www.rbi.org.in

RESERVE BANK OF INDIA

Capital Charge for Capital Charge for Credit RiskCredit Risk

Pillar 1 Pillar 1 Minimum Capital Minimum Capital

RequirementRequirement

Capital for Capital for Credit RiskCredit Risk

Basel 2Basel 2

Capital for Capital for Market RiskMarket Risk

     

Pillar 2Pillar 2Supervisory ReviewSupervisory Review

Pillar 3Pillar 3Market DisciplineMarket Discipline

Capital for Capital for Operational RiskOperational Risk

Definition of credit riskDefinition of credit risk• Credit risk is defined asCredit risk is defined as the the possibility of lossespossibility of losses

associated with diminution in the credit quality of associated with diminution in the credit quality of borrowers or counterparties. borrowers or counterparties.

In a bank’s portfolio, losses stem from In a bank’s portfolio, losses stem from outright outright defaultdefault due to inability or unwillingness of a due to inability or unwillingness of a customer or counterparty to meet commitments in customer or counterparty to meet commitments in relation to lending, trading, settlement and other relation to lending, trading, settlement and other financial transactions. financial transactions.

Alternatively, losses result from reduction in Alternatively, losses result from reduction in portfolio value arising from portfolio value arising from actual or perceived actual or perceived deterioration in credit qualitydeterioration in credit quality. .

Manifestation of credit risk Manifestation of credit risk • Direct lendingDirect lending: principal/and or interest amount may not be : principal/and or interest amount may not be

repaid;repaid;

• Guarantees or Letters of creditGuarantees or Letters of credit: funds may not be : funds may not be forthcoming from the constituents upon crystallization of the forthcoming from the constituents upon crystallization of the liability;liability;

• Treasury operationsTreasury operations: the payment or series of payments due : the payment or series of payments due from the counter parties under the respective contracts may from the counter parties under the respective contracts may not be forthcoming or ceases;not be forthcoming or ceases;

• Securities trading businessesSecurities trading businesses: funds/ securities settlement : funds/ securities settlement may not be effected;may not be effected;

• Cross-border exposureCross-border exposure: the availability and free transfer of : the availability and free transfer of foreign currency funds may either cease or restrictions may be foreign currency funds may either cease or restrictions may be imposed by the sovereign.imposed by the sovereign.

Basel 1Basel 1

• Not risk sensitiveNot risk sensitive • Broad Brush ApproachBroad Brush Approach • Lack of flexibility & incentives for better risk Lack of flexibility & incentives for better risk

managementmanagement• No incentives for credit risk mitigation techniquesNo incentives for credit risk mitigation techniques

Thus Basel I uses arbitrary risk categories and arbitrary risk weights Thus Basel I uses arbitrary risk categories and arbitrary risk weights having no relation to default rates. All assets are considered within having no relation to default rates. All assets are considered within

one category as equally riskyone category as equally risky

Basel 2Basel 2

• More risk sensitive More risk sensitive • Provides a range of options for estimating regulatory Provides a range of options for estimating regulatory

capital for credit riskcapital for credit risk• Provides incentives to improved credit risk managementProvides incentives to improved credit risk management

Need for Basel 2 Need for Basel 2

Standardised ApproachStandardised Approach(Option 1)(Option 1)

Foundation IRB Foundation IRB ApproachApproach(Option 2)(Option 2)

Approaches for computingApproaches for computing Capital charge for Capital charge for

Credit RiskCredit Risk

Advanced IRB Advanced IRB Approach Approach (Option 3)(Option 3)

     

Internal Ratings Based Internal Ratings Based ApproachApproach

Transition Transition • Standardised Approach – by end December 2006Standardised Approach – by end December 2006

• Capital floor, as above, will apply to banks adopting Capital floor, as above, will apply to banks adopting IRB Approaches up to year ending December 2008IRB Approaches up to year ending December 2008

