External Ratings under the Basel

II framework

Aditya Lathe

Basel II FrameworkPart A

Calculation of Risk Weighted AssetsPart B• Mapping of Risk Weights to Rating Scales

• Treatment of Off Balance Sheet Exposure

External Ratings - General Guidelines Part C

Basel II Framework: Introduction

Basel II Framework : Indian Scenario

Pillar I: Min CRAR for Banks in India set at 9%. Banksencouraged to maintain Tier I CRAR of at least 6%.

Pillar II: Banks to establish Internal Capital AdequacyAssessment Process which shall be subject to rigorousSupervisory Review Process.

Pillar III: Public disclosures to enhance market transparency.Among others, capital structure, capital adequacy, compositionof loan/credit portfolios by risk rating and detailed riskparameters for each risk-rating category, market risk inTrading Book, Interest rate risk in the Banking Book,Operational risk etc to be disclosed.

Banks in India to continue to have parallel run of Basel I &Basel II till March 31, 2013, subject to review, and ensure thattheir Basel II minimum capital requirement continues to behigher than the prudential floor of 80% of the minimum capitalrequirement computed as per Basel I framework for credit andmarket risks.

Basel II Framework: Risk Measurement Approaches

Market Risk

Standardized Approach

Alternative Approach

Operational Risk

Basic Indicator Approach

Standardized Approach

Advanced Measurement

Approach

Credit Risk

Standardized Approach

Simple Approach

Comprehensive Approach

Foundation IRB Approach

Advanced IRB Approach

Credit Risk Measurement: Indian Scenario

RBI mandate: All commercial banks in India required to adopt

Comprehensive Approach under the Standardised Approach for

measurement of Credit Risk.

Foreign banks operating in India and Indian banks having

operational presence outside India migrated to this approach with

effect from March 31, 2008. All other commercial banks migrated

from March 31, 2009.

RBI timeline for eventual migration to more advanced approaches for

Credit Risk measurement:Approach Earliest date for

applying to RBI

Likely date of

approval by RBI

IRB Approach (Both

Foundation &

Advanced)

April 1, 2012 March 31, 2014

Credit Risk Measurement: Indian Scenario

Credit Risk: Standardized Approach - Measurement of credit risk supported

by ratings assigned by eligible External Credit Rating Agencies (ECRAs)

Eligible ECRAs as recognized by RBI:

Domestic Credit Rating Agencies

Credit Analysis and Research Limited

CRISIL Limited

FITCH India

ICRA Limited

Brickworks Rating India Pvt Ltd.

SMERA

International Credit Rating Agencies

Fitch

Moodys

Standard & Poor’s

Basel II FrameworkPart A

Calculation of Risk Weighted AssetsPart B• Mapping of Risk Weights to Rating Scales

• Treatment of Off Balance Sheet Exposure

External Ratings - General Guidelines Part C

Mapping of Risk Weights to Rating Scales

Risk Weight for claims on:

Sovereigns - Domestic & Foreign

Public Sector Enterprises - Domestic & Foreign

Multilateral Agencies

Banks- Domestic & Foreign

Corporates - Domestic & Foreign

Primary Dealers (PDs), Asset Finance Companies (AFCs), NBFCs,

Infrastructure Finance Companies (IFCs)

Retail portfolio

Loans secured by Residential Property (Housing Loans)

Commercial Real Estate, Capital Market Exposure

Non Performing Assets (NPAs)

Others

Claims on Sovereigns - Domestic

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* Also applicable for exposure to RBI, DICGC, CGFTSI and loans under

Agriculture Debt Waiver Scheme 2008

** Also applicable for claims on ECGC

Exposure Type Risk Weight

All claims on GoI* 0%

Claims guaranteed by GoI 0%

Claims on State Govt. 0%

Claims guaranteed by State Govt.** 20%

Claims on Sovereigns - Foreign

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Claims denominated in domestic currency of the

foreign sovereign, met out of the resources in the

same currency raised in the jurisdiction of that

sovereign to attract 0% risk weight.

