated. For example: stakeholders withdrawing during a
project may endanger funding of the project; privacy information may be stolen by employees
even within a closed network; lightning striking a B747 during takeoff may make all people
onboard immediate casualties.
The chosen method of identifying risks may depend on culture, industry practice and
compliance. The identification methods are formed by templates or the development of
templates for identifying source, problem or event. Common risk identification methods are:

Objectives-based Risk Identification - Organizations and project teams have

objectives. Any event that may endanger achieving an objective partly or completely is
identified as risk. Objective-based risk identification is at the basis of COSO's.
Scenario-based Risk Identification - In scenario analysis different scenarios is
created. The scenarios may be the alternative ways to achieve an objective, or an
analysis of the interaction of forces in, for example, a market or battle. Any event that
triggers an undesired scenario alternative is identified as risk.
Taxonomy-based Risk Identification - The taxonomy in taxonomy-based risk
identification is a breakdown of possible risk sources. Based on the taxonomy and
knowledge of best practices, a questionnaire is compiled. The answers to the questions
reveal risks.
Common-risk checking - In several industries lists with known risks are available.
Each risk in the list can be checked for application to a particular situation.

Assessment
Once risks have been identified, they must then be assessed as to their potential severity of loss
and to the probability of occurrence. These quantities can be either simple to measure, in the
case of the value of a lost building, or impossible to know for sure in the case of the probability
of an unlikely event occurring. Therefore, in the assessment process it is critical to make the
best educated guesses possible in order to properly prioritize the implementation of the risk
management plan.

Risk avoidance
Includes not performing an activity that could carry risk. An example would be not buying a
property or business in order to not take on the liability that comes with it. Another would be
not flying in order to not take the risk that the airplane was to be hijacked. Avoidance may
seem the answer to all risks, but avoiding risks also means losing out on the potential gain that
accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of
loss also avoids the possibility of earning the profits.

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Risk reduction
Involves methods that reduce the severity of the loss. Examples include sprinklers designed to
put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water
damage and therefore may not be suitable. Halon fire suppression systems may mitigate that
risk, but the cost may be prohibitive as a strategy.
Modern software development methodologies reduce risk by developing and delivering
software incrementally. Early methodologies suffered from the fact that they only delivered
software in the final phase of development; any problems encountered in earlier phases meant
costly rework and often jeopardized the whole project. By developing in increments, software
projects can limit effort wasted to a single increment. A current trend in software development,
spearheaded by the Extreme Programming community, is to reduce the size of increments to
the smallest size possible, sometimes as little as one week is allocated to an increment.

Risk retention
Involves accepting the loss when it occurs. True self insurance falls in this category. Risk
retention is a viable strategy for small risks where the cost of insuring against the risk would be
greater over time than the total losses sustained. All risks that are not avoided or transferred are
retained by default. This includes risks that are so large or catastrophic that they either cannot
be insured against or the premiums would be infeasible. War is an example since most property
and risks are not insured against war, so the loss attributed by war is retained by the insured.
Also any amount of potential loss (risk) over the amount insured is retained risk. This may also
be acceptable if the chance of a very large loss is small or if the cost to insure for greater
coverage amounts is so great it would hinder the goals of the organization too much.

Risk transfer
Means causing another party to accept the risk, typically by contract or by hedging. Insurance
is one type of risk transfer that uses contracts. Other times it may involve contract language
that transfers a risk to another party without the payment of an insurance premium. Liability
among construction or other contractors is very often transferred this way. On the other hand,
taking offsetting positions in derivative securities is typically how firms use hedging to
financial risk management: financially manage risk.
Some ways of managing risk fall into multiple categories. Risk retention pools are technically
retaining the risk for the group, but spreading it over the whole group involves transfer among
individual members of the group. This is different from traditional insurance, in that no
premium is exchanged between members of the group up front, but instead losses are assessed
to all members of the group.

Create the plan

Decide on the combination of methods to be used for each risk

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Implementation
Follow all of the planned methods for mitigating the effect of the risks. Purchase insurance
policies for the risks that have been decided to be transferred to an insurer, avoid all risks that
can be avoided without sacrificing the entity's goals, reduce others, and retain the rest.

Review and evaluation of the plan

Initial risk management plans will never be perfect. Practice, experience, and actual loss
results, will necessitate changes in the plan and contribute information to allow possible
different decisions to be made in dealing with the risks being faced.

1.3 About Credit Risk

Credit risk arises from the potential that an obligor is either unwilling to perform on an
obligation or its ability to perform such obligation is impaired resulting in economic loss to
the bank.
In a banks portfolio, losses stem from outright default due to inability or unwillingness of a
customer or counter party to meet commitments in relation to lending, trading, settlement and
other financial transactions. Alternatively losses may result from reduction in portfolio value
due to actual or perceived deterioration in credit quality. Credit risk emanates from a banks
dealing with individuals, corporate, financial institutions or a sovereign. For most banks, loans
are the largest and most obvious source of credit risk; however, credit risk could stem from
activities both on and off balance sheet.
In addition to direct accounting loss, credit risk should be viewed in the context of economic
exposures. This encompasses opportunity costs, transaction costs and expenses associated with
a non-performing asset over and above the accounting loss.
Credit risk can be further sub-categorized on the basis of reasons of default. For instance the
default could be due to country in which there is exposure or problems in settlement of a
transaction.
Credit risk not necessarily occurs in isolation. The same source that endangers credit risk for
the institution may also expose it to other risk. For instance a bad portfolio may attract liquidity
problem.

Components of credit risk management

A typical Credit risk management framework in a financial institution may be broadly
categorized into following main components.
Board and senior Managements Oversight
Organizational structure
Systems and procedures for identification, acceptance, measurement, monitoring and
control risks.

Board and Senior Managements Oversight

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It is the overall responsibility of banks Board to approve banks credit risk strategy and
significant policies relating to credit risk and its management which should be based on the
banks overall business strategy. To keep it current, the overall strategy has to be reviewed by
the board, preferably annually. The responsibilities of the Board with regard to credit risk
management shall, interalia, include:
Delineate banks overall risk tolerance in relation to credit risk.
Ensure that banks overall credit risk exposure is maintained at prudent levels and
consistent with the available capital
Ensure that top management as well as individuals responsible for credit risk management
possess sound expertise and knowledge to accomplish the risk management function
Ensure that the bank implements sound fundamental principles that facilitate the
identification, measurement, monitoring and control of credit risk.
Ensure that appropriate plans and procedures for credit risk management are in place.
The very first purpose of banks credit strategy is to determine the risk appetite of the bank.
Once it is determined the bank could develop a plan to optimize return while keeping credit
risk within predetermined limits. The banks credit risk strategy thus should spell out
The institutions plan to grant credit based on various client segments and products,
economic sectors, geographical location, currency and maturity
Target market within each lending segment, preferred level of diversification.
Pricing strategy.
It is essential that banks give due consideration to their target market while devising credit risk
strategy. The credit procedures should aim to obtain an in depth understanding of the banks
clients, their credentials & their businesses in order to fully know their customers.
The strategy should provide continuity in approach and take into account cyclic aspect of
countrys economy and the resulting shifts in composition and quality of overall credit
portfolio. While the strategy would be reviewed periodically and amended, as deemed
necessary, it should be viable in long term and through various economic cycles.
The senior management of the bank should develop and establish credit policies and credit
administration procedures as a part of overall credit risk management framework and get those
approved from board. Such policies and procedures shall provide guidance to the staff on
various types of lending including corporate, SME, consumer, agriculture, etc. At minimum the
policy should include
Detailed and formalized credit evaluation/ appraisal process.
Credit approval authority at various hierarchy levels including authority for approving
exceptions.
Risk identification, measurement, monitoring and control
Risk acceptance criteria
Credit origination and credit administration and loan documentation procedures
Roles and responsibilities of units/staff involved in origination and management of credit.
Guidelines on management of problem loans.
In order to be effective these policies must be clear and communicated down the line. Further
any significant deviation/exception to these policies must be communicated to the top

14

management/board and corrective measures should be taken. It is the responsibility of senior

management to ensure effective implementation of these policies.

1.5 CREDIT RISK POLICY AND STRATEGY

Policy and Strategy
The Board of Directors of each bank shall be responsible for approving and periodically
reviewing the credit risk strategy and significant credit risk policies.
Credit Risk Policy
1. Every bank should have a credit risk policy document approved by the Board. The
document should include risk identification, risk measurement, risk grading/
aggregation techniques, reporting and risk control/ mitigation techniques,
documentation, legal issues and management of problem loans.
2. Credit risk policies should also define target markets, risk acceptance criteria, credit
approval authority, credit origination/ maintenance procedures and guidelines for
portfolio management.
3. The credit risk policies approved by the Board should be communicated to
branches/controlling offices. All dealing officials should clearly understand the bank's
approach for credit sanction and should be held accountable for complying with
established policies and procedures.
4. Senior management of a bank shall be responsible for implementing the credit risk
policy approved by the Board.
Credit Risk Strategy
1. Each bank should develop, with the approval of its Board, its own credit risk strategy or
plan that establishes the objectives guiding the bank's credit-granting activities and
adopt necessary policies/ procedures for conducting such activities. This strategy
should spell out clearly the organizations credit appetite and the acceptable level of
risk-reward trade-off for its activities.
2. The strategy would, therefore, include a statement of the bank's willingness to grant
loans based on the type of economic activity, geographical location, currency, market,
maturity and anticipated profitability. This would necessarily translate into the
identification of target markets and business sectors, preferred levels of diversification
and concentration, the cost of capital in granting credit and the cost of bad debts.
3. The credit risk strategy should provide continuity in approach as also take into account
the cyclical aspects of the economy and the resulting shifts in the composition/ quality
of the overall credit portfolio. This strategy should be viable in the long run and
through various credit cycles.
4. Senior management of a bank shall be responsible for implementing the credit risk
strategy approved by the Board.

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16

INTRODUCTION TO BASEL COMMITTEE ACCORD

2.1 ABOUT THE BASEL COMMITTEE
The Basel Committee on Banking Supervision provides a forum for regular cooperation on
banking supervisory matters. Its objective is to enhance understanding of key supervisory
issues and improve the quality of banking supervision worldwide. It seeks to do so by
exchanging information on national supervisory issues, approaches and techniques, with a
view to promoting common understanding. At times, the Committee uses this common
understanding to develop guidelines and supervisory standards in areas where they are
considered desirable. In this regard, the Committee is best known for its international standards
on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat
on cross-border banking supervision.
The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan,
Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the
United States. Countries are represented by their central bank and also by the authority with
formal responsibility for the prudential supervision of banking business where this is not the
central bank. The present Chairman of the Committee is Mr Nout Wellink, President of the
Netherlands Bank.
The Committee encourages contacts and cooperation among its members and other banking
supervisory authorities. It circulates to supervisors throughout the world both published and
unpublished papers providing guidance on banking supervisory matters. Contacts have been
further strengthened by an International Conference of Banking Supervisors (ICBS) which
takes place every two years.
The Committee's Secretariat is located at the Bank for International Settlements in Basel,
Switzerland, and is staffed mainly by professional supervisors on temporary secondment from
member institutions. In addition to undertaking the secretarial work for the Committee and its
many expert sub-committees, it stands ready to give advice to supervisory authorities in all
countries. Mr Stefan Walter is the Secretary General of the Basel Committee.

2.2 History of the Basel Committee

The Basel Committee, established by the central-bank Governors of the Group of Ten countries
at the end of 1974, meets regularly four times a year. It has four main working groups which
also meet regularly.
The Committee's members come from Belgium, Canada, France, Germany, Italy,
Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and
States. Countries are represented by their central bank and also by the authority with
responsibility for the prudential supervision of banking business where this is not the

17

Japan,
United
formal
central

bank. The present Chairman of the Committee is Mr Nout Wellink, President of the
Netherlands Bank, who succeeded Mr Jaime Caruana on 1 July 2006.
The Committee does not possess any formal supranational supervisory authority, and its
conclusions do not, and were never intended to, have legal force. Rather, it formulates broad
supervisory standards and guidelines and recommends statements of best practice in the
expectation that individual authorities will take steps to implement them through detailed
arrangements - statutory or otherwise - which are best suited to their own national systems. In
this way, the Committee encourages convergence towards common approaches and common
standards without attempting detailed harmonisation of member countries' supervisory
techniques.
The Committee reports to the central bank Governors of the Group of Ten countries and to the
heads of supervisory authorities of these countries where the central bank does not have formal
responsibility. It seeks their endorsement for its major initiatives. These decisions cover a very
wide range of financial issues. One important objective of the Committee's work has been to
close gaps in international supervisory coverage in pursuit of two basic principles: that no
foreign banking establishment should escape supervision; and that supervision should be
adequate. To achieve this, the Committee has issued a long series of documents since 1975.
In 1988, the Committee decided to introduce a capital measurement system commonly referred
to as the Basel Capital Accord. This system provided for the implementation of a credit risk
measurement framework with a minimum capital standard of 8% by end-1992. Since 1988,
this framework has been progressively introduced not only in member countries but also in
virtually all other countries with internationally active banks. In June 1999, the Committee
issued a proposal for a revised Capital Adequacy Framework. The proposed capital framework
consists of three pillars: minimum capital requirements, which seek to refine the standardised
rules set forth in the 1988 Accord; supervisory review of an institution's internal assessment
process and capital adequacy; and effective use of disclosure to strengthen market discipline as
a complement to supervisory efforts. Following extensive interaction with banks, industry
groups and supervisory authorities that are not members of the Committee, the revised
framework was issued on 26 June 2004. This text serves as a basis for national rule-making
and for banks to complete their preparations for the new framework's implementation.
Over the past few years, the Committee has moved more aggressively to promote sound
supervisory standards worldwide. In close collaboration with many non-G10 supervisory
authorities, the Committee in 1997 developed a set of "Core Principles for Effective Banking
Supervision", which provides a comprehensive blueprint for an effective supervisory system.
To facilitate implementation and assessment, the Committee in October 1999 developed the
"Core Principles Methodology". The Core Principles and the Methodology were revised
recently and released in October 2006.
In order to enable a wider group of countries to be associated with the work being pursued in
Basel, the Committee has always encouraged contacts and cooperation between its members
and other banking supervisory authorities. It circulates to supervisors throughout the world
published and unpublished papers. In many cases, supervisory authorities in non-G10 countries
have seen fit publicly to associate themselves with the Committee's initiatives. Contacts have

18

been further strengthened by International Conferences of Banking Supervisors (ICBS) which

take place every two years. The last ICBS was held in Mexico in the autumn of 2006.
The Committee's Secretariat is provided by the Bank for International Settlements in Basel.
The fifteen person Secretariat is mainly staffed by professional supervisors on temporary
secondment from member institutions. In addition to undertaking the secretarial work for the
Committee and its many expert sub-committees, it stands ready to give advice to supervisory
authorities in all countries.

2.3 Basel Accord,1988

Credit management is the challenging functional area in a commercial bank. It calls for expert
handling, assessing risk exposure at every stage and securing adequately the safety of funds
exposed. In spite of best efforts there can be no full-proof safety standards, resulting in the
unpreventable emergence of sticky or overdue credit periodically. Credit management is
therefore a continuous search for more secure de-risking (effective risk-management)
standards, and Asset-Liability Management strategies. Such risk-management expertise built
and implemented helps at not eliminating risk altogether, but minimising the same.
Risk management is a subject for advanced study in the western countries. The subject has also
attracted the attention of our business managers recently. In the coming years risk-management
and Asset-Liability Management strategies will receive increasing attention in India, as a
consequence of deregulation measures implemented in Indian Banking by RBI and the
Government of India. While banks face a variety of risks, the effect of "Credit-Risk" is being
severely felt in India. In fact the 1988 Basle Accord exclusively addresses at handling
effectively credit-risks. However the proposed New accord to be implemented from 2004 hopes
to cover other risks also. Relevant extract from the Consultative Paper issued by Basel
Committee on Banking Supervision covering the New Capital Adequacy Framework speaks as
under.
"While the original Accord focused mainly on credit risk, it has since been amended to address
market risk. Interest rate risk in the banking book and other risks, such as operational, liquidity,
legal and reputational risks, are not explicitly addressed. Implicitly, however, the present
Accord takes account of such risks by setting a minimum ratio that has an acknowledged buffer
to cover unquantified risks."
In India the first effort for standardisation of credit-assets for a better understanding of the
inherent risk-component was made in the Eighties, when RBI introduced categorisation of
bank-advances termed "Health Code" graded as per risk-content in each type of advance. The
object of any coding system is standardization. RBI introduced the Health code system of
commercial bank credit to bring industry level uniformity and intended for better transparency.
All bank advances are categorized under eight health codes as underWhile Health Code provided for the categorisation of Bank-credit based on risk-exposure, it did
not provide for risk-coverage on account of Credit-Assets turning non-productive or sticky . It
is in this background that Prudential norms of Income recognition and provisioning for sticky
accounts were introduced in 1992 when RBI considered it essential to accept Basel Committee
Recommendations for Capital Adequacy. Brief description of measures implemented as per

19

guidelines of RBI is given hereunder.

Asset Classification
The banks should classify their assets based on weaknesses and dependency on collateral
securities into four categories:
1. Standard Assets- It carries not more than the normal risk attached to the business and is
not an NPA
2. Sub-standard Asset - An asset which remains as NPA for a period not exceeding 24
months, where the current net worth of the borrower, guarantor or the current market
value of the security charged to the bank is not enough to ensure recovery of the debt
due to the bank in full.
3. Doubtful Assets- An NPA which continued to be so for a period exceeding two years
(18 months, with effect from March, 2001).
4. Loss Assets - An asset identified by the bank or internal/ external auditors or RBI
inspection as loss asset, but the amount has not yet been written off wholly or partly
Capital Adequacy Ratio - Basle Accord 1988
The growing concern of commercial banks regarding international competitiveness and capital
ratios led to the Basle Capital Accord 1988. The accord sets down the agreement among the G10 central banks to apply common minimum capital standards to their banking industries. The
standards are almost entirely addressed to credit risk, the main risk incurred by banks. The
document consists of two main sections, which cover
a. The definition of capital and
b. The structure of risk weights.
Based on the Basle norms, the RBI also issued similar capital adequacy norms for the Indian
banks. According to these guidelines, the banks will have to identify their Tier-I and Tier-II
capital and assign risk weights to the assets. Having done this they will have to assess the
Capital to Risk Weighted Assets Ratio (CRAR). The minimum CRAR which the Indian banks
are required to meet is set at 9 percent.
Tier-I Capital

Paid-up capital
Statutory Reserves
Disclosed free reserves
Capital reserves representing surplus arising out of sale proceeds of assets

Equity investments in subsidiaries, intangible assets and losses in the current period and those
brought forward from previous periods will be deducted from Tier I capital.

