RISK MANAGEMENT IN BANKS

- REGULATORY PROSPECTIVE

Dr. Mustari Hanmanth N.

Dr. Waghamare Shivaji

FIRST EDITION

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1
Rs: 200 /-

“RISK MANAGEMENT IN BANKS - REGULATORY PROSPECTIVE”

Dr. Mustari Hanmanth N.

Dr. Waghamare Shivaji

© 2014 by Laxmi Book Publication, Solapur

All rights reserved. No part of this book may be reproduced in any form, by
mimeograph or any other means, without permission in writing from the
publisher.

ISBN- 978-1-304-92362-2

Published by,
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258/34, Raviwar Peth,
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2
 PREFACE
Banking is the life line of the economy. Prosperity and adversity of
an economy hinges upon the performance of its banking sector. Banks are
primarily engaged in mobilisation of funds and its subsequent
channelization towards productive activities which are must for economic
development. In trying to do so banks are exposed to wide variety of risks,
an effective and efficient bank risk management is essential but not so easy.
In fact risk management in banks is over sold conceptually yet underutilized
in practice. In this backdrop, we felt the need for a book which through
flood light on different dimensions of risk management in banks. This has
resulted in to the emergence of this book. It is our immense pleasure to
place this book with humbleness in to the hands of readers so as to add to
pool of their knowledge. In this book, we have aimed a modest attempt to
provide succinct picture of risk, contents of Basel 1 to 3 and particular
attention is given to narrate the regulatory framework so that this treatise
acts as a ready reckoner to both practitioners and academicians engaged
directly or indirectly in risk management. We hope that this book would
help to broaden and deepen the knowledge box of the readers in the area
of risk management.
Finally, we would like to remain over grateful to various authors whose
writing on this field have provided on quite insight.
Suggestions for improvement from readers are welcome.

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4
 Contents

CHAPTER TITLE Page No.

1 Risk Management In Banks 7

Basel Committee On Banking Super

2 70
Vision

3 Credit Risk Management 100

4 Market Risk Management 267

5 Liquidity Risk Management 278

6 Interest Rate Risk Management 314

7 Foreign Exchange Risk 355

8 Operational Risk Management 388

9 Bibliography 430

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6
 Chapter-1

RISK MANAGEMENT IN BANKS

Introduction:
Financial sector reforms worldwide have brought about rapid
changes in the structure of financial markets including India. Before the
sixties, banks in India were mainly involved in certain traditional activities
i.e., lending to traders in agricultural commodities, conventional agro-based
industries such as textiles, rice and oil mills and cotton ginning factories.
And also the Banking industry was state controlled and state protected for
foreign competition through the barrier of high walls of import tariffs.
Protection and resultant lack of competition enabled industry to face little
risks. With liberalisation of the Indian financial markets and growing
integration of domestic markets with foreign markets, the risk associated
with the operations of banks have become complex and large, requiring
strategic and sophisticated risk management. Banks are now operating in a
fairly deregulated environment and are required to determine on their own,
interest rates on deposits and advances both in domestic and foreign
currencies. The interest rates on the bank investments in government and
other securities are also now market related. Intense competition for
business involving both the assets and liabilities, together with increasing
volatility in the domestic interest rates as well as foreign exchange rates,
has brought tremendous pressure on the management of banks to maintain
a delicate balance between spreads, profitability and long term viability.
Imprudent liquidity management can expose the banks earnings and
reputation to great risk. These pressures require structured and
comprehensive measures and not just adhoc responses. The management
of banks has to base their business decision on a dynamic and integrated
risk management system and process, driven by corporate strategy.
Deregulation in the financial sector had widened the products
range in the developed markets. Some of the new products introduced are
structured transactions, credit cards, housing finance, derivatives and
various off balance sheet items. Thus, new vistas have created multiple
sources for banks to generate higher profits than the traditional financial
intermediation. Simultaneously they have opened new areas of risk also.
Many unknown issues that are intricately related to new products have
exposed banks to various risks across the globe and India is no exception.
During the past decade, the Indian banking industry continued to
respond to the emerging challenges of competition, risks and uncertainties.
Measuring and quantifying risk is neither easy nor intuitive. In fact, it
demands Herculean efforts. Indian regulators have made some sincere

7
attempts to bring prudential and supervisory norms confirming with
international bank practices with an intention to strengthen the stability of
the banking system in India.
The long-term health and survival of financial services entity hinges
upon its ability to understand, appreciate, quantify and manage the range of
risks associated with its line of business. Therefore, quantitative and
qualitative competence and regulatory pressure makes it mandatory to a
banking organization to have a wide range of risk management framework
in place. The banking organizations that do not implement such risk
management framework may be unable to compete effectively in the
market place. The practice and implementation of risk management around
the world is evolved in to a complex, technical and ticklish domain. This
necessitates incorporation of sophisticated techniques for forecasting,
.
analyzing and managing the risk that they are dealing with them
Risk management in banking reflects the entire set of risk
management process and models allowing banks to implement risk based
polices and practices. They cover all techniques and management tools
required for measuring, monitoring and controlling risks. Risk based policies
and practices have a common goal-enhancing the risk return profile of the
portfolio. Current risks are tomorrow’s potential loss. Still, they are not as
visible as tangible revenues and costs are. Risk management is a conceptual
and a practical challenge, which probably explains why risk management
suffered from lack of credible measures. In the recent past variety of
modules and risk management tools were emerged for quantifying and
monitoring risks. Such tools contribute a lot in the right identification of risk
and, thus, enhance ability of banking entity to control them more
appropriately. The move towards risk based practices gained attraction in
the recent years and now extends to the entire banking industry.
Though risk is important in banking, it is surprising to note that risk
quantification was practiced to a limited extent until recently. Quantitative
finance addresses extensively risks in the capital markets. However, the
extended application in relation to the various risks of the financial
institutions remained a challenge for multiple reasons. Firstly, risks are less
tangible and visible than income. Secondly, academic models though
provided foundations for risk modelling, but did not provide instrumental
tools helping decision-makers. Indeed, a large fraction of this thesis
addresses the gap between conceptual models and banking management
practices. Moreover, the focus of the regulators on risks is of recent origin.
In view of this growing complexity of banks business and the
dynamic operating environment, risk management has become very
significant in financial sector. Keeping this in view, Reserve Bank of India

8
(RBI) has already issued guidelines to all banks for devising and
implementing risk management system.
CONCEPT OF RISK
“Uncertainty is inherent in Human World.” We do not know
exactly or accurately what will happen to us tomorrow. But this is not so in
the physical world. Occurrences in the physical world are exact and
uniform. Sequence, there, also decides consequence. The exact and
mathematically accurate laws of physics and chemistry are on account of
this “uniformity of nature”. Water quenches thirst to everyone, everywhere
on every day. The physical world is, thus, predictable. On the other hand,
the prevailing disposition in the human world is the “laws of probability”.
Our efforts may or may not bring desired results. But we are not deterred.
If we think, the whole human world is under risk. This was very good
explained by H.F. Kloman (in 1992, Geneva) in his paper “Rethinking Risk
Management”. He explained with the help of “Risk spectrum”, how the
Global and organizational risks interrelated and affects to the human world.
That risk spectrum is shown below.
Figure-1.1

These global risks surround the “organizational risks” that are more
susceptible to management control. Internal specialists have attacked these
risks for years, but separately, not together, Hedgers and credit managers
address financial and market risks. Lawyers and compliance officers treat
regulatory and political risks. Insurance buyers finance operational and
liability risks. Security specialists, occupational safety and health advisors,
environmental engineers and contingency and crisis management planners
all work individually to discrete boxes, rudely slopping over in to one
another. An employee mistake results in injury to other employees, damage

9
to property, owned and others, liability lawsuits, crackdowns from
regulators and inspectors, and possible reductions in liquidity and the credit
worthiness of commercial paper. All risks are interconnected and
interdependent. The process of analysis and response, including mitigating
controls and financing, needs a simple overview of the entire environment.
The risk spectrum is a quick and intuitive glimpse of the total pluses and
minuses that affect an organization.
The word risk is derived from an Italian world “risicare” which means
‘to dare’. It means risk is more a matter of “choice” than ‘fate’. An
extension of this analogy further reveals that risk is not something to be
faced but a set of opportunities open to choice. There is, however, no one
precise definition of risk that captures the entire gamut of risk but a
plethora of opinions do exist providing different contents about risk such as:
1. Possibility of loss or injury.
2. A dangerous element or factor.
3. A chance of loss or the perils and degree of probability of such loss.
4. Chances of damage.
5. The possibility of suffering harm or loss; danger; hazard.
6. The danger or probability of loss; and
7. Risk is just chance of losing money.
The Oxford dictionary defines risk as “the possibility of loss, injury,
disadvantage or destruction”. But in the lexicon of banking business risk can
be defined as:
1. The probability of loss due to default of a customer or counter-party,
2. The probability of loss due to non-occurrence of events as anticipated;
and
3. The probability of loss due to occurrence of unexpected events. The loss
due to the above causes may be financial or non-financial. It could also
be expected loss or unexpected loss.

Risk Vs Uncertainty:
In the lexicon of finance, the word ‘uncertainty’ is often inter-
changed with ‘risk’ as the synonymous terms. But, ‘uncertainty’ literally
means “not known or not certainly knowing” whereas ‘risk’ means a chance
or possibility of danger, loss or injury or other adverse consequences”.
Uncertainty is thus radically different from risk. Thus a line of demarcations
can be drawn in between uncertainty and risk as below:
1. Uncertainty means unknown probabilities, whereas, risk means
uncertainty with a known probability.
2. Uncertainty simply means “I do not know” (what is going to happen).
And by definition, we can not have measures for what we can not know. It
is in this context that a measurable uncertainty becomes risk.

10
Risk is often defined as the portion of uncertainty, which is measurable. The
condition of uncertainty may be converted in to risk by using subjective
probabilities. Thus, an identified and measured uncertainty becomes risk.

Risk Vs Time:
Risk is always in the future. If something bad has happened, the
risk of it occurring no longer exists. Of course, it is altogether different that
a bad thing may happen again. Tsunami may hit the same place twice, but
risk always pertains to what can happen but not what has happened. Risk
being the function of time it continues to remain as risk till it happens. In
short, if there is no tomorrow, there is perhaps no risk.
As organisations become more and more knowledgeable,
perceived risks would obviously increase. Its natural corollary is, the more
we know about what can happen, the more we can try to avoid the hazards.
Of course, there is always a danger of too much of information about future
and the resultant risk perception generating ‘fear of the known’ syndrome
that may result inaction rather than optimising hedging efforts.

Characteristics of risk:
Risk is prelude exercise for effective management, in this
connection the following features of risk are worth considerable:

 Risk is always bad:

Though risk is known as variation from expectation it is only the down
side variation that is regarded as risk. ‘Risk’ is never applied with reference
to good events. It is always attached to things that are bad. It is common to
hear about the risk of heart attack from smoking; but not about the risk of
winning a lottery, as the latter is perceived as something good/favourable.
It is the loss that expected to be incurred due to the happening or non-
happening of certain events or activities which are treated as risk and hence
its connotation is always bad / adverse.

 Risk is Dynamic:
Risk is not static. It keeps oscillating with time. A risk perceived
today may disappear after sometime and similarly a no-risk situation may
turn risky after a certain time. Risk simply keeps on migrating. It, thus,
matters less where an organization starts in the risk co-ordinate system
than how it changes overtime and in what specific direction it moves within
the co-ordinate system.
The following figure shows the co-ordinate system divided into four
quadrants. These four sections signify directions of movement indicating a

11
change in risk from one state to another. Each direction has different risk
assessment implications.
Figure-1.2
Risk Movement Direction Categories
High C High C
Low P High P
C
Low C Low C
Low P High P
P
Source: G.R.K. Murthy “Credit Risk Management”, IBA Bulletine, November,
2000, p. 32.

High consequence – High probability:

This is, perhaps the worst possible scenario where any organization
would love to stay for, the risk exposure is at its highest value. Continue
movement in this direction from any other quadrate increases the chances
of experiencing catastrophic results that can even throw units out of
business.
How far risk value can be allowed to move in this direction? It
depends on how much an organisation can afford to lose from the
occurrence of the events that make up the total risk value. Generally,
organizations that are greedy of profits tend to entertain such migration for
long since high rewards are associated with high risk.

Low consequence – High probability:

A movement in this direction is more of a nuisance value. Though
probability is high, the associated consequence being low, the perceived risk value
gets reduced. A movement in this direction is perhaps the second best desired
outcome of risk management.

Low consequence – Low probability:

A movement in this direction is the obvious objective of any
mitigation exercise. It is not an ideal, but realistic achievable goal with the
proper measurements and management systems of risk in place. Such a
movement ensures safety and productivity of an organisation.

High consequence – Low probability:

Though probability is low, consequences being of high value, a
movement in this direction are likely to be catastrophic, should the event
occur. Hence, it needs to be monitored very closely. Further, in such
situations it is often noticed that availability of data is meager making the
scene further worse.

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Risk Management in Banking Sector
Banking is nothing but financial intermediation. There are people in
the market with surplus capital looking for safe investment opportunities.
Simultaneously there are entrepreneurs desirous of building up productive
assets but with no matching capital resource. Yet the ‘savers’ do not want
to directly lend to capital seeking entrepreneurs as they are not certain of
safety. That is where Banks enter the scene and accept deposits from savers
with promise to pay them on demand. The depositors simply perceive the
deposit predominantly in the form of ‘money’ as they are sure of accessing
the deposits at any time and use it as a principal source of making
payments. Banks bundle the deposits and lend to the entrepreneurs at a
spread over the cost of acquisition. Banks in their attempt to maintain the
requisite liquidity, strike a balance between low yielding, high quality liquid
assets and high yielding risky / illiquid assets. Therefore, risk is inherent and
absolutely unavoidable in banking.
Figure-1.3
Bank as a Financial Intermediary

Investments in Govt.
securities / capital
market

People Banks as a Loans to people

who want financial who need capital
to save intermediary

Trading position in
forex/debt/money
market

(Source: IBA Bulletin November 2000 Article on Credit Risk Management, G.R.K. Murthy).

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Types of Bank Risks
The banks may be faced with one or more of the following risk
categories.
Chart-1.1
Financial Intermediation Risks

Financial Risk Non-Financial Risk

Credit Risk Market Risk Operational Business Strategic

Risk Risk Risk
1. Portfolio Risk 1. Human Risk
2. Concentration Risk 2. Process
3. Intrinsic Risk 3. System Risk
4. Reputation Risk

Liquidity Interest Rate Forex Commodity Prince

Risk Risk Risk Risk
1. Funding Risk 1. Gap/Mismatching
2. Time risk 2. Basis risk
3. Call risk 3. Embeded option risk
4. Yield curve risk
5. Price risk
6. Re-investment risk
Source: 1. IBA Bulletin Nov. 2000, Attraction Credit risk management by
G.R.K. Murty.
2. Indian Gandhi National Open University, book on International
Baking Management.

Financial Risks
1. Credit risk:
Credit risk involves the in ability or unwillingness of a borrower or
counter party to meet its obligations in accordance to the agreed terms.
There is always scope for the borrower to default from his/her comments
for one or other reason resulting in crystallization of credit risk to the bank.
These losses could take the form of outright default or alternatively, losses
from changes in portfolio value arising from actual or perceived
deterioration in credit quality short of default. Credit risk is inherent to the
business of lending funds to the operations linked closely to market risk
variables. The objective of credit risk management is to minimize the risk

14
and maximize bank risk adjusted rate of return by assuming and maintaining
credit exposure within the expectable parameters.
The credit risk is generally made up of following risks:
Portfolio Risk: it is the loss, which arises due to holding two or more assets
in the portfolio.
Concentration Risk: it is the additional portfolio risk resulting from
increased exposure to one obligor or group of correlated obligors.
 Business group
 Industry
 Sector
 Geographical Area
Intrinsic Risk: it is the unique risk, which contributes to overall portfolio,
defaults in a particular line of business/product (e.g. Credit Cards, lease and
Hire purchase business, Merchant Banking activities etc.)

2. Market Risk:
Traditionally, credit risk management was the primary challenge
for banks. With progressive deregulations, market risk arising from adverse
changes in market variables, such as Liquidity Risk, Interest Rate Risk,
Foreign exchange rate, and Commodity Price Risk. Even a small change in
market variables causes substantial changes in income and economic value
4
of banks. Market risk takes of :

a. Liquidity Risk: Liquidity is defined as the ability to meet all legitimate

demands for funds. A financial Institutions or a bank must stand ready to
meet all the legitimate demands for funds at all times. Failure to meet the
demands quickly would erode the confidence of the depositors.

b. Funding Risk: needs to replace the net outflows due to unanticipated

withdrawal/non-renewal of deposits.
 Time Risk: needs to compensate for non receipt of expected
inflows of funds, i.e. performing assets turning into non performing assets
and
 Call Risk: due to crystallization of contingent liabilities and unable
to undertake profitable business opportunities when desirable.

c. Interest Rate Risk: Interest Rate Risk (IRR) refers to potential impact
on Net Interest Income (NII) or Net Interest Margin (NIM) or Market Value
of Equity (MVE), caused by expected changes in market interest rates.
Interest Rate Risk can take different forms:
 GAP or Mismatch Risk: a GAP mismatch risk arises from holding
assets and liabilities and off-balance sheet items with different principal

15
amounts, maturity dates or re-pricing dates, thereby creating exposure to
un-expected changes in the level of market interest rates.
 Basis Risk: market interest rates of various instruments seldom
change by the same degree during a given period of time. The risk that the
interest rate of different assets, liabilities and off-balance sheet items may
change in different magnitudes is termed as basis risk. The degree of basis
risk is fairly high in respect of banks that create composite assets out of the
composite liabilities.
 Embedded Option Risk: significant changes in market interest
rates creates another source of risks to bank’s profitability by encouraging
prepayment of cash credit/demand loans/term loans and exercise of
call/put options on bonds/debentures and/ or premature withdrawal term
deposits before their stated maturities. The embedded option risk is
becoming a reality in India and is experienced in volatile situations. The
faster and higher the magnitude of changes in interest rate, the greater will
be the embedded option risk to the bank’s NII.
 Yield Curve Risk: in a floating interest rate scenario, banks may
price their assets and liabilities based on different benchmarks, i.e. Treasury
Bills yields, fixed deposit rates, call money rates, etc. Incase the banks use
two different instruments maturing at different time horizon for pricing
their assets and liabilities, any non-parallel movements in yield curves would
affect the NII. The movements in yield curve are rather frequent when the
economy moves through business cycles
 Price Risk: price risk occurs when assets are sold before their
stated maturities. In the financial market, bond prices and yield are
inversely related. The price risk is closely associated with the trading book,
which is created for making profit out of short-term movements in interest
rates. Banks which have an active trading book should, therefore, formulate
policies to limit the portfolio size, holding period, duration, stop loss limits,
marking to market etc.
 Reinvestment Risk: uncertainty with regard to interest rate at
which the future cash flows could be reinvested is called reinvestment risk.
Any mismatches in cash flows would expose the banks to variations in NII as
the market interest rates move in different directions.
 Net Interest Position Risk: The size of nonpaying liabilities is one
of the significant factors contributing towards profitability of the banks.
When banks have more earning assets than paying liabilities, interest rate
risk arises when the market interest rates adjusted downwards. Thus, banks
with positive net interest positions will experience a reduction in NII as the
market interest rate declines and increase when interest rate rises. Thus,
large float is natural hedge against the variations in interest rates.

16
 d. Foreign Exchange Risk: It arises from changes in foreign exchange
rates, which effects the value of commercial Banks assets and liabilities
located abroad.

e. Commodity Price Risk: commodity risk is more complex then market

instrument risk because its combines a pure commodity price risk with
other risk, such as basis risk (mismatch of price of similar commodities,
interest rate risk (for carrying cost of exposures) and forward price risk. in
addition, there is a directional risk in a commodities prices. The principle is
to assign transactions to maturity buckets, to allow off-setting of matched
exposures and to assign a higher capital charge for risk.

Non-Financial Risk
1. Operational risk: It arises from the problems of accurately processing,
setting and taking or making delivery on trades in exchange for costs. It is
also associated with record keeping, processing, system failures and
compliance with various regulations5.
a) Human Risk: it’s the loss caused by intentional or unintentional
behavior of employees, which cause the interest of the bank to be
compromised in some other way (managers, dealers, lending officers, other
staff exceeding their authority or conducting business in an unethical or
risky manner.
b) System Risk: losses due to technical factors such as technical
disruptions, down times, theft or piracy, hacking, disruption or distortion in
data/information of transaction or leakage of information.
c) Process Risk: A process risk can arise at any stage in the value chain
and can result in losses that have been incurred due to a deficiency in an
existing procedure, or the absence of a procedure.

2) Business risk: These are the risks that the bank willingly assumes in
order to create a competitive advantage and add value for shareholders.
Business or operating risk pertains to the product in which bank is operating
in market and includes technological innovations, marketing and product
design.

3) Strategic risk: These are the results from a fundamental shift in economy
or political environment.

4) Legal risk: legal risk arises when a counter party does not have the legal
or regulatory authority to engage in transaction. It can take the form of
share holder law suits against corporations that suffers large losses.

17
5) Country risk: Exposure to a Government or one of its official entities is
essentially a country risk. Exposure to the private sector also contains
varying elements of country risk. Analysis of country risk usually classified
as combination of (a) Economic and (b) Political.

6) Reputation Risk: The risk to capital or earning arising from negative

public opinion. The risk can arise from failure to assess and control
compliance risk and can result in harm to existing or potential business
relationships, damaging litigation, other financial losses.

Indian Banking Scenario

Before the sixties, banks in India were mainly involved in lending to
traders in agricultural commodities and conventional agro-based industries,
like textiles, rice and oil mills, cotton ginning factories etc. Indian Bankers
actively entered the field of industrial finance from the mid-sixties, when a
number of industrial projects were promoted as a result of the then ongoing
process of development planning in India. Industry was state controlled and
state protected from foreign competition through the barrier of high walls
of import tariffs. Protection and lack of competition enabled industry to
face little risk. Thumb rules for financing term loans and working capital
through memorized norms enabled bankers to manage credit assessment,
delivery and monitoring, facing no more than normal risks.
Financial Sector Reforms were initiated as part of the overall
structural reforms aimed at improving the productivity and efficiency of the
economy. The financial sector reforms recognize the fact that the Indian
banking system had over the years grown and that the geographical and
financial coverage of the banking system have been truly impressive.
However, questions have been raised from time to time on the viability of
the banking institutions. Concerns have also been expressed about the
deterioration in the quality of services provided by banks. It is with a view
to finding solutions to these problems that financial sector reforms were
initiated. The broard objective of the reforms has thus been to create a
banking system that is both viable and efficient.
In an attempt to improve the financial health and credibility of
Banks, a major step that has been undertaken has been to introduce
internationally accepted prudential norms relating to income recognition,
asset classification and provisioning and capital adequacy. The origin of the
prescription of capital adequacy norms goes back to the Basel Committee
Report on International Convergence of Capital Measurement and capital
standards published in July 1988. In the early eighties, increased
competition internationally led to a concern over deteriorating capital levels
in international banks and erosion of reasonable risk / return relationship

18
for banking business. Consequently, national authorities in many countries
began to press their banks to improve their capital ratios. The framework
employed by these countries suggested a minimum of eight percent capital
to risk weighted assets ratio, which includes both on and off balance – sheet
items. The aim of this system is to relate capital to the risk of the portfolio
of assets held by a bank. Further, at least four percent risk weighted assets
was to be in the form of pure capital that is equity capital and free reserves.
As all around the world, there were some adverse comments
against prescription of allocation of minimum of eight percent of risk-
weighted assets. It was believed that eight percent norm could not be
12
operated like a ‘one size fits all’ formula . The concerns over the broad
weighting categorizations and the lack of allowance for differences in
quality between borrowers are being met by countries setting individual
target ratios above 8% bank wise where the regulatory perception is that
the bank’s portfolio carries a higher element of risk. Countries are at liberty
to follow a detailed risk weighted model but this could distort comparisons
among banks across countries. The risk weighting categorization was only a
broad brush formula so as not to make it too complicated.
Reserve Bank of India issued guidance note on market risk in 1999
indicating the guidelines on the implementation of the Asset Liability
Management (ALM) system in banks. Additional guidelines were issued in
October 1999, covering contours for management of credit, liquidity,
interest rate, foreign exchange and operational risks. The ALM system laid
down certain minimum requirements which need to be satisfied by every
13
bank such as : formation of risk management committee, responsibilities of
risk taking unit and line management, responsibilities of market risk
manager, handling of entries risk management life cycle, organization set
up.
In year 2001 in order to enhance and fine tune the existing risk
management practices in banks, two working group were constituted in RBI
drawing experts from selected banks and FIs for preparing detailed guidance
not on credit Risk Market Risk Management by banks. In March 2005 the
RBI also had given guidelines for operational risk and different models for
quantification of risks for, market, credit and operational risks.

Reasons for increase in Bank Risks

It is observed that the magnitude of risk faced by the banks is escalating
rapidly over the years since liberalization and deregulation. The following
are the some important reasons for increasing Bank Risk6:
1. Deregulation and financial liberalisation brought in the economy of
most of the countries including our have initiated large scale
disintermediation and flexibility in market.

19
2. Technological developments which have removed the barriers of time
and distance and have unveiled unlimited opportunities for expansion of
business both nationally and internationally have also created a stiff
competitive environment.
3. Globalization has integrated the financial markets and has created
scope for cross-border trade, better avenues for management of risks
associated with fluctuation of market rates and interest rates liquidity as
well as for operational flexibility needed to absorb shocks and to counter
competition from the other players in the market.
4. Commercialization of the banking system in letter and spirit and thrust
on profitability as also on other parameters to ensure better rating under
CAMELS criteria have changed their outlook radically.
5. Limitations of Balance sheet. Items towards generation of income
within the constraints of capital adequacy Norms and Prudential Accounting
standards has necessitated an emphasis on off balance sheet items to earn
handsome income on the one hand and to satisfy the ever growing
demands from the customers on the other.

Banking and Financial sector Reforms

Banking and Financial Sector reforms came to the forefront for
active implementation in 1992-93 after first Report of Narashimham
Committee.

Recommendations of Narasimham Committee I & II:

The regulatory frame work for banks was one area which has seen a
sea – change after the financial reforms. The economic liberalisation and
globalisation measures were introduced in 1992-93. These reforms followed
broadly the approaches suggested by the two Expert Committees. Both the
committees were set up under the chairmanship of Sri. M. Narasimham in
1991 and 1998, the recommendations of which are by now well known. The
underlying theme of both the committees was to enhance the competitive
efficiency and operational flexibility of Indian banks, which would enable
them to meet the global competition as well as to respond in a better way to
the regulatory and supervisory demand arising out of such liberalisation of the
financial sector. Most of the recommendations made by the two expert
committees which continued to be subject matter of close monitory by the
Government of India as well as RBI have been implemented. In view of this
Government of India and RBI have initiated several steps to. a. Strengthen the
banking sector: b. Provide more operational flexibility to banks: c. Enhance
the competitive efficiency of banks, and d. Strengthen the legal frame work
governing operations of banks. In this context, the suggestions prescribed

20
by Narasimham Committee on banking sector reforms and the action taken by
RBI is summarized and presented below:

Committee on Banking Sector Reforms (Narasimham Committee II) -

Action taken on the recommendations
Recommendation Action Taken
Measures to strengthen the banking system:
Capital Adequacy:
1. The Committee suggests that Banks are now required to assign
pending the emergence of markets in capital for market risk. A risk
India where market risks can be weight of 2.5% for market risk has
covered, it would be desirable that been introduced on investments in
capital adequacy requirements take Govt. and other approved securities
into account market risks in addition with effect from the year ending
st
to the credit risks. (Chapter III Para
31 March, 2000. For investments
3.10)
in securities outside SLR, a risk
weight of 2.5% for market risk has
been introduced with effect from
st
the year ending 31 March, 2001.
(Circulars DBOD.No.BP.BC.103
/21.01.002/98 dated 31.10.98 and
121/21.04.124/99-2000 dated
3.11.99).

2. In the next three years, the entire The percentage of banks’portfolio

portfolio of Government securities of Govt. and approved securities
should be marked to market and this which is required to be marked to
schedule of adjustment should be market has progressively been
st
announced at the earliest. It would be
increased. For the year ending 31
appropriate that there should be a
March, 2000, banks were required
5% weight for market risk for Govt.
to mark to market 75% of their
and approved securities. (Chapter III
investments. In order to align the
para 3.11)
Indian accounting standards with
the international best practices and
taking into consideration the
evolving international
developments, the norms for
classification and valuation of
investments have been modified
with effect from September 30,

21
 2000. The entire investment
portfolio of banks is required to be
classified under three categories,
viz., Held to Maturity, Available for
Sale and Held for Trading. While the
securities ‘Held for Trading’ and
‘Available for Sale’ should be
marked to market periodically, the
securities ‘Held to Maturity’, which
should not exceed 25% of total
investments are carried at
acquisition cost unless it is more
than the face value, in which case,
the premium should be amortised
over a period of time. (Circular
DBOD. No
BP.BC.32/21.04.048/2000-2001
dated 16.10.2000. )

3. The risk weight for a Government In cases of Govt. guaranteed

guaranteed advance should be the advances, where the guarantee has
same as for other advances. To been invoked and the concerned
ensure that banks do not suddenly State Govt. has remained in default
face difficulties in meeting the capital as on March 31, 2000, a risk weight
adequacy requirement, the new of 20% on such advances, has been
prescription on risk weight for introduced. State Govts. Who
Government guaranteed advances continue to be in default in respect
should be made prospective from the of such invoked guarantees even
time the new prescription is put in after March 31, 2001, a risk weight
place. (Chapter III para 3.12) of 100% is being assigned.
(Circular DBOD.NO.
BP.BC.103/21.01.002/98 dated
31.10.98)

4. There is an additional capital Risk weight of 100% has been

requirement of 5% of the foreign introduced for foreign exchange
exchange open position limit. Such open position limits with effect from
risks should be integrated into the March 31, 1999. (Circular DBOD.
calculation of risk weighted assets. No. BP. BC.103/21.01.002/98
The Committee recommends that dt.31.10.98)
the foreign exchange open position
limits should carry a 100% risk

22
weight. (Chapter III para 3.13)

5. The Committee believes that it The minimum capital to risk asset

would be appropriate to go beyond ratio (CRAR) for banks has been
the earlier norms and set new and enhanced to 9% with effect from
higher norms for capital adequacy. the year ending March 31, 2000.
The Committee accordingly (Circular
recommends that the minimum DBOD.No.BP.BC.103/21.01.002/98
capital to risk assets ratio be dated 31.10.98).
increased to 10% from its present
level of 8%. It would be appropriate
to phase the increase as was done on
the previous occasion. Accordingly,
the Committee recommends that an
intermediate minimum target of 9%
be achieved by the year 2000 and the
ratio of 10% by 2002.
The RBI should also have the
authority to raise this further in
respect of individual banks if in its
judgement the situation with respect
to their risk profile warrants such an
increase. The issue of individual
banks' shortfalls in the CRAR needs to
be addressed in much the same way
that the discipline of reserve
requirements is now applied, viz., of
uniformity across weak and strong
banks. (Chapter III, para 3.15 –3.16)

6. In respect of PSBs, the additional Banks are permitted to access the

capital requirement will have to come capital market. Till today, 12 banks
from either the Govt. or the market. have already accessed capital
With the many demands on the market.
budget and the continuing
imperative need for fiscal
consolidation, subscription to bank
capital funds cannot be regarded as a
priority claim on budgetary
resources. Those banks which are in a
Position to access the capital market
at home or abroad should, therefore,

23
be encouraged to do so. (Chapter III,
para 3.17)

Asset quality, NPAs and Directed Credit:

7. The Committee recommends that Banks have been advised that an
an asset be classified as doubtful if it asset will be classified as ‘doubtful’if
is in the substandard category for 18 it has remained in the substandard
months in the first instance and category for 18 months instead of
eventually for 12 months and loss if it 24 months as at present, by March
has been so identified but not written 31, 2001. Banks have been
off. These norms, which should be permitted to achieve these norms
regarded as the minimum, may be for additional provisioning in
brought into force in a phased phases, as under : As on 31.3.2001
manner.(Chapter III, para 3.18) Provisioning of not less than 50% on
the assets which have become
doubtful on account of the new
norm.
As on 31.3.2002 Balance of the
provisions not made during the
previous year, in addition to the
provisions needed as on 31.3.2002.
(Circular
DBOD.No.BP.BC.103/21.01.002/98
dt.31.10.98)

8. The Committee has noted that NPA Prudential norms in respect of

figures do not include advances advances guaranteed by State
covered by Government guarantees Governments where guarantee has
which have turned sticky and which been invoked and has remained in
in the absence of such guarantees default for more than two quarters
would have been classified as NPAs. has been introduced in respect of
The Committee is of the view that for advances sanctioned against State
the purposes of evaluating the Government guarantee with effect
quality of asset portfolio such from April 1, 2000. Banks have been
advances should be treated as NPAs. advised to make provisions for
If , however, for reason of the advances guaranteed by State
sovereign guarantee argument such Governments which stood invoked
advances are excluded from as on March 31, 2000, in phases,
computation, the Committee would during the financial years ending
recommend that Government March 31, 2000 to March 31, 2003
guaranteed advances which with a minimum of 25% each year.
otherwise would have been classified (Circular DBOD. No.

24
as NPAs should be separately shown BP.BC.103/21.01.002/98
as an aspect of fuller disclosure and dt.31.10.98).
greater transparency of operations.
(Chapter III, para 3.21)

9. Banks and financial institutions The RBI has reiterated that banks
should avoid the practice of and financial institutions should
"evergreening" by making fresh adhere to the prudential norms on
advances to their troubled asset classification, provisioning,
constituents only with a view to etc. and avoid the practice of
settling interest dues and avoiding “evergreening”.
classification of the loans in question (Cir.DBOD. No. BP.
as NPAs. The Committee notes that BC.103/21.01.002/98 dt.31.10.98)
the regulatory and supervisory
authorities are paying particular
attention to such breaches in the
adherence to the spirit of the NPA
definitions and are taking
appropriate corrective action. At the
same time, it is necessary to resist
the suggestions made from time to
time for a relaxation of the definition
of NPAs and the norms in this regard
(Chapter III, para 3.22)

10. The Committee believes that the This is the long-term objective
objective should be to reduce the which RBI wants to pursue.
average level of net NPAs for all Towards this direction, a number of
banks to below 5% by the year 2000 measures have been taken to arrest
and to 3% by 2002. For those banks the growth of NPAs: banks have
with an international presence the been advised to tone up their credit
minimum objective should be to risk management systems; put in
reduce gross NPAs to 5% and 3% by place a loan review mechanism to
the year 2000 and 2002, respectively, ensure that advances, particularly
and net NPAs to 3% and 0% by these large advances are monitored on an
dates. These targets cannot be on-going basis so that signals of
achieved in the absence of measures weaknesses are detected and
to tackle the problem of backlog of corrective action taken early;
NPAs on a one time basis and the enhance credit appraisal skills of
implementation of strict prudential their staff, etc. In order to ensure
norms and management efficiency to recovery of the stock of NPAs,
prevent the recurrence of this guidelines for one-time settlement

25
problem. (Chapter III, para 3.26) have been issued in July, 2000.

11. The Committee is of the firm Banks have been advised to take
view that in any effort at financial effective steps for reduction of
restructuring in the form of hiving off NPAs and also put in place risk
the NPA portfolio from the books of management systems and practices
the banks or measures to mitigate to prevent re-emergence of fresh
the impact of a high level of NPAs NPAs. (Cir. DBOD. No. BP. BC. 103
must go hand in hand with /21.01.002/98 dated 31.10.1998)
operational restructuring. Cleaning
up the balance sheets of banks would
thus make sence only if
simultaneously steps were taken to
prevent or limit the re-emergence of
new NPAs which could only come
about through a strict application of
prudential norms and managerial
improvement.(Chapter III, para 3.27)

12. For banks with a high NPA The proposal to set up an Asset
portfolio, the Committee suggests Reconstruction Company (ARC) on a
consideration of two alternative pilot basis to take over the NPAs of
approaches to the problem as an the three weak public sector banks,
alternative to the ARF proposal made has been announced in the Union
by the earlier CFS. In the first Budget for 1999 – 2000. The
approach, all loan assets in the modalities for setting up the ARC
doubtful and loss categories - which are being examined.
in any case represent bulk of the
hard core NPAs in most banks, should
be identified and their realisable
value determined. These assets could
be transferred to an Asset
Reconstruction Company (ARC which
would issue to the banks NPA Swap
Bonds representing the realisable
value of the assets transferred,
provided the stamp duties are not
excessive.
The ARC could be set up by one bank
or a set of banks or even in the
private sector. In case the banks
themselves decide to set up an ARC,

26
it would need to be ensured that the
staff required by the ARC is made
available to it by the banks
concerned either on transfer or on
deputation basis, so that staff with
institutional memory on NPAs is
available to ARC and there is also
some rationalisation of staff in the
banks whose assets are sought to be
transferred to the ARC. Funding of
such an ARC could be facilitated by
treating it on par with venture capital
for purpose of tax incentives. Some
other banks may be willing to fund
such assets in effect by securitising
them. This approach would be
worthwhile and workable if stamp
duty rates are minimal and tax
incentives are provided to the
banks.(Chapter III, para 3.28)

13. An alternative approach could be Banks are permitted to issue bonds

to enable the banks in difficulty to for augmenting their Tier II capital.
issue bonds which could form part of Guarantee of the Govt. for these
Tier II capital. This will help the banks bonds is not considered necessary.
to bolster capital adequacy which has
been eroded because of the
provisioning requirements for NPAs.
As the banks in difficulty may find it
difficult to attract subscribers to
bonds. Government will need to
guarantee these instruments which
would then make them eligible for
SLR investments by banks and
approve instruments by LIC, GIC and
Provident Funds (Chapter III, para
3.29 )

14. Directed credit has a The loans to agricultural and SSI

proportionately higher share in NPA sectors are now generally being
portfolio of banks and has been one granted on commercial
of the factors in erosion in the quality considerations and on the basis of

27
of bank assets. There is continuing creditworthiness of the borrower.
need for banks to extend credit to Further, the concessionality on
agriculture and small scale sector interest rates for advances has
which are important segments of the been done away with, except for
national economy, on commercial advances under the DRI Scheme.
considerations and on the basis of While advances upto Rs.2 lakh
creditworthiness. In this process, should carry interest rate not
there is scope for correcting the exceeding PLR, interest rates on
distortions arising out of directed advances of over Rs.2 lakh have
credit and its impact on banks’assets been freed.
quality. (Chapter III, para 3.31)

15. The Committee has noted the As per the present stipulation,
reasons why the Government could banks are required to lend 10% of
not accept the recommendation for net bank credit (NBC) for weaker
reducing the scope of directed credit sections which includes all small and
under priority sector from 40% to marginal farmers, all IRDP and DRI
10%. The Committee recognises that borrowers, borrowers under SUME
the small and marginal farmers and etc. The Committee has
the tiny sector of industry and small recommended that the present
businesses have problems with stipulation may continue.
regard to obtaining credit and some As recommended by the
earmarking may be necessary for this Committee, some activities like
sector. Under the present food processing, related service
dispensation, within the priority activities in agriculture, fisheries,
sector 10% of net bank credit is poultry, dairying have been brought
earmarked for lending to weaker under priority sector.
sections. A major portion of this (Circular RPCD. NO. Plan. BC.
lending is on account of Government 60/04.09.01/ 98-99 dt.28-1-99).
sponsored poverty alleviation and Under the existing dispensation,
employment generation schemes. Units in sectors like food processing,
The Committee recommends that etc., satisfying either the definition
given the special needs of this sector, of SSI [the ceiling of investment in
the current practice may continue. plant and machinery (original cost)
The Branch Managers of banks for a unit being classified under this
should, however, be fully responsible category has since been enhanced
for the identification of beneficiaries to Rs. 3 crore from Rs.60 lakhs /
under the Government sponsored Rs.75 laks for ancillaries and export
credit linked schemes. The oriented units] or small business
Committee proposes that given the are already covered under priority
importance and needs of sector. No further changes are
employment oriented sectors like considered necessary, as larger units

28
food processing and related service need not be given any advantage
activities in agriculture, fisheries, by enlarging the scope of definition
poultry and dairying, these sectors of priority sector advances.
should also be covered under the As a first step towards deregulation
scope of priority sector lending. The of interest rates on credit limits up
Committee recommends that the to R.2 lakh and eliminating interest
interest subsidy element in credit for subsidy element in credit for priority
the priority sector should be totally sector, in the Monetary and Credit
eliminated and even interest rates on Policy announced in April, 1998, it
loans under Rs.2 lakh should be has been stipulated that interest
deregulated for scheduled rates on loans up to Rs.2 lakh
commercial banks as has been done should not exceed PLR as against
in the case of Regional Rural Banks the earlier stipulation of ‘not
and co-operative credit institutions. exceeding 13.5%’, for credit limits of
The Committee believes that it is the Rs.25,000--Rs.2 lakh and 12% for
timely and adequate availability of credit limit up to Rs.25,000. Banks
credit rather than its cost which is are free to decide their PLR subject
material for the intended to their obtaining the prior approval
beneficiaries. The reduction of the of their Boards therefor. As the PLR
pre- empted portion of banks' differs from bank to bank,
resources through the SLR and CRR depending on their cost of funds
would, in any case, enlarge the ability and competitive strategies, the
of banks to dispense credit to these measure is a step towards
sectors. (Chapter III, para 3.32) deregulation of interest rates. Thus
the recommendation of the
Committee has been implemented
in spirit. It may be stated that
except for loans under DRI there is
no subsidisation of interest. (Cir.
MPD.BC.175/07.01.279/97-98
dated
29.4.98)

Prudential Norms and Disclosure Requirements:

16. With regard to income The recommendation of the
recognition, in India, income stops Committee that we should move
accruing when interest or instalment towards international practices in
of principal is not paid within 180 regard to income recognition is
days. The Committee believes that accepted in principle. However,
we should move towards tightening of the prudential norms
international practices in this regard should be made keeping in view the
and recommends the introduction of existing legal framework,

29
the norm of 90 days in a phased production and payment cycles,
manner by the year 2002.(Chapter III, business practices, the predominant
para 3.35) share of agriculture in the country’s
economy, etc. The production and
repayment cycles in the industry in
the country generally involve a
period of not less than from 4 to 6
months. A large number of SSIs also
have difficulties in timely realization
of their bills drawn on the suppliers.
These have to be taken into account
while contemplating any change in
the norm. Implementation of the
recommendation would have
serious implications on the asset
Portfolio of banks and even good
quality borrowers and find it
difficult to comply with the norms
recommended. There have been
representations from banks and
financial institutions seeking
relaxations in the above instructions
by increasing the period to 3-4
quarters. Keeping in view the
current industrial scenario,
implementation of the
recommendation would have
serious implications even to healthy
borrowers. Furthermore, interest
on advances is calculated by banks
at quarterly rests.
Keeping in view the large number
and volume of accounts, if we have
to implement the recommendation,
a few preconditions should be met :
[a] Banks should introduce
calculation of interest at monthly
rests;
[b] There should be 100%
computerization of banks’
operations. Unless 100%
computerization is made, it may not

30
 be feasible to implement the
recommendation ;
[c] It is also necessary to tone up the
legal machinery for speedy disposal
of the collateral taken as security
for the advance. However,
considering the need to bring our
norms in line with the best
international practices, the
recommendations made by the
Committee would be our long term
objective. As the level of gross NPAs
of banks come down because of
better management practices, the
recommendation to introduce the
norm of 90 days will be examined.

17. At present, there is no To start with, a general provision on

requirement in India for a general standard assets of a minimum of
provision on standard assets. In the 0.25% from the year ended March
Committee’s view a general provision, 31, 2000 introduced.
say, of 1% would be appropriate and (Cir.DBOD.
RBI should consider its introduction in No.BP.BC.103/21.01.002/98
a phased manner. (Chapter III, para dt.31.10.98)
3.36)

18. The Committee believes that in Please see comments in respect of

the case of future loans, the income item No.8 above.
recognition and asset classification
and provisioning norms should apply
even to Government guaranteed
advances in the same manner as for
any other advance. For existing
Government guaranteed advances,
RBI, Government and banks may
work out a mechanism for a phased
rectification of the irregularities in
these accounts. (Chapter III, para
3.37)

19. There is a need for disclosure, in a Banks have been advised to disclose
phased manner, of the maturity the following information, in

31
pattern of assets and liabilities, addition to the existing disclosures,
foreign currency assets and liabilities, in the ‘N otes on Accounts’ to the
movements in provision account and balance sheet from the accounting
NPAs. The RBI should direct banks to year ended March 31, 2000.
publish, in addition to financial Maturity pattern of loans and
statements of independent entities, advances, Maturity pattern of
a consolidated balance sheet to investment securities, Foreign
reveal the strength of the group. Full currency assets and liabilities
disclosure would also be required of iv. Movement in NPAs,
connected lending and lending to v. Maturity pattern of deposits
sensitive sectors. Furthermore, it vi. Maturity pattern of borrowings
should also ask banks to disclose vii. Lending to sensitive sectors as
loans given to related companies in defined from time to time
the bank's balance sheets. Full (Cir.DBOD.No.BP.BC.9/21.04.018/99
disclosure of information should not dt.10.2.99)
be only a regulatory requirement. It
would be necessary to enable a
bank’s creditors, investors and rating
agencies to get a true picture of its
functioning– an important
requirement in a market driven
financial sector. (Chapter III, para
3.38)

20. Banks should also pay greater Detailed guidelines issued to banks
attention to asset liability on asset – liability management.
management to avoid mismatches Implementation of these guidelines
and to cover, among others, liquidity would enable banks to avoid
and interest rate risks. (Chapter III, liquidity mismatches as also to
para 3.41). cover, among others, liquidity and
interest rate risks. (Circular.
DBOD.No.BP.BC.8/21.04.098/99
dated 10th February, 1999).

21. Banks should be encouraged to Comprehensive guidelines have

adopt statistical risk management been issued to enable banks to put
techniques like Value-at-Risk in in place appropriate risk
respect of balance sheet items which management systems. Banks have
are susceptible to market price also been advised to adopt
fluctuations, forex rate volatility and statistical risk management
interest rate changes. While the techniques like Value-at-Risk (which
Reserve Bank may initially, prescribe is a statistical method of assessing

32
certain normative models for market the potential maximum loss from a
risk management, the ultimate credit or investment exposure, over
objective should be that of banks a definite holding period at a given
building up their own models and RBI confidence level) or other models
backtesting them for their validity on appropriate to their level of
a periodical basis.(Chapter III, para business operation. (Circular. DBOD.
3.41 –3.42) No. BP.BC
98/21.04.103/99 dated 7.10.99)

Systems and Methods in Banks :

22. Banks should bring out revised Banks have been advised to bring
Operational Manuals and update out revised Operative Manuals and
them regularly, keeping in view the update them regularly. Banks have
emerging needs and ensure confirmed having brought out
adherence to the instructions so that revised Manuals. (Circular. DBOD.
these operations are conducted in the No.BP.BC.29/21.01.023/98-99 dt.
best interest of a bank and with a 16.4.99)
view to promoting good customer
service. These should form the basic
objective of internal control systems,
the major components of which are :
(I) Internal Inspection and Audit,
including concurrent audit,
(2) Submission of Control Returns by
branches/controlling offices to higher
level offices
(3) Visits by controlling officials to
the field level offices
(4) Risk management systems
(5) Simplification of documentation,
procedure and of inter office
communication channels.(Chapter IV,
para 4.3)

23. An area requiring close scrutiny Banks have been advised to set up
in the coming years would be EDP Audit Cell, as part of their
computer audit, in view of large Inspection Department.
scale usage and reliance on (Circular DBS. No. CO
information technology (Chapter IV, PP.BC.55/11.01.005/
para (4.7) 98-99 dated 19.6.99).

33
24. There is enough international RBI had in 1992 emphasised to
experience to show the dangers to an banks the importance of an
institution arising out of inadequate effective management reporting
reporting to and checking by the back system, segregation of the trading
offices of trading transactions and and back office functions, etc. The
positions taken. Banks should pay efficacy of the systems put in place
special attention to this aspect by banks is being constantly
(Chapter IV, para 4.8). reviewed by the RBI through
periodical inspections.
(Circular DBOD. No. FSC. BC. 143A/
24.48.001/91-92 dt.20.6.92)

25. There is need to institute an Banks have been advised to put in

independent loan review mechanism place an independent Loan Review
especially for large borrowal Mechanism, as recommended by
accounts and systems to identify the Committee.
potential NPAs. It would be desirable (Cir.
that banks evolve a filtering DBOD.No.BP.BC.103/21.01.002/98
mechanism by stipulating in-house dated 31.10.98).
prudential limits beyond which
exposures on single/group
borrowers are taken keeping in view
their risk profile as revealed through
credit rating and other relevant
factors. Further, in-house limits could
be thought of to limit the
concentration of large exposures and
industry/sector/geographical
exposures within the Board approved
exposure limits and proper
overseeing of these by the senior
management/ boards. (Chapter IV,
para 4.12 –4.16)

26. The Committee feels that the The recommendation was put up
present practice of RBI selection of before the Audit Sub-Committee of
statutory auditors for banks with the Board for Financial Supervision
Board of Directors having no role in which was of the view that the
the appointment process is not existing practice should continue.
conducive to sound corporate
governance. We would recommend
that the RBI may review the existing

34
practice in this regard. It may also
reassess the role and function of the
Standing Advisory Committee on
Bank Audit in the light of the setting
up of the Audit Committee under the
aegis of the Board for Financial
Supervision.(Chapter IV, para 4.19)

27. The Committee notes that public The public sector banks have been
sector banks and financial permitted to recruit from the open
institutions have yet to introduce a market or by way of campus
system of recruiting skilled recruitment, skilled personnel in
manpower from the open market. areas like information technology,
The Committee believes that this risk management, treasury
delay has had an impact on the operations, etc.
competency levels of public sector As regards the recommendation in
banks in some areas and they have regard to discontinuing the practice
consequently lost some ground to of recruitment of officers through
foreign banks and the newly set up Banking Services Recruitment
private sector banks. The Committee Boards, Govt. May furnish
urges that this aspect be given urgent comments.
consideration and in case there
areany extant policy driven
impediments to introducing this
system, appropriate steps be taken
by the authorities towards the
needed deregulation. Banks have to
tone up their skills base by resorting,
on an ongoing basis, to lateral
induction of experienced and skilled
personnel, particularly for quick entry
into new activity/areas. The
Committee notes that there has been
considerable decline in the scale of
merit-based recruitment even at the
entry level in many banks. The
concept of direct recruitment itself
has been considerably diluted by
many PSBs including the State Bank
of India by counting internal
promotions to the trainee officers'
cadre as direct recruitment. The

35
Committee would strongly urge the
managements of public sector banks
to take steps to reverse this trend.
The CFS had recommended that
there was no need for continuing
with the Banking Service Recruitment
Boards insofar as recruitment of
officers was concerned. This
Committee, upon examination of the
issue, reaffirms that
recommendation. As for recruitment
in the clerical cadre, the Committee
recommends that a beginning be
made in this regard by permitting
three or four large. Well-performing
banks, including State Bank of India,
to set up their own recruitment
machinery for recruiting clerical staff.
If the experience under this new
arrangement proves satisfactory, it
could then pave the way for
eventually doing away completely
with the Banking Service Recruitment
Boards.(Chapter IV, para 4.21 – 4.23)

28. It seems apparent that there are While some of the public sector
varying levels of overmanning in banks have introduced VRS after
public sector banks. The consultations with Employees’
managements of individual banks Unions, others are in the process of
must initiate steps to measure what introducing such schemes.
adjustments in the size of their work
force is necessary for the banks to
remain efficient, competitive and
viable. Surplus staff, where identified,
would need to be redeployed on new
business and activities, where
necessary after suitable retraining. It
is possible that even after this some
of the excess staff may not be
suitable for redeployment on grounds
of aptitude and mobility. It will,
therefore, be necessary to introduce

36
an appropriate Voluntary Retirement
Scheme with incentives. The
managements of banks would need
to initiate dialogue in this area with
representatives of labour. (Chapter
IV, para 4.5 & 4.24).

29. The Committee would urge the Banks have been advised to review
managements of Indian banks to the training needs and give more
review the changing training needs in focus to emerging areas like Credit
individual banks keeping in mind Management, Treasury
their own business environment and Management, Risk Management,
to address these urgently. (Chapter Information Technology, etc.
IV, para 4.32) (Circular
DBOD.No.BP.BC.103/21.01.002/98
dated 31.10.1998).

30. Globally, banking and financial A Working Group was set up with
systems have undergone representation from public sector
fundamental changes because of the banks, technology experts, to
ongoing revolution in information operationalise and implement the
and communications technology. programme of computerisation for
Information technology and banks within a definite time frame.
electronic funds transfer systems All the recommendations of Group
have emerged as the twin pillars of have been accepted for
modern banking development. This implementation.
phenomenon has largely bypassed In pursuance of the
the Indian banking system although recommendations of the Working
most technologies that could be Group, the Indian Financial Network
considered suitable for India have (INFINET), a wide area Satellite
been introduced in some diluted based network using VSAT
form. The Committee feels that technology has been commissioned
th
requisite success in this area has not
on 24 June, 1999 at IDRBT,
been achieved because of the
Hyderabad which will connect bank
following reasons:
branches and RBI Offices in a
Inadequate bank automation.
phased manner.
Not so strong commercially oriented
The development of the Payment
inter-bank platform.
System Generic Architecture Model
Lack of a planned, standardised,
for both domestic and cross-border
electronic payment systems
payments has been undertaken.
backbone. Inadequate telecom
A consultant has been appointed to
infrastructure. Inadequate marketing

37
effort. assist in the implementation of the
Lack of clarity and certainty on legal RTGS. Progress is also being made
issues and Lack of data warehousing towards developing standards for
network. newer payment instruments such as
The Committee has tried to list out Smart Cards.
series of implementation steps for Three standing Committees to
achieving rapid induction of review security policies, message
information technology in the formats, software, to examine legal
banking system. Further, information issues on electronic banking and to
and control systems need to be monitor progress of
developed in several areas like Better computerization of branches of
tracking of spreads, costs and NPAs banks handling Govt. transactions
for higher profitability. Accurate and have been formed. Public Sector
timely information for strategic Banks have been advised to report
decisions to identify and promote technology progress on 20 short-
profitable products and customers. listed action points.
Risk and Asset-Liability management;
and Efficient Treasury management.
(Chapter IV, para 4.66 & 4.70)

Structural Issues :
31. The Committee has taken note of Based on the recommendations of
the twin phenomena of consolidation the Khan Working Group on
and convergence which the financial Harmonisation of the Role and
system is now experiencing globally. Operations of banks and DFIs, RBI
In India also banks and DFIs are had released a Discussion Paper in
moving closer to each other in the January, 1999 for wider public
scope of their activities. The debate. The feedback on the
Committee is of the view that with discussion paper indicated that
such convergence of activities while universal banking is desirable
between banks and DFIs, the DFIs from the point of view of efficiency
should, over a period of time, convert of resource use, there is need for
themselves to banks. There would caution in moving towards such a
then be only two forms of system by banks and DFIs. Major
intermediaries, viz. banking areas requiring attention are the
companies and non-banking finance status of financial sector reforms,
companies. If a DFI does not acquire the state of preparedness of
a banking licence within a stipulated concerned institutions, the
time it would be categorised as a evolution of regulatory-regime and
non-banking finance company. A DFI above all a viable transition path for
which converts to a bank can be institutions which are desirous of
given some time to phase in reserve moving in the direction of universal

38
requirements in respect of its banking. The Monetary and Credit
liabilities to bring it on par with the Policy for the year 2000 –2001
requirements relating to commercial proposed to adopt the following
banks. Similarly, as long as a system broad approach for considering
of directed credit is in vogue a proposals in this area :
formula should be worked out to. The principle of “Universal Banking”
extend this to DFIs which have is a desirable goal and some
become banks (Chapter V, para 5.6). progress has already been made by
permitting banks to diversify into
investments and lo ng-term
financing and the DFIs to lend for
working capital, etc. However,
banks have certain special
characteristics and as such any
dilution of RBI’s prudential and
supervisory norms for conduct of
banking business would be
inadvisable. Further, any
conglomerate, in which a bank is
present, should be subject to a
consolidated approach to
supervision and regulation.
b. Any DFI, which wishes to do so,
should have the option to transform
into bank (which it can exercise),
provided the prudential norms as
applicable to banks are fully
satisfied. To this end, a DFI would
need to prepare a transition path in
order to fully comply with the
regulatory requirement of a bank.
The DFI concerned may consult RBI
for such transition arrangements.
Reserve Bank will consider such
requests on a case by case basis.
(Circular
MPD.BC.196/07.01.279/99-
2000 dt. 27.4.2000)

32. Mergers between banks and The recommendation has been

between banks and DFIs and NBFCs noted. A non- banking finance
need to be based on synergies and company has since been permitted

39
locational and business specific to merge with a bank. Two banks
complimentarities of the concerned in the private sector have also
institutions and must obviously make merged based on synergies and
sound commercial sense. Mergers of business specific
public sector banks should emanate complementarities.
from management of banks with
Govt. as the common shareholder
playing a supportive role. Such
mergers, however, can be worthwhile
if they lead to rationalisation of
workforce and branch network;
otherwise the mergers of public
sector banks would tie down the
managements with operational
issues and distract attention from the
real issue. It would be necessary to
evolve policies aimed at "rightsizing"
and redeployment of the surplus staff
either by way of retraining them and
giving them appropriate alternate
employment or by introducing a VRS
with appropriate incentives. This
would necessitate the co- operation
and understanding of the employees
and towards this direction,
managements should initiate
discussions with the representatives
of staff and would need to convince
their employees about the intrinsic
soundness of the idea, the
competitive benefits that would
accrue and the scope and potential
for employees' own professional
advancement in a larger institution.
Mergers should not be seen as a
means of bailing out weak banks.
Mergers between strong banks/FIs
would make for greater economic
and commercial sense and would be
a case where the whole is greater
than the sum of its parts and have a
"force multiplier effect".(Chapter V,

40
para 5.13 – 5.15)

33. A ‘weak bank’ should be one In addition to the two definitions

whose accumulated losses and net for identifying ‘w eak’ banks
NPAs exceed its net worth or one recommended by the Committee,
whose operating profits less its RBI monitors banks to identify
income on recapitalisation bonds is ‘potential weakness’ on the basis of
negative for three consecutive years. five more parameters (related to
A case by case examination of the solvency, profitability and earnings)
weak banks should be undertaken to as recommended by the Working
identify those which are potentially Group on Restructuring of Weak
revivable with a programme of Public Sector Banks (Chairman : Shri
financial and operational M.S.Verma ).
restructuring. Such banks could be In respect of weak banks, a bank-
nurtured into healthy units by specific restructuring programme
slowing down on expansion, aimed at turning around the bank
eschewing high cost by reducing their cost of operation,
funds/borrowings, judicious and improving income levels, has
manpower deployment, recovery been put in place.
initiatives, containment of
expenditure etc. The future set up of The recommendation for setting up
such banks should also be given due of a Restructuring Commission has
consideration. Merger could be a not been considered. However, the
solution to the problem of weak Union Budget for 2000 – 2001 has
banks but only after cleaning up their proposed setting up of a Financial
balance sheets. If there is no Restructuring Authority for a weak
voluntary response to a takeover of or potentially weak bank.
these banks, it may be desirable to
think in terms of a Restructuring
Commission for such public sector
banks for consideringother options
including restructuring, merger
amalgamation or failing these
closures. Sucha Commission could
have terms of reference which, inter
alia, should include suggestion of
measures to safeguard the interest of
depositors and employees and to
deal with possible negative
externalities. Weak banks which on a
careful examination are not capable
of revival over a period of three years

41
should be referred to the
Commission.
(Chapter V, para 5.16 –5.18)

34. The policy of licensing new The policy of licensing new banks in
private banks (other than local area the private sector has been
banks) may continue. The start up reviewed by an in- house Working
capital requirements of Rs.100 crore Group set up by RBI. Based on the
were set in 1993 and these may be recommendations of the Working
reviewed. The Committee would Group, the licensing policy is being
recommend that there should be well revised.
defined criteria and a transparent
mechanism for deciding the ability of
promoters to professionally manage
the banks and no category should be
excluded on a priori grounds. The
question of a minimum threshold
capital for old private banks also
deserves attention and mergers could
be one of the options available for
reaching the required capital
thresholds. The Committee would
also, in this connection, suggest that
as long as it is laid down (as now)
that any particular promoter group
cannot hold more than 40% of the
equity of a bank, any further
restriction of voting rights by limiting
it to 10% may be done away with.
(Chapter V, para 5.20)

35. The Committee is of the view that The recommendation has been
foreign banks may be allowed to set examined. It has been felt that
up subsidiaries or joint ventures in branch presence by foreign banks
India. Such subsidiaries or joint would be better for the reason that
ventures should be treated on par the parent bank would stand ready
with other private banks and subject to support the branch in times of
to the same conditions with regard to distress. Since subsidiaries would be
branches and directed credit as these set up as a joint stock companies
banks (Chapter V, para 5.21) . with limited liability, the parent
bank’s liability to its subsidiary
would be limited to its shareholding.

42
 In the case of branches, the parent
bank has responsibility both
towards capital and management
whereas in the case of subsidiaries,
the parent bank’s responsibility
towards capital is limited.

36. All NBFCs are statutorily required In respect of new NBFCs, which
to have a minimum net worth of seek registration with the RBI and
Rs.25 lakhs if they are to be commence the business on or after
registered. The Committee is of the April 20,1999 the criteria in regard
view that this minimum figure should to minimum net worth has been
be progressively enhanced to Rs.2 increased to Rs.2 crore, vide the
crores which is permissible now Monetary and Credit Policy for the
under the statute and that in the first year 1999-2000. (Circular
instance it should be raised to Rs.50 MPD.BC.185/07.01.279/98-99
th
lakhs. (Chapter V, para 5.36)
Dated 20 April, 1999).

37. Deposit insurance for NBFCs could The recommendation on not

blur the distinction between banks, providing insurance cover for
which are much more closely deposits with NBFCs has been
regulated, and the non banks as far noted.
as safety of deposit is concerned and
consequently lead to a serious moral
hazard problem and adverse portfolio
selection. The Committee would
advise against any insurance of
deposits with NBFCs.(Chapter V, para
5.38)

38. RBI should undertake a review of The norms with regard to minimum
the current entry norms for urban capital requirements for urban
cooperative banks and prescribe cooperative banks (UCBs) have
st
revised prudent minimum capital
been revised with effect from 1
norms for these banks. Though
April, 1998. Implementation of this
cooperation is a state subject, since
recommendation on doing away
UCBs are primarily credit institutions
with duality of control over UCBs
meant to be run on commercial lines,
would involve amendments to
the Committee recommends that this
State Cooperative Societies Acts.
duality in control should be dispensed
The Government therefore, has to
with. It should be primarily the task
consider.

43
of the Board of Financial Supervision
to set up regulatory standards for
Urban Cooperative Banks and ensure
compliance with these standards
through the instrumentality of
supervision. (Chapter V, para 5.39)

39. The Committee is of the view This has been accepted for
that there is need for a reform of the implementation. The Working
deposit insurance scheme. In India, Group on Deposit Insurance
deposits are insured upto Rs.1 lakh. appointed by RBI has recommended
There is no need to increase the the modalities for switching over to
amount further. There is, however, ‘risk based’ premium for deposit
need to shift away from the 'flat' rate insurance and the
premiums to 'risk based' or 'variable recommendations are under
rate' premiums. examination.
Under risk based premium system all
banks would not be charged a
uniform premium. While there can be
a minimum flat rate which will have
to be paid by all banks on all their
customer deposits, institutions which
have riskier porfolios or which have
lower ratings should pay higher
premium. There would thus be a
graded premium. As the Reserve
Bank is now awarding CAMELS
ratings to banks, these ratings could
form the basis for charging deposit
insurance premium. (Chapter V, para
5.42)

40. The Committee is of the view that The phasing out of non-bank
the inter-bank call and notice money participants from inter-bank
market and inter-bank term money Call/Notice Money market will be
market should be strictly restricted synchronized with the development
to banks. The only exception should of repo market. Keeping in view
be the primary dealers who, in a this objective, RBI has widened the
sense, perform a key function of scope of repo market to include all
equilibrating the call money market entities having SGL Account and
and are formally treated as banks for Current Account in Mumbai, thus
the purpose of their inter-bank increasing the number of eligible

44
transactions. All the other present non-bank entities to 64. Further,
non-bank participants in theinter- the permission given to non-bank
bank call money market should not entities to lend in the call/notice
be provided access to the inter-bank money market by routing their
call money market. These operations through PDs has been
institutions could be provided access extended upto June, 2001. RBI aims
to the money market through to move towards a pure inter- bank
different segments.(Chapter V, (including PDs) call/notice money
Annexure para A7) market. With a view to further
deepening the mo ney market and
enable banks, PDs and AIFIs to
hedge interest rate risk, these
entities are allowed to undertake
FRA/IRSs as a product for their own
balance sheet management and for
market making purposes. Mutual
Funds, in addition to corporates are
also permitted to undertake
FRAs/IRSs with these players. This
measure is, inter alia, expected to
help development of a term mo ney
market.

41. There must be clearly defined RBI has advised banks to put in
prudent limits beyond which banks place comprehensive ALM System
should not be allowed to rely on the with effect from 1.4.1999. ALM
call money market. This would reduce would effectively put a cap on
the problem of vulnerability of reliance on call money market.
chronic borrowers. Access to the call Detailed Risk Management
market should be essentially for Guidelines have also been issued
meeting unforeseen swings and not vide circular DBOD No.
th
as a regular means of financing
BP.BC.98/21.04.103/99 dated 7
banks’ lending operations (Chapter
Oct. 1999.
V, Annexure, para A8).