Rating AAA AA A BBB BB B Below B Unrated

Risk

Weight

0% 0% 20% 50% 100

%

100

%

150% 100%

Claims on PSEs & Multilateral Agencies

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Domestic PSE: Same Risk Weight as for Corporates

Foreign PSEs:

Claims on following multilateral agencies at flat rate of

20%

Rating AAA AA A BBB BB Below BB Unrated

Risk Weight 20% 20% 50% 100

%

100

%

150% 100%

Bank for International Settlements International Monetary Fund

World Bank Group Asian Development Bank

African Development Bank European Bank for Reconstruction &

Development

Inter-American Development Bank European Investment Bank

European Investment Fund Nordic Investment Bank

Caribbean Development Bank Islamic Development Bank

Council of Europe Development Bank

Claims on Banks - Domestic

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Banks incorporated in India & branches of foreign

banks in India (All Scheduled Commercial Banks)

Level of CRAR Investment within 10% limit Other claims

9% and above Higher of 100 % or the risk weight as

per the rating of the instrument or

counterparty, whichever is higher

20%

6% to <9% 150% 50%

3% to <6% 250% 100%

0% to <3% 350% 150%

Negative 625% 625%

Claims on Banks - Foreign

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Exposures of Indian branches of foreign banks,guaranteed / counter-guaranteed by the overseas HeadOffices or the bank’s branch in another country wouldamount to a claim on the parent foreign bank and wouldalso attract the risk weights as above

However, claims on a bank denominated in 'domestic'foreign currency met out of the resources in the samecurrency raised in that jurisdiction, to be risk weighted at20% provided the bank complies with the minimumCRAR prescribed by the concerned bank regulator

Rating AAA AA A BB

B

BB B Below B Unrated

Risk

Weight

20% 20% 50% 50% 100% 100

%

150% 100%

Claims on Corporates - Domestic

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Long Term Claims (Contractual maturity of above 1 year)

Short Term Claims (Contractual maturity of 1 year and below)

Where “+” or “-” notation is attached to the rating, the correspondingmain rating category risk weight to be used.

Restructured / Re-scheduled Assets: Unrated standard /performing claims to be assigned a risk weight of 125% untilsatisfactory performance under the revised payment schedulehas been established for 1 year from the date when the firstpayment of interest / principal falls due under the revisedschedule.

Rating AAA AA A BBB BB & Below Unrated

Risk

Weight

20% 30% 50% 100% 150% 100%

Rating A1+ A1 A2 A3 A4 A5 Unrated

Risk Weight 20% 30% 50% 100% 150% 150% 100%

Claims on Corporates: Foreign

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Claim on an unrated corporate cannot be given a

risk weight preferential to that assigned to its

sovereign of incorporation.

Rating AAA AA A BBB BB Below

BB

Unrated

Risk

Weight

20% 20% 50% 100% 100% 150% 100%

Claims on PDs, AFCs, NBFCs, IFCs

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Same as Risk Weight for Corporates - Domestic

Claims on Retail portfolio

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Qualifying Criteria for Retail:

Orientation Criterion - The exposure is to an individual person or persons orto a small business (where the total average annual turnover of last 3 yearsis less than Rs. 50 crs)

Product Criterion - The exposure is in the form of revolving credits and linesof credit (including overdrafts), term loans and leases (e.g. instalment loansand leases, student and educational loans) and small business facilities andcommitments.