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Tier-II Capital

Undisclosed Reserves and Cumulative Perpetual Preference Shares

Revaluation Reserves
General Provisions and Loss Reserves

Background of the Basel Accord of 1988

The major impetus for the 1988 Basel Capital Accord was the concern of the Governors of the
G10 central banks that the capital of the world's major banks had become dangerously low after
persistent erosion through competition. Capital is necessary for banks as a cushion against
losses and it provides an incentive for the owners of the business to manage it in a prudent
manner.
The Existing Framework
The 1988 Accord requires internationally active banks in the G10 countries to hold capital
equal to at least 8% of a basket of assets measured in different ways according to their
riskiness. The definition of capital is set (broadly) in two tiers, Tier 1 being shareholders' equity
and retained earnings and Tier 2 being additional internal and external resources available to
the bank. The bank has to hold at least half of its measured capital in Tier 1 form.
A portfolio approach is taken to the measure of risk, with assets classified into four buckets
(0%, 20%, 50% and 100%) according to the debtor category. This means that some assets
(essentially bank holdings of government assets such as Treasury Bills and bonds) have no
capital requirement, while claims on banks have a 20% weight, which translates into a capital
charge of 1.6% of the value of the claim. However, virtually all claims on the non-bank private
sector receive the standard 8% capital requirement.
There is also a scale of charges for off-balance sheet exposures through guarantees,
commitments, forward claims, etc. This is the only complex section of the 1988 Accord and
requires a two-step approach whereby banks convert their off-balance-sheet positions into a
credit equivalent amount through a scale of conversion factors, which then are weighted
according to the counterparty's risk weighting.
The 1988 Accord has been supplemented a number of times, with most changes dealing with
the treatment of off-balance-sheet activities. A significant amendment was enacted in 1996,
when the Committee introduced a measure whereby trading positions in bonds, equities,
foreign exchange and commodities were removed from the credit risk framework and given
explicit capital charges related to the bank's open position in each instrument.
Impact of the 1988 Accord
The two principal purposes of the Accord were to ensure an adequate level of capital in the
international banking system and to create a "more level playing field" in competitive terms so
that banks could no longer build business volume without adequate capital backing. These two
objectives have been achieved. The merits of the Accord were widely recognized and during
the 1990s the Accord became an accepted world standard, with well over 100 countries

21

applying the Basel framework to their banking system. However, there also have been some
less positive features. The regulatory capital requirement has been in conflict with increasingly
sophisticated internal measures of economic capital. The simple bucket approach with a flat 8%
charge for claims on the private sector has given banks an incentive to move high quality assets
off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the
1988 Accord does not sufficiently recognise credit risk mitigation techniques, such as collateral
and guarantees. These are the principal reasons why the Basel Committee decided to propose a
more risk-sensitive framework in June 1999.
The June 1999 Proposal
The initial consultative proposal had a strong conceptual content and was deliberately rather
vague on some details in order to solicit comment at a relatively early stage of the Basel
Committee's thinking. It contained three fundamental innovations, each designed to introduce
greater risk sensitivity into the Accord. One was to supplement the current quantitative standard
with two additional "Pillars" dealing with supervisory review and market discipline. These
were intended to reduce the stress on the quantitative Pillar 1 by providing a more balanced
approach to the capital assessment process. The second innovation was that banks with
advanced risk management capabilities would be permitted to use their own internal systems
for evaluating credit risk, known as "internal ratings", instead of standardized risk weights for
each class of asset. The third principal innovation was to allow banks to use the gradings
provided by approved external credit assessment institutions (in most cases private rating
agencies) to classify their sovereign claims into five risk buckets and their claims on corporates
and banks into three risk buckets. In addition, there were a number of other proposals to refine
the risk weightings and introduce a capital charge for other risks. The basic definition of capital
stayed the same.
The comments on the June 1999 paper were numerous and can be said to reflect the important
impact the 1988 Accord has had. Nearly all commentaries welcomed the intention to refine the
Accord and supported the three Pillar approach, but there were many comments on the details
of the proposal. A widely-expressed comment from banks in particular was that the threshold
for the use of the IRB approach should not be set so high as to prevent well-managed banks
from using their internal ratings.
Intensive work has taken place in the eighteen months since June 1999. Much of this has
leveraged off work undertaken in parallel with industry representatives, whose cooperation has
been greatly appreciated by the Basel Committee and its Secretariat.

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2.4

The New Basel Capital Accord - An Explanatory Note)

Need for Revising/Improving the 1988-Accord - June 1999
Proposals)

More than a decade has passed since the Basel Committee on Banking Supervision (the
Committee) introduced its 1988 Capital Accord (the Accord). The business of banking, riskmanagement practices, supervisory approaches, and financial markets each have undergone
significant transformation since then. In June 1999 the Committee released a proposal to
replace the 1988 Accord with a more risk-sensitive framework.

Rationale for a New Accord: Need for more flexibility and Risk
THE EXISTING ACCORD

THE PROPOSED NEW ACCORD

Focus on a single risk measure

More emphasis on banks' own internal methodologies,

supervisory review, and market discipline

One size fits all

Flexibility, menu of approaches, incentives for better risk

management

Broad brush structure

More risk sensitivity

Safety and soundness in today's dynamic and complex financial system can be attained only by
the combination of effective bank-level management, market discipline, and supervision.
The 1988 Accord focussed on the total amount of bank capital, which is vital in reducing the
risk of bank insolvency and the potential cost of a bank's failure for depositors.
Building on this, the new framework intends to improve safety and soundness in the financial
system by placing more emphasis on banks' own internal control and management, the
supervisory review process, and market discipline.
Although the new framework's focus is primarily on internationally active banks, its underlying
principles are intended to be suitable for application to banks of varying levels of complexity
and sophistication. The Committee has consulted with supervisors worldwide in developing the
new framework and expects the New Accord to be adhered to by all significant banks within a
certain period of time.
The 1988 Accord provided essentially only one option for measuring the appropriate capital of
internationally active banks. The best way to measure, manage and mitigate risks, however,
differs from bank to bank. An Amendment was introduced in 1996 which focussed on trading
risks and allowed some banks for the first time to use their own systems to measure their
market risks. The new framework provides a spectrum of approaches from simple to advanced
methodologies for the measurement of both credit risk and operational risk in determining
capital levels. It provides a flexible structure in which banks, subject to supervisory review, will

23

adopt approaches which best fit their level of sophistication and their risk profile. The
framework also deliberately builds in rewards for stronger and more accurate risk
measurement.
The new framework intends to provide approaches which are both more comprehensive and
more sensitive to risks than the 1988 Accord, while maintaining the overall level of regulatory
capital. Capital requirements that are more in line with underlying risks will allow banks to
manage their businesses more efficiently.
The new framework is less prescriptive than the original Accord. At its simplest, the framework
is somewhat more complex than the old, but it offers a range of approaches for banks capable
of using more risk-sensitive analytical methodologies. These inevitably require more detail in
their application and hence a thicker rule book. The Committee believes the benefits of a
regime in which capital is aligned more closely to risk significantly exceed the costs, with the
result that the banking system should be safer, sounder, and more efficient.
Structure of the New Accord - Three pillars of the New Accord
First pillar: minimum capital requirement
Second pillar: supervisory review process
Third pillar: market discipline
The new Accord consists of three mutually reinforcing pillars, which together should contribute
to safety and soundness in the financial system. The Committee stresses the need for rigorous
application of all three pillars and plans to work actively with fellow supervisors to achieve the
effective implementation of all aspects of the Accord.
The First Pillar: Minimum Capital Requirement
The first pillar sets out minimum capital requirements. The new Accord maintains both the
current definition of capital and the minimum requirement of 8% of capital to risk-weighted
assets. To ensure that risks within the entire banking group are considered, the revised Accord
will be extended on a consolidated basis to holding companies of banking groups. The revision
focuses on improvements in the measurement of risks, i.e., the calculation of the denominator
of the capital ratio. The credit risk measurement methods are more elaborate than those in the
current Accord. The new framework proposes for the first time a measure for operational risk,
while the market risk measure remains unchanged.
For the measurement of credit risk, two principal options are being proposed. The first is the
standardised approach, and the second the internal rating based (IRB) approach. There are
two variants of the IRB approach, foundation and advanced. The use of the IRB approach will
be subject to approval by the supervisor, based on the standards established by the Committee.
The Second Pillar: Supervisory Review Process
The supervisory review process requires supervisors to ensure that each bank has sound internal
processes in place to assess the adequacy of its capital based on a thorough evaluation of its
risks. The new framework stresses the importance of bank management developing an internal
capital assessment process and setting targets for capital that are commensurate with the bank's

24

particular risk profile and control environment. Supervisors would be responsible for evaluating
how well banks are assessing their capital adequacy needs relative to their risks. This internal
process would then be subject to supervisory review and intervention, where appropriate.
The implementation of these proposals will in many cases require a much more detailed
dialogue between supervisors and banks. This in turn has implications for the training and
expertise of bank supervisors, an area in which the Committee and the BIS's Financial Stability
Institute will be providing assistance.
The Third Pillar: Market Discipline
The third pillar of the new framework aims to bolster market discipline through enhanced
disclosure by banks. Effective disclosure is essential to ensure that market participants can
better understand banks' risk profiles and the adequacy of their capital positions. The new
framework sets out disclosure requirements and recommendations in several areas, including
the way a bank calculates its capital adequacy and its risk assessment methods.
The core set of disclosure recommendations applies to all banks, with more detailed
requirements for supervisory recognition of internal methodologies for credit risk, credit risk
mitigation techniques and asset securitization

2.5 Pillar 1: Minimum capital requirements

While the proposed New Accord differs from the current Accord along a number of
dimensions, it is important to begin with a description of elements that have not changed. The
current Accord is based on the concept of a capital ratio where the numerator represents the
amount of capital a bank has available and the denominator is a measure of the risks faced by
the bank and is referred to as risk-weighted assets. The resulting capital ratio may be no less
than 8%.
Under the proposed New Accord, the regulations that define the numerator of the capital ratio
(i.e. the definition of regulatory capital) remain unchanged. Similarly, the minimum required
ratio of 8% is not changing. The modifications, therefore, are occurring in the definition of riskweighted assets, which is in the methods used to measure the risks faced by banks. The new
approaches for calculating risk-weighted assets are intended to provide improved bank
assessments of risk and thus to make the resulting capital ratios more meaningful.
The current Accord explicitly covers only two types of risks in the definition of risk weighted
assets: (1) credit risk and (2) market risk. Other risks are presumed to be covered implicitly
through the treatments of these two major risks. The treatment of market risk arising from
trading activities was the subject of the Basel Committee's 1996 Amendment to the Capital
Accord. The proposed New Accord envisions this treatment remaining unchanged.
The pillar one proposals to modify the definition of risk-weighted assets in the New Accord
have two primary elements:

25

1. Substantive changes to the treatment of credit risk relative to the current Accord;
2. The introduction of an explicit treatment of operational risk that will result in a measure
of operational risk being included in the denominator of a bank's capital ratio. The
discussions below will focus on these two elements in turn.
In both cases, a major innovation of the proposed New Accord is the introduction of three
distinct options for the calculation of credit risk and three others for operational risk. The
Committee believes that it is not feasible or desirable to insist upon a one-size-fits-all approach
to the measurement of either risk. Instead, for both credit and operational risk, there are three
approaches of increasing risk sensitivity to allow banks and supervisors to select the approach
or approaches that they believe are most appropriate to the stage of development of banks'
operations and of the financial market infrastructure.

2.5(1) Standardised Approach to Credit Risk

The standardised approach is similar to the current Accord in that banks are required to slot
their credit exposures into supervisory categories based on observable characteristics of the
exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The
standardised approach establishes fixed risk weights corresponding to each supervisory
category and makes use of external credit assessments to enhance risk sensitivity compared to
the current Accord. The risk weights for sovereign, interbank, and corporate exposures are
differentiated based on external credit assessments. For sovereign exposures, these credit
assessments may include those developed by OECD export credit agencies, as well as those
published by private rating agencies.
The standardised approach contains guidance for use by national supervisors in determining
whether a particular source of external ratings should be eligible for banks to use. The use of
external ratings for the evaluation of corporate exposures, however, is considered to be an
optional element of the framework. Where no external rating is applied to an exposure, the
standardised approach mandates that in most cases a risk weighting of 100% be used, implying
a capital requirement of 8% as in the current Accord. In such instances, supervisors are to
ensure that the capital requirement is adequate given the default experience of the exposure
type in question. An important innovation of the standardised approach is the requirement that
loans considered past-due be risk weighted at 150%, unless a threshold amount of specific
provisions has already been set aside by the bank against that loan.
Another important development is the expanded range of collateral, guarantees, and credit
derivatives that banks using the standardised approach may recognise. Collectively, Basel II
refers to these instruments as credit risk mitigants. The standardised approach expands the
range of eligible collateral beyond OECD sovereign issues to include most types of financial
instruments, while setting out several approaches for assessing the degree of capital reduction
based on the market risk of the collateral instrument. Similarly, the standardised approach
expands the range of recognised guarantors to include all firms that meet a threshold external
credit rating.
The standardised approach also includes a specific treatment for retail exposures. The risk
weights for residential mortgage exposures are being reduced relative to the current Accord, as
are those for other retail exposures, which will now receive a lower risk weight than that for
unrated corporate exposures. In addition, some loans to small- and mediumsized enterprises

26

(SMEs) may be included within the retail treatment, subject to meeting various criteria.
By design the standardised approach draws a number of distinctions between exposures and
transactions in an effort to improve the risk sensitivity of the resulting capital ratios. The same
can also be said of the IRB approaches to credit risk and those for assessing the capital
requirement for operational risk where capital requirements are more closely linked to risk. In
order to assist banks and national supervisors where circumstances may not warrant a broad
range of options, the Committee has developed the 'simplified standardised approach' outlined
in Annex 9 of CP3. The annex collects in one place the simplest options for calculating risk
weighted assets. Banks intending to adopt the simplified standardised methods are also
expected to comply with the corresponding supervisory review and market discipline
requirements of the New Accord.

2.5(2) Internal Ratings-based (IRB) Approaches

One of the most innovative aspects of the New Accord is the IRB approach to credit risk, which
includes two variants: a foundation version and an advanced version. The IRB approach differs
substantially from the standardised approach in that banks' internal assessments of key risk
drivers serve as primary inputs to the capital calculation. Because the approach is based on
banks' internal assessments, the potential for more risk sensitive capital requirements is
substantial. However, the IRB approach does not allow banks themselves to determine all of the
elements needed to calculate their own capital requirements. Instead, the risk weights and thus
capital charges are determined through the combination of quantitative inputs provided by
banks and formulas specified by the Committee.
Corporate, Bank and Sovereign Exposures
The IRB calculation of risk-weighted assets for exposures to sovereigns, banks, or corporate
entities uses the same basic approach. It relies on four quantitative inputs:
1. Probability of default (PD), which measures the likelihood that the borrower will
default over a given time horizon;
2. Loss given default (LGD), which measures the proportion of the exposure that will be
lost if a default occurs;
3. Exposure at default (EAD), which for loan commitments measures the amount of the
facility that is likely to be drawn if a default occurs; and
4. Maturity (M), which measures the remaining economic maturity of the exposure.
Implementation of IRB
By relying on internally generated inputs to the Basel II risk weight functions, there is bound to
be some variation in the way in which the IRB approach is carried out. To ensure significant
comparability across banks, the Committee has established minimum qualifying criteria for use
of the IRB approaches that cover the comprehensiveness and integrity of banks' internal credit
risk assessment capabilities. While banks using the advanced IRB approach will have greater
flexibility relative to those relying on the foundation IRB approach, at the same time they must

27

also satisfy a more stringent set of minimum standards.

The Committee believes that banks' internal rating systems should accurately and consistently
differentiate between different degrees of risk. The challenge is for banks to define clearly and
objectively the criteria for their rating categories in order to provide meaningful assessments of
both individual credit exposures and ultimately an overall risk profile. A strong control
environment is another important factor for ensuring that banks' rating systems perform as
intended and the resulting ratings are accurate. An independent ratings process, internal review
and transparency are control concepts addressed in the minimum IRB standards.
Clearly, an internal rating system is only as good as its inputs. Accordingly, banks using the
IRB approach will need to be able to measure the key statistical drivers of credit risk. The
minimum Basel II standards provide banks with the flexibility to rely on data derived from
their own experience, or from external sources as long as the bank can demonstrate the
relevance of such data to its own exposures. In practical terms, banks will be expected to have
in place a process that enables them to collect, to store and to utilise loss statistics over time in
a reliable manner.

2.6 Pillar 2: Supervisory Review

The second pillar of the New Accord is based on a series of guiding principles, all of which
point to the need for banks to assess their capital adequacy positions relative to their overall
risks, and for supervisors to review and take appropriate actions in response to those
assessments. These elements are increasingly seen as necessary for effective management of
banking organisations and for effective banking supervision, respectively.
Feedback received from the industry and the Committee's own work has emphasised the
importance of the supervisory review process. Judgements of risk and capital adequacy must
be based on more than an assessment of whether a bank complies with minimum capital
requirements. The inclusion of a supervisory review element in the New Accord, therefore,
provides benefits through its emphasis on the need for strong risk assessment capabilities by
banks and supervisors alike. Further, it is inevitable that a capital adequacy framework, even
the more forward looking New Accord, will lag to some extent behind the changing risk
profiles of complex banking organisations, particularly as they take advantage of newly
available business opportunities. Accordingly, this heightens the importance of, and attention
supervisors must pay to pillar two.
The Committee has been working to update the pillar two guidance as it finalises other aspects
of the new capital adequacy framework. One update is in relation to stress testing. The
Committee believes it is important for banks adopting the IRB approach to credit risk to hold
adequate capital to protect against adverse or uncertain economic conditions. Such banks will
be required to perform a meaningfully conservative stress test of their own design with the aim
of estimating the extent to which their IRB capital requirements could increase during a stress
scenario. Banks and supervisors are to use the results of such tests as a means of ensuring that
banks hold a sufficient capital buffer. To the extent there is a capital shortfall, supervisors may,

28

for example, require a bank to reduce its risks so that existing capital resources are available to
cover its minimum capital requirements plus the results of a recalculated stress test.
Other refinements focus on banks' review of concentration risks, and on the treatment of
residual risks that arise from the use of collateral, guarantees and credit derivatives. Further to
the pillar one treatment of securitisation, a supervisory review component has been developed,
which is intended to provide banks with some insight into supervisory expectations for specific
securitisation exposures. Some of the concepts addressed include significant risk transfer and
considerations related to the use of call provisions and early amortisation features. Further,
possible supervisory responses are outlined to address instances when it is determined that a
bank has provided implicit (non-contractual) support to a securitisation structure.

2.7 Pillar 3: Market Discipline

The purpose of pillar three is to complement the minimum capital requirements of pillar one
and the supervisory review process addressed in pillar two. The Committee has sought to
encourage market discipline by developing a set of disclosure requirements that allow market
participants to assess key information about a bank's risk profile and level of capitalisation.
The Committee believes that public disclosure is particularly important with respect to the
New Accord where reliance on internal methodologies will provide banks with greater
discretion in determining their capital needs. By bringing greater market discipline to bear
through enhanced disclosures, pillar three of the new capital framework can produce
significant benefits in helping banks and supervisors to manage risk and improve stability.
Over the past year, the Committee has engaged various market participants and supervisors in a
dialogue regarding the extent and type of bank disclosures that would be most useful. The aim
has been to avoid potentially flooding the market with information that would be hard to
interpret or to use in understanding a bank's actual risk profile. After taking a hard look at the
disclosures proposed in its second consultative package on the New Accord, the Committee has
since scaled back considerably the requirements, particularly those relating to the IRB
approaches and securitizations. The Committee is aware that supervisors may have different
legal avenues available in having banks satisfy the disclosure requirements. The various means
may include public disclosures deemed necessary on safety and supervision grounds or
information that must be disclosed in regulatory reports. The Committee recognises that the
means by which banks will be expected to share information publicly will depend on the legal
authority of supervisors. Another important consideration has been the need for the Basel II
disclosure framework to align with national accounting standards. Considerable efforts have
been made to ensure that the disclosure requirements of the New Accord focus on bank capital
adequacy and do not conflict with broader accounting disclosure standards with which banks
must comply. This has been accomplished through a strong and co-operative dialogue with
accounting authorities. Going forward, the Committee will look to strengthen these
relationships given that the continuing work of accounting authorities may have implications
for the disclosures required in the New Accord. With respect to potential future modifications
to the capital framework itself, the Committee intends to also consider the impact of such
changes on the amount of information a bank should be required to disclose.