42. The RBI support to the market The ILAF (Interim Liquidity
should be through a Liquidity Adjustment Facility) introduced
Adjustment Facility under which the earlier has served its purpose as a
RBI would periodically, if necessary transitional measure for providing
daily reset its Repo and Reverse Repo reasonable access to liquid funds at
rates which would in a sense provide set rates of interest. In view of the
a reasonable corridor for market experience gained in operating the

45
play. While there is much merit in an interim scheme last year, an
inter-bank reference rate like a Internal Group was set up by RBI to
LIBOR, such a reference rate would consider further steps to be taken.
emerge as banks implement sound Following the recommendation of
liquidity management facilities and the Internal Group, it was
the other suggestions made above announced in the Monetary and
are implemented. Such a rate cannot Credit Policy Measures in April,
be anointed, as it has to earn its 2000 to proceed with the
position in the market by being a implementation of a full-fledged
fairly stable rate which signals small LAF. The new scheme will be
discrete interest rate changes to the introduced progressively in
rest of the system. (Chapter V, convenient stages in order to
Annexure para A8). ensure smooth transition.
In the first stage, with effect from
June 5, 2000, the Additional CLF and
level II support to PDs will be
replaced by variable rate repo
auctions with same day settlement.
In the second stage, the effective
date for which will be decided in
consultation with banks and PDs,
CLF and level I liquidity support will
also be replaced by variable rate
repo auctions. Some minimum
liquidity support to PDs will be
continued but at interest rate linked
to variable rate in the daily repos
auctions as determined by RBI from
time to time. With full
computerisation of Public Debt
Office (PDO) and introduction of
RTGS expected to be in place by the
end of the current year, in the third
stage, repo operations through
electronic transfers will be
introduced. In the final stage, it will
be possible to operate LAF at
different timings of the same day.
(Cir. MPD.BC. 196/07.01.279/99-
2000 dated
27.4.2000)

46
43. The minimum period of FD be The minimum maturity of CDs has
reduced to 15 days and all money been reduced to 15 days, vide
market instruments should likewise circular DBOD. No. BP. BC.
have a similar reduced minimum 169/21.01.002/2000 dated
duration.(Chapter V, Annexure para 3.5.2000.
A9)

44. Foreign institutional investors FIIs have been permitted to invest

should be given access to the in Treasury Bills, vide Monetary and
Treasury Bill market. Broadening the Credit Policy announced in April
market by increasing the participants 1998.
would provide depth to the market (Cir. MPD.BC. 175/07.01.279/97-98
(Chapter V, Annexure para A 10) dated
29.4.98).

45. With the progressive expansion With effect from June 11, 1998
of the forward exchange market, Foreign Institutional investors were
there should be an endeavour to permitted to take forward cover
integrate the forward exchange from Authorised Dealers to the
market with the spot forex market by extent of 15 per cent of their
allowing all participants in the spot existing investment as on that date.
forex market to participate in the Any incremental investment over
forward market upto their the level prevailing on June 11,
exposures. Furthermore, the forex 1998 was also made eligible for
market, the money market and the forward cover. The Monetary and
securities should be allowed to Credit Policy for 1999-2000 has
integrate and the forward premia further simplified the procedure by
should reflect the interest rate linking the above mentioned limits
differential. As instruments move in to FIIs’ outstanding investments as
tandem in these markets the on March 31, 1999. In other words,
desiderative of a seamless and 15 per cent of outstanding
vibrant financial market would investment on March 31, 1999 as
hopefully emerge (Chapter V, well as the entire amount – 100 per
Annexure para A 11). cent - of any additional investment
made after this date will be eligible
for forward cover. Further, any FII
which has exhausted the limits
mentioned above can apply to RBI
for additional forward cover for a
further 15 per cent of their
outstanding investments in India at
the end of March 1999.

47
Rural and Small Industrial Credit :
46. The Committee also recommends In the event of adverse agro-climatic
that a distinction be made between and environmental factors, covering
NPAs arising out of client specific and all natural calamities, outstanding
institution specific reasons and loans are
general (agro-climatic and converted/rescheduled/rephrased
environmental issues) factors. While suitably. Agricultural advances so
there should be no concession in rescheduled are provided relief for
treatment of NPAs arising from client NPA classification. The decision to
specific reasons, any decision to declare a particular crop or product
declare a particular crop or product or a particular region as distress hit
or a particular region to be distress is at present vested in the
hit should be taken purely on techno- concerned District Administration
economic consideration by a Authority and the desirability of
technical body like NABARD.(Chapter consulting NABARD which is the
VI, para 6.6) technical body, before taking the
decision, would be examined.

47. As a measure of improving the The recommendation of the

efficiency and imparting a measure of Committee, which basically aims at
flexibility the committee recommends ensuring that the target for priority
consideration of the debt sector lending is achieved by each of
securitisation concept within the the banks, has been re-examined.
priority sector. This could enable As of March 2000, all public sector
banks, which are not able to reach banks with the exception of UCO
the priority sector target to purchase Bank have achieved the priority
the debt from the institutions, which sector lending target individually
are able to lend beyond their and the public sector banks as a
mandated percentage.(Chapter VI, Group has exceeded the target at
para(6.8) the macro- level. The UCO Bank is
short of achievement only
marginally.
Furthermore, every year the Govt.
has been setting up a Rural
Infrastructure Development
Fund(RIDF) in which all banks which
do not achieve the priority sector
target contribute the amount of
shortfall. Thus all banks, directly or
indirectly are able to fulfill the
priority sector lending targets.
Though the concept of debt

48
 securitisation is a novel idea, it will
not have any practical application
since it will not help in augmenting
the flow of credit to the priority
sector nor will it help in addressing
the question of regional imbalances.
It has, therefore, been decided that
the recommendation need not be
considered for the present.

48. Banking policy should facilitate In principle approval has been

the evolution and growth of micro granted for setting up of 10 Local
credit institutions including LABs Area Banks (LABs). Out of these, on
which focus on agriculture, tiny and account of non-compliance with the
small scale industries promoted by terms and conditions, the ‘in
NGOs for meeting the banking needs principle’ approvals given to 4
of the poor. Third-tier banks should banks were withdrawn. Of the
be promoted and strengthened to be remaining, 4 LABs have already
autonomous, vibrant, effective and started functioning after obtaining
competitive in their licences under Section 22 of
operations.(Chapter VI, para 6.16) Banking Regulation Act, 1949.

49. Banks should devise appropriate 48 recommendations of the S.L.

criteria suited to the small industrial Kapur Committee conveyed to
sector and be responsive to its banks for implementation. As a
genuine credit needs but this should further impetus to the flow of
not be by sacrificing cannons of credit, banks have been advised
sound banking. Borrowers also need that the credit requirement of SSIs
to accept credit discipline. There is having credit limits upto Rs.5 crore,
also need to review the present instead of Rs.4 crore, may be
institutional set up of state level assessed on the basis of 20% of the
financial/industrial development projected annual turnover.
institutions.(Chapter VI, para 6.19).

Regulation and Supervision :

50. The Committee recommends that Banks are now required to assign
to improve the soundness and capital for market risk.
stability of the Indian banking Please see comments against item 1
system, the regulatory authorities above.
should make it obligatory for banks As indicated against item 19 above,
to take into account risk weights for the disclosure requirements of
market risks. The movement towards banks have been strengthened.

49
greater market discipline in a sense
would transform the relationship
between banks and the regulator. By
requiring greater internal controls,
transparency and market discipline,
the supervisory burden itself would
be relatively lighter.(Chapter VII, para
7.13)

51. There is a need for all market We have endorsed the ‘Core
participants to take note of the core Principles for Effective Banking
principles and to formally announce Supervision’ and complied with
full accession to these principles and almost all of them. Our compliance
their full and effective with the Core Principles has been
implementation.(Chapter VII, para rated as satisfactory by IMF Mission.
7.14)

52. Proprietorial concerns in the case The prudential / regulatory norms

of public sector banks impact on the stipulated by RBI are applicable to
regulatory function leading to a public sector banks, private sector
situation of ‘regulatory capture’ banks and foreign banks uniformly.
affecting the quality of
regulation.(Chapter VII, para 7.16)

53. The Committee recommends that The Regulatory / Supervisory norms

the regulatory and supervisory have been formulated taking into
authorities should take note of the account the best international
developments taking place elsewhere practices. RBI has not waived
in the area of devising effective adherence to the regulatory norms
regulatory norms and to apply them by any individual bank or category
in India taking into account the of banks.
special characteristics but not in
any way diluting the rigour of the
norms so that the prescriptions
match the best practices abroad. It is
equally important to recognise
that pleas for regulatory forbearance
such as waiving adherence to the
regulations to enable some (weak)
banks more time to overcome their
deficiencies could only compound
their problems for the future and

50
further emasculate their balance
sheets.(Chapter VII, para 7.17)

54. An important aspect of We are moving towards greater

regulatory concern should be transparency and Statutory Auditors
ensuring transparency and credibility of banks are now under the
particularly as we move into a more obligation to report on the
market driven system where the deviations from adherence to the
market should be enabled to form its prudential norms prescribed by RBI
judgement about the soundness of in their ‘Notes to Accounts’. These
an institution. There should be observations are followed up by the
punitive penalties both for the RBI with the concerned banks. In
inaccurate reporting to the supervisor terms of the provisions of Section
or inaccurate disclosures to the public 47A of the B.R. Act, 1949, as
and transgressions in spirit of the amended in 1994, the RBI can
regulations.(Chapter VII, para 7.19). impose a penalty not exceeding Rs.
5 lakh or twice the amount involved
in such contravention or default
where such amount is quantifiable
whichever is more and where such
contravention or default is a
continuing one, a further penalty
which may extent to Rs. 25,000 for
every day after the first day when
the contravention or default
continues.

55. The Committee is of the view that - dbs -

banks should be required to publish
half yearly disclosure requirements in
two parts. The first should be
ageneral disclosure, providing a
summary of performance over a
period of time, say 3 years, including
the overall performance, capital
adequacy, information on the bank’s
risk management systems, the credit
rating and any action by the
regulator/supervisor. The disclosure
statement should be subject to full
external audit and any falsification
should invite criminal procedures. The

51
second disclosure, which would be a
brief summary aimed at the ordinary
depositor/ investor should provide
brief information on matters such as
capital adequacy ratio, non
performing assets and profitability,
vis-à-vis, the adherence to the
stipulated norms and a comparison
with the industry average. This
summary should be in a language
intelligible to the depositor and be
approved by the supervisors before
being made fully public when
soliciting deposits. Such disclosure,
the Committee believes, will help the
strong banks to grow faster than the
weaker banks and thus lead to
systematic improvement.(Chapter
VII, para 7.20)

56. The Committee recommends that BFS needs to be strengthened

an integrated system of regulation before regulatory functions are
and supervision be put in place to vested with it. It was, therefore, felt
regulate and supervise the activities that while the Committee’s
of banks, financial institutions and recommendations to set up an
non banking finance companies agency named Board for Financial
(NBFCs). The functions of regulation Regulation and Supervision (BFRS)
and supervision are organically linked to provide an integrated system of
and we propose that this agency be regulation and supervision over
renamed as the Board for Financial banks, FIs and NBFCs could be a
Regulation and Supervision (BFRS) to long term objective. For the time
make this combination of functions being, BFS may continue with its
explicit. An independent regulatory present mandate.
supervisory system which provides for
a closely coordinated monetary policy
and banking supervision would be the
ideal to work towards.(Chapter VII,
para 7.24).

57. The Board for Financial Please see comments against item
Regulation and Supervision (BFRS) 56 above.
should be given statutory powers and

52
be reconstituted in such a way as to
be composed of professionals. At
present, the professional inputs are
largely available in an advisory board
which acts as a distinct entity
supporting the BFS.
Statutory amendment which would
give the necessary powers to the
BFRS should develop its own
autonomous professional character.
The Committee, taking note of the
formation of BFS, recommends that
the process of separating it from the
Reserve Bank qua central bank
should begin and the Board should be
invested with requisite autonomy and
armed with necessary powers so as
to allow it to develop experience and
professional expertise and to function
effectively. However, with a view to
retain an organic linkage with RBI,
the Governor, RBI should be head of
the BFRS. The Committee has also
set out specific measures to ensure
an effective regulatory/supervisory
system which are detailed in para
7.27 (Chapter VII, para 7.24)

Legal and Legislative Framework :

58. With the advent of The Group set up by the RBI has
computerisation there is need for submitted its Report and the
clarity in the law regarding the recommendations are in various
evidentiary value of computer stages of implementation.
generated documents. The Shere
Committee had made some
recommendations in this regard and
the Committee notes that the
Government is having consultations
with public sector banks in this
matter. With electronic funds
transfer several issues regarding
authentication of payment

53
instruments, etc. require to be
clarified. The Committee
recommends that a group be
constituted by the Reserve Bank to
work out the detailed proposals in
this regard and implement them in a
time bound manner.
(Chapter VIII, para. 8.15 8.16)

59. Although there is a provision in As the Committee has noted,

our legislation effectively prohibiting Section 20 of the Banking
loans by banks to companies in Regulation Act, 1949 prohibits banks
which their directors are interested from entering into any commitment
as directors or employees of the for granting of any loan or advance
latter with liberalisation and the to or on behalf of any of its
emergence of more banks on the directors, any firm in which any of
scene and with the induction of its directors is interested as partner,
private capital through public issue manager, employee or guarantor or
in some of the nationalised banks any company of which any of the
there is a possibility that the directors of the banking company is
phenomenon of connected lending a director, managing agent,
might reappear even while adhering manager, employee, or guarantor or
to the letter of law. It is necessary in which he holds substantial
to have prudential norms which are interest or, any individual in respect
addressed to this problem by of whom any of its directors is a
stipulating concentration ratios in partner or guarantor.
terms of which no bank can have
more than a specified proportion of The RBI has, as noted by the
its net worth by way of lending to Committee, laid down prudential
any single industrial concern and a ceilings on exposures to single /
higher percentage in respect of group of borrowers.
lending to an industrial group. At
present, lending to any single Banks on their own, have also
concern is limited to 25% of a bank’s prescribed exposure ceilings on
capital and free reserves. This would single borrower and group of
seem to be appropriate along with borrowers. As regards the
the existing enhanced figure of 50% recommendation that prudential
for group exposure except in the norms be set by way of prescription
case of specified infrastructure of exposure limits to sensitive
projects. Similarly, concentration sectors, i.e. those sectors where
ratios would need to be indicated, asset prices are subject to
even if not specifically prescribed, in fluctuations, RBI has already put in

54
respect of any bank’s exposure to place a cap on a bank’s exposure to
any particular industrial sector so share market. The banks on their
that in the event of cyclical or other own have limited their exposure to
changes in the industrial situation, real estate business. Banks are
banks have an element of protection expected to set norms for lending
from over exposure in that sector. to any particular industrial sector in
Prudential norms would also need to their lending policy. Banks have
be set by way of prescription of been advised to disclose in ‘Notes
exposure limits to sectors particularly on Account’to their balance sheets,
sensitive to asset price fluctuations lending to sensitive sectors, (i.e.,
such as stock markets and real advances to sectors such as, capital
estate. As it happens, Indian banks market, real estate, etc.) and such
do not have much exposure to the other sectors to be defined as
real estate sector in the form of ‘sensitive’by RBI from time to time
lending for property development as with effect from the year ended
distinct from making housing loans. March 31, 2000.
The example of banks in East and (Cir. BOD.No.BP.BC.9/21.04.018/99
South East Asia which had over dt.10 February, 1999).
extended themselves to these two
sectors has only confirmed the need
for circumspection in this regard. We
would leave the precise stipulation of
these limits and, if necessary, loan to
collateral value ratios to the
authorities concerned. The
implementation of these exposure
limits would need to be carefully
monitored to see that they are
effectively implemented and not
circumvented, as has sometimes
happened abroad, in a variety of
ways. Another salutary prescription
would be to require full disclosure of
connected lending and lending to
sensitive sectors. (Chapter III, para.
3.40)

60. The Committee recommends that Please see comments against item
to improve the soundness and 1 above.
stability of the Indian banking
system, the regulatory authorities
should make it obligatory for banks

55
to take into account risk weights for
market risks. The movement towards
greater market discipline in a sense
would transform the relationship
between banks and the regulator. By
requiring greater internal controls,
transparency and market discipline,
the supervisory burden itself would
be relatively lighter.(Chapter VII,
para. 7.13 )

61. The Committee recommends that The withdrawal of RBI from the
the RBI should totally withdraw from primary market in 91 day Treasury
the primary market in 91 days Bills is the long term objective. The
Treasury Bills; the RBI could, of pace of implementation of the
course, have a presence in the recommendation should depend
secondary market for 91 days upon the development and depth
Treasury Bills. If the 91 days Treasury of the Govt. securities market. One
Bill rate reflects money market of the objectives of evolving the
conditions, the money and securities system of Primary Dealers is to
market would develop an integral improve the underwriting and
link. … .The Committee also market making capabilities in
recommends that foreign Government securities market so
institutional investors should be given that RBI could eventually withdraw
access to the Treasury Bill market. from primary subscriptions. This will
(Chapter V, Annexure, para. A-10 ) be possible only when Primary
Dealers are capable of taking
devolvement, if any, to the full
extent.
As regards giving access to FIIs to
the Treasury Bill market it has been
implemented. ((Cir. MPD.BC.
175/07.01.279/97-98 dated
29.4.98).

d) Recommendations on which a view has to be taken by Govt.

(i) So far, a sum of Rs.20,000 crore Govt. to reply
has been expended for
recapitalisation and to the extent to
which recapitalisation has enabled
banks to write off losses, this is the
cost which the Exchequer has had to

56
bear for the bad debts of the banks.
Recapitalisation is a costly and, in the
long run, not a sustainable option.
Recapitalisation involves budgetary
commitments and could lead to a
large measure of monetisation. The
Committee urges that no further
recapitalisation of banks be
undertaken from the Government
budget. As the authorities have
already proceeded on the
recapitalisation route it is perhaps
not necessary to consider de novo the
institution of an ARF of the type
envisaged by the earlier CFS Report.
The situation would perhaps have
been different if the recapitalisation
exercise had not been undertaken in
the manner in which it has been.
(Chapter III, para. 3.24 –3.25)

(ii) As an incentive to banks to make -do-

specific provisions, the Committee
recommends that consideration be
given to making such provisions tax
deductible. (Chapter III, para. 3.39)

(iii) It would be appropriate if the -do-

management committees are
reconstituted to have only whole
time functionaries in it, somewhat on
the pattern of Central Office Credit
Committee constituted in the State
Bank of India. All decisions taken by
these committees could be put up to
the Board of Directors for
information.(Chapter IV, para. 4.12 –
4.16)

(iv) It would be appropriate to induct -do-

an additional whole time director on
the Board of the banks with an

57
enabling provision for more whole
time directors for bigger banks.
(Chapter IV, para.4.17)

(v) There are opportunities of

outsourcing in other activities like
building maintenance, cleaning,
security, despatch of mail and more
importantly, in computer related
areas. The Committee has been
informed that in some areas banks
are unable to subcontract work
because of a notification issued by
the Labour Ministry under Contract
Labour (Regulation and Abolition)
Act, 1970. The Committee would
urge that this be looked into by the
authorities so that banks are enabled
to effect efficiency and productivity
improvements. The global trend in
the banking and financial sector also
reflects an increasing reliance on
outsourced services.
In an increasingly competitive
environment, statutory provisions
should not lead to banks having to
carry on internally functions and
tasks which can be performed more
efficiently by outside service
provides. (Chapter IV, para. 4.18).

(vi) The Committee feels that the The recent wage settlement of
issue of remuneration structure at bank staff with Unions has broadly
managerial levels prevailing in public kept this in view and leaving the
sector banks and financial decision on other perquisites to the
institutions needs to be addressed. potential of individual banks
There is an urgent need to ensure concerned. Govt. to reply.
that public sector banks are given
flexibility to determine managerial
remuneration levels taking into
account market trends. The
Committee recommends that the

58
necessary authority in this regard be
given to the Boards of the banks
initially in the case of profit making
public sector banks which have gone
public, for they would, in any case, be
required to operate with
anaccountability to the market. The
forthcoming wage negotiations
provide an opportunity to review the
existing pattern of industry-wise
negotiations and move over to bank-
wise negotiations.(Chapter IV, para.
4.26 )

(vii) This Committee is of the view The recommendation pertaining to

that in today's increasingly reasonable length of tenure for the
challenging business environment, a Chief Executive has been
large institution can only be led implemented while appointing the
effectively by a Chief Executive who new Chairmen of PSBs. As regards
has a reasonable length of tenure, the recommendation regarding
which the Committee believes should delinking of pay scales of Chief
not be less than five years. Since, Executives of public sector banks
however, moving over to this tenure from that of the Civil Service, this
may be difficult, we suggest that in will have to be considered by the
the first instance, the minimum Government.
tenure should be three years. The
Committee feels that there is now a
need to delink the pay scales of the
Chief Executives of public sector
banks and financial institutions from
the Civil Service pay scales and that
this should be left to be decided by
the individual banks, not excluding
the possibility of performance based
remuneration. The Committee would
like to add that these observations
and recommendations also apply to
the whole time Directors on the
Boards of banks and financial
institutions appointed by the
Government.
(Chapter IV, para.4.29 –4.30 )

59
(viii) There may be need to redefine A separate chapter capturing
the scope of external vigilance and special features of banking
investigative agencies with regard to transactions has been incorporated
banking business. External agencies in the Vigilance Manual.
should have the requisite skill and
expertise to take into account the
commercial environment in which
decisions are taken. The vigilance
manual now being used has been
designed mainly for use by
Government Departments and public
sector undertakings. It may be
necessary that a separate vigilance
manual which captures the special
features of banking should be
prepared for exercising vigilance
supervision over banks. The
Committee feels that this is an
extremely critical area and
arrangements similar to the Advisory
Board for Bank Frauds be made for
various levels of staff of
banks.(Chapter IV, para. 4.35 –4.37)

(ix) The Committee attaches the Banks have been given further
greatest importance to the issue of autonomy in matters relating to
functional autonomy with their business operations. These
accountability within the framework relate to greater autonomy to open
of purposive, rule bound, non- branches, freedom to charge
discretionary prudential regulation interest on advances as also on
and supervision. Autonomy is a deposits, recruitment of specialist
prerequisite for operational flexibility officers and other matters of
and for critical decision making corporate strategy.
whether in terms of strategy or day
to day operations. There is also the Public sector banks are encouraged
question whether full autonomy with to go to the market raise capital to
accountability is consistent and enhance their capital. Eleven public
compatible with public ownership. sector banks have since accessed
Given the dynamic context in which the capital market for raising
the banks are operating and additional capital.
considering the situational
experience further capital The recommendation has been

60
enhancement would be necessary for accepted. The Bill to bring down
the larger Indian banks. Against the the shareholding of the Govt. of
background of the need for fiscal India in nationalised banks has been
consolidation and given the many introduced in Parliament.
demands on the budget for
investment funds in areas like
infrastructure and social services, it
cannot be argued that subscription to
the equity of public sector banks to
meet their enhanced needs for
capital should command priority.
Public sector banks should be
encouraged, therefore, to go to the
market to raise capital to enhance
their capital. At present, the laws
stipulate that not less than 51% of
the share capital of public sector
banks should be vested with the
Government and similarly not less
than 55% of the share capital of the
State Bank of India should be held by
the Reserve Bank of India.
The current requirement of minimum
Government of India/Reserve Bank of
India shareholding is likely to become
a constraint for raising additional The recommendation in regard to
capital from the market by some of bringing down shareholding of the
the better placed banks unless Govt. of India in nationalized banks
Government also decides to provide to 33% has been accepted. A Bill has
necessary budgetary resources to been introduced in the Parliament
proportionately subscribe to the for the purpose.
additional equity, including the Govt. to reply.
necessary premium on the share
price, so as to retain its minimum
stipulated shareholding. The
Committee believes that these
minimum stipulations should be
reviewed. It suggests that the
minimum shareholding by
Government/RBI in the equity of
nationalised banks and SBI should be
brought down to 33%.

61
The Reserve Bank as a regulator of
the monetary system should not be
also the owner of a bank in view of
the potential for possible conflict of
interest. It would be necessary for the
Government/RBI to divest their stake
in these nationalised banks and in the
State Bank of India. A reduction in
their shares would come about
through additional subscription by
the market to their enhanced capital.
A portion of upto 5 or 10% of the
equity of the bank concerned may be
reserved for employees of the bank
with a provision of some later date
for the introduction of stock options.
The appointment by the Government
of Boards and top executives of
banks derives from its majority
holding and if, as suggested above,
the majority holding itself were to be
given up, the appointment of
Chairmen and Managing Directors Govt. to reply.
should be left to the Boards of the
banks and the Boards themselves left
to be elected by shareholders.
Needless to say, with a significant
stock holding of not less than 33%
Government would have a say in the
election of Boards and indirectly of
the chief executives without their
being seen as administrative
appointments. The reduction in the
minimum holding of Government
below 51% would in itself be a major
and clear signal about the
restoration to banks and financial
institutions of autonomy in their
functioning. The Committee makes
this recommendation in the firm
belief that this is essential for
enhancing the effectiveness and

62
efficiency of the system and not on
any other consideration.(Chapter V,
para 5.27 –5.33)

(x) To provide the much needed Govt. to reply.

flexibility in its operations, IDBI
should be Corporatized and
converted into a Joint Stock Company
under the Companies Act on the lines
of ICICI, IFCI and IDBI. For providing
focussed attention to the work of
State Financial Corporations, IDBI
shareholding in them should be
transferred to SIDBI which is currently
providing refinance assistance to
State Financial Corporations. To give
it greater operational autonomy,
SIDBI should also be delinked from
IDBI (Chapter V, para 5.34).

(xi) Though cooperation is a state Govt. to reply

subject, since UCBs are primarily
credit institutions meant to be run on
commercial lines, the Committee
recommends that this duality in
control should be dispensed with. It
should be primarily the task of the
Board for Financial Supervision to set
up regulatory standards for Urban
Cooperative banks and ensure
compliance with these standards
through the instrumentality of
supervision. (Chapter V, para 5.39)

(xii) The Committee is of the view -do-

that the banking system should be in
a position to equip itself to identify
the eligible clients based on
prescribed norms in the Government
sponsored programmes so that the
full responsibility for all aspects of
the credit decision remains with it.

63
This should also help improve the
client bank relationship instead of the
present system of virtually imposed
clientele and build a credit culture
and discipline. (Chapter VI, para
6.3)

(xiii) The Committee strongly urges -do-

that there should be no recourse to
any scheme of debt waiver in view of
its serious and deleterious impact on
the culture of credit. (Chapter VI,
para 6.7)

(xiv) Evolution of a risk management -do-

system would provide the needed
comfort to the banking system to
finance agriculture. At present, under
the Income Tax Act, provision for bad
and doubtful debts not exceeding 5%
of income and 10% of the aggregate
average advances made by rural
branches of a scheduled or a non
scheduled bank are allowed as
deduction in computing the income
chargeable to tax. Consideration
could be given to increasing this to
5% of income and 20% of average
aggregate advances of rural
branches to provide incentive to
banks for lending to rural
sectors.(Chapter VI, para 6.10)

(xv) The Committee recommends that This recommendation has been

the RRBs and cooperative banks accepted in principle. Govt. of India
should reach a minimum of 8% is also contemplating suitable
capital to risk weighted assets over a amendments to RRB Act, 1976 to
period of five years. A review of the facilitate further restructuring of
capital structure of RRBs should be RRBs involving changes in capital
undertaken with a view to enlarging structure, ownership, etc. Pending
public subscription and give the amendments to RRB Act, sponsor
sponsor banks greater ownership and banks have been entrusted with

64
responsibility in the operation of greater powers to guide and
RRBs. While considering the issue of monitor the operations of RRBs.
salaries of employees of RRBs the As regards the salary structure of
Committee strongly urges that there employees of RRBs, the S.L.
should be no further dilution of the Mahalik Committee appointed by
basic feature of RRBs as low cost Reserve Bank of India has made
credit delivery institutions. certain recommendations on
Cooperative credit institutions also restructuring of the pay scales of
need to enhance their capital through RRB employees and these have
subscription by their members and been forwarded to the Govt. for
not by Government. There should be consideration. As regards
a delayering of the cooperative credit delayering of cooperative credit
institutions with a view to reducing structure, the suggestion would be
the intermediation cost and thus forwarded to NABARD for detailed
providing the benefit of cheaper examination. Govt. will have to
NABARD credit to the ultimate consider amendment to the
borrowers. (Chapter VI, para 6.12 ) Cooperative Societies Act.

(xvi) The supervisory function over Govt. to reply since implementation

rural financial institutions has been of the recommendation would
entrusted to NABARD. While this require amendments to relevant
arrangement may continue for the Acts.
present, over the longer term, the
Committee would suggest that all
regulatory and supervisory functions
over rural credit institutions should
vest with the Board for Financial
Regulation and Supervision.( Chapter
VI para 6.13 )

(xvii) The present duality of control Govt. to reply since implementation

over the cooperative credit of the recommendation would
institutions by State Government and require amendments to relevant
RBI/NABARD should be eliminated Acts.
and all the cooperative banking
institutions should come under the
discipline of Banking Regulation Act,
under the aegis of RBI/NABARD/BFS.
Thus would require amendments to
the Banking Regulation Act. The
control of the Registrar of
cooperative sector over cooperatives

65
would then be somewhat on the lines
of control that Registrar of
Companies has over the Banking
Institutions, registered under the
Companies Act.(Chapter VI, para
6.14 )

(xviii) A legal framework that clearly Govt. to reply.

defines the rights and liabilities of
parties to contracts and provides for
speedy resolution of disputes is
essential for financial intermediation.
The evolution of the legal framework
has not kept pace with the changing
commercial practices and with the
financial sector reforms. The Transfer
of Property Act enacted in 1882 is a
case in point.(Chapter VIII, para 8.1 )

(xix) Given the unsatisfactory state of -do-

the law of mortgage, the response
has been to vest through special
statute the power of sale in certain
institutions like Land Development
Banks and State Finance
Corporations. This approach could be
extended to other financial
institutions and, if possible, to banks.
The other approach is to set up
special tribunals for recovery of dues
to banks and financial institutions.
These Tribunals need to have powers
of attachment before judgement, for
appointment of receivers and for
ordering preservation of property.
For this purpose, an amendment to
the concerned legislation may be
necessary. The Committee would like
to emphasise the importance of
having in place a dedicated and
effective machinery for debt recovery
for banks and financial

66
institutions.(Chapter VIII, para 8.2 –
8.4 )

(xx) Securitisation of mortgages is Govt. to reply.

also critically dependent on the ease
of enforcement and the costs
associated with transfer of
mortgages. The power of sale
without judicial intervention is not
available to any class of mortgages
except where the mortgages is the
Government or the mortgage
agreement so provides and the
mortgaged property is situated in
Mumbai, Chennai and Calcutta and
other towns so notified. Even if the
power of sale without judicial
intervention were available there
would need to be measure to put the
buyer in possession. (Chapter VIII,
para 8.5 –8.6 )

(xxi) The question of stamp duties -do-

and registration fees also requires
review. There is a case for reducing
stamp duties and registration fees
substantially.(Chapter VIII, para 8.7 )

(xxii) In view of the recent -do-

amendments to Section 28 of Indian
Contract Act, banks have expressed a
fear that they can no longer limit
their liabilities under bank
guarantees to a specified period and
that they would have to carry such
guarantee commitments for long
periods as outstanding obligations.
Government departments do not
generally return the original
guarantee papers even after the
purpose is served. This whole issue
needs to be re-examined and bank

67
guarantees exempted from the
purview of the recent amendment to
Section 28 of the Indian Contract Act.
The issue of enforcing securities in
the form of book debts also calls for
review. The Committee also agrees
with the proposal to amend the Sick
Industrial Companies Act, seeking to
trigger off the remedial mechanism
on the sight of incipient sickness.
(Chapter VIII, para 8.9 –8.14)

(xxiii) Certain legislative requirements Govt. to reply

would also be needed to implement
some of the Committee's
recommendations regarding the
structure of the banking system and
matters pertaining to regulation and
supervision. The Banking Regulation
Act is structured on the premise that
bank supervision is essentially a
Government function and that the
Reserve Bank of India’s position is
somewhat on the lines of an agent.
The Act also provides appellate
powers to Government over the
decisions of the RBI in this regard. It
also provides original powers in
certain instances. The Committee
feels that these provisions should be
reviewed. (Chapter VIII, para
8.17)

(xxiv) With respect to -do-

recommendations regarding
constitution of a Board for Financial
Regulation and Supervision, it would
be necessary for amendments in the
Banking Regulation Act and Reserve
Bank of India Act. Amendments
would also be needed in the Bank
Nationalisation Acts to enable grant

68
of greater managerial autonomy to
public sector banks for lowering the
minimum requirements of 51%
Government ownership and as
regards the constitution of Boards of
Directors and of the Management
Committees. The provisions relating
to prior approval of Government for
regulations framed under the Act
would also need to be reviewed. In
line with the above, amendments
would also be needed in the State
Bank of India Act with regard to
shareholding of the RBI and
constitution of its Central Board.
(Chapter VIII, para 8.19 – 8.23 )

(xxv) These suggestions are not An Expert Legal Group under the
exhaustive and we would chairmanship of Shri. T. R.
recommend that the legal Andhyarujina, former Solicitor
implications with reference to each of General, was set up . The Group’s
these recommendations be examined report is under examination of the
and detailed legislative steps Govt. of India.
identified by the Ministry of Finance,
Banking Division in consultation with
the Ministry of Law. In view or the
wide-ranging changes needed in the
legal framework the Committee
recommends setting up of an expert
Committee comprising among others,
representatives from the Ministry of
Law, Banking Division, Ministry of
Finance, RBI and some outside
experts to formulate specific
legislative proposals to give effect to
the suggestions made above.
(Chapter VII, para 8.22 –8.23)

Source: www.rbi.in NCII-CC27112000

69
 Chapter-2

BASEL COMMITTEE ON BANKING SUPERVISION

A Brief History of the Basel Committee and its membership:

The Basel Committee was established as the committee on Bank
Regulations and supervisory practices the year 1974. It was established by
the central bank Governors of the Group Ten Countries when serious
disturbance taken in international currency and banking markets (notably
the failure of Bank hours Herstatt in West Germany). The first meeting took
place in February 1975. And meetings have been held regularly three or
four times a year since.
The committee’s members come from Belgium, Canada, France,
Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden,
Switzerland, United Kingdom and 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 committee provides a forum for regular co-operation between
its member countries on banking supervisory matters. Initially, it discussed
modalities for international co-operation in order to close gaps in the
supervisory understanding and the quality of banking supervision
worldwide. It seeks to do this in three principal ways; by exchanging
information on national supervisory arrangements; by improving the
effectiveness of techniques for supervising international banking business;
and setting minimum supervisory standards in area where they are
considered desirable.
The committee does not possess any formal supranational
supervisory authority. Its conclusions do not have, 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 towards
common approaches and common standards without attempting detailed
hormonisation of member countries supervisory techniques.
One important objective of the committee’s work has been to close
gaps in international supervisory coverage in pursuit of two basic principles.
One that no foreign banking establishment should escape supervision. And
another one is that supervision should be adequate. In May 1983 the
committee finalised a document “Principles for the supervision of Banks’
Foreign Establishments” which set down the principles for sharing

70
supervisory responsibility for banks foreign branches, subsidiaries and joint
ventures between host and parent (or home) supervisory authorities. This
document is a revised version of a paper originally issued in 1975 which
came to be known as the “concordat”. The text of the earlier paper was
expended and reformulated to take account of changes in the market.
Since 1975 the committee has been issuing guidelines to Banks for
Managing Risks.

Pre-Basel
During the pre-Basel era the culture of risk management centered
around strengthening the transaction procedures aimed at filtering risk
encroachments. The art of balancing the cycle of payments and receipts as
a going concern was the major risk management technique. The size of the
exposures and the risks they carry were not related to capital. Irrespective
of the smallness of capital, exposures could swell in tune with the ability to
raise public deposits. Adequacy or otherwise was never explored.

Base-I Accord, 1988

The Basel Committee for banking Supervision (BCBS) has been
making efforts over the years to secure international convergence of
supervisory regulations governing the capital adequacy of international
banks. The Committee adopted a consultative process wherein the
proposals are circulated not only to the central bank Governors of G-10
countries, but also to the supervisory authorities worldwide. Basel norms of
capital measurement and capital standards are: Capital Accord of 1988,
market risk amendment of January 1996, New Capital Adequacy framework
of June 2004. The two fundamental objectives of the Committee’s work on
regulatory convergence are: (i) the framework should serve to strengthen
the soundness and stability of the international banking system; and (ii) the
framework should be fair and have a high degree of consistency in its
application to banks in different countries with a view to diminishing an
existing source of competitive inequality among international banks.
The Basel Accord was endorsed by 12 countries (all G-10 countries
plus Luxembourg and Switzerland) in July 1988 under the chairmanship of W
P Cooke (Bardos, 1988). As many banks were undercapitalised at that time,
a target of 7.25 per cent was set to be met by the end of 1990, and the 8 per
cent requirement was to be achieved by the end of 1992. Since then, the
Basel Accord has been subjected to several amendments and has itself been
evolving under a consultative framework. The Accord has been endorsed by
many countries other than G-10 countries, and applied to many banks other
than those conducting significant international business. The Accord was

71
phased in by January 1993, and currently more than hundred countries have
adopted the Basel Norms.
The main features of Basel I are documented in ‘International
3
Convergence of Capital Measurement and Capital Standards’ over three
sections (BCBS, 1998). While the first two describe the framework in terms
of the constituents of capital and the risk weighting system, the third
section deals with the target ratio. The framework provides a framework for
fair and reasonable degree of consistency in the application of capital
standards in different countries, on a shared definition of capital. The
central focus of this framework is credit risk and, as a further aspect of
credit risk, country transfer risk.
Capital as per Basel Accord, better known as regulatory capital, is
sum of Tier I and Tier II capital which a bank is required to maintain in
relation to its risk-weighted assets. Under both Basel I and Basel II the
regulatory definition of capital is comprised of three levels (or‘tiers’) of
capital. An item qualifies for a given tier if it satisfies the specific criteria.
Tier 1 Capital (or ‘core capital’) comprises only those elements which have
the highest capacity for absorbing losses on an ongoing basis. Tier 2 Capital
(or ‘supplementary capital’) is made up of a broad mix of near equity
components and hybrid capital/debt instruments, the total of which is
limited to 100 per cent of Tier 1 Capital. It is subdivided into two categories:
(i) Upper Tier 2 comprises items closer to common equity, like perpetual
subordinated debt; (ii) Lower Tier 2 comprises items closer to debt than of
equity. It also includes various types of reserves whose values and/or
availability are more uncertain than disclosed reserves. Tier 3 Capital
(or‘additional supplementary capital’) was added in 1996 and can onlybe
used to meet capital requirements for market risk.
The Committee recommended a weighted risk ratio in which
capital is related to different categories of asset or off-balance-sheet
exposure, weighted according to broad categories of relative riskiness, as
the preferred method for assessing the capital adequacy of banks - other
methods of capital measurement are considered to be supplementary to
the risk-weighted approach. The risk weighted approach has been preferred
over a simple gearing ratio approach because: (i) it provides a fairer basis for
making international comparisons between banking systems whose
structures may differ; (ii) it allows off-balance-sheet exposures to be
incorporated more easily into the measure; (iii) it does not deter banks from
holding liquid or other assets which carry low risk. There were inevitably
some broad-brush judgements in deciding which weight should apply to
different types of asset and the framework of weights has been kept as
simple as possible with only five weights being used for on balance-sheet
items i.e., 0, 10, 20, 50 and 100 per cent (Table 2.1). Government bonds of

72
the countries that were members of the Organisation for Economic
Cooperation and Development (OECD) (which includes all members of the
Basel Committee) were assigned a zero risk weight, all short-term interbank
loans and all long-term interbank loans to banks headquartered in OECD
countries a 20 per cent risk weight, home mortgages a 50 per cent risk
weight, and most other loans a 100 per cent risk weight.
Table 2. 1: Risk Weights by Category of On-balance Sheet Assets
Risk Weight Categories of Asset
0% (a) Cash
(b) Claims on central governments and central banks
denominated in national currency and funded in that
currency
(c) Other claims on OECD, central governments, and central
banks
(d) Claims collateralised by cash of OECD central-
government securities or guaranteed by OECD central
governments
0, 10, 20 or 50% Claims on domestic public-sector entities, excluding central
(at national government, and loans guaranteed by or collateralised by
discretion) securities issued by such entities

20% (a) Claims on multilateral development banks (IBRD, IADB,

AsDB, AfDB, EIB, EBRD) and claims guaranteed by, or
collateralised by securities issued by such banks
(b) Claims on banks incorporated in the OECD and claims
guaranteed by OECD incorporated banks
(c) Claims on securities firms incorporated in the OECD
subject to comparable supervisory and regulatory
arrangements, including in particular risk-based capital
requirements,6 and claims guaranteed by these securities
firms
(d) Claims on banks incorporated in countries outside the
OECD with a residual maturity of up to one year and claims
with a residual maturity of up to one year guaranteed by
banks incorporated in countries outside the OECD
(e) Claims on non-domestic OECD public-sector entities,
excluding central government, and claims guaranteed by or
collateralised by securities issued by such entities
(f) Cash items in process of collection

50% Loans fully secured by mortgage on residential property

that is or will be occupied by the borrower or that is rented

73
100% (a) Claims on the private sector
(b) Claims on banks incorporated outside the OECD with a
residual maturity of over one year
(c) Claims on central governments outside the OECD (unless
denominated in national currency - and funded in that
currency)
(d) Claims on commercial companies owned by the public
sector
(e) Premises, plant and equipment and other fixed assets
(f) Real estate and other investments (including non-
consolidated investment participations in other companies)
(g) Capital instruments issued by other banks (unless
deducted from capital)
All other assets
Off-balance sheet contingent contracts, such as letters of credit,
loan commitments and derivative instruments, which are traded over the
counter, needed to be first converted to a credit equivalent and then
assigned appropriate risk weights (Table 2.2).
The initial standards required internationally active banks to meet
two minimum capital ratios, both computed as a percentage of the risk-
weighted (both on- and off-balance sheet) assets. The minimum Tier 1 ratio
was 4 per cent of risk-weighted assets, while total capital
Table 2.2: Credit Conversion Factors for Off-balance Sheet Items
Credit
Instruments Conversion
1. Direct credit substitutes, for example, general guarantees of Factors
100(Per
indebtedness (including standby letters of credit serving as
financial guarantees for loans and securities) and acceptances
(including endorsements with the character of acceptances)

2. Certain transaction-related contingent items (for example, 50

performance bonds, bid bonds, warranties and standby letters
of credit related to particular transactions)

3. Short-term self-liquidating trade-related contingencies (such 20

as documentary credits collateralised by the underlying
shipments)
4. Sale and repurchase agreements and asset sales with 100
recourse,1 where the credit risk remains with the bank
5. Forward asset purchases, forward deposits and partly-paid 100
shares and securities, which represent commitments with
certain drawdown
6. Note issuance facilities and revolving underwriting facilities 50

74
 7. Other commitments (for example, formal standby facilities 50
and credit lines) with an original maturity of over one year
8. Similar commitments with an original maturity of up to one 0
year, or which can be unconditionally cancelled at any time
(tiers 1 and 2) had to exceed 8 per cent of risk-weighted assets. The three
major principles of the Basel Accord are as follows:
(1) A bank must hold equity capital to at least a fixed per cent (8 per cent)
of its risk-weighted credit exposures as well as capital to cover market risks
in the bank’s trading account.
(2) When capital falls below this minimum requirement, shareholders may
be permitted to retain control, provided that they recapitalize the bank to
meet the minimum capital ratio.
(3) If the shareholders fail to do so, the bank’s regulatory agency is
empowered to sell or liquidate the bank.
Capital adequacy is just one of the several factors for assessing the strength
of banks, and therefore capital ratios, judged in isolation, may provide a
misleading guide to relative strength. Much also depends on the quality of a
bank’s assets and, importantly, the level of provisions a bank may be
holding outside its capital against assets of doubtful value. Recognising the
close relationship between capital and provisions, monitoring the
provisioning policies by banks in member countries and convergence of
policies in this field as well has come to engage the attention of the Basel
Committee. The fiscal treatment and accounting presentation for tax
purposes of certain classes of provisions for losses and of capital reserves
derived from retained earnings, which differ for different countries, may to
some extent distort the comparability of the real or apparent capital
positions of international banks. Convergence in tax regimes, though
desirable, lies outside the purview of the Committee, though tax
considerations also need to be reviewed to the extent that they affect the
comparability of the capital adequacy. Another issue of relevance is the
ownership structures and the position of banks within financial
conglomerate groups. The capital requirement should be applied to banks
on a consolidated basis, including subsidiaries undertaking banking and
financial business. The ownership structures should not be such as to
weaken the capital position of the bank or expose it to risks stemming from
other parts of the group.
Most regulatory authorities have adopted allocation of capital to
risk assets ratio system as the basis of assessment of capital adequacy which
takes into account the element of risk associated with various types of
assets reflected in the balance sheet as well as in respect of off-balance
sheet assets. With due regard to particular features of the existing

75
supervisory and accounting systems in individual member countries, the
capital adequacy framework allowed for a degree of national discretion in
the way in which it is applied. It also provided for a transitional period so
that the existing circumstances in different countries can be reflected in
flexible arrangements that allow time for adjustment.

Amendment to the Basel Accord 1996

The Basel Capital Accord of July 1988 was amended in January
1996 with the objective of providing an explicit capital cushion for the price
risks to which banks are exposed, particularly those arising from their
trading activities (BCBS, 1998). The amendment covers market risks arising
from banks’ open positions in foreign exchange, traded debt securities,
traded equities, commodities and options. A companion paper describing
the way in which G-10 supervisory authorities plan to use ‘backtesting’ (i.e.,
ex-post comparisons between model results and actual performance) in
conjunction with banks’ internal risk measurement systems as a basis for
applying capital charges was also released.
The novelty of this amendment lied in the fact that it allowed banks
to use, as an alternative to the standardized measurement framework
originally put forward in April 1993, their internal models to determine the
required capital charge for market risk. The standard approach defines the
risk charges associated with each position and specifies how these charges
are to be aggregated into an overall market risk capital charge. The
minimum capital requirement is expressed in terms of two separately
calculated charges, one applying to the ‘specific risk’ of each security,
whether it is a short or a long position, and the other to the interest rate risk
in the portfolio (termed ‘general market risk’) where long and short
positions in different securities or instruments can be offset.
The internal models approach, in contrast, allows a bank to use its
proprietary in-house models to estimate the value-at-risk (VaR) in its trading
account, that is, the maximum loss that the portfolio is likely to experience
over a given holding period with a certain probability. The market risk
capital requirement is then set based on the VaR estimate as the higher of
the following two: (i) the previous day’s value-at-risk; and (ii) three times
the average of the daily value-at-risk of the preceding sixty business days.
This amendment also defined a Tier 3 capital to cover market risks, and
allowed banks to count subordinated debt (with an original maturity of at
least two years) in this tier.

Criticisms of Basel I
The major achievement of the Basel Capital Accord 1988 has been
introduction of discipline through imposition of risk-based capital standards

76
both as measure of the strength of banks and as a trigger device for
supervisors’ intervention under the scheme of prompt corrective action
(PCA). The fundamental objective of the
1988 Accord has been to develop a framework that would further
strengthen the soundness and stability of the international banking system
while maintaining sufficient consistency that capital adequacy regulation
will not be a significant source of competitive inequality among
internationally active banks. The design of the Accord, however, has met
with severe criticisms which are discussed in detail in this Section.
First, the standards have not been able to meet one of the central
objectives, viz., to make the competitive playing field more even for
international banks. For example, in a comparison of the competitiveness of
banks in the United States and Japan after the implementation of Basel
Accord, it was found that the Accord had no impact on competitiveness
(Scott and Iwahara, 1994). The authors also showed that other factors such
as taxes, accounting requirements, disclosure laws, implicit and explicit
deposit guarantees, social overhead expenditures, employment restrictions,
and insolvency laws, also affect the competitiveness of an institution.
Consequently, imposing the same capital standard on institutions that differ
with regard to those other factors is unlikely to enhance competitive equity.
The other fundamental objective of the Accord in terms of
increasing the soundness and stability of the banking system need not
necessarily be met. Capital adequacy regulation in some contexts could
even accentuate systemic risk. Therefore, under international financial
integration, a simple coordination on some parts of banking regulation
(uniform capital requirements), but not others (the forbearance in
supervisor’s closure policies), could give rise to international negative
externalities that destabilize the global system. Furthermore, a design of
capital adequacy requirements, based only on individual bank risk, as the
actual proposed in the Basel Accord, is showed to be suboptimal in both
papers. All the above arguments suggest the need for an analysis of how
banks set their capital to assets ratio.
The bank capital adequacy regulation as in Basel I is also criticised
for imposing the same rules on all banks even within a country. The simple
‘one-size-fits-all’ standard under Basel I encouraged transactions using
securitisation and off-balance sheet exposures, whose principal aim was to
arbitrage bank capital. The Basel rules encouraged some banks to move to
high quality assets off their balance sheet, thereby reducing the average
quality of bank loan portfolios. Furthermore, banks took large credit risks in
the least creditworthy borrowers who had the highest expected returns in a
risk-weighted class (Kupiec, 2004).

77
 Table 2.3 Comparative Analysis Basel-I & II Accords
BASEL 1 BASEL2
1. Focus on single 1. More emphasis on bank’s own internal methodology,
risk measure supervisory review and market discipline
2. One size fits all 2. Flexibility, menu of approaches, incentive for better risk
management
3. Broad brush 3. More risk sensitivity
structure
Perhaps the most fundamental problem with the Basel I standards
stems from the fact that they attempt to define and measure bank portfolio
risk categorically by placing different types of bank exposures into separate
‘buckets’. Banks are then required to maintain minimum capital
proportional to a weighted sum of the amounts of assets in the various risk
buckets. That approach incorrectly assumes, however, that risks are
identical within each bucket and that the overall risk of a bank’s portfolio is
equal to the sum of the risks across the various buckets. But, most of the
times, the risk-weight classes did not match realised losses. In an
examination of loan charge-offs and delinquency rates for banks, it was
found that the 1988 Capital Accord risk weights did not accurately track the
credit experience in the US. Collateralised loans had the least risk.
Commercial loans appear to be under-burdened by the Basel I weights and
mortgages were overburdened. All activities or loans within a particular
category do not have the same market-based credit risk. For example, not
all mortgages are exactly or even approximately half as risky as all
commercial loans (reflecting the assigned risk weights).
Securitisation of banks’ credit portfolios has become a widespread
phenomenon in industrialized countries. At first, banks used to sell their
mortgage loans, for such loans represented accurately evaluated risks. But
since the advent of e-finance, it is now possible to expand this activity to
other types of loans, including those made to small businesses. This type of
activity also allows banks to have a much more liquid credit-risk portfolio
and, in theory, to adjust their capital ratio to an optimal economic level
rather than sticking to the ratio decreed by the Basel Committee.
Moreover, diversification of a bank’s credit-risk portfolio is not
taken into account in the computation of capital ratios. The aggregate risk
of a bank is not equal to the sum of its individual risks - diversification
through the pooling of risks can significantly reduce the overall portfolio risk
of a bank. Indeed, a well-established principle of finance is that the
combination in a single portfolio of assets with different risk characteristics
can produce less overall risk than merely adding up the risks of the
individual assets. The Accord does not take into account the benefits of
portfolio diversification.

78
 The standards have also been criticized for failing to assign ‘correct’
risk weights and for failing to promote bank safety effectively. Although the
risk weights attempt to reflect credit risk, they are not based on market
assessments but instead favor claims on banks headquartered in OECD
countries and OECD Governments, and on residential mortgages. The 1988
standards also assign a zero risk weight to all sovereign debt issued by
countries belonging to the OECD. Although sovereign debt was not at the
centre of the Asian financial crises, it played a central role in the earlier
Mexican financial and currency crisis of 1994-1995. Illustratively, Mexico
and South Korea, both of which experienced substantial bank insolvencies,
are now members of the OECD; and hence, the bonds issued by their
Governments are subject to the zero risk weight.
Cosmetic changes in bank capital are possible because the
measures of both capital and risk are imperfect proxies for the economically
relevant variables. Regulators cannot construct perfect measures as long as
bank managers have private information about the value or risk of their
portfolios. However, even granting the impossibility of perfect measures,
the crudeness of current measures offers substantial measures for cosmetic
changes in capital ratios. Capital-to-total asset measures (leverage
standards) are easily defeated by reducing low-risk, high-liquidity assets and
substituting a smaller quantity of higher risk, lower liquidity assets. The
existing risk-based standards are slightly more sophisticated, but numerous
flaws remain. The standards (i) require that most commercial and consumer
loans carry the same risk weighting and do not allow for differential asset
quality within asset classes, (ii) do not allow for risks other than credit risks
and (iii) do not account for diversification across different types of risk or
even across credit risks. Banks, can therefore, exploit accounting
conventions by accelerating the recognition of gains on assets with market
value greater than book value, while slowing the recognition of losses on
assets with market value less than book value.
The problems are compounded by the fact that the Basel standards
are computed on the basis of book-value accounting measures of capital,
not market values. Accounting practices vary significantly across the G-10
countries and often produce results that differ markedly from market
assessments.
The Subgroup of the Shadow Financial Regulatory Committees of
Europe, Japan, Latin America and the United States observed that problems
inherent in assigning risk weights in the Basel standards are compounded by
the inappropriate division of bank capital into different ‘tiers’. In the
process, the Basel Committee implicitly favors equity over other forms of
capital, specifically, subordinated debt. The preference for equity not only is
unwarranted but also may be counterproductive since subordinated debt,

79
which is included in Tier2 capital, but not in Tier 1, often can be superior to
equity from a regulatory standpoint.
The financial crises of the 1990s involving international banks have
highlighted several additional weaknesses in the Basel standards that
permitted and in some cases even encouraged, excessive risk taking and
misallocations of bank credit. Notably, Asian banks’ short- term borrowing
of foreign currencies was a major source of vulnerability in the country’s
most seriously affected by the Asian financial crisis. The current Basel
standards contributed to that problem by assigning a relatively favorable 20
per cent risk weight to short-term interbank lending - only one-fifth as large
as the weight assigned to longer-term lending or to lending to most private
non- bank borrowers. Putting aside the important issue of whether the
standards should have assigned different risk weights for short-term lending
to banks in the developed and in the developing world–a distinction not
captured by the current system of weighting asset risks– it is clear that the
much lower risk weight given to interbank lending than to other types of
bank loans encouraged some large internationally active banks to lend too
much for short durations to banks in Southeast Asia. Those banks reloaned
the funds in domestic currency at substantially higher rates and assumed
large foreign exchange rate risk. One would expect those distortions to be
most pernicious for banks that are capital-constrained. Therefore, it is not
surprising that Japanese banks, which have been weakly capitalized
throughout the 1990s, had accumulated the heaviest concentrations of
claims on faltering Asian banks.

Basel-2 Accord 1999

The Basel II framework entails a more comprehensive measure and
minimum standard for capital adequacy that national supervisory
authorities are working to implement through domestic rule-making and
adoption procedures. It seeks to improve on the existing rules by aligning
regulatory capital requirements more closely to the underlying risks that
banks face, i.e., trend towards convergence of the regulatory and economic
capital, which is especially evident in the advanced approaches. In addition,
the Basel II framework is intended to promote a more forward-looking
approach to capital supervision, one that encourages banks to identify the
risks they may face, today and in the future, and to develop or improve their
ability to manage those risks. As a result, it is intended to be more flexible
and better able to evolve with advances in markets and risk management
practices.
The fundamental objective of the Committee’s work to revise the
1988 Accord has been to develop a more comprehensive approach towards
addressing risks, and, thereby, improve the way regulatory capital

80
requirements reflect underlying risks, i.e., better risk sensitivity. The review
of the Accord was designed to better address the financial innovations that
have occurred in recent years, for example, asset securitisation structures.
The review was also aimed at recognising the improvements in risk
measurement and control that have occurred. In June 1999, the BCBS
released for comments its proposal to introduce a new capital adequacy
framework for International Convergence of Capital Measurement and
Capital Standards, more popularly known as the Basel II. The BCBS held
three quantitative impact studies4 apart from several rounds of
consultations and discussions with the member countries, and the final
version of the New Basel Norms was released by the BIS on June 26, 2004,
which would replace the 1988 Capital Accord by year-end 2007. In March
2005, the Basel Committee on Banking Supervision re-discussed
the schedules for national rule-making processes within member countries
and decided to review the calibration of the Basel II framework in spring
2006. In November 2005, the Committee issued an updated version of the
revised framework incorporating the additional guidance set forth in the
Committee’s paper, ‘The Application of Basel II to Trading Activities and the
Treatment of Double Default Effects’ (July 2005). In July 2006, the
Committee issued a comprehensive version of the Basel II framework, which
is a compilation of the (i) June 2004 Basel II framework, (ii) the elements of
the 1988 Accord that were not revised during the Basel II process, (iii) the
1996 Amendment to the Capital Accord to Incorporate Market Risks, and
(iv) the 2005 paper on the Application of Basel II to Trading Activities and
the Treatment of Double Default Effects. No new elements have been
introduced in this compilation. The key elements of the 1988 capital
adequacy framework that were retained in the revised framework include
the general requirement for banks to hold total capital equivalent to at least
8 per cent of their risk-weighted assets and the definition of eligible capital.
The Committee also proposed to develop capital charges for risks not taken
into account by the 1988 Accord, such as interest rate risk in the banking
book and operational risk. The greater risk sensitivity under Basel II would
be achieved by linking each bank’s capital requirements to empirically based
measures of credit and operational risk as determined in part by risk
parameters estimated by that organisation, such as a loan’s probability of
default and its expected loss given default.

Components of Basel 2
Basel II consists of three mutually reinforcing pillars: minimum
capital requirements, supervisory review process and market discipline.
Within the three pillar approach, minimum capital requirement seeks to
develop and expand on the standardised rules set forth in the 1988 Accord,

81
supervisory review of a bank’s capital adequacy and internal assessment
process, and effective use of market discipline as a lever to strengthen
disclosure and encourage safe and sound banking practices, has been
designed to strengthen the international financial architecture.
Table 2.4 Basel-II Accord
Pillar Focus Area
First pillar Minimum capital requirement
Second pillar Supervisory Review process
Third pillar Market Discipline

Capital Adequacy

Minimum Capital Supervisory Market Deplane

Requirements Review

Figure 2.1 Pillars of Basel-II

Source: BIS working papers on Basel-II (www.bis.org.com)

The First Pillar – Minimum Capital Requirements

In the revised capital framework, the importance of minimum
regulatory capital requirements continues to be recognized as the first pillar
of the framework5. The measures for credit risk are more complex, market
risk is the same, while operational risk is new.

Credit Risk
With regard to minimum capital requirements for credit risk, a
modified version of the existing Accord has come to be known as the
‘standardised’ approach. The alternative methodology, which is subject to
the explicit approval of the bank’s supervisor, would allow banks to use
their internal rating systems for credit risk. For some sophisticated banks,
use of internal credit ratings and, at a later stage, portfolio models could
contribute to a more accurate assessment of a bank’s capital requirement in

82
relation to its particular risk profile. The capital treatment of a number of
important credit risk mitigation techniques, risk reducing effects of
guarantees, credit derivatives, and securitisation, is also provided under
Pillar 1, thus improving regulatory capital incentive for banks to hedge
portfolio credit risks.

The Standardized Approach

Under the standardised approach, one of the main innovations
relative to the 1988 Accord is the use of external ratings agencies to set the
risk weights for corporate, bank and sovereign claims. More specifically, the
new proposals include tables defining ‘buckets’ of ratings for corporate and
for sovereign credits to translate a particular rating into a risk weight. The
approach is most clear for corporates. The rules for claims on banks are
slightly more complex than those of corporates. One alternative allows
banks to be rated one notch worse (i.e., one risk weight category higher)
than the sovereign but with a cap at a risk. For sovereigns, there are slightly
different buckets in the basic approach but there are also some special rules
that apply. For example, at national discretion, there is a special rule for
claims on the sovereign of the country where the bank is incorporated
where the claim is denominated in the currency of the sovereign and also
funded in that currency (i.e., loans to sovereigns funded and lent in the
domestic currency). At first sight this allows banks in emerging countries to
lend to their Governments (or hold bonds in an investment account) with a
zero or low capital charge. However, in many emerging countries such loans
and bonds are often expressed in dollars or other non -local currencies, and
these would not then attract this special treatment. In this case, credit
extended to a Government of an emerging country would attract the capital
charge given the rating of the sovereign. It is not entirely clear what the
treatment would be in Ecuador, El Salvador or Panama (3 dollarized
countries) or for that matter for the countries of EMU. If the special
treatment exists because the ‘credit risk’ of a local currency claim will, in
general, be less than that of a foreign currency claim when there is a
devaluation or sharp depreciation of the local currency then this suggests
the special treatment should not be extended to dollarized countries or
members of EMU and this takes as a given that any currency risk mismatch
is treated in an appropriate manner separately. The view that local currency
claims are different because of the existence of a lender of last resort
appears to confuse ‘credit risk’ with liquidity considerations and suggests
that banks’ capital requirements should explicitly reflect the fact that
Governments would deflate away debts that goes against any credible
commitment to, say, an inflation target.

83
Internal Rating Approach
Under the internal rating approach banks may employ their own
opinions regarding borrowers in setting capital requirements. More
specifically, there are a set of basic parameters that banks may estimate and
then feed into a formula to determine actual risk weights. Two crucial
parameters required are the probability of default (PD) and the loss given
default (LGD). Two alternative approaches are proposed (1) a foundation
and (2) an advanced approach. Under the foundation approach banks
determine the probability of default and all other parameters are essentially
set by supervisory rules. Under the advanced approach, banks may also
determine the loss given default (LGD). Other parameters also important for
the calculation of the actual risk weight, including in some cases the
maturity of the transaction and the exposure at default (EAD) are
determined by supervisory rules under both alternatives.
Besides, proposals to develop a capital charge for interest rate risk
in the banking book for banks, where interest rate risk is significantly above
average, have also been provided.

Operational risk
Operational risk has been defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, but excludes strategic and
reputational risk, whereby legal risk includes, but is not limited to,
exposures to fines, penalties, or punitive damages resulting from
supervisory actions, as well as private settlements. The framework outlines
three methods for calculating operational risk capital charges in a
continuum of increasing sophistication and risk sensitivity: (i) the Basic
Indicator Approach; (ii) the Standardised Approach; and (iii) Advanced
Measurement Approaches (AMA). Banks are encouraged to move along the
spectrum of available approaches as they develop more sophisticated
operational risk measurement systems and practices.

The Second Pillar – Supervisory Review Process

Pillar 2 (Supervisory Review Process) requires banks to implement
an internal process for assessing their capital adequacy in relation to their
risk profiles as well as a strategy for maintaining their capital levels, i.e., the
Internal Capital Adequacy Assessment Process (ICAAP). On the other hand,
Pillar 2 also requires the supervisory authorities to subject all banks to an
evaluation process and to impose any necessary supervisory measures
based on the evaluations.
A significant innovation of the revised framework is the greater use
of assessments of risk provided by banks’ internal systems as inputs to

84
capital calculations. Each supervisor is expected to develop a set of review
procedures for ensuring that banks’ systems and controls are adequate to
serve as the basis for the capital calculations. There are three main areas
that might be particularly suited to treatment under Pillar 2: risks
considered under Pillar 1 that are not fully captured by the Pillar 1 process
(e.g. credit concentration risk); those factors not taken into account by the
Pillar 1 process (e.g. interest rate risk in the banking book, business and
strategic risk); and factors external to the bank (e.g. business cycle effects).
A further important aspect of Pillar 2 is the assessment of compliance with
the minimum standards and disclosure requirements of the more advanced
methods in Pillar 1, in particular the internal rating based (IRB) framework
for credit risk and the advanced measurement approaches for operational
risk. Supervisors must ensure that these requirements are being met, both
as qualifying criteria and on a continuing basis. Four key principles of
supervisory review were identified, based on the Core Principles for
Effective Banking Supervision and the Core Principles Methodology. First,
banks should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital
levels. Second, supervisors should review and evaluate banks’ internal
capital adequacy assessments and strategies, as well as their ability to
monitor and ensure their compliance with regulatory capital ratios.
Supervisors should take appropriate supervisory action if they are not
satisfied with the result of this process. Third, supervisors should expect
banks to operate above the minimum regulatory capital ratios and should
have the ability to require banks to hold capital in excess of the minimum.
Fourth, supervisors should seek to intervene at an early stage to prevent
capital from falling below the minimum levels required to support the risk
characteristics of a particular bank and should require rapid remedial action
if capital is not maintained or restored.

The Third Pillar – Market Discipline

The third pillar is a set of disclosure requirements included in the
Basel II framework to allow market participants assess the capital adequacy
of the institution based on information on the scope of application, capital,
risk exposures, risk assessment processes, etc. Such disclosures are of
particular relevance keeping in view the greater discretion allowed to banks
in using internal methodologies for assessing capital requirements under
Pillar 1. Supervisors have different powers available to them under Pillar 2,
ranging from ‘moral suasion’ to reprimands or financial penalties, that they
can use to make banks to make such disclosures. Market discipline can
contribute to a safe and sound banking environment, and complement the

85
minimum capital requirements (Pillar 1) and the supervisory review process
(Pillar 2).
Banks should have a formal disclosure policy approved by the
board of directors that addresses the bank’s approach regarding the
disclosures they make, and the internal controls over the disclosure process.
In addition, banks should implement a process for assessing the
appropriateness of their disclosures, including validation and frequency.
Several key banking risks to which banks are exposed, such as credit risk,
market risk, interest rate risk and equity risk in the banking book and
operational risk, and the techniques that banks use to identify, measure,
monitor and control those risks such as disclosures relating to credit risk
mitigation and asset securitisation, both of which alter the risk profile of the
institution, are important factors market participants consider in their
assessment of an institution.