Granularity Criterion- Aggregate exposure to a single counterpart (orbusiness group) does not exceed 0.2 % of the overall regulatory retailportfolio of the bank

Low value of individual exposures - The maximum aggregated retailexposure to a single counterpart does not exceed Rs. 5 crs

Notable Exclusions:

Loans and Advances to bank’s own staff, fully covered by superannuationbenefits and / or mortgage of flat/ house;

Consumer Credit, (including Personal Loans and credit card receivables)

Housing Loans

Category All

Exposure

Risk Weight 75%

Claims on Loans secured by Residential Property

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Amount of Loan Risk Weight

Upto Rs.30 Lakhs 50%

Above Rs. 30 Lakhs but below Rs.75 Lakhs 75%

Above Rs.75 Lakhs 125%

Amount of Loan Risk Weight

Upto Rs.75 Lakhs 100%

Above Rs.75 Lakhs 125%

Claims on CRE & Capital Market Exposure

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Commercial Real Estate:

The funding results in creation or acquisition of real estate (such as, officebuildings to let, retail space, multifamily residential buildings, industrial orwarehouse space, and hotels)

The prospects for repayment depend primarily on cash flows generated bythe asset. Prospect of recovery in event of default also depend primarily onthe cash flows generated from the funded asset.

Capital Market Exposure:

Direct investment in capital markets,

Advance against capital market instruments, or on clean basis to individualsfor investment in capital market instruments

Advances for any other purpose where capital market instruments are takenas primary security.

(For detailed guidelines, consult References)

Category Risk Weight

Commercial Real Estate 100%

Capital Market Exposure 125%

Claims on Non Performing Assets

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For defining secured portion of NPA, eligiblecollateral will be the same as recognised for creditrisk mitigation purposes (Cash, Gold, Securitiesissued by Central or State Govt, KVP, NSC, LifeInsurance Policies, Debt securities rated by a CreditRating Agency, Units of MFs). Other forms ofcollateral like land, buildings, plant, machinery,current assets, etc. not allowable for capitaladequacy purposes.

Unsecured portion of NPA, where specific provisions are Risk Weight

Less than 20% of outstanding 150%

At least 20% of outstanding 100%

At least 50% of outstanding 50%

Claims on Others

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Category Risk Weight

High Risk Venture Capital Funds 150%

Consumer Credit (Personal loans, credit card receivables) 125%

Non-deposit Taking Systemically Important Non-Banking

Financial Companies (NBFC-ND-SI),

100%

All investments in the paid up equity of non-financial entities,

which are not consolidated for capital purposes with the bank

125%

Loans and advances to bank’s own staff which are fully

covered by superannuation benefits and/or mortgage of flat/

house

20%

Treatment of Off Balance Sheet Exposure

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Off Balance Sheet Exposure

-Market Related -Non Market Related

• Notional Exposure

Credit Equivalent Exposure

• Notional Exposure X CCF

Risk Weighted Asset • CEE X Risk Weight

Off Balance Sheet Exposure- Non- Market related

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Instrument CCF

Direct credit substitutes and acceptances, where the risk of loss depends

on the credit worthiness of the counterparty or the party against whom a

potential claim is acquired

(eg. standby L/Cs serving as financial guarantees for loans and

securities, credit enhancements, liquidity facilities for securitisation

transactions etc.)

100%

Transaction-related contingent items

(e.g. performance bonds, bid bonds, warranties, indemnities and standby

letters of credit related to particular transaction).

50%

Short-term self-liquidating trade letters of credit arising from the

movement of goods for both issuing bank & confirming bank.

(e.g. documentary credits collateralised by the underlying shipment)

20%

Sale & repurchase agreements, and asset sales with recourse, where the

credit risk remains with the bank.

100%

Forward asset purchases, forward deposits and partly paid shares and

securities, which represent commitments with certain drawdown.

100%

Off Balance Sheet Exposure- Non- Market related

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Instrument CCF

Lending of banks’ securities or posting of securities as collateral by

banks, including instances where these arise out of repo style

transactions

100%

Note issuance facilities and underwriting facilities. 50%

Commitments with certain drawdown 100%

Other commitments (e.g., formal standby facilities and credit lines) with

an original maturity of

a) up to 1 year

b) over 1 year.