29

RBI GUIDELINES ON CREDIT RISK MANAGEMENT

3.1 Credit Rating Framework
A Credit-risk Rating Framework (CRF) is necessary to avoid the limitations associated with a
simplistic and broad classification of loans/exposures into a "good" or a "bad" category. The
CRF deploys a number/ alphabet/ symbol as a primary summary indicator of risks associated
with a credit exposure. Such a rating framework is the basic module for developing a credit
risk management system and all advanced models/approaches are based on this structure. In
spite of the advancement in risk management techniques, CRF is continued to be used to a
great extent. These frameworks have been primarily driven by a need to standardise and
uniformly communicate the "judgement" in credit selection procedures and are not a substitute
to the vast lending experience accumulated by the banks' professional staff.
Basic Architecture of CRFs
The following elements outline the basic architecture and the operating principles of any CRF.
Grading system for calibration of credit risk
Operating design of CRF
GRADING SYSTEM FOR CALIBRATION OF CREDIT RISK
The grades (symbols, numbers, alphabets, descriptive terms) used in the internal credit-risk
grading system should represent, without any ambiguity, the default risks associated with an
exposure. The grading system should enable comparisons of risks for purposes of analysis and
top management decision-making. It should also reflect regulatory requirements of the
supervisor on asset classification (e.g. the RBI asset classification). It is anticipated that, over a
period of time, the process of risk identification and risk assessment will be further refined.
The grading system should, therefore, be flexible and should accommodate the refinements in
risk categorisation.
Nature of Grading System for the CRF
The grading system adopted in a CRF could be an alphabetic or numeric or an alpha-numeric
scale. Since rating agencies follow a particular scale (AAA, AA+, BBB etc.), it would be
prudent to adopt a different rating scale to avoid confusion in internal communications.
Besides, adoption of a different rating scale would permit comparable benchmarking between
the two mechanisms. Several banks utilise a numeric rating scale. The number of grades for the
"acceptable" and the "unacceptable" credit risk categories would depend on the finesse of risk
gradation. Normally, numeric scales developed for CRFs are such that the lower the credit-risk,
the lower is the calibration on the scale.
30

Illustration
A rating scale could consist of 9 levels, of which levels 1 to 5 represent various grades of
acceptable credit risk and levels 6 to 9 represent various grades of unacceptable credit risk
associated with an exposure.
The scale, starting from "1" (which would represent lowest level credit risk and highest level of
safety/ comfort) and ending at "9" (which would represent the highest level of credit risk and
lowest level of safety/ comfort), could be deployed to calibrate, benchmark, compare and
monitor credit risk associated with the bank's exposures and give indicative guidelines for
credit risk management activities. Each bank may consider adopting suitable alphabetic prefix
to their rating scales, which would make their individual ratings scale distinct and unique.
OPERATING DESIGN OF THE CRF
Which Exposures are Rated?
The first element of the operating design is to determine which exposures are required to be
rated through the CRF. There may be a case for size-based classification of exposures and
linking the risk-rating process to these size-based categories. The shortcoming of this
arrangement is that though significant credit migration/deterioration/erosion occurs in the
smaller sized exposures, these are not captured by the CRF. In addition, the size-criteria are
also linked with the tenure-criteria for an exposure. In several instances, large-sized exposures
over a short tenure may not require the extent of surveillance and credit monitoring that is
required for a smaller sized long-tenure exposure. Given this apparent lack of clarity, a policy
of 'all exposures are to be rated' should be followed.
The Risk-Rating Process
The credit approval process within the bank is expected to replicate the flow of analysis/
appraisal of credit-risk calibration on the CRF. As indicated above the CRF may be designed in
such a way that the risk rating has certain linkages with the amount, tenure and pricing of
exposure. These default linkages may be either specified upfront or may be developed with
empirical details over a period of time. The risk rating assigned to each credit proposal would
thus directly lead into the related decisions of acceptance (or rejection), amount, tenure and
pricing of the (accepted) proposal.
For each proposal, the credit/ risk staff would assign a rating and forward the recommendation
to the higher level of credit selection process. The proposed risk rating is either reaffirmed or
re-calibrated at the time of final credit approval and sanction. Any revisions that may become
necessary in the risk-ratings are utilised to upgrade the CRF system and the operating
guidelines. In this manner, the CRF maintains its "incremental up gradation" feature and
changes in the lending environment are captured by the system. The risk-rating process would
be equally relevant in the credit-monitoring/ surveillance stage. All changes in the underlying
credit-quality are calibrated on the risk-scale and corresponding remedial actions are initiated.
31

Assigning & Monitoring Risk-Ratings

In conventional banks, the practice of segregating the "relationship management" and the
"credit appraisal" functions is quite prevalent. One of the variants of this arrangement is that
responsibilities for calibration on the risk-rating scale are divided between the "relationship"
and the "credit" groups. All large sized exposures (above a limit) are appraised independently
by the "credit" group. Generally, the activities of assigning and approving risk-ratings need to
be segregated. Though the front-office or conventional relationship staff can assign the riskratings, the responsibilities of final approval and monitoring should be vested with a separate
credit staff.
Mechanism of Arriving at Risk-Ratings
The risk ratings, as specified above, are collective readings on the pre-specified scale and
reflect the underlying credit-risk for a prospective exposure. The CRF could be separate for
relatively peculiar businesses like banking, finance companies, real-estate developers, etc. For
all industries (manufacturing sector), a common CRF may be used. The peculiarity of a
particular industry can be captured by assigning different weights to aspects like entry barriers,
access to technology, ability of new entrants to access raw materials, etc. The following stepwise activities outline the indicative process for arriving at risk-ratings.
1.
2.
3.
4.
5.
6.
7.
8.

Step I: Identify all the principal business and financial risk elements
Step II: Allocate weights to principal risk components
Step III: Compare with weights given in similar sectors and check for consistency
Step IV: Establish the key parameters (sub-components of the principal risk elements)
Step V: Assign weights to each of the key parameters
Step VI: Rank the key parameters on the specified scale
Step VII: Arrive at the credit-risk rating on the CRF
Step VIII: Compare with previous risk-ratings of similar exposures and check for
consistency
9. Step IX: Conclude the credit-risk calibration on the CRF
The risk-rating process would represent collective decision making principles and as indicated
above, would involve some in-built arrangements for ensuring the consistency of the output.
The rankings would be largely comparative. As a bank's perception of the exposure
improves/changes during the course of the appraisal, it may be necessary to adjust the weights
and the rankings given to specific risk-parameters in the CRF. Such changes would be
deliberated and the arguments for substantiating these adjustments would be clearly
communicated in the appraisal documents. 2.5.5 Standardisation and Benchmarks for RiskRatings
In a lending environment dominated by industrial and corporate credits, the assignors of riskratings utilise benchmarks or pre-specified standards for assessing the risk profile of a potential
borrower. These standards usually consist of financial ratios and credit-migration statistics,
which capture the financial risks faced by the potential borrower (e.g. operating and financial
leverage, profitability, liquidity, debt-servicing ability, etc.). The business risks associated with
an exposure (e.g. cyclicality of industry, threats of product or technology substitution etc.) are
also addressed in the CRF. The output of the credit-appraisal process, specifically the financial
ratios, is directly compared with the specified benchmarks for a particular risk category. In

32

these cases, the risk rating is fairly standardised and CRF allocates a grade or a numeric value
for the overall risk profile of the proposed exposure.
Illustration
The CRF may specify that for the risk-rating exercise:
i.
ii.
iii.
iv.
v.
vi.

If Gross Revenues are between Rs.800 to Rs.1000 crore - assign a score of 2

If Operating Margin is 20% or more - assign a score of 2
If Return on Capital Employed (ROCE) is 25% or more - assign a score of 1
If Debt : Equity is between 0.60 and 0.80 - assign a score of 2
If interest cover is 3.50 or more - assign a score of 1
If Debt Service Coverage Ratio (DSCR) is 1.80 or more - assign a score of 1

The next step would be to assign weights to these risk-parameters. In an industrial credit
environment, the CRF may place higher weights on size (as captured in gross revenues),
profitability of operations (operating margins), financial leverage (debt: equity) and debtservicing ability (interest cover). Assume that the CRF assigns a 20% weightage to each of
these four parameters and the ROCE and DSCR are given a 10% weightage each. The
weighted-average score for the financial risk of the proposed exposure is 1.40, which would
correspond with the extremely low risk/highest safety level-category of the CRF (category 1).
Similarly, the business and the management risk of the proposed exposure are assessed and an
overall/ comprehensive risk rating is assigned.
The industrial credit environment permits a significantly higher level of benchmarking and
standardisation, specifically in reference to calibration of financial risks associated with credit
exposures. For all prominent industry-categories, any lender can compile profitability, leverage
and debt-servicing details and utilise these to develop internal benchmarks for the CRF. As
evident, developing such benchmarks and risk-standards for a portfolio of project finance
exposures, as in the case of the bank, would be an altogether diverse exercise.
The CRF may also use qualitative/ subjective factors in the credit decisions. Such factors are
both internal and external to the company. Internal factors could include integrity and quality
of management of the borrower, quality of inventories/ receivables and the ability of borrowers
to raise finance from other sources. External factors would include views on the economy and
industry such as growth prospects, technological change and options.

3.2 Credit Risk Models

A credit risk model seeks to determine, directly or indirectly, the answer to the following
question: Given our past experience and our assumptions about the future, what is the present
value of a given loan or fixed income security? A credit risk model would also seek to
determine the (quantifiable) risk that the promised cash flows will not be forthcoming. The
techniques for measuring credit risk that have evolved over the last twenty years are prompted
by these questions and dynamic changes in the loan market.
The increasing importance of credit risk modelling should be seen as the consequence of the
following three factors:
1. Banks are becoming increasingly quantitative in their treatment of credit risk.
33

2. New markets are emerging in credit derivatives and the marketability of existing loans
is increasing through securitization/ loan sales market."
3. Regulators are concerned to improve the current system of bank capital requirements
especially as it relates to credit risk.
Importance of Credit Risk Models
Credit Risk Models have assumed importance because they provide the decision maker with
insight or knowledge that would not otherwise be readily available or that could be marshalled
at prohibitive cost. In a marketplace where margins are fast disappearing and the pressure to
lower pricing is unrelenting, models give their users a competitive edge. The credit risk models
are intended to aid banks in quantifying, aggregating and managing risk across geographical
and product lines. The outputs of these models also play increasingly important roles in banks'
risk management and performance measurement processes, customer profitability analysis,
risk-based pricing, active portfolio management and capital structure decisions. Credit risk
modeling may result in better internal risk management and may have the potential to be used
in the supervisory oversight of banking organisations.

3.3 Techniques for Measuring Credit Risk

The following are the more commonly used techniques:
1. Econometric Techniques such as linear and multiple discriminant analysis, multiple
regression, logic analysis and probability of default, etc.
2. Neural networks are computer-based systems that use the same data employed in the
econometric techniques but arrive at the decision model using alternative
implementations of a trial and error method.
3. Optimisation models are mathematical programming techniques that discover the
optimum weights for borrower and loan attributes that minimize lender error and
maximise profits.
4. Rule-based or expert are characterised by a set of decision rules, a knowledge base
consisting of data such as industry financial ratios, and a structured inquiry process to
be used by the analyst in obtaining the data on a particular borrower.
5. Hybrid Systems In these systems simulation are driven in part by a direct causal
relationship, the parameters of which are determined through estimation techniques.
Domain of application: These models are used in a variety of domains:
Credit approval: - Models are used on a stand alone basis or in conjunction with a judgemental
override system for approving credit in the consumer lending business. The use of such models
has expanded to include small business lending. They are generally not used in approving large
corporate loans, but they may be one of the inputs to a decision.
Credit rating determination: - Quantitative models are used in deriving 'shadow bond rating'
for unrated securities and commercial loans. These ratings in turn influence portfolio limits and
other lending limits used by the institution. In some instances, the credit rating predicted by the
model is used within an institution to challenge the rating assigned by the traditional credit
analysis process. Credit risk models may be used to suggest the risk premia that should be
charged in view of the probability of loss and the size of the loss given default. Using a mark-

34

to-market model, an institution may evaluate the costs and benefits of holding a financial asset.
Unexpected losses implied by a credit model may be used to set the capital charge in pricing.
Early warning: - Credit models are used to flag potential problems in the portfolio to facilitate
early corrective action.
Common credit language: - Credit models may be used to select assets from a pool to
construct a portfolio acceptable to investors at the time of asset securitisation or to achieve the
minimum credit quality needed to obtain the desired credit rating. Underwriters may use such
models for due diligence on the portfolio (such as a collateralized pool of commercial loans).
Collection strategies: - Credit models may be used in deciding on the best collection or
workout strategy to pursue. If, for example, a credit model indicates that a borrower is
experiencing short-term liquidity problems rather than a decline in credit fundamentals, then an
appropriate workout may be devised.

3.4 Managing Credit Risk in Inter-bank Exposure

During the course of its business, a bank may assume exposures on other banks, arising from
trade transactions, money placements for liquidity management purposes, hedging, trading and
transactional banking services such as clearing and custody, etc. Such transactions entail a
credit risk, as defined, and therefore, it is important that a proper credit evaluation of the banks
is undertaken. It must cover both the interpretation of the bank's financial statements as well as
forming a judgement on non-financial areas such as management, ownership, peer/ market
perception and country factors.
The key financial parameters to be evaluated for any bank are:
1.
2.
3.
4.
5.

Capital Adequacy
Asset Quality
Liquidity
Profitability
Banks will normally have access to information available publicly to assess the credit
risk posed by the counter party bank.

Capital Adequacy
Banks with high capital ratios above the regulatory minimum levels, particularly Tier I, will be
assigned a high rating whereas the banks with low ratios well below the standards and with low
ability to access capital will be at the other end of the spectrum. Capital adequacy needs to be
appropriate to the size and structure of the balance sheet as it represents the buffer to absorb
losses during difficult times. Over capitalization can impact overall profitability. Related to the
issue of capitalization, is also the ability to raise fresh capital as and when required. Publicly
listed banks and state owned banks may be best positioned to raise capital whilst the unlisted
private banks or regional banks are dependant entirely on the wealth and/ or credibility of their
owners. The capital adequacy ratio is normally indicated in the published audited accounts. In
addition, it will be useful to calculate the Capital to Total Assets ratio which indicates the
owners' share in the assets of the business. The ratio of Tier I capital to Total Assets represents
the extent to which the bank can absorb a counterparty collapse. Tier I capital is not owed to

35

anyone and is available to cover possible losses. It has no maturity or repayment requirement,
and is expected to remain a permanent component of the counter party's capital. The Basel
standards currently require banks to have a capital adequacy ratio of 8% with Tier I ratio not
less than 4%. The Reserve Bank of India requirement is 9%. The Basel Committee is planning
to introduce the New Capital Accord and these requirements could change the dimension of the
capital of banks.
Asset Quality
The asset portfolio in its entirety should be evaluated and should include an assessment of both
funded items and off-balance sheet items. Whilst non-performing assets and provisioning ratios
will reflect the quality of the loan book, high volatility of valuations and earnings will reflect
exposure to the capital market and sensitive sectors. The key ratios to be analysed are
1.
2.
3.
4.

Gross NPAs to Gross Advances ratio,

Net NPAs to Net Advances ratio
Provisions Held to Gross Advances ratio and
Provisions Held to Gross NPAs ratio.

Commercial banks are increasingly venturing into investment banking activities where asset
considerations additionally focus on the marketability of the assets, as well as the quality of the
instruments. Preferably banks should mark-to-market their entire investment portfolio and treat
sticky investments as "non-performing", which should also be adequately provided for.
Liquidity
Commercial bank deposits generally have a much shorter contractual maturity than loans, and
liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. The
key ratios to be analysed are
1.
2.
3.
4.

Total L.A. to T.A. ratio (the higher the ratio the more liquid the bank is),
Total L.A. to T.D. ratio (this measures the bank's ability to meet withdrawals),
Loans to Deposits ratio and
Inter-bank deposits to total deposits ratio.

It is necessary to develop an appropriate level of correlation between assets and liabilities.

Account should be taken of the extent to which borrowed funds are required to bolster capital
and the respective redemption profiles.
Profitability
A consistent year on year growth in profitability is required to provide an acceptable return to
shareholders and retain resources to fund future growth. The key ratios to be analysed are:
1. Return on Average Assets (measures a bank's growth/ decline in profits in comparison
with its balance sheet expansion/ contraction),
2. Return on Equity (provides an indication of how well the bank is performing for its
owners),

36

3. Net Interest Margin (measures the difference between interest paid and interest earned,
and therefore a bank's ability to earn interest income) and
4. Operating Expenses to Net Revenue ratio (the cost/income ratio of the bank).
The degree of reliance upon interest income compared with fees earned heavy dependency on
certain sectors, and the sustainability of income streams are relevant factors to be borne in
mind. The ability of a bank to analyse another bank on the above lines will depend upon the
information available publicly and also the strength of disclosures in the financial statements.
Banks should be rated (called Bank Tierings) on the basis of the above factors. An indicative
tiering scale is:
BANK TIER

DESCRIPTION

Low risk

Modest risk

Satisfactory risk

Fair Risk

Acceptable Risk

Watch List

Substandard

Doubtful

Loss

The tiering system enables a bank to establish internal parameters to help determine acceptable
limits of exposure to a particular bank/ banking group. These parameters should be used to
determine the maximum level of (a) and (b) above, maximum tenors for term products which
may be considered prudent for a bank and settlement limits. Medium term loan facilities and
standby facilities should be sanctioned very exceptionally. Standby lines, by their very nature,
are likely to be drawn only at a time when the risk in making funds available is generally
perceived to be unattractive. Bank-wise exposure limits should be set taking into account the
counter party and country risks. The credit risk management of exposure to banks should be
centralised on a bank-wide basis. The rating scale for bank rating should be in tandem with
CRF to synthesize credit risk on account of all activities for the bank as a whole.