Basel II: An Evaluation

Even though implementation of Basel II is in progress with
approximately 57 countries adopting all or parts of the framework by end-
2008, the major advantages and deficiencies in Basel II have been discussed
widely by the practitioners, policymakers and academicians. The main
incentives for adoption of Basel II are (a) it is more risk sensitive; (b) it
recognises developments in risk measurement and risk management
techniques employed in the banking sector and accommodates them within
the framework; and (c) it aligns regulatory capital closer to economic
capital. These elements of Basel II take the regulatory framework closer to
the business models employed in several large banks. In Basel II framework,
banks’ capital requirements are more closely aligned with the underlying
risks in the balance sheet. Basel II compliant banks can also achieve better
capital efficiency as identification, measurement and management of credit,
market and operational risks have a direct bearing on regulatory capital
relief. Operational risk management would result in continuous review of
systems and control mechanisms. Capital charge for better managed risks is
lower and banks adopting risk-based pricing are able to offer a better price
(interest rate) for better risks. This helps banks not only to attract better
business but also to formulate a business strategy driven by efficient risk-
return parameters. Marketing of products, thus, becomes more
focused/targeted.
The movement towards Basel II has prompted banks to make
necessary improvement in their risk management and risk measurement
systems. Thus, banks would be required to adopt superior technology and
information systems which aid them in better data collection, support high
quality data and provide scope for detailed technical analysis. For instance,

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the framework requires fundamental improvement in the data supporting
the probability of default (PD), exposure at default (EAD) and loss given
default (LGD). Basel II incorporates much of the latest ‘technology’ in the
financial arena for managing risk and allocating capital to cover risk.
Basel II goes beyond merely meeting the letter of the rules. Under
Pillar 2, when supervisors assess economic capital, they are expected to go
beyond banks’ systems. Pillar 2 of the framework provides greater scope for
bankers and supervisors to engage in a dialogue, which ultimately will be
one of the important benefits emanating from the implementation of Basel
II. The added transparency in Pillar 3 should also generate improved market
discipline for banks, in some cases forcing them to run a better business.
Indeed, market participants play a useful role by requiring banks to hold
more capital than implied by minimum regulatory capital requirements - or
sometimes their own economic capital models - and by demanding
additional disclosures about how risks are being identified, measured, and
managed. A strong understanding by the market of Pillars 1 and 2 would
make Pillar 3 more comprehensible and market discipline a more reliable
tool for supervisors and the market.
According to a survey published by Ernst & Young, processes and
systems are expected to change significantly, alongwith the ways in which
risks are managed. Over three-quarters of respondents believed that Basel II
will change the competitive landscape for banking. Those organisations with
better risk systems are expected to benefit at the expense of those which
have been slower to absorb change. Eighty-five per cent of respondents
believed that economic capital would guide some, if not all, pricing. Greater
specialisation was also expected, due to increased use of risk transfer
instruments. A majority of respondents (over 70 per cent) believe that
portfolio risk management would become more active, driven by the
availability of better and more timely risk information as well as the
differential capital requirements resulting from Basel II. This could improve
the profitability of some banks relative to others, and encourage the trend
towards consolidation in the sector.

Limitations of Basel II
The Basel II framework also suffers from several limitations,
especially from the angle of implementation in emerging economies. In its
attempt to strive for more accurate measure of risks in banks, the simplicity
of the 1988 Capital Accord has been replaced by a highly complex
methodology which needs the support of highly sophisticated MIS/data
processing capabilities. The complexity of Basel II also arises from several
options available. The complexity and sophistication essential for banks for
implementing the New Capital Accord restricts its universal application.

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Consequently, many of the countries that have voluntarily adopted Basel I
also view these issues with considerable caution. While it is true that the
Basel II framework is more complex, at the same time, it has also been
argued that this complexity is largely unavoidable mainly because the
banking system and related instruments that have evolved in recent times
are inherently complex in nature. The risk management system itself has
become more sophisticated over the time and applying equal risk weights
(as done in the Basel I accord) may not be realistic anymore.
The more sophisticated risk measures unfairly advantage the larger
banks that are able to implement them and, from the same perspective,
that the developing countries generally also do not have these banks and
that Basel II will disadvantage the economically marginalized by restricting
their access to credit or by making it more expensive.
In the standardised approach for credit risk measurement, rating
agencies have been assigned a crucial role. Rating agencies move slowly,
and changes in ratings, lag changes in actual credit quality, so that the
ratings have a questionable ability to predict default (Altman and Saunders,
2001). Moreover, rating agencies have limited penetration in many
emerging countries. In the absence of reliable ratings for different assets,
banking industry will not be able to fully exploit the flexibility of Basel II and
most credit risks will tend to end up in the unrated 100 per cent category
and as a result there will be little change in capital requirements relative to
Basel I. It has also been argued that in the case of standardised approach,
unrated borrowers will have a lower risk weight (100 per cent) as compared
to the lowest graded borrower (150 per cent) and this may lead to moral
hazard problem with lower grade borrowers preferring to remain unrated.
This may also lead to adverse selection. Concerns have also been expressed
about the quality of rating agencies’ judgements. Even in the developed
economies, the recent sub-prime crisis has highlighted the problems
relating to the role of rating agencies which is discussed in the following
section.
Under the IRB approaches, greater reliance on banks’ own internal
risk ratings may be an improvement, but this is also not free from
difficulties. Specifically, the proposal does not indicate how regulators will
evaluate the accuracy of banks’ own internal credit- risk ratings or how they
would be translated into capital requirements. Nor does it explain how it
would achieve comparability across the variety of internal rating systems in
different banks. Most important, the proposal does not explain how
regulators will enforce the ratings that banks produce or impose sanctions if
the ratings turn out to be inaccurate and capital is insufficient or depleted.
In any event, even if an effective enforcement mechanism is put in place,
summing across risk buckets is just as deficient when the risk buckets are

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determined by internal ratings as when they are determined by external risk
ratings or the current arbitrary regulatory distinctions.
The interactions between regulatory and accounting approaches at
both the national and international level to reduce, wherever possible,
inappropriate disparities between regulatory and accounting standards
which can have significant consequences for the comparability of the
resulting measures of capital adequacy and for the costs associated with the
implementation of these approaches. Keeping this in view, changes in the
treatments of unexpected and expected losses, credit risk mitigation,
treatment of securitisation exposures and qualifying revolving retail
exposures, among others, are being incorporated.
A more serious criticism is that the operation of Basel II will lead to
a more pronounced business cycle. This criticism arises because the credit
models used for Pillar 1 compliance typically use a one year time horizon.
This would mean that, during a downturn in the business cycle, banks would
need to reduce lending as their models forecast increased losses, increasing
the magnitude of the downturn. Regulators should be aware of this risk and
can be expected to include it in their assessment of the bank models used.
That the risk-based capital requirements are pro-cycle in nature (more
capital is required in recessions because credit risk in banks’ portfolios
increases in cyclical downturns) was also recognised by the Basel Committee
on Banking Supervision (BCBS). In a Consultative Paper issued by the BCBS in
1999, the Financial Stability Forum had raised the question whether several
features of the new capital framework discussed by the BCBS could increase
the cyclical fluctuations in the economy. In response, the BCBS confirmed
that risk-based capital requirements were inevitably pro-cyclical, but could
be addressed by different instruments. During the course of consultation,
the Basel Committee maintained that various features of the risk weights of
the IRB approach under Pillar 1 can be expected to mitigate its pro-cyclical
impact. For example, the length of the observation period mandated for
estimating PD is at least five years and that for LGD and EAD seven years,
with the qualification that if the observations for any of the sources used
span a longer period, then the latter should be used. Basel II requires banks
to estimate long run average PD and downturn LGD, which to a great extent
reduced the variability of capital requirement with respect to business
cycles. The greater allowance for eligible provisions can also be expected to
reduce the importance in risk-weighted assets of defaulted loans during
cyclical downturns, when such loans increase as a proportion of banks’
portfolios. The Committee further recommended that national supervisors
could also promote the use of internal models leading to lower pro-
cyclicality. Measures such as through-the-cycles rating methodologies could
also ‘filter-out’ the impact of business cycle on borrower rating. Supervisors

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could also prescribe additional capital under Pillar 2 during a business cycle
expansion.

Challenges to Effective Implementation of Basel II

Apart from certain deficiencies of Basel II, its implementation
presents several challenges, especially in emerging market economies. Data
limitation is a key impediment to the design and implementation of credit
risk models. Most credit instruments are not marked to market; hence, the
predictive nature of a credit risk model does not derive from a statistical
projection of future prices based on comprehensive historical experience.
The scarcity of the data required to estimate credit risk models also stems
from the infrequent nature of default events and the longer term time
horizons used in measuring credit risk. Thus, in specifying model
parameters, credit risk models require the use of simplifying assumptions
and proxy data. One of the major challenges is the availability of long-time
series and reliable data and information as also sophisticated IT resources.
In view of these constraints, banks in emerging economies are forced to
adopt the standardised approach.
Banks need to put in place sound and efficient operational risk
management framework since this will be a focus under the Pillar 2. The
most important Pillar 2 challenge relates to acquiring and upgrading the
human and technical resources necessary for the review of banks’
responsibilities under Pillar 1 by the supervisors. Other areas of concern
include coordination of home and host supervisors in the cross-border
implementation of Basel II; issues relating to outsourcing; common
reporting templates for easy comparability; and external benchmarks to be
made available by the regulator, and to be used for comparison/self-
evaluation for the risk components/ operational losses.
Aligning supervisory disclosures under Pillar 3 with international
and domestic accounting standards has emerged as a major challenge.
There are also issues relating to (i) reporting framework/disclosures in the
context of risk appetite for the stated business objectives and risk
management systems in place; and (ii) providing information, on the risks
and the risk management systems in place, in the public domain which
could be used for comparison among banks. Market discipline is not
possible if counterparties and rating agencies do not have good information
about banks’ risk positions and the techniques used to manage those
positions.
Full implementation of Basel II would require upgradation of skills
both at the level of supervisory authority and the banks. Banks would be
required to use fully scalable state of the art technology, ensure enhanced
information system security and develop capability to use the central

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database to generate any data required for risk management as well as
reporting. The emphasis on improved data standards in the revised accord is
not merely a regulatory capital requirement, but rather it is a foundation for
risk-management practices that will strengthen the value of the banking
franchise.
The validation of credit risk models is also fundamentally more
difficult than the back testing of market risk models. Where market risk
models typically employ a horizon of a few days, credit risk models generally
rely on a timeframe of one year or more. The longer holding period, coupled
with the higher target loss quantiles used in credit risk models, presents
problems to model-builders in assessing the accuracy of their models. A
quantitative validation standard similar to that in the Market Risk
Amendment would require an impractical number of years of data,
spanning multiple credit cycles. The costs associated with Basel II
implementation, particularly costs related to information technology and
human resources, are expected to be quite significant for both banks and
supervisors. Even in the absence of Basel II, well managed financial
institutions and regulatory authorities would have continued to update and
improve their IT systems and risk management practices simply to keep
pace with the evolving practices in the marketplace. However, Basel II has
pushed banks and supervisors for development of human resource skills and
IT up-gradation. In this context, the challenge that banks are likely to face
will have many facets, viz., assessing requirements, identifying and bridging
the gaps, identifying talents, putting the available talents to optimum use,
attracting fresh talents, retention of talents and change management.
Though, the Basel II framework aims to achieve common
standards, its implementation also requires closer cooperation, information
sharing and co-ordination of policies among supervisors. The existence of
separate supervisory bodies to regulate different segments of the markets
within a jurisdiction may create challenges in implementation of Basel II not
only within a jurisdiction but also across jurisdictions. This is because when
different market participants are regulated by separate supervisors, it is
difficult to maintain comparable quality of policy formulation and vigilance.
In many developing countries, only the banks are coming under the ambit of
Basel II and not other financial services providers, thus creating some scope
for regulatory arbitrage. As the main objective of the New Accord is to
ensure competitive equality and providing a reasonable degree of
consistency in application, it is necessary that supervisors across the globe
should have a common definition of internationally active banks. Basel
Committee may, therefore, define what constitute internationally active
banks. For example, in Indian conditions, those banks with cross-border
business exceeding 20-25 per cent of their total business may be classified

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as internationally active banks. The foreign banks in EMEs are the ones
which would be implementing the advanced approaches of Basel II on a
world-wide consolidated basis. However, the home-host regulatory and
supervisory issues would get accentuated due to the greater scope for
multiple regulatory treatments as also the several unresolved cross-border
issues under the different Basel II approaches. The risk weights/implied
correlations for different exposures under standardised or IRB approaches
are based upon certain assumptions which may not be applicable in the
context of emerging economies. For instance, 35 per cent risk weight for
mortgage lending is based upon PD estimates and LGD of developed
European/US markets and may not be adequate as the losses in secured
real estate lending in countries like Taiwan, Thailand and Indonesia have at
times exceeded 35 per cent. Thus, the regulators in developing countries
need to independently assess whether all the assumptions of Basel II
framework are applicable to their domestic markets and modify them
suitably, if required.
Countries that have already adopted Basel I and are complying with
the reasonable minimum BCP (Basel Core Principles of Effective Banking
Supervision), are in a better position to choose among the various
alternatives offered under Basel II. In environments where banking
supervision is weak as reflected in a poor BCP compliance, implementing
sophisticated methods of calculating bank capital may pose challenges for
the supervisors that far outweigh the benefits derived from more accurate
calculation of bank risk and capital prescribed under Basel II. Furthermore,
the thin regulatory resources have a tendency to deflect away from the
priority areas. Such countries would need to adopt the BCP more fully and
are advised to focus primarily on Basel Pillars 2 and 3. Though there is
enough room for country specific adaptations, it should be borne in mind
that such adaptations should not take away the essence of a ‘standard’. The
IMF (jointly with the World Bank), as a part of its financial sector assessment
programs, have reviewed countries’ compliance with the Basel Core
Principles (BCP). In the course of 71 confidential assessments covering 12
advanced, 15 transition and 44 emerging economies, it was found that all
advanced economies under consideration complied with the core principles
regarding market risk and risk management. In contrast, 66 per cent of
emerging economies and 53 per cent of transition economies did not
comply with such principles. Given this level of compliance, the challenges
that are likely to be faced by the emerging economies in implementing the
Basel II framework is daunting indeed.
As countries are moving forward with Basel II implementation,
supervisors are closely monitoring its impact on overall bank capital levels. A
capital monitoring exercise is in place to track minimum capital

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requirements, actual capital buffers above the minimum and how the
minimum requirements compare to Basel II floors. Analysis of the first data
submissions will be available to the BCBS in the first quarter of 2009, and
data will continue to be collected on an ongoing semi-annual basis.

Basel-3 Accord 2009

In light of recent financial market turbulence, the importance of
implementing Basel II capital framework and strengthening supervision and
risk management practices, and improving the robustness of valuation
practices and market transparency for complex and less liquid products,
have assumed greater significance. Moreover, it has become indispensable
to have robust and resilient core firms at the centre of the financial system
operating on safe and sound risk management practices. The Basel II plays
an important role in this respect by ensuring the robustness and resilience
of these firms through a sound global capital adequacy framework along
with other benefits including greater operational efficiencies, better capital
allocation and greater shareholder value through the use of improved risk
models and reporting capabilities.
The recent financial turmoil exhibited that even such technical analysis has
their limitations, such as incomplete data or assumptions that have not
been tested across business cycles. Therefore, quantitative assessment of
risks also needs to be supplemented by qualitative measures and sound
judgment. The Financial Stability Forum (FSF) made comprehensive
proposals that were ratified in early April 2008 by the G-7 to be
implemented over the next 100 days. The proposals include inter alia full
and prompt disclosure of risk exposures; urgent action by setters of
accounting standards and other relevant standard setters to improve
accounting and disclosure standards for off-balance sheet or entities and to
enhance guidance on fair value accounting, particularly on valuing financial
instruments in periods of stress; strengthening of risk management
practices, supported by supervisors’ oversight, including rigorous stress
testing; and strengthening of capital positions as needed. In addition, the
FSF emphasised on a number of proposals for implementation by end-2008
which include inter alia strengthening prudential oversight of capital,
liquidity, and risk management under Basel II, especially for complex
structured credit instruments and off-balance sheet vehicles; enhancing
transparency and valuation for off-balance sheet entities, securitisation
exposures, and liquidity commitments under the Basel Committee’s
guidance; enhancing due diligence in the use of ratings.
As part of its capital monitoring exercise, the BCBS would be
tracking on an ongoing basis the impact of Basel II on bank capital levels.
This will shed light on the effects of the proposed amendments to Basel II

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and help determine whether additional efforts are needed to strengthen
capital in the banking system. In addition, BCBS members regularly
exchange information on how supervisors are implementing the various
aspects of Basel II and conducting model approvals in practice.
The BCBS has also launched a joint undertaking with the FSF to
examine the impact of Basel II on the cyclicality of capital requirements and
possible measures for mitigating it. The FSF will report to the G7 on progress
with this work in April 2009. The BCBS announced a comprehensive strategy
on November 20, 2008 to address the fundamental weaknesses revealed by
the financial market crisis related to the regulation, supervision and risk
management of internationally-active banks. The primary objective was to
strengthen capital buffers and help contain leverage in the banking system
arising from both on- and off-balance sheet activities. The key building
blocks of the Committee’s strategy include the following:
● strengthening the risk capture of the Basel II framework (in particular
for trading book and off-balance sheet exposures);
● enhancing the quality of Tier 1 capital;
● building additional shock absorbers into the capital framework that can
be drawn upon during periods of stress and dampen procyclicality;
● evaluating the need to supplement risk-based measures with simple
gross measures of exposure in both prudential and risk management
frameworks to help contain leverage in the banking system;
● strengthening supervisory frameworks to assess funding liquidity at
cross-border banks;
● leveraging Basel II to strengthen risk management and governance
practices at banks;
● strengthening counterparty credit risk capital, risk management and
disclosure at banks; and
● promoting globally coordinated supervisory follow-up exercises to
ensure implementation of supervisory and industry sound principles.
Under Basel II, though liquidity risk is not reckoned explicitly as
Pillar 1 risk, it is provided that a bank’s Pillar 2 assessment should cover the
full range of risks facing an institution, including liquidity risks. Effective
liquidity risk management usually emerges as a challenge during periods of
financial stress, when many markets become less liquid, making it difficult
for some entities to fund themselves. In recent months, some of the well-
known challenges associated with liquidity risk management became
evident in the light of the US sub-prime crisis and the failure of the Northern
Rock bank in the UK. Even banks with strong capital base experienced
liquidity problems as they did not have a strong liquidity risk management
system in place. The adequate stress and scenario testing for potential asset
expansions arising from liquidity shocks becomes crucial to communicate to

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market participants about their risk profiles. The BCBS has already initiated
the process of assessment of the weaknesses identified by the recent crisis
with a view to setting global standards for liquidity risk management and
supervision, and integrating it more closely with other risk management
disciplines. After issuing a public consultation document in June, the BCBS
released in September Principles for Sound Liquidity Risk Management and
Supervision. The Principles materially raise standards for sound liquidity risk
management and measurement – including the capture of off-balance sheet
exposures, securitisation activities and other contingent liquidity risks that
were not well managed during the turmoil. The Principles underscore the
importance of establishing a robust liquidity risk management framework
that is well integrated into the bank-wide risk management process. Key
elements of a bank’s governance of its liquidity risk management are also
emphasised. Moreover, the document sets out principles to strengthen the
measurement and management of their liquidity risk, which include inter
alia, the requirement of a bank to: (i) maintain a cushion of unencumbered,
high quality liquid assets as insurance against a range of stress scenarios; (ii)
actively manage its intraday liquidity positions and risks to meet payment
and settlement obligations on a timely basis under both normal and
stressed conditions, and thus contribute to the smooth functioning of
payment and settlement systems; (iii) conduct regular stress tests for a
variety of short-term and protracted institution-specific and market-wide
stress scenarios and use the outcomes to develop robust and operational
contingency funding plans; and (iv) ensure the alignment of risk-taking
incentives of individual business lines with the liquidity risk exposures the
activities create.
The Principles highlight the key role of supervisors, including the
responsibility to intervene to require effective and timely remedial action by
a bank to address liquidity risk management deficiencies. The Principles also
stress the need for regular communication with other supervisors and public
authorities, both within and across national borders. They also recommend
regular public disclosure that enables market participants to make an
informed judgement about the soundness of a bank’s liquidity risk
management framework and liquidity position. The guidance focuses on
liquidity risk management at medium and large complex banks, but the
sound principles have broad applicability to all types of bank. The document
notes that implementation of the sound principles by both banks and
supervisors should be tailored to the size, nature of business and complexity
of a bank’s activities. Other factors that a bank and its supervisors should
consider include the bank’s role and systemic importance in the financial
sectors of the jurisdictions in which it operates. The BCBS expects banks and
supervisors to implement the Principles thoroughly and quickly, and will

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assess progress in this area. It will also start to examine possible steps to
promote more robust and internationally consistent liquidity approaches for
cross-border banks. This will include assessing the scope for further
convergence of liquidity supervision.
In September 2010, the Group of Governors and Heads of
Supervision announced higher global minimum capital standards for
commercial banks. This followed an agreement reached in July regarding
the overall design of the capital and liquidity reform package, now referred
to as “Basel III”. In November 2010, the new capital and liquidity standards
were endorsed at the G20 Leaders Summit in Seoul.
The new proposed standards were set out in Basel III: International
framework for liquidity risk measurement, standards and monitoring, issued
by the Committee in mid-December 2010. A new capital framework revises
and strengthens the three pillars established by Basel II. The accord is also
extended with several innovations, namely:
 an additional layer of common equity – the capital conservation buffer
– that, when breached, restricts payouts of earnings to help protect the
minimum common equity requirement;
 a countercyclical capital buffer, which places restrictions on
participation by banks in system-wide credit booms with the aim of
reducing their losses in credit busts;
 proposals to require additional capital and liquidity to be held by banks
whose failure would threaten the entire banking system;
 a leverage ratio – a minimum amount of loss-absorbing capital relative
to all of a bank’s assets and off-balance-sheet exposures regardless of
risk weighting;
 liquidity requirements – a minimum liquidity ratio, intended to provide
enough cash to cover funding needs over a 30-day period of stress; and
a longer-term ratio intended to address maturity mismatches over the
entire balance sheet; and
 additional proposals for systemically important banks, including
requirements for augmented contingent capital and strengthened
arrangements for cross-border supervision and resolution.
In January 2012, the Group of Central Bank Governors and Heads of
Supervision (GHOS) endorsed the comprehensive process proposed by the
Committee to monitor members’ implementation of Basel III. The process
consists of the following three levels of review:
• Level 1: ensuring the timely adoption of Basel III;
• Level 2: ensuring regulatory consistency with Basel III; and
• Level 3: ensuring consistency of outcomes (initially focusing on risk-
weighted assets).

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 The Basel Committee has worked in close collaboration with the
Financial Stability Board (FSB) given the FSB’s role in coordinating the
monitoring of implementation of regulatory reforms. The Committee
designed its programme to be consistent with the FSB’s Coordination
Framework for Monitoring the Implementation of Financial Reforms (CFIM)
as agreed by the G20. These tightened definitions of capital, significantly
higher minimum ratios and the introduction of a macro-prudential overlay
represent a fundamental overhaul for banking regulation. At the same time,
the Basel Committee, its governing body and the G20 Leaders have
emphasised that the reforms will be introduced in a way that does not
impede the recovery of the real economy. In addition, time is needed to
translate the new internationally agreed standards into national legislation.
To reflect these concerns, a set of transitional arrangements for the new
standards was announced as early as September 2010, although national
authorities are free to impose higher standards and shorten transition
periods where appropriate. The new, strengthened definition of capital will
be phased in over five years: the requirements were introduced in 2013 and
will be fully implemented by the end of 2017. Capital instruments that no
longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be
phased out over 10 years beginning 1 January 2013.
Turning to the minimum capital requirements, the higher
minimums for common equity and Tier 1 capital are being phased in from
2013, and will become effective at the beginning of 2015. The schedule will
be as follows:
• The minimum common equity and Tier 1 requirements increased from
2% and 4% levels to 3.5% and 4.5%, respectively, at the beginning of
2013.
• The minimum common equity and Tier 1 requirements will be 4% and
5.5%, respectively, starting in 2014.
• The final requirements for common equity and Tier 1 capital will be
4.5% and 6%, respectively, beginning in 2015.
The 2.5% capital conservation buffer, which will comprise common
equity and is in addition to the 4.5% minimum requirement, will be phased
in progressively starting on 1 January 2016, and will become fully effective
by 1 January 2019. The leverage ratio will also be phased in gradually. The
test (the so-called “parallel run period”) began in 2013 and will run until
2017, with a view to migrating to a Pillar 1 treatment on 1 January 2018
based on review and appropriate calibration. The liquidity coverage ratio
(LCR) will be phased in from 1 January 2015 and will require banks to hold a
buffer of high-quality liquid assets sufficient to deal with the cash outflows
encountered in an acute short-term stress scenario as specified by
supervisors. To ensure that banks can implement the LCR without disruption

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to their financing activities, the minimum LCR requirement will begin at 60%
in 2015, rising in equal annual steps of 10 percentage points to reach 100%
on 1 January 2019.

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 Chapter-3

CREDIT RISK MANAGEMENT

Introduction
The major business activity of any commercial banking in India is
lending. Lending is the heart of the banking Industry. The major risk in
lending is credit risk. Credit risk is the oldest and biggest risk that a bank by
virtue of its very nature of business inherits credit risk is the possibility of
losses associated with changes in the credit profile of borrowers or counter
parties. These losses could take the form of outright default or
alternatively, losses from changes in portfolio value arising from factual or
perceived deterioration in credit quality.
The RBI defines the credit risk as “The possibility of losses
associated with diminution in the credit quality of borrowers or counter
parties. In a bank’s portfolio, losses stem from outright default due to
inability or unwillingness of customer or counter party to meet
commitments in relation to lending, trading, settlement and other financial
transactions. Alternatively, losses result from reduction in portfolio value
arising from actual or perceived deterioration in credit quality.
In other words credit risk means that payment may be delayed or
ultimately not paid at all, which can in turn cause cash flow problems and
affect bank liquidity. It emanates from a bank’s dealings with an individual,
corporate, bank, financial institution or a sovereign. Credit risk may take
the following forms:
 In the case of direct lending: principal and/or interest amount may not
be repaid;
 In the case of guarantees or letters of credit; funds may not be
forthcoming from the constituents upon crystallization of the liability;
 In the case of treasury operations; the payment or series of payments
due from the counter parties under the respective contracts may not
forthcoming or ceases;
 In the case of securities trading business; funds/securities settlement
may not effected;
 In the case of cross-border exposure; the availability and free transfer
of foreign currency funds may either cease or restrictions may be
imposed by the soveign.
In this backdrop, it is imperative that banks have a robust credit
risk management system.

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Factor affecting credit risk:
The credit risk of a bank’s portfolio depends on both external and
internal factors2.

1. External factors:
The followings are the factor’s which affects the credit risks.
1. State of the Economy.
2. Foreign exchange rates.
3. Interest rates.
4. Trade restrictions.
5. Economic sanctions.
6. Technological development.
7. Government policies etc.

2. Internal factors:
The internal factors are, lending policies of the bank, recovery
systems, reputation, volatility of earnings.

Need for Credit Risk Management:

Focused approach to credit risk management is a must as
otherwise banks are likely to be affected by market uncertainties that are so
common to market driven economies. Any lax in this regard is potential
enough to inflict catastrophic losses to banks. A sound practice of credit risk
management ensures:
 Organisation accountabilities to maximise share holder’s value.
 By defining a credit officer’s role and responsibilities, bank’s can ensure
that everyone works within the prescribed parameters and accepts risks
within the pre-defined ranges. It ensures effective “transaction
management” resulting in value-creation by facilitating selection of
worthy business / loan portfolio.
 Gaining control: well-drawn risk management systems and procedures
help banks in keeping the accepted risk under control. This ensures
quality of credit portfolio. It also helps banks in protecting themselves
from ‘Interest-rate-risk’.
 Maintaining control: Constant observance of sound credit risk
management practices both at micro and macro level maintain control
on the individual accounts and portfolio level risk and thereby keep the
volatility in credit losses under check.
 Enhancing control: An alert credit risk management helps banks in
identifying suitable warning signals emanating from the portfolio that
foretell incipient sickness paving way for timely exit. It ensures ‘value-

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 preservation’ at portfolio level that in turn helps banks in maintaining
their ‘net interest margins’ at the desired / pre-designated levels.

Components of credit risk

The credit risk is generally made up of the following components3.
1. Transaction or default risk.
2. Portfolio risk or concentration risk.
Components of Credit Risk

Credit

Portfolio Transaction

Concentration Interinsic Downgrade Default

Risk Risk Risk Risk

The general framework for measuring credit risk is simple. Credit risk can be
divided into two components; expected loss and unexpected loss. As
formalized in Pillar I and Basel II, expected losses are calculated as 4.
Exposure
× Probability of Default (PD)
× Loss given Default (LGD)
× Exposure at Default (EAD)
= Expected loss (EL)
Historically, banks have combined at the risk of PD and LGD into a
single measure. Rather than having dual rating systems (one rating for PD
and the other for LGD), most banks had a one dimensional rating system.
Borrower and facility were considered together in assigning a rating, which
was the product of the probability of default (PD) and the fraction of the
loan value likely to be lost in the event of default (LGD). Many researchers
suggest the above formula for calculating the Expected loss. The theorists
can deal in concepts, but practitioners need concrete (and consistent)
results. Given the costs of being wrong, the process of quantifying credit
risk is like walking through a mine field. Every step requires judgment and
experience, and a misstep can have disastrous results. This is why Indian
Banks are not ready to quantity risks, of course the RBI giving guidelines. A
sound understanding will help banker choose lending opportunities to

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pursue and then price and monitor the credits appropriately. But according
to my knowledge very few explained about how to calculate probability of
default, loss Given Default (LGD) and Exposure at default. This was very
good explained by peter Davis, the director of credit risk services in Ernst
and Young LLP’s Global Financial services Advisory practice. In his article
credit Risk Management – Avoiding Unintended Results, in The RMA Journal
2004.

Measuring Default Risk:

Default risk can be measured in two ways. First, we can measure
the probability that an obligor will default over a given time horizon. A 2%
default rate would indicate that two out of 100 obligors are expected to
default over a given period. Alternatively, we can measure the probability
that a certain amount of obligations will be defaulted on over a given time
horizon. In this case, a 2% default rate would indicate that Rs. 2 out of
every Rs. 100 are likely to go to default over a given time horizon. This
exposure weighted metric provides a measure of the dollars expected to go
to default over a given time period.
In recent years, large defaults, such as Enron and World com, have
demonstrated how different these two metrics can be. While these two
firms only counted as two “incidents”, they represented over $30 billion in
defaulted corporate bond obligations, driving up the dollar-based corporate
default rate in 2001 and 2002.
While these two metrics are clearly different, they may not
necessarily produce different results. If the average balance on defaulted
loans is equal to the average balance on outstanding loans, incidence-based
and rupees based default rates will be the same. However, in case where
this is not true, using the two metrics interchangeably may result in a
significant measurement of credit risk. Given that default probabilities are a
foundation in put to calculations of credit risk, misstating default risk will
cause all other dependent metrics (such as expected loss and credit capital)
to be off significantly.

Using Default Rates:

It is not uncommon for institutions to assume that dollar based and
incidence-based default rates are equal. The standard expected loss
formula as given by Peter O. Davis is as follows5.

Formula for Expected Loss

Expected Loss (EL) = Outstanding balance
× Probability of default
× Loss given default

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Probability of Default = Number of obligors that default during period
Total number of obligors at start of period
Rupees value of loans to obligor th at
defaulted during period
Probabilit y of default; Rupees - weighted Basis
Rupees value of all loans at start of period

Using an incidence based default probability in this formula

implicitly assumes that the two default metrics are equal. These Rupee-
based expected loss figures are after applied to loan loss reserves, economic
capital frame works, and various portfolio risk analyses and reporting.
The challenge with using incidence-based default probability for
expected loss calculations is that it says nothing about the Rupee-weighted
default rate. A portfolio with exposure 100 borrowers-99 for Rs. 10,000 and
one for Rs. 1 million could lose over half its Rupee Value (assuming zero
recovery) and still have only 1% incidence based default rate. Moreover, the
incidence-based rate cannot be compared directly with the historical loss
since it implies a loss of Rs. 19,900 (1% of Rs. 1.99 million), not the Rs. 1
million that was actually lost.
Expected loss frame works based on incidence rates of default may
implicitly assume that the underlying portfolios are perfectly granular in
other words; the portfolio is reasonably “fine-grained” with exposures being
eventually spread out across a large number of obligors. If commercial
portfolios were perfectly granular, incidence based and Rupee-weighted
default rates would always be the same.
Since commercial portfolios are not perfectly granular, banks using
incidence-based default rates to calculate expected loss in Rupees have to
assume that there is not a significant difference between the size of the
defaulted credits and other credits in the portfolio.
Addressing differences in the two metrics seems obvious; when
calculating expected loss, use Rupee weighted rather than incidence-based
default probabilities. Unfortunately, incidence-based probabilities are
primary basis for quantification of defaults therefore in third-party credit
models, internal rating systems, vendor default databases, and ratings
agencies’ bond default studies. Further, the use of Rupee-weighted default
rate creates complications when working with usage given Default (UGD)
assumptions for unused commitments. If Rupees weighted default rate is
applied, the impact future draws have on expected loss is already captured,
making it difficult to appropriately measure UGD for unused commitments

Credit Risk Management

The sound practices for managing the credit are given below:
I. Establishing an appropriate credit risk environment;

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II. Operating under a sound credit-granting process;
III. Maintaining an appropriate credit administration, measurement and
monitoring process; and
IV. Ensuring adequate controls over credit risk

 Establishing an Appropriate Credit Risk Environment

Principle 1:
The board of directors should have responsibility for approving and
periodically (at least annually) reviewing the credit risk strategy and
significant credit risk policies of the bank. The strategy should reflect the
bank’s tolerance for risk and the level of profitability the bank expects to
achieve for incurring various credit risks.
As with all other areas of a bank’s activities, the board of directors3
has a critical role to play in overseeing the credit-granting and credit risk
management functions of the bank. Each bank should develop a credit risk
strategy or plan that establishes the objectives guiding the bank’s credit-
granting activities and adopt the necessary policies and procedures for
conducting such activities. The credit risk strategy, as well as significant
credit risk policies, should be approved and periodically (at least annually)
reviewed by the board of directors. The board needs to recognise that the
strategy and policies must cover the many activities of the bank in which
credit exposure is a significant risk.
The strategy should include a statement of the bank’s willingness
to grant credit based on exposure type (for example, commercial,
consumer, and real estate), economic sector, geographical location,
currency, maturity and anticipated profitability. This might also include the
identification of target markets and the overall characteristics that the bank
would want to achieve in its credit portfolio (including levels of
diversification and concentration tolerances).
The credit risk strategy should give recognition to the goals of
credit quality, earnings and growth. Every bank, regardless of size, is in
business to be profitable and, consequently, must determine the acceptable
risk/reward trade-off for its activities, factoring in the cost of capital. A
bank’s board of directors should approve the bank’s strategy for selecting
risks and maximising profits. The board should periodically review the
financial results of the bank and, based on these results, determine if
changes need to be made to the strategy. The board must also determine
that the bank’s capital level is adequate for the risks assumed throughout
the entire organisation.
The credit risk strategy of any bank should provide continuity in
approach. Therefore, the strategy will need to take into account the cyclical
aspects of any economy and the resulting shifts in the composition and

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quality of the overall credit portfolio. Although the strategy should be
periodically assessed and amended, it should be viable in the long-run and
through various economic cycles.
The credit risk strategy and policies should be effectively
communicated throughout the banking organisation. All relevant personnel
should clearly understand the bank’s approach to granting and managing
credit and should be held accountable for complying with established
policies and procedures.
The board should ensure that senior management is fully capable
of managing the credit activities conducted by the bank and those activities
are done within the risk strategy, policies and tolerances approved by the
board. The board should also regularly (i.e. at least annually), either within
the credit risk strategy or within a statement of credit policy, approve the
bank’s overall credit granting criteria (including general terms and
conditions). In addition, it should approve the manner in which the bank will
organise its credit-granting functions, including independent review of the
credit granting and management function and the overall portfolio.
While members of the board of directors, particularly outside
directors, can be important sources of new business for the bank, once a
potential credit is introduced, the bank’s established processes should
determine how much and at what terms credit is granted. In order to avoid
conflicts of interest, it is important that board members not override the
credit-granting and monitoring processes of the bank. The board of
directors should ensure that the bank’s remuneration policies do not
contradict its credit risk strategy. Remuneration policies that reward
unacceptable behaviour such as generating short-term profits while
deviating from credit policies or exceeding established limits weaken the
bank’s credit processes.

Principle 2:
Senior management should have responsibility for implementing
the credit risk strategy approved by the board of directors and for
developing policies and procedures for identifying, measuring, monitoring
and controlling credit risk. Such policies and procedures should address
credit risk in all of the bank’s activities and at both the individual credit and
portfolio levels.
Senior management of a bank is responsible for implementing the
credit risk strategy approved by the board of directors. This includes
ensuring that the bank’s credit-granting activities conform to the
established strategy, that written procedures are developed and
implemented, and that loan approval and review responsibilities are clearly
and properly assigned. Senior management must also ensure that there is a

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periodic independent internal assessment of the banks credit-granting and
management functions.
A cornerstone of safe and sound banking is the design and
implementation of written policies and procedures related to identifying,
measuring, monitoring and controlling credit risk. Credit policies establish
the framework for lending and guide the credit-granting activities of the
bank. Credit policies should address such topics as target markets, portfolio
mix, price and non-price terms, the structure of limits, approval authorities,
exception processing/reporting, etc. Such policies should be clearly defined,
consistent with prudent banking practices and relevant regulatory
requirements, and adequate for the nature and complexity of the bank’s
activities. The policies should be designed and implemented within the
context of internal and external factors such as the bank’s market position,
trade area, staff capabilities and technology. Policies and procedures that
are properly developed and implemented enable the bank to: (i)maintain
sound credit-granting standards; (ii)monitor and control credit risk;
(iii)properly evaluate new business opportunities; and (iv)identify and
administer problem credits.
In order to be effective, credit policies must be communicated
throughout the organisation, implemented through appropriate procedures,
monitored and periodically revised to take into account changing internal
and external circumstances. They should be applied, where appropriate, on
a consolidated bank basis and at the level of individual affiliates. In addition,
the policies should address equally the important functions of reviewing
credits on an individual basis and ensuring appropriate diversification at the
portfolio level. When banks engage in granting credit internationally, they
undertake, in addition to standard credit risk, risk associated with conditions
in the home country of a foreign borrower or counterparty. Country or
sovereign risk encompasses the entire spectrum of risks arising from the
economic, political and social environments of a foreign country that may
have potential consequences for foreigners’ debt and equity investments in
that country. Transfer risk focuses more specifically on a borrower’s
capacity to obtain the foreign exchange necessary to service its cross-border
debt and other contractual obligations. In all instances of international
transactions, banks need to understand the globalisation of financial
markets and the potential for spill over effects from one country to another
or contagion effects for an entire region.
Banks that engage in granting credit internationally must therefore
have adequate policies and procedures for identifying, measuring,
monitoring and controlling country risk and transfer risk in their
international lending and investment activities. The monitoring of country
risk factors should incorporate (i) the potential default of foreign private

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sector counterparties arising from country-specific economic factors and (ii)
the enforceability of loan agreements and the timing and ability to realise
collateral under the national legal framework. This function is often the
responsibility of a specialist team familiar with the particular issues.

Principle 3:
Banks should identify and manage credit risk inherent in all
products and activities. Banks should ensure that the risks of products and
activities new to them are subject to adequate risk management procedures
and controls before being introduced or undertaken, and approved in
advance by the board of directors or its appropriate committee. The basis
for an effective credit risk management process is the identification and
analysis of existing and potential risks inherent in any product or activity.
Consequently, it is important that banks identify all credit risk inherent in
the products they offer and the activities in which they engage. Such
identification stems from a careful review of the existing and potential
credit risk characteristics of the product or activity.
Banks must develop a clear understanding of the credit risks
involved in more complex credit-granting activities (for example, loans to
certain industry sectors, asset securitisation, customer-written options,
credit derivatives, credit-linked notes). This is particularly important
because the credit risk involved, while not new to banking, may be less
obvious and require more analysis than the risk of more traditional credit-
granting activities. Although more complex credit-granting activities may
require tailored procedures and controls, the basic principles of credit risk
management will still apply.
New ventures require significant planning and careful oversight to
ensure the risks are appropriately identified and managed. Banks should
ensure that the risks of new products and activities are subject to adequate
procedures and controls before being introduced or undertaken. Any major
new activity should be approved in advance by the board of directors or its
appropriate delegated committee.
It is critical that senior management determine that the staff
involved in any activity where there is borrower or counterparty credit risk,
whether established or new, basic or more complex, be fully capable of
conducting the activity to the highest standards and in compliance with the
bank’s policies and procedures.

 Operating under a Sound Credit Granting Process

Principle 4:
Banks must operate within sound, well-defined credit-granting criteria.
These criteria should include a clear indication of the bank’s target market

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and a thorough understanding of the borrower or counterparty, as well as
the purpose and structure of the credit, and its source of repayment.
Establishing sound, well-defined credit-granting criteria is essential
to approving credit in a safe and sound manner. The criteria should set out
who is eligible for credit and for how much, what types of credit are
available, and under what terms and conditions the credits should be
granted.
Banks must receive sufficient information to enable a
comprehensive assessment of the true risk profile of the borrower or
counterparty. Depending on the type of credit exposure and the nature of
the credit relationship to date, the factors to be considered and
documented in approving credits include:
• the purpose of the credit and sources of repayment;
• the current risk profile (including the nature and aggregate amounts of
risks) of the borrower or counterparty and collateral and its sensitivity
to economic and market developments;
• the borrower’s repayment history and current capacity to repay, based
on historical financial trends and future cash flow projections, under
various scenarios;
• for commercial credits, the borrower’s business expertise and the
status of the borrower’s economic sector and its position within that
sector;
• the proposed terms and conditions of the credit, including covenants
designed to limit changes in the future risk profile of the borrower; and
• Where applicable, the adequacy and enforceability of collateral or
guarantees, including under various scenarios.
In addition, in approving borrowers or counterparties for the first
time, consideration should be given to the integrity and reputation of the
borrower or counterparty as well as their legal capacity to assume the
liability. Once credit-granting criteria have been established, it is essential
for the bank to ensure that the information it receives is sufficient to make
proper credit-granting decisions. This information will also serve as the basis
for rating the credit under the bank’s internal rating system.
Banks need to understand to whom they are granting credit.
Therefore, prior to entering into any new credit relationship, a bank must
become familiar with the borrower or counterparty and be confident that
they are dealing with an individual or organisation of sound repute and
creditworthiness. In particular, strict policies must be in place to avoid
association with individuals involved in fraudulent activities and other
crimes. This can be achieved through a number of ways, including asking for
references from known parties, accessing credit registries, and becoming
familiar with individuals responsible for managing a company and checking

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their personal references and financial condition. However, a bank should
not grant credit simply because the borrower or counterparty is familiar to
the bank or is perceived to be highly reputable.
Banks should have procedures to identify situations where, in
considering credits, it is appropriate to classify a group of obligors as
connected counterparties and, thus, as a single obligor. This would include
aggregating exposures to groups of accounts exhibiting financial
interdependence, including corporate or non-corporate, where they are
under common ownership or control or with strong connecting links (for
example, common management, familial ties). Banks should also have
procedures for aggregating exposures to individual clients across business
activities.
Many banks participate in loan syndications or other such loan
consortia. Some institutions place undue reliance on the credit risk analysis
done by the lead underwriter or on external commercial loan credit ratings.
All syndicate participants should perform their own due diligence, including
independent credit risk analysis and review of syndicate terms prior to
committing to the syndication. Each bank should analyse the risk and return
on syndicated loans in the same manner as directly sourced loans.
Granting credit involves accepting risks as well as producing profits.
Banks should assess the risk/reward relationship in any credit as well as the
overall profitability of the account relationship. In evaluating whether, and
on what terms, to grant credit, banks need to assess the risks against
expected return, factoring in, to the greatest extent possible, price and non-
price (e.g. collateral, restrictive covenants, etc.) terms. In evaluating risk,
banks should also assess likely downside scenarios and their possible impact
on borrowers or counterparties. A common problem among banks is the
tendency not to price a credit or overall relationship properly and therefore
not receive adequate compensation for the risks incurred. In considering
potential credits, banks must recognise the necessity of establishing
provisions for identified and expected losses and holding adequate capital
to absorb unexpected losses. The bank should factor these considerations
into credit-granting decisions, as well as into the overall portfolio risk
management process.
Banks can utilise transaction structure, collateral and guarantees to
help mitigate risks (both identified and inherent) in individual credits but
transactions should be entered into primarily on the strength of the
borrower’s repayment capacity. Collateral cannot be a substitute for a
comprehensive assessment of the borrower or counterparty, nor can it
compensates for insufficient information. It should be recognised that any
credit enforcement actions (e.g. foreclosure proceedings) can eliminate the
profit margin on the transaction. In addition, banks need to be mindful that

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the value of collateral may well be impaired by the same factors that have
led to the diminished recoverability of the credit. Banks should have policies
covering the acceptability of various forms of collateral, procedures for the
ongoing valuation of such collateral, and a process to ensure that collateral
is, and continues to be, enforceable and realisable. With regard to
guarantees, banks should evaluate the level of coverage being provided in
relation to the credit-quality and legal capacity of the guarantor. Banks
should be careful when making assumptions about implied support from
third parties such as the government.
Netting agreements are an important way to reduce credit risks,
especially in interbank transactions. In order to actually reduce risk, such
agreements need to be sound and legally enforceable. Where actual or
potential conflicts of interest exist within the bank, internal confidentiality
arrangements (e.g. “Chinese walls”) should be established to ensure that
there is no hindrance to the bank obtaining all relevant information from
the borrower.

Principle 5:
Banks should establish overall credit limits at the level of individual
borrowers and counterparties, and groups of connected counterparties that
aggregate in comparable and meaningful manner different types of
exposures, both in the banking and trading book and on and off the balance
sheet.
An important element of credit risk management is the
establishment of exposure limits on single counterparties and groups of
connected counterparties. Such limits are frequently based in part on the
internal risk rating assigned to the borrower or counterparty, with
counterparties assigned better risk ratings having potentially higher
exposure limits. Limits should also be established for particular industries or
economic sectors, geographic regions and specific products.
Exposure limits are needed in all areas of the bank’s activities that involve
credit risk. These limits help to ensure that the bank’s credit-granting
activities are adequately diversified. As mentioned earlier, much of the
credit exposure faced by some banks comes from activities and instruments
in the trading book and off the balance sheet. Limits on such transactions
are particularly effective in managing the overall credit risk profile or
counterparty risk of a bank. In order to be effective, limits should generally
be binding and not driven by customer demand.
Effective measures of potential future exposure are essential for
the establishment of meaningful limits, placing an upper bound on the
overall scale of activity with, and exposure to, a given counterparty, based
on a comparable measure of exposure across a bank’s various activities

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(both on and off-balance-sheet).
Banks should consider the results of stress testing in the overall
limit setting and monitoring process. Such stress testing should take into
consideration economic cycles, interest rate and other market movements,
and liquidity conditions. Bank’s credit limits should recognise and reflect the
risks associated with the near-term liquidation of positions in the event of
8
counterparty default. Where a bank has several transactions with a
counterparty, its potential exposure to that counterparty is likely to vary
significantly and discontinuously over the maturity over which it is
calculated. Potential future exposures should therefore be calculated over
multiple time horizons. Limits should also factor in any unsecured exposure
in a liquidation scenario.

Principle 6:
Banks should have a clearly-established process in place for
approving new credits as well as the amendment, renewal and re-financing
of existing credits.
Many individuals within a bank are involved in the credit-granting
process. These include individuals from the business origination function,
the credit analysis function and the credit approval function. In addition, the
same counterparty may be approaching several different areas of the bank
for various forms of credit. Banks may choose to assign responsibilities in
different ways; however, it is important that the credit granting process
coordinate the efforts of all of the various individuals in order to ensure that
sound credit decisions are made.
In order to maintain a sound credit portfolio, a bank must have an
established formal transaction evaluation and approval process for the
granting of credits. Approvals should be made in accordance with the bank’s
written guidelines and granted by the appropriate level of management.
There should be a clear audit trail documenting that the approval process
was complied with and identifying the individual(s) and/or committee(s)
providing input as well as making the credit decision. Banks often benefit
from the establishment of specialist credit groups to analyse and approve
credits related to significant product lines, types of credit facilities and
industrial and geographic sectors. Banks should invest in adequate credit
decision resources so that they are able to make sound credit decisions
consistent with their credit strategy and meet competitive time, pricing and
structuring pressures.
Each credit proposal should be subject to careful analysis by a
qualified credit analyst with expertise commensurate with the size and
complexity of the transaction. An effective evaluation process establishes
minimum requirements for the information on which the analysis is to be

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based. There should be policies in place regarding the information and
documentation needed to approve new credits, renew existing credits
and/or change the terms and conditions of previously approved credits. The
information received will be the basis for any internal evaluation or rating
assigned to the credit and its accuracy and adequacy is critical to
management making appropriate judgements about the acceptability of the
credit.
Banks must develop a corps of credit risk officers who have the
experience, knowledge and background to exercise prudent judgement in
assessing, approving and managing credit risks. A bank’s credit-granting
approval process should establish accountability for decisions taken and
designate who has the absolute authority to approve credits or changes in
credit terms. Banks typically utilise a combination of individual signature
authority, dual or joint authorities, and a credit approval group or
committee, depending upon the size and nature of the credit. Approval
authorities should be commensurate with the expertise of the individuals
involved.

Principle 7:
All extensions of credit must be made on an arm’s-length basis. In
particular, credits to related companies and individuals must be authorised
on an exception basis, monitored with particular care and other appropriate
steps taken to control or mitigate the risks of non-arm’s length lending.
Extensions of credit should be made subject to the criteria and
processes described above. These create a system of checks and balances
that promote sound credit decisions. Therefore, directors, senior
management and other influential parties (e.g. shareholders) should not
seek to override the established credit-granting and monitoring processes of
the bank.
A potential area of abuse arises from granting credit to non-arms-
length and related parties, whether companies or individuals. Consequently,
it is important that banks grant credit to such parties on an arm’s-length
basis and that the amount of credit granted is suitably monitored. Such
controls are most easily implemented by requiring that the terms and
conditions of such credits not be more favourable than credit granted to
non-related borrowers under similar circumstances and by imposing strict
absolute limits on such credits. Another possible method of control is the
public disclosure of the terms of credits granted to related parties. The
bank’s credit-granting criteria should not be altered to accommodate
related companies and individuals. Material transactions with related
parties should be subject to the approval of the board of directors
(excluding board members with conflicts of interest), and in certain

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circumstances (e.g. a large loan to a major shareholder) reported to the
banking supervisory authorities.

 Maintaining an Appropriate Credit Administration, Measurement

and Monitoring Process
Principle 8:
Banks should have in place a system for the ongoing administration of their
various credit risk-bearing portfolios.
Credit administration is a critical element in maintaining the safety
and soundness of a bank. Once a credit is granted, it is the responsibility of
the business unit, often in conjunction with a credit administration support
team, to ensure that the credit is properly maintained. This includes keeping
the credit file up to date, obtaining current financial information, sending
out renewal notices and preparing various documents such as loan
agreements. Given the wide range of responsibilities of the credit
administration function, its organisational structure varies with the size and
sophistication of the bank. In larger banks, responsibilities for the various
components of credit administration are usually assigned to different
departments. In smaller banks, a few individuals might handle several of the
functional areas. Where individuals perform such sensitive functions as
custody of key documents, wiring out funds, or entering limits into the
computer database, they should report to managers who are independent
of the business origination and credit approval processes.
In developing their credit administration areas, banks should
ensure:
The efficiency and effectiveness of credit administration
operations, including monitoring documentation, contractual requirements,
legal covenants, collateral, etc.;
The accuracy and timeliness of information provided to
management information systems; Adequate segregation of duties; The
adequacy of controls over all “back office” procedures; and Compliance with
prescribed management policies and procedures as well as applicable laws
and regulations.
For the various components of credit administration to function
appropriately, senior management must understand and demonstrate that
it recognises the importance of this element of monitoring and controlling
credit risk.
The credit files should include all of the information necessary to
ascertain the current financial condition of the borrower or counterparty as
well as sufficient information to track the decisions made and the history of
the credit. For example, the credit files should include current financial
statements, financial analyses and internal rating documentation, internal

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memoranda, reference letters, and appraisals. The loan review function
should determine that the credit files are complete and that all loan
approvals and other necessary documents have been obtained.

Principle 9:
Banks must have in place a system for monitoring the condition of
individual credits, including determining the adequacy of provisions and
reserves.
Banks need to develop and implement comprehensive procedures
and information systems to monitor the condition of individual credits and
single obligors across the bank’s various portfolios. These procedures need
to define criteria for identifying and reporting potential problem credits and
other transactions to ensure that they are subject to more frequent
monitoring as well as possible corrective action, classification and/or
provisioning.
An effective credit monitoring system will include measures to:
Ensure that the bank understands the current financial condition of the
borrower or counterparty; Monitor compliance with existing covenants;
Assess, where applicable, collateral coverage relative to the obligor’s
current condition; Identify contractual payment delinquencies and classify
potential problem credits on a timely basis; and Direct promptly problems
for remedial management.
Specific individuals should be responsible for monitoring credit quality,
including ensuring that relevant information is passed to those responsible
for assigning internal risk ratings to the credit. In addition, individuals should
be made responsible for monitoring on an ongoing basis any underlying
collateral and guarantees. Such monitoring will assist the bank in making
necessary changes to contractual arrangements as well as maintaining
adequate reserves for credit losses. In assigning these responsibilities, bank
management should recognise the potential for conflicts of interest,
especially for personnel who are judged and rewarded on such indicators as
loan volume, portfolio quality or short-term profitability.

Principle 10:
Banks are encouraged to develop and utilise an internal risk rating
system in managing credit risk. The rating system should be consistent with
the nature, size and complexity of a bank’s activities.
An important tool in monitoring the quality of individual credits, as
well as the total portfolio, is the use of an internal risk rating system. A well-
structured internal risk rating system is a good means of differentiating the
degree of credit risk in the different credit exposures of a bank. This will
allow more accurate determination of the overall characteristics of the

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credit portfolio, concentrations, problem credits, and the adequacy of loan
loss reserves. More detailed and sophisticated internal risk rating systems,
used primarily at larger banks, can also be used to determine internal
capital allocation, pricing of credits, and profitability of transactions and
relationships. Typically, an internal risk rating system categorises credits into
various classes designed to take into account gradations in risk. Simpler
systems might be based on several categories ranging from satisfactory to
unsatisfactory; however, more meaningful systems will have numerous
gradations for credits considered satisfactory in order to truly differentiate
the relative credit risk they pose. In developing their systems, banks must
decide whether to rate the riskiness of the borrower or counterparty, the
risks associated with a specific transaction, or both.
Internal risk ratings are an important tool in monitoring and
controlling credit risk. In order to facilitate early identification of changes in
risk profiles, the bank’s internal risk rating system should be responsive to
indicators of potential or actual deterioration in credit risk. Credits with
deteriorating ratings should be subject to additional oversight and
monitoring, for example, through more frequent visits from credit officers
and inclusion on a watch list that is regularly reviewed by senior
management. The internal risk ratings can be used by line management in
different departments to track the current characteristics of the credit
portfolio and help determine necessary changes to the credit strategy of the
bank. Consequently, it is important that the board of directors and senior
management also receive periodic reports on the condition of the credit
portfolios based on such ratings.
The ratings assigned to individual borrowers or counterparties at
the time the credit is granted must be reviewed on a periodic basis and
individual credits should be assigned a new rating when conditions either
improve or deteriorate. Because of the importance of ensuring that internal
ratings are consistent and accurately reflect the quality of individual credits,
responsibility for setting or confirming such ratings should rest with a credit
review function independent of that which originated the credit concerned.
It is also important that the consistency and accuracy of ratings is examined
periodically by a function such as an independent credit review group.

Principle 11:
Banks must have information systems and analytical techniques
that enable management to measure the credit risk inherent in all on- and
off-balance sheet activities. The management information system should
provide adequate information on the composition of the credit portfolio,
including identification of any concentrations of risk.

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 Banks should have methodologies that enable them to quantify the
risk involved in exposures to individual borrowers or counterparties. Banks
should also be able to analyse credit risk at the product and portfolio level in
order to identify any particular sensitivities or concentrations. The
measurement of credit risk should take account of (i) the specific nature of
the credit (loan, derivative, facility, etc.) and its contractual and financial
conditions (maturity, reference rate, etc.); (ii) the exposure profile until
maturity in relation to potential market movements; (iii) the existence of
collateral or guarantees; and (iv) the potential for default based on the
internal risk rating. The analysis of credit risk data should be undertaken
at an appropriate frequency with the results reviewed against relevant
limits. Banks should use measurement techniques that are appropriate to
the complexity and level of the risks involved in their activities, based on
robust data, and subject to periodic validation.
The effectiveness of a bank’s credit risk measurement process is
highly dependent on the quality of management information systems. The
information generated from such systems enables the board and all levels of
management to fulfil their respective oversight roles, including determining
the adequate level of capital that the bank should be holding. Therefore, the
quality, detail and timeliness of information are critical. In particular,
information on the composition and quality of the various portfolios,
including on a consolidated bank basis, should permit management to
assess quickly and accurately the level of credit risk that the bank has
incurred through its various activities and determine whether the bank’s
performance is meeting the credit risk strategy.
Banks should monitor actual exposures against established limits. It
is important that banks have a management information system in place to
ensure that exposures approaching risk limits are brought to the attention
of senior management. All exposures should be included in a risk limit
measurement system. The bank’s information system should be able to
aggregate credit exposures to individual borrowers and counterparties and
report on exceptions to credit risk limits on a meaningful and timely basis.
Banks should have information systems in place that enable
management to identify any concentrations of risk within the credit
portfolio. The adequacy of scope of information should be reviewed on a
periodic basis by business line managers and senior management to ensure
that it is sufficient to the complexity of the business. Increasingly, banks are
also designing information systems that permit additional analysis of the
credit portfolio, including stress testing.

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Principle 12:
Banks must have in place a system for monitoring the overall
composition and quality of the credit portfolio.
Traditionally, banks have focused on oversight of contractual
performance of individual credits in managing their overall credit risk. While
this focus is important, banks also need to have in place a system for
monitoring the overall composition and quality of the various credit
portfolios. This system should be consistent with the nature, size and
complexity of the bank's portfolios.
A continuing source of credit-related problems in banks is concentrations
within the credit portfolio. Concentrations of risk can take many forms and
can arise whenever a significant number of credits have similar risk
characteristics. Concentrations occur when, among other things, a bank’s
portfolio contains a high level of direct or indirect credits to (i) a single
11
counterparty, (ii) a group of connected counterparties , (iii) a particular
industry or economic sector, (iv) a geographic region, (v) an individual
foreign country or a group of countries whose economies are strongly
interrelated, (vi) a type of credit facility, or (vii) a type of collateral.
Concentrations also occur in credits with the same maturity. Concentrations
can stem from more complex or subtle linkages among credits in the
portfolio. The concentration of risk does not only apply to the granting of
loans but to the whole range of banking activities that, by their nature,
involve counterparty risk. A high level of concentration exposes the bank to
adverse changes in the area in which the credits are concentrated.
In many instances, due to a bank’s trade area, geographic location
or lack of access to economically diverse borrowers or counterparties,
avoiding or reducing concentrations may be extremely difficult. In addition,
banks may want to capitalise on their expertise in a particular industry or
economic sector. A bank may also determine that it is being adequately
compensated for incurring certain concentrations of risk. Consequently,
banks should not necessarily forego booking sound credits solely on the
basis of concentration. Banks may need to make use of alternatives to
reduce or mitigate concentrations. Such measures can include pricing for
the additional risk, increased holdings of capital to compensate for the
additional risks and making use of loan participations in order to reduce
dependency on a particular sector of the economy or group of related
borrowers. Banks must be careful not to enter into transactions with
borrowers or counterparties they do not know or engage in credit activities
they do not fully understand simply for the sake of diversification.
Banks have new possibilities to manage credit concentrations and
other portfolio issues. These include such mechanisms as loan sales, credit
derivatives, securitisation programs and other secondary loan markets.

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However, mechanisms to deal with portfolio concentration issues involve
risks that must also be identified and managed. Consequently, when banks
decide to utilise these mechanisms, they need to first have policies and
procedures, as well as adequate controls, in place.

Principle 13:
Banks should take into consideration potential future changes in
economic conditions when assessing individual credits and their credit
portfolios, and should assess their credit risk exposures under stressful
conditions.
An important element of sound credit risk management involves discussing
what could potentially go wrong with individual credits and within the
various credit portfolios, and factoring this information into the analysis of
the adequacy of capital and provisions. This “what if” exercise can reveal
previously undetected areas of potential credit risk exposure for the bank.
The linkages between different categories of risk that are likely to emerge in
times of crisis should be fully understood. In case of adverse circumstances,
there may be a substantial correlation of various risks, especially credit and
market risk. Scenario analysis and stress testing are useful ways of assessing
areas of potential problems. Stress testing should involve identifying
possible events or future changes in economic conditions that could have
unfavourable effects on a bank’s credit exposures and assessing the bank’s
ability to withstand such changes. Three areas that banks could usefully
examine are: (i) economic or industry downturns; (ii) market-risk events;
and (iii) liquidity conditions. Stress testing can range from relatively simple
alterations in assumptions about one or more financial, structural or
economic variables to the use of highly sophisticated financial models.
Typically, the latter are used by large, internationally active banks.
Whatever the method of stress testing used, the output of the
tests should be reviewed periodically by senior management and
appropriate action taken in cases where the results exceed agreed
tolerances. The output should also be incorporated into the process for
assigning and updating policies and limits. The bank should attempt to
identify the types of situations, such as economic downturns, both in the
whole economy or in particular sectors, higher than expected levels of
delinquencies and defaults, or the combinations of credit and market events
that could produce substantial losses or liquidity problems. Such an analysis
should be done on a consolidated bank basis. Stress-test analyses should
also include contingency plans regarding actions management might take
given certain scenarios. These can include such techniques as hedging
against the outcome or reducing the size of the exposure.

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 Ensuring Adequate Controls over Credit Risk
Principle 14:
Banks must establish a system of independent, ongoing assessment
of the bank’s credit risk management processes and the results of such
reviews should be communicated directly to the board of directors and
senior management.
Because various appointed individuals throughout a bank have the
authority to grant credit, the bank should have an efficient internal review
and reporting system in order to manage effectively the bank’s various
portfolios. This system should provide the board of directors and senior
management with sufficient information to evaluate the performance of
account officers and the condition of the credit portfolio.
Internal credit reviews conducted by individual’s independent from
the business function provide an important assessment of individual credits
and the overall quality of the credit portfolio. Such a credit review function
can help evaluate the overall credit administration process, determine the
accuracy of internal risk ratings and judge whether the account officer is
properly monitoring individual credits. The credit review function should
report directly to the board of directors, a committee with audit
responsibilities, or senior management without lending authority (e.g.,
senior management within the risk control function).

Principle 15:
Banks must ensure that the credit-granting function is being
properly managed and that credit exposures are within levels consistent
with prudential standards and internal limits. Banks should establish and
enforce internal controls and other practices to ensure that exceptions to
policies, procedures and limits are reported in a timely manner to the
appropriate level of management for action.
The goal of credit risk management is to maintain a bank’s credit
risk exposure within parameters set by the board of directors and senior
management. The establishment and enforcement of internal controls,
operating limits and other practices will help ensure that credit risk
exposures do not exceed levels acceptable to the individual bank. Such a
system will enable bank management to monitor adherence to the
established credit risk objectives.
Limit systems should ensure that granting of credit exceeding
certain predetermined levels receive prompt management attention. An
appropriate limit system should assist management in controlling credit risk
exposures, initiating discussion about opportunities and risks, and
monitoring actual risk taking against predetermined credit risk tolerances.
Internal audits of the credit risk processes should be conducted on a

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periodic basis to determine that credit activities are in compliance with the
bank’s credit policies and procedures, that credits are authorised within the
guidelines established by the bank’s board of directors and that the
existence, quality and value of individual credits are accurately being
reported to senior management. Such audits should also be used to identify
areas of weakness in the credit risk management process, policies and
procedures as well as any exceptions to policies, procedures and limits.

Principle 16:
Banks must have a system in place for early remedial action on
deteriorating credits, managing problem credits and similar workout
situations.
One reason for establishing a systematic credit review process is to
identify weakened or problem credits. A reduction in credit quality should
be recognised at an early stage when there may be more options available
for improving the credit. Banks must have a disciplined and vigorous
remedial management process, triggered by specific events, that is
administered through the credit administration and problem recognition
systems.
A bank’s credit risk policies should clearly set out how the bank will
manage problem credits. Banks differ on the methods and organisation they
use to manage problem credits. Responsibility for such credits may be
assigned to the originating business function, a specialised workout section,
or a combination of the two, depending upon the size and nature of the
credit and the reason for its problems.
Effective workout programs are critical to managing risk in the
portfolio. When a bank has significant credit-related problems, it is
important to segregate the workout function from the area that originated
the credit. The additional resources, expertise and more concentrated focus
of a specialised workout section normally improve collection results. A
workout section can help develop an effective strategy to rehabilitate a
troubled credit or to increase the amount of repayment ultimately
collected. An experienced workout section can also provide valuable input
into any credit restructurings organised by the business function.