Commitments that are unconditionally cancellable at any time by the

bank without prior notice or that effectively provide for automatic

cancellation due to deterioration in a borrower’s credit worthiness

20%

50%

0%

Take-out Finance in the books of taking-over institution

(i) Unconditional take-out finance

(ii) Conditional take-out finance

100%

50%

Off Balance Sheet Exposure- Non Market related

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Following transactions to be treated as claims on

banks:

Guarantees issued by banks against the counter

guarantees of other banks.

LCBD Cases: Rediscounting of documentary bills

discounted by other banks, and bills discounted by

banks which have been accepted by another bank

Off Balance Sheet Exposure- Market related

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Market related off-balance sheet items

Interest Rate Contracts – single currency interest rate swaps, basis swaps, forward rate agreements, and interest rate futures;

Foreign Exchange Contracts - contracts involving gold,cross currency swaps, cross currency interest rateswaps, forward foreign exchange contracts, currencyfutures, currency options

Any other market related contracts specifically allowed byRBI which gives rise to credit risk.

Does not include foreign exchange (except gold) contractswhich have an original maturity of 14 calendar days or less;and instruments traded on futures and options exchangeswhich are subject to daily mark-to-market and marginpayments.

Off Balance Sheet Exposure- Market related

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CCF Calculation: Current Exposure Method:

Credit Equivalent Amount = Current Credit Exposure + Potential Future

Exposure

Current Credit Exposure is sum of positive mark-to-market value of

contracts

Potential Future Exposure determined by multiplying notional

principal amount of the contract with following CCF:

Maturity CCF

Interest Rate

Contracts

Exchange Rate Contracts &

Gold

1 year or less 0.50% 2.00%

Over 1 year to 5

years

1.00% 10.00%

Over 5 years 3.00% 15.00%

Basel II FrameworkPart A

Calculation of Risk Weighted AssetsPart B• Mapping of Risk Weights to Rating Scales

• Treatment of Off Balance Sheet Exposure

External Ratings - General Guidelines Part C

External Ratings - General Guidelines

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Publicly available ratings:

Only publically available credit assessments to be

used. (i.e. rating must be published in an accessible

form and included in the external credit rating

agency’s transition matrix). Ratings made available

only to the parties to a transaction are ineligible.

Currently Valid ratings:

Only ratings currently in force and confirmed from

the monthly bulletin of the concerned rating agency

to be used. The rating agency should have reviewed

the rating at least once during the previous 15

months.

External Ratings - General Guidelines

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Unsolicited ratings:

Banks to use only solicited ratings. A rating issolicited only if the issuer of the instrument hasrequested the credit rating agency for the rating andhas accepted the rating assigned by the agency.

Cherry Picking

Banks not allowed to use one agency’s rating for oneexposure, while using another agency’s rating foranother exposure to the same counter-party, unlessthe respective exposures are rated by only one ofthe chosen credit rating agencies, whose ratings thebank has decided to use.

External Ratings - General Guidelines

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Multiple Ratings:

In case of divergent ratings from two different ECRAs,

rating with higher risk weight to be used.

In case of divergent ratings from three or more different

ECRAs, ratings corresponding to the two lowest risk

weights to be considered and the higher of those two risk

weights to be applied. i.e., the second lowest risk weight.

Double Counting of Credit Mitigants

To avoid double counting of credit enhancement factors,

credit risk mitigation techniques should not be taken into

account if the credit enhancement is already reflected in

the rating.

External Ratings - General Guidelines

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Application of Issue Rating to unrated claims

Sort-term ratings are issue-specific. Cannot be

generalised to other short-term claims or long-term

claims.

In cases where the Bank’s exposure is not a part of the

rated exposure of the borrower, the long term rating of

the rated exposure may be applied to the bank’s un-

assessed claim if this claim ranks pari passu or senior to

the specific rated exposure in all respects and the

maturity of the un-assessed claim is not later than the

maturity of the rated claim.

Note: Substitution of Foreign currency ratings only for

exposures in foreign currency.

External Ratings - General Guidelines

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Higher weightage to unrated claims

In case an issuer has long-term/ short-term exposure

with rating that has a risk weight of 150%, all unrated

claims to also receive a 150% risk weight.