3.5 New Capital Accord: Implications for Credit Risk Management

The Basel Committee on Banking Supervision had released in June 1999 the first Consultative
Paper on a New Capital Adequacy Framework with the intention of replacing the current
broad-brush 1988 Accord. The Basel Committee has released a Second Consultative Document
in January 2001, which contains refined proposals for the three pillars of the New Accord Minimum Capital Requirements, Supervisory Review and Market Discipline.
The Committee proposes two approaches, for estimating regulatory capital. Viz.,
1. Standardised and
2. Internal Rating Based (IRB)

37

Under the standardised approach, the Committee desires neither to produce a net increase nor a
net decrease, on an average, in minimum regulatory capital, even after accounting for
operational risk. Under the Internal Rating Based (IRB) approach, the Committee's ultimate
goals are to ensure that the overall level of regulatory capital is sufficient to address the
underlying credit risks and also provides capital incentives relative to the standardised
approach, i.e., a reduction in the risk weighted assets of 2% to 3% (foundation IRB approach)
and 90% of the capital requirement under foundation approach for advanced IRB approach to
encourage banks to adopt IRB approach for providing capital.
The minimum capital adequacy ratio would continue to be 8% of the risk-weighted assets,
which cover capital requirements for market (trading book), credit and operational risks. For
credit risk, the range of options to estimate capital extends to include a standardised, a
foundation IRB and an advanced IRB approaches.
Standardised Approach
Under the standardised approach, preferential risk weights in the range of 0%, 20%, 50%,
100% and 150% would be assigned on the basis of ratings given by external credit assessment
institutions.
Orientation of the IRB Approach
Banks' internal measures of credit risk are based on assessments of the risk characteristics of
both the borrower and the specific type of transaction. The probability of default (PD) of a
borrower or group of borrowers is the central measurable concept on which the IRB approach
is built. The PD of a borrower does not, however, provide the complete picture of the potential
credit loss. Banks should also seek to measure how much they will lose should a borrower
default on an obligation. This is contingent upon two elements. First, the magnitude of likely
loss on the exposure: this is termed the Loss Given Default (LGD), and is expressed as a
percentage of the exposure. Secondly, the loss is contingent upon the amount to which the bank
was exposed to the borrower at the time of default, commonly expressed as Exposure at
Default (EAD). These three components (PD, LGD & EAD) combine to provide a measure of
expected intrinsic, or economic, loss. The IRB approach also takes into account the maturity
(M) of exposures. Thus, the derivation of risk weights is dependent on estimates of the PD,
LGD and, in some cases, M, that are attached to an exposure. These components (PD, LGD,
EAD, M) form the basic inputs to the IRB approach, and consequently the capital requirements
derived from it.
IRB Approach
The Committee proposes two approaches - foundation and advanced - as an alternative to
standardised approach for assigning preferential risk weights.
Under the foundation approach, banks, which comply with certain minimum requirements viz.
comprehensive credit rating system with capability to quantify Probability of Default (PD)
could assign preferential risk weights, with the data on Loss Given Default (LGD) and
Exposure at Default (EAD) provided by the national supervisors. In order to qualify for
adopting the foundation approach, the internal credit rating system should have the following
parameters/conditions:

38

1. Each borrower within a portfolio must be assigned the rating before a loan is
originated.
2. Minimum of 6 to 9 borrower grades for performing loans and a minimum of 2 grades
for non-performing loans.
3. Meaningful distribution of exposure across grades and not more than 30% of the gross
exposures in any one borrower grade.
4. Each individual rating assignment must be subject to an independent review or
approval by the Loan Review Department.
5. Rating must be updated at least on annual basis.
6. The Board of Directors must approve all material aspects of the rating and PD
estimation.
7. Internal and External audit must review annually, the banks' rating system including the
quantification of internal ratings.
8. Banks should have individual credit risk control units that are responsible for the
design, implementation and performance of internal rating systems. These units should
be functionally independent.
9. Members of staff responsible for rating process should be adequately qualified and
trained.
10. Internal rating must be explicitly linked with the banks' internal assessment of capital
adequacy in line with requirements of Pillar 2.
11. Banks must have in place sound stress testing process for the assessment of capital
adequacy.
12. Banks must have a credible track record in the use of internal ratings at least for the last
3 years.
13. Banks must have robust systems in place to evaluate the accuracy and consistency with
regard to the system, processing and the estimation of PDs.
14. Banks must disclose in greater detail the rating process, risk factors and validation etc.
of the rating system.
Under the advanced approach, banks would be allowed to use their own estimates of PD, LGD
and EAD, which could be validated by the supervisors. Under both the approaches, risk
weights would be expressed as a single continuous function of the PD, LGD and EAD. The
IRB approach, therefore, does not rely on supervisory determined risk buckets as in the case of
standardised approach. The Committee has proposed an IRB approach for retail loan portfolio,
having homogenous characteristics distinct from that for the corporate portfolio. The
Committee is also working towards developing an appropriate IRB approach relating to project
finance.
The adoption of the New Accord, in the proposed format, requires substantial upgradation of
the existing credit risk management systems. The New Accord also provided in-built capital
incentives for banks, which are equipped to adopt foundation or advanced IRB approach.
Banks may, therefore, upgrade the credit risk management systems for optimising capital.

3.6 Comments of the Reserve Bank of India on New Capital

Adequacy Framework
INTERNALRATINGSBASEDAPPROACH

39

RBI recognises the inherent attractiveness of the approach that is based on banks own
quantitative and qualitative assessment of its credit risk. However, RBI believes that an
internalratingsbasedapproachshouldformthebasisforsettingcapitalchargesforallbanks
andthattheoptionshouldnotbelimitedonlytosophisticatedbanks.Nationalsupervisors
couldsetminimumstandardsandsoundpractices,includingkeycharacteristicsoftherating
systems and process. The internal ratingsbased approaches should also be subjected to
validationbythe
nationalsupervisors.
ASSETSECURITISATION
RBIagreeswiththeCommitteesproposalstoassignriskweightsonthebasisofexternal
credit assessments (by domestic credit rating agencies) and convert offbalance sheet
securitizedreceivables,toacreditequivalentat20%andriskweightedonthebasisofobligors
weighting.However,itshouldbeensuredthatinsuchoffbalancesheetsecuritisedreceivables,
banksshouldnotdevelopinnovativestructures,whichcouldconcealtherealnatureofcredit
risktransfer.
Further, differential risk weighting treatment between securitised assets and claims on
corporateswouldencourageregulatoryarbitrage.Forinstance,whiletheclaimsoncorporates
ratedA+toAareassignedariskweightof100%,suchpoolofloanswhensecuritisedwith
very little or no credit enhancement, would be risk weighted at 50%, a whopping 50%
reduction,eventhoughnochangeintheriskprofileoftheclaimshadoccurred.Theissue
needsreconsiderationbytheBaselCommittee.
CREDITRISKMODELS
RBIisinagreementwiththeCommitteesproposalthatcreditriskmodellingmayproveto
result in better internal risk management and may have the potential to be used in the
supervisionofbanks.However,significanthurdles,principallyconcerningdataavailability
andmodelvalidationstillneedtobeclearedbeforetheseobjectivesaremet.Conceptually,
thoughtheproposalisgood,theadoptionofcreditriskmodelsasanalternativeforsetting
capital charge in emerging markets is severely constrained by data limitations and model
validation.Thehistoricaldatasupportandmodellingcapabilitiesofbanksinsuchcountriesare
alsonotofinternationalstandards.Thus,modelbasedapproachcouldbeadoptedonlywhen
thebanksdevelopsufficientexpertiseanddatabasetoestimatetheeconomiccapital.
SUPERVISORYREVIEWPROCESSTHESECONDPILLAR
RBIisinagreementwiththeCommitteesproposalsthateachfinancialinstitutioncritically
assesses its capital adequacy and future capital needs in relation to risk profile and that
supervisorsshouldhaveamethodforreviewingtheinternalcapitaladequacyassessmentsof
individualbanksanddiscussinginternalcapitaltargetssetbythebanks.RBIalsoagreeswith
theCommitteethatnationalsupervisorsshouldinterveneatanearlystagetopreventcapital
fromfallingbelowprudentlevels.Atthesametime,theburdenofestimatingeconomiccapital
maynotbemandatedtosmallerbanks,whicharenotofferingcomplexproductsandoperating
predominantlyindomestic/segmentedmarkets.RBIalsoagreesthatsupervisorsshouldhave
themandatetorequirebankstoholdcapitalinexcessofminimumregulatorycapitalratios.

40

MARKETDISCIPLINETHETHIRDPILLAR
RBIisinagreementwiththeCommitteesviewsthatincreaseddisclosures,enhanced
transparencyandmarketdisciplinearebecominganimportanttoolofsupervision.However,
atthesametime,nationalsupervisoryauthorityshouldalsoconsidertheabilityofthemarket
tologicallyinterprettheavailableinformation;otherwise,thereisapossibilityofoverreaction
toinsignificanteventsorfactors,whichcandestabilisethesystem

3.7 Risk management in ICICI

INDUSTRIAL CREDIT & INVESTMENT CORPORATION OF
INDIA (ICICI)
Risk Management
As a financial intermediary, ICICI Bank is exposed to risks that are particular to its lending and
trading businesses and the environment within which it operates. ICICI Banks goal in risk
management is to ensure that it understands measures and monitors the various risks that arise
and that the organization adheres strictly to the policies and procedures which are established
to address these risks.
As a financial intermediary, ICICI Bank is primarily exposed to credit risk, market risk,
liquidity risk, operational risk and legal risk. ICICI Bank has a central Risk, Compliance and
Audit Group with a mandate to identify, assess, monitor and manage all of ICICI Banks
principal risks in accordance with well-defined policies and procedures. The Head of the Risk,
Compliance and Audit Group reports to the Executive Director responsible for the Corporate
Center, which does not include any business groups, and is thus independent from ICICI
Banks business units. The Risk, Compliance and Audit Group coordinate with representatives
of the business units to implement ICICI Banks risk methodologies.
Committees of the board of directors have been constituted to oversee the various risk
management activities. The Audit Committee of ICICI Banks board of directors provides
direction to and also monitors the quality of the internal audit function. The Risk Committee of
ICICI Banks board of directors reviews risk management policies in relation to various risks
including portfolio, liquidity, interest rate, off-balance sheet and operational risks, investment
policies and strategy, and regulatory and compliance issues in relation thereto. The Credit
Committee of ICICI Banks board of directors reviews developments in key industrial sectors
and ICICI Banks exposure to these sectors. The Asset Liability Management Committee of
ICICI Banks board of directors is responsible for managing the balance sheet and reviewing
the asset-liability position to manage ICICI Banks market risk exposure. The Agriculture &
Small Enterprises Business Committee of ICICI Banks board of directors, which was
constituted in June 2003 but has not held any meetings to date, will, in addition to reviewing
ICICI Banks strategy for small enterprises and agri-business, also review the quality of the

41

agricultural lending and small enterprises finance credit portfolio. For a discussion of these and
other committees see ''Management''.
As shown in the following chart, the Risk, Compliance and Audit Group is organized into six
subgroups:
Credit Risk Management, Market Risk Management, Analytics, Internal Audit, Retail Risk
Management and Credit Policies and Reserve Bank of India Inspection. The Analytics Unit
develops proprietary quantitative techniques and models for risk measurement.

The Risk, Compliance and Audit Group is also responsible for assessing the risks pertaining to
international business, including review of credit policies and setting sovereign and
counterparty limits
.

Credit Risk
In our lending operations, we are principally exposed to credit risk. Credit risk is the risk of
loss that may occur from the failure of any party to abide by the terms and conditions of any
financial contract with us, principally the failure to make required payments on loans due to us.
We currently measure, monitor and manage credit risk for each borrower and also at the

42

portfolio level. We have a structured and standardized credit approval process, which includes
a well-established procedure of comprehensive credit appraisal.

Credit Risk Assessment Procedures for Corporate Loans

In order to assess the credit risk associated with any financing proposal, ICICI Bank assesses a
variety of risks relating to the borrower and the relevant industry. Borrower risk is evaluated by
considering:

The financial position of the borrower by analyzing the quality of its financial
statements, its past financial performance, its financial flexibility in terms of ability to
raise capital and its cash flow adequacy;
The borrower's relative market position and operating efficiency; and
The quality of management by analyzing their track record, payment record and
financial conservatism.

Industry risk is evaluated by considering:

Certain industry characteristics, such as the importance of the industry to the economy,
its growth outlook, cyclicality and government policies relating to the industry;
The competitiveness of the industry; and
Certain industry financials, including return on capital employed, operating margins
and earnings stability.

After conducting an analysis of a specific borrower's risk, the Credit Risk Management Group
assigns a credit rating to the borrower. ICICI Bank has a scale of 10 ratings ranging from AAA
to Band an additional default rating of D. Credit rating is a critical input for the credit approval
process ICICI Bank determines the desired credit risk spread over its cost of funds by
considering the borrower's credit rating and the default pattern corresponding to the credit
rating. Every proposal for a financing facility is prepared by the relevant business unit and
reviewed by the appropriate industry specialists in the Credit Risk Management
Group before being submitted for approval to the appropriate approval
authority. The approval process for non-fund facilities is similar to that for
fund based facilities. The credit rating for every borrower is reviewed at
least annually and is typically reviewed on a more frequent basis for higher
risk credits and large exposures. ICICI Bank also reviews the ratings of all
borrowers in a particular industry upon the occurrence of any significant event impacting that
industry.
Working capital loans are generally approved for a period of 12 months. At the end of 12
months, ICICI Bank reviews the loan arrangement and the credit rating of the borrower and
takes a decision on continuation of the arrangement and changes in the loan covenants as may
be necessary.

Credit Approval Procedures for Corporate Loans

Project Finance Procedures

43

ICICI Bank has a strong framework for the appraisal and execution of project finance
transactions. ICICI Bank believes that this framework creates optimal risk identification,
allocation and mitigation, and helps minimize residual risk.
The project finance approval process begins with a detailed evaluation of technical,
commercial, financial, marketing and management factors and the sponsor's financial strength
and experience once this review is completed, an appraisal memorandum is prepared for credit
approval purposes. As part of the appraisal process, a risk matrix is generated, which identifies
each of the project risks, mitigating factors and residual risks associated with the project. The
appraisal memorandum analyzes the risk matrix and establishes the viability of the project.
Typical key risk mitigating factors include the commitment of stand-by funds from the
sponsors to meet any cost overruns and a conservative collateral position. After credit
approval, a letter of intent is issued to the borrower, which outlines the principal financial
terms of the proposed facility, sponsor obligations, conditions precedent to disbursement,
undertakings from and covenants on the borrower. After completion of all formalities by the
borrower, a loan agreement is entered into with the borrower.
In addition to the above, in the case of structured project finance in areas such as infrastructure
and oil, gas and petrochemicals, as a part of the due diligence process, ICICI Bank appoints
consultants, wherever considered necessary, to advise the lenders, including technical advisors,
business analysts, legal counsel and insurance consultants. These consultants are typically
internationally recognized and experienced in their respective fields. Risk mitigating factors in
these financings generally also include creation of debt service reserves and channeling project
revenues through a trust and retention account.
ICICI Banks project finance credits are generally fully secured and have full recourse to the
borrower. In most cases, ICICI Bank has a security interest and first lien on all the fixed assets
and a second lien on all the current assets of the borrower. Security interests typically include
property, plant and equipment as well as other tangible assets of the borrower, both present and
future. Typically, it is ICICI Banks practice to lend between 60.0% and 80.0% of the appraised
value of these types of collateral securities. ICICI Banks borrowers are required to maintain
comprehensive insurance on their assets where ICICI Bank is recognized as payee in the event
of loss. In some cases, ICICI Bank also takes additional collateral in the form of corporate or
personal guarantees from one or more sponsors of the project and a pledge of the sponsors'
equity holding in the project company. In certain industry segments, ICICI Bank also takes
security interest in relevant project contracts such as concession agreements, off-take
agreements and construction contracts as part of the security package. In limited cases, loans
are also guaranteed by commercial banks and, in the past, have also been guaranteed by Indian
state governments or the government of India.
It is ICICI Banks current practice to normally disburse funds after the entire project funding is
committed and all necessary contractual arrangements have been entered into. Funds are
disbursed in tranches to pay for approved project costs as the project progresses. When ICICI
Bank appoints technical and market consultants, they are required to monitor the project's
progress and certify all disbursements. ICICI Bank also requires the borrower to submit
periodic reports on project implementation, including orders for machinery and equipment as
well as expenses incurred. Project completion is contingent upon satisfactory operation of the
project for a certain minimum period and, in certain cases, the establishment of debt service
reserves. ICICI Bank continues to monitor the credit exposure until its loans are fully repaid.

Corporate Finance Procedures

44

As part of the corporate loan approval procedures, ICICI Bank carries out a detailed analysis of
funding requirements, including normal capital expenses, long-term working capital
requirements and temporary imbalances in liquidity. ICICI Banks funding of long-term core
working capital requirements is assessed on the basis, among other things, of the borrower's
present and proposed level of inventory and receivables. In case of corporate loans for other
funding requirements, ICICI Bank undertakes a detailed review of those requirements and an
analysis of cash flows. A substantial portion of ICICI Banks corporate finance loans are
secured by a lien over appropriate assets of the borrower.
The focus of ICICI Banks structured corporate finance products is on cash flow based
financings. ICICI Bank has a set of distinct approval procedures to evaluate and mitigate the
risks associated with such products. These procedures include:
carrying out a detailed analysis of cash flows to accurately forecast the amounts that
will be paid and the timing of the payments based on an exhaustive analysis of
historical data;
conducting due diligence on the underlying business systems, including a detailed
evaluation of the servicing and collection procedures and the underlying contractual
arrangements; and
paying particular attention to the legal, accounting and tax issues that may impact any
structure.
ICICI Banks analysis enables it to identify risks in these transactions. To mitigate risks, ICICI
Bank uses various credit enhancement techniques, such as over-collateralization, cash
collateralization, creation of escrow accounts and debt service reserves and performance
guarantees. The residual risk is typically managed by complete or partial recourse to the
borrowing company whose credit risk is evaluated as described above. ICICI Bank also has a
monitoring framework to enable continuous review of the performance of such transactions.

Working Capital Finance Procedures

ICICI Bank carries out a detailed analysis of its borrowers' working capital requirements.
Credit limits are approved in accordance with the approval authorization approved by ICICI
Banks board of directors. Once credit limits are approved, ICICI Bank calculates the amounts
that can be lent on the basis of monthly statements provided by the borrower and the margins
stipulated. Quarterly information statements are also obtained from borrowers to monitor the
performance on a regular basis. Monthly cash flow statements are obtained where considered
necessary. Any irregularity in the conduct of the account is reported to the appropriate
authority on a monthly basis. Credit limits are reviewed on an annual basis.
Working capital facilities are primarily secured by inventories and receivables. Additionally, in
certain cases, these credit facilities are secured by personal guarantees of directors, or
subordinated security interests in the tangible assets of the borrower including plant and
machinery.

Credit Approval Authority for Corporate Loans

ICICI Bank has established four levels of credit approval authorities for its corporate banking
activities, the Credit Committee of the board of directors, the Committee of Directors, the

45

Committee of Executives (Credit) and the Regional Committee (Credit). The Credit Committee
has the power to approve all financial assistance. ICICI Banks board of directors has delegated
the authority to the Committee of Directors, consisting of ICICI Bank's whole time directors,
to the Committee of Executives (Credit) and the Regional Committee (Credit), both consisting
of designated executives of ICICI Bank, to approve financial assistance to any company within
certain individual and group exposure limits set by the board of directors. The following
table sets forth the composition and the approval authority of these
committees.

(1) Capital funds consist of Tier 1 and Tier 2 capital, as defined in the Reserve Bank of
India regulations, under Indian GAAP. See Supervision and Regulation Capital
Adequacy Requirements.
46

All new loans must be approved by the above committees in accordance with their respective
powers. Certain designated executives are authorized to approve:
Ad-hoc/ additional working capital facilities not exceeding the lower of 10.0% of
existing approved facilities and Rs. 20 million (US$ 420,610);
Temporary accommodation not exceeding the lower of 20.0% of existing approved
facilities and Rs. 20 million (US$ 420,610); and
Facilities fully secured by deposits, cash margin and letters of credit of approved banks
or approved sovereign debt instruments.
In addition to the above loan products, ICICI Banks Rural Micro Banking Group provides
loans to self-help groups, rural agencies, as well as certain categories of agricultural loans and
loans under government-sponsored schemes. These loans are typically of small amounts. The
credit approval authorization approved by the board of directors of ICICI Bank requires that all
such loans aboveRs.1.5 million (US$ 31,546) be approved by the Committee of Directors
comprising all the whole time directors, while the authority to approve loans up to Rs.1.5
million (US$ 31,546) has been delegated to designated executives.

Credit Monitoring Procedures for Corporate Loans

The Credit Middle Office Group monitors compliance with the terms and conditions for credit
facilities prior to disbursement. It also reviews the completeness of documentation, creation of
security and insurance policies for assets financed. All borrower accounts are reviewed at least
once a year. Larger exposures and lower rated-borrowers are reviewed more frequently.

Retail Loan Procedures

Our customers for retail loans are typically middle and high-income, salaried or self-employed
individuals, and, in some cases, partnerships and corporations. Except for personal loans and
credit cards, we require a contribution from the borrower and our loans are secured by the asset
financed.
Our retail credit product operations are sub-divided into various product lines. Each product
line is further sub-divided into separate sales and marketing and credit groups. The Risk,
Compliance and Audit Group, which is independent of the business groups, approves all new
retail products and product policies and credit approval authorizations. All products and
policies require the approval of the Committee of Directors comprising all the whole time
directors. All credit approval authorizations require the approval of ICICI Banks board of
directors.
We have an established process for evaluating and selecting our dealers and franchisees and
there is a clear segregation between the group responsible for originating loans and the group
that approves the loans. A centralized set of risk assessment criteria has been created for retail
lending operations after approval by the Risk, Compliance and Audit Group. These criteria
vary across product segments but typically include factors such as the borrower's income, the
loan-to-value ratio and certain stability factors. The loan approval authority is delegated to
credit officers, subject to loan amount limits, which vary across different loan products. We use
Direct Marketing Agents (DMAs) for the marketing and sale of retail credit products. Credit
approval authority lies only with our credit officers.