 The Role of Supervisors

Principle 17:
Supervisors should require that banks have an effective system in
place to identify measure, monitor and control credit risk as part of an
overall approach to risk management. Supervisors should conduct an
independent evaluation of a bank’s strategies, policies, procedures and
practices related to the granting of credit and the ongoing management of

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the portfolio. Supervisors should consider setting prudential limits to restrict
bank exposures to single borrowers or groups of connected counterparties.
Although the board of directors and senior management bear the
ultimate responsibility for an effective system of credit risk management,
supervisors should, as part of their ongoing supervisory activities, assess the
system in place at individual banks to identify, measure, monitor and
control credit risk. This should include an assessment of any measurement
tools (such as internal risk ratings and credit risk models) used by the bank.
In addition, they should determine that the board of directors effectively
oversees the credit risk management process of the bank and that
management monitors risk positions, and compliance with and
appropriateness of policies.
To evaluate the quality of credit risk management systems,
supervisors can take a number of approaches. A key element in such an
evaluation is the determination by supervisors that the bank is utilising
sound asset valuation procedures. Most typically, supervisors, or the
external auditors on whose work they partially rely, conduct a review of the
quality of a sample of individual credits. In those instances where the
supervisory analysis agrees with the internal analysis conducted by the
bank, a higher degree of dependence can be placed on the use of such
internal reviews for assessing the overall quality of the credit portfolio and
the adequacy of provisions and reserves. Supervisors or external auditors
should also assess the quality of a bank’s own internal validation process
where internal risk ratings and/or credit risk models are used. Supervisors
should also review the results of any independent internal reviews of the
credit-granting and credit administration functions. Supervisors should also
make use of any reviews conducted by the bank’s external auditors, where
available.
Supervisors should take particular note of whether bank
management recognises problem credits at an early stage and takes the
14
appropriate actions. Supervisors should monitor trends within a bank’s
overall credit portfolio and discuss with senior management any marked
deterioration. Supervisors should also assess whether the capital of the
bank, in addition to its provisions and reserves, is adequate related to the
level of credit risk identified and inherent in the bank’s various on- and off-
balance sheet activities.
In reviewing the adequacy of the credit risk management process,
home country supervisors should also determine that the process is
effective across business lines, subsidiaries and national boundaries. It is
important that supervisors evaluate the credit risk management system not
only at the level of individual businesses or legal entities but also across the
wide spectrum of activities and subsidiaries within the consolidated banking

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organisation.
After the credit risk management process is evaluated, the
supervisors should address with management any weaknesses detected in
the system, excess concentrations, the classification of problem credits and
the estimation of any additional provisions and the effect on the bank’s
profitability of any suspension of interest accruals. In those instances where
supervisors determine that a bank’s overall credit risk management system
is not adequate or effective for that bank’s specific credit risk profile, they
should ensure the bank takes the appropriate actions to improve promptly
its credit risk management process.
Supervisors should consider setting prudential limits (e.g., large
exposure limits) that would apply to all banks, irrespective of the quality of
their credit risk management process.
Such limits would include restricting bank exposures to single
borrowers or groups of connected counterparties. Supervisors may also
want to impose certain reporting requirements for credits of a particular
type or exceeding certain established levels. In particular, special attention
needs to be paid to credits granted to counterparties “connected” to the
bank, or to each other.

Capital Charge for Credit risk under Basel-II:

The Basel Committee for Bank Supervision in its Basel-II accord suggests two
approaches to compute minimum capital for credit risk6:
1. Standardised Approach
2. Internal Rating Basis (IRB)
As the new Accord seeks to improve the risk sensitivity of banks, it has an
built-in incentive for the banks to adopt the IRB approach. For this reason,
it provides for a reduction in the risk weighted assets of 2 to 3% (foundation
of IRB approach) and 90% of the capital requirement under the foundation
approach for advanced IRB approach to encourage banks to adopt specific
risk management practices. The details of these two approaches are as
follows:

 Standardised Approach
The standardised approach is conceptually the same as the 1998
accord, but is more risk sensitive. As in the 1998 accord, there are three
exposure classes, viz., sovereigns, banks and corporates, unlike in the 1988
accord; there will be no distinction on the sovereign risk weighting
depending on whether or not the sovereign is a member of the organisation
for Economic Coordination and Development (OECD). Instead the risk
weights for exposures will depend on external credit assessments. The

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treatment of off-balance sheet exposures will largely remain unchanged,
with a few exceptions.
The standardised approach aligns regulatory capital requirements
more closely with the key elements of banking risk by introducing a wide
differentiation of risk weights. And wider recognition of credit risk
mitigation techniques, while avoiding excessive complexity. Accordingly,
the standardised approach should produce capital ratios more in line with
the actual economic risks that banks are facing, compared to the present
accord. This should improve the incentive for banks to enhance the risk
measurement and management capabilities and should also reduce the
incentives for regulatory capital arbitrage. It is intended that the application
of standardised approach should neither produce a net increase nor a net
decrease average – in minimum regulatory capital, after accounting for
operational risk.
Under the standardised approach the risk weights are assigned
based on the credit ratings accorded by External Credit Assessment
Institutions (ECAIs) as shown in Table-1.
Table-1 Risk weights for different credit ratings
Exposures AAA to A+ to A- BBB+ to BB+ to Below Unrated
AA- (%) (%) BBB- (%) B- (%) B- (%)
Sovereigns 0 20 50 100 150 100
Banks- 20 50 100 100 150 100
Option 1
Banks 20 50 50 100 150 50
Option 2
Short term 20 20 20 50 150 20
claims
Corporates 20 50 100 150 100
Source: P.V. Subba Rao, Minimum Capital Requirement. The Journal of
Indian Institute of Banking Finance Vol. 74, No. 3, July-Sept. Bank Quest p.
17.

Risks weights for sovereigns:

As shown above the risk weights for sovereigns would range from 0
to 150% depending on its credit rating. The above credit rating symbols are
used by standard and poor’s and in case of rating by other agencies such as
Moody’s and Fitch IBCA comparable ratings should be used. The ratings for
claims on sovereigns should generally be in respect of the sovereign’s long
term domestic rating for domestic currency obligations and foreign rating
for foreign currency obligations. At national discreation, a lower risk weight
may be applied to banks exposures to the sovereign of incorporation
denominated in domestic currency and funded in that currency.

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Risk Weights for Banks:
Under option 1 for banks, all banks incorporated in a given
currency will be assigned a risk weight one category less favourable than
that assigned to claims on the sovereign of incorporation. However, there
will be a cap of 100% risk weight, except for banks in corporation in
countries rated below B-, where the risk weight will be capped at 150%. The
option 2 for banks bases the risk weighting on the external credit
assessment of the bank itself. Under this option, a preferential risk weight
that is one category more favourable than risk weight shown in the table
above may be applied to claims with an original maturity of three months or
less, subject to a floor of 20%. This treatment will be available to both rated
and unrated bank claims, but not to banks risk weighted at 150%. The
claims on securities firms may be rated as claims on banks provided they are
subject to supervisory and regulatory arrangements comparable to those
under the new capital adequacy frame work (including, in a particular, risk
based capital requirement). The interbank short-term claims are defined as
having an original maturity of three months or less and these receive
preferential risk weight as shown in table.

Risk weights for corporates:

The risk weights of rated corporate claims, including claims on
insurance companies is shown in the last row of table. It seems anomalous
that unrated corporates are assigned 100% risk weight as compared to
150% risk weight for corporates rated BB- or below. This may provide an
incentive to the corporates to remain unrated. The above risk weights are,
however, based on recognition of the fact that the majority of corporates do
not need to acquire a rating in order to fund their activities. The fact that a
borrower is not rated does not, therefore, necessarily signal low credit
quality. The committee has also emphasized that it does not wish to cause
an unwarranted increase in the cost of funding for small and medium-sized
businesses, which in most countries are a primary, source of job creation
and of economic growth. Due to the above reasons a 100% risk weight has
been assigned to unrated corporates which is the same risk weight that such
corporates exposures received under the 1998 accord.
It should, however, be recognized that the 100% risk weight for
unrated corporates is a floor. In countries where corporates have higher
default rates, supervisory authorities should increase the standard risk
weight for unrated claims where they judge that a higher risk weight is
warranted by the overall default experience in their jurisdiction. As part of
the supervisory review process, supervisors may also consider whether the
credit quality of corporate claims held by individual banks than 100%.

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 “On July 10, 2002 the Basel Committee announced that the risk
weights for residual mortgages under standardised Approach had been
reduced from 50% to 40%. The risk weights for non-mortgage retail
exposures (including small and medium enterprise (SME). Exposures of less
than Euro 1 Million) were also reduced from 100% to 75%. The Basel
Committee has, therefore, introduced two new risk weights of 40% and 75%
under the standardised approach, which was not prescribed in January 2001
paper8.

Concept of Risk-Weighted Assets (RWA):

The Accord achieves a major break-through in suggesting a
measure of assets, weighted by corresponding risks – the so called RWA
9
measure. Four weight categories have been suggested

1. Category I (Weight 0%)

a) Cash
b) Gold bullion (at national discretions)
c) Claims on central government and central bank (domestic or foreign),
denominated in national currency.
d) Claims on OECD Central governments and OECD Central banks.
e) Claims guaranteed by OECD Central Governments.

2. Category II (Weight 20%)

a) Claims on multilateral development banks or claims guaranteed by
them or claims collateralised by securities issued by such banks
(multilateral development banks include the world bank, Asian
development bank, African Development Bank, European Investment
Bank etc).
b) Claims on banks incorporated in the OECD and loans guaranteed by
such banks.
c) Claims on banks outside OECD and loans guaranteed by such banks
provided the claims and loans have a residual maturity of less than 1
year.
d) Claims on non-domestic OECD public sector entities (PSEs are defined
to include state governments, local authorities such as municipalities
but not public sector enterprise engaged in commercial operations).
e) Cash receivables.

3. Category III (Weight 50%)

a) Loans fully secured by mortgage on residential property.

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4. Category IV (Weight 100%)
a) Claims on the private sector and public sector commercial companies.
b) Claims on non-OECD banks of residual maturity exceeding 1 year.
c) Claims on non-OECD Central governments, which are no denominated
in national currency.
d) Office premises, plant and equipment, and fixed machinery.
e) Real estate and investments (excluding residual premises).
f) Capital instruments issued by other banks.
g) All other assets.

The External Credit Assessments:

As the risk weights under the standardised approach are based on
external credit assessments. It is very important to ensure that the
institutions carrying out rating are sound and reliable. The supervisors have
to determine whether an External Credit Assessment Agency (ECAI) meets
the prescribed eligibility criteria. The supervisory process for recognizing
ECAI should be made public to avoid unnecessary barriers to entry. The
reviewing and recognising the rating agencies in the credit risk area would
be a challenge for the supervisors as this would be a totally new activity for
them.

 The Internal Ratings Based (IRB) Approach

The Basel II framework provides two broad methodologies to banks
to calculate capital requirements for credit risk, namely, Standardised
Approach (SA) and Internal Rating Based (IRB) Approach. The IRB approach
is again classified into Foundation IRB (FIRB) approach and Advanced IRB
(AIRB) approach.
The Standardised Approach measures credit risk based on external
credit assessments, guidelines for which had already been issued by Reserve
Bank of India (RBI) vide its circular DBOD. No. BP. BC. 90 / 20.06.001/ 2006-
07 dated April 27, 2007, and updated from time to time.
The IRB Approach allows banks, subject to the approval of RBI, to
use their own internal estimates for some or all of the credit risk
components [Probability of Default (PD), Loss Given Default (LGD), Exposure
at Default (EAD) and Effective Maturity (M)] in determining the capital
requirement for a given credit exposure. This guideline is meant for the
banks which are willing and allowed by the RBI to adopt more sophisticated
IRB approach. RBI will allow banks to adopt IRB approach if, inter alia, banks
meet the requirements mentioned in Appendix 1 of this guideline and
obtain RBI’s approval for the same.
IRB approach to capital calculation for credit risk is based upon
measures of unexpected losses (UL) and expected losses (EL). The risk

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components and risk-weight functions (equations by which risk components
are transformed into capital requirements and risk weighted assets)
detailed in this guideline help to calculate
1
Capital requirements for the UL portion . For EL, the bank must
compare the sufficiency of eligible provisions against EL (generally for
corporate, sovereign, bank and retail exposures) amounts and adjust the
regulatory capital accordingly (as given in para 200). For a non-technical
explanation of Basel II IRB Risk weight functions, please see BCBS Paper
entitled “An Explanatory Note on the Basel II IRB Risk Weight Functions”
October 2004
Under IRB approach, the risk-weighted asset amounts that are
derived from the IRB risk-weight functions must be multiplied by a factor of
1.06. The bank must sum the risk-weighted amounts for UL for all IRB asset
classes to determine the total risk-weighted asset amount under any of the
IRB approaches.

Key terminologies used in this guideline

The following terminologies are used in this guideline:
• Probability of Default (PD) - Probability that the borrower will default
within one year horizon.
• Loss Given Default (LGD) - Bank’s economic loss upon the default of a
debtor/borrower.
• Exposures at Default (EAD) - Gross exposure/potential gross exposure
under a facility (i.e. the amount that is legally owed to the bank) at the
time of default by a borrower.
• Effective Maturity (M) - Effective maturity of the underlying should be
gauged as the longest possible remaining time before the borrower is
scheduled to fulfil its obligation.
• Purchased Receivables – A pool of receivables purchased by the bank
from another entity. Among others, this may also include those
exposures when a bank is buying loans from other banks.
• Dilution Risk- This arises out of the possibility of reduction in the
amount of total purchased receivables through cash or non cash
credits to receivables’ obligors. Suppose an entity has supplied some
goods to a buyer on credit basis, recorded the future payments due as
receivables, and subsequently sells the receivables to a bank. In this
scenario, if the bank buying the receivables sees the possibility that
because of the agreement between seller of the receivables and the
buyer of the goods (like on account of return of goods sold, dispute
regarding product quality, promotional discount offered by the
supplier etc.), there is a chance of material decrease in the amount of
the receivables after purchasing the same, it has to account for dilution

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 risk.
• Eligible Guarantor - Specific entities which can provide guarantee on
behalf of the borrower, by virtue of which the lender may have a direct
claim on those entities and these guarantees given should be
referenced to a specific exposure or a pool of exposures.
The remaining parts of the guidelines are divided into seven
sections along with eleven Appendices at the end. Section A talks about the
categorisation of exposures, issues related to adoption of IRB approaches in
the banks and the transitional floors that the banks need to follow once
they receive the approval for using IRB approaches. Section B talks about
the treatments of corporate, sovereign and banks exposures. Section C and
D talk about the treatment of retail and equity exposures respectively.
Section E deals with the securitisation exposures in the banking book and
section F touches upon supervisory review process under Pillar 2. Finally,
section G describes the application process that the banks need to follow to
get approval for adoption of IRB approaches.

Categorisation of Exposures
Under the IRB approach, to arrive at the risk weighted assets
(RWA) for exposures, banks may categorise banking-book exposures into
broad asset classes with different underlying risk characteristics, subject to
the definitions elaborated subsequently. There are broadly six asset classes.
They are:
i. Corporate,
ii. Sovereign,
iii. Bank,
iv. Retail,
v. Equity, and
vi. Others
It is the responsibility of banks to convince RBI that the
categorisation of exposures in different asset classes is appropriate and
consistent over time given their business practices.

Corporate Exposure
A corporate exposure is defined as a debt owed by a company,
partnership or proprietorship to a bank. Claims on Indian Public Sector
Undertakings (PSUs), foreign Public Sector Entities (PSEs), and Primary
Dealers (PDs) will be treated as claims on corporate. Trusts and societies
which have features like the corporate and function like corporate will fall
under this asset class.

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Specialised Lending Sub- Classes
The corporate asset class includes, but is not limited to, four
separate sub-classes of specialised lending (SL). The four sub-classes of
specialised lending are project finance (PF), object finance (OF),
commodities finance (CF) and income-producing real estate (IPRE). Each of
these sub-classes is defined in the Appendix 2. Also, such lending should
possess the following characteristics, either in legal form or economic
substance:
• The exposure is typically to an entity [often a special purpose vehicle
(SPV) also known as special purpose entity (SPE)] which was created
specifically to finance and/or operate physical assets;
• The borrowing entity has little or no other material assets or activities,
and therefore little or no independent capacity to repay the obligation,
apart from the income that it receives from the asset(s) being
financed; and
• The lender has a substantial degree of control over the asset(s) and the
income that it generates from the use of the assets.

Sovereign Exposure
The sovereign exposure covers all credit exposures to
counterparties as mentioned below:
• Fund and non-fund based claims on the Central Government along
with Central Government guaranteed claims,
• Claims on the Reserve Bank of India (RBI), DICGC and Credit Guarantee
Fund Trust for Small Industries (CGFTSI),
• Direct loan/credit/overdraft exposure to the State Governments,
investment in State Government securities and State Government
guaranteed claims, and
• Claims on foreign sovereigns and their central banks.
In the absence of sufficient data points, if banks find it difficult to
apply IRB approaches to the exposures mentioned above, they may be
treated as per Standardised Approach with the prior approval of RBI. The
IRB applicant banks may, however, make an endeavour to apply IRB
approaches to these exposures at the earliest.

Bank Exposure
The bank exposure includes claims on:
• Banks incorporated in India, branches of foreign banks operating in
India as well as branches of foreign banks in foreign countries. This will
also include exposure to ECGC,
• Bank for International Settlements (BIS) and the International
Monetary Fund (IMF), and

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• Claims on Multilateral Development Banks (MDBs) as given below:
1. World Bank Group: IBRD and IFC
2. Asian Development Bank
3. African Development Bank
4. European Bank for Reconstruction and Development
5. Inter-American Development Bank
6. European Investment Bank
7. European Investment Fund
8. Nordic Investment Bank
9. Caribbean Development Bank
10. Islamic Development Bank
11. Council of Europe Development Bank
12. International Finance Facility for Immunization
In the absence of sufficient data points, if banks find it difficult to
apply IRB approaches to the exposures to ECGC, BIS, IMF and other MDBs,
they may be treated as per Standardised Approach with the prior approval
of RBI. The IRB applicant banks may, however, make an endeavour to apply
IRB approaches to these exposures at the earliest.

Retail Exposure
An exposure is categorised as a retail exposure if it is extended to
an individual (i.e. a natural person) or individuals and is part of a large pool
of exposures that is managed by the bank on a pooled basis, e.g. credit
cards, overdrafts, retail facilities secured by financial instruments,
residential mortgage loans, etc. Loans extended to small businesses (not
necessarily to an individual) and managed as retail exposures by the bank in
its internal risk management systems consistently, may be treated as retail
exposures, provided that the conditions mentioned in para 132 are fulfilled.
Within the retail asset class category, banks are required to identify three
separate sub-classes of exposures, namely, exposures secured by residential
properties, qualifying revolving retail exposures and other retail exposures.

Equity Exposure
Equity exposures include both direct and indirect (say holding of derivative
instruments tied to equity, holdings in those institutions that issue
ownership interests) ownership interest, whether voting or non-voting, in
the assets and income of a commercial enterprise or of a financial
institution. Equity exposures are defined on the basis of the economic
substance of the instrument and required to meet all the following
requirements:
• It is irredeemable i.e., the return of invested funds can be achieved
only by the sale of the investment or sale of the rights to the

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 investment or by liquidation of the issuer,
• It does not embody an obligation on the part of the issuer, and
• It conveys a residual claim on the assets or income of the issuer.

Others
This category may include fixed assets, fund and non-fund based
claims on venture capital funds, loans and advances to bank’s own staff
which are fully covered by superannuation benefits and/or mortgage and
any other exposures which the bank is not able to categorise under the five
asset classes viz. corporate, sovereign, banks, retail and equity, as detailed
above. Banks need to take approval from RBI for categorising the exposures
under this category. Banks may apply risk weights to such exposures as per
the standardised approach as mentioned in Para 189 of this guideline.

Different approaches under IRB

For the corporate (except in case of some of the specialised lending
sub-classes), sovereign and bank asset classes, there are two IRB
approaches to derive the capital requirement for credit risk:
I. Foundation IRB approach (FIRB)
II. Advanced IRB approach (AIRB)
Under the FIRB, banks are generally expected to provide their own
estimates of PD and rely on the supervisory estimates for other risk
components, namely LGD, EAD and M while under the AIRB, banks provide
their own estimates of PD, LGD and EAD and their own calculation of M.
Under both approaches, banks are required to use the relevant IRB risk
weighted function, as detailed subsequently in para 114 and 115, for the
purpose of deriving the capital requirement for UL for the relevant
exposures. In some cases of Specialised Lending (SL) sub-asset classes under
Corporate IRB asset class, where banks do not meet PD estimation
requirements, specific risk weights associated with slotting categories may
be used.
For the retail asset class, banks are required to provide their own
estimates of PD, LGD and EAD. There is no explicit maturity adjustment and
no distinction between FIRB and AIRB for this asset class.
Within the corporate and retail asset classes, a separate treatment
for purchased receivables may also apply, provided certain conditions are
met. For purchased receivables in both the corporate and retail asset
classes, banks are required to hold regulatory capital for default risk and
wherever material, dilution risk.
There are two broad approaches to calculate RWA for equity
exposures which are not held in the trading book of the bank: a market
based approach and a PD/LGD approach. The PD/LGD approach to equity

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exposures will be available for those banks that adopt advanced IRB
approach for other exposure types (viz. corporate, sovereign, bank and by
default retail).
Further, it may be added that banks’ exposures which are kept
under Available for Sale (AFS) category, will be attracting risk weight as per
foundation/advanced IRB approach only, even if those banks continue to be
under Standardised Measurement Method (SMM) for market risks.

Adoption of IRB Approach

Banks, at their discretion, would have the options either to remain
on Standardised Approach or of adopting the IRB Approach for credit risk.
They may thus undertake an internal assessment of their preparedness for
migration to IRB, in the light of the criteria envisaged in this document
(Appendix 1) and take a decision on their migration to IRB. Banks are then
needed to invariably obtain prior approval of RBI for adopting IRB Approach.
If, however, RBI examines and finds that the bank applying to adopt IRB
approach does not meet required criteria, it may reject the application.
Further, in the instance when a bank is given initial approval but in
subsequent periods it is found that it no longer meets the requirements for
IRB approach, RBI may require the bank to revert to a simpler approach for
some or all of its operations, until it meets the conditions specified by RBI
for adopting/returning to the more advanced approach.
Once a bank adopts IRB approach, it is expected to extend it across
all material asset classes within the bank and the entire banking group.
However, for some banks, if it is not be practicable for various reasons to
implement the IRB approach at the same time, RBI may permit banks to
adopt a phased roll out of the IRB approach.
An overriding consideration for allowing partial use is that banks
must submit an acceptable rationale for any requested carve outs and the
rationale should not be based on minimising regulatory capital charge.
Further, the applicant bank must produce an implementation plan,
specifying to what extent and when it intends to roll out IRB approaches
across all material asset classes within the bank, and different entities in the
same group over time. The plan should be exacting, yet realistic, and must
be agreed with the RBI. The roll out period should not be long, preferably
not more than 24 months.
During the roll out period, no capital relief is granted for intra-
group transactions which are designed to reduce the banking groups’
aggregate capital charge by transferring credit risk among entities on the
standardised/foundation IRB/advanced IRB approaches. This will include but
not limited to asset sales or cross guarantees.
Some exposures that are immaterial in terms of size and perceived risk

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profile may be exempted from the requirements specified in paragraphs 25
and 26, subject to approval from the RBI. Capital requirements for such
operations will be determined according to standardised approach. The
total exemptions (which includes exposures where phased roll out is
allowed or which are immaterial in terms of size and perceived risk profile)
should not be more than 15% of the total assets or net revenue (operating
profit before provisions), whichever is lower, of the applicant bank.
However, the total exemptions may be arrived at after excluding those
exposures, for which banks have been given option to use other approaches
viz. Slotting criteria approach for Specialised Lending exposures and
Standardised Approach treatment for some of other exposures as per this
guideline.
Once a bank has adopted IRB approach for all or part of any of the
corporate, bank, sovereign or retail asset classes, it will be required to adopt
IRB approach for its equity exposure at the same time, subject to materiality
(say less than 0.5% of the total banking book exposure to be treated as
immaterial). RBI, at its discretion, may require a bank to employ one of the
IRB equity approaches if its equity exposures are a significant part of bank’s
business, even though the bank may not employ an IRB approach in other
asset classes. Further, banks adopting IRB approaches are expected to
continue with IRB approaches. A voluntary return to the standardised from
IRB approaches or IRB foundation approach from IRB advanced approach is
permitted only in extraordinary circumstances, such as divestiture of a large
fraction of the banks’ credit related business and must be approved by the
RBI.
Given the data limitations associated with SL exposures, a bank
may remain on the supervisory slotting criteria (given in para 121 and 122)
approach and move to the foundation or advanced approach for other sub
classes within the corporate asset class.

Transition arrangements
31. As per the time frame specified for implementation of IRB
approach in India, the earliest date of making application by banks to RBI is
April 1, 2012 and likely date of approval by RBI is March 31, 2014. RBI
expects that 18 months of parallel run and detailed analysis of the adequacy
of applicant bank’s rating system, governance and operational integrity,
data management, use and experience may be carried out before the final
approval is given to a bank.
The transition period starts on the date of implementation of this
framework by the bank and will continue for minimum of two years from
that date. Banks adopting IRB Approach are required to calculate minimum
capital requirement using IRB Approach as well as the Standardised

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Approach of Basel II. During the transition period, the minimum capital
maintained by banks for implementation of IRB Approach will be subjected
to prudential floor which shall be higher of the minimum capital required to
be maintained as per the IRB Approach and a specified percentage of
minimum capital required to be maintained as per the Standardised
Approach. The specified percentage will progressively decline as indicated
below:
Financial year ending Year 1 Year 2 and
onwards
Prudential floor (Minimum Capital
requirement computed As per 100% 90%
Standardised Approach of Basel II)
Any change in the prudential floor subsequent to second year of
IRB implementation, if any, will be communicated by RBI at that time.
At the beginning of the transition period, pertaining to corporate,
sovereign, bank and equity exposures, banks need to take note of the
following –
• For corporate, sovereign and bank exposures, the bank must
demonstrate that it has been using a rating system which was broadly
in line with the minimum requirements articulated in this document
for at least three years prior to qualification to these approaches.
• The transitional approaches mentioned above will be applicable to
PD/LGD approach to equity as well. However, there is no transitional
arrangement for market based approach for equity exposure.
For a maximum of ten years, RBI may exempt, from the IRB
treatment, particular equity investments held by the applicant bank. The
exempted position is measured as the number of shares as on that date and
any additional shares arising directly as a result of owning those holdings, as
long as those do not increase the proportional share of ownership in an
investee company.
If an acquisition increases the proportional share of ownership in a
specific holding (say, due to change of ownership initiated by the investing
company subsequent to the date of this circular), the exceeding part of the
holding is not subject to exemption. Nor will the exemption apply to
holdings that were originally subject to the exemption, but have been sold
and then brought back. Equity holdings covered by these transitional
provisions will be subject to the capital requirements as per the
standardised approach.

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Estimation of Risk components for Corporate, Sovereign and Bank
exposures
Probability of Default (PD)
PD estimation should always be borrowers specific i.e. all
exposures to a single borrower will be assigned a single PD. For corporate
and bank exposures, PD is greater of the one year PD associated with the
internal borrower grade to which that exposure is assigned or 0.03%. For
sovereign exposures, the PD is the one year PD associated with the internal
borrower grade to which that exposure is assigned. For both FIRB and AIRB,
banks should be estimating PDs of the exposures. The PD of the borrowers
assigned to a default grade, consistent with default criteria is 100%. The
minimum requirements for the derivation of the PD estimates associated
with each internal borrower grade are mentioned below:

Requirements for PD estimation for corporate, sovereign and bank

exposures
Banks must use information and techniques that take appropriate
account of the long-run experience when estimating the average PD (i.e.
long term average PD) for each rating grade. For example, banks may use
one or more of the three specific techniques: internal default experience,
mapping to external data, and statistical default models.
The minimum requirements for the three specified techniques are:
(i) Banks may use data on internal default experience for the estimation of
PD. A bank must demonstrate in its analysis that the estimates are reflective
of underwriting standards and of any differences in the rating system that
generated the data and the current rating system. Where only limited data
are available, or where underwriting standards or rating systems have
changed, the bank must add a greater margin of conservatism in its
estimate of PD. The use of pooled data across institutions may also be
recognised. A bank must demonstrate that the internal rating systems and
criteria of other banks in the pool are comparable with its own.
(ii) Banks may associate or map their internal grades to the scale used by
an external credit rating agency and then attribute the default rate
observed for the external credit rating agency’s grades to the bank’s grades.
Mappings may be based on a comparison of internal rating criteria
(including risk drivers) to the criteria used by the external rating agency and
on a comparison of the internal and external ratings of any common
borrowers. Biases or inconsistencies in the mapping approach or underlying
data must be avoided. The external agency’s criteria underlying the data
used for quantification must be oriented to the risk of the borrower and not
reflect transaction characteristics. The bank’s analysis must also include a
comparison of the default definitions used.

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(iii) A bank is allowed to use a simple average of PD estimates for
individual borrowers in a given grade, where such estimates are drawn from
statistical default prediction models. The bank’s use of PD models along
with other models used for capital calculation purpose must meet the
standards specified in Para 28-40 of Appendix 1.
Irrespective of whether a bank is using external, internal, or pooled
data sources, or a combination of the three, for its PD estimation, the length
of the underlying historical observation period used must be the long one
(preferably to cover the entire economic cycle) for each rating grade, and
minimum of five years for at least one of these three sources. If the
available observation period spans a longer period for any source, and this
data are relevant and material, this longer period must be used.
Banks may have a primary technique for PD computation and use
others as a point of comparison and potential adjustment. The mechanical
application of a technique without supporting analysis is not sufficient.
Banks must recognise the importance of judgmental considerations in
combining results of techniques and in making adjustments for limitations
of techniques and information.

Loss Given Default (LGD)

The LGD attached to any particular exposure is maximum of
downturn LGD or long run default weighted average LGD associated with
that exposure, should a default occur. LGD is usually shown as the
percentage of EAD that the bank might lose in case the borrower defaults. It
depends, among others, on the type and amount of collateral as well as the
type of borrower and the expected proceeds from the work out (e.g. sales
proceeds from sales of collaterals/securities) of the assets.
Also, LGD is exposure specific i.e., different exposures to the same
borrower may have different LGDs.
Loss estimates must be based on economic rather than accounting
concepts i.e. material discount effects and material direct and indirect cost
associated with collecting an exposure must also be taken into account.
Therefore, care should be taken so that banks must not simply measure the
loss recorded in accounting books, although they should be able to compare
and reconcile accounting and economic losses. The bank’s own work out
and collection expertise influences their recovery rates and may be
reflected in their LGD estimates, but adjustments to estimates for such
expertise must be conservative until the bank has sufficient internal
empirical evidence of the impact of its expertise.
Estimates of LGD for exposures in the corporate, sovereign and
bank asset classes must be based on a minimum data observation period
that should ideally cover at least one complete cycle but, in any case, must

137
 not be shorter than a period of seven years from at least one source. If the
available observation period spans a longer period from any source and the
data are relevant and material, this longer period must be used. Further,
LGD estimates must reflect economic downturn, where necessary, to
capture relevant risks.
A bank must estimate LGD for each of the corporate, sovereign and
bank exposures. There are two approaches by which the banks can calculate
LGD of an exposure under the IRB Approach:
a. A foundation approach
b. An advanced approach

LGD under the Foundation IRB Approach

Under the foundation approach, banks must use RBI’s estimates for
the LGD for the corporate, sovereign and bank asset classes (or for a certain
exposure within these asset classes), as summarised below in Table 1.
In the Table 1, the estimates of minimum LGDs for both unsecured
and secured exposures under F-IRB framework have been provided, which
will be subject to review by RBI from time to time. LGD prescription for
exposures collateralised with eligible financial collateral is discussed in para
56-57.
Table-1
LGD for unsecured and non-recognised collateralised exposures
Type of exposure Minimum LGD (%)
Senior Unsecured Claim 65
Subordinated claim 75
LGD for collateralised exposures – under eligible collaterals
Type of collateral Minimum LGD Threshold level of Required level of
(%) collaboration (over)
required for partial Collaboration for
Recognition of full recognition of
collateral for the collateral for the
exposure(C*) exposure(C**)

Eligible financial - - -
collateral@
Eligible financial 50 0 125
Receivables
Eligible Commercial 50 30 140
Real Estate (CRE)/
Residential Real
Estate(RRE)
Other physical collateral ₤ 60 30 140
@ treatment has been dealt with in detail in para 56 and 57 of the guidance
and Appendix 3 ₤may include industrial properties, land, etc.

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LGD with eligible financial receivables, eligible CRE/RRE and other physical
collateral (eligible IRB collaterals)
When the level of collateralisation is between the levels C* and
C**, then the exposure should be divided in two parts. The collateralised
portion of the exposure should be allotted the collateral in such a way that
the level of collateralisation for that part of the exposure is at C** level and
accordingly minimum LGD should be assigned as per the above table. The
other part of the exposure will be treated as unsecured as full amount of
collateral has already been used up and will be assigned an LGD of 65%.
Example: Suppose the exposure is of Rs. 100 crore and is collateralised with
eligible CRE/RRE of the value of Rs. 70 core. In this case, Rs. 50 crore of the
exposure will thus be treated as fully collateralised as Rs. 70 crore of the
collateral becomes 140% (C**) of that Rs. 50 crore portion of the exposure.
This will be assigned an LGD of 50%. The remaining exposure of Rs. 50 crore
will be treated as unsecured and should be assigned an LGD of 65%.
On the other hand, if the same exposure were collateralised with
eligible CRE/RRE of Rs. 28 crore then LGD applicable on the whole exposure
would be 65% as the entire exposure would be treated as unsecured as the
collateral is below the threshold level of 30% (C*) of the total exposure of
Rs. 100 crore. On the other extreme, if the eligible CRE/RRE collateral were
of Rs. 142 crore then the LGD applicable on the entire exposure would be
the minimum applicable i.e. 50%, as the collateral amount is more than
140% of the exposure.
While using the LGD figures for its exposures, banks may take into
account the effects of different risk mitigating methods/instruments on the
exposures to mitigate the credit risks which they are exposed to. For
example, exposures may be collateralised in whole or in part by cash or
securities, deposits from the same counterparty, guarantee of a third party,
etc. as detailed below.

General Principles for credit risk mitigation

The general principles applicable to use of credit risk mitigation techniques
are as under:
(i) No transaction in which Credit Risk Mitigation (CRM) techniques
are used should receive a higher capital requirement than an otherwise
identical transaction where such techniques are not used.
(ii) While the use of CRM techniques reduces or transfers credit risk, it
simultaneously may increase other risks (residual risks). Residual risks
include legal, operational, liquidity, market risk etc. Therefore, it is
imperative that banks employ robust procedures and processes to control
these risks, including strategy; consideration of the underlying credit;
valuation; policies and procedures; systems; control of roll-off risks; and

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management of concentration risk arising from the bank's use of CRM
techniques and its interaction with the bank's overall credit risk profile.
Where these risks are not adequately controlled, the RBI may impose
additional capital charges or take other supervisory actions. The disclosure
requirements prescribed in Appendix 4 must also be observed to obtain
capital relief in respect of any CRM techniques.
(iii) In order for banks to obtain capital relief for any use of CRM
techniques, some minimum standards for legal documentation must be
met. All documentation used in collateralised transactions, credit
derivatives and guarantees must be binding on all parties and legally
enforceable in all relevant jurisdictions. Banks must have conducted
sufficient legal review, which should be well documented, to verify this.
Such verification should have a well founded legal basis for reaching the
conclusion about the binding nature and enforceability of the documents.
Banks should also undertake such further review as necessary to ensure
continuing enforceability.
The methods/instruments that are allowed for this risk mitigation
purpose in respect of LGD calculation are namely (i) Collaterals, and (ii)
Guarantee/Credit derivatives. The treatment of these credit mitigation
techniques under the foundation IRB for assigning LGD to an exposure are
discussed below.

Collateralised Transaction
A collateralised transaction is one in which
(i) banks have a credit exposure and that credit exposure is hedged in
whole or in part by collateral posted by a counterparty or by a third
party on behalf of the counterparty. Here, "counterparty" is used to
denote a party to whom a bank has an on- or off-balance sheet credit
exposure, and
(ii) banks have a specific lien on the collateral and the requirements of
legal certainty are met.
LGD applicable to uncollateralised exposures and exposures
collateralised with eligible IRB collaterals have been mentioned in Table 1 of
para 48.
LGD calculation and relevant issues applicable for exposures
collateralised by eligible financial collateral are mentioned in para 56 and
57.

Exposures which are collateralised by eligible financial collaterals

Banks applying FIRB approach may be required to adopt
Comprehensive Approach to collaterals as in the SA (allows fuller offset of
collateral against the exposure by effectively reducing the exposure amount

140
by the value ascribed to the collateral) for the recognition of eligible
financial collateral. In addition, it may be mentioned that the legal
mechanism by which collateral is pledged or transferred must ensure that
the bank has the right to liquidate or take legal possession of it, in a timely
manner, in the event of default, insolvency or bankruptcy (or otherwise
defined credit events set out in the transaction document) of the
counterparty (and where applicable of the custodian holding the collateral).
Also, the credit quality of the counterparty and the value of the collateral
should not ideally have a material positive correlation. Banks must have
clear and robust procedures for the timely liquidation of collateral and
ensure that any legal conditions required for declaring the default of the
counterparty and liquidation of the collateral are observed and that
collaterals are liquidated promptly.
If the collateral is with a custodian then the banks must take steps
to ensure that the custodian segregates the collateral from its own assets.
Modalities for collaterals under IRB approach and also the aspects of haircut
applicable to eligible financial collaterals are detailed in Appendix 3.

LGD for collateralised (with eligible financial collateral) exposures

57. Following the comprehensive approach, the effective Loss Given Default
(LGD*) applicable to the collateralised transaction (with eligible financial
collateral) can be expressed as follows:
LGD* = LGD x (E* / E)
Where LGD is that of the senior unsecured exposure before recognition of
collateral (65%); E is the current value of the exposure (i.e. cash lent or
securities lent or posted); E* is the exposure value after risk mitigation as
discussed in the Appendix 3. This concept is only used to calculate LGD*.
Banks must continue to calculate EAD without taking into account the
presence of any collateral, unless otherwise specified.
Where repo-style transactions are subject to a master netting
agreement, a bank may choose not to recognise the netting effects in
calculating capital. However, banks that want to recognise the effect of
master netting agreements on such transactions for capital purposes must
satisfy the criteria under Treatment of repo-style transactions covered
under master netting agreements as given subsequently in para 89-93.

Methodology for the treatment of pools of collateral

The methodology for determining the effective LGD (LGD*) of a
transaction under the foundation approach where banks have taken both
financial collateral and other eligible IRB collateral is aligned to the
treatment in the standardised approach as per the following guidance:
• In the case where a bank has obtained multiple forms of credit risk

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 mitigation (CRM), it will be required to subdivide the adjusted value of
the exposure (after the haircut for eligible financial collateral) into
portions each covered by only one CRM type. That is, the bank must
divide the exposure into the portion covered by eligible financial
collateral, the portion covered by receivables, the portion covered by
CRE/RRE collateral, a portion covered by other collateral, and an
unsecured portion, where relevant.
• Where the ratio of the sum of the value of the CRE/RRE and other
collateral to the reduced exposure (reduced after recognising the
effect of eligible financial collateral and receivable collateral) is below
the associate threshold level (i.e. the minimum degree of
collateralisation of the exposure) the exposure would receive the
appropriate unsecured LGD value of 65%.
• The risk-weighted assets for each fully secured portion of exposure
must be calculated separately.

Treatment of LGD under guarantees and credit derivative

60. Where guarantees are direct, explicit, irrevocable and unconditional,
banks may take account of such credit protection in calculating capital
requirements. Only guarantees issued by entities with a lower risk weight
than the counterparty will lead to reduced capital charges since the
protected portion of the counterparty exposure is assigned the risk weight
of the guarantor, whereas the uncovered portion retains the risk weight of
the underlying counterparty. However, it is to be noted that credit risk
mitigation in the form of guarantee/credit derivative must not result in
adjusted risk weight that is less than that of a similar direct exposure to the
guarantor or credit protection provider. Detailed operational requirements
for guarantees and credit derivatives eligible for being treated as CRM are
given in para 87-96 of Appendix 1 and also in Appendix 5.
The range of eligible guarantors is the same as under the SA.
Eligible guarantors are also discussed in para 4 of Appendix 5.
Eligible guarantee and credit derivatives may be treated under
Double Default framework. Otherwise, eligible guarantees/credit derivatives
from eligible guarantors/credit protection providers may also be recognised
under F-IRB as given below:
i. First the exposure is to be divided into two parts – a covered portion
with exposure equal to the notional amount of the eligible
guarantee/credit protection bought and the uncovered portion equal to
total exposure minus the covered portion.
ii. For the covered portion of the exposure, a risk weight is derived by
taking the PD appropriate to the guarantor or credit protection
provider’s borrower grade or some grade between that of the

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 underlying debtor and the guarantor or the credit protection provider if
the bank feels that full substitution of the borrower grade with that of
the guarantor or credit protection provider may not be appropriate.
The capital requirement will be based on the capital calculation formula
applicable to the guarantor or credit protection provider. The bank may
or may not replace the LGD of the underlying transaction with the LGD
applicable to the guarantee taking into account seniority and any
collateralisation of a guaranteed commitment.
iii. The uncovered portion of the exposure is assigned LGD in the same
manner as a direct exposure to the underlying borrower.
iv. If the guarantee or credit derivative stipulates for any materiality
threshold below which no payment will be made by
guarantor/protection provider in the event of credit loss, then this
threshold is effectively equivalent to a retained first loss position and
must be fully deducted from common equity Tier 1 of the bank availing
the guarantee/protection.
v. Similar to the cases where partial coverage exists, in cases where there
is a currency mismatch (discussed in para 63) between the underlying
obligation and the credit protection, it is necessary to split the exposure
into a covered and an uncovered amount. The treatment in the
foundation approach follows the treatment outlined in para 6 and 7 in
Appendix 5, and depends upon whether the cover is proportional or
tranched.

Currency mismatch
Where the credit protection (by way of guarantee or credit
derivative) is denominated in a currency different from that in which the
exposure is denominated i.e. there is a currency mismatch the amount of
the exposure deemed to be protected will be reduced by the application of
a haircut HFX, i.e.,
GA = G x (1 – HFX), where:
GA= Effective amount of credit protection on account of currency mismatch
G = nominal amount of the credit protection
HFX = haircut appropriate for currency mismatch between the credit
protection and underlying obligation. The appropriate haircut based on a
10-business day holding period (assuming daily marking to market) will be
applied. If a bank uses supervisory haircuts, it will be 8%. The haircuts must
be scaled up using the square root of time formula, depending on the
frequency of revaluation of the credit protection as described in Appendix 3.
Maturity Mismatch
The maturity of the underlying exposure and the maturity of the
credit risk mitigant instruments (e.g. collateral, guarantee and credit

143
derivative) should be defined conservatively. The effective maturity of the
underlying should be gauged as the longest possible remaining time before
the counterparty is scheduled to fulfil its obligation, taking into account any
applicable grace period. For risk mitigants, embedded options which may
reduce the term of the mitigants should be taken into account so that the
shortest possible effective maturity is used. The maturity relevant here is
the residual maturity.
For the purposes of calculating risk-weighted assets, a maturity
mismatch occurs when the residual maturity of credit risk mitigation
instruments is less than that of the underlying exposure. Where there is a
maturity mismatch and the CRM instruments have an original maturity of
less than one year, the instrument is not recognised for capital calculation
purposes. However, in case of loans collateralised by the borrower's own
deposits in the bank, even if the tenor of such deposits is less than three
months or deposits have maturity mismatch vis-à-vis the tenor of the loan,
the provisions of this paragraph regarding de-recognition of collateral would
not be attracted provided an explicit consent of the depositor (i.e. the
borrower) has been obtained for adjusting the maturity proceeds of such
deposits against the outstanding loan or for renewal of such deposits till the
full repayment of the underlying loan.

Adjustments for Maturity Mismatches

As outlined above, credit risk mitigants with maturity mismatches
are only recognised when their original maturities are greater than or equal
to one year. As a result, the maturity of risk mitigants against exposures
with original maturities of less than one year must be matched to be
recognised. Further, collateral with maturity mismatches will no longer be
recognised when they have a residual maturity of three months or less
When there is a maturity mismatch with recognised credit risk mitigants,
the following adjustment will be applied to find out the effective value of
credit protection:
Pa = P x (t - 0.25) ÷ (T - 0.25)
where:
Pa = value of the credit protection (e.g. collateral amount, guarantee/credit
protection amount) adjusted for maturity mismatch
P = credit protection adjusted for any haircuts
t = min (T, residual maturity of the collateral/guarantee/credit protection
arrangement) expressed in years
T = min (5, residual maturity of the exposure) expressed in years.

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LGD under the Advanced IRB Approach
RBI may permit banks to use their own internal estimates of LGD
for corporate, sovereign and bank exposures. LGD must be measured as the
loss given default as a percentage of the EAD. Banks eligible for the IRB
approach that are unable to meet the additional minimum requirements as
given below must utilise the LGD estimate under foundation IRB approach.
It may be noted that in case of foundation IRB approach, LGD estimates
have been prescribed by the RBI and collateral value is based on the current
realisable value of the collateral. However, in case of advanced IRB
approach, LGD estimates computed by the banks should be based on
historical recovery rates of the collaterals.

Requirements for all asset classes

A bank must estimate an LGD for each facility that aims to reflect
economic downturn conditions i.e., downturn LGD, to capture the relevant
risks. The examples of some possible economic downturn conditions may
be:
• Periods of negative GDP growth and high unemployment rate (for a
well diversified portfolio).
• Periods in which observed default rates have been high for a portfolio
of exposures that is representative of reporting bank’s current
portfolio.
• Periods in which common risk drivers (e.g. collateral values) that
influence default and recovery rates are expected to be distressed.
This downturn LGD cannot be less than the long-run default-
weighted average LGD calculated based on the average economic loss of all
observed defaults within the data source for that type of facility.
A care must be taken that default weighted average LGD is
different from exposure weighted average LGD.
Example: Suppose in a portfolio of defaulted asset, there were a total
number of 100 exposures out of which 75 exposures were of Rs.1000 each
and 25 exposures of Rs. 2000 each. Now the bank could recover nothing
(i.e., 100% loss) from the first 75 exposures but could recover Rs.1500 each
(i.e., 25% loss) from the 25 exposures.
In this case, the default weighted average LGD will be {(75*100) +
(25*25)}/100 = 81.25%, while the exposure weighted average LGD would be
[{(75*1000) + (25*500)}/{(75*1000) + (25*2000)}] =70%.
In its analysis, the bank must consider the extent of any
dependence between the risk of the borrower and that of the collateral or
collateral provider. Cases where there is a significant degree of dependence
must be addressed in a conservative manner. Any currency mismatch
between the underlying obligation and the collateral must also be

145
considered and treated conservatively in the bank’s assessment of LGD.
LGD estimates must be grounded in historical recovery rates and,
when applicable, must not solely be based on the collateral’s estimated
market value. This requirement recognises the potential inability of banks to
gain both control of their collateral and liquidate it expeditiously. To the
extent that LGD estimates take into account the existence of collateral,
banks must establish internal requirements for collateral management,
operational procedures, legal certainty and risk management process.
Recognising the principle that realised losses can at times
systematically exceed expected levels, the LGD assigned to a defaulted asset
(downturn LGD) should reflect the possibility that the bank would have to
recognise additional, unexpected losses during the recovery period in
downturn conditions. For each defaulted asset, the bank must also
construct its best estimate of the expected loss on that asset based on
existing economic circumstances and facility status. The amount, if any, by
which the LGD on a defaulted asset exceeds the bank’s best estimate of
expected loss on the asset represents the capital requirement for that asset,
and should be set by the bank on a risk-sensitive basis in accordance with
paragraph 117. Instances where the best estimate of expected loss on a
defaulted asset is less than the sum of specific provisions and partial charge-
offs on that asset may attract RBI scrutiny and must be justified by the bank.

Additional requirements for corporate, sovereign, and bank exposures

Estimates of LGD must be based on a minimum data observation
period that should ideally cover at least one complete economic cycle but
must in any case be no shorter than a period of seven years for at least one
source. If the available observation period spans a longer period for any
source, and the data are relevant, this longer period must be used.

Principles to be followed by the banks while calculating own estimates of

LGD
While calculating historical LGD and then estimating the probable
future LGDs, a bank should observe the following principles:
(i) All factors which may have a probable effect on the cost of holding (e.g.
interest forgone) or collection on a defaulted facility should be
considered for LGD calculation. Direct and indirect cost associated with
the recovery process should be taken into account. Therefore, not only
accounting loss but also the economic loss aspects should be looked
into by the bank.
The economic loss as mentioned above may be calculated using
EAD, loss of principal, interest, fees (if applicable), present value of the
subsequent recoveries and present value of the material direct and

146
 indirect cost associated with collecting an exposure, discounted at an
appropriate discount rate.
The discount rate used to calculate the economic loss should not
result in negative or zero LGD. The discount rate may be either cost of
equity or average cost of funds or opportunity cost or some other
relevant rates, subject to a floor of the contract rate and penalty, if any.
(ii) The cost of recovery, if can distinctly be assigned to certain exposure
should facilitate the calculation of LGD for that exposure. But in cases
where this is not feasible, then the banks should use averages of
recovery costs over the possible related exposures. In these cases,
banks should use their judgement and discretions to allocate and
average the recovery costs to different exposures.
(iii) If the bank notionally ends the period of recovery for a particular
defaulted exposure in its records when most of the recovery has taken
place and most of the costs related to that have been incurred then
also the bank should take into consideration the likely remaining
additional recovery and cost amount for estimating LGD for that
exposure.

Issues to be taken care of by the banks to calculate downturn LGD

The effect of the economic downturn conditions on the recovery
and hence on estimated LGD should be documented properly and followed
rigorously by the banks so that no ‘cherry picking’ is done to tone down the
effect of downturn and hence lowering an LGD estimate.
The downturn conditions can be assumed to be country specific as
well. For a bank having exposures in foreign countries should take into
account the economic indicators of those countries to determine whether
any of those countries are experiencing economic downturns. If a bank finds
that defaulted exposures in some asset class/various asset classes are
showing strong correlation (historically) in recovery rates then the bank may
group those countries together for the purpose of ascertaining the
downturn conditions. The bank may estimate the negative correlation
between the occurrence of defaults and recovery rates. The banks may
compare with the average ‘through the cycle’ recovery rates and compare it
with ‘point in time’ recovery rates in appropriate downturn periods.
Difference between these two estimates can help the banks find out the
impact of downturn on the recovery rates. Banks may also do a statistical
analysis of the relationship between observed default and recovery rates
over a complete economic cycle.
In case of the exposures secured with collaterals, banks may need
to see the effect of the change in the value of the collaterals and hence on
the recovery under the economic downturn conditions. Banks may also

147
identify risk factors that determine their recovery rates and analyse the
relation between those risk factors and default rates under both the normal
conditions and downturn conditions. They could calibrate the LGD estimate
with these findings.

Treatment of certain repo-style transactions

Banks that want to recognise the effects of master netting
agreements on repo-style transactions for capital purposes must apply the
methodology outlined in para 89 to 93 for determining exposure value after
risk mitigation i.e., E* for use as the EAD and not for use in LGD calculation.
However if the banks do not want to recognise master netting agreement,
then they can use E* for LGD calculation as in para 57 (in foundation IRB).
For banks using the advanced approach, own LGD estimates would be
applied for the unsecured exposure amount (E*).

Recognition of risk mitigation (guarantees/credit derivatives) in LGD under

the advanced IRB approach
Banks using the advanced approach for estimating LGDs may
reflect the risk mitigating effect of guarantees/credit derivatives through
either adjusting PD or LGD estimates in a consistent manner. In doing so,
banks must not include the effect of double default in such adjustments.
However, the adjusted risk weight must not be less than that of a
comparable direct exposure to the protection provider.
81. A bank relying on own-estimates of LGD has the option to adopt the
treatment outlined above in para 62, or to make an adjustment to its own
LGD estimate of the exposure to reflect the presence of the guarantee or
credit derivative. Other requirements for recognition of guarantee and
credit derivatives in A-IRB are discussed in para 87-96 in Appendix 1.

Exposure at Default (EAD)

83. Exposure at Default gives an estimate of the amount outstanding (drawn
amounts plus likely future drawdown of yet undrawn lines) when the
borrower defaults. On and off balance sheet items will get different
treatment under Exposure at Default and it needs to be calculated for each
exposure individually. But EAD for both the on and off balance sheet items
are measured gross of specific provisions or partial write off.

EAD under Foundation IRB

EAD for on balance sheet items
EAD estimate of an on balance sheet exposure (i.e. the drawn
amount) should the amount by which a bank’s regulatory capital would be
reduced if the exposure were fully written off ,Any associated specific

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provisions and partial write offs .
85. When the difference between the particular exposure’s EAD and the
sum of (i) and (ii) is positive, the amount is termed as discount. The
calculation of risk weighted assets is independent of any discounts. Under
the limited circumstances i.e. in case of defaulted assets, discounts may be
included in the measurement of total eligible provisions for the purpose of
EL and provision calculation.
86. For calculation of EAD, on balance sheet netting of loans and deposits
is permissible subject to the conditions mentioned below. In these cases,
assets (loans) will be treated as exposures and liabilities (deposits) will be
treated as collaterals. The specific treatment for case of currency or
maturity mismatches, in cases of on balance sheet netting will be the same
as mentioned in para no 63 and 64.
Calculation of exposure under on balance sheet netting
87. On-balance sheet netting is confined to loans / advances and deposits,
where banks have legally enforceable netting arrangements, involving
specific lien with proof of documentation. Banks may calculate EAD and
capital requirements on the basis of net credit exposures subject to the
following conditions:
Where a bank,
a) has a well-founded legal basis for concluding that the netting or
offsetting agreement is enforceable in each relevant jurisdiction
regardless of whether the counterparty is insolvent or bankrupt;
b) is able at any time to determine the loans / advances and deposits with
the same counterparty that are subject to the netting agreement;
c) monitors and controls the relevant exposures on a net basis; and
d) monitors and controls roll over risk.
It may use the net exposure (the value of E* after risk mitigation in
the form of on the balance sheet netting) of loans / advances and deposits
in accordance with the formula in equation A in para 15 of Appendix 3.
Loans / advances are treated as exposure and deposits as collateral.
88. The haircuts will be zero except when a currency mismatch exists. A ten
business day holding period will apply when daily mark to market and daily
re-margining is conducted (else equation B or C of para 24 and 25
respectively of Appendix 3 should be used for adjusted parameters).
Treatment of repo-style transactions covered under master netting
agreements
89. Currently in India, Securities Financing Transactions (SFT) like repo and
reverse repo, CBLO in G-Sec are settled with guarantee by CCIL as central
counterparty. Exposures (calculated as E* as given in equation A of para 15
of Appendix 3) related to SFTs settled with guarantee from CCIL will be
treated as per standardised approach. Only the market repo in corporate

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debt securities takes place without any guarantee and without any netting
provision. In future, if the counterparties in market repo enter into
agreements with netting provisions (as per some master netting agreement
e.g. Global Master Netting Agreement) then only para 89-93 will apply. In
that case, E* mentioned in para 92 will be used for calculation of EAD and
not for LGD. Effects of bilateral netting agreements (if any) covering repo-
style transactions (for corporate debt securities only) will be recognised on a
counterparty-by-counterparty basis if the agreements are legally
enforceable upon the occurrence of an event of default and regardless of
whether the counterparty is insolvent or bankrupt. In addition, netting
agreements must:
(a) provide the non-defaulting party the right to terminate and close-out in
a timely manner all transactions under the agreement upon an event of
default, including in the event of insolvency or bankruptcy of the
counterparty;
(b) provide for the netting of gains and losses on transactions (including the
value of any collateral) terminated and closed out under it so that a single
net amount is owed by one party to the other; for forwards, swaps, options
and similar derivative contracts, this will include the positive and negative
mark to market values of individual transactions;
(c) allow for the prompt liquidation or setoff of collateral upon the event of
default; and
(d) be, together with the rights arising from the provisions required in (a) to
(c) above, legally enforceable in each relevant jurisdiction upon the
occurrence of an event of default and regardless of the counterparty's
insolvency or bankruptcy.
90. Netting across positions in the banking and trading book will only be
recognised when the netted transactions fulfil the following conditions:
(a) All transactions are marked to market daily (the holding period for
haircut will depend as in other repo style transactions on the frequency
of margining) and
(b) The collateral instruments used in the transactions are recognised as
eligible financial collateral in the banking book.
91. The formula in Equation A in para 15 of Appendix 3 will be slightly
modified to calculate the EAD for capital requirements for transactions with
netting agreements as mentioned in the next para.
92. For banks using the standard supervisory haircuts or own-estimate
haircuts (as described in Appendix 3), the framework below will apply to
take into account the impact of netting in case of repo style transactions for
calculating the adjusted exposure (provided the bank is not using VaR model
approach to calculate E* as described in para 31 of Appendix 3) .

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E* = max {0, [(Σ(E) – Σ(C)) + Σ (Es x Hs) +Σ (Efx x Hfx)]}
(Similar to the equation given in A in para15 of Appendix 3) where:
E* = the exposure value after risk mitigation
E = current value of the exposure
C = the value of the collateral received
Es = absolute value of the net position (long or short) in a given security(s).
Hs = haircut appropriate to Es
Efx = absolute value of the net position (long or short) in a currency different
from the settlement currency
Hfx = haircut appropriate for currency mismatch
93. The intention here is to obtain a net exposure amount after netting of
the exposures and collateral and have an add-on amount reflecting possible
price changes for the securities involved in the transactions and for foreign
exchange risk if any. The net long or short position of each security included
in the netting agreement will be multiplied by the appropriate haircut. All
other rules regarding the calculation of haircuts stated in Appendix 3
equivalently apply for banks using bilateral netting agreements for repo-
style transactions.
EAD for off balance sheet items (with the exception of FX and interest rate,
equity and commodity related derivatives)
94. For off balance sheet items, exposure is calculated as the committed but
undrawn amount multiplied by a credit conversion factor (CCF). Estimation
of CCFs for the off balance sheet items can be done under both the
foundation and advanced approaches.
CCF under Foundation Approach
95. The credit equivalent amount in relation to a non market based off-
balance sheet items like direct credit substitutes, trade and performance
related contingent items and other drawdown commitments etc. will be
determined by multiplying the contracted amount of that particular
transaction by the relevant CCF.
Where the off-balance sheet item is secured by eligible collateral or
guarantee, the credit risk mitigation guidelines detailed in Appendix 3 may
be applied if the mitigants are not considered for LGD calculation.
96. Where the non-market related off-balance sheet item is an undrawn or
partially undrawn fund-based facility, the amount of undrawn commitment
to be included in calculating the off-balance sheet non-market related credit
exposures is the maximum unused portion of the commitment that could be
drawn during the remaining period to maturity. Any drawn portion of a
commitment forms a part of bank's on-balance sheet credit exposure.
97. In the case of irrevocable commitments to provide off-balance sheet
facilities, the original maturity will be measured from the commencement of
the commitment until the time the associated facility expires. For example,

151
an irrevocable commitment with an original maturity of 15 months (50 per
cent - CCF) to issue a six month documentary letter of credit (20 per cent -
CCF) would attract the lower of the CCF i.e., the CCF applicable to the six
month’s documentary letter of credit viz. 20 per cent.
98. The types of instruments and the CCFs applied to them are the same as
those in the SA, with the exception of commitments, Note Issuance Facilities
(NIFs) and Revolving Underwriting Facilities (RUFs).
99. A CCF of 75% will be applied to commitments, NIFs and RUFs regardless
of the maturity of the underlying facility. This does not apply to those
facilities which are uncommitted, that are unconditionally cancellable, or
that effectively provide for automatic cancellation, for example due to
deterioration in a borrower’s creditworthiness, at any time by the bank
without prior notice. A CCF of 0% will be applied to these facilities.
100. The amount to which the CCF is applied is the lower of the value of
the unused committed credit line, and the value that reflects any possible
constraining availability of the facility, such as the existence of a ceiling on
the potential lending amount which is related to a borrower’s reported cash
flow. If the facility is constrained in this way, the bank must have sufficient
monitoring and management procedures to support this contention.
101. In order to apply a 0% CCF for unconditionally and immediately
cancellable corporate overdrafts and other facilities, banks must
demonstrate that they actively monitor the financial condition of the
borrower, and that their internal control systems are such that they could
cancel the facility upon evidence of deterioration in the credit quality of the
borrower.
102. Where a bank has given a commitment to provide an off-balance
sheet exposure, under the foundation approach it has to apply the lower of
the CCFs applicable to the commitment and the off balance sheet exposure.
The credit conversion factors for the non-market related off-balance sheet
transactions are given as per Appendix 6.
Market related Off-balance Sheet Items
103. In calculating the off-balance sheet credit exposures arising from
market related off-balance sheet items that expose the bank to
counterparty credit risk, the bank should include all its market related
transactions held in the banking and trading book which give rise to off-
balance sheet credit risk.
The credit risk on market related off-balance sheet items is the cost to the
bank of replacing the cash flow specified by the contract in the event of
counterparty default. This would depend, among other things, upon the
maturity of the contract and on the volatility of rates underlying the type of
instrument.
104. Market related off-balance sheet items would include

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a) interest rate contracts - including single currency interest rate swaps,
basis swaps, forward rate agreements, and interest rate futures;
b) foreign exchange contracts, contracts involving gold, cross currency
swaps (including cross currency interest rate swaps), forward foreign
exchange contracts, currency futures, currency options; and
c) any other market related contracts specifically allowed by the Reserve
Bank which give rise to credit risk.
105. Exemption from capital requirements is permitted for
a) foreign exchange (except gold) contracts which have an original
maturity of 14 calendar days or less; and
b) instruments traded on futures and options exchanges which are subject
to daily mark-to-market and margin payments.
Under both the FIRB and AIRB approaches, banks may determine
EAD for market related off-balance sheet exposure according to the
methods as detailed in Appendix 7.

EAD under Advanced IRB Approach

106. Banks that meet the minimum requirements for use of their own
estimates of EAD as given in Appendix 8, will be allowed to use their internal
estimates of CCFs provided the exposures are not allotted a CCF of 100%
under standardised approach (these exposures will then mandatorily have
CCF of 100% even under advanced IRB as well). A bank must estimate an
EAD for each facility that aims to reflect economic downturn conditions i.e.
downturn EAD to capture the relevant risks. This downturn EAD cannot be
less than the long-run average EAD for that type of facility.

Effective maturity (M)

107. For banks using the F-IRB approach, effective maturity (M) will be 2.5
years except for repo-style transactions where the effective maturity will be
6 months. RBI may, however, subsequently choose to require all banks
(those using the foundation approach) to measure M for each facility using
the definition provided below (even if the bank is using foundation IRB).
108. Banks using A-IRB approach are required to measure effective maturity
for each facility as in para 109. However, if requested by a bank, RBI may
exempt facilities to certain smaller domestic corporate borrowers from the
explicit maturity adjustment if the reported exposure to the consolidated
group based in India is less than Rs. 100 crore subject to the condition that
the total exposure of the borrower is less than or equal to Rs. 5 crore from
the banking system. If the exemption is applied, all exposures to qualifying
smaller domestic firms as mentioned above will be assumed to have an
average maturity of 2.5 years on a consistent basis, similar to foundation IRB
approach.

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109. Except as noted in paragraph 110, M is defined as the greater of one
year and the remaining effective maturity in years as defined below. In all
cases, M will be no greater than 5 years.
For an instrument subject to a determined cash flow schedule, effective
maturity M is defined as:
Effective Maturity (M) = ∑t *CFt / ∑CFt
t t
Where CFt denotes the cash flows (principal, interest payments and
fees) contractually payable by the borrower in period t (expressed in
number of years). However, if a bank is not in a position to calculate the
effective maturity of the contracted payments as noted above, it is allowed
to use a more conservative measure of M such as that it equals the
maximum remaining time (in years) that the borrower is permitted to take
to fully discharge its contractual obligation (principal, interest, and fees)
under the terms of loan agreement. Normally, this will correspond to the
nominal remaining maturity of the instrument.
110. The one-year floor principally may not apply to certain short-term
exposures which are not relationship driven. Such exceptions may include
fully or nearly-fully collateralised capital market-driven transactions (i.e.
OTC derivatives transactions and margin lending) and repo-style
transactions (i.e. repos/reverse repos and securities lending/borrowing)
with an original maturity of less than one year, where the documentation
contains daily re-margining clauses. For all eligible transactions, the
documentation must require daily revaluation, and must include provisions
that must allow for the prompt liquidation or setoff of the collateral in the
event of default or failure to re-margin. The maturity of such transactions
must be calculated as the greater of one-day and the effective maturity (M),
consistent with the definition given in para 109. Short term self liquidating
trade finance instruments (which may include issued and confirmed self
liquidating letter of credit with maturity of less than a year) may also be
exempted from one year floor for AIRB banks.
111. In addition to the transactions considered in paragraph 110 above,
other short-term exposures with an original maturity of less than one year
that are not part of a bank’s ongoing financing of a borrower may be eligible
for exemption from the one-year floor on a case to case basis by RBI.
112. For transactions falling within the scope of paragraph 110 and subject
to a master netting agreement (if applicable), the weighted average
maturity of the transactions should be used when applying the explicit
maturity adjustment. A floor equal to the minimum holding period for the
transaction type set out in paragraph 22 of Appendix 3 will apply to the
average. Where more than one transaction type is contained in the master
netting agreement, a floor equal to the highest holding period will apply to

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the average. Further, the notional amount of each transaction should be
used for weighting maturity.
113. Where there is no explicit maturity adjustment, the effective maturity
(M) assigned to all exposures is set at 2.5 years unless otherwise specified in
paragraph 107.

Risk-weighted assets framework (Risk weight functions with risk

component) for corporate, sovereign and bank exposures not in default
114. Risk weighted functions are used to transform risk components capital
requirements and then into risk weighted assets.
The formula for deriving the risk weighted assets in case of
corporate, sovereign and bank exposures not in default is given below. The
derivation of risk-weighted assets is dependent on estimates of the PD, LGD,
EAD and, in some cases, effective maturity (M), for a given exposure. For
calculating risk weight assets, PD and LGD are expressed as decimals and
EAD in Indian Rupees.