Short Term Claims: Unrated short term claim to

attract a risk weight of at least one level higher than

the risk weight applicable to the rated short term

claim on that counter-party. (Eg. If a short-term rated

facility attracts a 20% or 50% risk-weight, unrated

short-term claims to the same counter-party cannot

attract a risk weight lower than 30% or 100%

respectively).

External Ratings - General Guidelines

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Substitution of guarantor’s rating: Guaranteed portion of the counterparty

exposure to be assigned risk weight of the guarantor, whereas the uncovered

portion to retain the risk weight of the underlying counterparty. Substitution of

risk weight is allowable in cases where available guarantee meets the following

criteria:

Direct & Explicit: The guarantee must represent a direct claim on the

protection provider and must be explicitly referenced to specific exposures or

a pool of exposures, so that extent of the cover is clearly defined and

incontrovertible.

Irrevocable: The guarantee must be irrevocable; there must be no clause in

the contract that would allow the protection provider unilaterally to cancel the

cover or that would increase the effective cost of cover as a result of

deteriorating credit quality in the guaranteed exposure.

Unconditional: The guarantee must be unconditional; there should be no

clause in the guarantee outside the direct control of the bank that could

prevent the protection provider from being obliged to pay out in a timely

manner in the event that the original counterparty fails to make the payment

due.

External Ratings - General Guidelines

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Eligible Guarantors: (i) Sovereigns, sovereign entities

(including BIS, IMF, European Central Bank and European

Community as well as other mentioned Multilateral

Agencies; banks and primary dealers with a lower risk

weight than the counterparty

(ii) other entities rated AA- or better. (including parent,

subsidiary and affiliate companies when they have a lower

risk weight than the obligor). Rating of the guarantor should

be an entity rating which has factored in all the liabilities

and commitments (including guarantees) of the entity.

No adjustment permitted on account of guarantees in

case of NPAs.

Capital Saving: Unconditional Cancellability Clause

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Undrawn portion of CC limit: Non market Off Balance Sheet exposure arises on

account of maximum unused portion of the commitment that could be drawn during

the remaining period to maturity.

Example: Sanctioned CC Limits: Rs. 100 crs

Company Rating : A

Facilities not unconditionally cancellable

Details Amount

(A)

CCF

(B)

Risk Weight

(C)

RWA

(A*B*C)

Cash Credit Facility Rs. 100 crs - - -

Drawn Portion Rs.60 crs NA 50% Rs.30 crs

Undrawn Portion Rs.40 crs 20% 50% Rs.4 crs

Total Rs.34 crs

Capital Saving: Project Sequencing

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Commitments with certain drawdown:

Example: Sanctioned Term Loan: Rs.1000 crs

Drawdown Period : 3 Years (Bank’s explicit approval needed for each drawdown)

Stage I : Amount- Rs.200 crs, Time period of execution-1 year

Stage II : Amount- Rs.300 crs, Time period of execution- 1.5 years

Stage III : Amount- Rs. 500 crs, Time period of execution- 2 years

Company Rating : A

Details Amount

(A)

CCF

(B)

Risk Weight

(C)

RWA

(A*B*C)

Term Loan Facility Rs. 1000 crs - - -

Amount for Stage I Rs.200 crs - - -

Drawn Portion Rs.150 crs NA 50% Rs.75 crs

Undrawn Portion Rs.50 crs 20% 50% Rs.5 crs

Total Rs.80 crs

Thank You

References

Documents Consulted

International Convergence of Capital Measurement

and Capital Standards – A Revised Framework

(June 2006) (Source)

RBI Master Circular on Prudential Guidelines on

Capital Adequacy and Market Discipline-

Implementation of New Capital Adequacy

Framework (July 2011) (Source)

RBI Guideline on Classification of Exposures as

CRE (Sep 2009) (Source)

RBI Master Circular on Exposure Norms (July 2011)

(Source)