47

Credit officers approve loans in compliance with the risk assessment criteria. External agencies
are used to facilitate a comprehensive due diligence process including visits to office or home
in the case of loans to individual borrowers. Before disbursements are made, the credit officer
conducts a centralized check and review of the borrower's profile.
In order to limit the scope of individual discretion in the loan assessment and approval process,
ICICI Bank has implemented a credit-scoring program for credit cards. ICICI Bank has also
implemented a credit-scoring program for certain variants within the consumer durables loan
product.
The credit-scoring program is an automated credit approval system for evaluating loan
applications by assigning a credit score to each applicant based on certain demographic
attributes like earnings stability, educational background and age. The credit score then forms
the basis of loan evaluation. Though a formal credit bureau does not as yet operate in India, we
avail the services of certain private agencies operating in India to check applications before
disbursement.
ICICI Bank has a separate retail credit team, which undertakes review and audit of credit
quality across each credit approval team. ICICI Bank has established centralized operations to
manage operating risk in the various back office processes of its retail loan business except for
a few operations which are decentralized to improve turnaround time for our customers. The
Risk, Compliance and Audit Group conduct an independent audit of processes and documents
at periodic intervals. As with our other retail credit products, ICICI Bank emphasizes
conservative credit standards, including credit scoring and strict monitoring of repayment
patterns, to optimize risks associated with credit cards.
ICICI Bank has a collections unit structured along various product lines and geographical
locations, to manage delinquency levels. The collections unit operates under the guidelines of a
standardized recovery process. ICICI Bank also makes use of external collection agents to aid
ICICI Bank in its collection efforts, including collateral repossession in accounts that are
overdue for more than 90 days. A fraud control department has been set up to manage levels of
fraud, primarily through fraud prevention in the form of forensic audits and also through
recovery of fraud losses. The fraud control department is aided by specialized agencies.
External agencies for collections are strictly governed by standardized process guidelines.
External agencies are also used to facilitate a comprehensive due diligence process including
property valuation prior to the approval of home loans and visits to home or office in the case
of loans to individual borrowers.

Small Enterprises Loan Procedures

The Small Enterprises Group finances dealers and vendors of companies by implementing
structures to enhance the base credit quality of the vendor / dealer, that involve an analysis of
the base credit quality of the vendor / dealer pool and an analysis of the linkages that exist
between the vendor/ dealer and the company.
The group is also involved in financing based on a cluster community based approach that is,
financing of small enterprises that have a homogeneous profile such as apparel manufacturers
and manufacturers of pharmaceuticals. The risk assessment of such communities involves
identification of appropriate credit norms for target market, use of scoring models for
enterprises that satisfy these norms and applying pre-determined exposure limits to enterprises
that are awarded a minimum required score in the scoring model. The assessment also involves

48

setting up of portfolio control norms, individual borrower approval norms and stringent exit
triggers to be followed while financing such clusters or communities.

Investment Banking Procedures

ICICI Securities provides investment banking services, including corporate advisory, fixed
income and equity services, to corporate customers. All investment banking mandates,
including underwriting commitments, are approved by the Managing Director and the relevant
business group heads of ICICI Securities. ICICI Securities is registered with the Securities and
Exchange Board of India as a merchant bank. In that capacity, ICICI Securities has decided not
to engage in any lending and leasing activities and conducts only activities related to the
securities markets and corporate advisory services.

Quantitative and Qualitative Disclosures About Market Risk

Market risk is exposure to loss arising from changes in the value of a financial instrument as a
result of changes in market variables such as interest rates, exchange rates and other asset
prices. The prime source of market risk for us is the interest rate risk we are exposed to as a
financial intermediary, which arises on account of our asset liability management activities. In
addition to interest rate risk, we are exposed to other elements of market risk such as, liquidity
or funding risk, price risk on trading portfolios, and exchange rate risk on foreign currency
positions.

Market Risk Management Procedures

The board of directors of ICICI Bank reviews and approves the policies for the management of
market risk. The board has delegated the responsibility for market risk management on the
banking book to the Asset Liability Management Committee and the trading book to the
Committee of Directors, under the Risk Committee of the Board. The Asset Liability
Management Committee is responsible for approving policies and managing interest rate risk
on the banking book and liquidity risks reflected in the balance sheet. The Committee of
Directors is responsible for setting policies and approving risk controls for the trading
portfolio.
The Asset Liability Management Committee is chaired by the Joint Managing Director and all
four Executive Directors are members of the Committee. The Committee generally meets on a
monthly basis and reviews the interest rate and liquidity gap positions on the banking book,
formulates a view on interest rates, sets deposit and benchmark lending rates, reviews the
business profile and its impact on asset liability management and determines the asset liability
management strategy, as deemed fit, in light of the current and expected business environment.
The Committee reports to the Risk Committee. A majority of the members of the Risk
Committee are independent directors and the committee is chaired by an independent director.
The Balance Sheet Management Group, reporting to the Chief Financial Officer, is responsible
for managing interest rate risk on the banking book, and liquidity, under the supervision of the
Asset Liability Management Committee.
An independent Market Risk Management Group, which is part of the Risk, Compliance and
Audit Group, recommends changes in risk policies and controls, including for new trading
products, and the processes and methodologies for quantifying and assessing market risks. Risk
limits including position limits and stop loss limits for the trading book are monitored on a
daily basis and reviewed periodically. In addition to risk limits, risk monitoring tools such as
49

Value-at-Risk models are also used for measuring market risk in the trading portfolio. ICICI
Securities, our investment banking subsidiary which is a primary dealer in government of India
securities and has government of India securities as a significant proportion of its portfolio, has
a corporate risk management group formanaging its interest rate and liquidity risk.

Interest Rate Risk

Since our balance sheet consists predominantly of rupee assets and liabilities, movements in
domestic interest rates constitute the main source of interest rate risk. Our portfolio of traded
and other debt securities and our loan portfolio are negatively impacted by an increase in
interest rates. Exposure to fluctuations in interest rates is measured primarily by way of gap
analysis, providing a static view of the maturity and re-pricing characteristics of balance sheet
positions. An interest rate gap report is prepared by classifying all assets and liabilities into
various time period categories according to contracted maturities or anticipated re-pricing date.
The difference in the amount of assets and liabilities maturing or being re-priced in any time
period category, would then give an indication of the extent of exposure to the risk of potential
changes in the margins on new or re-priced assets and liabilities. ICICI Bank prepared interest
rate risk reports on a fortnightly basis in fiscal 2003. The same were reported to the Reserve
Bank of India on a monthly basis. Interest rate risk is further monitored through interest rate
risk limits approved by the Asset Liability Management Committee.
Our core business is deposit taking and lending in both rupees and foreign currencies, as
permitted by the Reserve Bank of India. These activities expose us to interest rate risk. As the
rupee market is significantly different from the international currency markets, gap positions in
these markets differ significantly.
In the rupee market, most of our deposit taking is at fixed rates of interest for fixed periods,
except that savings deposits and current deposits which do not have any specified maturity and
can be withdrawn on demand. We usually borrow for a fixed period with a one-time repayment
on maturity, with some borrowings having European call/put options, exercisable only on
specified dates, attached to them. However, we have a mix of floating and fixed interest rate
assets. Our loans generally are repaid more gradually, with principal repayments being made
over the life of the loan. Our housing loans are primarily floating rate loans where the rates are
reset every quarter. We follow a four-tier prime rate structure, namely, a short-term prime rate
for one-year loans or loans that re-price at the end of one year, a medium-term prime rate for
one to three year loans, a long-term prime rate for loans with maturities greater than three years
and a prime rate for cash credit products. We seek to eliminate interest rate risk on un disbursed
commitments by fixing interest rates on rupee loans at the time of loan disbursement.
In contrast to our rupee loans, a large proportion of our foreign currency loans are floating rate
loans. These loans are generally funded with floating rate foreign currency funds. Our fixed
rate foreign currency loans are generally funded with fixed rate foreign currency funds. We
generally convert all our foreign currency borrowings and deposits into floating rate dollar
liabilities through the use of interest rate and currency swaps with leading international banks.
The foreign currency gaps are generally significantly lower than rupee gaps, representing a
considerably lower exposure to fluctuations in foreign currency interest rates.
We use the duration of our government securities portfolio as a key variable for interest rate
risk management. We increase or decrease the duration of government securities portfolio to

50

increase or decrease our interest rate risk exposure. In addition, we also use interest rate
derivatives to manage the asset and liability positions. We are an active participant in the
interest rate swap market and are one of the largest counterparties in India.
Sensitivity analysis, which is based upon a static interest rate risk profile of assets and
liabilities, is used for risk management purposes only and the model above assumes that during
the course of the year no other changes are made in the respective portfolios. Actual changes in
net interest income will vary from the model.

Price Risk (Trading book)

We undertake trading activities to enhance earnings through profitable trading for our own
account. ICICI Securities, our investment banking subsidiary, is a primary dealer in
government of India securities, and a significant proportion of its portfolio consists of
government of India securities.
As noted above, sensitivity analysis is used for risk management purposes only and the model
used above assumes that during the course of the year no other changes are made in the
respective portfolios. Actual changes in the value of the fixed income portfolio will vary from
the model above.
We revalue our trading portfolio on a daily basis and recognize aggregate re-valuation losses in
our profit and loss account. The asset liability management policy stipulates an interest rate
risk limit which seeks to cap the risk on account of the mark-to-market impact on the mark-tomarket book (under the Indian GAAP classification which is different from the US GAAP
classification see Supervision and Regulation Banks Investment Classification and
Valuation Norms) and the earnings at risk on the banking book, based on a sensitivity analysis
of a 100 basis points parallel and immediate shift in interest rates.
In addition, the Market Risk Management Group stipulates risk limits including position limits
and stop loss limits for the trading book. These limits are monitored on a daily basis and
reviewed periodically. In addition to risk limits, we also have risk monitoring tools such as
Value-at-Risk models for measuring market risk in our trading portfolio.
ICICI Bank is required to invest a specified percentage, currently 25.0%, of its liabilities in
government of India securities to meet the statutory ratio requirement prescribed by the
Reserve Bank of India. As a result, we have a very large portfolio of government of India
securities and these are primarily classified as available for sale securities. Our available for
sale securities included Rs. 244.1billion (US$ 5.1 billion) of government of India securities.

Equity Risk
We assume equity risk both as part of our investment book and our trading book. On the
investment book, investments in equity shares and preference shares are essentially long-term
in nature. Nearly all the equity investment securities have been driven by our project financing
activities. The decision to invest in equity shares during project financing activities has been a
conscious decision to participate in the equity of the company with the intention of realizing
capital gains arising from the expected increases in market prices, and is separate from the
lending decision.

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Trading account securities are recorded at market value. For the purpose of valuation of our
available for sale equity investment securities, an assessment is made whether a decline in the
fair value, below the amortized cost of the investments, is other than temporary. If the decline
in fair value below the amortized cost is other than temporary, the decline is provided for in the
income statement.
A temporary decline in value is excluded from the income statement and charged directly to the
shareholders equity. To assess whether a decline in fair value is temporary, the duration for
which the decline had existed, industry and company specific conditions and dividend record
are considered .Non-readily marketable securities for which there is no readily determinable
fair value are recorded at cost. Venture capital investments are carried at fair value. However,
they are generally carried at cost during the first year, unless a significant event occurs that
affected the long-term value of the investment.
At year-end fiscal 2003, the fair value of trading account equity securities was Rs. 187 million
(US$ 4 million). The fair value of our available for sale equity securities investment portfolio,
including non-readily marketable securities of Rs. 9.4 billion (US$ 198 million), was Rs. 25.5
billion(US$ 537 million). This included investments of approximately Rs. 5.4 billion (US$ 115
million) in liquid mutual fund units at year-end fiscal 2003. At year-end fiscal 2002, the fair
value of trading equity securities was Rs. 742 million (US$ 16 million). The fair value of the
available for sale equity securities investment portfolio, including non-readily marketable
securities of Rs. 8.3 billion (US$ 174 million), was Rs. 28.5 billion (US$ 600 million).

Exchange Rate Risk

We offer foreign currency hedge instruments like swaps, forwards, and currency options to
clients, which are primarily banks and highly rated corporate customers. We actively use cross
currency swaps, forwards, and options to hedge against exchange risks arising out of these
transactions. Trading activities in the foreign currency markets expose us to exchange rate
risks. This risk is mitigated by setting counterparty limits, stipulating daily and cumulative
stop-loss limits, and engaging in exception reporting.
Recently, the Reserve Bank of India has authorized the dealing of foreign currency-rupee
options by banks for hedging foreign currency exposures including hedging of balance sheet
exposures. We have begun offering such products to corporate clients and other inter-bank
counterparties and are one of the largest participants in the currency options market accounting
for a significant share of daily trading volume.
In addition, foreign currency loans are made on terms that are similar to foreign currency
borrowings, thereby transferring the foreign exchange risk to the borrower. Foreign currency
cash balances are generally maintained abroad in currencies matching with the underlying
borrowings.

Liquidity Risk
Liquidity risk arises in the funding of lending, trading and investment activities and in the
management of trading positions. It includes both the risk of unexpected increases in the cost
of funding an asset portfolio at appropriate maturities and the risk of being unable to liquidate a
position in a timely manner at a reasonable price. The goal of liquidity management is to be
able, even under adverse conditions, to meet all liability repayments on time, to meet
contingent liabilities, and fund all investment opportunities.
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We maintain diverse sources of liquidity to facilitate flexibility in meeting funding

requirements. We fund our operations principally by accepting deposits from retail and
corporate depositors and through public issuance of bonds. We also borrow in the short-term
inter-bank market. Loan maturities, securitization of assets and loans, and sale of investments
also provide liquidity. See Operating and Financial Review and Prospects Financial
Condition Liquidity Risk for a detailed description of liquidity risk.

Operational Risk
ICICI Bank is exposed to many types of operational risk. Operational risk can result from a
variety of factors, including failure to obtain proper internal authorizations, improperly
documented transactions, failure of operational and information security procedures, computer
systems, software or equipment, fraud, inadequate training and employee errors. ICICI Bank
attempts to mitigate operational risk by maintaining a comprehensive system of internal
controls, establishing systems and procedures to monitor transactions, maintaining key back
up procedures and undertaking regular contingency planning.

Operational Controls and Procedures in Branches

ICICI Bank has operating manuals detailing the procedures for the processing of various
banking transactions and the operation of the application software. Amendments to these
manuals are implemented through circulars sent to all offices.
When taking a deposit from a new customer, ICICI Bank requires the new customer to
complete a relationship form, which details the terms and conditions for providing various
banking services. Photographs of customers are also obtained for ICICI Banks records, and
specimen signatures are scanned and stored in the system for online verification. ICICI Bank
enters into a relationship with a customer only after the customer is properly introduced to
ICICI Bank. When time deposits become due for repayment, the deposit is paid to the
depositor. System generated reminders are sent to depositors before the due date for
repayment. Where the depositor does not apply for repayment on the due date, the amount is
transferred to an overdue deposits account for follow up.
ICICI Bank has a scheme of delegation of financial powers that sets out the monetary limit for
each employee with respect to the processing of transactions in a customer's account.
Withdrawals from customer accounts are controlled by dual authorization. Senior officers have
delegated power to authorize larger withdrawals. ICICI Banks operating system validates the
check number and balance before permitting withdrawals. Cash transactions over Rs. 1 million
(US$ 21,030) are subject to special scrutiny to avoid money laundering. ICICI Banks banking
software has multiple security features to protect the integrity of applications and data.
ICICI Bank gives importance to computer security and has s a comprehensive information
technology security policy. Most of the information technology assets including critical servers
are hosted in centralized data centers which are subject to appropriate physical and logical
access controls.

Operational Controls and Procedures for Internet Banking

53

In order to open an Internet banking account, the customer must provide ICICI Bank with
documentation to prove the customer's identity, including a copy of the customer's passport, a
photograph and specimen signature of the customer. After verification of the same, ICICI Bank
opens the Internet banking account and issues the customer a user ID and password to access
his account online.

Operational Controls and Procedures in Regional Processing Centers &

Central Processing Centers
To improve customer service at ICICI Banks physical locations, ICICI Bank handles
transaction processing centrally by taking away such operations from branches. ICICI Bank
has centralized operations at regional processing centers located at 15 cities in the country.
These regional processing centers process clearing checks and inter-branch transactions, make
inter-city check collections, and engage in back office activities for account opening, standing
instructions and auto-renewal of deposits.
In Mumbai, ICICI Bank has centralized transaction processing on a nationwide basis for
transactions like the issue of ATM cards and PIN mailers, reconciliation of ATM transactions,
monitoring of ATM functioning, issue of passwords to Internet banking customers, depositing
postdated cheques received from retail loan customers and credit card transaction processing.
Centralized processing has been extended to the issuance of personalized check books, back
office activities of non-resident Indian accounts, opening of new bank accounts for customers
who seek web broking services and recovery of service charges for accounts for holding shares
in book-entry form.

Operational Controls and Procedures in Treasury

ICICI Bank has a high level of automation in trading operations. ICICI Bank
uses technology to monitor risk limits and exposures. ICICI Banks front
office, back office and accounting and reconciliation functions are fully
segregated in both the domestic treasury and foreign exchange treasury.
The respective middle offices use various risk monitoring tools such as
counterparty limits, position limits, exposure limits and individual dealer
limits. Procedures for reporting breaches in limits are also in place.
ICICI Banks front office treasury operation for rupee transactions consists
of operations in fixed income securities, equity securities and inter-bank
money markets. ICICI Banks dealers analyze the market conditions and
take views on price movements. Thereafter, they strike deals in conformity
with various limits relating to counterparties, securities and brokers. The
deals are then forwarded to the back office for settlement.
The inter-bank foreign exchange treasury operations are conducted through
Reuters dealing systems. Brokered deals are concluded through voice
systems. Deals done through Reuters systems are captured on a real time
basis for processing. Deals carried out through voice systems are input in
the system by the dealers for processing. The entire process from deal
origination to settlement and accounting takes place via straight through
processing. The processing ensures adequate checks at critical stages.
Trade strategies are discussed frequently and decisions are taken based on

54

market forecasts, information and liquidity considerations. Trading

operations are conducted in conformity with the code of conduct prescribed
by internal and regulatory guidelines.
The Treasury Middle Office Group, which reports to the Executive Director,
Corporate Centre, monitors counterparty limits, evaluates the mark-tomarket impact on various positions taken by dealers and monitors market
risk exposure of the investment portfolio and adherence to various market
risk limits set up by the Risk, Compliance and Audit Group.
ICICI Banks back office undertakes the settlement of funds and securities.
The back office has procedures and controls for minimizing operational
risks, including procedures with respect to deal confirmations with
counterparties, verifying the authenticity of counterparty checks and
securities, ensuring receipt of contract notes from brokers, monitoring
receipt of interest and principal amounts on due dates, ensuring transfer of
title in the case of purchases of securities, reconciling actual security
holdings with the holdings pursuant to the records and reports any
irregularity or shortcoming observed.