80%80%90%90%ParallelParallelParallel/ Parallel/ impact impact

AIRBAIRB80%80%90%90%95%95%ParallelParallelFIRBFIRBDec 08Dec 08Dec 07Dec 07Dec 06Dec 06Dec 05Dec 05Year endYear end

Standardised ApproachStandardised Approach• Based on the risk weighted assets method followed Based on the risk weighted assets method followed

under Basel 1 where risk weights are linked to external under Basel 1 where risk weights are linked to external ratings of counter-partyratings of counter-party

• Sovereign, banks, PSUs, corporateSovereign, banks, PSUs, corporate Risk weight linked to external rating of the counter-party Risk weight linked to external rating of the counter-party (0 to (0 to

150% RW)150% RW) Better the credit rating, lesser the risk weightBetter the credit rating, lesser the risk weight Unrated exposures attract Unrated exposures attract 100% RW100% RW Ratings below threshold levels attract Ratings below threshold levels attract 150%150% RWRW

• Portfolio approach adopted for following exposuresPortfolio approach adopted for following exposures Regulatory retail Regulatory retail (75% RW)(75% RW) Residential mortgage Residential mortgage (35% RW)(35% RW) Commercial real estate Commercial real estate (100% RW)(100% RW) NPAs NPAs (100 or 150% RW)(100 or 150% RW)

• Maximum risk weight is Maximum risk weight is 350%350%

• SovereignsSovereigns Range - 0, 20, 50, 100, 150 (UR – 100)Range - 0, 20, 50, 100, 150 (UR – 100) National discretion for exposure to sovereign of incorporation National discretion for exposure to sovereign of incorporation National discretion to keep claims on certain domestic PSUs on National discretion to keep claims on certain domestic PSUs on

par with claims on sovereignpar with claims on sovereign

• Banks & PSUs Banks & PSUs Two options Two options

Linked to rating of the sovereignLinked to rating of the sovereign(Range – 20, 50, 100, 150 (UR – 100)(Range – 20, 50, 100, 150 (UR – 100)

Rating of the bank; with lower RW for exposures of 3 months Rating of the bank; with lower RW for exposures of 3 months or less (Range – 20, 50, 100, 150 (UR – 50)or less (Range – 20, 50, 100, 150 (UR – 50)

• CorporatesCorporates Range - 20, 50, 100, 150 (UR – 100)Range - 20, 50, 100, 150 (UR – 100) National discretion to increase RW for unrated claims > 100 in National discretion to increase RW for unrated claims > 100 in

countries where corp. NPA level is highcountries where corp. NPA level is high NPAs (> 90 days) – 150 %NPAs (> 90 days) – 150 %

Standardised Approach Standardised Approach (2)(2)

Standardised Approach Standardised Approach (3)(3)

• Retail (75%) – qualificationRetail (75%) – qualification Orientation – exposures to individuals or small Orientation – exposures to individuals or small

businessbusiness Product criterion – specified types of financial Product criterion – specified types of financial

assistance (including non fund based)assistance (including non fund based) Granularity criterion – Aggregate exposure to one Granularity criterion – Aggregate exposure to one

counter-party to be within 0.2% of overall retail counter-party to be within 0.2% of overall retail portfolioportfolio

Absolute threshold – Not to exceed Euro 1 millionAbsolute threshold – Not to exceed Euro 1 million• Residential Property (35%)Residential Property (35%)

Residential property – self occupied or rentedResidential property – self occupied or rented Existence of substantial margin based on strict Existence of substantial margin based on strict

valuation normsvaluation norms• Commercial real estate (100%)Commercial real estate (100%)

Mortgage of office or multi purpose commercial Mortgage of office or multi purpose commercial premisespremises

Standardised Approach Standardised Approach (4)(4)

• Unsecured portion of NPAs net of specific provisionsUnsecured portion of NPAs net of specific provisions 150% RW if specific provisions are less than 20% of the 150% RW if specific provisions are less than 20% of the

outstanding loan amountoutstanding loan amount

100% RW if specific provisions are no less than 20% of the 100% RW if specific provisions are no less than 20% of the outstanding loan amountoutstanding loan amount