2
Maturity adjustment (b) = {0.11852 − 0.05478* ln(PD)}
Capital requirement

Risk-weighted assets (RWA) = K*12.50*EAD...................eqn. B

Where,
K = Minimum capital requirement expressed as a percentage of EAD
for the exposure
EAD= Exposure at Default
LGD= Loss Given Default of the exposure
PD= One year Probability of Default of the borrower
M= Remaining effective maturity of the exposure
R= Asset Correlation (correlation between borrower’s exposure and
systematic risk factor)
b= Maturity Adjustment for the exposure
N(x)= Cumulative normal distribution for a standard normal random
variable (i.e. probability that a normal random variable with mean zero and
variance of one is less than or equal to x)
G (z)= Inverse Cumulative normal distribution for a standard normal
random variable (i.e. value of x such that N(x) = z).
Ln = Natural Logarithm

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116. If the calculation for capital requirement (K) results in a negative
capital charge for any individual sovereign exposure, banks should apply a
zero capital charge for that exposure.

Framework for exposures in default

117. The capital requirement (K) for a defaulted exposure is equal to the
greater of zero and the difference between its LGD (downturn) and the
bank’s best estimate of expected loss (as mentioned in para 71). The risk-
weighted asset amount for the defaulted exposure is calculated in the
same way as that in case of non-defaulted exposure i.e. product of K, 12.50,
and the EAD. Restructured exposures under corporate, sovereign and bank
asset classes will attract risk weight as applicable to exposures in default
except for ‘hardship’ clauses as mentioned in para 74 of Appendix 1.
However, such restructured accounts would be eligible for upgrade to the
non defaulted category after observation of ‘satisfactory performance’
during the period of one year from the date when the first payment of
interest or instalment of principal falls due under the terms of restructuring
package.

Firm-size adjustment for small and medium-sized entities (SME)

118. The firm size of the borrower is assumed to have an impact on
correlation and the same is therefore adjusted in the corporate risk weight
formula. The firm size adjustment is, however, applicable to SME borrowers
only.
119. SME borrowers under corporate asset class will be defined as those
to whom the banking exposure is above Rs. 5 crore but upto Rs. 25 crore,
and who are broadly associated with SME characteristics. The firm size
adjustment is based on the assumption that in the event of economic
downturn, an exposure to SME borrower may be less correlated to the
systematic risk than an exposure to a bigger corporate and hence the
reduction in Asset Correlation.
The following firm-size adjustment is made to the corporate risk
weight formula for exposures to SME borrowers.

Where S= size of the total banking exposure for the entity

The correlation formula takes the form of:

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Treatment for specialised lending
120. Banks that meet the requirements for the estimation of PD will be able
to use the general foundation approach for the corporate asset class to
derive risk weights for SL sub-classes subject to RBI approval. Banks that
meet the requirements for the estimation of PD and LGD and/or EAD will
also be able to use the general advanced approach for the corporate asset
class to derive risk weights for SL sub-classes also subject to RBI approval.
Risk weights for PF, OF, CF, and IPRE
121. Banks that do not meet the requirements for the estimation of PD
under the IRB approach for SL exposures under corporate, will be required
to follow the supervisory slotting criteria approach i.e. they will be required
to map their internal grades to five supervisory categories (including default
category), each of which is associated with a specific risk weight. This is
termed as Supervisory Slotting criteria approach. The slotting criteria on
which this mapping must be based are provided in Appendix 9. The risk
weights for unexpected losses associated with each supervisory category
are given in the table below. Each of the Supervisory categories for
Specialised Lending broadly corresponds to a range of external credit
assessments which is also outlined in the table below.
Supervisory categories and UL risk weights for other SL exposures

Supervisory
Strong Good Satisfactory Weak Default
Categories

UL Risk Weights 70% 90% 115% 250% 0%

External Rating BBB- or Not
Equivalent Better BB+ or BB BB- or B+ B to C- applicable
122. RBI may allow banks, on a case to case basis, to assign preferential risk
weights of 50% to “strong” exposures, and 70% to “good” exposures,
provided they have a remaining maturity of less than 2.5 years or the RBI
determines that banks’ underwriting and other risk characteristics are
substantially stronger than specified in the slotting criteria for the relevant
supervisory risk category.

Calculation of risk-weighted assets for exposures subject to the double

default framework
123. When a bank is adopting credit risk mitigation (CRM) through
guarantees or credit derivatives, there may be three approaches to account
for this CRM namely FIRB (bank uses RBI prescribed LGD), AIRB (bank is
permitted by RBI to use its own estimate of LGD) and double default
framework. This may be decided by the bank whether FIRB, AIRB or double
default framework needs to be chosen.

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124. To fully reflect the additional benefit obtained from the presence of
credit protection i.e. both the underlying borrower and protection provider
must default for a loss to be incurred and a bank might recover from both
(the debtor and the protection provider) in the event of double default, the
following formula may be used by the banks.
Capital requirement for a hedged exposure subject to the double default
treatment (referred as KDD) is calculated as under:
K DD = K0 * (0.15 +160 * PDg )

PD0 = PD of the Borrower (subject to PD floor of 0.03% for corporate and

bank exposures)
PDg = PD of the guarantor or credit protection provider (subject to the
above floor)
M = the maturity of the credit protection (subject in all cases to a floor of
one year)
b = the maturity adjustment coefficient (b) calculated as
2
(0.11852 – 0.05478 × ln(PD)) , with PD being the minimum of PDo and PDg.
ρos = Correlation as given by the formula below (whichever is applicable)

Or,

with PD being equal to PDo in the above correlation formula, and

LGDg is the LGD of a comparable direct exposure to the
guarantor/protection provider. This is the LGD associated with an unhedged
facility to the guarantor or the unhedged facility to the borrower (in case
LGD of the guarantor results in higher capital requirements), depending
upon whether, in the event both the guarantor and the borrower default
during the life of the hedged transaction, available evidence and the
structure of the guarantee indicate that the amount recovered would
depend on the financial condition of the guarantor or borrower,
respectively.
125. In this context, when there is partial coverage of an exposure by a
guarantee/credit derivative and there is a difference in seniority between
the covered portion and the uncovered portion of the exposure, the
arrangement will be considered as securitisation and the treatment of the
same will be as per the securitisation framework of this document.
126. Only single name credit default swaps (CDS) (as permitted by RBI)

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and single name guarantees will be considered as eligible risk mitigants for
banks for using Double Default Framework. The other operational criteria to
be met, for banks to use this framework are given below:
(i) The risk weight that is associated with the exposure prior to the
application of double default framework does not reflect any aspect of the
credit protection provided by the guarantee of credit derivative.
(ii) The entity selling credit protection (CDS) must be a bank or a
primary dealer (or any other entity as permitted by RBI). The eligible
guarantor/credit protection provider must have an internal rating of A- or
equivalent. Subsequently, during the tenor of the contract, this internal
rating should not come below a rating which is equivalent to an external
rating of investment grade.
(iii) The underlying exposure in the Double default framework must be
a corporate exposure (with the exception of Specialised Lending exposures
which are subject to supervisory slotting) as detailed in this guideline or an
exposure to PSE.
(iv) The underlying borrowers which is availing risk mitigation should
not be a financial company or member of the same group as the
guarantee/credit protection provider.
(v) The credit protection or guarantee availed must be complying with
all the requirements as given in Appendix 5 of this guideline.
(vi) The bank has the right to receive payment from the
guarantor/credit protection provider without having to take legal action in
order to pursue the counterparty for payment.
(vii) The credit protection provided by the guarantee or the credit
derivative absorbs all credit losses incurred on the covered portion of the
exposure that arise due to the credit events detailed in the contract
between the parties.
(viii) If the payment structure of the credit protection provides for
physical settlement, the bank should have legal certainty with respect to the
deliverability of a loan, bond or contingent liability. If the bank intends to
deliver an obligation other than the underlying exposure, it must ensure
that the deliverable obligation is sufficiently liquid so that the bank has the
ability to purchase it for delivery in accordance with the contract.
(ix) The terms and conditions of the credit protection contract are
legally confirmed by the guarantor/credit protection provider and the bank.
(x) There is no excessive correlation between the creditworthiness of
the guarantor or credit protection provider and the debtor of the underlying
exposure due to their performance being dependent on common factors
beyond the systematic risk factor. The bank should preferably have
procedures in place to detect such excessive correlation.
(xi) The bank should have the right to receive payment from

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guarantor/credit protection provider without having to take legal action in
order to pursue the counterparty for payment.
127. In estimating either of these LGDs, a bank may recognise either the
collateral posted exclusively against the exposure or credit protection, in a
manner consistent with the foundation IRB or Advanced IRB approach as
applicable. There may not be any consideration of double recovery in the
LGD estimate.
128. The risk-weighted asset amount is calculated in the same way as for
unhedged exposures, i.e.
RWADD = KDD × 12.50× EADg.
129. The treatments to Purchased corporate receivables and Purchased
retail receivables have been prescribed in para 97-98 of Appendix 1 and also
in Appendix 10.

Rules for Retail Exposure

130. Claims (include both fund-based and non-fund based) that meet four
criteria listed in paragraph 132 and not relationship driven, may be
considered as retail claims for regulatory capital purposes and included in a
regulatory retail portfolio.
131. The following claims, both fund based and non fund based, shall be
excluded from the regulatory retail portfolio:
(a) Exposures by way of investments in securities (such as bonds and
equities), whether listed or not;
(b) Loans and advances to banks’ own staffs which are fully covered by
superannuation benefits and / or mortgage of flat / house;
(c) Capital market exposures;
(d) Venture capital funds.
Capital calculation for the exposures mentioned in (b) and (d) will be treated
as per RBI directives of standardised approach of Basel II. Exposure to bonds
will be under corporate asset class. Exposure to capital market, as detailed
in para 153 (iii), will be treated under equity asset class.
132. Qualifying Criteria
(i) Orientation Criterion - The exposure (both fund-based and non fund-
based) is to an individual person or persons (regardless of the size of
exposure) or to a small business; Person under this clause would mean
any legal person capable of entering into contracts and would include
but not be restricted to individual, HUF, partnership firm, trust, private
limited companies, public limited companies, co-operative societies,
small businesses etc. Small business is one where the total average
annual turnover is less than Rs.25 crore. The turnover criterion will be
linked to the average of the last three years in the case of existing
entities; projected turnover in the case of new entities; and both actual

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 and projected turnover for entities which are yet to complete three
years.
(ii) Product Criterion - The exposure (both fund-based and non fund-based)
takes the form of any of the following: revolving credits and lines of
credit (including overdrafts), term loan and leases (e.g. instalment
loans, leases and educational loans) and small business facilities and
commitments.
(iii) Granularity Criterion - Banks must ensure that the regulatory retail
portfolio is sufficiently diversified to a degree that reduces the risks in
the portfolio, so as to treat them under retail assets. One way of
achieving this is that no aggregate exposure to one counterpart should
exceed 0.2 per cent of the overall regulatory retail portfolio. 'Aggregate
exposure' means gross amount (i.e. not taking any benefit for credit risk
mitigation into account) of all forms of exposures (e.g. loans or
commitments) that individually satisfy the three other criteria. In
addition, 'one counterpart' means one or several entities that may be
considered as a single beneficiary (e.g. in the case of a small business
that is affiliated to another small business, the limit would apply to the
bank's aggregated exposure on both businesses). While banks may
appropriately use the group exposure concept for computing aggregate
exposures, they should evolve adequate systems to ensure strict
adherence with this criterion. NPAs under retail loans are to be
excluded from the overall regulatory retail portfolio when assessing the
granularity criterion for risk-weighting purposes.
(iv) Low Value of Individual Exposures - The maximum aggregated retail
exposure to one counterpart, except for individual person or persons as
mentioned in para 132 (i), should be less than the threshold limit of Rs.
5 crore.
133. For the purpose of ascertaining compliance with the absolute
threshold, exposure would mean sanctioned limit or the actual outstanding,
whichever is higher, for all fund based and non-fund based facilities,
including all forms of off-balance sheet exposures. In the case of term loans
and EMI based facilities, where there is no scope for redrawing any portion
of the sanctioned amounts, exposure shall mean the actual outstanding.
134. RBI would evaluate at periodic intervals, the bank’s processes and
estimates of PD, LGD, EAD assigned to the retail portfolio with reference to
the default experience for these exposures. As part of the supervisory
review and evaluation process, the RBI would also consider whether the
credit quality of regulatory retail claims held by individual banks should
warrant a more conservative estimate of PD, LGD and EAD than that arrived
by the banks.
135. The exposure must be one of a large pool of exposures, which are

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managed by the bank on a pooled basis. Furthermore, these must not be
managed individually in a way comparable to corporate exposures, but
rather as part of a portfolio segment or homogeneous pool of exposures
with similar risk characteristics for purposes of risk assessment and
quantification. However, this does not preclude retail exposures from being
treated individually at some stages of the risk management process. The
fact that an exposure is rated individually does not by itself deny the
eligibility as a retail exposure.

Sub Classification of retail assets

136. Within the retail asset class category, banks are required to identify
separately three sub-classes of exposures: (a) exposures secured by
residential properties, (b) qualifying revolving retail exposures and (c) all
other retail exposures subject to the condition that these exposures broadly
meet the retail asset criteria as mentioned in para 132. Exposures secured
by residential properties and qualifying revolving retail exposures are
mentioned below. Retail exposures which may not be categorised under
these two heads will fall under ‘other retail’ asset category which may
include agricultural and allied activities and SME loans provided these
comply with retail criteria.
Exposures secured by residential properties
137. Loans secured by mortgage of residential properties may be eligible for
retail treatment provided the credit is extended to an individual, which
should not include credit extended to builders/developers.
Qualifying revolving retail exposures
138. All of the following criteria must be satisfied for a sub-portfolio to be
treated as a qualifying revolving retail exposure (QRRE). These criteria must
be applied at a sub-portfolio level consistent with the bank’s segmentation
of its retail activities. Segmentation at the country level (or below) should be
the general rule.
(a) The exposures are revolving, unsecured, and uncommitted (both
contractually and in practice). In this context, revolving exposures are
defined as those where customers’ outstanding balances are permitted
to fluctuate based on their decisions to borrow and repay, up to a limit
established by the bank.
(b) The exposures are to individuals.
(c) Because the asset correlation assumptions for the QRRE risk-weight
function are markedly below those for the other retail risk-weight
function at low PD values, banks must demonstrate that the use of the
QRRE risk-weight function is constrained to portfolios that have
exhibited low volatility of loss rates, relative to their average level of
loss rates, especially within the low PD bands. RBI will review the

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 relative volatility of loss rates across the QRRE sub portfolios, as well as
the aggregate QRRE portfolio.
(d) Data on loss rates for this sub-portfolio must be retained in order to
allow analysis of the volatility of loss rates.
(e) The bank must demonstrate satisfactorily that treatment as a qualifying
revolving retail exposure is consistent with the underlying risk
characteristics of the sub-portfolio.

Implementation plan
139. A bank, while submitting the detailed implementation plan for rollout
of IRB approaches across significant asset classes, should specify a detailed
plan for retail assets including its sub-classes. The plan should specify the
extent to which the bank seeks to implement the IRB Approach for various
sub-classes of retail assets, the methodology proposed to be used for
calculation of various risk components i.e. PD, LGD and EAD, data
characteristics and the timeline for the rollout. Some exposures in certain
sub-classes in case of retail assets may be immaterial in terms of size and
perceived risk profile. For such cases, the bank should specifically seek
permission of the RBI to exempt it from applying the IRB approach. Capital
requirements for such exposures should be calculated according to the
Standardised approach or as specified by Reserve Bank of India. However,
RBI may refuse such exemption or apply more capital under Pillar 2.

Transition Arrangements
140. At the beginning of the transition period, a bank must demonstrate
that it has been using a rating system which was broadly in line with the
minimum requirements articulated in this document for at least three years
prior to qualification to these approaches.

IRB Approach for Retail Exposure

141. For retail assets, there is no distinction between Foundation and
Advanced approaches and hence banks have to calculate their own PD, LGD
and EAD. There is no maturity adjustment necessary in the risk weight
function for capital calculation.

Risk components
Calculation of PD & LGD
142. For each identified homogeneous pool of exposures, banks are
expected to provide an estimate of the PD and LGD associated with the
pool, subject to the prescribed minimum requirements in this guideline.
Further, the PD for retail exposure is greater of the one year PD associated
with the internal borrower grade to which the pool has been assigned or

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0.03%. The minimum data observation period for PD and LGD estimates for
retail exposure is 5 years. However, the banks may give different weightage
to historic data provided it can demonstrate that more recent data is a
better predictor of loss rates. Further, because of the potential for very long
cycles in house prices, LGDs for retail exposures secured by residential
properties cannot be set below 20% for using in the formula given in para
148 (with correlation applicable for exposures secured by residential
mortgage properties).

Calculation of EAD
143. All retail exposures (both on and off balance sheet) are measured gross
of specific provisions or partial write offs. The EAD on drawn amounts
should not be less than the sum of (i) the amount by which a bank’s
regulatory capital would be reduced if the exposure is fully written off and
(ii) any specific provisions and partial write-offs. For retail off balance sheet
items, banks must use their own estimates of Credit Conversion Factors
subject to the prescribed minimum requirements for EAD in this guideline.
The minimum data observation period for EAD estimates for retail exposure
is 5 years.

Recognition of Guarantees and Credit derivatives

144. Banks may reflect the risk reducing effects of guarantees (whether to
an individual obligation or pool of exposures) and credit derivatives by
adjusting either the Probability of Default or Loss Given Default estimates,
subject to the minimum requirements as given in Appendix 5 of this
guideline.

On balance sheet netting

145. On balance sheet netting of loans and deposits of a bank from a retail
customer will be permitted subject to the same conditions outlined in
paragraph 87-88 of this guideline.
146. For retail exposures with uncertain future drawdown such as credit
cards, the banks should adjust its estimates of LGD or EAD to reflect the
possibility of additional drawings prior to default. The adjustment should
reflect the past experience/history or expectation of such additional
drawing prior to default.
147. When the drawn balances of the retail facilities have been securitised,
banks should hold capital against their share (i.e. seller’s interest) of
undrawn balances related to the securitised exposures. The undrawn
balances of such securitised exposures should be divided between the
seller’s and investor’s interests on a pro rata basis. The investor’s interest
should be subject to the treatment given in this circular for securitisation

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exposures.

Risk Weight Function for retail assets

Risk Weight Function for retail assets not in default
148. The Risk weight functions for three different classes of retail exposures
are described below. These functions must be used by banks along with
their estimates of PD, LGD and EAD for calculation of capital and risk
weighted assets. For retail exposures not in default, the risk weights will be
assigned as per the following function:

Risk weighted assets = K × 12.5 × EAD

Correlation (R) for residential mortgage exposures = 0.15
Correlation (R) for Qualifying revolving retail exposures = 0.04
Correlation (R) for all other retail exposures =

N(x): denotes the cumulative distribution function for a standard normal

random variable (i.e. the probability that a normal random variable with
mean zero and variance of one is less than or equal to x).
G(Z): denotes the inverse cumulative distribution function for a standard
normal random variable (i.e. the value x such that N(x) = z).
Risk Weight Framework for retail assets in default
149. The capital requirement for a defaulted retail exposure is equal to the
greater of zero and the difference between its LGD and the bank’s best
estimate of expected loss as given in para 71 of this circular. The risk
weighted asset amount for the defaulted exposure is the product of K, 12.5
and the EAD.

Restructured retail exposures

150. Restructured retail exposures will attract risk weight as applicable to
defaulted retail assets as mentioned in the para 149 barring the cases where
‘hardship’ clauses (as mentioned in para 74 in Appendix 1) might have been
extended to the exposures. However, all such restructured exposures would
be eligible for treatment as under non defaulted category after observation
of ‘satisfactory performance’ during the period of one year from the date
when the first payment of interest or instalment of principal falls due under
the terms of restructuring package.

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Treatment of Expected losses and Provisions
151. Treatment of expected loss and provisions applicable to retail
exposures have been discussed along with corporate, bank and sovereign
exposures in para 191 to 203.

Rules for Equity Exposures

Definition of Equity Exposures
152. RWA for equity exposures detailed here is meant for the equity
exposures lying in the banking book (HTM and AFS) of the banks. RWA for
equity exposures lying in the trading book (HFT) will be calculated as per
market risk guidelines. In general, equity exposures are defined on the basis
of the economic substance of the instrument. They include both direct and
indirect ownership interests, whether voting or non-voting, in the assets
and income of a commercial enterprise or of a financial institution that is
not consolidated or deducted. Indirect equity interests include holdings of
derivative instruments tied to equity interests, and holdings in corporations,
partnerships, limited liability companies or other types of enterprises that
issue ownership interests and are engaged principally in the business of
investing in equity instruments.
An instrument is considered to be an equity exposure if it meets all of the
following requirements:
It is irredeemable in the sense that the return of invested funds can be
achieved only by the sale of the investment or sale of the rights to the
investment or by the liquidation of the issuer;
It does not embody an obligation on the part of the issuer; and
It conveys a residual claim on the assets or income of the issuer.
153. Additionally, any of the following instruments must be categorised as
an equity exposure:
(i) An instrument with the same structure as those permitted as Tier 1
capital for banking organisations.
(ii) An instrument that embodies an obligation on the part of the issuer and
meets any of the following conditions:
(a) The issuer may defer indefinitely the settlement of the obligation;
(b) The obligation requires (or permits at the issuer’s discretion)
settlement by issuance of a fixed number of the issuer’s equity
shares;
(c) The obligation requires (or permits at the issuer’s discretion)
settlement by issuance of a variable number of the issuer’s equity
shares and (ceteris paribus) any change in the value of the
obligation is attributable to and comparable to, and in the same
direction as the change in the value of a fixed number of the
issuer’s equity shares; or

166
 (d) The holder has the option to require that the obligation be settled
in equity shares, unless either (i) in the case of a traded instrument,
the RBI is satisfied that the bank has demonstrated that the
instrument trades more like the debt of the issuer than like its
equity, or (ii) in the case of non-traded instruments, RBI is content
that the bank has demonstrated that the instrument should be
treated as a debt position. In cases (i) and (ii), the bank may
decompose the risks for regulatory purposes, with the consent of
RBI.
(iii) An instrument that can be categorised under Capital Market Exposure.
In case of advances/guarantees issued to stock brokers/market makers
which are secured by primary or collateral security by way of equity,
convertible bonds, etc. they may be categorised under Equity.
However, if such instruments are not secured by primary or collateral
security by way of equity, convertible bonds, etc. they may be
categorised either under Corporate or retail asset class, depending on
type of exposure and the borrower.
154. Debt obligations and other securities, partnerships, derivatives or
other vehicles structured with the intent of conveying the economic
substance of equity ownership are considered an equity holding. This
includes liabilities from which the return is linked to that of equities.
Conversely, equity investments that are structured with the intent of
conveying the economic substance of debt holdings or securitisation
exposures would not be considered an equity holding, subject to the
approval of RBI. Equities that are recorded as loans but arise from a
debt/equity swap made as part of the orderly realisation or restructuring of
the debt are included in the definition of equity holdings. However, these
instruments may not attract a lower capital charge than what would apply if
the holdings remained in the debt portfolio.
155. The RBI reserves the right to re-characterize debt holdings as equities
for regulatory purposes and to otherwise ensure the proper treatment of
holdings under Pillar-II.
156. In general, the measure of an equity exposure on which capital
requirements is based is the value presented in the financial statements,
which depending on national accounting and regulatory practices may
include unrealised revaluation gains (once IFRS accounting standard
becomes applicable for Indian banks). Thus, for example, equity exposure
measures will be:
(i) For investments held at fair value with changes in value flowing directly
through income and into regulatory capital, exposure is equal to the fair
value presented in the balance sheet.
(ii) For investments held at fair value with changes in value not flowing

167
 through income but into a tax-adjusted separate component of equity,
exposure is equal to the fair value presented in the balance sheet.
(iii) For investments held at cost or at the lower of cost or market, exposure
is equal to the cost or market value presented in the balance sheet.
157. Holdings in funds containing both equity investments and other non-
equity types of investments can be either treated, in a consistent manner,
as a single investment based on the majority of the fund’s holdings or,
where possible, as separate and distinct investments in the fund’s
component holdings based on a look-through approach.
158. Where only the investment mandate of the fund is known, the fund
can still be treated as a single investment. For this purpose, it is assumed
that the fund first invests, to the maximum extent allowed under its
mandate, in the asset classes attracting the highest capital requirement, and
then continues making investments in descending order until the maximum
total investment level is reached. The same approach can also be used for
the look-through approach, but only where the bank has rated all the
potential constituents of such a fund.
159. There are two approaches to calculate risk-weighted assets for equity
exposures held in the banking book:
(i) Market-based approach.
(ii) PD/LGD approach.
160. Certain equity holdings are excluded as defined in paragraphs 173-176
given below and are subject to the capital charges required under the
standardised approach. PD/LGD approach will be available to the banks only
if they have adopted A-IRB approach for all other asset types. Where both
methodologies are permitted by RBI, banks’ choices must be made
consistently, and in particular not determined by regulatory arbitrage
considerations.

Market-based approach
161. Under the market-based approach, banks are permitted to calculate
the minimum capital requirements for credit risk for their banking book
equity holdings using either or both of two following methods:
(i) Simple risk weight method.
(ii) Internal models method.
The method used should be consistent with the amount and
complexity of the bank’s equity holdings and commensurate with the
overall size and sophistication of the bank. However, RBI may require the
use of either method based on the individual circumstances of a bank.
Simple risk weight method
162. Under the simple risk weight method, a 300% risk weight is to be
applied to equity holdings that are publicly traded and a 400% risk weight is

168
to be applied to all other equity holdings. A publicly traded holding is
defined as any equity securities traded on a security exchange recognised by
SEBI or other national securities regulatory authority and provide a liquid
two way market for the exposures.

Internal models method

163. Under this alternative, banks must hold capital equal to the potential
loss on the bank’s equity holdings as derived using internal value-at-risk
th
models subject to the 99 percentile, one-tailed confidence interval of the
difference between quarterly returns and an appropriate risk-free rate
computed over a long-term sample period. The capital charge would be
incorporated into a bank’s risk-based capital ratio through the calculation of
risk-weighted equivalent assets.
164. The risk weight used to convert holdings into risk-weighted
equivalent assets would be calculated by multiplying the derived capital
charge by 12.50. Capital charges calculated under the internal models
method may be no less than the capital charges that would be calculated
under the simple risk weight method using a 200% risk weight for publicly
traded equity holdings and a 300% risk weight for all other equity holdings.
These minimum capital charges would be calculated separately using the
methodology of the simple risk weight approach. Further, these minimum
risk weights are to apply at the individual exposure level rather than at the
portfolio level.
165. A bank may be permitted to employ different market-based
approaches to different portfolios based on appropriate considerations and
where the bank itself uses different approaches internally.
166. Banks are permitted to recognise guarantees but not collateral
obtained on an equity position wherein the capital requirement is
determined through use of the market- based approach.

PD/LGD approach
167. The minimum requirements and methodology for the PD/LGD
approach for equity exposures are the same as those for the IRB foundation
approach for corporate exposures subject to the following specifications:
(i) The bank’s estimate of the PD of a corporate entity in which it holds an
equity position must satisfy the same requirements as the bank’s
estimate of PD of a corporate entity where the entity owes debt to the
bank. If a bank has not extended debt to the company in whose equity
it has invested, and does not have sufficient information on the position
of that company to be able to use the applicable definition of default in
practice but meets the other standards, a 1.5 scaling factor will be
applied to the risk weights derived from the corporate risk-weight

169
 function, given the PD set by the bank. If, however, the bank’s equity
holdings are material and it is permitted to use a PD/LGD approach for
regulatory purposes but the bank has not yet met the relevant
standards, the simple risk-weight method under the market-based
approach will apply.
(ii) An LGD of 90% would be assumed in deriving the risk weight for equity
exposures.
(iii) For these purposes, the risk weight is subject to a five-year maturity
adjustment (i.e. M=5 in the formula as given in eqn. A in para 115)
whether or not the bank is using the explicit approach to maturity
elsewhere in its IRB portfolio.
168. Under the PD/LGD approach, minimum risk weights as given in the
paragraph 169 below would apply. When the sum of UL and EL associated
with the equity exposure results in less capital than would be required from
application of one of the minimum risk weights, the minimum risk weights
must be used. In other words, the minimum risk weights must be applied, if
the risk weights, calculated according to paragraph 167 plus the EL
associated with the equity exposure multiplied by 12.5 are smaller than the
applicable minimum risk weights.
169. A minimum risk weight of 100% applies for the following types of
equities for as long as the portfolio is managed in the manner outlined
below:
(i) Public equities where the investment is part of a long-term customer
relationship, any capital gains are not expected to be realised in the
short term and there is no anticipation of capital gains in the long term.
It is expected that in almost all cases, the bank will have lending and/or
general banking relationships with the portfolio company so that the
estimated probability of default is readily available. Given their long-
term nature, specification of an appropriate holding period for such
investments merits careful consideration. In general, it is expected that
the bank will hold the equity over the long term (at least five years).
(ii) Private equities where the returns on the investment are based on
regular and periodic cash flows not derived from capital gains and there
is no expectation of future capital gain or of realising any existing gain.
170. For all other equity positions, capital charges calculated under the
PD/LGD approach may be no less than the capital charges that would be
calculated under a simple risk weight method using a 200% risk weight for
publicly traded equity holdings and a 300% risk weight for all other equity
holdings.
171. The maximum risk weight for the PD/LGD approach for equity
exposures is 1111%. This maximum risk weight can be applied, if risk
weights calculated according to paragraph 167 plus the EL associated with

170
the equity exposure multiplied by 12.5 exceed the 1111% risk weight.
172. Calculating capital requirement for hedged equity exposures (by means
of credit derivatives) under PD/LGD method is also possible. If there is both
a protected and an unprotected portion of the exposure then the protected
portion will be assigned PD of the protection provider (or a PD above the PD
of the protection provider but below the PD of the obligor) with LGD of 90%
and maturity of 5 years and using the risk weight function as given in para
115. For the unprotected portion, method for computing capital
requirement would be the same except that the PD used should be of the
obligor.

Exclusions to the market-based and PD/LGD approaches

173. Equity holdings in entities, if any, whose debt obligations qualify for a
zero risk weight under the standardised approach to credit risk, can be
excluded from the IRB approaches to equity, at the discretion of the RBI.
174. To promote specified sectors of the economy, RBI may exclude from
the IRB capital charges, equity investments made under legislated
programmes that provide significant subsidies for the investment to the
bank and involve some form of government oversight and restrictions on
the equity investments.
175. Equity holdings made under legislated programmes can only be
excluded from the IRB approaches up to an aggregate of 10% of Tier 1 plus
Tier 2 capital.
176. RBI may also exclude the equity exposures of a bank from the IRB
treatment based on materiality. The equity exposures of a bank are
considered material if aggregate value of equity exposures in banking book
exceeds 0.5% of total banking book exposures, excluding all legislative
programmers as discussed above in para 174.

Minimum Requirements specific to equity exposures under internal

models market-based approach
177. To be eligible for the internal models market-based approach, a bank
must demonstrate that it meets certain quantitative and qualitative
minimum requirements at the outset and on an ongoing basis. Failure to
meet these requirements will render banks ineligible to use the internal
models market-based approach. A bank that fails to demonstrate continued
compliance with the minimum requirements must develop a plan for rapid
return to compliance, obtain RBI’s approval of the plan, and implement that
plan in a timely fashion. In the interim, banks would be expected to
compute capital charges using a simple risk weight approach.
178. The following minimum standards apply for the purpose of calculating
minimum capital charges under the internal models approach.

171
(i) The capital charge is equivalent to the potential loss on the institution’s
equity portfolio arising from an assumed instantaneous shock
th
equivalent to the 99 percentile, one-tailed confidence interval of the
difference between quarterly returns and an appropriate risk-free rate
computed over a long-term sample period.
(ii) The estimated losses should be sensitive to adverse market movements
relevant to the long-term risk profile of the institution’s specific
holdings. The data used to represent return distributions should reflect
the longest sample period for which data are available and meaningful
in representing the risk profile of the bank’s specific equity holdings.
The data used should be sufficient to provide conservative, statistically
reliable and robust loss estimates that are not based purely on
subjective or judgmental considerations. Banks must demonstrate to
RBI that the shock employed provides a conservative estimate of
potential losses over a relevant long-term market or business cycle.
Models, if estimated, by using data not reflecting realistic ranges of
long-run experience, including a period of reasonably severe declines in
equity market values relevant to a bank’s holdings, are presumed to
produce optimistic results unless there is credible evidence of
appropriate adjustments built into the model. In the absence of built-in
adjustments, the bank must combine empirical analysis of available
data with adjustments based on a variety of factors in order to attain
model outputs that achieve appropriate realism and conservatism.
In constructing Value at Risk (VaR) models estimating potential
quarterly losses, banks may use quarterly data or convert shorter
horizon period data to a quarterly equivalent using an analytically
appropriate method supported by empirical evidence. Such
adjustments must be applied through a well-developed and well-
documented thought process and analysis. In general, adjustments
must be applied conservatively and consistently over time.
Furthermore, where only limited data are available or where technical
limitations are such that estimates from any single method will be of
uncertain quality, banks must add appropriate margins of conservatism
in order to avoid over-optimism.
(iii) No particular type of VaR model (e.g. variance-covariance, historical
simulation, or Monte Carlo) is prescribed. However, the model used
must be able to capture adequately all of the material risks embodied in
equity returns including both the general market risk and specific risk
exposure of the institution’s equity portfolio. Internal models must
adequately explain historical price variation, capture both the
magnitude and changes in the composition of potential concentrations,
and be robust to adverse market environments. The population of risk

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 exposures represented in the data used for estimation must be closely
matched to or at least comparable with those of the bank’s equity
exposures.
(iv) Banks may also use modelling techniques such as historical scenario
analysis to determine minimum capital requirements for banking book
equity holdings. The use of such models is conditioned upon the bank
demonstrating to RBI that the methodology and its output can be
quantified in the form of the loss percentile specified under (a).
(v) Banks must use an internal model that is appropriate for the risk profile
and complexity of their equity portfolio. Banks with material holdings
with values that are highly non-linear in nature (e.g. equity derivatives,
convertibles) must employ an internal model designed to capture
appropriately the risks associated with such instruments.
(vi) Subject to RBI review, equity portfolio correlations can be integrated
into a bank’s internal risk measures. The use of explicit correlations (e.g.
utilisation of a variance/covariance VaR model) must be fully
documented and supported using empirical analysis. The
appropriateness of implicit correlation assumptions will be evaluated by
supervisors in their review of model documentation and estimation
techniques.
(vii) Mapping of individual positions to proxies, market indices, and risk
factors should be plausible, intuitive, and conceptually sound. Mapping
techniques and processes should be fully documented, and
demonstrated with both theoretical and empirical evidence to be
appropriate for the specific holdings. Where professional judgement is
combined with quantitative techniques in estimating a holding’s return
volatility, the judgement must take into account the relevant and
material information not considered by the other techniques utilised.
(viii) Where factor models are used, either single or multi-factor models are
acceptable depending upon the nature of an institution’s holdings.
Banks are expected to ensure that the factors are sufficient to capture
the risks inherent in the equity portfolio. Risk factors should correspond
to the appropriate equity market characteristics (for example, public,
private, market capitalisation, industry sectors and sub-sectors,
operational characteristics) in which the bank holds significant
positions. While banks will have discretion in choosing the factors, they
must demonstrate through empirical analyses the appropriateness of
those factors, including their ability to cover both general and specific
risk.
(ix) Estimates of the return volatility of equity investments must
incorporate relevant and material available data, information, and
methods. A bank may utilise independently reviewed internal data or

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 data from external sources (including pooled data). The number of risk
exposures in the sample, and the data period used for quantification
must be sufficient to provide the bank with confidence in the accuracy
and robustness of its estimates. Banks should take appropriate
measures to limit the potential of both sampling bias and survivorship
bias in estimating return volatilities.
(x) A rigorous and comprehensive stress-testing programme must be in
place. Banks are expected to subject their internal model and
estimation procedures, including volatility computations, to either
hypothetical or historical scenarios that reflect worst-case losses given
underlying positions in both public and private equities. At a minimum,
stress tests should be employed to provide information about the effect
of tail events beyond the level of confidence assumed in the internal
models approach.

Risk management process and controls

179. Banks’ overall risk management practices used to manage their
banking book equity investments are expected to be consistent with the
evolving sound practice guidelines issued by the RBI. With regard to the
development and use of internal models for capital purposes, banks must
have established policies, procedures, and controls to ensure the integrity of
the model and modelling process used to derive regulatory capital
standards. These policies, procedures, and controls should include the
following:
(i) Full integration of the internal model into the overall management
information systems of the institution and in the management of the
banking book equity portfolio. Internal models should be fully
integrated into the institution’s risk management infrastructure
including use in: (a) establishing investment hurdle rates and evaluating
alternative investments if any; (b) measuring and assessing equity
portfolio performance (including the risk-adjusted performance); and
(c) allocating economic capital to equity holdings and evaluating overall
capital adequacy as required under Pillar 2. The bank should be able to
demonstrate through, for example, investment committee minutes,
that internal model output plays an essential role in the investment
management process.
(ii) Established management systems, procedures, and control functions
for ensuring the periodic and independent review of all elements of the
internal modelling process, including approval of model revisions,
vetting of model inputs, and review of model results, such as direct
verification of risk computations. Proxy and mapping techniques and
other critical model components should receive special attention. These

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 reviews should assess the accuracy, completeness, and appropriateness
of model inputs and results and focus on both finding and limiting
potential errors associated with known weaknesses and identifying
unknown model weaknesses. Such reviews may be conducted as part of
internal or external audit programmes, by an independent risk control
unit, or by an external third party.
(iii) Adequate systems and procedures for monitoring investment limits and
the risk exposures of equity investments.
(iv) The units responsible for the design and application of the model must
be functionally independent from the units responsible for managing
individual investments.
(v) Parties responsible for any aspect of the modelling process must be
adequately qualified. Management must allocate sufficient skilled and
competent resources to the modelling function.

Validation and documentation

180. Banks employing internal models for regulatory capital purposes are
expected to have in place a robust system to validate the accuracy and
consistency of the model and its inputs. They must also fully document all
material elements of their internal models and modelling process. The
modelling process itself as well as the systems used to validate internal
models including all supporting documentation, validation results, and the
findings of internal and external reviews are subject to oversight and review
by the bank’s supervisor.

Validation
181. Banks must have a robust system in place to validate the accuracy and
consistency of their internal models and modelling processes. A bank must
demonstrate that the internal validation process enables it to assess the
performance of its internal model and processes consistently and
meaningfully.
182. Banks must regularly compare actual return performance (computed
using realised and unrealised gains and losses) with modelled estimates and
be able to demonstrate that such returns are within the expected range for
the portfolio and individual holdings. Such comparisons must make use of
historical data that are over as long a period as possible. The methods and
data used in such comparisons must be clearly documented by the bank.
This analysis and documentation should be updated at least annually.
183. Banks should make use of other quantitative validation tools and
comparisons with external data sources. The analysis must be based on data
that are appropriate to the portfolio, are updated regularly, and cover a
relevant observation period. Banks’ internal assessments of the

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performance of their own model must be based on long data histories,
covering a range of economic conditions, and ideally one or more complete
business cycles.
184. Banks must demonstrate that quantitative validation methods and
data are consistent through time. Changes in estimation methods and data
(both data sources and periods covered) must be clearly and thoroughly
documented.
185. Since the evaluation of actual performance to expected performance
over time provides a basis for banks to refine and adjust internal models on
an ongoing basis, it is expected that banks using internal models will have
established well-articulated model review standards. These standards are
especially important for situations where actual results significantly deviate
from expectations and where the validity of the internal model is called into
question. These standards must take account of business cycles and similar
systematic variability in equity returns. All adjustments made to internal
models in response to model reviews must be well documented and
consistent with the bank’s model review standards.
186. To facilitate model validation through back testing on an ongoing basis,
banks using the internal model approach must construct and maintain
appropriate databases on the actual quarterly performance of their equity
investments as well on the estimates derived using their internal models.
Banks should also back test the volatility estimates used within their internal
models and the appropriateness of the proxies used in the model. RBI may
ask banks to scale their quarterly forecasts to a different, in particular
shorter, time horizon, store performance data for this time horizon and
perform back tests on this basis.

Documentation
187. The burden is on the bank to satisfy RBI that a model has good
predictive power and that regulatory capital requirements will not be
distorted as a result of its use. Accordingly, all critical elements of an
internal model and the modelling process should be fully and adequately
documented. Banks must document in writing their internal model’s design
and operational details. The documentation should demonstrate banks’
compliance with the minimum quantitative and qualitative standards, and
should address topics such as the application of the model to different
segments of the portfolio, estimation methodologies, and responsibilities of
parties involved in the modelling, and the model approval and model review
processes. In particular, the documentation should address the following
points:
(a) A bank must document the rationale for its choice of internal modelling
methodology and must be able to provide analyses demonstrating that

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 the model and modelling procedures are likely to result in estimates
that meaningfully identify the risk of the bank’s equity holdings.
Internal models and procedures must be periodically reviewed to
determine whether they remain fully applicable to the current portfolio
and to external conditions. In addition, a bank must document a history
of major changes in the model over time and changes made to the
modelling process subsequent to the last supervisory review. If changes
have been made in response to the bank’s internal review standards,
the bank must document that these changes are consistent with its
internal model review standards.
(b) In documenting their internal models, banks should:
Provide a detailed outline of the theory, assumptions and/or
mathematical and empirical basis of the parameters, variables, and
data source(s) used to estimate the model; establish a rigorous
statistical process (including out-of-time and out-of-sample
performance tests) for validating the selection of explanatory variables;
and indicate circumstances under which the model does not work
effectively or limitations of the model.
188. Where proxies and mapping are employed, banks must have
performed and documented rigorous analysis demonstrating that all chosen
proxies and mappings are sufficiently representative of the risk of the equity
holdings to which they correspond. The documentation should show, for
instance, the relevant and material factors (e.g. business lines, balance
sheet characteristics, geographic location, company age, industry sector and
subsector, operating characteristics) used in mapping individual investments
into proxies. In summary, banks must demonstrate that the proxies and
mappings employed: are adequately comparable to the underlying holding
or portfolio; are derived using historical economic and market conditions
that are relevant and material to the underlying holdings or, where not, that
an appropriate adjustment has been made; and, are robust estimates of the
potential risk of the underlying holding.

Risk weight for ‘others’ asset class

189. In addition to all these (five) asset classes if the banks have some
exposures which can be classified as ‘others’ assets, then these assets may
directly be assigned risk weights as per the prescriptions given in
Standardised Approach.

Treatment of expected loss and provisions

This section of the guideline states the method by which difference
between total eligible provisions and expected loss (EL) may be included in
or deducted from regulatory capital.

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Calculation of expected losses
191. To obtain a total EL amount, bank must add up the EL amount (defined
as PD*LGD multiplied by EAD) associated with its (individual) exposures
(excluding the EL amount associated with equity exposures under the
PD/LGD approach and securitisation exposures). While the EL amount
associated with equity exposures subject to the PD/LGD approach is
excluded from the total EL amount, paragraphs 192 and 203 apply to such
exposures.

Expected loss for exposures other than SL subject to the supervisory slotting
criteria
192. Banks must calculate an EL as PD*LGD multiplied by EAD for corporate,
sovereign, bank, and retail exposures which are not treated as hedged
exposures under the double default treatment. For corporate, sovereign,
bank, and retail exposures that are in default, banks must use their best
estimate of expected loss as defined in paragraph 71 and banks on the
foundation approach must use the supervisory LGD. For SL exposures
subject to the supervisory slotting criteria, EL is calculated as described in
paragraphs 193 and 194. For equity exposures subject to the PD/LGD
approach, the EL is calculated as PD * LGD multiplied by EAD unless
paragraphs 168-169 and 171 apply. Securitisation exposures do not
contribute to the EL amount. For all other exposures, including hedged
exposures under the double default treatment, the EL is zero.
Expected loss for SL exposures subject to the supervisory slotting criteria
193. For SL exposures subject to the supervisory slotting criteria, the EL
amount is - 9% of the risk-weighted assets produced from the appropriate
risk weights, as specified below, multiplied by EAD.
Supervisory categories and EL risk weights for other SL exposures
194. The risk weights for SL are as follows:
Strong Good Satisfactory Weak Default
5% 10% 35% 100% 625%
195. Where, RBI allows banks to assign preferential risk weights to other SL
exposures falling into the “strong” and “good” supervisory categories as
outlined in paragraph 122 of this document, the corresponding EL risk
weight is 0% for “strong” exposures, and 5% for “good” exposures.

Calculation of provisions
Exposures subject to IRB approach
196. Total eligible provisions are defined as the sum of all provisions (e.g.
specific provisions, partial write-offs, portfolio-specific general provisions
such as country risk provisions or general provisions) that are attributed to
exposures treated under the IRB approach. In addition, total eligible

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provisions may include any discounts on defaulted assets. Specific
provisions set aside against equity and securitisation exposures must not be
included in total eligible provisions.

Portion of exposures subject to the standardised approach to credit risk

197. Banks using the standardised approach for a portion of their credit risk
exposures, either on a transitional basis (as defined in paragraphs 25, 26), or
on a permanent basis and if the exposures subject to the standardised
approach are immaterial (as mentioned earlier in paragraph 28), the bank
must determine the portion of general provisions to be attributed to the
standardised or IRB treatment of provisions as per the methods outlined in
following two paragraphs.
198. Banks should generally attribute total general provisions on a pro rata
basis according to the proportion of credit risk-weighted assets subject to
the standardised and IRB approaches. However, when one approach to
determining credit risk-weighted assets (e.g. standardised or IRB approach)
is used exclusively within an entity, general provisions booked within the
entity may be attributed to that approach only (e.g. standardised or IRB
approach).
199. Subject to the RBI approval on a case to case basis, banks using both
the standardised and IRB approaches may also rely on their internal
methods for allocating general provisions for recognition in capital under
either the standardised or IRB approach, subject to the condition that where
the internal allocation method is made available, RBI will establish the
standards surrounding their use. Further, banks will need to obtain prior
approval from RBI to use an internal allocation method for this purpose.

Sufficiency of provisions to meet EL

200. Banks using the IRB approach must compare the amount of total
eligible provisions (as defined in paragraph 196) with the total EL amount as
calculated within the IRB approach (as defined in paragraph 191). If the total
eligible provisions are over and above the EL amount, the excess can be
included in Tier 2 capital up to a maximum of 0.6% of credit risk weighted
assets.
201. However, where the calculated EL amount is lower than the
provisions of the bank, RBI will consider whether the EL fully reflects the
conditions in the market in which it operates before allowing the difference
to be included in Tier 2 capital. Further, comparison of the amount of
eligible provisions and EL may be done separately for defaulted and non-
defaulted exposures. Excess of eligible provisions over EL for defaulted
assets may not be allowed to compensate lower general provisioning for
non-defaulted exposures unless RBI is satisfied that the EL fully reflects the

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conditions in the market in which it operates.
202. Where the total EL amount exceeds total eligible provisions, banks
must deduct the difference from its common equity (subject to transitional
arrangements under Basel III).
203. The full EL amount for equity exposures under the PD/LGD approach
will be risk weighted at 1111% to derive the capital requirement for the
same. Provisions or write-offs for equity exposures under the PD/LGD
approach will not be used in the EL-provision calculation.

Credit Risk – Securitisation Framework

An overview
204. A securitisation exposure, as defined in RBI ‘Guidelines on
Securitisation of Standard Assets’, issued vide circular DBOD.No.BP.BC.60/
21.04.048/ 2005-06 dated February 1, 2006, would qualify for the following
prudential treatment of securitisation exposures for capital adequacy
purposes. Banks’ exposures to a securitisation transaction, referred to as
securitisation exposures, can include, but are not restricted to the following:
as investor, as credit enhancer, as liquidity provider, as underwriter, as
provider of credit risk mitigants and cash collaterals provided as credit
enhancements. Repurchased securitisation exposures should be treated as
retained securitisation exposures. Further, as securitisation may be
structured in many different ways, the capital treatment of a securitisation
shall be determined on the basis of its economic substance rather than its
legal form. The terms used in this section with regard to securitisation are
mostly defined in RBI ‘Guidelines on Securitisation of Standard Assets’.
Some of the additional terms used in the section are defined below:
a) A ‘credit enhancing interest only strip (I/Os)’ – It is an on-balance sheet
asset, which (i) represents a valuation of cash flows related to future
margin income to be derived from the underlying exposures, and
(ii) Is subordinated to the claims of other parties to the transaction in
terms of priority of repayment.
b) ‘Implicit support’ – the support provided by a bank to a securitisation in
excess of its predetermined contractual obligation.
c) A ‘gain-on-sale’ – any profit realised at the time of sale of the
securitised assets to SPV.

Operational criteria for Credit Analysis

205. For enabling the transferred assets to be removed from the balance
sheet of the originator in a securitisation structure, the isolation of assets or
‘true sale’ from the originator to the SPV is an essential prerequisite. In case
the assets are transferred to the SPV by the originator in full compliance
with all the conditions of true sale as given in the extant RBI Guidelines on

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Securitisation of Standard Assets, the transfer would be treated as a 'true
sale' and originator will not be required to maintain any capital against the
value of assets so transferred from the date of such transfer.

Implicit Support
206. The originator shall not provide any implicit support to investors in
a securitisation transaction.
207. When a bank is deemed to have provided implicit support to a
securitisation:
a) It must, at a minimum, hold capital against all of the exposures
associated with the securitisation transaction as if they had not been
securitised.
b) Additionally, the bank would need to deduct any gain-on-sale (if
recorded) from common equity.
c) Furthermore, in respect of securitisation transactions where the bank is
deemed to have provided implicit support, it is required to disclose
publicly that (i) it has provided non-contractual support, (ii) the details
of the implicit support, and (iii) the impact of the implicit support on
the bank’s regulatory capital.
208. Where a securitisation transaction contains a clean up call and the
clean up call can be exercised by the originator in circumstances where
exercise of the clean up call effectively provides credit enhancement, the
clean up call shall be treated as implicit support and the concerned
securitisation transaction will attract the above prescriptions. However, the
clean up call up to the extant regulatory permissible limit, if any, may not be
treated as credit enhancement.
209. IRB banks are required to hold regulatory capital against all of their
securitisation exposures. The other prudential requirements relating to
securitisation exposures will be applicable as per the extant RBI guidelines
on securitisation.

Internal Ratings-Based (IRB) Approach for Securitisation Exposures

210. Scope of IRB approach
i) Banks shall use the Standardised Approach to calculate the credit risk-
weighted exposure amounts for its securitisation exposures where it
uses the Standardised Approach for the asset sub-class to which the
underlying exposures in the securitisation belong.
ii) Banks that have received approval from RBI to use the IRB approach for
the type of underlying exposures securitised (e.g. for their corporate or
retail portfolio) must use the IRB approach for securitisations.
Conversely, banks may not use the IRB approach to securitisation unless
they receive approval to use the IRB approach for the underlying

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 exposures from RBI.
iii) If the bank is using the IRB approach for some exposures and the
standardised approach for other exposures in the underlying pool, it
should generally use the approach corresponding to the predominant
share of exposures within the pool. However, in case of doubt, the bank
should consult with RBI on which approach to apply to its securitisation
exposures, to ensure appropriate capital levels.
iv) Where there is no specific IRB treatment for the underlying asset type,
originating banks that have received approval to use the IRB approach
must calculate capital charges on their securitisation exposures using
the standardised approach in the securitisation framework, and
investing banks with approval to use the IRB approach must apply the
Rating Based Approach, as detailed below.

Hierarchy of Approaches
211. There are two approaches under the Internal Ratings Based
Approach:
a. the Ratings-Based Approach (“RBA”)
b. the Supervisory Formula (“SF”)
212. Under the IRB approach, a bank must follow the hierarchy of
approaches to determine the regulatory capital for credit risk in respect of
securitisation exposures, as under:
a. The Ratings-Based Approach (RBA) must be applied to securitisation
exposures that are externally rated, or where a rating can be inferred as
described in paragraph 221.
b. For securitisation exposures where the bank cannot use the RBA, the
Supervisory Formula (SF) may be applied (unless the bank cannot use
the SF because the bank is unable to reliably determine KIRB)
c. Securitization exposures to which none of these approaches can be
applied must receive 1111% risk weight.

Maximum capital requirement

213. For a bank using the IRB approach to securitisation, the maximum
capital requirement for the securitisation exposures it holds is equal to the
IRB capital requirement that would have been assessed against the
underlying exposures had they not been securitised and treated under the
appropriate sections of the IRB framework.
214. In addition, irrespective of the approach applied, banks must deduct
any gain-on-sale (if recorded) and credit enhancing I/Os arising from the
securitisation transaction, if not permitted to be recognised, from its
common equity.

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Ratings-Based Approach (RBA)
215. Under the RBA, the banks shall determine the amount of risk-
weighted assets by multiplying the amount of the securitisation exposure (in
the case of an off-balance sheet exposure, securitisation exposure will be
multiplied with the credit equivalent amount, before applying risk weights)
with the appropriate risk weights provided in the tables A and B below.
The relevant risk weights under the RBA depend upon:
a. the external credit rating grade or an available inferred rating,
b. whether the credit rating (external or inferred) represents a long-term
or a short-term credit rating,
c. the granularity of the underlying pool and
d. the seniority of the securitisation exposure.
For the purposes of the RBA, a securitisation exposure is treated as a senior
tranche if it is effectively backed or secured by a first claim on the entire
amount of the assets in the underlying securitised pool. While this generally
includes only the most senior position within a securitisation transaction, in
some instances there may be some other claim that, in a technical sense,
may be more senior in the waterfall (e.g. a swap claim) but may be
disregarded for the purpose of determining which positions are subject to
the “senior tranches” column. For example, in a traditional securitisation
where all tranches above the first-loss piece are rated, the most highly rated
position would be treated as a senior tranche. However, when there are
several tranches that share the same rating, only the most senior one in the
waterfall would be treated as senior.
The risk weights provided in the Table A apply when the external
assessment represents a long-term credit rating, as well as when an inferred
rating based on a long-term rating is available. Banks may apply the risk
weights for senior positions if the effective number of underlying exposures
(N as defined in para 229) is 6 or more and the position is senior. When N is
less than 6, the risk weights in column 4 of the table A apply. In all other
cases, the risk weights in column 3 of the table A apply.
Table A
RBA risk weights when the external assessment represents a long-term
credit rating and/or an inferred rating derived from a long-term
assessment
External Rating N* ≥ 6 N<6
(Illustrative) / Risk weights for Base risk weights, Risk weights for
Inferred senior positions** i.e. Risk weights for tranches backed
Rating other exposures By non-granular
Pools
AAA 7% 12% 20%
AA 8% 15% 25%

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 A+ 10% 18%
35%
A 12% 20%
A- 20% 35%
BBB+ 35% 50%
BBB 60% 75%
BBB- 100%
BB+ 250%
BB 425%
BB- 650%
Below BB- and
unrated 1111%

Table B
RBA risk weights when the external assessment represents a short-term
credit rating and/or an inferred rating derived from a short-term
assessment
N≥6 N<6
External Rating
(Illustrative) / Base risk weights, Risk weights for
Risk weights for
Inferred Rating i.e. Risk weights tranches backed
senior positions
for other By non-granular
exposures pools
A-1/P-1 7% 12% 20%
A-2/P-2 12% 20% 35%
A-3/P-3 60% 75% 75%
All other
ratings/unrated 1111% 1111% 1111%

*A bank shall calculate the effective number of underlying exposures (N) for
each securitisation exposure in accordance with paragraph 232.
**a securitisation exposure is treated as a senior tranche if it is effectively
backed or secured by a first claim on the entire amount of the assets in the
underlying securitised pool.
A bank need not consider interest rate or currency swaps when determining
whether a securitisation exposure is the most senior in a securitisation for
the purpose of applying the RBA.

Operational requirements for use of external credit assessments

219. A bank relying upon credit ratings for risk weighting its securitization
exposures under IRB Approaches should meet the requirements specified in
paragraph (i) through (ii) below.

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(i) A bank should meet the following operational requirements for use of
external credit assessments in determination of capital requirements for
securitization exposures:
(a) To be eligible for risk-weighting purposes, the external credit
assessment must take into account and reflect the entire amount of
credit risk exposure the bank has with regard to all payments owed
to it. For example, if a bank is owed both principal and interest, the
assessment must fully take into account and reflect the credit risk
associated with timely repayment of both principal and interest.
(b) The external credit assessments must be from an eligible ECAI as
recognised by RBI (in the case of securitization exposures originated
by entities outside India the credit assessments must be from the
ECAI recognised by the local national supervisors). The rating must be
published in an accessible form and included in the ECAI’s transition
matrix. Consequently, ratings that are made available only to the
parties to a transaction do not satisfy this requirement.
(c) Eligible ECAIs must have a demonstrated expertise in assessing
securitisations, which may be evidenced by strong market
acceptance.
(d) A bank must apply external credit assessments from eligible ECAIs
consistently across a given type of securitisation exposure.
Furthermore, a bank cannot use the credit assessments issued by
one ECAI for one or more tranches and those of another ECAI for
other positions (whether retained or purchased) within the same
securitisation structure that may or may not be rated by the first
ECAI. Where two or more eligible ECAIs can be used and these assess
the credit risk of the same securitization exposure differently,
guidance given by RBI under Standardised Approach will apply.
(e) Where CRM is provided directly to an SPE by an eligible guarantor
and is reflected in the external credit assessment assigned to a
securitisation exposure(s), the risk weight associated with that
external credit assessment should be used. In order to avoid any
double counting, no additional capital recognition is permitted. If the
CRM provider is not recognised as an eligible guarantor the covered
securitisation exposures should be treated as unrated.
(f) In the situation where a credit risk mitigant is not obtained by the
SPE but rather applied to a specific securitisation exposure within a
given structure (e.g. ABS tranche), the bank must treat the exposure
as if it is unrated and then use the CRM treatment to recognise the
hedge.
(iii) The bank must perform proper due diligence of securitization exposures
based on the information specified in paragraphs (a) through (c) below

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 on the underlying collateral supporting securitisation exposures’ and any
other information the bank may consider necessary in this regard:
(a) As a general rule, a bank must, on an ongoing basis, have a
comprehensive understanding of the risk characteristics of its
individual securitisation exposures, whether on balance sheet or off
balance sheet, as well as the risk characteristics of the pools
underlying its securitisation exposures.
(b) Banks must be able to access performance information on the
underlying pools on an ongoing basis in a timely manner. Such
information may broadly include, as appropriate: exposure type;
percentage of loans 30, 60 and 90 days past due; default rates;
prepayment rates; loans in foreclosure; property type; occupancy;
average credit score or other measures of creditworthiness; average
loan-to-value ratio; and industry and geographic diversification.
(c) A bank must have a thorough understanding of all structural features
of a securitisation transaction that would materially impact the
performance of the bank’s exposures to the transaction, such as the
contractual waterfall and waterfall-related triggers, credit
enhancements, liquidity enhancements, market value triggers, and
deal-specific definitions of default.
220. A bank is not permitted to use any external credit assessment for risk
weighting purposes where the assessment is at least partly based on
unfunded support provided by the bank. For example, if a bank buys an
ABS/MBS where it provides an unfunded securitisation exposure extended
to the securitisation (e.g. liquidity facility or credit enhancement), and that
exposure plays a role in determining the credit assessment on the
securitised assets/various tranches of the ABS/MBS, the bank must treat the
securitised assets/various tranches of the ABS/MBS as if these were not
rated.

Use of Inferred Ratings

221. Banks may attribute an inferred rating to an unrated securitisation
exposure if the following requirements are complied with:
(a) If there is a securitisation exposure which has an external credit
assessment by a recognised ECAI (the “reference securitisation
exposure”) and which is subordinate in all respects to the unrated
securitisation exposure. Credit enhancements, if any, must be taken into
account when assessing the relative subordination of the unrated
exposure and the reference securitisation exposure. For example, if the
reference securitisation exposure benefits from any third-party
guarantees or other credit enhancements that are not available to the
unrated exposure, then the latter may not be assigned an inferred rating

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 based on the reference securitisation exposure.
(b) The maturity of the reference securitisation exposure is equal to or
longer than that of the unrated securitisation exposure; and
(c) The bank has an established internal process to ensure that any inferred
rating will be updated immediately to reflect any changes in the external
credit assessment of the reference securitisation exposure.
(d) The external rating of the reference securitization exposure must satisfy
the operational requirements for its use.

Supervisory Formula (SF)

222. Under the SF, the regulatory capital for credit risk in respect of a
securitisation exposure depends upon the following bank-supplied inputs:
(a) the IRB capital requirement had the pool not been securitised (KIRB);
(b) the credit enhancement level (L);
(c) the thickness (T);
(d) the effective number of exposures in the pool (N); and
(e) the pool’s exposure-weighted average loss given default (LGD).

Definition of KIRB
223. KIRB is the ratio (in decimal form) of:
(a) the IRB capital requirement, including the expected loss (EL) portion, for
the pool; to
(b) the exposure amount of the pool, i.e. the sum of drawn amounts plus
the estimated exposure at default of undrawn commitments.
The amount in (a) above must be calculated in accordance with the
applicable minimum IRB standards as if the exposures in the pool were held
directly by the bank. This calculation may reflect the effects of any CRM that
is applied on the underlying exposures in the pool (either individually or to
the entire pool), and hence benefits all of the securitisation exposures. For
structures involving an SPV/SPE, all the assets of the SPV/SPE that are
related to the securitisation must be treated as exposures in the pool,
including assets in which the SPV may have invested a reserve account, such
as a cash collateral account.

Definition of the credit enhancement level (L)

Credit enhancement level (L) is measured as the ratio (in decimal form) of:
(a) the outstanding amount of all securitisation exposures subordinate to
the tranche in question; to
(b) the amount of exposures in the pool
225. Banks must determine L before considering the effects of any
tranche-specific credit enhancements that benefit only a single tranche. Any
gain on sale and/or credit enhancing I/Os associated with the securitisation

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must not be included in the measurement of L. The size of interest rate or
currency swaps that are more junior than the tranche may be measured at
their current mark-to-market value (i.e. excluding the amount estimated for
potential future exposure) when calculating L. If the mark-to-market value
cannot be measured, the derivative instrument must be ignored in the
calculation of L.
226. Unfunded reserve accounts must not be included in the calculation of
L if they are to be funded from future receipts from the underlying
exposures. If there is any reserve account that has already been funded by
accumulated cash flows from the underlying exposures that is more junior
than the tranche in question, it may be included in the calculation of L.

Definition of the thickness of exposure (T)

227. Thickness of exposure (T) is measured as the ratio (in decimal form)
of:
(a) the nominal size of the securitisation exposure or tranche; to
(b) the notional amount of the exposures in the pool. (may be the same
amount as the denominators of KIRB and L)
Where an exposure arises from an interest rate or currency swap, the bank
must incorporate the potential future exposure of the swap in the
measurement of the nominal size of the securitisation exposure. If the
mark-to-market value of the derivative instrument is positive, the exposure
size must be measured by the current exposure method. If the mark-to-
market value of the derivative instrument is negative, the exposure must be
measured by using the potential future exposure only.

Definition of the effective number of exposures (N)

229. Effective number of exposures (N) is calculated as:

where exposure at default (EADi) represents the exposure at default

th
associated with the i exposure in the pool. Multiple exposures to the same
obligor must be consolidated when calculating the effective number of
exposures. If the portfolio share associated with the largest exposure (C1) is
available, the bank may compute N as 1/C1.
Definition of the exposure-weighted average loss given default (LGD)
230. The exposure-weighted average LGD is calculated as follows:

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where LGDi represents the average LGD associated with all exposures to the
th
i borrower. When default and dilution risks for purchased receivables are
treated in an aggregate manner (e.g. a single reserve or over-
collateralisation is available to cover losses from either source) within a
securitisation, the LGD input must be constructed as a weighted average of
the LGD for default risk and 100 per cent LGD for dilution risk. The weights
to be used in this calculation are the stand-alone IRB risk-weights for default
risk and dilution risk, respectively.

Capital charge under the supervisory formula

231. The capital charge under the SF is calculated as the value of exposures
that have been securitised multiplied by the greater of:
(a) 0.0056 × T; and
(b) (S [L+T] – S [L])
where the function S[.] (the supervisory formula) is defined below. When
the bank holds only a proportional interest in the tranche, that position’s
capital charge equals the prorated share of the capital charge for the entire
tranche. The supervisory formula is given by the following expression:
S[L ]= L, when L≤ KIRB
S[L ] = K IRB + K[L ] − K[K IRB ]+ (d ∗ K IRB / ω)(1 − eω(KIRB −L)/ KIRB ), when KIRB<L
Where

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In the above equations, Beta (L;a,b) refers to the cumulative beta
distribution with parameters a and b and evaluated at L. Banks may
consider the following values for using in the above equations ω= 20, ‫=ז‬
1000
232. Risk-weighted asset amounts generated through the use of the SF are
calculated by multiplying the capital requirement as determined above by
12.5. If the risk-weight resulting from the SF is 1111% of the exposure value
or greater, the bank must deduct the securitisation exposure from its
common equity. In the case where a bank has set aside a specific provision
or has a non refundable purchase price discount on an exposure in the pool,
KIRB and L must be calculated using the gross amount of the exposure,
without taking into account the specific provision and/or non-refundable
purchase price discount. In this case, the amount of the non-refundable
purchase price discount on a defaulted asset or the specific provision can be
used to reduce the amount of any deduction from capital associated with
the securitisation exposure.