Audit
The Internal Audit Group undertakes a comprehensive audit of all business
groups and other functions, in accordance with a risk-based audit plan. This
plan allocates audit resources based on an assessment of the operational
risks in the various businesses. The Internal Audit group conceptualizes and
implements improved systems of internal controls, to minimize operational
risk. The audit plan for every fiscal year is approved by the Audit
Committee of ICICI Banks board of directors.
The Internal Audit group also has a dedicated team responsible for
information technology security audits. Various components of information
technology from applications to databases, networks and operating
systems are covered under the annual audit plan.
The Reserve Bank of India requires banks to have a process of concurrent
audits at branches handling large volumes, to cover a minimum of 50.0% of
business volumes. ICICI Bank has instituted systems to conduct concurrent
audits, using reputed chartered accountancy firms. Concurrent audits have
also been arranged at the Regional Processing Centers and other
centralised processing operations to ensure existence of and adherence to
internal controls.

Legal Risk
The uncertainty of the enforceability of the obligations of ICICI Banks
customers and counterparties, including the foreclosure on collateral,
creates legal risk. Changes in law and regulation could adversely affect
ICICI Bank. Legal risk is higher in new areas of business where the law is
often untested by the courts. ICICI Bank seeks to minimize legal risk by
using stringent legal documentation, employing procedures designed to

55

ensure that transactions are properly authorized and consulting internal

and external legal advisors.

Derivative Instruments Risk

ICICI Bank engages in limited trading of derivative instruments on its own
account and generally enters into interest rate and currency derivative
transactions primarily for the purpose of hedging interest rate and foreign
exchange mismatches. ICICI Bank provides limited derivative services to
selected major corporate customers and other domestic and international
financial institutions, including foreign currency forward transactions and
foreign currency and interest rate swaps.
ICICI Banks derivative transactions are subject to counter-party risk to the
extent particular obligors are unable to make payment on contracts when
due.

Controls and Procedures

ICICI Banks Chief Executive Officer and Chief Financial Officer have
evaluated the effectiveness of ICICI Banks disclosure controls and
procedures (as defined in Rule 13a-15(e)under the Securities Exchange
Act of 1934, as amended) as of a date within 90 days prior to the filing date
of this annual report and concluded that, as of the date of their evaluation,
ICICI Banks disclosure controls and procedures were effective to ensure
that information required to be disclosed by ICICI Bank in the reports that it
files or submits under the Securities Exchange Act of 1934, as amended, is
recorded, processed, summarized and reported, within the time periods
specified in the Securities and Exchange Commissions rules and forms.
There has been no change in ICICI Banks internal control over financial
reporting that has occurred subsequent to the date of their most recent
evaluation that has materially affected, or is reasonably likely to materially
affect, ICICI Banks internal control over financial reporting.

Loan Portfolio
Our gross loan portfolio, which includes loans structured as debentures and
preferred stock, was Rs. 684.6 billion (US$ 14.4 billion) at year-end fiscal
2003, an increase of 22.2% over ICICIs gross loan portfolio of Rs. 560.2
billion (US$ 11.8 billion), at year-end fiscal 2002. At year-end fiscal 2002,
ICICIs gross loan portfolio decreased 11.8% to Rs. 560.2 billion (US$ 11.8
billion) from Rs. 635.1billion (US$ 13.3 billion) at year-end fiscal 2001,
primarily due to securitization and sell-down of ICICIs loan portfolio.
Approximately 86.5% of our gross loans were rupee loans at year-end fiscal
2003. At year-end fiscal 2003, our balance outstanding in respect of loans
of corporates outside India was Rs. 536 million (US$ 11 million),
representing approximately 0.1% of our total gross loan portfolio.

Collateral Completion, Perfection and Enforcement

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Our loan portfolio consists largely of project and corporate finance and
working capital loans to corporate borrowers, and loans to retail customers
for financing purchase of residential property, vehicles, consumer durable
products, medical equipment and farm and construction equipment, and
personal loans and credit card receivables. Corporate finance and project
finance loans are typically secured by a first lien on fixed assets, which
normally consists of property, plant and equipment.
These security interests are perfected by the registration of these interests
within 30 days with the Registrar of Companies pursuant to the provisions
of the Indian Companies Act. We may also take security of a pledge of
financial assets like marketable securities, corporate guarantees and
personal guarantees. This registration amounts to a constructive public
notice to other business entities.
Working capital loans are typically secured by a first lien on current assets,
which normally consist of inventory and receivables. Additionally, in some
cases, we may take further security of a first or second lien on fixed assets,
a pledge of financial assets like marketable securities, corporate
guarantees and personal guarantees. A substantial portion of our loans to
retail customers is also secured by a first lien on the assets financed
(predominantly property and vehicles). In general, our loans are overcollateralized. In India, there are no regulations stipulating any loan-tocollateral limits.
In India, foreclosure on collateral generally requires a written petition to an
Indian court. An application, when made, may be subject to delays and
administrative requirements that may result, or be accompanied by, a
decrease in the value of the collateral. These delays can last for several
years leading to deterioration in the physical condition and market value of
the collateral. In the event a corporate borrower makes an application for
relief to a specialized quasi-judicial authority called the Board for Industrial
and Financial Reconstruction, foreclosure and enforceability of collateral is
stayed. In fiscal 2003, the Indian Parliament passed the Securitization and
Reconstruction of Financial Assets and Enforcement of Security Interest Act,
2002, which is expected to strengthen the ability of lenders to resolve nonperforming assets by granting them greater rights as to enforcement of
security and recovery of dues. Petitions challenging the constitutional
validity of this legislation are currently pending before the Indian Supreme
Court. There can be no assurance that the legislation in its current form will
be upheld by the Indian Supreme Court or that it will have a favorable
impact on our efforts to resolve non-performing assets. See Overview of
the Indian Financial Sector Recent Structural Reforms Legislative
Framework for Recovery of Debts due to Banks.
We recognize that our ability to realize the full value of the collateral in
respect of current assets is difficult, due to, among other things, delays on
our part in taking immediate action, delays in bankruptcy foreclosure
proceedings, defects in the perfection of collateral and fraudulent transfers
by borrowers. However, cash credit facilities are so structured that we are
able to capture the cash flows of our customers for recovery of past due
57

amounts. In addition, we have a right of set-off for amounts due to us on

these facilities. Also, we monitor the cash flows of our working capital loan
customers on a daily basis so that we can take any actions required before
the loan becomes impaired. On a case-by case basis, we may also stop or
limit the borrower from drawing further credit from its facility.

Loan Concentration
We follow a policy of portfolio diversification and evaluate our total
financing exposure in a particular industry in light of our forecasts of growth
and profitability for that industry. ICICI Banks Risk, Compliance and Audit
Group monitors all major sectors of the economy and specifically follows
industries in which ICICI Bank has credit exposures. We seek to respond to
any economic weakness in an industrial segment by restricting new credits
to that industry segment and any growth in an industrial segment by
increasing new credits to that industry segment, resulting in active portfolio
management. ICICI Banks current policy is to limit its loan portfolio to any
particular industry (other than retail loans) to 15.0%.
Pursuant to the guidelines of the Reserve Bank of India, ICICI Banks credit
exposure to individual borrowers must not exceed 15.0% of its capital funds
comprising Tier 1 and Tier 2 capital, calculated pursuant to the guidelines
of the Reserve Bank of India, under Indian GAAP. Credit exposure to
individual borrowers may exceed the exposure norm of 15.0% of a banks
capital funds by an additional 5.0% (i.e. up to 20.0%) provided the
additional credit exposure is on account of infrastructure financing. ICICI
Banks exposure to a group of companies under the same management
control must not exceed 40.0% of its capital funds unless the exposure is in
respect of an infrastructure project. In that case, the exposure to a group of
companies under the same management control may be up to 50.0% of
ICICI Banks capital funds. Pursuant to the Reserve Bank of India guidelines,
exposure for funded facilities is calculated as the total approved limit or the
outstanding funded amount, whichever is higher (for term loans, as undisbursed commitments plus the outstanding amount). Exposure for nonfunded facilities is calculated as 50.0% of the approved amount or the
outstanding non-funded amount, whichever is higher (100.0% of the
approved amount or the outstanding non-funded amount, whichever is
higher, with effect from fiscal 2004). ICICI Bank is incompliance with these
limits, except in the case of two borrowers to whom its exposure is in
excess of the single exposure limit. The excess over the single borrower
exposure limits in respect of these two borrowers is mainly due to the
reduction in the level of reserves under Indian GAAP, as a result of
adjustments arising out of the amalgamation. ICICIs exposure to these
borrowers was not in excess of the limit at the time of providing the
assistance. The Reserve Bank of India has granted its approval for
exceeding the single exposure limit in the case of these two borrowers until
the date of completion
or stabilization of the projects.

58

Geographic Diversity
Except as described below, our portfolios were geographically diversified throughout India,
primarily reflecting the location of our corporate borrowers. The states of Maharashtra and
Gujarat, two of the most industrialized states in India, accounted for the largest proportion of
our gross loans outstanding at year-end fiscal 2003.

Directed Lending
The Reserve Bank of India requires banks to lend to certain sectors of the economy. Such
directed lending is comprised of priority sector lending, export credit and housing finance.

Priority Sector Lending

The Reserve Bank of India has established guidelines requiring banks to lend 40.0% of their
net bank credit (total domestic loans less marketable debt instruments and certain exemptions
permitted by the Reserve Bank of India from time to time) to certain specified sectors called
priority sectors.
Priority sectors include small-scale industries, the agricultural sector, food and agri-based
industries, small businesses and housing finance up to certain limits. Out of the 40.0%, banks
are required to lend a minimum of 18.0% of their net bank credit to the agriculture sector and
the balance to certain specified sectors, including small scale industries (defined as
manufacturing, processing and services businesses with a limit on investment in plant and
machinery of Rs. 10 million), small businesses, including retail merchants, professional and
other self employed persons and road and water transport operators, housing loans up to certain
limits and to specified state financial corporations and state
industrial development corporations.
While granting its approval for the amalgamation, the Reserve Bank of India stipulated that
since ICICIs loans transferred to us were not subject to the priority sector lending requirement,
we are required to maintain priority sector lending of 50.0% of our net bank credit on the
residual portion of our advances (i.e. the portion of our total advances excluding advances of
ICICI at year-end fiscal, 2002, henceforth referred to as residual net bank credit). This
additional 10.0% priority sector lending requirement will apply until such time as our
aggregate priority sector advances reach a level of40.0% of our total net bank credit.
The Reserve Bank of Indias existing instructions on sub-targets under priority sector lending
and eligibility of certain types of investments/ funds for qualification as priority sector
advances apply to us.
We are required to comply with the priority sector lending requirements at the end of each
fiscal year. Any shortfall in the amount required to be lent to the priority sectors may be
required to be deposited with government sponsored Indian development banks like the
National Bank for Agriculture and Rural Development and the Small Industries Development
Bank of India. These deposits have a maturity of up to five years and carry interest rates lower
than market rates.

Application of Information Systems

Treasury and Trade Finance Operations

59

ICICI Bank uses technology to monitor risk limits and exposures. ICICI Bank has invested
significantly to acquire advanced systems from some of the worlds leading vendors and
connectivity to the SWIFT network. In fiscal 2003, ICICI Bank successfully rolled out a
business process management solution to automate its activities in the areas of trade services
and general banking operations. Through integration of the workflow system with the imaging
and document management system, ICICI Bank has achieved substantial savings and
practically eliminated the use of paper for these processes.

Banking Application Software

ICICI Bank has installed an advanced banking system that is robust, flexible and scaleable and
allows ICICI Bank to effectively and efficiently serve its growing customer base.

High-Speed Electronic Communications Infrastructure

ICICI Bank has installed a nationwide data communications network linking all its offices. The
network design is based on a mix of dedicated leased lines and satellite links to provide for
reach and redundancy, which is imperative in a vast country like India. The communications
network is monitored 24 hours a day using advanced network management software. ICICI
Bank also uses a data center in Mumbai for centralized data base management, data storage
and retrieval.

Customer Relationship Management

In fiscal 2002, ICICI Bank implemented a customer relationship management solution for
automation of customer handling in all key retail products. ICICI Bank increased the
deployment of its customer relationship management software. ICICI Banks customer
relationship management solution enables various channels to service the customer needs at all
touch points, and across all products and services. The solution has been deployed at the
telephone banking call centers as well as a large number of branches. ICICI Bank has also
undertaken a retail data warehouse initiative to achieve customer data integration at the backoffice level.
ICICI Bank has implemented an Enterprise Application Integration (EAI) initiative across its
retail and corporate products and services, to link various products, delivery and channel
systems. This initiative underpins ICICI Bank's multi-channel customer service strategy and
seeks to deliver customer related information consistently across access points.

Competition
As a result of the acquisition of Bank of Madura, we became and continue to be the largest
private sector bank in India and as a result of the amalgamation; we became and continue to be
the second largest bank in India, in terms of total assets. We face strong competition in all our
principal areas of business from Indian and foreign commercial banks, housing finance
companies, mutual funds and investment banks. We believe that our principal competitive
advantage over our competitors arises from our innovative products and services, our use of
technology, our long-standing customer relationships and our highly motivated and skilled
employees. Because of these factors, we believe that we have a strong competitive position in
the Indian financial services market. We evaluate our competitive position separately in respect
of our products and services for retail and corporate customers.

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Corporate products and services

In products and services for corporate customers, we face strong competition primarily from
public sector banks, foreign banks and other new private sector banks. Our principal
competition in these products and services comes from public sector banks, which have built
extensive branch networks that have enabled them to raise low-cost deposits and, as a result,
price their loans and fee based services very competitively. Their wide geographical reach
facilitates the delivery of banking products to their corporate customers located in most parts of
the country. We have been able, however, to compete effectively because of our efficient
service and prompt turnaround times that are significantly faster than public sector banks. We
seek to compete with the large branch networks of the public sector banks through our multichannel distribution approach and technology-driven delivery capabilities.
Traditionally, foreign banks have been active in providing trade finance, fee-based services and
other short-term financing products to top tier Indian corporations. We effectively compete
with foreign banks in cross-border trade finance as a result of our wider geographical reach
relative to foreign banks and our customized trade financing solutions. We have established
strong fee-based cash management services and compete with foreign banks due to our
technological edge and competitive pricing strategies.
Other new private sector banks also compete in the corporate banking market on the basis of
efficiency, service delivery and technology. However, our strong corporate relationships, wider
geographical reach and ability to use technology to provide innovative, value-added products
and services provide us with a competitive edge. In project finance, ICICIs primary
competitors were established long-term lending institutions. In recent years, Indian and foreign
commercial banks have sought to expand their presence in this market. We believe that we
have a competitive advantage due to our strong market reputation and expertise in risk
evaluation and mitigation. We believe that our in-depth sector specific knowledge has allowed
us to gain credibility with project sponsors, overseas lenders and policy makers.

Retail products and services

The retail credit business in India is in a relatively early stage of development. The retail
business has witnessed substantial growth over the last two years and as per-capita income
levels continue to grow, we expect continued strong growth in retail lending in future. In the
retail markets, competition is primarily from foreign and Indian commercial banks and housing
finance companies. Foreign banks have the product and delivery capabilities but are likely to
focus on limited customer segments.
We have capitalized on the first mover advantage to emerge as market leader in several
segments within the retail credit business. With a full product portfolio, effective distribution
channels, which include direct selling agents, robust credit processes and collection
mechanisms, experienced professionals and superior technology, we expect to maintain our
market position in retail credit Indian commercial banks attract the majority of retail bank
deposits, historically the preferred retail savings product in India. We have capitalized on our
corporate relationships to gain individual customer accounts through payroll management
products and will continue to pursue a multi-channel distribution strategy utilizing physical
branches, ATMs, telephone banking call centers and the Internet to reach customers. Further,
following a strategy focused on customer profiles and product segmentation, we offer
differentiated liability products to customers of various ages and income profiles. This strategy
has contributed significantly to the rapid growth in our retail liability base.

61

Mutual funds are another source of competition to us. Mutual fund offerings have the capacity
to earn competitive returns and hence, have increasingly become a viable alternative to bank
deposits.

STATE BANK OF INDIA

Risk Management
Banks aim has been to reach global best standards in the area of risk management and to
ensure that risk-management processes are sufficiently robust and efficient.

Credit Risk Management

A revised Credit Risk Assessment (CRA) System detailing a unified structure for C&I, SSI and
AGL segments were rolled out across the whole Bank with effect from April 2004.
The Risk Management Committee of the Board (RMCB) oversees the policy and strategy for
integrated risk management relating to various risk exposures of the Bank and the Credit Risk
Management Committee (CRMC) has been monitoring the Banks domestic credit portfolio.

Market Risk Management

Bank has developed sensitive tools to hedge and minimize the risk arising out of movements in
interest rates, currency exchange rates and
commodity prices.

Asset Liability Management

The Asset Liability Management Committee (ALCO) at the Corporate Centre is engaged in
evolving optimal asset/liability structure for the Bank on an on-going basis with a view to
containing mismatches, optimizing profits and ensuring risk management.
The Bank is using Risk Manager Module (part of the ALM Software) to strengthen the
processes of Risk Management.

Operational Risk Management

The Operational Risk Management Committee in the Bank oversees the Operational Risks and
the requisite control measures. An Operational Risk Management Policy duly approved by
Central Board of the Bank is in place.

Country Risk & Bank Exposure

Prudent exposure risk management is being ensured by setting up appropriate bank exposure
limits product-wise, on a large number of Foreign Commercial Banks and a revised Country
Risk Management Policy, in line with RBI guidelines, for setting up country exposure limits is
in place and the overall country risk for the Bank as a whole is monitored on a regular basis.

62

Internal Controls
The Bank has an in-built internal control system with well-defined responsibilities at each
level. The Inspection & Management Audit Department of the Bank carries out 3 streams of
audit- Inspection and Audit, Credit Audit and Management Audit covering different facets of
Banks activities.

Inspection and Audit

Risk Focused Internal Audit (RFIA), an adjunct to risk based supervision, as per RBI directives
has been introduced in the Banks audit system on 01.04.2003. All the domestic Branches have
been segregated into 3 Groups on the basis of business profile and risk exposures and are being
subjected to RFIA.

Credit Audit
Credit Audit aims at achieving continuous improvement in the quality of Commercial Credit
portfolio with the exposures of Rs. 5 crore and above. Duly aligned with Risk Focused Internal
Audit, it examines the probability of default, identifies risks and suggests risk mitigation
measures.

Management Audit
Management audit which has been reoriented to focus on the effectiveness of risk management
in processes and the procedures is conducted under 2 streams viz. General Management Audit
(GMA Every 4/5 years) and Risk Management Audit (RMA Every 2/3 years). Risk
Management Audit of four Circles was taken up and completed during the current year.

Risk Management Committee of the Board

The Central Board approved the constitution of Risk Management Committee of the Board
(RMCB) on March 23, 2004 to oversee the policy and strategy for integrated risk management
relating to credit risk, market risk and operational risk.
Composition of the Committee
The Committee has 4 members:
1. MD&GE (NB)
2. MD & GE (CB)
3. Two non-executive Directors Sarvashri P.R. Khanna and Suman K. Bery

Meetings
RMCB meets quarterly or more often if the situation so demands. The Committee met 4 times
during the year.

Shareholders/Investors Grievance Committee

In pursuance of clause 49 of the Listing Agreement with the Stock Exchanges,
Shareholders/Investors Grievance Committee of the Board (SGCB) was formed to look into
63

the redressal of shareholders and investors complaints regarding transfer of shares, nonreceipt of balance sheet, non-receipt of interest on bonds/declared dividends, etc.

LITERATURE REVIEW
The Basel Committee on Banking Supervision, hosted by the BIS, issued a paper on Sound
practices for managing liquidity in banking organisations in February 2000. The Committee is
currently taking a fresh look at liquidity risk in the context of banks' growing reliance on
market liquidity to distribute risk, and their associated vulnerability to market liquidity shocks.
Some of the areas being reviewed which have been much in the news lately include the
growing links between market and funding liquidity, the use of stress testing exercises, and the
impact of "originate to distribute" strategy on the funding liquidity of institutions. A
stocktaking of the current regulatory frameworks for liquidity risk management is also being
undertaken. Based on the findings, the Committee will identify issues that may need to be
addressed.
.