100% RW if specific provisions are no less than 50% of the 100% RW if specific provisions are no less than 50% of the outstanding loan amount, but can be reduced to 50% RW outstanding loan amount, but can be reduced to 50% RW at the discretion of the supervisorat the discretion of the supervisor

• Higher risk categories – 150 % or more RWHigher risk categories – 150 % or more RW

Standardised Approach – Sources Standardised Approach – Sources of impactof impact

• Higher RW on sovereigns as per ratings other than country of Higher RW on sovereigns as per ratings other than country of incorporation (<=20% at present)incorporation (<=20% at present)

• Higher RW on banks as per ratings (20% at present)Higher RW on banks as per ratings (20% at present)

• Benefit of lower RW for corporates limited – since majority Benefit of lower RW for corporates limited – since majority are unratedare unrated

• Benefits of lower risk weights for residential mortgages & Benefits of lower risk weights for residential mortgages & retail sectorretail sector

• Higher RW on unsecured, unprovided NPA of > 90 daysHigher RW on unsecured, unprovided NPA of > 90 days

• Higher RW for high risk ventures (150)Higher RW for high risk ventures (150)

• Operational riskOperational risk

Credit Risk MitigationCredit Risk Mitigation

• Simple ApproachSimple Approach As in 1988 Accord substitutes the risk weight of As in 1988 Accord substitutes the risk weight of

the collateral for the risk weight of the counter the collateral for the risk weight of the counter partyparty

Eligible collateralsEligible collaterals Cash, Deposit with lending banks, CDs Cash, Deposit with lending banks, CDs

issued by lending banksissued by lending banks GoldGold Debt securities meeting criteriaDebt securities meeting criteria Equities included in a main indexEquities included in a main index Units meeting criteriaUnits meeting criteria

Credit Risk Mitigation Credit Risk Mitigation (2)(2)

• Comprehensive ApproachComprehensive Approach Allows a fuller offset of collateral against exposuresAllows a fuller offset of collateral against exposures Eligible collateralsEligible collaterals

All included under simple approachAll included under simple approach Other listed equitiesOther listed equities Other Units which include above equitiesOther Units which include above equities

• Collateral valuation as prescribedCollateral valuation as prescribed• Eligibility as per qualifying standardsEligibility as per qualifying standards

Legal certaintyLegal certainty No material positive correlationNo material positive correlation Clear & robust procedures for liquidation of collateralClear & robust procedures for liquidation of collateral

• On balance sheet nettingOn balance sheet netting (margin money, deposits) (margin money, deposits)• Guarantees and credit derivativesGuarantees and credit derivatives

Foundation ApproachFoundation Approach PD * LGD * EADPD * LGD * EAD PD by the bank (minimum requirements)PD by the bank (minimum requirements) LGD & EAD by the Regulator (rules)LGD & EAD by the Regulator (rules)

Advanced ApproachAdvanced Approach PD * LGD * EADPD * LGD * EAD All three by the bankAll three by the bank To be validated by the regulatorTo be validated by the regulator

General provisions/ general loan loss reserves not eligible General provisions/ general loan loss reserves not eligible for capital statusfor capital status

If EL is more than provisions held, difference should be If EL is more than provisions held, difference should be deducted from capital fundsdeducted from capital funds

Maximum risk weight Maximum risk weight 1250%1250%

IRB ApproachesIRB Approaches

IRB Approaches – Minimum IRB Approaches – Minimum requirementsrequirements

• Banks need supervisory approval to use IRB approachesBanks need supervisory approval to use IRB approaches• To be met at the outset and on an on-going basisTo be met at the outset and on an on-going basis• Separate treatment for different Asset classesSeparate treatment for different Asset classes• Credit risk management practices must be consistent with the Credit risk management practices must be consistent with the

evolving sound practice guidelines issued by the BCBS and evolving sound practice guidelines issued by the BCBS and supervisorssupervisors