Simplified method for computing the effective number of exposures (N)

and the exposure-weighted average loss given default (LGD)
Subject to approval from RBI, a bank that has a securitisation involving retail
exposures may use a simplified method for calculating (N) and (LGD)
whereby the SF may be implemented using the simplifications h = 0 andv = 0
Under the simplified method, if the portfolio share associated with the
largest exposure (C1) is no more than three per cent ( i.e. a value of .03) of
the underlying pool, for purposes of the SF a bank may set LGD equal to 50
per cent (0.5) and N equal to the following amount:

where Cm denotes the share of the securitised asset pool corresponding to

the sum of the largest m exposures. The level of m is decided by the bank.
Alternatively, if only C1 is available and this amount is no more than three
per cent, then the bank may set LGD equal to 50 per cent ( i.e. 0.5) and
N=1/C1.

Securitisation - Liquidity facilities

Under the IRB Approach, liquidity facilities are treated as any other
securitisation exposure and receive a CCF of 100%. If the facility is externally
rated, the bank may rely on the external rating and use the RBA risk
weights. Thus, the notional amount of the securitisation exposure must be
assigned the risk weight in the RBA appropriate to the credit rating
equivalent assigned to the bank’s exposure. If the facility is not rated (which

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is generally the case), the bank may use the inferred rating, if applicable, or
may apply the SFA. If neither approach can be used, then the facility must
be deducted risk weighted at 1111%.

Eligible liquidity facilities

Banks are permitted to treat off-balance sheet securitisation exposures as
eligible liquidity facilities if the following minimum requirements are
satisfied:
(a) The facility documentation must clearly identify and limit the
circumstances under which it may be drawn. Draws under the facility
must be limited to the amount that is likely to be repaid fully from the
liquidation of the underlying exposures and any seller-provided credit
enhancements. In addition, the facility must not cover any losses
incurred in the underlying pool of exposures prior to a draw, or be
structured such that draw-down is certain (as indicated by regular or
continuous draws);
(b) The facility must be subject to an asset quality test that precludes it from
being drawn to cover credit risk exposures that are in default. In
addition, if the exposures that a liquidity facility is required to fund are
externally rated securities, the facility can only be used to fund securities
that are externally rated investment grade at the time of funding;
(c) The facility cannot be drawn after all applicable credit enhancements
from which the liquidity would benefit have been exhausted; and
(d) Repayment of draws on the facility (i.e. assets acquired under a
purchase agreement or loans made under a lending agreement) must
not be subordinated to any interests of any note holder or subject to
deferral or waiver.
237. When it is not practical for the bank to use either the bottom-up
approach or the top-down approach for calculating KIRB, the bank may, on
an exceptional basis and subject to RBI’s consent, temporarily be allowed to
apply the following method. If the liquidity facility is an eligible liquidity
facility as defined above, the highest risk weight assigned under the
Standardised approach to any of the underlying individual exposures
covered by the liquidity facility can be applied to the entire liquidity facility.
If the liquidity is an eligible liquidity facility as defined above, the CCF must
be 100%. In all other cases, the notional amount of the liquidity facility must
be deducted from common equity.

Treatment of overlapping exposures

A bank may provide several types of facilities that can be drawn under
various conditions. The same bank may be providing two or more of these
facilities. Given the different triggers found in these facilities, it may be the

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case that a bank provides duplicative coverage to the underlying exposures.
In other words, the facilities provided by a bank may overlap since a draw
on one facility may preclude (in part) a draw under the other facility. In the
case of overlapping facilities provided by the same bank, the bank does not
need to hold additional capital for the overlap. Rather, it is only required to
hold capital once for the position covered by the overlapping facilities
(whether they are liquidity facilities or credit enhancements). Where the
overlapping facilities are subject to different conversion factors, the bank
must attribute the overlapping part to the facility with the highest
conversion factor. However, if overlapping facilities are provided by
different banks, each bank must hold capital for the maximum amount of
the facility.

Eligible servicer cash advance facilities

If contractually provided for, servicers may advance cash to ensure an
uninterrupted flow of payments to investors so long as the servicer is
entitled to full reimbursement and this right is senior to other claims on
cash flows from the underlying pool of exposures. Such undrawn servicer
cash advances or facilities that are unconditionally cancellable without prior
notice may be eligible for a 0% CCF.

Treatment of credit risk mitigation for securitisation exposures

As with the RBA, banks are required to apply the CRM techniques as
specified in the foundation IRB approach when applying the SF. The bank
may reduce the capital charge proportionally when the credit risk mitigant
covers first losses or losses on a proportional basis. For all other cases, the
bank must assume that the credit risk mitigant covers the most senior
portion of the securitisation exposure (i.e. that the most junior portion of
the securitisation exposure is uncovered).

Off-balance sheet exposures and securitisation risk

Banks’ use of securitisation has grown dramatically over the last several
years. It has been used as an alternative source of funding and as a
mechanism to transfer risk to investors. While the risks associated with
securitisation are not new to banks, the recent financial turmoil highlighted
unexpected aspects of credit risk, concentration risk, market risk, liquidity
risk, legal risk and reputational risk, which banks failed to adequately
address. For instance, a number of banks that were not contractually
obligated to support sponsored securitisation structures were unwilling to
allow those structures to fail due to concerns about reputational risk and
future access to capital markets. The support of these structures exposed
the banks to additional and unexpected credit, market and liquidity risk as

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they brought assets onto their balance sheets, which put significant
pressure on their financial profile and capital ratios.
Weaknesses in banks’ risk management of securitisation and off-balance
sheet exposures resulted in large unexpected losses during the financial
crisis. To help mitigate these risks, a bank’s on- and off-balance sheet
securitisation activities should be included in its risk management
disciplines, such as product approval, risk concentration limits, and
estimates of market, credit and operational risk
In light of the wide range of risks arising from securitisation activities, which
can be compounded by rapid innovation in securitisation techniques and
instruments, minimum capital requirements calculated under Pillar 1 are
often insufficient. All risks arising from securitisation, particularly those that
are not fully captured under Pillar 1, should be addressed in a bank’s ICAAP.
These risks include:
• Credit, market, liquidity and reputational risk of each exposure;
• Potential delinquencies and losses on the underlying securitised
exposures;
• Exposures from credit lines or liquidity facilities to special purpose
entities; and
Securitisation exposures should be included in the bank’s MIS to help
ensure that senior management understands the implications of such
exposures for liquidity, earnings, risk concentration and capital. More
specifically, a bank should have the necessary processes in place to capture
in timely manner updated information on securitisation transactions
including market data, if available, and updated performance data from the
securitisation trustee or servicer.

Supervisory Review Process under Pillar 2 Framework

245. A bank should ensure that it has sufficient capital to meet the Pillar
1 requirements and the results of the credit risk stress test as mentioned in
the Appendix 1. RBI may review the method and the results of the stress
test thus carried out under Supervisory Review and Evaluation Process
(SREP) under Pillar 2 and may require the bank to reduce risk and/or to hold
additional capital/provisions. In addition, residual risks arising out of use of
CRM techniques may be reviewed by the bank under Pillar 2.

Application process for IRB approval

Initially, banks need to submit a letter of intention to RBI (on or after April 1,
2012). Along with the letter of intention, the banks must also submit their
Board’s approval for the application of adoption of IRB approach for credit
risk. Banks should also do a self-assessment with reference to these
guidelines to check whether they fulfil the criteria mentioned in the

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guidelines. A gist of the self assessment exercise should also be submitted
to RBI along with the letter of intention. This self assessment exercise will
broadly cover the following aspects:
• IRB rating system should separately reflect PD (borrower wise) and LGD
(facility wise).
• IRB rating system and resultant risk estimates (PD, LGD, EAD and M)
must meaningfully assess and differentiate risk.
• IRB rating and risk estimates must be based on current and relevant
information. PD and LGD estimates must be reviewed periodically (at
least annually).
• IRB rating and risk estimates must be conceptually sound irrespective of
the type and complexity of the models used.
• Long term average PD and default weighted average LGD or downturn
LGD (whichever is higher) and EAD should be considered.
• Risk estimates/rating system may be grounded on past experience and
also give proper emphasis on empirical evidence.
• Risk estimates/rating system should also be forward looking and should
meet the minimum data requirement as prescribed in the guidelines.
• Banks must ensure that the default definition used are as per the
instructions given in the guideline and should be using this definition
consistently across the organisation.
• Banks must have a very robust validation methodology for the rating
system/risk estimates. This validation process should be well
documented. Operational integrity and consistency of rating system/risk
estimates should be given due importance in the validation process.
• Banks should have sound model risk policy with detailed documentation
of the model and related system development, validation and control
process. This should also have the provision to discuss the limitations of
the model as well as applicability of data used to build up the model.
• The Board and the senior management of banks should take the
ultimate responsibility of the risk rating system and risk estimates that
will be used by the bank for capital calculation. The bank should be able
to demonstrate to RBI that the Board and the senior management have
good general understanding of the risk rating process, risk estimates and
the limitations of the same.
• People responsible for development/buying, implementation and
ongoing usage of rating system/model should be separate from the
people originating the loans.
• An independent internal audit unit must verify development/buying,
implementation and validation of models (whether the process
mentioned in model risk policy are being adhered to) at least annually.
• All matters related to IRB risk rating system should be clearly

194
 documented and this should be updated on a regular basis to reflect any
material change in the system. The document should also be in line with
the current practices of the bank. Responsibilities of the persons
attached to performance of IRB rating system should be clearly defined
and documented as well.
• The bank must ensure that the risk rating system and the risk estimates
derived are meaningfully used for its day to day risk management
process as per the guideline. The bank must also satisfy itself that the
experience and data requirement as given in the guideline with
reference to usage of risk rating system is also fulfilled.
• Banks must have in place an adequate and robust data capture, storage
and management system with adequate scope, detail, consistency and
reliability which will support the IRB rating system and risk components
estimation.
After receiving letter of intention and the gist of self assessment exercise
from a bank, RBI will examine the same and may allow it to submit a
detailed application, depending on its primary assessment of the applicant
bank. The following information may be required to be provided as part of
the detailed application:
a. Cover letter requesting approval;
b. Copy of the Board Resolution approving submission of final application
for migrating to IRB;
c. Detailed application format duly filled in (will be given to the banks after
RBI is satisfied with initial assessment of the banks’ preparedness);
d. Confirmation from the respective heads responsible for risk
management and internal audit towards the bank’s compliance to IRB
requirements;
e. Documentation of planned credit risk measurement systems (including
rating systems and models to be used);
f. Control environment of the credit risk measurement system,
implementation procedures, and IT infrastructure;
g. Submission of an acceptable third party data management sign off in
respect of IRB portfolio;
h. Implementation plan (including roll-out); and
i. Any other information needed by RBI for the assessment.
All these documents will be scrutinised by the RBI and detailed assessment
of the bank’s risk rating system will be carried out in the light of the
requirements set in the guideline. RBI may examine the parallel run and its
reports alongside examination of the documents submitted by the banks
and observe the processes being followed by them during the parallel run
period. After a minimum of 18 months parallel run, if RBI is satisfied by the
performance of the bank in terms of its adherence to the IRB guidelines, RBI

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will give the its approval to the banks to adopt IRB approach for capital
calculation of credit risk. However, if subsequently at any point of time RBI
observes that a bank has deviated from IRB requirements, it may withdraw
the approval previously given.

Appendix 1
Minimum requirements for adoption of IRB approaches
This section states the minimum requirements for entry and on-going use of
the IRB approach. The minimum requirements are set out in 11 separate
sub-sections concerning: (A) composition of minimum requirements, (B)
compliance with minimum requirements, (C) rating system design, (D) risk
rating system operations, (E) corporate governance and oversight, (F) use of
internal ratings, (G) risk quantification, (H) validation of internal estimates,
(I) requirements for recognition of leasing, (J) eligibility criteria for
calculation of capital charges for equity exposures under internal model
method, and (K) disclosure requirements. It may be helpful to note that the
minimum requirements cut across asset classes. Therefore, more than one
asset classes may be discussed within the context of a given minimum
requirement.
1. Composition of minimum requirements
2. To be eligible for the IRB approach, a bank must demonstrate to RBI that
it meets certain minimum requirements at the outset and on an ongoing
basis. Many of these requirements are in the form of objectives that a
qualifying bank’s risk rating systems must fulfil. The focus is on banks’
abilities to quantify risk in a consistent, reliable and valid fashion.
3. The overarching principle behind these requirements is that rating and
risk estimation systems and processes provide for a meaningful assessment
of borrower and transaction characteristics; a meaningful differentiation of
risk; and reasonably accurate and consistent quantitative estimates of risk.
Furthermore, the systems and processes must be consistent with internal
use of these estimates.
4. The minimum requirements set out in this document apply to all asset
classes as also to foundation and advanced IRB approaches unless noted
otherwise. The standards related to the process of assigning exposures to
borrower or facility grades (and the related oversight, validation, etc.) apply
equally to the process of assigning retail exposures to pools of homogenous
exposures, unless noted otherwise.
5. Generally, all IRB banks must produce their own estimates of PD
(banks are not required to produce their own estimates of PD for certain
equity exposures under some specified methodologies and certain
exposures that fall within the Specialised Lending sub asset class.) and must
adhere to the overall requirements for rating system design, operations,

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controls, and corporate governance, as well as the requisite requirements
for estimation and validation of PD measures. Banks wishing to use their
own estimates of LGD and EAD must also meet the incremental minimum
requirements for these risk factors included in this guideline. IRB risk
estimates must include a margin of conservatism. Where the estimation
method and the data are less satisfactory and the likely range of errors is
larger, the margin of conservatism should also be larger.

(B) Compliance with minimum requirements

To be eligible for an IRB approach, a bank must demonstrate to RBI that it
meets the IRB
6. Requirements, at the outset and on an ongoing basis. There may be
circumstances when a bank is not in complete compliance with all the
minimum requirements. Where this is the case, the bank must produce a
plan for a timely return to compliance, and seek approval from the RBI, or
the bank must demonstrate that the effect of such non-compliance is
immaterial in terms of the risk posed to the institution. Failure to produce
an acceptable plan or to demonstrate immateriality will lead RBI to
reconsider the bank’s eligibility for the IRB approach. Furthermore, for the
duration of any non-compliance, RBI may consider the bank to compute
capital under standardised approach. In addition, as per the assessment, the
bank may also be required to hold additional capital under Pillar 2.

(C) Rating system design

7. The term “rating system” comprises all of the methods, processes,
controls, and data collection and IT systems that support the assessment of
credit risk, the assignment of internal risk ratings, and the quantification of
default and loss estimates. Within each asset class, a bank may utilise
multiple rating methodologies/systems. For example, a bank may have
customised rating systems for specific industries or market segments (e.g.
mid corporate and large corporate). If a bank chooses to use multiple
systems, the rationale for assigning a borrower to a particular rating system
must be documented and applied in a manner that best reflects the level of
risk of the borrower. Banks must not allocate borrowers across rating
systems inappropriately to minimise regulatory capital requirements (i.e.
cherry-picking by choice of rating system). Banks must demonstrate that
each system used for IRB purposes is in compliance with the minimum
requirements at the outset and on an ongoing basis.

197
Rating dimensions
Standard for corporate, sovereign and bank exposures
8. A qualifying IRB rating system must have two separate and distinct
dimensions: (i) the risk of borrower default, and (ii) transaction-specific
factors.
9. The first dimension (borrower grade and must solely reflect PD)
must be oriented to the risk of borrower default. Separate exposures to the
same borrower must be assigned to the same borrower grade, irrespective
of any differences in the nature of each specific transaction. There are two
exceptions to this. Firstly, in the case of country transfer risk, where a bank
may assign different borrower grades depending on whether the facility is
denominated in local or foreign currency and secondly, when the treatment
of associated guarantees to a facility may be reflected in an adjusted
borrower grade. A bank must articulate in its credit policy the relationship
between borrower grades in terms of the level of risk each grade implies.
Perceived and measured risk must increase as credit quality declines from
one grade to the next. The policy must articulate the risk of each grade in
terms of both a description of the probability of default risk typical for
borrowers assigned the grade and the criteria used to distinguish that level
of credit risk.
10. The second dimension (facility grade and should solely express
LGD) must reflect transaction-specific factors, such as collateral, seniority,
product type, etc. But as an exception for F-IRB banks, this requirement can
also be fulfilled by the existence of a facility dimension, which reflects both
borrower (to the extent that PD may be related with LGD) and transaction-
specific factors. For example, a rating dimension that reflects EL by
incorporating both borrower strength (PD) and loss severity (LGD)
considerations would also qualify besides a rating system that exclusively
reflects LGD. Where a rating dimension reflects EL and does not separately
quantify LGD, the supervisory estimates of LGD must be used.
11. For banks using the advanced IRB approach, facility ratings must
exclusively reflect LGD. These ratings can reflect any and all factors that can
influence LGD including, but not limited to, the type of collateral, product,
industry, and purpose. Borrower characteristics may be included as LGD
rating criteria only to the extent they are predictive of LGD. Banks may alter
the factors that influence facility grades across segments of the portfolio as
long as they can satisfy RBI that it improves the relevance and precision of
their estimates.
12. Banks using the supervisory slotting criteria for the SL sub-class are
exempt from this two-dimensional requirement for these exposures. Given
the interdependence between borrower/transaction characteristics in SL,
banks may satisfy the requirements under this heading through a single

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rating dimension that reflects EL by incorporating both borrower strength
(PD) and loss severity (LGD) considerations. This exemption does not apply
to banks using either the corporate foundation or advanced IRB approach
for the SL sub-class.

Standards for retail exposures

13. Rating systems for retail exposures must capture all relevant
borrower and transaction characteristics. Banks must assign each exposure
that falls within the definition of retail for IRB purposes into a particular
pool. Banks must demonstrate that this process provides for a meaningful
differentiation of risk, provides for a pooling of sufficiently homogenous
exposures with similar risk characteristics for purposes of risk assessment
and quantification, and allows for accurate and consistent estimation of loss
characteristics at pool level.
14. For each pool, banks must estimate PD, LGD, and EAD. Some of the
indicative risk drivers when assigning exposures to a pool, are given below:
• Borrower risk characteristics (e.g. borrower type, demographics such as
age/occupation);
• Transaction risk characteristics, including product and/or collateral types
[e.g. loan to value measures, seasoning, guarantees; and seniority (first
vs. second lien)]. Banks must explicitly address cross-collateral provisions
where present;
• Banks are expected to separately identify exposures that are delinquent
and those that are not.

Rating structure
Standards for corporate, sovereign, and bank exposures
15. A bank must have a meaningful distribution of exposures across
grades with no excessive concentrations, on both its borrower-rating and its
facility-rating scales. To meet this objective, a bank must have a minimum of
seven borrower grades for non-defaulted borrowers and one for those that
have defaulted. Banks with lending activities focused on a particular market
segment may satisfy this requirement with the minimum number of grades.
However, RBI may require banks, which lend to borrowers of diverse credit
quality, to have a greater number of borrower grades on a case to case
basis.
16. A borrower grade is defined as an assessment of borrower risk on
the basis of a specified and distinct set of rating criteria, from which
estimates of PD are derived. The grade definition must include both a
description of the degree of default risk typical for borrowers assigned the
grade and the criteria used to distinguish that level of credit risk.
Furthermore, “+” or “-” modifiers to alpha or numeric grades will only

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qualify as distinct grades if the bank has developed complete rating
descriptions and criteria for their assignment, and separately quantifies PDs
for these modified grades.
17. In case of banks with loan portfolios concentrated in a particular
market segment, range of default risk must have enough grades to avoid
undue concentrations of borrowers in a particular grade. Significant
concentrations within a single grade or grades must be supported by
convincing empirical evidence that the grade or grades cover reasonably
narrow PD bands and that the default risk posed by all borrowers in a grade
fall within that band.
18. There is no specific minimum number of facility grades for banks
using the advanced approach for estimating LGD. A bank must have a
sufficient number of facility grades to avoid grouping facilities with widely
varying LGDs into a single grade. The criteria used to define facility grades
must be grounded in empirical evidence.
19. Banks using the supervisory slotting criteria for the SL asset classes
must have at least four grades for non-defaulted borrowers, and one for
defaulted borrowers. The requirements for SL exposures that qualify for the
corporate foundation and advanced approaches are the same as those for
general corporate exposures.
Standards for retail exposures
20. For each pool identified, the bank must be able to provide
quantitative measures of loss characteristics (PD, LGD, and EAD) for that
pool. The level of differentiation for IRB purposes must ensure that the
number of exposures in a given pool is sufficient so as to allow for
meaningful quantification and validation of the loss characteristics at the
pool level. There must be a meaningful distribution of borrowers and
exposures across pools. A single pool must not include an undue
concentration of the bank’s total retail exposure.

Rating criteria
21. A bank’s internal risk rating policy for its exposures must document
the bank’s rating philosophy which determines how the borrower rating is
affected by bank’s assumptions on economic, business and specific industry
conditions. This is important as it determines frequency of borrower rating
changes in changing economic scenarios depending on whether the bank is
using point-in-time or through-the-cycle approach. Many banks will also use
a rating system which is a combination of point-in-time and through-the-
cycle approach and the bank must estimate the effect of rating migration on
its capital requirement at all phases of economic cycle. Further, a bank must
document specific rating definitions, processes and criteria for assigning
exposures to grades within a rating system. The rating definitions and

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criteria must be both plausible and intuitive and must result in a meaningful
differentiation of risk. The internal rating policy should also ideally be having
the following features:
• The grade descriptions and criteria must be sufficiently detailed to
allow those charged with assigning ratings to consistently assign the
same grade to borrowers or facilities posing similar risk. This
consistency should exist throughout the bank. If rating criteria and
procedures differ for different types of borrowers or facilities, the bank
must monitor for possible inconsistency, and must alter rating criteria
to improve consistency when appropriate.
• Written rating definitions must be clear and detailed enough to allow
third parties to understand the assignment of ratings, such as internal
audit or an equally independent function and RBI, to replicate rating
assignments and evaluate the appropriateness of the grade/pool
assignments.
• The criteria must also be consistent with the bank’s internal lending
standards and its policies for handling troubled borrowers and facilities.
22. To ensure that banks are consistently taking into account available
information, they must use all relevant and material information in
assigning ratings to borrowers and facilities. Information must be current.
The less information a bank has, the more conservative must be its
assignments of exposures to borrower and facility grades or pools. An
external rating can be the primary factor determining an internal rating
assignment; however, the bank must ensure that it considers other relevant
information.

SL product lines within the corporate asset class

23. Banks using the supervisory slotting criteria for SL exposures must
assign exposures to their internal rating grades based on their own criteria,
systems and processes, subject to compliance with the requisite minimum
requirements. Banks must then map these internal rating grades into the
five (including default category) supervisory rating categories. Tables 1 to 4
in Appendix 9 provide, for each sub-class of SL exposures, the general
assessment factors and characteristics exhibited by the exposures that fall
under each of the supervisory categories. Each lending activity has a unique
table describing the assessment factors and characteristics.
24. It may so happen that the criteria that banks use to assign
exposures to internal grades will not perfectly align with criteria that define
the supervisory categories in case of SL exposures; however, banks must
demonstrate that their mapping process has resulted in an alignment of
grades which is consistent with the preponderance of the characteristics in
the respective supervisory category. Banks should take special care to

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ensure that any overrides of their internal criteria do not render the
mapping process ineffective.

Rating assignment horizon

25. Although the time horizon used in PD estimation is one year, banks
are expected to use a longer time horizon in assigning ratings.
26. A borrower rating must represent the bank’s assessment of the
borrower’s ability and willingness to contractually perform despite adverse
economic conditions or the occurrence of unexpected events. For example,
a bank may base rating assignments on specific, appropriate stress
scenarios. Alternatively, a bank may take into account borrower
characteristics that are reflective of the borrower’s vulnerability to adverse
economic conditions or unexpected events, without explicitly specifying a
stress scenario. The range of economic conditions that are considered when
making assessments must be consistent with current conditions and those
that are likely to occur over a business cycle within the respective
industry/geographic region.
27. Given the difficulties in forecasting future events and the influence
they will have on a particular borrower’s financial condition, a bank must
take a conservative view of projected information. Furthermore, where
limited data are available, a bank must adopt a conservative bias to its
analysis.

Use of models
28. The following requirements are applicable to statistical models and
other mechanical method used to assign obligor or exposure rating or to
estimate PD, LGD or EAD. Sufficient human judgement and human oversight
is necessary to ensure that all relevant and material information including
those which are outside the scope of the models are also taken into
consideration (so that the model results may be supplemented) and that the
model are used appropriately.
29. The responsibility is on the bank to satisfy RBI that a model or the
procedure used has good predictive power and that regulatory capital
requirements will not be distorted as a result of its use. The variables that
are input to the model must form a reasonable set of predictors. The model
must be accurate on average across the range of obligors or exposures to
which the bank is exposed to and there must not be any material bias. Also,
use of a model bought from a third party vendor that claims proprietary
technology is not a justification for exemption from documentation or any
other requirements for internal rating system.
30. The bank must have in place a process for vetting data inputs into a
statistical default or loss prediction model which includes an assessment of

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the accuracy, completeness and appropriateness of the data specific to the
assignment of the approved rating. Bank must be able to demonstrate that
the data used to build the models are representative of the population of
the bank’s existing obligors or exposures.
31. When combining model results with human judgement, the
judgement must take into account all relevant and material information not
considered by the model. The bank must have written, well documented
guidance describing how human judgement and model results are to be
combined. The bank must have procedures for human review of model
based rating assignments. Such procedures should focus on finding and
limiting errors associated with known model weaknesses and must also
include credible ongoing efforts to improve the model’s performance.
32. The bank must have a regular cycle of model validation that
includes monitoring of model performance and stability; review of model
relationship; and testing of model outputs against outcomes.
33. Models purchased from vendors may be having sophisticated
techniques embedded in it. However, whether the methods on which a
model is based are simple or complex, it is important that users be able to
acquire very good understanding of those methods in order to evaluate the
suitability of the model for specific business applications under
consideration. In this regard, clear documentation and description of the
methods are essential.
34. Although users should be expected to perform appropriate testing
of a model before deciding to use it, review of documentation provided by
the vendor also typically forms part of the decision process for acceptance
of the model. Vendor documentation varies considerably in the level of
detail provided about key elements, such as the nature of the reference
data used for model development and the results of validation. However, it
should be kept in mind that vendors are understandably reluctant to include
in their documentation any information that might reflect unfavourably on
the product; as a result, it is difficult to regard vendor documentation as
unbiased. So it is the responsibility of the bank to verify “suitability and
appropriateness” of the model in all respects in relation to its business at
the time of adopting the model.
35. Many models are developed from data with limited geographic
coverage. It is possible that as a result of the location of the primary vendors
or data availability, some models are developed on data sets that primarily
or exclusively reflect other jurisdictions’ data. Developmental or reference
samples also often are skewed toward larger obligors or publicly traded
obligors, either by design or because those are the only data available to the
vendor at reasonable cost. Certain types of obligors, such as financial firms,
are routinely excluded from reference data sets by many vendors. However,

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credit-risk models are most reliable when applied to obligors or exposures
that are similar to those used in their development. Banks should proceed
more cautiously when attempting to apply a model to obligors or exposures
that differ substantially from those in the reference data set for the model.
36. In many cases, there is an element of tension between the natural
desire of vendors to protect proprietary elements of models and the needs
of model users to have enough information about models to comply with
regulatory expectations and principles of sound model use. These tensions
likely will always exist to some extent. However, there appear to be a
number of areas in which a modest amount of additional disclosure by
vendors could significantly enhance the ability of institutions to use credit
risk models in ways that conform more closely to supervisory expectations
and sound management practices.
37. It is important that users of a model have a clear understanding of
the nature of the reference data set and its limitations. Some vendors
provide greater levels of detail regarding the composition of the sample
along key dimensions. Vendors often have the most comprehensive
understanding of the limitations of the data, and therefore are in the best
position to assist clients in understanding the relative applicability of the
model to different exposures, obligor or lines of business. Vendors may be
able to provide guidance on whether there are some situations in which the
model should not be applied, or should be applied only with extreme
caution. Banks need to keep this in mind and coordinate with the vendors
accordingly.
38. It has to be seen specifically whether the definition of default as
used in the vendor model is in consonance with the definition of default as
mentioned in para 74- 80 of this Appendix.
39. Periodical validation of models at the banks’ end is very important
and as such effective validation will warrant appropriate data from the bank
and competence of the banks’ staff doing the validation. The staff should
have adequately detailed understanding of the model so that they can
identify and test all the relevant aspects of the model. Also keeping in mind
the proprietary nature of many vendor models, bank staff should coordinate
with technically proficient staff of the vendors as those are best equipped to
do a thorough and effective validation. As the banks may need to perform
customisation on the models supplied by the vendors, it is essential for
them to understand which areas of the models can be modified and what
are the effects of those modifications. In this regard also the vendors’ advice
may be very useful for the banks.
40. The RBI has been emphasising the importance of rigorous stress
testing to identify and assess risks in banks. Some vendor models may
explicitly allow for the creation and evaluation of stress scenarios by users.

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However, others make stress testing difficult. In some cases, difficulties
arise because key inputs or relationships cannot be modified by the user. In
other cases, the model requires certain relationships to be maintained
between variables, and it may difficult or impossible for the user to assess
whether these relationships are being maintained as assumptions
associated with a stress scenario are applied to the model. Stress testing
using vendor models also confronts a trade-off related to model complexity.
Models that include more variables or more complex relationships may lead
to a richer and more realistic description of how risk is related to underlying
factors. However, such models may also make stress testing more difficult; a
larger number of variables require a more elaborate specification of the
stress scenario, creating the challenge of ensuring that all key elements of
the scenario are internally consistent. Again, because of the necessarily
proprietary nature of vendor products, vendors may try not to fully reveal
all of the model details that users might find useful for stress testing.
However, it is the responsibility of the banks to see to it that proper stress
testing may be performed using the model and if possible whether
additional helpful disclosure might be possible by the vendor without
jeopardising the competitive position and value of the product.

Documentation of rating system design

41. Banks must document in writing their rating systems’ design and
operational details. The documentation must evidence banks’ compliance
with the minimum standards, and must address topics such as portfolio
differentiation, rating criteria, responsibilities of parties that rate borrowers
and facilities, definition of what constitutes a rating exception, parties that
have authority to approve exceptions, frequency of rating reviews, and
management oversight of the rating process. A bank must document the
rationale for its choice of internal rating criteria and must be able to provide
analyses demonstrating that rating criteria and procedures are likely to
result in ratings that meaningfully differentiate risk. Rating criteria and
procedures must be periodically reviewed to determine whether they
remain fully applicable to the current portfolio and to external conditions. In
addition, a bank must document a history of major changes in the risk rating
process, and such documentation must support identification of changes
made to the risk rating process subsequent to the last supervisory review by
the RBI. The system of rating assignment, including the internal control
structure, must also be documented.
42. Banks must document the specific definitions of default and losses
used internally and demonstrate consistency with the reference definitions
set out in paragraphs 74-81 of this Appendix.

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43. If the bank employs statistical models in the rating process, the
bank must document their methodologies in addition to complying with the
requirements as specified in paras 28 to 40 of this Appendix. This material
must:
• Provide a detailed outline of the theory, assumptions and/or
mathematical an empirical basis of the assignment of estimates to
grades, individual obligors, exposures, or pools, and the data source(s)
used to estimate the model;
• Establish a rigorous statistical process (including out-of-time and out-of-
sample performance tests) for validating the model; and
• Indicate any circumstances under which the model does not work
effectively.

(D) Risk rating system operations

Coverage of ratings
44. For corporate, sovereign, and bank exposures, each borrower and
all recognised guarantors must be assigned a rating and each exposure must
be associated with a facility rating as part of the loan approval process.
Similarly, for retail, each exposure must be assigned to a homogeneous pool
as part of the loan approval process.
45. Each separate legal entity to which the bank is exposed must be
separately rated. A bank must have policies acceptable to the RBI regarding
the treatment of individual entities in a connected group including
circumstances under which the same rating may or may not be assigned to
some or all related entities.

Integrity of rating process

Standards for corporate, sovereign, and bank exposures
46. Rating assignments and periodic rating reviews must be completed
or approved by a party that does not directly stand to benefit from the
extension of credit. Independence of the rating assignment process can be
achieved through a range of practices that will be carefully reviewed by the
RBI. These operational processes must be documented in the bank’s
procedures and incorporated into bank policies. Credit policies and
underwriting procedures must reinforce and foster the independence of the
rating process.
47. Borrowers and facilities must have their ratings refreshed at least
on an annual basis. Certain credits, especially higher risk borrowers or
problem exposures, must be subject to more frequent review. In addition,
banks must initiate a new rating if material information on the borrower or
facility comes to light.

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48. The bank must have an effective process to obtain and update
relevant and material information on the borrower’s financial condition, and
on facility characteristics that affect LGDs and EADs (such as the condition of
collateral). Upon receipt, the bank needs to have a procedure to update the
borrower’s rating in a timely fashion.
Standards for retail exposures
49. A bank must review the loss characteristics and delinquency status
of each identified risk pool on at least an annual basis. It must also review
the status of individual borrowers within each pool as a means of ensuring
that exposures continue to be assigned to the correct pool. This
requirement may be satisfied by review of a representative sample of
exposures in the pool.

Overrides
50. For rating assignments based on expert judgement, banks must
clearly articulate the situations in which bank officers may override the
outputs of the rating process, including how and to what extent such
overrides can be used and by whom.
For model-based ratings, the bank must have guidelines and processes for
monitoring cases where human judgement has overridden the model’s
rating, variables were excluded or inputs were altered. These guidelines
must include identifying personnel that are responsible for approving these
overrides. Banks must identify overrides and separately track their
performance.

Data maintenance
51. A bank must collect and store data on key borrower and facility
characteristics of sufficient detail, scope, reliability and consistency to
provide effective support to its internal credit risk measurement and
management process, to enable itself to meet the other requirements in
this document, and to serve as a basis for supervisory reporting to the RBI.
These data should be sufficiently detailed to allow retrospective reallocation
of borrowers and facilities to grades, for example if increasing sophistication
of the internal rating system suggests that finer segregation of portfolios
can be achieved then endeavour should be made to that direction. Further,
banks are expected to have in place data management policies and
procedures consistent with their process validation criteria.

For corporate, sovereign, and bank exposures

52. Banks must maintain rating histories on borrowers and recognised
guarantors, including the rating since the borrower/guarantor was assigned
an internal grade, the dates the ratings were assigned, the methodology and

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key data used to derive the rating and the person/model responsible. The
identity of borrowers and facilities that default, and the timing and
circumstances of such defaults, must be retained. Banks must also retain
data on the PDs and realised default rates associated with rating grades and
ratings migration in order to track the predictive power of the borrower
rating system.
53. Banks using the advanced IRB approach must also collect and store
a complete history of data on the LGD and EAD estimates associated with
each facility and the key data used to derive the estimate and the
person/model responsible. Banks must also collect data on the estimated
and realised LGDs and EADs associated with each defaulted facility. Banks
that reflect the credit risk mitigating effects of guarantees/credit derivatives
through LGD must retain data on the LGD of the facility before and after
evaluation of the effects of the guarantee/credit derivative. Information
about the components of loss or recovery for each defaulted exposure must
be retained, such as amounts recovered, source of recovery (e.g. collateral,
liquidation proceeds and guarantees), time period required for recovery,
and administrative costs etc.
54. Banks under the foundation approach which utilise supervisory
estimates are encouraged to retain the relevant data (i.e. data on loss and
recovery experience for corporate exposures under the foundation
approach, data on realised losses for banks using the supervisory slotting
criteria for SL) which will help them to switch over to advanced IRB in due
course.

For retail exposures

55. Banks must retain data used in the process of allocating exposures
to pools, including data on borrower and transaction risk characteristics
used either directly or through use of a model, as well as data on
delinquency. Banks must also retain data on the estimated PDs, LGDs and
EADs, associated with pools of exposures. For defaulted exposures, banks
must retain the data on the pools to which the exposure was assigned over
the year prior to default and the realised outcomes on LGD and EAD.

Stress tests used in assessment of capital adequacy

56. An IRB bank must have in place sound stress testing processes for
use in the assessment of capital adequacy. Stress testing must involve
identifying possible events or future changes in economic conditions that
could have unfavourable effects on a bank’s credit exposures and
assessment of the bank’s ability to withstand such changes. Examples of
scenarios that could be used are (i) economic or industry downturns; (ii)
market-risk events; and (iii) liquidity conditions.

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57. In addition to the more general tests described above, the bank
must perform a credit risk stress test to assess the effect of certain specific
conditions on its IRB regulatory capital requirements. The test to be
employed would be one chosen by the bank, subject to RBI review. The test
to be employed must be meaningful and reasonably conservative. Individual
banks may develop different approaches to undertaking this stress test
requirement, depending on their circumstances. For this purpose, the
objective is not necessarily to require banks to consider worst-case
scenarios. The bank’s stress test in this context should, however, consider at
least the effect of moderate recession scenarios. In this case, one example
might be to use two consecutive quarters of zero growth to assess the effect
on the bank’s PDs, LGDs and EADs, taking into account on a conservative
basis all of the bank’s international diversification.
58. Banks using the double default framework must consider as part of
their stress testing framework the impact of a deterioration in the credit
quality of protection providers, in particular the impact of protection
providers falling outside the eligibility criteria due to rating changes. Banks
should also consider the impact of the default of one but not both of the
obligor and protection provider, and the consequent increase in risk and
capital requirements at the time of that default.
59. Whatever method is used, the bank must include a consideration
of the following sources of information. First, a bank’s own data should
allow estimation of the ratings migration of at least some of its exposures.
Second, banks should consider information about the impact of smaller
deterioration in the credit environment on a bank’s ratings, giving some
information on the likely effect of bigger, stress circumstances. Third, banks
should evaluate evidence of ratings migration in external ratings. This would
include the bank broadly matching its buckets to rating categories.
60. RBI, if considered necessary, will issue guidance to Indian banks on
how the tests to be used for this purpose should be designed. The results of
the stress test may indicate no difference in the capital calculated under the
IRB rules described in this section of this Framework if the bank already uses
such an approach for its internal rating purposes. Where a bank operates in
several markets, it does not need to test for such conditions in all of those
markets, but a bank should stress portfolios containing the vast majority of
its total exposures.

(E) Corporate governance and oversight

Corporate governance
All material aspects of the rating and estimation processes must be
approved by the bank’s board of directors or a designated committee of the
Board. The Board/its designated committee must possess a general

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understanding of the bank’s risk rating system and detailed comprehension
of its associated management reports. Senior management must provide
notice to the board of directors or a designated committee thereof of
material changes or exceptions from established policies that will materially
impact the operations of the bank’s rating system.
61. Senior management also must have a good understanding of the
rating system’s design and operation, and must approve material
differences between established procedure and actual practice.
Management must also ensure, on an ongoing basis, that the rating system
is operating properly. Management and staff in the credit control function
must meet regularly to discuss the performance of the rating process, areas
needing improvement, and the status of efforts to improve previously
identified deficiencies.
62. Internal ratings must be an essential part of the reporting to the
Board/senior management. Reporting must include risk profile by grade,
migration across grades, estimation of the relevant parameters per grade,
and comparison of realised default rates (and LGDs and EADs for banks on
advanced approaches) against expectations. Reporting frequencies may
vary with the significance and type of information and the level of the
recipient.

Credit risk control

64. Banks must have independent Credit Risk Control Units (CRCU) or
equivalents that are responsible for the design or selection, implementation
and performance of their internal rating systems. The unit(s) must be
functionally independent from the personnel and management functions
responsible for originating exposures. Areas of responsibility must include:
• Testing and monitoring internal grades;
• Production and analysis of summary reports from the bank’s rating
system, to include historical default data sorted by rating at the time of
default and one year prior to default, grade migration analyses, and
monitoring of trends in key rating criteria;
• Implementing procedures to verify that rating definitions are
consistently applied throughout the bank;
• Reviewing and documenting any changes to the rating process, including
the reasons for the changes; and
• Reviewing the rating criteria to evaluate if they remain predictive of risk.
Changes to the rating process, criteria or individual rating parameters
must be documented and retained for RBI to review.
65. The model construction and validation teams function independent
of each other although both these groups may be part of CRCU. A CRCU may
thus actively participate in the development, selection, implementation and

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validation of rating models. It must assume oversight and supervision
responsibilities for any models used in the rating process, and ultimate
responsibility for the ongoing review and alterations to rating models.
However, it should be kept in mind that that the model building and
validation team should necessarily be consisting of different individuals. The
validation unit must validate the model and document the basis of certifying
the model before it is put into use /the results from it are taken into
account for the regulatory capital calculation of the bank.

Internal and external audit

66. Internal audit or an equally independent function must review at
least annually the bank’s rating system and its operations, including the
operations of the credit function and the estimation of PDs along with LGDs
and EADs where applicable. All applicable minimum requirements should be
adhered to for carrying out the independent review. Internal audit must
document its findings. Banks may consider their credit risk models’ accuracy
by external auditors who should ensure inter alia the following:
(i) It should be checked whether internal validation of models is being done
satisfactorily and objectively by the CRCU.
(ii) It should be verified whether the internal models used by the bank is
sufficient to cover all of the bank’s activities and geographical coverage
of operations.
(iii) It should also be ensured that data flows and processes associated with
risk measurement system are transparent and accessible to both the
internal and external auditors and they have access to model’s
specifications and parameters.
(iv) External auditors must document the validation procedure, tests and
reasons if applicable to conclude that the model is valid.

(F) Use of internal ratings

67. Internal ratings and default and loss estimates must play an
essential role in the credit approval, risk management, internal capital
allocations, and corporate governance functions of banks using the IRB
approach. Ratings systems and estimates designed and implemented
exclusively for the purpose of qualifying for the IRB approach and used only
to provide IRB inputs are not acceptable. It is recognised that banks will not
necessarily be using exactly the same estimates for both IRB and all internal
purposes. For example, pricing models are likely to use PDs and LGDs
relevant to the life of the asset. Where there are such differences, a bank
must document them and demonstrate their reasonableness to the RBI.
68. A bank must have a credible track record in the use of internal
ratings information. Thus, the bank must demonstrate that it has been using

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a rating system that was broadly in line with the minimum requirements
articulated in this document for at least the three years prior to
qualification. A bank using the advanced IRB approach must demonstrate
that it has been estimating and employing LGDs and EADs in a manner that
is broadly consistent with the minimum requirements for use of own
estimates of LGDs and EADs for at least the three years prior to
qualification. Improvements to a bank’s rating system will not render a bank
non-compliant with the three-year requirement.

(G) Risk quantification

Overall requirements for estimation
Structure and intent
69. This section addresses the broad standards for own-estimates of
PD, LGD, and EAD. Generally, all banks using the IRB approaches must
estimate a PD (with exception in regard to certain equity exposures and
specialised lending (SL) asset sub classes) for each internal borrower grade
for corporate, sovereign and bank exposures or for each pool in the case of
retail exposures.
70. Internal estimates of PD, LGD, and EAD must incorporate all
relevant, material and available data, information and methods. A bank may
utilise internal data and data from external sources (including pooled data).
Where internal or external data is used, the bank must demonstrate that its
estimates are representative of long run experience.
71. Estimates must be grounded in historical experience and empirical
evidence, and not based purely on subjective or judgmental considerations.
Any changes in lending practice or the process for pursuing recoveries over
the observation period must be taken into account. A bank’s estimates must
promptly reflect the implications of technical advances and new data and
other information, as it becomes available. Banks must review their
estimates on a yearly basis or more frequently.
72. The population of exposures represented in the data used for
estimation, and lending standards in use when the data were generated,
and other relevant characteristics should be closely matched to or at least
comparable with those of the bank’s extant exposures and standards. The
bank must also demonstrate that economic or market conditions that
underlie the data are relevant to current and foreseeable conditions. For
estimates of LGD and EAD, banks must take into account the minimum
requirements for LGD and EAD calculation as given in the annex and this
appendix. The number of exposures in the sample and the data period used
for quantification must be sufficient to provide the bank with confidence in
the accuracy and robustness of its estimates. The estimation technique
must perform well in out-of-sample tests.

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73. In general, estimates of PDs, LGDs, and EADs are likely to involve
unpredictable errors. In order to avoid over-optimism, a bank must add to
its estimates a margin of conservatism that is related to the likely range of
errors. Where methods and data are less satisfactory and the likely range of
errors is larger, the margin of conservatism must be larger. RBI may allow
some flexibility in application of the required standards for data that are
collected prior to the date of implementation of this Framework. However,
in such cases banks must demonstrate to the RBI that appropriate
adjustments have been made to achieve broad equivalence to the data
without such flexibility. Data collected beyond the date of implementation
must conform to the minimum standards unless otherwise stated.

Definition of default
74. A default is considered to have occurred when an asset is classified
as NPA (Non performing asset) as per extant RBI guideline on Income
recognition, Asset classification and provisioning pertaining to advances.
Default regarding agricultural loans also will be considered as per the same
guideline. As indicated in paragraph 75 below, restructured assets classified
as standard assets will be treated as defaulted for the limited purpose of
computation of capital under IRB. Restructured assets will thus be given risk
weights as applicable to defaulted asset barring the cases where ‘hardship’
clauses might have been extended to the borrowers, as per the RBI Master
Circular on Relief Measures by Banks in Areas affected by Natural Calamities
dated July 1, 2011 or with the prior approval from RBI. However, such
restructured accounts would be eligible for upgrade to the non defaulted
category after observation of ‘satisfactory performance’ during the period
of one year from the date when the first payment of interest or instalment
of principal falls due under the terms of restructuring package. This
treatment of restructured assets classified as standard assets is from the
perspective of capital adequacy and should not be seen as a contradiction of
asset classification norms which have implications for provisioning.
75. The banks may also consider an exposure to be in default if it
believes that the borrower is unwilling to pay off the existing debt. The
elements to be taken as indications of unlikeliness to pay include:
• The bank puts the credit obligation on non-accrued status.
• The bank makes account-specific provision resulting from a significant
perceived decline in credit quality subsequent to the bank taking on the
exposure.
• The bank sells the credit obligation at a material credit-related
economic loss.
• The bank consents to a distressed restructuring of the credit obligation
where this is likely to result in a diminished financial obligation caused

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 by the material forgiveness, or postponement, of principal, interest or
(where relevant) fees.
• The bank has filed for the debtor’s bankruptcy or a similar order in
respect of the obligor’s credit obligation to the banking group.
• The debtor has sought or has been placed in bankruptcy or similar
protection where this would avoid or delay repayment of the credit
obligation to the banking group.
76. For retail exposures, the definition of default can be applied at the
level of a particular facility, rather than at the level of the obligor unless
total interest and/or principal due from the defaulted borrower exceed 50%
of the total retail exposure to the borrower. If total interest and/or principal
exceeds 50% of the total retail exposure to a particular borrower than all
the exposures to that borrower will be considered to be in default.
77. A bank must record actual defaults on IRB exposure classes using
this reference definition. A bank must also use the reference definition for
its estimation of PDs, and (where relevant) LGDs and EADs. In arriving at
these estimations, a bank may use external data available to it that is not
itself consistent with that definition, subject to the requirements set out in
paragraph 39 of the Annex of this guideline. However, in such cases, banks
must demonstrate to the RBI that appropriate adjustments to the data have
been made to achieve broad equivalence with the reference definition. This
same condition would apply to any internal data used up to implementation
of this Framework. Internal data (including that pooled by banks) used in
such estimates beyond the date of implementation of this Framework must
be consistent with the reference definition.
78. If the bank considers that a previously defaulted exposure’s status
is such that default definition no longer applies, the bank must rate the
borrower and estimate LGD as they would for a non-defaulted facility.
However, if the definition of default is subsequently triggered, a second
default would be deemed to have occurred.
79. A bank must record default in accordance with the IRB definition of
default. The definition of default must be consistent across PD, LGD, EAD
estimates and also across the bank.

Treatment of overdrafts
80. Authorised overdrafts must be subject to a credit limit set by the
bank and brought to the knowledge of the client. Any break of this limit
must be monitored; if the account remains ‘out of order’ (as per extant RBI
master circular on Income recognition, asset classification and provisioning
pertaining to advances) for more than 90 days, it would be considered as
defaulted. Non-authorised overdrafts will be associated with a zero limit for
IRB purposes. Thus, days past due commence once any credit is granted to

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an unauthorised customer; if such credit were not repaid within 90 days,
the exposure would be considered in default. Banks must have in place
rigorous internal policies for assessing the creditworthiness of customers
who are offered overdraft accounts.

Definition of loss for all asset classes

81. The definition of loss used in estimating LGD is economic loss.
When measuring economic loss, all relevant factors should be taken into
account. This must include material discount effects and material direct and
indirect costs associated with collecting on the exposure. Banks must not
simply measure the loss recorded in accounting records, although they must
be able to compare accounting and economic losses. The bank’s own
workout and collection expertise significantly influences their recovery rates
and must be reflected in their LGD estimates, but adjustments to estimates
for such expertise must be conservative until the bank has sufficient internal
empirical evidence of the impact of its expertise.

Requirements specific to PD estimation for retail assets

82. Given the bank-specific basis of assigning exposures to pools, banks
must regard internal data as the primary source of information for
estimating loss characteristics. Banks are permitted to use external data or
statistical models for quantification provided a strong link can be
demonstrated between (a) the bank’s process of assigning exposures to a
pool and the process used by the external data source, and (b) the bank’s
internal risk profile and the composition of the external data. In all cases,
banks must use all relevant and material data sources as points of
comparison.
83. Irrespective of whether banks are using external, internal, pooled
data sources or a combination of the three, for their estimation of loss
characteristics, the length of the underlying historical observation period
used must be at least five years. If the available observation spans a longer
period for any source, and these data are relevant, this longer period must
be used. A bank need not give equal importance to historic data if it can
convince the RBI that more recent data are a better predictor of loss rates.
84. It is recognised that seasoning (i.e. ageing) can be quite material for
some long-term retail exposures characterised by seasoning effects that
peak several years after origination. Banks should anticipate the
implications of rapid exposure growth and take steps to ensure that their
estimation techniques are accurate, and that their current capital level and
earnings and funding prospects are adequate to cover their future capital
needs (in light of probable increase in PD with more and more ageing of the
exposure). In order to avoid gyrations in their required capital positions

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arising from short-term PD horizons, banks are also encouraged to adjust PD
estimates upward for anticipated seasoning effects, provided such
adjustments are applied in a consistent fashion over time.

Additional standards for own LGD estimation for retail exposure

85. The minimum data observation period for LGD estimates for retail
exposures is five years. The less data a bank has the more conservative it
must be in its estimation. A bank need not give equal importance to historic
data if it can demonstrate to the RBI that more recent data are a better
predictor of loss rates.

Additional standards for own EAD estimation for retail exposure

86. The minimum data observation period for EAD estimates for retail
exposures is five years. The less data a bank has the more conservative it
must be in its estimation. A bank need not give equal importance to historic
data if it can demonstrate to the RBI that more recent data are a better
predictor of draw downs.
Minimum requirements for assessing effect of guarantees and credit
derivatives-Standards for corporate, sovereign, and bank exposures where
own estimates of LGD (A-IRB) are used and standards for retail exposures

Guarantees
87. When a bank uses its own estimates of LGD, it may reflect the risk-
mitigating effect of guarantees through an adjustment to PD or LGD
estimates. The option to adjust LGDs is available only to those banks that
have been approved to use their own internal estimates of LGD. For retail
exposures, where guarantees exist, either in support of an individual
obligation or a pool of exposures, a bank may reflect the risk-reducing effect
either through its estimates of PD or LGD, provided this is done consistently.
In adopting one or the other technique, a bank must adopt a consistent
approach, both across types of guarantees and over time.
88. In all cases, both the borrower and all recognised guarantors must
be assigned a borrower rating at the outset and on an ongoing basis. A bank
must follow all minimum requirements for assigning borrower ratings set
out in this document, including the regular monitoring of the guarantor’s
condition and ability and willingness to honour its obligations. Consistent
with the requirements in paragraphs 52-53 of this appendix, a bank must
retain all relevant information on the borrower without the guarantee and
the guarantor. In the case of retail guarantees, these requirements also
apply to the assignment of an exposure to a pool, and the estimation of PD.
89. In no case, the bank can assign the guaranteed exposure an
adjusted PD or LGD such that the adjusted risk weight would be lower than

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that of a comparable, direct exposure to the guarantor. Neither criteria nor
rating processes are permitted to consider possible favourable effects of
imperfect expected correlation between default events for the borrower
and guarantor for purposes of regulatory minimum capital requirements. As
such, the adjusted risk weight must not reflect the risk mitigation of “double
default.”

Eligible guarantors and guarantees

90. There are no restrictions on the types of eligible guarantors. The
bank must, however, have clearly specified criteria for the types of
guarantors it will recognise for regulatory capital purposes.
91. The guarantee must be evidenced in writing, non-cancellable on
the part of the guarantor, in force until the debt is satisfied in full (to the
extent of the amount and tenor of the guarantee) and legally enforceable
against the guarantor in a jurisdiction where the guarantor has assets to
attach and enforce a judgement.

Adjustment criteria
92. A bank must have clearly specified criteria for adjusting borrower
grades or LGD estimates (or in the case of retail and eligible purchased
receivables, the process of allocating exposures to pools) to reflect the
impact of guarantees for regulatory capital purposes. These criteria must be
as detailed as the criteria for assigning exposures to grades consistent with
paragraphs 21 and 22 of this Appendix, and must follow all minimum
requirements for assigning borrower or facility ratings set out in this
document.
93. The criteria must be plausible and intuitive, and must address the
guarantor’s ability and willingness to perform under the guarantee. The
criteria must also address the likely timing of any payments and the degree
to which the guarantor’s ability to perform under the guarantee is
correlated with the borrower’s ability to repay. The bank’s criteria must also
consider the extent to which residual risk to the borrower remains, for
example a currency mismatch between the guarantee and the underlying
exposure.

Credit derivatives
94. The minimum requirements for guarantees are relevant also for
single-name credit derivatives. Additional considerations arise in respect of
asset mismatches. The criteria used for assigning adjusted borrower grades
or LGD estimates (or pools) for exposures hedged with credit derivatives
must require that the asset on which the protection is based (the reference
asset) cannot be different from the underlying asset, unless the conditions

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outlined in the foundation approach as mentioned in para 3(vii) of Appendix
5 are met.
95. In addition, the criteria must address the payout structure of the
credit derivative and conservatively assess the impact this has on the level
and timing of recoveries. The bank must also consider the extent to which
other forms of residual risk remain.
For banks using foundation LGD estimates
96. The minimum requirements outlined in paragraphs 87 -95 of this
Appendix will also apply to banks using the foundation LGD estimates (along
with the conditions mentioned in Appendix 5) with the following exceptions:
(a) The bank is not able to use an ‘LGD-adjustment’ option as mentioned in
para 87 of this appendix; and
(b) The range of eligible guarantees and guarantors is limited to those
outlined in para 4 of Appendix 5 of this guideline.
Requirements specific to estimating PD and LGD for qualifying purchased
receivables
97. The following minimum requirements for risk quantification must
be satisfied for any purchased receivables (corporate or retail) making use
of the top-down treatment of default risk and/or the IRB treatments of
dilution risk.
• The purchasing bank will be required to group the receivables into
sufficiently homogeneous pools so that accurate and consistent
estimates of PD and LGD (or EL) for default losses and EL estimates for
dilution losses can be determined. In general, the risk bucketing process
will reflect the seller’s underwriting practices and the heterogeneity of
its customers. In addition, methods and data for estimating PD, LGD, and
EL must comply with the existing risk quantification standards for retail
exposures. In particular, quantification should reflect all information
available to the purchasing bank regarding the quality of the underlying
receivables, including data for similar pools provided by the seller, by the
purchasing bank, or by external sources. The purchasing bank must
determine whether the data provided by the seller are consistent with
expectations agreed upon by both parties concerning, for example, the
type, volume and on-going quality of receivables purchased. Where this
is not the case, the purchasing bank is expected to obtain and rely upon
more relevant data.
• A bank purchasing receivables has to justify confidence that current and
future advances can be repaid from the liquidation of (or collections
against) the receivables pool.
• To qualify for the top-down treatment of default risk, the receivable pool
and overall lending relationship should be closely monitored and
controlled. Specifically, a bank will have to demonstrate the following:

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(a) Legal certainty
The structure of the facility must ensure that under all foreseeable
circumstances, the bank has effective ownership and control of the cash
remittances from the receivables, including incidences of seller or servicer
distress and bankruptcy. When the obligor makes payments directly to a
seller or servicer, the bank must verify regularly that payments are
forwarded completely and within the contractually agreed terms as well.
Ownership over the receivables and cash receipts should be protected
against bankruptcy stays or legal challenges that could materially delay the
lender’s ability to liquidate/assign the receivables or retain control over cash
receipts.
(b) Effectiveness of monitoring system
The bank must be able to monitor both the quality of the receivables and
the financial condition of the seller and services. In particular:
• The bank must (a) assess the correlation among the quality of the
receivables and the financial condition of both the seller and servicer,
and (b) have in place internal policies and procedures that provide
adequate safeguards to protect against such contingencies, including the
assignment of an internal risk rating for each seller and servicer.
• The bank must have clear and effective policies and procedures for
determining seller and servicer eligibility. The bank or its agent must
conduct periodic reviews of sellers and servicers in order to verify the
accuracy of reports from the seller/servicer, detect fraud or operational
weaknesses, and verify the quality of the seller’s credit policies and
servicer’s collection policies and procedures. The findings of these
reviews must be well documented.
• The bank must have the ability to assess the characteristics of the
receivables pool, including (a) over-advances; (b) history of the seller’s
arrears, bad debts, and bad debt allowances; (c) payment terms, and (d)
potential contra accounts.
• The bank must have effective policies and procedures for monitoring on
an aggregate basis single-obligor concentrations both within and across
receivables pools.
• The bank must receive timely and sufficiently detailed reports of
receivables ageing and dilutions to (a) ensure compliance with the
bank’s eligibility criteria and advancing policies governing purchased
receivables, and (b) provide an effective means with which to monitor
and confirm the seller’s terms of sale (e.g. invoice date ageing) and
dilution.
(c) Effectiveness of work-out systems
An effective programme requires systems and procedures not only for
detecting deterioration in the seller’s financial condition and deterioration

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in the quality of the receivables at an early stage, but also for addressing
emerging problems pro-actively. In particular,
• The bank should have clear and effective policies, procedures, and
information systems to monitor compliance with (a) all contractual
terms of the facility (including covenants, advancing formulas,
concentration limits etc.) as well as (b) the bank’s internal policies
governing advance rates and receivables eligibility. The bank’s systems
should track covenant violations and waivers as well as exceptions to
established policies and procedures.
• To limit inappropriate draws, the bank should have effective policies and
procedures for detecting, approving, monitoring, and correcting over-
advances.
• The bank should have effective policies and procedures for dealing with
financially weakened sellers or servicers and/or deterioration in the
quality of receivable pools. These include, but are not necessarily limited
to, early termination triggers in revolving facilities and other covenant
protections, a structured and disciplined approach to dealing with
covenant violations, and clear and effective policies and procedures for
initiating legal actions and dealing with problem receivables.
(d) Effectiveness of systems for controlling collateral, credit availability and
cash
The bank must have clear and effective policies and procedures governing
the control of receivables, credit, and cash. In particular,
• Written internal policies must specify all material elements of the
receivables purchase programme, including the advancing rates, eligible
collateral, necessary documentation, concentration limits, and how cash
receipts are to be handled. These elements should take appropriate
account of all relevant and material factors, including the
seller’s/servicer’s financial condition, risk concentrations, and trends in
the quality of the receivables and the seller’s customer base.
• Internal systems must ensure that funds are advanced only against
specified supporting collateral and documentation (such as servicer
attestations, invoices, shipping documents, etc.).
(e) Compliance with bank’s internal policies and procedures
Given the reliance on monitoring and control systems to limit credit risk, the
bank should have an effective internal process for assessing compliance
with all critical policies and procedures, including
• regular internal and/or external audits of all critical phases of the bank’s
receivables purchase programme.
• verification of the separation of duties (i) between the assessment of the
seller/servicer and the assessment of the obligor and (ii) between the
assessment of the seller/servicer and the field audit of the

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 seller/servicer.
98. A bank’s effective internal process for assessing compliance with all
critical policies and procedures should also include evaluations of back
office operations, with particular focus on qualifications, experience,
staffing levels, and supporting systems.

(H) Validation of internal estimates

99. Banks must have a robust, documented system in place to validate
on an ongoing basis the accuracy of rating systems, associated risk
estimates (quantitative validation), and operational integrity and
consistency of those systems and estimates (process validation). A bank
must demonstrate to the RBI that the internal validation process enables it
to assess the performance of internal rating and risk estimation systems
consistently and meaningfully. Further banks must ensure that the process
for developing and initially implementing all IRB rating system and risk
estimates quantification processes include the initial validation which may
involve initial testing of the model and associated data reference sets
(quantitative validation) and the model’s robust implementation (process
validation)
100. Banks must regularly compare realised default rates with estimated
PDs for each grade and be able to demonstrate that the realised default
rates are within the expected range for that grade. Banks using the
advanced IRB approach must also complete such analysis for their estimates
of LGDs and EADs. Such comparisons must make use of historical data that
are over as long a period as possible. The methods and data used in such
comparisons by the bank must be clearly documented by the bank. This
analysis and documentation must be updated at least annually.
101. Banks must also use other quantitative validation tools and
comparisons with relevant external data sources. The analysis must be
based on data that are appropriate to the portfolio, are updated regularly,
and cover a relevant observation period. Banks’ internal assessments of the
performance of their own rating systems must be based on long data
histories, covering a range of economic conditions, and ideally one or more
complete business cycles.
102. Banks must demonstrate that quantitative testing methods and
other validation methods do not vary systematically with the economic
cycle. Changes in methods and data (both data sources and periods
covered) must be clearly and thoroughly documented.
103. Banks must have well-articulated internal standards for situations
where deviations in realised PDs, LGDs and EADs from expectations become
significant enough to call the validity of the estimates into question. These
standards must take account of business cycles and similar systematic

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variability in default experiences. Where realised values continue to be
higher than expected values, banks must revise estimates upward to reflect
their default and loss experience.
104. Where banks rely on the RBI for LGD and EAD, rather than internal
estimates of these risk parameters, they are encouraged to compare
realised LGDs and EADs to those set by the RBI. The information on realised
LGDs and EADs should form part of the bank’s assessment of economic
capital.

(I) Requirements for recognition of leasing

105. Leases other than those that expose the bank to residual value risk
(see the following paragraph 106) will be accorded the same treatment as
exposures collateralised by the same type of collateral. The minimum
requirements for the collateral type must be met (CRE/RRE or other
collateral). In addition, the bank must also meet the following standards:
• Robust risk management on the part of the lessor with respect to the
location of the asset, the use to which it is put, its age, and planned
obsolescence;
• A robust legal framework establishing the lessor’s legal ownership of the
asset and its ability to exercise its rights as owner in a timely fashion;
and
• The difference between the rate of depreciation of the physical asset
and the rate of amortisation of the lease payments must not be so large
as to overstate the CRM attributed to the leased assets.
106. Residual value risk is the bank’s exposure to potential loss due to
the fair value of the leased asset declining below its residual value at lease
inception. Leases that expose the bank to residual value risk will be treated
in the following manner.
• The discounted lease payment stream i.e. the exposure will receive a risk
weight appropriate for the lessee’s financial strength (PD) and
supervisory or own-estimate of LGD, whichever is appropriate.
• The residual value of the leased asset will be risk-weighted at 100%.

(J) Eligibility criteria for calculation of capital charges for equity

exposures under internal model method
The internal models method of market-based approach
107. To be eligible for the internal models method of market-based
approach, a bank must demonstrate to the RBI that it meets certain
quantitative and qualitative minimum requirements at the outset and on an
ongoing basis. A bank that fails to demonstrate continued compliance with
the minimum requirements must develop a plan for rapid return to
compliance, obtain RBI’s approval of the plan, and implement that plan in a

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timely fashion. In the interim, banks would be expected to compute capital
charges using a simple risk weight approach or PD/LGD approach if
permissible.