First, on all important issues, workings group are constituted or technical reports are prepared,
generally encompassing a review of the international best practices, options available and way

64

forward. The group membership may be internal or external to the RBI or mixed. Draft reports
are often placed in public domain and final reports take account of inputs, in particular from
industry associations and self-regulatory organizations. The reform-measures emanate out of
such a series of reports, the pioneering ones being: Report of the Committee on the Financial
System (Chairman: Shri M. Narasimham), in 1991; Report of the High Level Committee on
Balance of Payments (Chairman: Dr. C. Rangarajan) in 1992; and the Report of the Committee
on Banking Sector Reforms (Chairman: Shri M. Narasimham) in 1998.
The three important issues were offered in the Speech by Mr Malcolm D Knight, General
Manager of the BIS, at the Federation of Indian Chambers of Commerce and Industry
(FICCI) Indian Banks' Association (IBA) Conference, Mumbai and 12 September
2007.
in the context of globalisation and the move towards global banking. First, market participants
need to understand the changing nature of risk in the context of the increasing use of
innovative and complex instruments that can be traded across markets and borders. In
particular, credit risk transfer and liquidity risk management need to be looked at from a fresh
perspective. Second, disclosures need to keep pace with market developments. The enhanced
disclosures under international financial reporting standards (IFRS) and Basel II will
strengthen market discipline and contribute to the soundness of the international financial
system. Third, good governance is important for supervisory agencies and central banks. It
lends credibility to their actions and enhances their legitimacy as public policy institutions.
Market discipline across countries and industries, MIT Press, 2004 gives the two important
initiatives that require the effective management of the transition process were. The Basel II
regulatory and supervisory framework for banking institutions, which is now in the process of
being implemented by most jurisdictions in both advanced and emerging market economies,
has important change management implications for banks and supervisory agencies alike. The
framework requires implementation of three "pillars". Pillar 1 aligns a bank's holding of
regulatory capital with the underlying risks in its specific business. Pillar 2 requires each bank
to operate a comprehensive internal capital allocation process and the supervisors to review
banks' methodologies for risk management. Pillar 3 fosters transparency and public disclosures
by banks that are intended to promote market discipline. Basel II implementation requires,
inter alia, improvements in banks' risk management systems, enhancement of data management
and IT capabilities, and upgrading of human resource skills. Each jurisdiction should determine
its schedule for Basel II implementation over the next few years, based on a consideration of
all the relevant factors. In order to ensure adequate preparedness on the part of all stakeholders
and to facilitate a smooth transition to Basel II, India has extended the time frame for its
implementation. Indian banks that have a foreign presence and foreign banks that operate in
India will implement Basel II by March 2008, while all other Indian banks will do so no later
than March 2009.
Two dimensions of liquidity risk are well known: funding liquidity risk and market liquidity
risk. Funding liquidity risk relates to a firm not being able to efficiently meet both expected
and unexpected current and future cash flow and collateral needs without affecting either the
daily operations or the financial condition. Market liquidity risk relates to the difficulty a firm
has in offsetting or eliminating a position without significantly affecting the market price
because of inadequate market depth or a market disruption. The same factors could trigger both

65

types of liquidity risk. The management of liquidity risk in financial groups, Joint Forum
Report, Bank for International Settlements, May 2006.

RESEARCH METHODOLOGY
6.1 OBJECTIVES
1. To identify the sources of credit risk and financial vulnerability.
2. To determine the minimum Capital Adequacy ratio necessary to reduce the risk.
3. To study Basel committee recommendations on credit risk management.
4. To determine the Credit Granting Standards and Credit monitoring process.

66

5. To determine the techniques of prevention of credit risk.

6.2 RESEARCH METHODOLOGY

PROBLEM DEFINITION
To assess and analyze the credit risk faced by the Indian banking sector and to determine the
techniques to minimize this risk.
ANALYTICAL RESEARCH
The study utilizes a combination of theoretical frameworks so in it, I have to use facts and
information already available and will analyze these facts and information to make a critical
evaluation of the material.

6.3 DATA COLLECTION METHOD

Data Collection can be broadly classified into two categories:
Primary Data: Primary Data are those collected a fresh and for first time and thus happen to
be original in character.
Secondary Data: Secondary Data are those, which have already been collected, and which
have already been passed through the statistical process, secondary data can be collected from:
Books
Journals & Magazines
Websites
The project includes secondary source of data. The data collected through these sources will be
organized, analyzed and interpreted so as to draw conclusion and arrive at appropriate
recommendations. The secondary sources of data includes: Academic Journals, Government
reports like Basel committee reports of RBI credit and monetary policy, and books on credit
risk management.

6.5 STEPS OF METHODOLOGY

67

C o lle c t io n O f D a t a

O r g a n is in g t h e D a t a

P r e s e n t a t io n o f D a t a

A n a ly s is o f D a t a

I n t e r p r e t a t io n
COLLECTION OF DATA
The data has been collected through Books, Journals & Magazines and Websites.
ORGANISING THE DATA
The data collected during data collection process are organized and presented in a
comprehensible sequence to make them more meaningful.
PRESENTATION
After the data has been properly organized, it is ready for presentation. The main objectives of
presentation are to put collected data into an easy readable form.

ANALYSIS OF DATA
After organizing and presenting the data, the researcher then has to proceed towards conclusion
by logical inferences. The raw data is then analyzed:

68

 By bringing raw data to measured data.

Summarizing the data.
INTERPRETATION
Interpretation means to bring out meaning of data or to convert mere data into information.
From the analysis of data the various conclusions are find out on the basis of logical
inferences.

FINDINGS

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1. CAPITAL ADEQUACY RATIO

The Basel II norms for capital adequacy, aims to reduce risk in the financial system by closely
aligning capital requirements to the underlying credit, market and operational risks; executing
new supervisory review processes and improving market disclosure. Banks that embrace the
Basel II norms will be better geared to optimize capital allocation and improve their
competitiveness in the market place.
The first pillar establishes a way to quantify the minimum capital requirements. While the new
framework retains both existing capital definition and minimal capital ratio of 8%, some major
changes have been introduced in measurement of the risks. The main objective of Pillar I is to
introduce greater risk sensitivity in the design of capital adequacy ratios and, therefore, more
flexibility in the computation of banks' individual risk. This will lead to better pricing of Risks.
Capital Adequacy Ratio signifies the amount of regulatory capital to be maintained by a bank
to account for various risks inherent in the banking system. The Capital Adequacy ratio is
measured as:
Total Regulatory Capital (unchanged) = Bank's Capital (minimum 8%)
Credit Risk + Market Risk + Operational Risk
Regulatory capital is defined as the minimum capital, banks are required to hold by the
regulator, i.e. "The amount of capital a bank must have". It is the summation of Tier I and Tier
II capital.
2. TECHNIQUES OF SETTING CREDIT LIMITS.
The commonly used techniques of setting credit limits which is used by Credit Agencies are:
a) Financial Statements: Financial statements are also used in assigning Credit Limits.
Mainly ratios or factors like net worth and working capital are taken and trended or compared
to Industry norms or standards. If a customer shows liquidity and efficiency as per industry
norms then a more confident approach can be taken in setting the credit limits. One has to also
consider if short-term liquidity is important or meaningful to the nature of your credit or is
long-term liquidity more consequential
For Example: Some companies will take the Tangible Net worth [Total tangible assets
Total liabilities. From the Balance Sheet] and assign anywhere between 5% to 15% of the
Tangible Net worth as a credit limit for the customer provided the customer has shown pre-tax
profits.
Others consider Net Working Capital [Current Assets-Currents Liabilities] because it
measures the short-term liquidity of a company. While doing such analysis one has to also
consider elements outside the domain of the financial statements before making a conclusive
decision. For example the company that is being assessed might have suits or judgments
against them. On the other hand the financial statements could be un-audited or company
prepared.
Another ratio that is of importance to lenders is the Debt to Equity Ratio. The ratio is
typically calculated by combining noted payables and all secured debt (such as short term and
long term bank loans and debentures) and dividing it by net worth. The ratio shows how the
company is leveraged and illustrates the stake of the lenders as opposed to the owners. A
70

secured creditor (like a bank) may request to maintain a certain level of Debt to Equity.
Otherwise upon default such loans become payable upon demand, which could lead to sale of
assets to prepayment of the loan. If this ratio is within industry norms and to the satisfaction of
the secured lender then a more liberal approach can be taken in setting the credit limit for this
customer. The contribution to the credit limit can range anywhere from 5% to 15% of the
customers Net Worth.
The Days Sales Outstanding also known as D.S.O is a rough indication of the quality of a
companys receivables. It is calculated by dividing the net receivables by average daily sales.
If the DSO is in line with the norms for the industry then a liberal approach can be taken in
setting the limit for this customer. The formula that is used with DSO is that, for each day of
deviation from the norm or the selling terms you add or subtract .10% of the Net Worth.
b) Past Performance: Credit Limit in this case is based on the past history of the customer as
per the information contained in your books. The two elements that you would consider and
weigh would be the past:
Payment performance
Purchase Pattern
c) Need Based: In this case Credit Limits are set based on the needs of the customer. It could
be set to accommodate the first Requested Credit Limit or the Size of the first Order. It should
not be done in isolation but by a combination of the other methods. In a survey that was
conducted by the Conference Board one of the most popular techniques used for setting credit
limits was by using the information and ratings given by credit agencies.
3. RBIS ASSOCIATION WITH THE BASEL COMMITTEE
RBIs association with the Basel Committee on Banking Supervision dates back to 1997 as
India was among the 16 non-member countries that were consulted in the drafting of the Basel
Core Principles. Reserve Bank of India became a member of the Core Principles Liaison
Group in 1998 and subsequently became a member of the Core Principles Working Group on
Capital. Within the Working Group, RBI has been actively participating in the deliberations on
the New Accord and had the privilege to lead a group of six major non-G-10 supervisors which
presented a proposal on a simplified approach for Basel II to the Committee.
Commercial banks in India will start implementing Basel II with effect from March 31, 2007.
They will adopt Standardized Approach for credit risk and Basic Indicator Approach for
operational risk, initially. After adequate skills are developed, both at the banks and also at
supervisory levels, some banks may be allowed to migrate to the Internal Rating Based (IRB)
Approach.
4.BASELCOMMITTEERECOMMENDATIONSONBANKRISKMANAGEMENT
One of the unique aspects of Basel II is its comprehensive approach to risk measurement in the
banking entities, by adopting the now-familiar three-Pillar structure, which goes far beyond
the first Basel Accord. To recapitulate, these are:
Pillar 1 the minimum capital ratio,
Pillar 2 the supervisory review process and
Pillar 3 the market discipline.

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The Pillar 1 provides a menu of alternative approaches, from simple to advanced ones, for
determining the regulatory capital towards credit risk, market risk and operational risk, to cater
to the wide diversity in the banking system across the world. Pillar 2 requires the banks to
establish an Internal Capital Adequacy Assessment Process (ICAAP) to capture all the material
risks, including those that are partly covered or not covered under the other two Pillars. The
ICAAP of the banks is also required to be subject to a supervisory review Pillar 3 prescribes
public disclosures of information on the affairs of the banks to enable effective market
discipline on the banks operations.
The Basel II proposed the broad set of requirements that have profound implications on some
practices within the Banks. The need to allocate capital to safe guard Banks against unexpected
losses arising from credit risk requires that they implement systems for quantifying their
exposure to credit risk. The advanced implementation options of Basel II explicitly require
financial institutions to assess the credit exposure for each customer and for each credit facility
using the following measures:

Probability of Default (PD) - the probability that a specific customer will default within
the next 12 months.

Loss Given Default (LGD) - the percentage of each credit facility that will be lost if the
customer defaults.

Exposure at Default (EAD) - the expected exposure for each credit facility in the event of
a default.

Once the Banks are able to assess the PD, LGD and EAD for its customers and for its credit
facilities, the calculation of the minimum capital requirement is straightforward.
6. CREDIT-GRANTING STANDARDS AND CREDIT MONITORING PROCESS
Anessentialpartofanysupervisorysystemistheindependentevaluationofabank'spolicies,
practicesandproceduresrelatedtothegrantingofloansandmakingofinvestmentsandthe
ongoingmanagementoftheloanandinvestmentportfolios.Supervisorsneedtoensurethatthe
credit and investment function at individual banks is objective and grounded in sound
principles. The maintenance of prudent written lending policies, loan approval and
administration procedures, and appropriate loan documentation are essential to a bank's
managementofthelending function.Lendingandinvestmentactivitiesmustbebasedon
prudentunderwritingstandardsthatareapprovedbythebank'sboardofdirectorsandclearly
communicatedtothebank'slendingofficersandstaff.Itisalsocritical forsupervisorsto
determine theextent to which theinstitution makes its credit decisions freeofconflicting
interests and inappropriate pressure from outside parties. Banks must also have a well
developed process for ongoing monitoring of credit relationships, including the financial
condition ofsignificant borrowers.Akeyelement ofanymanagement information system
shouldbeadatabasethatprovidesessentialdetails ontheconditionoftheloanportfolio,
includinginternalloangradingandclassifications.

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ANALYSIS AND INTERPRETATION.

BASEL I FRAMEWORK
It was the first ever attempt at harmonizing the banks capital standards across the countries,
for securing greater international competitive equality and to obviate regulatory capital as a
source of competitive inequality. The Accord, in its was only in 1996 that an amendment was
made to cover the market risks also. The had adopted a risk-sensitive approach for making the
banks capital more responsive riskiness of their operations. This meant that a bank with a
higher risk profile would have to maintain a higher quantum of regulatory capital while also
ensuring the minimum capital ratio. The framework also stipulated, for the first time, a
regulatory capital charge for the off-balance sheet business of the banks so as to capture their
risk exposures more comprehensively. Pursuant to the recommendations of the Committee on
the Financial System (the first Narsimham Committee, 1991), this framework was
implemented in India in 1992 in a phased manner.
THE IMPERATIVES FOR BASEL II
With the passage of time, it was realised that the Basel I framework had several limitations.
The limitations related mainly to the underlying approach as also a less-than-comprehensive
scope of the Accord in capturing the entire risk universe of the banking entities. Let me dwell a
little more on these aspects.
1. The Accord had an approach under which the entire exposures of banks were categorized
into three broad risk buckets viz., sovereign, banks and corporates, with each category
attracting a risk weight of zero, 20 and 100 per cent, respectively. Such a risk weighting
scheme did not provide for sufficient calibration of the counterparty risk since, for instance, a
corporate with AAA rating and one with C rating would attract identical risk weight of
100 per cent and require the same regulatory capital charge, despite significant difference in
their credit standing. This, in turn, engendered a rather perverse incentive for the banks to
acquire higher-risk customers in pursuit of higher returns, without necessitating a higher capital
charge. Such bank behaviour could potentially heighten the risk profile of the banking systems
as a whole. The design of the Accord was, therefore, viewed as distorting the incentive
structure in the banking markets and dissuading better risk management.
2. The Accord addresses only the credit risk and market risk in the banks operations, ignoring
several other types of risks inherent in any banking activity. For instance, the operational risk,
that is, the risk of human error or failure of systems leading to financial loss, was not at all
addressed as were the liquidity risk, credit concentration risk, interest rate risk in the banking
book, etc.
3. Since 1988, the emergence of innovative financial products had transformed the contours of
the banking industry and its business model the world over. The credit-risk transfer products,
such as securitization and credit derivatives, enabled removal of on-balance sheet exposures
from the books of the banks when they perceived that the regulatory capital requirement for
such exposures was too high and hiving off such exposures would be a better strategy. The
Basel I framework did not accommodate such innovations and was, thus, outpaced by the
market developments.

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In this background, a need was felt to create a more comprehensive and risk-sensitive capital
adequacy framework to address the infirmities in the Basel-I Accord. The Basel Committee on
Banking Supervision (BCBS), therefore, after a world-wide consultative process and several
impact assessment studies, evolved a new capital regulation framework, called International
Convergence of Capital Measurement and Capital Standards: A Revised Framework, which
was released in June 2004. The revised framework has come to be commonly known as Basel
II framework and seeks to foster better risk management practices in the banking industry.
ENHANCING RISK MANAGEMENT UNDER BASEL II;
One of the unique aspects of Basel II is its comprehensive approach to risk measurement in the
banking entities, by adopting the now-familiar three-Pillar structure, which goes far beyond
the first Basel Accord. To recapitulate, these are:
Pillar 1 the minimum capital ratio,
Pillar 2 the supervisory review process and
Pillar 3 the market discipline.
The Pillar 1 provides a menu of alternative approaches, from simple to advanced ones, for
determining the regulatory capital towards credit risk, market risk and operational risk, to cater
to the wide diversity in the banking system across the world. Pillar 2 requires the banks to
establish an Internal Capital Adequacy Assessment Process (ICAAP) to capture all the material
risks, including those that are partly covered or not covered under the other two Pillars. The
ICAAP of the banks is also required to be subject to a supervisory review Pillar 3 prescribes
public disclosures of information on the affairs of the banks to enable effective market
discipline on the banks operations.
GUIDELINES ISSUED BY RBI
As, RBI has already issued the guidelines for the new capital adequacy framework in regard to
Pillar 1 and Pillar 3 on April 27, 2007. As regards Pillar 2, the banks have been advised to put
in place an ICAAP, with the approval of the Board. A two-stage implementation of the
guidelines is envisaged to provide adequate lead time to the banking system. Accordingly, the
foreign banks operating in India and the Indian banks having operational presence outside
India are required to migrate to the Standardised Approach for credit risk and the Basic
Indicator Approach for operational risk with effect from March 31, 2008. All other Scheduled
commercial banks are encouraged to migrate to these approaches under Basel II in alignment
with them, but, in any case, not later than March 31, 2009. It has been a conscious decision to
begin with the simpler approaches available under the framework, having regard to the
preparedness of the banking system. As regards the market risk, under Basel II also, the banks
will continue to follow the Standardised-Duration Method as already adopted under the Basel I
framework. For migration to the advanced approaches available under the framework, prior
approval of the RBI would be required.
PILLAR 2 CONSIDERATIONS
While the implications of Pillar 1 and Pillar 3 are fairly well known in the banking community,
the importance of Pillar 2 in the new framework is perhaps not that well understood. I would,
therefore, like to take this opportunity to dwell a little more on the criticality of effective
implementation of Pillar 2 by the banks while adopting the new framework, in view of its
importance. As I mentioned earlier, the Pillar 2 of the framework deals with the Supervisory
Review Process (SRP). The objective of the SRP is to ensure that the banks have adequate
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capital to support all material risks in their business as also to encourage them to adopt
sophisticated risk management techniques for monitoring and managing their risks. This, in
turn, would require a well-defined internal assessment process within the banks through which
they would determine the additional capital requirement for all material risks, internally, and
would also be able to assure the RBI that adequate capital is actually held towards their all
material risk exposures. The process of assurance could also involve an active dialogue
between the bank and the RBI so that, when warranted, appropriate intervention could be made
to either reduce the risk exposure of the bank or augment / restore its capital. Thus, ICAAP is
an important component of the Supervisory Review Process. What is important to note here is
that the Pillar 1 stipulates only the minimum capital ratio for the banks whereas the Pillar 2
provides for a bank-specific review by the supervisors to make an assessment whether all
material risks are getting duly captured in the ICAAP of the bank. If the supervisor is not
satisfied in this behalf, it might well choose to prescribe a higher capital ratio, as per its
assessment.
13. I would like to emphasise that the ICAAP under the Pillar 2 is the element which makes the
Basel II framework comprehensive in its sweep by addressing the entire risk domain of the
banks. As I mentioned, the ICAAP is expected to address all material risks facing the bank but
the three main areas in particular viz., those aspects not fully captured under the Pillar 1
process; factors not taken into account by Pillar 1 process; and the factors external to the bank.
Another dimension of the ICAAP would be to monitor compliance with the Pillar 1 and Pillar
3 requirements. Thus, illustratively, we would expect the banks ICAAP to take account of the
credit concentration risk, interest rate risk in the banking book, business and strategic risk,
liquidity risk, and other residual risks such as reputation risk and business cycle risk. The
challenge for the banks would be to quantify these risks and then, to translate those
consistently into an appropriate amount of capital needed, commensurate with the banks risk
profile and control environment. Needless to say, this would call for instituting sophisticated
risk management systems, including a robust stress-testing and economic capital allocation
framework, coupled with strong validation mechanisms to ensure the integrity of the entire
ICAAP, to be able to achieve the objectives underpinning the ICAAP and the Supervisory
Review envisaged under Pillar 2. I am sure; the Pillar 2 dimension would be receiving the high
priority it deserves in the implementation strategy of the banks. It is useful to note that the
ICAAP, as its name suggests, is envisaged to be essentially a bank-driven process, which
would of course be subject to a supervisory review.
BASEL II IMPACT ON INDIAN BANKS
There are broadly two sets of reasons often given for capital regulation in banks in particular.
One is depositor protection and the second is systemic risk. Banks are often thought to be a
source of systemic risk because of their central role in the payments system and in the
allocation of financial resources, combined with the fragility of their financial structure. Banks
are highly leveraged with relatively short-term liabilities, typically in the form of deposits, and
relatively illiquid assets, usually loans to firms or households. In that sense banks are said to be
"special" and hence subject to special regulatory oversight.
Before 1988, many central banks allowed different definitions of capital in order to make their
country's bank appear as solid than they actually were. In order to provide a level playing field
the concept of regulatory capital was standardized in BASEL I. Along with definition of
regulatory capital a basic formula for capital divided by assets was constructed and an arbitrary
ratio of 8% was chosen as minimum capital adequacy. However, there were drawbacks in the
BASEL I as it did not did not discriminate between different levels of risk. As a result a loan to