• Internal rating system should meet minimum requirementsInternal rating system should meet minimum requirements• Objectives which the qualifying bank’s risk rating systems must Objectives which the qualifying bank’s risk rating systems must

satisfysatisfy Focus will be on the bank’s abilities to rank order and quantify Focus will be on the bank’s abilities to rank order and quantify

risk in a consistent, reliable and valid fashionrisk in a consistent, reliable and valid fashion Systems and processes must be consistent with internal use Systems and processes must be consistent with internal use

of the risk estimatesof the risk estimates• Have in place sound back testing/ stress testing processesHave in place sound back testing/ stress testing processes• Disclosure requirements under Pillar 3Disclosure requirements under Pillar 3

IRB Approaches – phased roll-outIRB Approaches – phased roll-out

• Phasing out permitted as under:Phasing out permitted as under: Adoption across asset classes within the business unitAdoption across asset classes within the business unit Adoption across business units in the same banking groupAdoption across business units in the same banking group Move from FIRB to AIRB for some risk componentsMove from FIRB to AIRB for some risk components

• Realistic implementation plan to be settled with the Realistic implementation plan to be settled with the supervisorsupervisor

• Once IRB approach is adopted, it should be continued to Once IRB approach is adopted, it should be continued to be employed and no reversal without the approval of the be employed and no reversal without the approval of the supervisorsupervisor

IRB Approaches – phased roll-out IRB Approaches – phased roll-out (2)(2)

• Parallel calculationParallel calculation• Corporate, sovereign, bank & retail exposuresCorporate, sovereign, bank & retail exposures

Banks must have used a rating system broadly in line with the Banks must have used a rating system broadly in line with the minimum requirements for at least three years prior to qualificationminimum requirements for at least three years prior to qualification

Data to estimate PD for five years for C,S & BData to estimate PD for five years for C,S & B Data to estimate PD & LGD for five years for REData to estimate PD & LGD for five years for RE LGD for RE not less than 10%LGD for RE not less than 10% Mapping of internal ratings to supervisory risk category for SLMapping of internal ratings to supervisory risk category for SL

• Similar transition allowed for PD/ LGD for equity exposuresSimilar transition allowed for PD/ LGD for equity exposures• Must have at least two years of data at the time of Must have at least two years of data at the time of

implementation and will increase by one year with each of implementation and will increase by one year with each of the three years of transitionthe three years of transition

80%80%90%90%ParallelParallelParallel/ Parallel/ impact impact

AIRBAIRB80%80%90%90%95%95%ParallelParallelFIRBFIRBDec 08Dec 08Dec 07Dec 07Dec 06Dec 06Dec 05Dec 05Year endYear end

• The Sample for QIS of the above countries was The Sample for QIS of the above countries was - 111 banks from 18 countries on Standardized Approach 111 banks from 18 countries on Standardized Approach - 25 banks from 6 countries on FIRB, and 25 banks from 6 countries on FIRB, and - 9 banks from 3 countries on AIRB9 banks from 3 countries on AIRB

• SA: An average increase in RWA at 13%. This reflects impact of SA: An average increase in RWA at 13%. This reflects impact of the new operational risk charge (+11%) plus a credit risk the new operational risk charge (+11%) plus a credit risk contribution (+2%)contribution (+2%)

• FIRB : An average increase in RWA under the FIRB at 4%. This FIRB : An average increase in RWA under the FIRB at 4%. This reflects impact of the new operational risk charge of (+) 7% and a reflects impact of the new operational risk charge of (+) 7% and a credit risk contribution (-) 3%credit risk contribution (-) 3%

• AIRB AIRB (For G-10 countries)(For G-10 countries): An average decrease in RWA under the : An average decrease in RWA under the AIRB at (-) 2%. This reflects impact of the new operational risk AIRB at (-) 2%. This reflects impact of the new operational risk charge (+) 11% and a credit risk contribution (-) 13%charge (+) 11% and a credit risk contribution (-) 13%

Basel 2 – Likely impact Basel 2 – Likely impact QIS 3 results of Non-G 10 Countries

• Many banks have recently adopted internal rating systems. Many banks have recently adopted internal rating systems. They are in the process of building up data banks and in due They are in the process of building up data banks and in due course will have data on default probabilities, rating migration, course will have data on default probabilities, rating migration, LGD etc.LGD etc.