Capital charge and risk quantification

108. The following minimum quantitative standards apply for the
purpose of calculating minimum capital charges under the internal models
approach.
• The capital charge is equivalent to the potential loss on the institution’s
equity portfolio arising from an assumed instantaneous shock equivalent
th
to the 99 percentile, one-tailed confidence interval of the difference
between quarterly returns and an appropriate risk-free rate computed
over a long-term sample period.
• The estimated losses should be robust to adverse market movements
relevant to the long-term risk profile of the institution’s specific
holdings. The data used to represent return distributions should reflect
the longest sample period for which data are available and meaningful in
representing the risk profile of the bank’s specific equity holdings. The
data used should be sufficient to provide conservative, statistically
reliable and robust loss estimates that are not based purely on
subjective or judgmental considerations. Banks must demonstrate to RBI
that the shock employed provides a conservative estimate of potential
losses over a relevant long-term market or business cycle. Models
estimated using data not reflecting realistic ranges of long-run
experience, including a period of reasonably severe declines in equity
market values relevant to a bank’s holdings, are presumed to produce
optimistic results unless there is credible evidence of appropriate
adjustments built into the model. In the absence of built-in adjustments,
the bank must combine empirical analysis of available data with
adjustments based on a variety of factors in order to attain model
outputs that achieve appropriate realism and conservatism. In
constructing Value at Risk (VaR) models estimating potential quarterly
losses, institutions may use quarterly data or convert shorter horizon
period data to a quarterly equivalent using an analytically appropriate
method supported by empirical evidence. Such adjustments must be
applied through a well-developed and well-documented thought process
and analysis. In general, adjustments must be applied conservatively and
consistently over time. Furthermore, where only limited data are
available or where technical limitations are such that estimates from any
single method will be of uncertain quality, banks must add appropriate
margins of conservatism in order to avoid over-optimism.
• No particular type of VaR model (e.g. variance-covariance, historical

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 simulation, or Monte Carlo) is prescribed. However, the model used
must be able to capture adequately all of the material risks embodied in
equity returns including both the general market risk and specific risk
exposure of the institution’s equity portfolio. Internal models must
adequately explain historical price variation, capture both the magnitude
and changes in the composition of potential concentrations, and be
robust to adverse market environments. The population of risk
exposures represented in the data used for estimation must be closely
matched to or at least comparable with those of the bank’s equity
exposures.
• Banks may also use modelling techniques such as historical scenario
analysis to determine minimum capital requirements for banking book
equity holdings. The use of such models is conditioned upon the bank
demonstrating to RBI that the methodology and its output can be
quantified in the form of the loss percentile specified under the first
bullet here.
• Banks must use an internal model that is appropriate for the risk profile
and complexity of their equity portfolio. Banks with material holdings
with values that are highly non-linear in nature (e.g. equity derivatives,
convertibles) must employ an internal model designed to capture
appropriately the risks associated with such instruments.
• Subject to RBI review, equity portfolio correlations can be integrated
into a bank’s internal risk measures. The use of explicit correlations (e.g.
utilisation of a variance/covariance VaR model) must be fully
documented and supported using empirical analysis. The
appropriateness of implicit correlation assumptions will be evaluated by
RBI.
• Mapping of individual positions to proxies, market indices, and risk
factors should be plausible, intuitive, and conceptually sound. Mapping
techniques and processes should be fully documented, and
demonstrated with both theoretical and empirical evidence to be
appropriate for the specific holdings. Where professional judgement is
combined with quantitative techniques in estimating a holding’s return
volatility, the judgement must take into account the relevant and
material information not considered by the other techniques utilised.
• Where factor models are used, either single or multi-factor models are
acceptable depending upon the nature of an institution’s holdings. Banks
are expected to ensure that the factors are sufficient to capture the risks
inherent in the equity portfolio. Risk factors should correspond to the
appropriate equity market characteristics (for example, public, private,
market capitalisation industry sectors and sub-sectors, operational
characteristics) in which the bank holds significant positions. While

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 banks will have discretion in choosing the factors, they must
demonstrate through empirical analyses the appropriateness of those
factors, including their ability to cover both general and specific risk.
• Estimates of the return volatility of equity investments must incorporate
relevant and material available data, information, and methods. A bank
may utilise independently reviewed internal data or data from external
sources (including pooled data). The number of risk exposures in the
sample, and the data period used for quantification must be sufficient to
provide the bank with confidence in the accuracy and robustness of its
estimates. Institutions should take appropriate measures to limit the
potential of both sampling bias and survivorship bias in estimating
return volatilities.
• A rigorous and comprehensive stress-testing programme must be in
place. Banks are expected to subject their internal model and estimation
procedures, including volatility computations, to either hypothetical or
historical scenarios that reflect worst-case losses given underlying
positions in both public and private equities. At a minimum, stress tests
should be employed to provide information about the effect of tail
events beyond the level of confidence assumed in the internal models
approach.

Risk management process and controls

109. Banks’ overall risk management practices used to manage their
banking book equity investments are expected to be consistent with the
evolving sound practice guidelines issued by the RBI. With regard to the
development and use of internal models for capital purposes, banks must
have established policies, procedures, and controls to ensure the integrity of
the model and modelling process used to derive regulatory capital
standards. These policies, procedures, and controls should include the
following:
(a) Full integration of the internal model into the overall management
information systems of the bank and in the management of the banking
book equity portfolio.
Internal models should be fully integrated into the bank’s risk
management infrastructure including use in: (i) establishing investment
hurdle rates and evaluating alternative investments; (ii) measuring and
assessing equity portfolio performance (including the risk-adjusted
performance); and (iii) allocating economic capital to equity holdings and
evaluating overall capital adequacy as required under Pillar 2. The
institution should be able to demonstrate, through for example,
investment committee minutes, that internal model output plays an
essential role in the investment management process.

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(b) Established management systems, procedures, and control functions for
ensuring the periodic and independent review of all elements of the
internal modelling process, including approval of model revisions,
vetting of model inputs, and review of model results, such as direct
verification of risk computations. Proxy and mapping techniques and
other critical model components should receive special attention. These
reviews should assess the accuracy, completeness, and appropriateness
of model inputs and results and focus on both finding and limiting
potential errors associated with known weaknesses and identifying
unknown model weaknesses. Such reviews may be conducted as part of
internal or external audit programmes, by an independent risk control
unit, or by an external third party.
(c) Adequate systems and procedures for monitoring investment limits and
the risk exposures of equity investments.
(d) The units responsible for the design and application of the model must
be functionally independent from the units responsible for managing
individual investments.
(e) Parties responsible for any aspect of the modelling process must be
adequately qualified. Management must allocate sufficient skilled and
competent resources to the modelling function.

Validation and documentation

110. Institutions employing internal models for regulatory capital
purposes are expected to have in place a robust system to validate the
accuracy and consistency of the model and its inputs. They must also fully
document all material elements of their internal models and modelling
process. The modelling process itself as well as the systems used to validate
internal models including all supporting documentation, validation results,
and the findings of internal and external reviews are subject to oversight
and review by the RBI.

Validation
111. Banks must have a robust system in place to validate the accuracy
and consistency of their internal models and modelling processes. A bank
must demonstrate to RBI that the internal validation process enables it to
assess the performance of its internal model and processes consistently and
meaningfully.
112. Banks must regularly compare actual return performance
(computed using realised and unrealised gains and losses) with modelled
estimates and be able to demonstrate that such returns are within the
expected range for the portfolio and individual holdings. Such comparisons
must make use of historical data that are over as long a period as possible.

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The methods and data used in such comparisons must be clearly
documented by the bank. This analysis and documentation should be
updated at least annually.
113. Banks should make use of other quantitative validation tools and
comparisons with external data sources. The analysis must be based on data
that are appropriate to the portfolio, are updated regularly, and cover a
relevant observation period. Banks’ internal assessments of the
performance of their own model must be based on long data histories,
covering a range of economic conditions, and ideally one or more complete
business cycles.
114. Banks must demonstrate that quantitative validation methods and
data are consistent through time. Changes in estimation methods and data
(both data sources and periods covered) must be clearly and thoroughly
documented.
115. Since the evaluation of actual performance to expected
performance over time provides a basis for banks to refine and adjust
internal models on an ongoing basis, it is expected that banks using internal
models will have established well-articulated model review standards.
These standards are especially important for situations where actual results
significantly deviate from expectations and where the validity of the internal
model is called into question. These standards must take account of
business cycles and similar systematic variability in equity returns. All
adjustments made to internal models in response to model reviews must be
well documented and consistent with the bank’s model review standards.
116. To facilitate model validation through backtesting on an ongoing
basis, institutions using the internal model approach must construct and
maintain appropriate databases on the actual quarterly performance of
their equity investments as well on the estimates derived using their
internal models. Banks should also back test the volatility estimates used
within their internal models (for equity exposures in banking book) and the
appropriateness of the proxies used in the model. RBI may ask banks to
scale their quarterly forecasts to a different, in particular shorter, time
horizon, store performance data for this time horizon and perform back
tests on this basis.

Documentation
117. The burden is on the bank to satisfy the RBI that a model has good
predictive power and that regulatory capital requirements will not be
distorted as a result of its use. Accordingly, all critical elements of an
internal model and the modelling process should be fully and adequately
documented. Banks must document in writing their internal model’s design
and operational details. The documentation should demonstrate banks’

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compliance with the minimum quantitative and qualitative standards, and
should address topics such as the application of the model to different
segments of the portfolio, estimation methodologies, and responsibilities of
parties involved in the modelling, and the model approval and model review
processes. In particular, the documentation should address the following
points:
(a) A bank must document the rationale for its choice of internal modelling
methodology and must be able to provide analyses demonstrating that
the model and modelling procedures are likely to result in estimates that
meaningfully identify the risk of the bank’s equity holdings. Internal
models and procedures must be periodically reviewed to determine
whether they remain fully applicable to the current portfolio and to
external conditions. In addition, a bank must document a history of
major changes in the model over time and changes made to the
modelling process subsequent to the last supervisory review. If changes
have been made in response to the bank’s internal review standards, the
bank must document that these changes are consistent with its internal
model review standards.
(b) In documenting their internal models banks should:
• provide a detailed outline of the theory, assumptions and/or
mathematical and empirical basis of the parameters, variables, and
data source(s) used to estimate the model;
• establish a rigorous statistical process (including out-of-time and out-
of-sample performance tests) for validating the selection of
explanatory variables; and
• indicate circumstances under which the model does not work
effectively or its limitations.
(c) Where proxies and mapping are employed, institutions must have
performed and documented rigorous analysis demonstrating that all
chosen proxies and mappings are sufficiently representative of the risk
of the equity holdings to which they correspond. The documentation
should show, for instance, the relevant and material factors (e.g.
business lines, balance sheet characteristics, geographic location,
company age, industry sector and subsector, operating characteristics)
used in mapping individual investments into proxies. In summary,
institutions must demonstrate that the proxies and mappings employed:
• are adequately comparable to the underlying holding or portfolio;
• are derived using historical economic and market conditions that are
relevant and material to the underlying holdings or, where not, that
an appropriate adjustment has been made; and,
• are robust estimates of the potential risk of the underlying holding.

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K. Disclosure requirements
118. In order to be eligible for the IRB approach, banks must meet the
additional disclosure requirements set out in Appendix 11. These are
minimum requirements for use of IRB; failure to meet these will render
banks ineligible to use the relevant IRB approach.

Appendix 2
Categories of Specialised lending sub-asset classes under corporate
exposure
The corporate asset class includes, but is not limited to, the following four
asset sub classes of specialised lending (SL):
1. Project finance
Project finance (PF) is a method of funding in which the lender looks
primarily to the revenues generated by a single project, both as the source
of repayment and as security for the exposure (in case of default by the
borrower). This type of financing is usually for large, complex and expensive
installations that might include, power plants, chemical processing plants,
mines, transportation infrastructure, environment, and telecommunications
infrastructure etc. In such transactions, the repayment depends primarily on
the project’s cash flow and on the collateral value of the project’s assets. In
contrast, if repayment of the exposure depends primarily on a well
established, diversified, credit-worthy, contractually obligated end user for
repayment, it is considered a secured exposure i.e. usual corporate
exposure to that end-user.

2. Object finance
Object finance (OF) refers to a method of funding the acquisition of physical
assets (e.g. ships, aircraft, satellites, railcars, and fleets) where the
repayment of the exposure is dependent on the cash flows generated by the
specific assets that have been financed and pledged or assigned to the
lender. A primary source of these cash flows might be rental or lease
contracts with one or several third parties. In contrast, if the exposure is to a
borrower whose financial condition and debt-servicing capacity enables it to
repay the debt without undue reliance on the specifically pledged assets,
the exposure should be treated as a usual collateralised corporate exposure.

3. Commodities finance
Commodities finance (CF) refers to structured short-term lending to finance
reserves (e.g. minerals reserves), inventories, or receivables of exchange-
traded commodities where the exposure will be repaid from the proceeds
of the sale of the commodity and the borrower has no independent capacity
to repay the exposure. This is the case when the borrower has no other

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activities and no other material assets on its balance sheet. The structured
nature of the financing is designed to compensate for the weak credit
quality of the borrower. The exposure’s rating reflects its self-liquidating
nature and the lender’s skill in structuring the transaction rather than the
credit quality of the borrower. Such lending can be distinguished from
exposures financing the reserves, inventories, or receivables of other more
diversified corporate borrowers where the value of the commodity serves
as a risk mitigant (kind of collateral) rather than as the primary source of
repayment.

4. Income producing real estate (IPRE)/Commercial real estate (CRE)

This refers to a method of providing funding to real estate (such as, office
buildings to let, retail space, multifamily residential buildings, industrial or
warehouse space, and hotels) where the repayment and recovery on the
exposure primarily depends on the cash flows (i.e. more than 50% of cash
flows required for repayment and recovery are generated from the asset)
generated by the asset. These cash flows would generally be lease or rental
payments or the sale of the assets as also for recovery in the event of
default where such asset is taken as security. The borrower may be an SPE
(but not necessarily), an operating company focused on real estate
construction or holdings, or an operating company with sources of revenue
other than real estate. In case of CRE, there is a strong positive correlation
between the prospects for repayment of the exposure and the prospects for
recovery in the event of default, with both depending primarily on the cash
flows generated by a property (either from the lease or rental payments or
from sale of the asset). In case of other usual corporate exposures
collateralised by real estate, this correlation is low or negligible because of
the income generating capacity of the corporate from various other sources
than the real estate property funded by the exposure. Commercial Real
Estate as defined in the extant “Guidelines on classification of exposures as
Commercial Real Estate” will also be included in this asset class.

Appendix 3
Collateral related issues for LGD calculation
5. Two types of collateral that the banks may use for IRB approaches are
given below:
A. Eligible financial collateral
B. Eligible IRB collateral

A. Eligible financial collateral (also recognised under the standardised

approach of Basel II) will consist of the following items:
i. Cash (as well as certificates of deposit or comparable instruments,

230
 including fixed deposit receipts, issued by the lending bank) deposit
with the bank which is incurring the counterparty exposure
ii. Gold would include both bullion and jewellery. However, the value of
the collateralised jewellery should be arrived at after notionally
converting these to 99.99 purity
iii. Securities issued by Central and State Governments
iv. Kisan Vikas Patra and National Savings Certificates provided no lock-
in period is operational and if they can be encashed within the
holding period
v. Life insurance policies with a declared surrender value of an
insurance company which is regulated by an insurance sector
regulator
vi. Debt securities rated by a RBI approved Credit Rating Agency in
respect of which the banks should be sufficiently confident about the
market liquidity (A debenture would meet the test of liquidity if it is
traded on a recognised stock exchange(s) on at least 90 per cent of
the trading days during the preceding 365 days. Further, liquidity can
be evidenced in the trading during the previous one month in the
recognised stock exchange if there are a minimum of 25 trades of
marketable lots in securities of each issuer.) where these are either:
a) Attracting 100 per cent or lesser risk weight i.e. rated at least BBB(-
) when issued by public sector entities and other entities (including
banks and Primary Dealers); or
b) Attracting 100 per cent or lesser risk weight i.e., rated at least PR3
/P3/F3/A3 for short-term debt instruments.
vii. Debt securities not rated by a RBI approved Credit Rating Agency in
respect of which the banks should be sufficiently confident about the
market liquidity where these are:
a) issued by a bank; and
b) listed on a recognised exchange; and
c) classified as senior debt; and
d) all rated issues of the same seniority by the issuing bank are rated at
least BBB(-) or PR3/P3/F3/A3 by a RBI approved Credit Rating
Agency; and
e) the bank holding the securities as collateral has no information to
suggest that the issue justifies a rating below BBB(-) or PR3/P3/F3/A3
(as applicable) and
f) Banks should be sufficiently confident about the market liquidity of
the security
viii.Units of Mutual Funds regulated by SEBI where:
a) a price for the units is publicly quoted daily i.e., where the daily NAV
is available in public domain; and

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 b) Mutual fund is limited to investing in the instruments listed in this
paragraph.

B. Eligible IRB collateral

2. In addition to the eligible financial collateral as mentioned above, some
other collateral are also recognised under IRB approaches which are
mentioned as IRB collaterals. These may be of the following types
i. Eligible Financial Receivables
ii. Commercial or Residential Real Estate (CRE/RRE)
iii. Other physical Collaterals
The eligibility criteria of each of the three types of IRB collaterals will be as
given below:

Eligible Financial Receivables

3. Eligible financial receivables are claims with an original maturity of less
than or equal to one year where repayment will occur through the
commercial or financial flows related to the underlying assets of the
borrower. This includes both self-liquidating debt arising from the sale of
goods or services linked to a commercial transaction and general amounts
owed by buyers, suppliers, renters, national and local governmental
authorities, or other non-affiliated parties not related to the sale of goods or
services linked to a commercial transaction. Eligible receivables do not
include those associated with securitisations, sub-participations or any
derivatives.

Operational requirements
4. The operational requirements for the Financial Receivables are as
mentioned below:
(a) Legal Certainty
• The legal mechanism by which collateral is given must be robust and
ensure that the lender has clear rights over the proceeds from the
collateral.
• Banks must take all steps necessary to fulfil requirements in respect of
the enforceability of charge certificate, e.g. registering a charge on
collateral with a registrar. There should be a framework that allows the
potential lender to have a perfected first priority claim over the
collateral.
• All documentation used in collateralised transactions must be binding on
all parties and legally enforceable. Banks must have conducted sufficient
legal review to verify this and have a well founded legal basis to reach
this conclusion, and undertake such further review as necessary to
ensure continuing enforceability.

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• The collateral arrangements must be properly documented, with a clear
and robust procedure for the timely collection of collateral proceeds.
Banks’ procedures should ensure that any legal conditions required for
declaring the default of the customer and timely collection of collateral
are observed. In the event of the customer’s financial distress or default,
the bank should have legal authority to sell or assign the receivables to
other parties without consent of the receivables’ obligors.

(b) Risk Management

• The bank must have a sound process for determining the credit risk in
the receivables. Such a process should include, among other things,
analysis of the borrower’s business and industry (e.g. effects of the
business cycle) and the types of customers with whom the borrower
does business. Where the bank relies on the borrower to ascertain the
credit risk of the customers, the bank must review the borrower’s credit
policy to ascertain its soundness and credibility.
• The margin between the amount of the exposure and the value of the
receivables must reflect all appropriate factors, including the cost of
collection, concentration within the receivables pool pledged by an
individual borrower, and potential concentration risk within the bank’s
total exposures.
• The bank must maintain a continuous monitoring process that is
appropriate for the specific exposures (either immediate or contingent)
attributable to the receivable to be utilised as a risk mitigant. This
process may include, as appropriate and relevant, ageing reports,
control of trade documents, stock/receivables statement, frequent
audits of collateral, confirmation of accounts, control of the proceeds of
accounts paid, analysis of dilution (credits given by the borrower to the
issuers) and regular financial analysis of both the borrower and the
sellers of the receivables, especially in the case when a small number of
large-sized receivables are taken as collateral. Observance of the bank’s
overall concentration limits should be monitored. Additionally,
compliance with loan covenants, environmental restrictions, and other
legal requirements should be reviewed on a regular basis.
• The receivables pledged by a borrower should be diversified and not be
unduly correlated with the borrower. Where the correlation is high, e.g.
where some issuers of the receivables are reliant on the borrower for
their viability or the borrower and the issuers belong to a common
industry, the attendant risks should be taken into account in the setting
of margins for the collateral pool as a whole. Receivables from affiliates
of the borrower (including subsidiaries and employees) will not be
recognised as risk mitigants.

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• The bank should have a documented process for collecting receivable
payments in distressed situations. The requisite facilities for collection
should be in place, even when the bank normally looks to the borrower
for collections.

Commercial or Residential Real Estate (CRE/RRE)

5. Eligible CRE/RRE collaterals for exposures to corporate, sovereign and
banks are the ones where the risk of the borrower is not materially
dependent upon the performance of the underlying property or project, but
rather on the underlying capacity of the borrower to repay the debt from
other sources. As such, repayment of the facility is not materially dependent
on any cash flow generated by the underlying CRE/RRE serving as collateral.
6. Additionally, the value of the collateral pledged must not be materially
dependent on the performance of the borrower. This requirement is not
intended to preclude situations where purely macro-economic factors affect
both the value of the collateral and the performance of the borrower.
7. Commercial real estate that fall under the SL asset sub class of
corporate exposure should be excluded as eligible CRE collateral.

Operational requirements
8. The Operational requirements for the CRE/RRE collaterals are as
mentioned below:
Subject to meeting the definition above, CRE and RRE will be eligible for
recognition as collateral for corporate claims only if all of the following
operational requirements are met.
(a) Legal enforceability
Any claim on collateral taken must be legally enforceable in all relevant
jurisdictions, and any claim on collateral must be properly filed on a timely
basis. Collateral interests must reflect a perfected lien (i.e. all legal
requirements for establishing the claim has been fulfilled). Furthermore, the
collateral agreement and the legal process underpinning it must be such
that they provide for the bank to realise the value of the collateral within a
reasonable timeframe.
(b) Objective market value of collateral
The collateral must be valued at or less than the current fair value under
which the property could be sold under private contract between a willing
seller and an arm’s-length buyer on the date of valuation.
(c) Frequent revaluation
The bank is expected to monitor the value of the collateral on a frequent
basis and at a minimum once every year. More frequent monitoring is
suggested where the market is subject to significant changes in conditions.
Statistical methods of evaluation may be used to update estimates or to

234
identify collateral that may have declined in value and that may need re-
appraisal. A qualified professional valuer must evaluate the property when
information indicates that the value of the collateral may have declined
materially relative to general market prices or when a credit event, such as
default, occurs.
(d)Charges other than first charge
Subsequent (to the first charge) charges may be taken into account where
there is no doubt that the claim for collateral is legally enforceable and
constitutes an efficient credit risk mitigant. When recognised, these charges
are to be treated using the C*/C** threshold, which is used for first charges
(in table 1 of para 48 of the Annex of this guideline). In such cases, the C*
and C** are calculated by taking into account the sum of the subsequent
charge and all of the more senior charges.
Additional collateral management requirements are as follows:
• The types of CRE and RRE collateral accepted by the bank and lending
policies when this type of collateral is taken must be clearly
documented.
• The bank must take steps to ensure that the property taken as collateral
is adequately insured against damage or deterioration.
• The bank must monitor on an ongoing basis the extent of any
permissible prior claims (e.g. tax) on the property.
• The bank must appropriately monitor the risk of environmental liability
arising in respect of the collateral, such as the presence of toxic material
on a property.

Other Collaterals
9. In addition to the above types of collaterals, RBI may permit banks to
recognise other physical collaterals as risk mitigants which meet the
following two standards:
• Existence of liquid markets for disposal of collateral in an expeditious
and economically efficient manner.
• Existence of well established, publicly available market prices for the
collateral or Board approved policy of regular collateral valuation with
qualified professionals. RBI should be certain that the amount a bank
receives when collateral is realised does not deviate significantly from
these market prices.
In order for a given bank to receive recognition for additional physical
(other) collateral, it must meet all the standards in paragraphs (para 8
above), subject to the following modifications.
• First Claim: First charge/first pari-passu charge (proportionate claim)
over other collaterals is permissible. As such, the bank must have priority
over all other lenders to the realised proceeds of the collateral.

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• The loan agreement must include detailed descriptions of the collateral
plus detailed specifications of the manner and frequency of revaluation.
• The types of physical collateral accepted by the bank and policies and
practices in respect of the appropriate amount of each type of collateral
relative to the exposure amount must be clearly documented in internal
credit policies and procedures and available for examination and/or
audit review.
• Bank credit policies with regard to the transaction structure must
address appropriate collateral requirements relative to the exposure
amount, the ability to liquidate the collateral readily, the ability to
establish objectively a price or market value, the frequency with which
the value can readily be obtained (including a professional appraisal or
valuation), and the volatility of the value of the collateral. The periodic
revaluation process must pay particular attention to obsolescence prone
collaterals to ensure that valuations are appropriately adjusted
downward of fashion or model-year, obsolescence as well as physical
obsolescence or deterioration.
In cases of machinery/equipments, the periodic revaluation process must
include physical inspection of the collateral.
10. Once the banks have identified/categorised the collaterals, they need to
calculate LGDs. Banks would adjust the collaterals and sometimes exposures
with some percentage known as haircuts (in case of eligible financial
collaterals). How to calculate the haircuts and apply them to collaterals and
exposures is described below.

Calculation of Exposure amount after risk mitigation with eligible financial

collaterals
11. For Foundation IRB method, the Comprehensive Approach mentioned
in the Standardised method of Basel II for recognition of collateral will be
followed. In the Comprehensive Approach, when taking collateral, banks will
need to calculate their adjusted exposure to a counterparty for capital
adequacy purposes in order to take account of the effects of that collateral.
Banks are required to adjust both the amount of the exposure to the
counterparty or/and the value of any collateral received in support of that
counterparty to take account of possible future fluctuations in the value of
either, occasioned by market movements (exposure amount may vary when
securities have been lent by the banks or given as collateral for repo type
transactions. These adjustments are referred to as ‘haircuts’. The
application of haircuts will produce volatility adjusted amounts for both
exposure and collateral. The volatility adjusted amount for the exposure will
be higher than the exposure and the volatility adjusted amount for the
collateral will be lower than the collateral, unless either side of the

236
transaction is cash. In other words, the ‘haircut’ for the exposure will be a
premium factor and the ‘haircut’ for the collateral will be a discount factor.
It may be noted that the purpose underlying the application of haircut is to
capture the market-related volatility inherent in the value of exposures as
well as of the eligible financial collaterals. Since the value of credit
exposures acquired by the banks in the course of their banking operations,
would not be subject to market volatility, (since the loan disbursal /
investment would be a “cash” transaction) though the value of eligible
financial collateral would be, the haircut stipulated would apply in respect
of credit transactions would apply only to the eligible collateral but not to
the credit exposure of the bank.
12. Exposures of banks, arising out of repo-style transactions would require
upward adjustment for volatility, as the value of security sold/lent/pledged
by the borrowing bank in the repo transaction, would be subject to market
volatility. Hence, such exposures (as securities sold/lent/pledged is the
exposure of the bank and the cash borrowed will be treated as collateral)
shall attract haircut. But collateral such as cash will not attract any
adjustment in terms of discount.
13. However, where the exposure and collateral are held in different
currencies an additional downwards adjustment must be made to the
volatility adjusted collateral amount to take account of possible future
fluctuations in exchange rates.
14. Where the volatility-adjusted exposure amount is greater than the
volatility-adjusted collateral amount (including any further adjustment for
foreign exchange risk which is dealt with subsequently), banks shall
calculate the adjusted exposure framework for performing these
calculations is set out below.
15. For a collateralised transaction, the exposure amount after risk
mitigation is calculated as follows:
E* = max {0, [E x (1 + He) – C x (1 – Hc – Hfx)]}....................................(A)
where:
E* = the exposure value after risk mitigation
E = current value of the exposure without risk mitigation
He = haircut appropriate to the exposure (in case of repo style transactions)
C = the current value of the collateral received
Hc = haircut appropriate to the collateral
Hfx = haircut appropriate for currency mismatch between the collateral and
exposure.
This adjusted value of the collateralised exposure (E*) will later be used in
the formula meant for LGD* calculation given in eqn. Mentioned in para 57
of the annex of this guideline.

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Where the collateral is a basket of assets, the haircut on the basket will be,
H = ∑ai Hi
i
where ai is the weight of the asset (as measured by units of currency) in the
basket and Hi the haircut applicable to that asset.
16. In principle, banks have two ways of calculating the haircuts of the
exposures or the collaterals:
(i) standard supervisory haircuts, as given in Table 2 and 3 below, and
(ii) own estimate haircuts, using banks’ own internal estimates of
market price volatility.
17. The Standard Supervisory Haircuts (assuming daily mark-to-market,
daily re-margining and a 10 business-day holding period), expressed as
percentages, is as furnished in tables (2 and 3) below. Holding period
implies the time normally required by the bank to realise the value of the
collateral.
18. The ratings indicated in Table – 2 represent the ratings assigned by the
domestic rating agencies. In the case of exposures toward debt securities
issued by foreign Central Governments and foreign corporates, the haircut
may be based on ratings of the international rating agencies, as indicated in
Table 3.Sovereign will also include Reserve Bank of India, DICGC and CGTSI.
19. Banks may apply a zero haircut for eligible collateral where it is a
National Savings Certificate, Kisan Vikas Patras, surrender value of insurance
policies and banks’ own deposits.
20. The standard supervisory haircut for currency risk where exposure and
collateral are denominated in different currencies is eight per cent (based
on a 10-business day holding period and daily mark-to-market- Hfx in eqn. A
of para 15 of this appendix).
If securities arising out of securitisation transaction are used as collaterals
and fall under the same classification as in B (ii) and B (iii) categories as in
table 2, then those will attract double the haircut compared to haircut on
other securities in the same category. Also, in table 3, if securities arising
out of securitisation transactions are used as collaterals, then those will
attract double the haircut compared to the haircut applied to securities
issued by other issuers as given in column 4 under respective categories.

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Table 2 : Standard Su
pervisory Haircuts for Sovereign and other securities which constitute
Exposure and Collateral
Issue rating for debt
Sr. No. securities Residual maturity (yrs.) Haircut (%)

Securities issued / guaranteed by the Government of India and

A issued by the State Governments (Sovereign securities)

Rating not available as < or = 1 year 0.5

Govt. securities are > 1 yr. and < or = 5 yrs. 2
I currently not rated in
India > 5 yrs 4

Domestic debt securities other than those indicated at Item No. A above
B
including the securities guaranteed by Indian State Governments

AAA to AA < or = 1 year 1

> 1 yr. and < or = 5 yrs 4

Ii
PR1/P1/F1/A1
> 5 yrs 8

A to BBB < or = 1 year 2

PR2 / P2 / F2 /A2;
> 1 yr. and < or = 5 yrs. 6
PR3 /P3 / F3 / A3 and
Iii
unrated bank
securities > 5 yrs 12

Highest haircut applicable

to the any of the
Iv Units of Mutual Fund
eligible securities in which the fund can invest

C Cash in the same currency 0

D Gold 15

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Table 3 : Standard Supervisory Haircut for Exposures and Collaterals which
are obligations of foreign central sovereigns/foreign corporate
Issue rating for debt securities Residual Maturity Sovereigns Other issues
as assigned by international (Haircut %) (Haircut %)
rating agencies

< or = 1 year 0.5 1

AAA to AA / > 1 yr. and < or = 5
A-1 yrs. 2 4

> 5 yrs 4 8

A to BBB / < or = 1 year 1 2

A-2 / A-3 / P-3 and Unrated > 1 yr. and < or = 5
Bank yrs. 3 6
Securities
> 5 yrs 6 12
21. If banks’ exposures are unrated or bank lends non-eligible instruments
in Market Repo transactions (i.e. non-investment grade corporate
securities) then the haircut to be applied on such exposure should be 25 per
cent.
Adjustment to the Haircut (Supervisory or own estimate) when holding
periods and mark to market/remargining are not as per the standard ones
(daily mark to market, daily remargining and 10 business day holding
period) because of the nature of the transactions

Adjustment for Different holding periods

22. For some transactions, depending on the nature and frequency of the
revaluation and remargining provisions, different holding periods (other
than 10 business-days) are appropriate. The framework for collateral
haircuts distinguishes between repo-style transactions (i.e. repo / reverse
repos and securities lending / borrowing), "other capital-market-driven
transactions" (i.e. OTC derivatives transactions and margin lending) and
secured lending. In view of different holding periods, as per the nature of
these transactions, the minimum holding periods shall be taken as indicated
below
Transaction Type Minimum holding Period Condition
Repo-style transaction five business days Daily remargining
Other capital market transactions ten business days Daily remargining
Secured lending twenty business Days Daily revaluation

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23. However, the standard haircut for the types of transactions as
mentioned above will be assumed to be the ones as given in the table
instead of 10 business days holding period as considered in Table 2 and 3 in
para 20 of this appendix. Still, there may be transactions falling under the
above categories which have holding period or/and remargining/revaluation
provisions which are different than those mentioned in the above table. For
those transactions the haircut of the collateral securities will be adjusted as
mentioned in the paragraphs below

Adjustment in haircut for non-daily mark-to-market or remargining

24. In case a transaction has margining frequency longer than daily
margining assumed, the applicable haircut for the transaction will also need
to be adjusted by using the formula given below in equation B.

where :
H = adjusted haircut;
HM = haircut under minimum holding period (as in the table in para 20)
NR = actual number of business days between remargining for capital
market transactions or revaluation for secured transactions.
TM = minimum holding period for the type of transaction

Adjustments in haircut for holding period different from the minimum

holding periods
25. When the actual holding period for the above types of transactions are
different than the minimum ones (as given in the table in para 22) the
haircut for collateral securities under these transactions should be adjusted
as per the following formula

where :
TN = actual holding period of the transaction
HN = adjusted haircut based on holding period TN;
HM= Haircut applicable for minimum holding period (as given in the table in
para 20)
TM = minimum holding period for the type of transaction (as given in the
table in para 22)
These adjustments (as in para 24 and 25) have to be done for banks’ own
estimates of haircuts as well.

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26. Banks may apply zero haircuts only to National Savings certificate
(NSC), Kisan Vikas Patra (KVP), surrender value of the insurance policy,
deposits maintained by the bank itself.
27. Market participants for repo style transactions will include the entities
as mentioned by RBI from time to time (currently as per the extant Master
Circular on Prudential Norms for classification, valuation and operation of
investment portfolio by banks)
28. Own estimate of haircut
RBI may permit banks to calculate own estimate of haircuts using their own
internal estimates of market price volatility and foreign exchange volatility.
Permission to do so will be conditional on the satisfaction of minimum
qualitative and quantitative standards stated in para 29.
Categorisation of securities for haircut estimation
(a) For debt securities rated below BBB-/A-3 equivalent or for equities
(under units of mutual fund) eligible as collateral, banks must calculate
haircut for each individual securities.
(b) For debt securities rated BBB-/A-3 equivalent or higher, banks may
calculate volatility estimate for each category of security. In determining
relevant categories, institutions must take into account (a) the type of issuer
of the security, (b) its rating, (c) its residual maturity, and (d) its modified
duration. Volatility estimates must be representative of the securities
actually included in the category for that bank.
(c) Banks must estimate the volatility of the collateral instrument or
foreign exchange mismatch individually i.e. the estimated volatilities must
not include estimation of the correlation between unsecured exposure,
collateral and exchange rates. A bank, permitted to use own estimate of
haircut must also follow the requirements for maturity mismatches as given
in para 64 to 66 of the annex of this guideline.
29. Criteria for calculating own estimate of haircut
In order to be granted permission by RBI to use own estimate of haircuts the
banks have to meet the following criteria
Quantitative criteria
th
• In calculating the haircuts, a 99 percentile, one-tailed confidence
interval is to be used.
• The minimum holding period will be dependent on the type of
transaction and the frequency of remargining or marking to market as
given in para 22 of this appendix. Banks may use haircut numbers
calculated according to shorter holding periods, scaled up to the
appropriate holding period by the square root of time formula as given
in para 25 of this appendix.
• Banks must take into account the illiquidity of lower-quality assets. The
holding period should be adjusted upwards in cases where such a

242
 holding period would be inappropriate given the liquidity of the
collateral. They should also identify where historical data may
understate potential volatility, e.g. a pegged currency. Such cases must
be dealt with by subjecting the data to stress testing.
• The choice of historical observation period (sample period) for
calculating haircuts shall be a minimum of one year. For banks that use
a weighting scheme or other methods for the historical observation
period, the “effective” observation period must be at least one year.
• Banks should update their data sets no less frequently than once every
three months and should also reassess them whenever market prices
are subject to material changes. This implies that haircuts must be
computed at least every three months. The RBI may also require a bank
to calculate its haircuts using a shorter observation period if, in the
RBI's judgement; this is justified by a significant upsurge in price
volatility.

Qualitative criteria
In addition to the quantitative criteria as mentioned above, banks will also
have to meet the following qualitative criteria to be permitted to use own
estimate of haircut.
• The estimated volatility data (and holding period) must be used in the
day-to-day risk management process of the bank.
• Banks should have robust processes in place for ensuring compliance
with a documented set of internal policies, controls and procedures
concerning the operation of the risk measurement system.
• The risk measurement system should be used in conjunction with
internal exposure limits.
• An independent review of the risk measurement system should be
carried out regularly in the bank’s own internal auditing process. A
review of the overall risk management process should take place at
regular intervals (ideally not less than once a year) and should
specifically address, at a minimum:
• the integration of risk measures into daily risk management
• the validation of any significant change in the risk measurement
process;
• the accuracy and completeness of position data;
• the verification of the consistency, timeliness and reliability of data
sources used to run internal models, including the independence of
such data sources; and
• the accuracy and appropriateness of volatility assumptions.
All the adjustments as mentioned in para 22-25 of this appendix should be
applicable to own estimate of haircuts as well.

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Estimation of haircut by VaR
30. As an alternative to the use of standard or own-estimate haircuts,
banks may be permitted on a case to case basis by the RBI to use a VaR
model approach to reflect the price volatility of the exposure and collateral
for repo-style transactions, taking into account correlation effects between
security positions. This approach would apply to repo-style transactions
covered by bilateral netting agreements on a counterparty-by-counterparty
basis (In India, it will be applicable only when the market repo transactions
in corporate debt securities become eligible for netting). At the discretion of
the RBI, banks are also eligible to use the VaR model approach for margin
lending transactions, if the transactions are covered under a bilateral master
netting agreement that meets the requirements of paragraphs 89 and 90 in
Annex of this guideline. The VaR model approach is available to banks that
have received RBI approval for an internal market risk model as per the
applicable RBI guidelines Otherwise banks may separately apply for RBI
approval to use their internal VaR models for calculation of potential price
volatility for repo-style transactions. Internal models will only be accepted
when a bank can prove the quality of its model to the RBI through the
backtesting of its output using one year of historical data.
31. The quantitative and qualitative criteria for recognition of VaR models
for repo style and other similar transactions are in-principle the same to
IMA models for market risk. With regard to the holding period, the
minimum will be 5-business days for repo-style transactions, rather than the
10-business days. For other transactions eligible for the VaR models
approach, the 10-business day holding period will be retained. The
minimum holding period should be adjusted upwards for market
instruments where such a holding period would be inappropriate given the
liquidity of the instrument concerned. A bank’s VaR model used to
determine its net exposure (for repo style and SFT) for capital adequacy
purpose, must provide daily estimate of 99 per cent, one tailed confidence
interval of the potential change in value of the unsecured exposure amount
(Σ(E) – Σ(C)).
The calculation of the exposure E* for banks using their internal model will
be the following:
E* = max {0, [(ΣE – ΣC) + VaR output from internal model]}
In calculating capital requirements banks will use the previous business
day’s VaR number.

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 Appendix 4
Credit Risk Mitigation: Disclosure requirements
The disclosure requirement under Pillar 3 for the banks in respect of credit
risk mitigation is given below:

Qualitative Disclosures
(a) The general qualitative disclosure requirement with respect to credit risk
mitigation including:
• Policies and processes for, and an indication of the extent to which the
bank makes use of, on balance sheet netting;
• policies and processes for collateral valuation and management;
• a description of the main types of collateral taken by the bank;
• the main types of guarantor counterparty and their creditworthiness;
and information about (market or credit) risk concentrations within the
mitigation taken

Quantitative Disclosures
(b) For each separately disclosed credit risk portfolio the total exposure
(after, where applicable, on balance sheet netting) that is covered by
eligible financial collateral/IRB collaterals after the application of haircuts.
(c) For each separately disclosed credit risk portfolio the total exposure
(after, where applicable, on balance sheet netting) that is covered by
guarantees/credit derivatives (whenever specifically permitted by RBI).

Appendix 5
Operational Requirements common to Guarantees and credit derivatives
1. The operational requirements applicable to guarantees and credit
derivatives are mentioned below:
i) A guarantee (counter-guarantee) or credit derivative (as permitted by
the extant RBI guidelines) must represent a direct claim on the protection
provider and must be explicitly referenced to specific exposures or a pool of
exposures, so that the extent of the cover is clearly defined and
incontrovertible. Other than non payment by a protection purchaser of
money due in respect of the credit protection contract it 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/protected exposure. The guarantee must also 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

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make the payment(s) due.
ii) Capital requirement for all exposures will be calculated after taking
into account risk mitigation available in the form of guarantees. When a
guaranteed exposure is classified as non-performing, the guarantee will
cease to be a credit risk mitigant and no adjustment would be permissible
on account of credit risk mitigation in the form of guarantees. The entire
outstanding, net of specific provision and net of realisable value of eligible
collaterals / credit risk mitigants, will attract the appropriate risk weight.

Additional Operational Requirements for Guarantees

2. In addition to the legal certainty requirements (that all documentation
used in respect of guarantees and credit derivatives must be binding on all
parties and legally enforceable in all relevant jurisdictions), in order for a
guarantee to be recognised, the following conditions must be satisfied:
i) On the qualifying default / non-payment of the counterparty, the bank
is able in a timely manner to pursue the guarantor for any money
outstanding under the documentation governing the transaction. The
guarantor may make one lump sum payment of all money under such
documentation to the bank, or the guarantor may assume the future
payment obligations of the counterparty covered by the guarantee. The
bank must have the right to receive any such payments from the guarantor
without first having to take legal actions in order to pursue the counterparty
for payment.
ii) The guarantee is an explicitly documented obligation assumed by the
guarantor.
iii) Except as noted in the following sentence, the guarantee covers all
types of payments the underlying borrower is expected to make under the
documentation governing the transaction, for example notional amount,
margin payments etc. Where a guarantee covers payment of principal only,
interests and other uncovered payments should be treated as an unsecured
amount.

Additional operational requirements for credit derivatives

3. In order for a credit derivative contract to be recognised, the following
conditions must be satisfied.
(i) The credit events specified by the contracting parties must at a
minimum cover
• failure to pay the amounts due under terms of the underlying obligation
that are in effect at the time of such failure (with a grace period that is
closely in line with the grace period in the underlying obligation);
• bankruptcy, insolvency or inability of the borrower to pay its debts, or
its failure or admission in writing of its inability generally to pay its

246
 debts as they become due, and analogous events; and
• restructuring of the underlying obligation involving forgiveness or
postponement of principal, interest or fees that results in a credit loss
event (i.e. charge-off, specific provision or other similar debit to the
profit and loss account).
(ii) If the credit derivative specifies deliverable obligations that are
different from the (subject to RBI approval) underlying obligation, section
(vii) below governs whether the asset mismatch is permissible.
(iii) The credit derivative shall not terminate prior to expiration of any grace
period required for a default on the underlying obligation to occur as a
result of a failure to pay, subject to the provisions of paragraph 64 of the
Annex of this guideline.
(iv) Credit derivatives allowing for cash settlement are recognised for
capital purposes insofar as a robust valuation process is in place in order to
estimate loss reliably. There must be a clearly specified period for obtaining
post-credit event valuations of the underlying obligation. If the reference
obligation specified in the credit derivative for purposes of cash settlement
is different than the underlying obligation, section (vii) below governs
whether the asset mismatch is permissible.
(v) If the protection purchaser’s right/ability to transfer the underlying
obligation to the protection provider is required for settlement, the terms of
the underlying obligation must provide that any required consent to such
transfer may not be unreasonably withheld.
(vi) The identity of the parties responsible for determining whether a credit
event has occurred must be clearly defined. This determination must not be
the sole responsibility of the protection seller. The protection buyer must
have the right/ability to inform the protection provider of the occurrence of
a credit event.
(vii) A mismatch between the underlying obligation and the reference
obligation under the credit derivative (i.e. the obligation used for purposes
of determining cash settlement value or the deliverable obligation or
obligation referred for the purpose of ascertaining the credit events) is
permissible if (1) the reference obligation ranks pari passu with or is junior
to the underlying obligation, and (2) the underlying obligation and reference
obligation share the same obligor (i.e. the same legal entity) and legally
enforceable cross-default or cross-acceleration clauses are in place.

Range of Eligible Guarantors (Counter-guarantors)/protection providers for

F-IRB banks
4. Credit protection given by the following entities will be recognised:
(i) Sovereigns, sovereign entities (including BIS, IMF, European Central
Bank and European Community as well as those MDBs, ECGC and CGFTSI),

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banks and primary dealers with a lower risk weight than the counterparty;
(ii) Other entities rated AA (-) or better. This would include guarantee
cover provided by parent, subsidiary and affiliate companies when they
have a lower risk weight than the obligor. The rating of the guarantor should
be an entity rating which has factored in all the liabilities and commitments
(including guarantees) of the entity.

Sovereign Guarantees and Counter-guarantees

5. A claim may be covered by a guarantee that is indirectly counter-
guaranteed by a sovereign. Such a claim may be treated as covered by a
sovereign guarantee provided that:
(i) the sovereign counter-guarantee covers all credit risk elements of the
claim;
(ii) both the original guarantee and the counter-guarantee meet all
operational requirements for guarantees, except that the counter-
guarantee need not be direct and explicit to the original claim; and
(iii) the cover should be robust and no historical evidence suggests that the
coverage of the counter-guarantee is less than effectively equivalent to that
of a direct sovereign guarantee.
After the guarantee has been recognised (as per para 11-12 of the Annex of
this guideline) and it is found that guarantee portion does not cover the
whole exposure then the unsecured portion will be assigned LGD as per
table 1 of para no. 48.

Proportional Cover
6. Where the amount guaranteed, or against which credit protection is held,
is less than the amount of the exposure, and the secured and unsecured
portions are of equal seniority, i.e. the bank and the guarantor share losses
on a pro-rata basis capital relief will be afforded on a proportional basis: i.e.
the protected portion of the exposure will receive the treatment applicable
to eligible guarantees, with the remainder treated as unsecured.

Tranched cover
7. Where the bank transfers a portion of the risk of an exposure in one or
more tranches to a protection seller and retains some level of risk of the
loan and the risk transferred and the risk retained are of different seniority,
banks must obtain credit protection for either of the senior tranches or the
junior tranches. In this case Securitisation rule will apply.

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 Appendix 6
Credit Conversion Factors (CCFs) for non market related Off Balance sheet
items for EAD calculation
1. Credit Conversion factors (CCFs) for non-market related off balance sheet
items for EAD calculation are tabulated below:
Credit Conversion Factors
Non-market related Off-balance Sheet Items
Sr. No. Instruments Credit
Conversion
Factor (%)
1. Direct credit substitutes e.g. general guarantees of 100
indebtedness (including standby L/Cs serving as
financial guarantees for loans and securities, credit
enhancements, liquidity facilities for securitisation
transactions), and acceptances (including
endorsements with the character of acceptance).
(i.e., the risk of loss depends on the credit worthiness
of the counterparty or the party against whom a
potential claim is acquired)

2. Certain transaction-related contingent items (e.g. 50

performance bonds, bid bonds, warranties,
indemnities and standby letters of credit related to
particular transaction).
3. Short-term self-liquidating trade letters of credit 20
arising from the movement of goods (e.g.
documentary credits collateralised by the underlying
shipment) for both issuing bank and confirming bank.
4. Sale and repurchase agreement and asset sales with 100
recourse, where the credit risk remains with the bank
5. Forward asset purchases, forward deposits and partly 100
paid shares and securities, which represent
commitments with certain drawdown.
6. Lending of banks' securities or posting of securities as 100
collateral by banks, including instances where these
arise out of repo style transactions (i.e., repurchase /
reverse repurchase and securities lending / securities
borrowing transactions)
7. Commitments with certain drawdown 100
8. Note Issuance facilities and revolving/non 75%
revolving underwriting facilities
9. Other commitments (e.g., formal standby facilities 75%
and credit lines) , irrespective of the maturity
Similar commitments that are unconditionally 0

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 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. For this banks must
demonstrate that they actively monitor the financial
condition of the borrower, and that their internal
control systems are such that they could cancel the
facility upon evidence of adeterioration in the credit
quality of the borrower.
10. Take-out Finance in the books of taking-over
institution
(i) Unconditional take-out finance 100
(ii) Conditional take-out finance 50
@
11. Irrevocable payment commitments(IPCs) 100
@ Irrevocable payment commitments should be treated as equity
exposures.
2. In regard to non-market related off-balance sheet items, the following
transactions with non-bank counterparties will be treated as claims on
banks:
* Guarantees issued by banks against the counter guarantees of other
banks.
* Rediscounting of documentary bills discounted by other banks and bills
discounted by banks which have been accepted by another bank will be
treated as a funded claim on a bank.
In the above cases banks should be fully satisfied that the risk exposure is in
fact on the other bank.

Appendix 7
Calculation of EAD for market related off balance sheet items
The methodology for calculation of EAD for market related off balance sheet
items is discussed in this Appendix.
Transactions involving Central Counterparties
1. The exposures to Central Counter Parties (CCPs), on account of
derivatives trading and securities financing transactions (e.g. Collateralised
Borrowing and Lending Obligations, Repos, Reverse Repos) outstanding
against them will be assigned zero exposure value for counterparty credit
risk, as it is presumed that the CCPs' exposures to their counterparties are
fully collateralised on a daily basis, thereby providing protection for the
CCP's credit risk exposures.
2. Banks’ securities posted as collaterals with CCPs and the resultant off-
balance sheet exposure will be assigned risk weights as per the standardised
approach appropriate to the nature of the CCPs and will be subject to
review.

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Market related off balance sheet transactions not involving CCPs
3. The credit equivalent amount of a market related off-balance sheet item,
whether held in the banking book or trading book must be determined by
the current exposure method.

Current Exposure Method

4. The calculation methodology of the credit equivalent amount under
Current Exposure Method is mentioned below
(i) The credit equivalent amount of a market related off -balance sheet
transaction calculated using the current exposure method is the sum of
current credit exposure and potential future credit exposure of these
contracts. While computing the credit exposure banks may exclude 'sold
options', provided the entire premium / fee or any other form of income is
received / realised.
(ii) Current credit exposure is defined as the sum of the positive mark-to-
market value of these contracts. The Current Exposure Method requires
periodical calculation of the current credit exposure by marking these
contracts to market, thus capturing the current credit exposure.
(iv) Potential future credit exposure is determined by multiplying the
notional principal amount of each of these contracts irrespective of whether
the contract has a zero, positive or negative mark-to-market value by the
relevant add-on (credit conversion) factor indicated below according to the
nature and residual maturity of the instrument.
Credit Conversion Factors for Market-related
Off-balance Sheet Items
Credit Conversion Factors
Interest Rate Exchange Rate Contracts & Gold
One year or less 0.50 % 2.00 %
Over one year to five years 1.00 % 10.00 %
Over five years 3.00 % 15.00 %
(iv) For contracts with multiple exchanges of principal, the add-on/credit
conversion factors are to be multiplied by the number of remaining
payments in the contract.
(v) For contracts that are structured to settle outstanding exposure
following specified payment dates and where the terms are reset such that
the market value of the contract is zero on these specified dates (for ex-
Interest Rate Swap), the residual maturity would be set equal to the time
until the next reset date. However, in the case of interest rate contracts
which have residual maturities of more than one year and meet the above
criteria, the CCF or add-on factor is subject to a floor of 1.0 per cent.
(vi) No potential future credit exposure would be calculated for single
currency floating / floating interest rate swaps; the credit exposure on these

251
contracts would be evaluated solely on the basis of their mark-to-market
value.
(vii) Potential future exposures should be based on effective rather than
apparent notional amounts. In the event that the stated notional amount is
leveraged or enhanced by the structure of the transaction, banks must use
the effective notional amount when determining potential future exposure.
For example, a stated notional amount of Rs. 10 lakh with payments based
on an internal rate of two times the ‘base rate’ would have an effective
notional amount of Rs. 20 lakh.

Failed Transactions
5. The treatment for failed transactions is mentioned below:
i) With regard to unsettled securities and foreign exchange transactions,
banks are exposed to counter party credit risk from trade date, irrespective
of the booking or the accounting of the transaction. Banks are encouraged
to develop, implement and improve systems for tracking and monitoring the
credit risk exposure arising from unsettled transactions as appropriate for
producing management information that facilitates action on a timely basis.
ii) Banks must closely monitor securities and foreign exchange
transactions that have failed, starting from the day they fail for producing
management information that facilitates action on a timely basis. Failed
transactions give rise to risk of delayed settlement or delivery.
iii) Failure of transactions settled through a delivery-versus-payment
system (DvP), providing simultaneous exchanges of securities for cash,
expose banks to a risk of loss on the difference between the transaction
valued at the agreed settlement price and the transaction valued at current
market price (i.e. positive current exposure). Failed transactions where cash
is paid without receipt of the corresponding receivable (securities, foreign
currencies, or gold,) or, conversely, deliverables were delivered without
receipt of the corresponding cash payment (non-DvP, or free-delivery)
expose banks to a risk of loss on the full amount of cash paid or deliverables
delivered. Therefore, a capital charge is required for failed transactions and
must be calculated. The following capital treatment is applicable to all failed
transactions, including transactions through recognised clearing houses.
Repurchase and reverse-repurchase agreements as well as securities
lending and borrowing that have failed to settle are excluded from this
capital treatment.
iv) For DvP Transactions - If the payments have not yet taken place five
business days after the settlement date, banks are required to calculate a
capital charge by multiplying the positive current exposure of the
transaction by the appropriate factor as under. In order to capture the
information, banks will need to upgrade their information systems in order

252
to track the number of days after the agreed settlement date and calculate
the corresponding capital charge.

Number of Working Corresponding

Days After the Agreed Risk Multiplier
Settlement Date (in per cent)

From 5 to 15 9
From 16 to 30 50
From 31 to 45 75
46 or more 100
v) For non-DvP transactions (free deliveries) after the first contractual
payment / delivery leg, the bank that has made the payment will treat its
exposure as a loan if the second leg has not been received by the end of the
business day. If the dates when two payment legs are made are the same
according to the time zones where each payment is made, it is deemed that
they are settled on the same day. For example, if a bank in Tokyo transfers
Yen on day X (Japan Standard Time) and receives corresponding US Dollar
via CHIPS on day X (US Eastern Standard Time), the settlement is deemed to
take place on the same value date. Banks shall compute the capital
requirement using the counterparty risk weights prescribed in these
guidelines. However, if five business days after the second contractual
payment / delivery date the second leg has not yet effectively taken place,
the bank that has made the first payment leg will apply 1111% risk weight to
the full amount of the value transferred plus replacement cost, if any. This
treatment will apply until the second payment / delivery leg is effectively
made.

Appendix 8
Minimum requirements under Advanced IRB approach for banks’ own EAD
calculation
Minimum requirements to be met by the banks to calculate own estimate of
EAD under advanced IRB approach are given below.
Standards for all asset classes
1. For on-balance sheet items, banks must estimate EAD at no less than the
current drawn amount, subject to recognising the effects of on-balance
sheet netting as specified in para 87 of the Annex of this guideline. The
minimum requirements for the recognition of netting are the same as those
under the foundation approach. The additional minimum requirements for
internal estimation of EAD under the advanced approach focus on the

253
estimation of EAD for off-balance sheet items (excluding transactions that
expose banks to counterparty credit risk). Advanced IRB banks must have
established procedures in place for the estimation of EAD for off-balance
sheet items. These must specify the estimates of EAD to be used for each
facility type. Banks estimates of EAD should reflect the possibility of
additional drawings by the borrower up to and after the time a default
event is triggered. Where estimates of EAD differ by facility type, the
delineation of these facilities must be clear and unambiguous.
2. Advanced IRB banks must assign an estimate of EAD for each facility. It
must be an estimate of the long-run default-weighted average EAD for
similar facilities and borrowers over a sufficiently long period of time, but
with a margin of conservatism appropriate to the likely range of errors in
the estimate. If a positive correlation can reasonably be expected between
the default frequency and the magnitude of EAD, the EAD estimate must
incorporate a larger margin of conservatism. Moreover, for exposures for
which EAD estimates are volatile over the economic cycle, the bank must
use EAD estimates that are appropriate for an economic downturn, if these
are more conservative than the long run average. For banks that have been
able to develop their own EAD models, this could be achieved by
considering the cyclical nature, if any, of the drivers of such models. Other
banks may have sufficient internal data to examine the impact of previous
recession(s). However, some banks may only have the option of making
conservative use of external data.
3. The criteria by which estimates of EAD are derived must be plausible and
intuitive, and represent what the bank believes to be the material drivers of
EAD. The choices must be supported by credible internal analysis by the
bank. The bank must be able to provide a breakdown of its EAD experience
by the factors it sees as the drivers of EAD. A bank must use all relevant and
material information in its derivation of EAD estimates. Across facility types,
a bank must review its estimates of EAD when material new information
comes to light and at least on an annual basis.
4. Due consideration must be paid by the bank to its specific policies and
strategies adopted in respect of account monitoring and payment
processing. The bank must also consider its ability and willingness to
prevent further drawings in circumstances short of payment default, such as
covenant violations or other technical default events. Banks must also have
adequate systems and procedures in place to monitor facility amounts,
current outstanding against committed lines and changes in outstanding per
borrower and per grade. The bank must be able to monitor outstanding
balances on a daily basis.

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Additional standards for corporate, sovereign, and bank exposures
5. Estimates of EAD must be based on a time period that must ideally cover
a complete economic cycle but must in any case be no shorter than a period
of seven years. If the available observation period spans a longer period for
any source, and the data are relevant, this longer period must be used. EAD
estimates must be calculated using a default weighted average and not a
time-weighted average.

Appendix 10
Purchased Receivables
The treatment of Purchased Receivables under the foundation and
advanced IRB approach is discussed below.
1. This treatment for calculating capital requirements for unexpected loss
will be applicable in cases where the bank has purchased receivables from
other institutions (may be in the form of assignments as well). Ascertaining
capital requirement for corporate purchased receivables will not be allowed
under the advanced IRB approach if the bank is using Foundation IRB
approach for corporate exposures.
2. Before discussing purchased receivables, two conceptual approaches
need to be understood;
• Bottom up approach: This is the more common approach to measure
the risk weighted assets of the banks’ exposure to the corporate
receivables. In this case, receivables can be identified on an individual
borrower (those who actually will service the repayments) basis and
treatment can be same like normal corporate exposure.
• Top down approach: This approach is applied when the receivables
purchased from other entities are not treated individually but
considered to be a part of the pool and risk weighted asset of the pool
as a whole is calculated subject to certain conditions which will be
discussed below in para 4.
3. Risk weighted asset for purchased corporate receivables as per the
Bottom up approach, is similar to the method followed to find out the risk
weighted asset for other corporate exposures. The top down approach may
be used, provided that the purchasing bank’s programme for corporate
receivables complies with both the criteria for eligible receivables and the
minimum operational requirements of this approach as given in this
Appendix and also in para 97 of Appendix 1. Use of the top down approach
towards purchased receivables is limited to situations where it would be an
undue burden on a bank to be subjected to the minimum requirements for
the IRB approach to usual corporate exposures that would otherwise apply.
4. The top down approach can be used subject to obtaining permission from
RBI. RBI may deny the use of the top down approach for purchased

255
corporate receivables depending on the bank’s compliance with minimum
requirements as given in this appendix. In particular, to be eligible for the
proposed ‘top down’ treatment, purchased corporate receivables must
satisfy the following conditions:
• The receivables are purchased from unrelated, third party sellers, and
as such the bank has not originated the receivables either directly or
indirectly.
• The receivables must be generated on an arm’s-length basis between
the seller and the obligor. (as such, intercompany accounts receivable
and receivables subject to contra-accounts between firms that buy and
sell to each other are ineligible.)
• The purchasing bank has a claim on all proceeds from the pool of
receivables or a pro-rata interest in the proceeds commensurate with
its exposure to the pool.
• Concentration limit above which the capital charges must be calculated
using the minimum requirements for the bottom-up approach will be in
terms of size of individual exposure (maximum 1% of the total pool) or
as conveyed to the banks as and when considered necessary)
• The existence of full or partial recourse to the seller of the receivables
does not automatically disqualify a bank from adopting this top down
approach, as long as the cash flows from the purchased corporate
receivables are the primary protection against default risk.

Calculation of Capital Requirements for Default Risk of corporate

purchased receivables, using the top down approach
5. The treatment for Top down approach under foundation and advanced
IRB methods are mentioned below. A bank will be allowed to use IRB
approaches for purchased corporate receivables only if it is allowed by the
RBI to use IRB approaches for normal corporate exposures.
6. Under both the foundation and advanced methods, a bank should group
the qualifying purchased receivables into sufficiently homogeneous pools so
that accurate and consistent estimates of PD and LGD (or expected long run
average loss rate) for default losses and estimates of expected long run
average loss rate for dilution losses can be determined. For this purpose the
grouping should reflect the underwriting practices and the heterogeneity of
the customers of the corporate from which the receivables have been
bought. The purchasing bank must determine whether the data provided by
the seller are consistent with expectations agreed upon by both parties
concerning, for example, the type, volume and on-going quality of
receivables purchased. Where this is not the case, the purchasing bank is
expected to obtain and rely upon more relevant data.

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Foundation IRB approach
7. There may be cases where a bank is not able to calculate reliable
estimate PD for the segmented pools of purchased receivables and there
may also be cases where the bank is able to do so. Treatment under each of
these situations are described below
8. Where a bank is unable to reliably estimate PD for the segmented pools
of purchased corporate receivables, it must estimate the expected long run
average loss rate (EL) for each of the homogeneous segmented pool (The
expected long-run average loss rate must be a bank’s estimate of the
segmented pools’ long-run average annual loss rate for default risk where
the loss rate is expressed as a percentage of the exposure amount (i.e. the
total EAD owed to the bank by all borrowers in the segmented pool of
receivables)). The expected long-run average loss rate must be calculated
for the receivables on a stand-alone basis i.e. without regard to any
assumption of recourse or guarantee from the seller or other parties.
9. There may be instances where the bank is not able to decompose the EL
into reliable estimates of PD and LGD and there may be cases where the
bank is able to do the decomposition properly. The risk components to be
used; in cases where the bank is unable to decompose EL into PD and LGD;
to arrive at the capital requirement for default risk is mentioned below:
(i) (a) If the bank is unable to decompose its EL estimate into its PD
and LGD components in a reliable manner, but it is able to demonstrate that
the exposures are exclusively senior claims to corporate borrowers, it
should determine PD, LGD and EAD as follows:
• LGD = 0.65 and hence;
• PD = EL(expected long run average loss rate)/LGD; and
• EAD = (Outstanding amount for each segmented pool) – (Capital charge
for dilution risk (discussed subsequently) prior to credit risk mitigation)
After determining the risk components as mentioned above, the capital
requirement is found by using the same formula as used for usual corporate
exposure in equation (A) of para115 of the Annex.
(i) (b) If the bank is unable to decompose its EL estimate into its PD
and LGD components in a reliable manner, and it is unable to demonstrate
that the exposures are exclusively senior claims to corporate borrowers, it
should determine PD, LGD and EAD as follows:
• LGD = 1.00;
• PD = EL(expected long run average loss rate); and
• EAD = (Outstanding amount for each segmented pool) – (Capital charge
for dilution risk prior to credit risk mitigation)
10. However, EAD for a revolving purchase facility (e.g. credit card
receivables) will be;
EAD= {Current amount of the receivables purchased + 0.75 of the undrawn

257
purchase commitments – capital for Dilution Risk prior to credit risk
mitigation}.
11. On the other hand, if the purchasing bank is able to estimate PD in a
reliable manner, the risk weight is determined from the corporate risk
weight functions according to the specifications of LGD, M and the
treatment of guarantees under the Foundation Approach.
12. Maturity (M) for drawn amounts will equal the segmented pools’
exposure-weighted average effective maturity. This same value of M will
also be used for any undrawn amounts to which the bank is committed
under a purchased receivables facility, provided that the facility contains
covenants, or other features that protect the purchasing bank against a
significant deterioration in the quality of the future receivables it is required
to purchase over the facility’s term. In the absence of such protection, the
M for undrawn amounts will be calculated as the sum of:
(a) the longest-dated potential receivable under the purchase agreement;
and
(b) the remaining maturity of the purchase facility.

Advanced IRB approach

13. Under the advanced approach, a bank must estimate PD and LGD for
each of the homogeneous segmented pools of purchased corporate
receivables.
14. Where a bank can only reliably estimate one of either the default-
weighted average LGD or average PD for each segmented pool, the bank
may estimate the other required credit risk component based on its
estimate of the expected long-run average loss rate (PD= EL/LGD or
LGD=EL/PD) of the segmented pool. In either case, the LGD should not be
less than the long-run default-weighted average LGD and the bank must be
considering the facts that
• LGD estimate must reflect economic downturn conditions to capture
relevant risk
• There may be significant cyclical variability in loss severities of certain
exposures
EAD and M estimates under the advanced approach for purchased
corporate receivables are the same as those in the foundation approach as
discussed above.

Calculation of capital requirement for Dilution risk

15. Dilution refers to the possibility that the receivable amount is reduced
through cash or non-cash credit to the receivable’s obligor. Examples
include offsets or allowances arising from returns of goods sold, disputes
regarding product quality, possible debts of the borrower to a receivables

258
obligor and any payment or promotional discounts offered by the borrower
(e.g. a credit for cash payments within 30 days)
16. Unless a purchasing bank can demonstrate to RBI that dilution risk is
immaterial, a capital requirement for dilution risk is required for purchased
corporate receivables.
17. For the purposes of calculating the capital requirement for dilution risk
for either segmented pools or individual receivables making up a pool, a
purchasing bank must estimate the expected long-run average annual loss
rate for dilution risk; expressed in percentage of the receivables amount in
the respective pools.
18. A bank may utilise internal or external reference data to estimate an
expected long-run average annual loss rate for dilution risk. However, these
estimates must be calculated on a stand-alone basis without regard to any
assumption of recourse or guarantees from the seller or other parties.
19. For the purpose of calculating the capital requirement for dilution risk,
the corporate IRB risk-weight function must be used, with PD set equal to
the estimate of the expected long-run average annual loss rate and LGD set
to 100 per cent. So the values of PD and LGD should accordingly be put in
equation (A) in para115 to find the capital requirement for Dilution Risk.
20. An appropriate maturity must be used when determining the capital
requirement for dilution risk as per the paras 107-109 of the Annex. If the
bank can demonstrate to RBI that dilution risk is appropriately monitored
and managed so as to be resolved within one year of acquisition of the
purchased receivables, RBI may grant an approval allowing the bank to base
its calculations on a one-year maturity assumption.

Purchase price discounts and first loss protection

21. Where a portion of any purchase price discount is refundable by the
obligor to the seller of the receivables, the refundable amount must be
treated as first loss protection under IRB securitisation framework. Non
refundable purchase price discounts for purchased receivables do not affect
the regulatory capital calculation.
22. When collateral or partial guarantees obtained on purchased
receivables provide first loss protection covering default losses, dilution
losses, or both, they must be recognised as first loss protection under IRB
securitisation framework.