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an established corporate was deemed as risky as a loan to a new business. Also it assigned
lower weight age to loans to banks as a result banks were often keen to lend to other banks.
The BASEL II accord proposes getting rid of the old risk weighted categories that treated all
corporate borrowers the same replacing them with limited number of categories into which
borrowers would be assigned based on assigned credit system. Greater use of internal credit
system has been allowed in standardized and advanced schemes, against the use of external
rating. The new proposals avoid sole reliance on the capital adequacy benchmarks and
explicitly recognize the importance of supervisory review and market discipline in maintaining
sound financial systems.
THE THREE PILLAR APPROACH
The capital framework proposed in the New Basel Accord consists of three pillars, each of
which reinforces the other. The first pillar establishes the way to quantify the minimum capital
requirements, is complemented with two qualitative pillars, concerned with organizing the
regulator's supervision and establishing market discipline through public disclosure of the way
that banks implement the Accord. Determination of minimum capital requirements remains the
main part of the agreement, but the proposed methods are more risk sensitive and reflect more
closely the current situation on financial markets.
FIRST PILLAR: MINIMUM CAPITAL REQUIREMENT
The first pillar establishes a way to quantify the minimum capital requirements. While the new
framework retains both existing capital definition and minimal capital ratio of 8%, some major
changes have been introduced in measurement of the risks. The main objective of Pillar I am to
introduce greater risk sensitivity in the design of capital adequacy ratios and, therefore, more
flexibility in the computation of banks' individual risk. This will lead to better pricing of Risks.
Capital Adequacy Ratio signifies the amount of regulatory capital to be maintained by a bank
to account for various risks inherent in the banking system.
The Capital Adequacy ratio is measured as:
Total Regulatory Capital (unchanged) = Bank's Capital (minimum 8%)
Credit Risk + Market Risk + Operational Risk
Regulatory capital is defined as the minimum capital, banks are required to hold by the
regulator, i.e. "The amount of capital a bank must have". It is the summation of Tier I and Tier
II capital.
MEASUREMENT OF CREDIT RISK
The changes proposed to the measurement of credit risk are considered to have most far
reaching implications. Basel II envisages two alternative ways of measuring credit risk.
THE STANDARDIZED APPROACH
The standardized approach is conceptually the same as the present Accord, but is more risk
sensitive. The bank allocates a risk-weight to each of its assets and off-balance-sheet positions
and produces a sum of risk-weighted asset values. Individual risk weights currently depend on
the broad category of borrower (i.e. sovereigns, banks or corporates). Under the new Accord,
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the risk weights are to be refined by reference to a rating provided by an external credit
assessment institution that meets strict standards.
THE INTERNAL RATINGS BASED APPROACH (IRB)
Under the IRB approach, distinct analytical frameworks will be provided for different types of
loan exposures. The framework allows for both a foundation method in which a bank estimate
the probability of default associated with each borrower, and the supervisors will supply the
other inputs and an advanced IRB approach, in which a bank will be permitted to supply other
necessary inputs as well. Under both the foundation and advanced IRB approaches, the range
of risk weights will be far more diverse than those in the standardized approach, resulting in
greater risk sensitivity.
SECOND PILLAR: SUPERVISORY REVIEW PROCESS
The supervisory review process requires supervisors to ensure that each bank has sound
internal processes in place to assess the adequacy of its capital based on a thorough evaluation
of its risks. Supervisors would be responsible for evaluating how well banks are assessing their
capital adequacy needs relative to their risks. This internal process would then be subject to
supervisory review and intervention, where appropriate.
THE THIRD PILLAR: MARKET DISCIPLINE
The third pillar of the new framework aims to bolster market discipline through enhanced
disclosure by banks. Effective disclosure is essential to ensure that market participants can
better understand banks' risk profiles and the adequacy of their capital positions. The new
framework sets out disclosure requirements and recommendations in several areas, including
the way a bank calculates its capital adequacy and its risk assessment methods. The core set of
disclosure recommendations applies to all banks, with more detailed requirements for
supervisory recognition of internal methodologies for credit risk, credit risk mitigation
techniques and asset securitization.
CHALLENGES FOR INDIAN BANKING SYSTEM UNDER BASEL II
A feature, somewhat unique to the Indian financial system is the diversity of its composition.
We have the dominance of Government ownership coupled with significant private
shareholding in the public sector banks and we also have cooperative banks, Regional Rural
Banks and Foreign bank branches. By and large the regulatory standards for all these banks are
uniform.
Costly Database Creation and Maintenance Process:
The most obvious impact of BASEL II is the need for improved risk management and
measurement. It aims to give impetus to the use of internal rating system by the international
banks. More and more banks may have to use internal model developed in house and their
impact is uncertain. Most of these models require minimum 5 years bank data which is a
tedious and high cost process as most Indian banks do not have such a database
Additional Capital Requirement:
In order to comply with the capital adequacy norms we will see that the overall capital level of
the banks will raise a glimpse of which was seen when the RBI raised risk weightages for
mortgages and home loans in October 2004. Here there is a worrying aspect that some of the
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banks will not be able to put up the additional capital to comply with the new regulation and
they may be isolated from the global banking system.
Large Proportion of NPA's:
A large number of Indian banks have significant proportion of NPA's in their assets. Along
with that a large proportion of loans of banks are of poor quality. There is a danger that a large
number of banks will not be able to restructure and survive in the new environment. This may
lead to forced mergers of many defunct banks with the existing ones and a loss of capital to the
banking system as a whole.
Relative Advantage to Large Banks:
The new norms seem to favor the large banks that have better risk management and
measurement expertise. They also have better capital adequacy ratios and geographically
diversified portfolios. The smaller banks are also likely to be hurt by the rise in weightage of
inter-bank loans that will effectively price them out of the market. Thus banks will have to
restructure and adopt if they are to survive in the new environment.

HURDLES ON THE WAY

The road to the Basel-II will not be an easy one for Indian banks. The significant hurdles on its
way are:
IT infrastructure: The technology infrastructure in terms of computerisation is still in a
nascent stage in most Indian banks. Computerisation of branches, especially for those banks,
which have their network spread out in far flung areas, will be a daunting task. Penetration of
information technology in banking has been successful in the urban areas, unlike in the rural
areas where it is insignificant.
Data management: Collection of data for the last three to four years, a requirement for
conforming to the provisions of Basel-II is another difficult task. Due to a late start in
computerisation, most Indian banks lack robust data capture, cleansing and management
practices, and this will serve as the single largest limitation in adopting the accord. Moreover,
to get rid of the common tradition of individuals maintaining paper work, will be another
daunting task.
Risk Management Resources: Experts say that dearth of risk management expertise in the
Asia Pacific region will serve as a hindrance in laying down guidelines for a basic framework
for the new capital accord.
Communication gap: An integrated risk management concept, which is the need of the hour
to align market, credit and operational risk, will be difficult due to significant disconnect
between business, risk managers and IT across the organisations in their existing set up.

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Huge Investment: Implementation of the Basel-II will require huge investments in

technology. According to estimates Indian banks, especially those with a sizeable branch
network, will need to spend well over $50-70 million on this.
In a recent survey conducted by the Federation of Indian Chambers of Commerce & Industry
(FICCI), 55 per cent of the respondents' claim that Indian banks lack adequate preparedness to
be able to conform to the Basel-II provisions .
Whereas, 50 per cent of public sector banks have expressed their preparedness in meeting these
guidelines, only 25 per cent of the old and new private sector and foreign banks are likely to be
ready to meet them. According to the survey, concerns of the Indian banks in implementing
these norms are:
51.6 per cent said due to low levels of computerisation,
87 per cent said due to absence of robust internal credit rating mechanism,
80.6 per cent said due to lack a strong management information system,
And 58 per cent said due to lack of sufficient training and education to reach the levels
to conform to the provisions of Basel-II.

The FICCI survey was based on feedback from more than 75 respondents including leading
bankers, financial institutions, intermediaries and other market players in India.
Finance minister P Chidambaram, speaking at a conference, Indian Banking: Realising
Global Aspirations, said that one of the major threats to the health of the Indian banking sector
is the high level of non performing assets (NPAs). This problem has to be tackled by improving
credit quality in terms of better skills, better risk management systems and improvements in
monitoring and follow up.
On the whole, the system of supervision and accountability within public sector banks, and
many old private sector banks needs to be improved. Bank management need to compare their
own systems to those of the global banks, in which the quality of credit appraisals is far
superior, supervision is strict and penalties for serious mistakes instantaneous.
Although the level of bad loans in the banking system remains worryingly high, Indian banks
were not caught in the financial crisis that rocked East Asian economies in 1997-98. Thus, they
are typically healthier than those in some other Asian countries, such as Thailand.
A more practical approach is necessary to understand the current risk management framework
in the Indian banking industry and the successive progression to the Basel-II in a phased
manner. The steering committee formed by the RBI needs to become functional, instead of
being present only on paper. Regular meeting and consultations with the banks is essential to
guide them in adopting the strategy.
Though, they have a long way to go, the new capital regulation requirements have given
Indians banks a chance to re-look at their risk strategies, revamp and hone their current policies
to strengthen their immune system against any risk disaster.

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NOT WHEN BUT HOW?

The important decision for India is not whether to stay on Basel I or move to Basel II, but of
which of the many alternatives on offer, should be adopted. Given the lack of rating
penetration, the Standardized Approach yields little in linking capital to risk while the IRB
approach looks complex to implement and difficult to monitor. In the event of some banks
adopting IRB Approach, while other banks adopt Standardised Approach, banks adopting IRB
Approach will be much more risk sensitive than the banks on Standardised Approach, since
even a small change in degree of risk might translate into a large impact on additional capital
requirement for the IRB banks.
For banks adopting Standardised Approach the relative capital requirement would be less for
the same exposure and would be inclined to assume exposures to high risk clients, which were
not financed by IRB banks. As a result, high risk assets could flow towards banks on
Standardised Approach which need to maintain lower capital on these assets. Similarly, low
risk assets would tend to get concentrated with IRB banks which need to maintain lower
capital on these assets. Hence, system as a whole may maintain lower capital than warranted.
Keeping in view the above complications we suggest as a transitional tool, a Centralized
Rating Based(CRB) approach where the RBI dictates a rating scale and asks banks to rate
borrowers according to that centralized scale. The great benefit of the approach is that the RBI
would be able to monitor and control banks' ratings and hence monitor and control their capital
sufficiency in relation to risk much more effectively. These kinds of comparisons combined
with simple procedures for spotting outliers and keeping a track of the different banks' ratings
of the main borrowers from the financial system will be extremely valuable tools for a RBI.
Finally the CRB approach should be used as a precursor to IRB. Once the CRB approach is
working the RBI could then work with banks to approve their own rating scales and rating
methodology using the basic CRB approach as a reference tool

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CONCLUSION
Since exposure to bank risk continues to be the leading source of problems in banks worldwide, 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. The Basel Committee is issuing this
document in order to encourage banking supervisors globally to promote sound practices for
managing credit risk. 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 document specifically address the following areas:
establishing an appropriate credit risk environment; operating under a sound credit-granting
process; maintaining an appropriate credit administration, measurement and monitoring
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 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 provisions and reserves, and the disclosure of
credit risk, all of which have been addressed in other recent Basel Committee documents. It
wouldbefareasierforthelargerbankstoimplementthenorms,raisingtheirqualityofrisk
managementandcapitaladequacy.Thiscombinedwiththehighercostofcapitalforsmaller
playerswouldqueerthepitchinfavouroftheformer.Thelargerbankswouldalsohavea
distinctadvantageinraisingcapitalinequitymarkets.EmergingMarketBankscanturnthis
challengeintoanadvantagebyactiveimplementationandexpandingtheirhorizonsoutsidethe
country.TheBaselIIdefinitionofabankingcompanyisverybroadandincludesbanking
subsidiariessuchasinsurancecompanies.InIndiaandinmanyotheremergingcountriesthere
isnosingleregulatortogovernthewholebankasperBaselII.InIndiaIRDA,SEBI,
NABARD&RBIwouldregulatedifferentaspectsofBaselII.Theconsolidatedbalancesheet
ofthebankhastoconformtoCARregulations.InIndia,Regulatorycapitalnormsdonot
applytoInsurancecompanies.Recently,inthefallingbondmarketsscenarioLIC&other
Insurancecompanieshaveactedassavioursforthebanksbypurchasingtheirlongtenure
bonds.Consequently,theInterestRateRiskbroneisveryhigh.Thecomplexbankingstructure
inIndiaisanotherstumblingblock.ThePillarIIimplementationisthemoredifficultportion
ofthethreepillars.RiskAuditsinbanksarestillintheirnascentstagesinIndia.The
availabilityoftrainedriskauditorsisanotherproblems.BaselIIcallsforaRiskManagement
structureinbankswithRiskManagementcommitteesforCredit,Market&operationalRisk
formulatingtheRiskManagementstandards.WhilebanksinIndiaareimplementingthis,it
hasremainedaceremonialprocesswithoutthetrainingatthegrassrootleveltoseeevery
activitywiththelensofrisk.OneofthetwoapproachesprescribedforCreditRiskinBaselII
isthestandardisedapproach,whichmakesuseofexternalcreditratingsforattachingrisk
weights.Beingtheeasierofthetwoapproachesandalsobecauseofthecontinuityfromthe
BaselInormsitismostlikelytobeimplementedinemergingcountries.Oneofthemajor
problemsistheavailabilityofcreditratingsinemergingcountries.WhileIndiahasbeen
fortunateinthisrespectwiththreemajorCreditRatingagenciesinCRISIL,FITCH&ICRAin
thisfieldmanyemergingcountriesarenotsoequipped.EveninIndiathepenetrationofcredit

81

ratingsisnotdeep.Thesupplydemandimbalancewouldmakeitevenmoredifficultfor
smallerplayerstogetratings,Highpricesmakingcreditmorecostlyforthem.Variousmodels
havebeenproposedfortheInternalRatingBasedBankRiskAssessment.Amajorproblemis
dataavailability.InIndia,alargeno.ofPSUbanksarestillintheprocessofcomputerisation.
TheextentofhistoricaldatarequiredtoformulateandthenconvincinglytestIndigenousIRB
modelsissimplynotavailable.TheIRBbasedapproachbeingoneofthemorestringent
approachesisthemoreidealofthetwotostrengthenthefinancialsystem.Theactual
implementationofanIRBbasedmodelforcreditriskmitigationwouldrequireexcellent
informationretrievalandassessmentcapabilities.AhighendITInfrastructurewithRisk
ManagementSoftwarecollatingrealtimeinformationisneeded.Thispreparednessisnotthere
inamajorityofbanksinemergingmarketshurryingintoanIRBbasedapproachcouldcost
banksdearlybecauseoftheHighCapitalExpendituresinvolved.InaccurateIRBmodelscould
defeattheverypurposeofbetterriskmitigation

SUGGESTIONS
1) Banks should have written credit policies that define target markets, risk acceptance
criteria, credit approval authority, credit origination and maintenance procedures and
guidelines for portfolio management and remedial management.
2) Banks should establish proactive credit risk management practices like annual / half yearly
industry studies and individual obligor reviews, periodic credit calls that are documented,
periodic plant visits, and at least quarterly management reviews of troubled
exposures/weak credits.
3) Business managers in banks will be accountable for managing risk and in conjunction with
credit risk management framework for establishing and maintaining appropriate risk limits
and risk management procedures for their businesses.
4) Banks should have a system of checks and balances in place around the extension of credit.
5) The Credit Approving Authority to extend or approve credit will be granted to individual
credit officers based upon a consistent set of standards of experience, judgment and ability.
6) The level of authority required to approve credit will increase as amounts and transaction
risks increase and as risk ratings worsen.

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7) Every obligor and facility must be assigned a risk rating.

8) Banks should ensure that there are consistent standards for the origination, documentation
and maintenance for extensions of credit.
9) Banks should have a consistent approach toward early problem recognition, the
classification of problem exposures, and remedial action.
10) Banks should maintain a diversified portfolio of risk assets in line with the capital desired
to support such a portfolio.
Keeping in view the foregoing, each bank may, depending on the size of the organization or
loan book, constitute a high level Credit Policy Committee also called Bank 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 mechanism,
risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning,
regulatory/legal compliance, etc. Concurrently, each bank may 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.
1. Measure, control & manage bank risk on a bank-wide basis within the limits set by the
Board/CRMC
2. Enforce compliance with the risk parameters and prudential limits set by the Board/
CRMC.
3. Lay down risk assessment systems, develop MIS, monitor quality of loan/ investment
portfolio, identify problems, correct deficiencies and undertake loan review/audit. Large
banks could consider separate set up for loan review/audit.
4. Be accountable for protecting the quality of the entire loan/ investment portfolio. The
Department should undertake portfolio evaluations and conduct comprehensive studies on
the environment to test the resilience of the loan portfolio.

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THE BIBLIOGRAPHY

WEBSITES
www.bis.org
www.worldbank.com
www.rbi.org.in
www.creditguru.com
www.iba.org
www.Moodys.com
www.knowledgestorm.com
www.creditquest.com
www.bankersindia.com
www.moneycontrol.com
www.thehindubusinessline.com
JOURNALS,PAPERS&ARTICLES

Implementationofthenewbaselcapitalaccordinemergingmarket
ImplementationofBaselII:AnIndianPerspectiveKishoriJ.UdeshiDeputyGovernor
ReserveBankofIndiaWorldBankConference
ICFAIProfessionalBankerIssues
BOOKS
BankRiskManagementSKBagchi
The Indian Economy: A Different View By Ajit Mozoomdar
Indian Financial System: By MY Khan

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