• Acceptable PD history on rating scalesAcceptable PD history on rating scales• Asset classes & Business line definition & reporting within Asset classes & Business line definition & reporting within

banksbanks• Validation of internal rating systems/ modelsValidation of internal rating systems/ models• Cost of implementation – a relevant factorCost of implementation – a relevant factor• Desirability of having some banks on SA and others on IRB Desirability of having some banks on SA and others on IRB • Home and Host supervisor issuesHome and Host supervisor issues• Pro-cyclicality – how to addressPro-cyclicality – how to address• Evolution of LGD by RBIEvolution of LGD by RBI• Upgradation of supervisory skillsUpgradation of supervisory skills

Pillar 1 – Implementation Strategies – Pillar 1 – Implementation Strategies – Advanced approachesAdvanced approaches

Thank YouThank You

• Ratings of recognised rating agenciesRatings of recognised rating agencies

• Disclose the chosen rating agenciesDisclose the chosen rating agencies

• Consistent use of ratings by chosen agenciesConsistent use of ratings by chosen agencies

• Cherry picking of ratings not permittedCherry picking of ratings not permitted If two ratings: higher of the twoIf two ratings: higher of the two If more than two ratings: higher of the lowest twoIf more than two ratings: higher of the lowest two

• Issue rating Vs issuer rating – general principlesIssue rating Vs issuer rating – general principles

• Domestic currency rating Vs foreign currency ratingDomestic currency rating Vs foreign currency rating

External RatingsExternal Ratings

Asset ClassesAsset Classes• Corporate Corporate (5)(5)

Project financeProject finance Object financeObject finance Commodities financeCommodities finance Income producing real Income producing real

estateestate High-volatility High-volatility

commercial real estatecommercial real estate

• SovereignSovereign• BankBank• Retail Retail (3) – (3) – managed as a managed as a

pool; Exposures to pool; Exposures to individualsindividuals

Exposures secured Exposures secured by residential by residential propertiesproperties

Qualifying revolving Qualifying revolving retail exposuresretail exposures

All other retailAll other retail• EquityEquity

Key elements for each asset class• Risk components – estimates of risk parameters• Risk weight functions – means by which risk components are transformed to RWAs• Minimum requirements – the minimum standards that must be met by the bank for using IRB Approach for a given asset class

IRB Approaches – Rating system designIRB Approaches – Rating system design• Two separate and distinct dimensions – Two separate and distinct dimensions –

Risk of borrower defaultRisk of borrower default Transaction specific factorsTransaction specific factors

• At least Seven grades for non-default borrowers and one for default At least Seven grades for non-default borrowers and one for default categorycategory

• Significant concentration in one grade/ grades must be supported by Significant concentration in one grade/ grades must be supported by convincing empirical evidenceconvincing empirical evidence

• Separate PDs for each gradeSeparate PDs for each grade• Banks using AIRB approach should have sufficient number of facility Banks using AIRB approach should have sufficient number of facility

grades to avoid grouping facilities with widely varying LGDs into a grades to avoid grouping facilities with widely varying LGDs into a single grade.single grade.

• These banks should have facility-wise LGDThese banks should have facility-wise LGD• The minimum requirements are broadly classified in the following sub The minimum requirements are broadly classified in the following sub

systems:systems: Rating dimensionsRating dimensions Rating structureRating structure Rating criteriaRating criteria Rating assignment horizonRating assignment horizon Use of modelsUse of models Documentation of rating system designDocumentation of rating system design