Recognition of guarantees
23. Guarantees for purchased receivables are recognised in the same
manner as other guarantees under the IRB approach. The IRB rules for
guarantees may be applied to guarantees provided by the seller or a third

259
party regardless of whether the guarantee covers default risk, dilution risk
or both.
24. If the guarantee covers a pool’s default risk and dilution risk, the bank
may substitute the risk-weight for an exposure to the guarantor in place of
the relevant pool’s total risk-weight for default and dilution risks.
25. If the guarantee covers only one of the default risk or dilution risk, the
bank may substitute the risk-weight for an exposure to the guarantor in
place of the relevant pool’s risk-weight for the corresponding risk
component. The capital requirement for the non-guaranteed component
must then be added.
26. If a guarantee covers only a portion of the default or dilution risk of a
relevant pool, the uncovered portion must be treated as per the existing
CRM rules for proportional or tranched coverage (i.e. the risk weight of the
uncovered risk components will be added to the risk weights of the covered
risk components).
27. If the guarantee provides protection against dilution risk and the
conditions and operational requirements for recognition of double default
(para 126 of the Annex) are satisfied, the double default framework may be
used by the bank for the calculation of the risk-weighted asset amount for
dilution risk. In this case, the capital charge is the same as that detailed in
paragraph 124 of the Annex with PD0 being equal to the bank’s estimated
EL, LGDg being equal to 100 per cent and maturity determined in accordance
with the procedure for calculation of capital charge for dilution risk as
mentioned above.

Treatment of Purchased Retail Receivables

28. Purchased retail receivables will be subjected to IRB capital charges for
both default risk and if applicable; dilution risk. The underlying receivables
should meet the qualification requirements for retail assets as given in para
132 of this circular. The calculation of unexpected losses (UL) capital
requirement will be as provided in the following paras:

Computation of Risk weighted assets for default risk

Receivables belonging to single retail assets class
29. If the receivables belong to a single retail sub-asset class (e.g. retail
exposure secured by residential properties, Qualifying revolving retail
exposure and other retail exposures), the risk weight may be calculated as
per the treatment applicable to that retail sub-asset class and the respective
risk weight function and correlation factor may be used. The receivables
should have the same standards and qualification requirement as
prescribed for that retail asset sub group. The receivables should be
segmented into homogeneous pools and estimates of PD & LGD may be

260
calculated on a standalone basis without any assumption of recourse or
guarantees from seller or other parties.

Receivables belonging to more than one retail asset subclass (hybrid pools)
30. For purchased receivables containing pools of retail assets belonging to
more than one retail sub-asset class, the purchasing bank should try to
separate the exposure by type of retail sub-asset class and use the risk
weight function (given at para 148 of the Annex of this guideline)
accordingly. However, if the purchasing bank is not able to separate the
purchased receivables, the risk weight function that produces the highest
capital requirement for the exposure types in the receivables pool should be
used.

Computation of Risk weighted assets for dilution risk

31. Dilution refers to the possibility that the receivable amount is reduced
through cash or non cash credits such as return of goods sold, offsets due to
disputes regarding product quality or promotional discounts. Unless a bank
can demonstrate successfully that there is insignificant impact of dilution
risk, it must provide capital for dilution risk.
32. The purchasing bank should estimate the expected long run average
annual loss rate for dilution risk. The expected long run average loss rate is
defined as a percentage of the exposure amount i.e. the total EAD owed to
the bank by all borrowers in the relevant pool of receivables. The loss rate
may be calculated for each homogeneous segment of receivables or at the
level of individual receivables constituting the pool. The bank may utilise
internal or external reference data to calculate the loss rate.
33. The capital may be calculated using the corporate IRB function with PD
equal to EL and LGD equal to 100 per cent. An appropriate maturity must be
used when determining the capital requirement and the minimum maturity
may be one year where the bank has successfully demonstrated that the
dilution risk is appropriately monitored and managed so as to resolve it
within one year of acquisition pf the purchased receivables.
34. When a portion of any purchase price discount is refundable to the
seller, the refundable amount must be treated as first loss protection under
the IRB securitisation framework. Non refundable purchased price discounts
for purchased receivables do not affect the regulatory capital calculation.
When collateral or partial guarantees obtained on purchased receivables
provide first loss protection for default risk or dilution risk or both they must
be recognised as first loss protection under the IRB securitisation
framework.

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Risk mitigation for purchased retail receivables
35. Credit risk mitigants and guarantees will be recognised generally using
the same frame work as given in the IRB framework for corporate
exposures. Guarantees may be provided by seller or third party and will be
treated under the existing IRB framework. Further, for guarantees, following
rules will also apply:
If the guarantee covers default and dilution risk, the bank will
substitute the risk weight for an exposure to the guarantor in place of the
pool’s total risk weight for default and dilution risk.
If the guarantee is only for default risk or dilution risk, the banks
may substitute the risk weight for an exposure to the guarantor only for that
risk component.
ƒ If a guarantee covers only a portion of default and/or dilution risk, the
proportional risk weight for uncovered portion will be added to the risk
weight for covered portion.
36. When the protection against dilution risk has been purchased, the
double default framework may be used for the calculation of the
proportional risk weighted asset component for dilution risk, subject to the
fulfilment of conditions mentioned in the IRB risk framework for use of
Double Default framework. PD, LGD and appropriate maturity should be as
per para 19 of this appendix and the risk weight function mentioned in the
corporate IRB framework for use of Double Default approach should be
utilised for calculation of capital.

Appendix 11
Pillar 3 disclosures
To be compliant with IRB requirements, the banks are required to disclose
certain additional information under Pillar 3. The supplementary disclosure
requirements for this purpose have been given below. In this regard, banks
may be guided by the extant RBI guidelines on Market Discipline under
Basel II.
Table 1
Disclosure on capital adequacy
Quantitative (a) Capital requirements for credit risk:
disclosure Portfolios subject to the IRB approaches, disclosed separately for
each portfolio
(1)Corporate (including SL exposures), sovereign, bank
(2)Residential mortgage
(3)Qualifying revolving retail
(4)Other retail
(5)Others
(6)Securitisation exposures

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 (b) Capital requirement for equity exposures in the IRB approach:
• Equity portfolio subject to market based approach
(1) Equity portfolio subject to simple risk weight method
(2)Equities in the banking book under internal models
method (if banks are using IMA for market risk)
• Equity portfolio under PD/LGD approach
Table 2
Credit Risk: general disclosures requirements
Qualitative (a) The general qualitative disclosure requirement with
Disclosures respect to credit risk, including:
Description of approaches followedand statistical
methods
Quantitative (b)
Disclosures
Table 3
Credit risk: disclosures for portfolios subject to the supervisory risk weights
in the IRB approaches
Quantitative (a) • For exposures subject to the supervisory risk weights in
Disclosures IRB (any SL products subject to supervisory slotting criteria,
exposures which are permitted by RBI to be under
standardised approach, and equities under the simple risk
weight method), the aggregate amount of a bank’s
outstandings in each risk bucket.
Table 4
Credit risk: disclosures for portfolios subject to IRB approaches
Qualitative (a) RBI’s acceptance of approach/ RBI approved transition
Disclosures

(b) Explanation and review of the:

• Structure of internal rating systems and relation between
internal and external ratings, if applicable;
• use of internal estimates other than for IRB capital
purposes;
• process for managing and recognising credit risk
mitigation; and
•Control mechanisms for the rating system including
discussion of independence, accountability, and rating
systems review.
(c)
Description of the internal ratings process, provided
separately for five distinct portfolios:
• Corporate (including SMEs, specialised lending and
purchased corporate receivables), sovereign and bank;
1
•Equities;

263
 •Residential mortgages;

2
• Qualifying revolving retail; and
Other retail.
The description should include, for each portfolio:
• The types of exposure included in the portfolio;
• The definitions, methods and data for estimation and
validation of PD, and (for portfolios subject to the IRB
advanced approach) LGD and/or EAD, including
assumptions employed in the derivation of these
3
variables; and
 Description of deviations as permitted under
paragraph 74- 80 of Appendix 1 from the reference
definition of default where determined to be material,
including the broad segments of the portfolio(s) affected
4
by such deviations.
Quantitative (d) For each portfolio (as defined above) except retail, present
Disclosures: the following information across a sufficient number of PD
Risk grades (including default) to allow for a meaningful
5
assessment differentiation of credit risk:
•Total exposures (for corporate, sovereign and bank,
6
outstanding loans and EAD on undrawn commitments; for
equities, outstanding amount);
• For banks on the IRB advanced approach, exposure-
weighted average LGD (percentage); and Exposure-
weighted average risk-weight.
• For banks on the IRB advanced approach, amount of
undrawn commitments and exposure-weighted average
7
EAD for each portfolio;
8
For each retail portfolio (as defined above), either:
• Disclosures as outlined above on a pool basis (i.e. same
as for non-retail portfolios); or
• Analysis of exposures on a pool basis (outstanding loans
and EAD on commitments) against a sufficient number of
EL grades to allow for a meaningful differentiation of credit
risk.
Quantitative (e) Actual losses (e.g. charge-offs and specific provisions) in
disclosures: the preceding period for each portfolio (as defined above)
Historical and how this differs from past experience. A discussion of
Results the factors that impacted on the loss experience in the
preceding period — for example, has the bank experienced
higher than average default rates, or higher than average
LGDs and EADs.
(f) Banks’ estimates against actual outcomes over a longer

264
 9
period. At a minimum, this should include information on
estimates of losses against actual losses in each portfolio
(as defined above) over a period sufficient to allow for a
meaningful assessment of the performance of the
internal rating processes for each portfolio. Where
appropriate, banks should further decompose this to
provide analysis of PD and, for banks on the advanced IRB
approach, LGD and EAD outcomes against estimates
provided in the quantitative risk assessment disclosures
10
above.

1
Equities need only be disclosed here as a separate portfolio where the
bank uses the PD/LGD approach for equities held in the banking book.
2
In both the qualitative disclosures and quantitative disclosures that
follow, banks should distinguish between the qualifying revolving retail
exposures and other retail exposures unless these portfolios are
insignificant in size (relative to overall credit exposures) and the risk profile
of each portfolio is sufficiently similar such that separate disclosure would
not help users’ understanding of the risk profile of the banks’ retail
business.
3
This disclosure does not require a detailed description of the model in
full. It should provide the reader with a broad overview of the model
approach, describing definitions of the variables, and methods for
estimating and validating those variables set out in the quantitative risk
disclosures below. This should be done for each of the five portfolios. Banks
should draw out any significant differences in approach to estimating these
variables within each portfolio.
4
This is to provide the reader with context for the quantitative
disclosures that follow. Banks need only to describe main areas where there
has been material divergence from the reference definition of default such
that it would affect the readers’ ability to compare and understand the
disclosure of exposures by PD grade.
5
The PD, LGD and EAD disclosures here should reflect the effects of
collateral, netting and guarantees/credit derivatives, where recognised as
per this guideline. Disclosure of each PD grade should include the exposure
weighted-average PD for each grade. Where banks are aggregating PD
grades for the purposes of disclosure, this should be a representative
breakdown of the distribution of PD grades used in the IRB approach.
6
Outstanding loans and EAD on undrawn commitments can be presented
on a combined basis for these disclosures.
7
Banks need only to provide one estimate of EAD for each portfolio.
However, where banks believe it is helpful, in order to give a more
meaningful assessment of risk, they may also disclose EAD estimates across

265
a number of EAD categories, against the undrawn exposures to which these
relate.
8
Banks would normally be expected to follow the disclosures provided for
the non-retail portfolios. However, banks may choose to adopt EL grades as
the basis of disclosure where they believe this can provide the reader with a
meaningful differentiation of credit risk. Where banks are aggregating
internal grades (either PD/LGD or EL) for the purposes of disclosure, this
should be a representative breakdown of the distribution of those grades
used in the IRB approach.
9
These disclosures are a way of further informing the reader about the
reliability of the information provided in the “quantitative disclosures: risk
assessment” over the long run.
10
Banks should provide this further decomposition where it will allow users
greater insight into the reliability of the estimates provided in the
‘quantitative disclosures: risk assessment’. In particular, banks should
provide this information where there are material differences between the
PD, LGD or EAD estimates given by banks compared to actual outcomes
over the long run. Banks should also provide explanations for such
differences.
Table 5
Securitisation: disclosure for IRB approaches
Qualitative (a) The regulatory capital approaches (e.g. RBA and SFA) that the
Disclosures bank follows for its securitisation activities.
Quantitative (b) Aggregate amount of securitisation exposures retained or
Disclosure purchased and the associated IRB capital charges for these
exposures broken down into a meaningful number of risk
weight bands. Exposures that have been deducted from
common equity should be disclosed separately by type of
underlying asset.

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 Chapter-4

MARKET RISK MANAGEMENT

Introduction
The Indian financial markets, in the last few years have seen wide ranging
changes due to the deregulation of interest rate and foreign exchange
markets. Intense competition for business coupled with increasing volatility
in the domestic interest rates as well as foreign exchange rates have
brought pressure on banks to maintain a balance among spreads,
profitability and long-term viability. Banks have to base their business
decisions on a dynamic and integrated risk management system and
process, driven by corporate strategy. Further, the Core Principles for
Effective Banking Supervision (Principles 11, 12 and 13) of the Basel
Committee on Banking Supervision (BCBS) of the Bank for International
Settlements (BIS) mandate that Supervisors must be satisfied that banks
have adequate policies and procedures for identifying, monitoring and
controlling credit, market, operational, country and transfer risks. It is thus
essential that the banks adopt a more structured and comprehensive
approach to Market Risk Management.
Market Risk Management provides a comprehensive and dynamic
framework for measuring, monitoring and managing liquidity, interest rate,
foreign exchange and equity and commodity price risks of a bank that needs
to be closely integrated with the bank’s business strategy. Accordingly, the
Reserve Bank of India (RBI) vide circular (DBOD. No. BP.BC.8/21.04.098/99)
dated February 10, 1999 has issued guidelines on the implementation of the
Asset-Liability Management (ALM) system in banks. These guidelines were
implemented effective April 1, 1999. This was supplemented with detailed
operative Guidelines on Risk Management Systems issued in October 1999,
covering broad contours for management of credit, liquidity, interest rate,
forex and operational risks. These guidelines, together with the ALM
guidelines were purported to serve as a benchmark to those banks, which
have not established integrated risk management systems.
Market risk refers to the risk to a bank resulting from movements in
market prices in particular changes in interest rates, foreign exchange
rates and equity and commodity prices. In simpler terms, it may be defined
as the possibility of loss to a bank caused by changes in the market
variables. The Bank for International Settlements (BIS) defines market risk
as “the risk that the value of ‘on’ or ‘off’ balance sheet positions will be
adversely affected by movements in equity and interest rate markets,
currency exchange rates and commodity prices”. Thus, Market Risk is the
risk to the bank’s earnings and capital due to changes in the market level of

267
interest rates or prices of securities, foreign exchange and equities, as well
as, the volatilities of those changes. Even a small change in market variables
causes substantial changes in income and economic value of banks. The
market risk takes the form of:
1. Liquidity Risk
2. Interest Rate Risk
3. Foreign Exchange Rate Risk (Forex) Risk
4. Commodity Price Risk and
5. Equity Price Risk
The above mentioned forms of market risks are discussed in subsequent
chapters in detail. Market Risk Management of a bank thus involves
management of interest rate risk, foreign exchange risk, commodity price
risk and equity price risk. Besides, it is equally concerned about the bank’s
ability to meet its obligations as and when they fall due. In other words, it
should be ensured that the bank is not exposed to Liquidity Risk. This
Guidance Note would, thus, focus on the management of Liquidity Risk and
Market Risk, further categorized into interest rate risk, foreign exchange
risk, commodity price risk and equity price risk.

Market Risk Management Policy Framework

All banks should establish specific policies on market risk management. The
policies should represent minimum requirements for the bank including
approval levels and requirements for any exceptions, deviations or waivers.
The policies should cover the following minimum requirements.

The responsibilities of Market Risk Management Committee

- setting policies and guidelines for market risk measurement,
management and reporting
- ensuring that market risk management processes (including people,
systems, operations, limits and controls) satisfy bank’s policy
- reviewing and approving market risk limits, including triggers or stop-
losses for traded and accrual portfolios
- ensuring certification of financial models – through appointment of
qualified and competent staff – and the effectiveness of all systems
used to calculate market risk
- appointment of independent market risk manager/s, etc.

The responsibilities of Risk Taking Unit and Line Management:

• managing all aspects of market risk in accordance with approved
policies as established by Risk Policy Committee
• ensuring that people in the Risk Taking Unit have the capability and
capacity to meet their business objectives

268
• operating each Risk Taking Unit at all times at acceptable levels as
defined by internal audits and self-assessments
• maintaining independent checks and balances through Operations
(back-office)
• maintaining the integrity of financial reporting through financial control
department
• establishing a process to identify all market risk
• operating within approved Price and Liquidity Risk limits, etc.

The Responsibilities of Market Risk Manager:

• ensuring that Traders and Operations (back-office) are properly
applying all policies and procedures with respect to market risk
• immediately advising Line Management and if material, the Risk Policy
Committee, should any of those policies and procedures not be
observed, and reducing or curtailing business activity until they have
been restored
• ensuring that usage of risk limits accurately reflects current or
expected market conditions by making changes, amending the
volatility used incalculation of Value-At-Risk to capture changes in
market liquidity

Risk Identification
- All Risk Taking Units must operate within an approved, current Market
Risk Product Programme; this should define procedures, limits and
controls for all aspects of the product.
- New products may operate under a Product Transaction Memorandum
on a temporary, not more than one year, basis while a full Market Risk
Product Programme is being prepared. At the minimum this should
include procedures, limits and controls. The final product transaction
program should include market risk measurement at an individual
product and aggregate portfolio level.

Limits and Triggers

- All trading transactions will be booked on systems capable of accurately
calculating relevant sensitivities on a daily basis; usage of Sensitivity and
Value at Risk limits for trading portfolios and limits for accrual portfolios
(as prescribed for ALM) must be measured daily. Where market risk is
not measured daily, Risk Taking Units must have procedures that
monitor activity to ensure that they remain within approved limits at all
times.
- Mandatory market risk limits are required for Factor Sensitivities and
Value at Risk for mark to market trading and appropriate limits (to be

269
 determined) for accrual positions including Available-for-Sale portfolios.
Requests for limits will be submitted annually for approval by the Risk
Policy Committee. The approval will take into consideration the Risk
Taking Unit's capacity and capability to perform within those limits
evidenced by the experience of the Traders, controls and risk
management, audit ratings and trading revenues.
- Approved Management Action Triggers or Stop-loss are required for all
mark to market risk taking activities.
- Risk Taking Units are expected to apply additional, appropriate market
risk limits, including limits for basis risk, to the products involved; these
will be detailed in the Market Risk Product Programme.

Trading
1 All trading activities will be conducted on an arm’s length basis in a
manner conforming to applicable legal, tax, regulatory and accounting
provisions of the country as well as to bank’s own internal policies and
procedures.
2 Traders may only enter into transactions with counterparties or trade in
secondary market debt, equity and forex instruments if the
counterparties and the issuers have been approved. All transactions will
be executed at market rates, prevailing at the time the transaction was
entered into. All transactions must have complete documentation, both
for the transaction and for the counterparty; sales of derivative and
structured products must comply with requirements for Suitability and
Appropriateness.
3 Brokers must be on an annually approved list maintained by Risk Taking
Unit.
- All deals, external and internal, must represent an actual economic
market transaction to which the Risk Taking Unit is a party. Each deal
must be approved by a properly authorised trader. Deals are to be
recorded immediately. Confirmations must be sent to and received
from counterparties for all transactions; all aspects of the confirmation
process must be handled independently by Operations. Where
required, each Risk Taking Unit is required to install a specific approval
process for both off premises trading and after hours trading; those
Traders authorised to carry out such trading must be approved
individually.
- All involved in trading are expected to remain within approved limits
and triggers for market risk, credit risk and liquidity risk. Market risk
limits and triggers are allocated to individual Risk Taking Units, and may
not be reallocated. The bank should decide on the ratification
procedure for inadvertent limit excesses and the time limit within which

270
 the elimination of inadvertent limit excesses should be carried out.

Risk Monitoring
- A rate reasonability process is required to ensure that all transactions
are executed and revalued at prevailing market rates; rates used at
inception or for periodic marking to market for risk management or
accounting purposes must be independently verified.
- Financial Models used for revaluations for income recognition purposes
or to measure or monitor Price Risk must be independently tested and
certified.
- Stress tests must be performed at least quarterly for both trading and
accrual portfolios.

Funding and Liquidity

- Funding and liquidity management is both a business and a corporate
responsibility performed by the Asset-Liability Management Committee
(ALCO) and with oversight by the Risk Management Committee.
- A Liquidity and Capital Plan including Liquidity Limits and a Contingency
Funding Plan are required for each legal vehicle in the country, together
with where appropriate Liquidity ratios, limits on Large Funds Providers,
and limits on Cross Currency Funding.
- A Liquidity and Capital Plan must be submitted annually and
Contingency Funding Plans quarterly; Contingency Funding Plans should
not show a deficit for short tenors.

Models of analysis
 Line Management must ensure that the software used in Financial
Models that value positions or measure market risk has independent
certification that it is performing appropriate calculations accurately.
 The Risk Policy Committee is responsible for administering the model
control and certification policy, providing technical advice through
qualified and competent personnel, and maintaining a register of
qualified certifiers.
 Financial Models must be fully documented to qualify for certification
and minimum standards of documentation must be established.
 Certification of models must be performed by someone other than the
person who wrote the software code; testers must be competent in
designing and conducting tests; records of testing must be kept,
including details of the type of tests and their results. Assumptions
contained in the Financial Models must be documented as part of the
initial certification and reviewed annually by a qualified validator.
Unusual parameter sourcing conventions require annual approval by

271
 the Risk Policy Committee.
 Any mathematical model which uses theory, formulae or numerical
techniques involving more than simple arithmetic operations must be
validated to ensure that the algorithm employed is appropriate and
accurate.
 Models must be validated in writing by persons who are acceptable to
the Risk Policy Committee and independent of the area creating the
model.
 Models to calculate risk measures like Sensitivities to market factors
either at transaction or portfolio level and Value-at-Risk should be
certified independently as per the model control and certification
policy.
 Unauthorised or unintended changes cannot be made to the models.
These standards should also apply to models that are run on
spreadsheets until development of fully automated processors for
generating valuations and produce risk measurements.
 The models should also be subject to model assumption review on a
periodic basis. The purpose of this review is to ensure applicability of
the model over time and that the model is valid for its original intended
use. The review consists of evaluating the components of the financial
model and the underlying assumptions, if any.

Risk Reporting: Risk report should enhance risk communication across

different levels of the firm, from the trading desk to the CEO. In order of
importance, senior management reports should be timely be reasonably
accurate highlight portfolio risk concentrations include written commentary,
and be concise.

Organisational Set Up
Management of market risk should be the major concern of top
management of banks. The Boards should clearly articulate market risk
management policies, procedures, prudential risk limits, review mechanisms
and reporting and auditing systems. The policies should address the bank’s
exposure on a consolidated basis and clearly articulate the risk
measurement systems that capture all material sources of market risk and
assess the effects on the bank. The operating prudential limits and the
accountability of the line management should also be clearly defined. The
Asset-Liability Management Committee (ALCO) should function as the top
operational unit for managing the balance sheet within the
performance/risk parameters laid down by the Board.
Successful implementation of any risk management process has to emanate
from the top management in the bank and its strong commitment to

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integrate basic operations and strategic decision making with risk
management. Ideally, the organization set up for Market Risk Management
should be as under:-
o The Board of Directors
o The Risk Management Committee
o The Asset-Liability Management Committee (ALCO)
o The ALM support group/ Market Risk Group
i) The Board of Directors should have the overall responsibility for
management of risks. The Board should decide the risk management
policy of the bank and set limits for liquidity, interest rate, foreign
exchange and equity price risks.
ii) The Asset-Liability Management Committee, popularly known as ALCO
should be responsible for ensuring adherence to the limits set by the
Board as well as for deciding the business strategy of the bank in line
with bank’s budget and decided risk management objectives. The ALCO
is a decision-making unit responsible for balance sheet planning from
risk-return perspective including strategic management of interest rate
and liquidity risks. The role of the ALCO should include, inter alia, the
following :-
 product pricing for deposits and advances deciding on desired maturity
profile and mix of incremental assets and liabilities
 articulating interest rate view of the bank and deciding on the future
business strategy
 reviewing and articulating funding policy
 reviewing economic and political impact on the balance sheet
The ALCO will be responsible for ensuring the adherence to the limits set by
the Board of Directors. The ALCO will also decide the transfer pricing policy
of the bank. The ALCO will comprise of the Managing Director, heads of
various divisions and other senior personnel involved with the ALM process.
The ALM Support Groups consisting of operating staff should be responsible
for analysing, monitoring and reporting the risk profiles to the ALCO. The
Risk management group should prepare forecasts (simulations) showing the
effects of various possible changes in market conditions related to the
balance sheet and recommend the action needed to adhere to bank’s
internal limits, etc.

Composition of ALCO
The size (number of members) of ALCO would depend on the size of each
institution, business mix and organisational complexity. To ensure
commitment of the Top Management and timely response to market
dynamics, the CEO/CMD or the ED should head the Committee. The Chiefs
of Investment, Credit, Resources Management or Planning, Funds

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Management / Treasury (forex and domestic), International Banking and
Economic Research can be members of the Committee. In addition, the
Head of the Technology Division should also be an invitee for building up of
MIS and related computerisation. Some banks may even have Sub-
committees and Support Groups.

The Middle Office

The Middle Office is responsible for the critical functions of independent
market risk monitoring, measurement, analysis and reporting for the bank's
ALCO. Ideally this is a full time function reporting to, or encompassing the
responsibility for, acting as ALCO's secretariat. An effective Middle Office
provides the independent risk assessment which is critical to ALCO's key-
function of controlling and managing market risks in accordance with the
mandate established by the Board/Risk Management Committee. It is a
highly specialised function and must include trained and competent staff,
expert in market risk concepts. The methodology of analysis and reporting
will vary from bank to bank depending on their degree of sophistication and
exposure to market risks. These same criteria will govern the reporting
requirements demanded of the Middle Office, which may vary from simple
gap analysis to computedsed VaR modelling. Middle Office staff may
prepare forecasts (simulations) showing the effects of various possible
changes in market conditions related to risk exposures. Banks using VaR or
modelling methodologies should ensure that its ALCO are aware of and
understand the nature of the output, how it is derived, assumptions and
variables used in generating the outcome and any shortcomings of the
methodology employed. Segregation of duties principles must be evident in
this function which must report to ALCO independently of the treasury
function.
Bank's without formal Middle Offices must for banks without a formal
Middle Office, it should be ensured that risk control and analysis should rest
with a department with clear reporting independence from Treasury or risk
taking units, until formal Middle Office frameworks are established.

The Dealing Room

The Treasury Dealing Room within a bank is generally the clearinghouse for
matching, managing and controlling market risks. It may provide funding,
liquidity and investment support for the assets and liabilities generated by
regular business of the bank. The Dealing Room is responsible for the proper
management and control of market risks in accordance with the authorities
granted to it by the bank's Risk Management Committee. The Dealing Room
also is responsible for meeting the needs of business units in pricing market
risks for application to its products and services. The Dealing Room acts as

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the bank's interface to international and domestic financial markets and
generally bears responsibility for managing market risks in accordance with
instructions received from the bank's Risk Management committee.
The Dealing Room may also have allocated to it by Risk Management
Committee, a discretionary limit within which it may take market risk on a
proprietary basis. For these reasons effective control and supervision of
bank's Dealing Room activities is critical to its effectiveness in managing and
controlling market risks.
Critical to a Dealing Room's effective functioning is all dealer's access to a
comprehensive Dealing Room manual covering all aspects of their day to
day activities. All dealers active in day to day trading activities must
acknowledge familiarity with and provide an undertaking in writing to
adhere to the bank's dealing guidelines and procedures. A Dealing Room
procedures manual should be comprehensive in nature covering operating
procedures for all the bank’s trading activities in which the Dealing Room is
involved and in particular must cover the bank's requirements in respect of:
 Code of Conduct - all dealers active in day to day trading activities in
the Indian market must acknowledge familiarity with and provide an
undertaking to adhere to FEDAI code of conduct (and FIMMDA when
available).
 Adherence to Internal Limits - All dealers must be aware of,
acknowledge and provide an undertaking to adhere to the limits
governing their authority to commit the bank to risk exposures as they
apply to their own particular risk responsibilities and level of seniority.
 Adherence to RBI limits and guidelines - All dealers must acknowledge
and provide an undertaking to adhere to their responsibility to remain
within RBI limits and guidelines in their area of activity.
 Dealing with Brokers - All dealers should be aware of, acknowledge and
provide an undertaking to remain within the guidelines governing the
bank's activities with brokers including conducting business only with
brokers authorised by bank's Risk Management Committee on the
bank's Brokers Panel
 Ensuring their activities with brokers do not allow for the brokers to act
as principals in transactions but remain strictly in their authorised role
as market intermediaries
 Requiring brokers to provide all brokers notes and confirmations of
transactions before close of business each day (or exceptionally by the
beginning of the next business day, in which case the note must be
prominently marked by the broker as having been transacted the
previous day, and the Back Office must recast the previous night's
position against limits reports) to the bank's Back Office for
reconciliation with transaction data.

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 Ensuring all brokerage payments and statements are received.
reconciled and paid by the bank's Back Office department and under no
circumstances authorised or any payment released by dealers
 Prohibiting the acceptance by dealers of gifts, gratifications or other
favours from brokers, instances of which should be reported in detail to
RBI’s Department of Banking Supervision indicating the nature of the
case
 Prohibiting dealers from nominating a broker in transactions not done
through that broker.
 Rules for the prompt investigation of complaints against dealers and
malpractices by brokers and reporting to FEDAI and RBI’s Department
of Banking Supervision.
 Dealing Hours - All Dealers should be aware of the bank's normal
trading hours, cut off time for overnight positions and rules governing
after hours and off-site trading (if allowed by the bank)
 Security and Confidentiality - All dealers should be aware of the bank's
requirements in respect of maintaining confidentiality over its own and
its customers' trading activities as well as the responsibility for secure
maintenance of access media, keys, passwords and PINS.
 Staff Rotation and leave requirements - All dealers should be aware of
the requirement to take at least one period of leave of not less than 14
days continuously per annum, and the bank's internal policy in regards
to staff rotation.

The Back Office:

The key controls over market risk activities, and particularly over Dealing
Room activities, exist in the Back Office. It is critical that both a clear
segregation of duties and reporting lines is maintained between Dealing
Room staff and Back Office staff, as well as clearly defined physical and
systems access between the two areas. It is essential that critical Back
Office controls are executed diligently and completely at all times
including:
 The control over confirmations both inward and outward: All
confirmations for transactions concluded by the Dealing Room must be
issued and received by the Back Office only. Discrepancies in
transaction details, non-receipts and receipts of confirmations without
application must be resolved promptly to avoid instances of unrecorded
risk exposure.
 The control over dealing accounts (vostros and nostros)- Prompt
reconciliation of all dealing accounts is an essential control to ensure
accurate identification of risk exposures. Discrepancies, non-receipts
and receipts of funds without application must be resolved promptly to

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 avoid instances of unrecorded risk exposure. Unreconciled items and
discrepancies in these accounts must be kept under heightened
management supervision as such discrepancies may at times have
significant liquidity impacts, represent unrecognised risk exposures, or
at worst represent collusion or fraud.
 Revaluations and marking-to-market of market risk exposures: All
market rates used by the bank for marking risk exposures to market,
used to revalue assets or for risk analysis models such as Value at Risk
analysis, must be sourced independently of the Dealing Room to
provide an independent risk and performance assessment. If the bank
has an established and independent Middle Office function, this
responsibility may properly pass to the Middle Office.
 Monitoring and reporting of risk limits and usage: Reporting of usage
of risk against limits established by the Risk Management Committee
(as well as Credit Department for Counterparty risk limits) should be
maintained by the Back Office independently of the Dealing Room.
Maintenance of all limit systems must also be undertaken by the Back
Office and access to limit systems (such as counterparty limits,
overnight limits etc.) must be secure from access and tampering by
unauthorised personnel. If the bank has an established and
independent Middle Office function, this responsibility may properly
pass to the Middle Office.
 Control over payments systems: The procedures and systems for
making payments must be under at least dual control in the Back Office
independent from the dealing function. Payments systems should be at
all times secure from access or tampering by unauthorised personnel.

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 Chapter-5

LIQUIDITY RISK MANAGEMENT

Introduction
Liquidity risk is the potential inability to meet the bank’s liabilities as they
become due. It arises when the banks are unable to generate cash to cope
with a decline in deposits or increase in assets. It originates from the
mismatches in the maturity pattern of assets and liabilities. Measuring and
managing liquidity needs are vital for effective operation of commercial
banks. By assuring a bank’s ability to meet its liabilities as they become due,
liquidity management can reduce the probability of an adverse situation
developing.
Analysis of liquidity risk involves the measurement of not only the liquidity
position of the bank on an ongoing basis but also examining how funding
requirements are likely to be affected under crisis scenarios. Net funding
requirements are determined by analysing the bank’s future cash flows
based on assumptions of the future behaviour of assets and liabilities that
are classified into specified time buckets and then calculating the
cumulative net flows over the time frame for liquidity assessment. Future
cash flows are to be analysed under “what if” scenarios so as to assess any
significant positive / negative liquidity swings that could occur on a day-to-
day basis and under bank specific and general market crisis scenarios.
Factors to be taken into consideration while determining liquidity of the
bank’s future stock of assets and liabilities include their potential
marketability, the extent to which maturing assets /liability will be renewed,
the acquisition of new assets / liability and the normal growth in asset /
liability accounts. Factors affecting the liquidity of assets and liabilities of
the bank cannot always be forecast with precision; hence they need to be
reviewed frequently to determine their continuing validity, especially given
the rapidity of change in financial markets.
Liquidity risk for banks mainly manifests on account of the following:
(i) Funding Liquidity Risk – the risk that a bank will not be able to
meet efficiently the expected and unexpected current and future cash flows
and collateral needs without affecting either its daily operations or its
financial condition.
(ii) Market Liquidity Risk – the risk that a bank cannot easily offset or
eliminate a position at the prevailing market price because of inadequate
market depth or market disruption.
The recent events have brought to the fore several deficiencies in liquidity
risk management by banks, which include insufficient holdings of liquid

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assets, funding risky or illiquid asset portfolios with potentially volatile short
term liabilities, and a lack of meaningful cash flow projections and liquidity
contingency plans. After the global financial crisis, in recognition of the
need for banks to improve their liquidity risk management, the Basel
Committee on Banking Supervision (BCBS) published “Principles for Sound
Liquidity Risk Management and Supervision” in September 2008. While the
complete document is enclosed as Appendix I, the broad principles for
sound liquidity risk management by banks as envisaged by BCBS are as
under:
Fundamental principle for the management and supervision of liquidity
risk
Principle 1 A bank is responsible for the sound management of
liquidity risk. A bank should establish a robust liquidity
risk management framework that ensures it maintains
sufficient liquidity, including a cushion of
unencumbered, high quality liquid assets, to withstand a
range of stress events, including those involving the loss
or impairment of both unsecured and secured funding
sources. Supervisors should assess the adequacy of both
a bank’s liquidity risk management framework and its
liquidity position and should take prompt action if a
bank is deficient in either area in order to protect
depositors and to limit potential damage to the financial
system.risk management
Governance of liquidity
Principle 2 A bank should clearly articulate a liquidity risk tolerance
that is appropriate for its business strategy and its role in
the financial system.
Principle 3 Senior management should develop a strategy, policies
and practices to manage liquidity risk in accordance with
the risk tolerance and to ensure that the bank maintains
sufficient liquidity. Senior management should continuously
review information on the bank’s liquidity developments
and report to the board of directors on a regular basis.
A bank’s board of directors should review and approve the
strategy; policies and practices related to the management
of liquidity at least annually and ensure that senior
management manages liquidity risk effectively.

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Principle 4 A bank should incorporate liquidity costs, benefits and
risks in the internal pricing, performance measurement
and new product approval process for all significant
business activities (both on- and off-balance sheet),
thereby aligning the risk-taking incentives of
individual business lines with the liquidity risk
exposures their activities create for the bank as a whole.
Measurement and management of liquidity risk
Principle 5 A bank should have a sound process for identifying,
measuring, monitoring and controlling liquidity risk. This
process should include a robust framework for
comprehensively projecting cash flows arising from
assets, liabilities and off-balance sheet items over an
appropriate set of time horizons.
Principle 6 A bank should actively monitor and control liquidity
risk exposures and funding needs within and across
legal entities, business lines and currencies, taking into
account legal, regulatory and operational limitations to
the transferability of liquidity.
Principle 7 A bank should establish a funding strategy that provides
effective diversification in the sources and tenor of
funding. It should maintain an ongoing presence in its
chosen funding markets and strong relationships with
funds providers to promote effective diversification of
funding sources. A bank should regularly gauge its
capacity to raise funds quickly from each source. It
should identify the main factors that affect its ability to
raise funds and monitor those factors closely to ensure
that estimates of fund raising capacity remain valid.
Principle 8 A bank should actively manage its intraday liquidity
positions and risks to meet payment and settlement
obligations on a timely basis under both normal and
stressed conditions and thus contribute to the smooth
functioning of payment and settlement systems.
Principle 9 A bank should actively manage its collateral positions,
di f fer ent i a ti n g between encumbered and
unencumbered assets. A bank should monitor the
legal entity and physical location where collateral is held
and how it may be mobilised in a timely manner.

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Principle 10 A bank should conduct stress tests on a regular basis for
a variety of short-term and protracted institution-
specific and market-wide stress scenarios (individually
and in combination) to identify sources of potential
liquidity strain and to ensure that current exposures
remain in accordance with a bank’s established liquidity
risk tolerance. A bank should use stress test outcomes to
adjust its liquidity risk management strategies, policies,
and positions and to develop effective contingency plans.
Principle 11 A bank should have a formal contingency funding plan
(CFP) that clearly sets out the strategies for addressing
liquidity shortfalls in emergency situations. A CFP
should outline policies to manage a range of stress
environments, establish clear lines of responsibility,
include clear invocation and escalation procedures and
be regularly tested and updated to ensure that it is
operationally robust.
Principle 12 A bank should maintain a cushion of unencumbered,
high quality liquid including those that involve the
loss or impairment of unsecured and typically
available secured funding sources. There should be no
legal, regulatory or operational impediment to using
these assets to obtain funding.
Public disclosure
Principle 13 A bank should publicly disclose information on a regular
basis that enables market participants to make an
informed judgment about the soundness of its liquidity
risk management framework and liquidity position.
Thus, a sound liquidity risk management system would envisage that:
i) A bank should establish a robust liquidity risk management
framework.
ii) The Board of Directors (BoD) of a bank should be responsible for
sound management of liquidity risk and should clearly articulate a
liquidity risk tolerance appropriate for its business strategy and its role
in the financial system.
iii) The BoD should develop strategy, policies and practices to
manage liquidity risk in accordance with the risk tolerance and
ensure that the bank maintains sufficient liquidity. The BoD should
review the strategy, policies and practices at least annually.

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iv) Top management/ALCO should continuously review information on
bank’s liquidity developments and report to the BoD on a regular basis.
v) A bank should have a sound process for identifying, measuring,
monitoring and controlling liquidity risk, including a robust framework
for comprehensively projecting cash flows arising from assets, liabilities
and off-balance sheet items over an appropriate time horizon.
vi) A bank’s liquidity management process should be sufficient to meet its
funding needs and cover both expected and unexpected deviations
from normal operations.
vii) A bank should incorporate liquidity costs, benefits and risks in
internal pricing, performance measurement and new product
approval process for all significant business activities.
viii) A bank should actively monitor and manage liquidity risk exposure
and funding needs within and across legal entities, business lines
and currencies, taking into account legal, regulatory and operational
limitations to transferability of liquidity.
ix) A bank should establish a funding strategy that provides effective
diversification in the source and tenor of funding, and maintain
ongoing presence in its chosen funding markets and counterparties,
and address inhibiting factors in this regard.
x) Senior management should ensure that market access is being
actively managed, monitored, and tested by the appropriate staff.
xi) A bank should identify alternate sources of funding that
strengthen its capacity to withstand a variety of severe bank specific
and market-wide liquidity shocks.
xii) A bank should actively manage its intra-day liquidity positions and
risks.
xiii) A bank should actively manage its collateral positions.
xiv) A bank should conduct stress tests on a regular basis for short-
term and protracted institution-specific and market-wide stress
scenarios and use stress test outcomes to adjust its liquidity risk
management strategies, policies and position and develop effective
contingency plans.
xv) Senior management of banks should monitor for potential liquidity
stress events by using early warning indicators and event triggers.
Early warning signals may include, but are not limited to, negative
publicity concerning an asset class owned by the bank, increased
potential for deterioration in the bank’s financial condition,
widening debt or credit default swap spreads, and increased
concerns over the funding of off- balance sheet items.
xvi) To mitigate the potential for reputation contagion, a bank should
have a system of effective communication with counterparties,

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 credit rating agencies, and other stakeholders when liquidity
problems arise.
xvii) A bank should have a formal contingency funding plan (CFP) that
clearly sets out the strategies for addressing liquidity shortfalls in
emergency situations. A CFP should delineate policies to manage a
range of stress environments, establish clear lines of responsibility,
and articulate clear implementation and escalation procedures.
xviii) A bank should maintain a cushion of unencumbered, high quality
liquid assets to be held as insurance against a range of liquidity stress
scenarios.
xix) A bank should publicly disclose its liquidity information on a regular
basis that enables market participants to make an informed judgment
about the soundness of its liquidity risk management framework and
liquidity position.
Certain critical issues in respect of the bank’s liquidity risk management
systems and the related guidance are as follows:

Governance of Liquidity Risk Management

The Reserve Bank had issued guidelines on Asset Liability Management
(ALM) system, covering inter alia liquidity risk management system, in
February 1999 and October 2007. Successful implementation of any risk
management process has to emanate from the top management in the bank
with the demonstration of its strong commitment to integrate basis
operations and strategic decision making with risk management. Ideally, the
organisational set up for liquidity risk management should be as under:
* The Board of Directors (BoD)
* The Risk Management Committee
* The Asset-Liability Management Committee (ALCO)
* The Asset Liability Management (ALM) Support Group
The BoD should have the overall responsibility for management of
liquidity risk. The Board should decide the strategy, policies and
procedures of the bank to manage liquidity risk in accordance with the
liquidity risk tolerance/limits as detailed in paragraph 14. The risk
tolerance should be clearly understood at all levels of management. The
Board should also ensure that it understands the nature of the liquidity
risk of the bank including liquidity risk profile of all branches, subsidiaries
and associates (both domestic and overseas), periodically reviews
information necessary to maintain this understanding, establishes
executive-level lines of authority and responsibility for managing the
bank’s liquidity risk, enforces management’s duties to identify, measure,
monitor, and manage liquidity risk and formulates/reviews the contingent
funding plan.

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The Risk Management Committee, which reports to the Board,
consisting of Chief Executive Officer (CEO)/Chairman and Managing Director
(CMD) and heads of credit, market and operational risk management
committee should be responsible for evaluating the overall risks faced by
the bank including liquidity risk. The potential interaction of liquidity risk
with other risks should also be included in the risks addressed by the risk
management committee.
The Asset-Liability Management Committee (ALCO) consisting of the
bank’s top management should be responsible for ensuring adherence to
the risk tolerance/limits set by the Board as well as implementing the
liquidity risk management strategy of the bank in line with bank’s decided
risk management objectives and risk tolerance.
To ensure commitment of the top management and timely response to
market dynamics, the CEO/CMD or the Executive Director (ED) should head the
Committee. The Chiefs of Investment, Credit, Resource Management or
Planning, Funds Management / Treasury (forex and domestic), International
Banking and Economic Research may be members of the Committee.
In addition, the Head of the Technology Division should also be an invitee
for building up of MIS and related computerization. Some banks may even
have Sub-Committee and Support Groups. The size (number of members)
of ALCO would depend on the size of each institution, business mix and
organizational complexity.
The role of the ALCO with respect to the liquidity risk should include,
inter alia, the following:-
i. Deciding on desired maturity profile and mix of incremental assets
and liabilities.
ii. Deciding on source and mix of liabilities or sale of assets. Towards
this end, it will have to develop a view on future direction of interest
rate movements and decide on funding mixes between fixed v/s
floating rate funds, wholesale v/s retail deposits, money market
v/s capital market funding, domestic v/s foreign currency funding,
etc. ALCO should be aware of the composition, characteristics and
diversification of the bank’s assets and funding sources and should
regularly review the funding strategy in the light of any changes in the
internal or external environments.
iii. Determining the structure, responsibilities and controls for
managing liquidity risk and for overseeing the liquidity positions of all
branches and legal entities like subsidiaries, joint ventures and
associates in which a bank is active, and outline these elements
clearly in the bank’s liquidity policy.
iv. Ensuring operational independence of Liquidity Risk Management
function, with adequate support of skilled and experienced officers.

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v. Ensuring adequacy of cash flow projections and the assumptions
used.
vi. Reviewing the stress test scenarios including the assumptions as
well as the results of the stress tests and ensuring that a well
documented contingency funding plan is in place which is reviewed
periodically.
vii. Deciding the transfer pricing policy of the bank and making liquidity
costs and benefits an integral part of bank’s strategic planning.
viii. Regularly reporting to the BoD and Risk Management Committee on
the liquidity risk profile of the bank.
ALCO should have a thorough understanding of the close links between
funding liquidity risk and market liquidity risk, as well as how other risks
including credit, market, operational and reputational risks affect the bank’s
overall liquidity risk strategy. Liquidity risk can often arise from perceived
or actual weaknesses, failures or problems in the management of other risk
types. It should, therefore, identify events that could have an impact on
market and public perceptions about its soundness and reputation.
The ALM Support Group consisting of operating staff should be
responsible for analysing, monitoring and reporting the liquidity risk
profile to the ALCO. The group should also prepare forecasts
(simulations) showing the effect of various possible changes in market
conditions on the bank’s liquidity position and recommend action
needed to be taken to maintain the liquidity position/adhere to bank’s
internal limits.

Liquidity Risk Management Policy, Strategies and Practices

The first step towards liquidity management is to put in place an effective
liquidity risk management policy, which inter alia, should spell out the
liquidity risk tolerance, funding strategies, prudential limits, system for
measuring, assessing and reporting / reviewing liquidity, framework
for stress testing, liquidity planning under alternative scenarios/formal
contingent funding plan, nature and frequency of management
reporting, periodical review of assumptions used in liquidity projection,
etc. The policy should also address liquidity separately for individual
currencies, legal entities like subsidiaries, joint ventures and associates,
and business lines, when appropriate and material, and should place
limits on transfer of liquidity keeping in view the regulatory, legal and
operational constraints.
The BoD or its delegated committee of board members should oversee the
establishment and approval of policies, strategies and procedures to
manage liquidity risk, and review them at least annually.

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Liquidity Risk Tolerance
Banks should have an explicit liquidity risk tolerance set by the Board of
Directors. The risk tolerance should define the level of liquidity risk that the
bank is willing to assume, and should reflect the bank’s financial condition
and funding capacity. The tolerance should ensure that the bank manages
its liquidity in normal times in such a way that it is able to withstand a
prolonged period of, both institution specific and market wide stress events.
The risk tolerance articulation by a bank should be explicit, comprehensive
and appropriate as per its complexity, business mix, liquidity risk profile
and systemic significance. They may also be subject to sensitivity analysis.
The risk tolerance could be specified by way of fixing the tolerance levels
for various maturities under flow approach depending upon the bank’s
liquidity risk profile as also for various ratios under stock approach. Risk
tolerance may also be expressed in terms of minimum survival horizons
(without Central Bank or Government intervention) under a range of
severe but plausible stress scenarios, chosen to reflect the particular
vulnerabilities of the bank. The key assumptions may be subject to a
periodic review by the Board.

Strategy for Managing Liquidity Risk

The strategy for managing liquidity risk should be appropriate for the
nature, scale and complexity of a bank’s activities. In formulating the strategy,
banks/banking groups should take into consideration its legal structures,
key business lines, the breadth and diversity of markets, products,
jurisdictions in which they operate and home and host country
regulatory requirements, etc. Strategies should identify primary sources
of funding for meeting daily operating cash outflows, as well as expected
and unexpected cash flow fluctuations.

Management of Liquidity Risk

A bank should have a sound process for identifying, measuring, monitoring
and mitigating liquidity risk as enumerated below:

Identification
A bank should define and identify the liquidity risk to which it is exposed
for each major on and off-balance sheet position, including the effect of
embedded options and other contingent exposures that may affect the
bank’s sources and uses of funds and for all currencies in which a bank is
active.

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Measurement – Flow Approach
Liquidity can be measured through stock and flow approaches. Flow
approach measurement involves comprehensive tracking of cash flow
mismatches. For measuring and managing net funding requirements, the
format prescribed by the RBI i.e. the statement of structural liquidity
under ALM System for measuring cash flow mismatches at different time
bands should be adopted. The cash flows are required to be placed in
different time bands based on the residual maturity of the cash flows or
the projected future behaviour of assets, liabilities and off-balance sheet
items. The difference between cash inflows and outflows in each time
period thus becomes a starting point for the measure of a bank’s
future liquidity surplus or deficit, at a series of points of time.
Presently, banks are required to prepare domestic structural liquidity
statement (Rupee) on a daily basis and report to RBI on a fortnightly basis.
Further, structural liquidity statements in respect of overseas
operations are also reported to RBI on quarterly basis. The structural
liquidity statement has been revised and the revised formats of the
statement and the guidance for slotting the future cash flows of
banks in the time buckets are furnished as Appendix II (Refer
Liquidity Return, Part A1) and Appendix IVA, respectively. The
revised formats of statements of Structural Liquidity include five parts,
viz. (i) ‘Domestic Currency – Indian Operations’, (ii) ‘Foreign Currency –
Indian Operations’, (iii) ‘Combined Indian Operations – Domestic and
Foreign Currency’ i.e. solo bank level, (iv) ‘Overseas branch
Operations–Country-Wise’ and (v) ‘For Consolidated Bank Operations’.
Tolerance levels/prudential limits for various maturities may be fixed by the
bank’s Top Management depending on the bank’s asset - liability profile,
extent of stable deposit base, the nature of cash flows, regulatory
prescriptions, etc. In respect of mismatches in cash flows in the near term
buckets, say up to 28 days, it should be the endeavour of the bank’s
management to keep the cash flow mismatches at the minimum levels.
Banks should analyse the behavioural maturity profile of various
components of on / off-balance sheet items on the basis of assumptions
and trend analysis supported by time series analysis. The behavioural
analysis, for example, may include the proportion of maturing assets and
liabilities that the bank can rollover or renew, the behaviour of assets
and liabilities with no clearly specified maturity dates, potential cash
flows from off- balance sheet activities, including draw down under
loan commitments, contingent liabilities and market related
transactions. Banks should undertake variance analysis, at least once
in six months to validate the assumptions used in the behavioural analysis.
The assumptions should be fine-tuned over a period which facilitate

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near reality predictions about future behaviour of on / off-balance sheet
items.
Banks should also track the impact of prepayments of loans, premature
closure of deposits and exercise of options built in certain instruments
which offer put/call options after specified times. Thus, cash outflows
can be ranked by the date on which liabilities fall due, the earliest date a
liability holder could exercise an early repayment option or the
earliest date contingencies could be crystallised.
As assumptions play critical role in projections of cash flows and
measuring liquidity risk, assumptions used should be reasonable,
appropriate and adequately documented. They should be transparent to
the Board/Risk Management Committee and periodically reviewed.

Measurement – Stock Approach

Certain critical ratios in respect of liquidity risk management and their
significance for banks are given in the Table 1 below. Banks may
monitor these ratios by putting in place an internally defined limit
1
approved by the Board for these ratios. The industry averages for
these ratios are given for information of banks. They may fix their own
limits, based on their liquidity risk management capabilities, experience
and profile. The stock ratios are meant for monitoring the liquidity risk at
the solo bank level. Banks may also apply these ratios for monitoring
liquidity risk in major currencies, viz. US Dollar, Pound Sterling, Euro
and Japanese Yen at the solo bank level.
Table 1
Sl. No. Ratio Significance Industry
Average (in %)
1. 2 Measures the extent to which 40
(Volatile liabilities
3 volatile money supports bank’s
– Temporary Assets )/ basic earning assets. Since the
4 numerator represents short-
(Earning Assets –
Temporary Assets) term, interest sensitive funds, a
high and positive number
implies some risk of illiquidity.

2. 5 Measures the extent to which 50

Core deposits /Total
assets are funded through
Assets
stable deposit base.

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 3. (Loans + mandatory SLR Loans including mandatory cash 80
+ mandatory CRR + reserves and statutory liquidity
Fixed Assets )/Total investments are least liquid and
Assets hence a high ratio signifies the
degree of ‘illiquidity’ embedded
in the balance sheet.
4. (Loans + mandatory SLR Measure the extent to which 150
+ mandatory CRR + illiquid assets are financed out
Fixed Assets) / Core of core deposits.
Deposits
5. Temporary Measures the extent of 40
Assets/Total available liquid assets. A higher
Assets ratio could impinge on the asset
utilisation of banking system in
terms of opportunity cost of
holding liquidity.
6. Temporary Assets/ Measures the cover of liquid 60
Volatile investments relative to volatile
Liabilities liabilities. A ratio of less than 1
indicates the possibility of a
liquidity problem.

7. Volatile Measures the extent to which 60

Liabilities/Total volatile liabilities fund the
Assets balance sheet.
As mentioned above, the above stock ratios are only illustrative and
banks could also use other measures / ratios. For exampl e to identify
unstable liabilities and liquid asset coverage ratios banks may
include ratios of wholesale funding to total liabilities,
2
Volatile Liabilities: (Deposits + borrowings and bills payable up to 1 year).
Letters of credit – full outstanding. Component-wise CCF of other
contingent credit and commitments. Swap funds (buy/ sell) up to one year.
Current deposits (CA) and Savings deposits (SA) i.e. (CASA) deposits
reported by the banks as payable within one year (as reported in structural
liquidity statement) are included under volatile liabilities. Borrowings
include from RBI, call, other institutions and refinance.
3
Temporary assets =Cash + Excess CRR balances with RBI + Balances with
banks + Bills purchased/discounted up to 1 year + Investments up to one
year + Swap funds (sell/ buy) up to one year.
4
Earning Assets = Total assets – (Fixed assets + Balances in current accounts
with other banks + other assets excluding leasing + Intangible assets)

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5
Core deposits = All deposits (including CASA) above 1 year (as reported in
structural liquidity statement)+ net worth potentially volatile retail (e.g.
high cost or out of market) deposits to total deposits, and other
liability dependency measures, such as short term borrowings as a
percent of total funding.

Liquidity risk Monitoring

While the mismatches in the structural liquidity statement up to one year
would be relevant since these provide early warning signals of
impending liquidity problems, the main focus should be on the short-
term mismatches viz. say, up to 28 days. Banks, however, are expected to
monitor their cumulative mismatches (running total) across all time
buckets by establishing internal prudential limits with the approval of
the Board / Risk Management Committee. The net cumulative
negative mismatches in the domestic and overseas structural liquidity
statement (Refer Appendix II - Part A1 and Part B of Liquidity Return )
during the next day, 2-7 days, 8-14 days and 15-28 days bucket should not
exceed 5%, 10%, 15%, 20% of the cumulative cash outflows in the
respective time buckets. Banks may also adopt the above cumulative
mismatch limits for their structural liquidity statement for consolidated
bank operations (Appendix II – Part C).
In order to enable banks to monitor their short-term liquidity on a
dynamic basis over a time horizon spanning from 1-90 days, banks are
required to estimate their short-term liquidity profiles on the basis of
business projections and other commitments for planning purposes as per
the indicative format on estimating Short-Term Dynamic Liquidity
prescribed by the RBI in its circular DBOD. No. BP.BC. 8/21.04.098/99
dated February 10, 1999 on ALM system read with the circular
DBOD.No.BP.BC.38/21.04.098/2007-08 dated October 24, 2007 on ALM
system amendments. The statement has been revised and the revised
format is furnished as Appendix III. This will cover both domestic
operations and overseas branch operations (jurisdiction wise and
overall) of the bank. While estimating the liquidity profile in a dynamic
way, due importance may be given to the:
i. Seasonal pattern of deposits/loans; and
ii. Potential liquidity needs for meeting new loan demands,
unavailed credit limits, devolvement of contingent liabilities,
potential deposit losses, investment obligations, statutory
obligations, etc. Monitoring of Liquidity Standards
Banks are required to adhere to the following regulatory limits prescribed
to reduce the extent of concentration on the liability side of the banks.

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(i) Inter-bank Liability (IBL) Limit
Currently, the IBL of a bank should not exceed 200% of its net worth as
on 31st March of the previous year. However, individual banks may, with
the approval of their BoDs, fix a lower limit for their inter-bank
liabilities, keeping in view their business model. Banks whose Capital
to Risk-weighted Assets Ratio (CRAR) is at least 25% more than the
minimum CRAR (9%), i.e. 11.25% as on March 31, of the previous
year, are allowed to have a higher limit up to 300% of the net worth for
IBL. The limit prescribed above will include only fund based IBL within
India (including inter-bank liabilities in foreign currency to banks
operating within India). In other words, the IBL outside India are
excluded. The above limits will not include collateralized borrowings
under Collateralized Borrowing and Lending Obligation (CBLO) and
refinance from NABARD, SIDBI, etc.

(ii) Call Money Borrowing Limit

The limit on the call money borrowings as prescribed by RBI for
Call/Notice Money Market Operations will operate as a sub-limit within
the above IBL limits. At present, on a fortnightly average basis, such
borrowings should not exceed 100% of bank’s capital funds. However,
banks are allowed to borrow a maximum of 125% of their capital funds on
any day, during a fortnight.

(iii) Call Money Lending Limit

Banks are also required to ensure adherence to the call money lending
limit prescribed by RBI for Call/Notice Money Market Operations, which
at present, on a fortnightly average basis, should not exceed 25% of its
capital funds. However, banks are allowed to lend a maximum of 50% of
their capital funds on any day, during a fortnight.
28. Banks having high concentration of wholesale deposits (wholesale
deposits for this purpose would be Rs. 15 lakh or any such higher
threshold as approved by the banks’ Board) are expected to frame
suitable policies to contain the liquidity risk arising out of excessive
dependence on such deposits. Banks should also evolve a system for
monitoring high value deposits (other than inter-bank deposits) say Rs.1
crore or more to track the volatile liabilities, both in normal and stress
situation.

Off-balance Sheet Exposures and Contingent Liabilities

The management of liquidity risks relating to certain off-balance sheet
exposures on account of special purpose vehicles, financial derivatives, and
guarantees and commitments may be given particular importance due to

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the difficulties that many banks have in assessing the related liquidity risks
that could materialise in times of stress. Thus, the cash flows arising out of
contingent liabilities in normal situation and the scope for increase in cash
flows during periods of stress should also be estimated and monitored.
In case of securitization transactions, an originating bank should monitor, at
the inception and throughout the life of the transaction, potential risks
arising from the extension of liquidity facilities to securitisation
programmes. A bank’s processes for measuring contingent funding risks
should also consider the nature and size of the bank’s potential non-
contractual obligations; as such obligations can give rise to the bank
supporting related off-balance sheet vehicles in times of stress. This is
particularly true of securitisation programmes where the bank considers
such support critical to maintaining ongoing access to funding. Similarly, in
times of stress, reputational concerns might prompt a bank to purchase
assets from money market or other investment funds that it manages or
with which it is otherwise affiliated.
Where a bank provides contractual liquidity facilities to an SPV, or where
it may otherwise need to support the liquidity of an SPV under adverse
conditions, the bank needs to consider how the bank’s liquidity might be
adversely affected by illiquidity at the SPV. In such cases, the bank should
monitor the SPV’s inflows (maturing assets) and outflows (maturing
liabilities) as part of the bank’s own liquidity planning, including in its
stress testing and scenario analyses. In such circumstances, the bank
should assess its liquidity position with the SPV’s net liquidity deficits
(net liquidity surplus to the SPV to be ignored since such surplus in a
SPV will not increase the liquidity position of the bank).
With respect to the use of securitization SPVs as a source of funding, a
bank needs to consider whether these funding vehicles will continue to be
available to the bank under adverse scenarios. A bank experiencing
adverse liquidity conditions often will not have continuing access to the
securitization market as a funding source and should reflect this
appropriately in its prospective liquidity management framework.

Collateral Position Management

A bank should have sufficient collateral to meet expected and
unexpected borrowing needs and potential increases in margin
requirements over different timeframes, depending upon the bank’s
funding profile. A bank should also consider the potential for operational
and liquidity disruptions that could necessitate the pledging or delivery of
additional intra-day collateral.
A bank should have proper systems and procedure to calculate all of its
collateral positions in a timely manner, including the value of assets

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currently pledged relative to the amount of security required and
unencumbered assets available to be pledged and monitor them on an
ongoing basis. A bank should also be aware of the operational and timing
requirements associated with accessing the collateral given its physical
location.

Intra-day Liquidity Position Management

A bank’s failure to effectively manage intra-day liquidity could lead to
default in meeting its payment obligations in time, which may affect not
only its own liquidity position but also that of its counterparties. In the face
of credit concerns or general market stress, counterparties may view the
failure to settle payments as a sign of financial weakness and in turn,
withhold or delay payments to the bank causing additional liquidity
pressures. Given the inter- dependencies that exist among systems, this may
lead to liquidity dislocations that cascade quickly across many systems and
institutions. As such, the management of intra-day liquidity risk should be
considered as a crucial part of liquidity risk management of the bank.
A bank should develop and adopt an intra-day liquidity strategy that allows
it to monitor and measure expected daily gross liquidity inflows
and outflows and ensure that arrangements to acquire sufficient
intraday funding to meet its intraday needs is in place and it has the
ability to deal with unexpected disruptions to its liquidity flows. An
effective management of collateral is essential component of intra-day
liquidity strategy. In this regard banks may initially be guided by the
consultative document of Basel Committee on Banking Supervision on
‘Monitoring indicators for intraday liquidity management’ issued in July
2012 (available at http://www.bis.org/publ/bcbs225.pdf) and thereafter
the final document as and when it is issued.
A bank should have policies, procedures and systems to support the intra-
day liquidity risk management in all of the financial markets and currencies
in which it has significant payment and settlement flows, including when it
chooses to rely on correspondents or custodians to conduct payment and
settlement activities.
The intra-day liquidity risk management requirements as mentioned
above should be put in place at the earliest and will be applicable for banks
with effect from December 31, 2012 in respect of rupee liquidity and with
effect from June 30, 2013 in respect of any significant foreign currencies.

Incorporation of Liquidity Costs, Benefits and Risks in the Internal

Pricing
A scientifically evolved internal transfer pricing model by assigning values on
the basis of current market rates to funds provided and funds used is an

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important component for effective implementation of Liquidity Risk
Management System. The liquidity costs and benefits should therefore be
an integral part of bank’s strategy planning.
Banks should endeavour to develop a process to quantify liquidity costs and
benefits so that these same may be incorporated in the internal product
pricing, performance measurement and new product approval process for
all material business lines, products and activities. This will help in aligning
the risk taking incentives with the liquidity risk exposure and Board
approved risk tolerance of individual business lines.

Funding Strategy - Diversified Funding

A bank should establish a funding strategy that provides effective
diversification in the sources and tenor of funding. It should maintain an
ongoing presence in its chosen funding markets and strong relationships
with fund providers to promote effective diversification of funding sources.
A bank should regularly gauge its capacity to raise funds quickly from each
source. It should identify the main factors that affect its ability to raise
funds and monitor those factors closely to ensure that estimates of fund
raising capacity remain valid. These factors may also be incorporated in the
bank’s stress test scenario and contingent funding plan.
Over-reliance on a single source of funding should be avoided. Funding
strategy should also take into account the qualitative dimension of the
concentrated behaviour of deposit withdrawal in typical market
conditions and overdependence on non-deposit funding sources arising out
of unique business model. Funding diversification may be implemented by
way of placing limits (say by tenor, counterparty, secured versus
unsecured market funding, instrument type, currency wise, geographic
market wise, and securitization, etc.).

Liquidity risk due to Intra Group transfers

Intra-group transactions occur when entities within a Group carry out
operations among themselves. The key advantage is that the Intra-
Group transactions and exposures (ITEs) facilitate synergies within the
Group resulting in cost efficiencies. Such transactions may be undertaken
to improve inter-alia liquidity risk management, and for effective control
of funding. The Joint Forum (formed under the aegis of Basel Committee on
Banking Supervision, International Organization of Securities Commissions
and International Association of Insurance Supervisors) in its December
1999 paper on ITEs has emphasized that mere presence of ITEs is not a
matter of supervisory concern. They should be seen as a means to an end
which can be either beneficial or harmful to regulated entities in a

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conglomerate. But with a view to recognizing the likely increased risk arising
due to ITEs:
(i) The head of the Group financial conglomerate should develop and
maintain liquidity management processes and funding programmes
that are consistent with the complexity, risk profile, and scope of
operations of the financial conglomerate.
(ii) The liquidity risk management processes and funding programmes
should take into account lending, investment, and other activities, and
ensure that adequate liquidity is maintained at the head and each
constituent entity within the financial conglomerate. Processes and
programmes should fully incorporate real and potential constraints,
including legal and regulatory restrictions, on the transfer of funds
among these entities and between these entities and the head.
(iii) The liquidity risks should be managed by banks with: 1) effective
governance and management oversight as appropriate; 2) adequate
policies, procedures, and limits on risk taking; and 3) strong
management information systems for measuring, monitoring,
reporting, and controlling liquidity risks.

Stress Testing
Stress testing should form an integral part of the overall governance and
liquidity risk management culture in banks. A stress test is commonly
described as an evaluation of the financial position of a bank under a severe
but plausible scenario to assist in decision making within the bank. Stress
testing alerts bank’s management to adverse unexpected outcomes as it
provides forward looking assessment of risk and facilitates better planning
to address the vulnerabilities identified. The Reserve Bank has issued
guidelines to banks on stress testing in June 2007 (Ref. DBOD. No. BP.BC.
101/21.04.103/2006-07 dated June 26, 2007), which requires banks to
have in place a Board approved “stress testing framework”. Banks should
ensure that the framework as detailed in the guidelines and as specified
below is put in place.

Scenarios and Assumptions

A bank should conduct stress tests on a regular basis for a variety of short
term and protracted bank specific and market wide stress scenarios
(individually and in combination). In designing liquidity stress scenarios, the
nature of the bank’s business, activities and vulnerabilities should be taken
into consideration so that the scenarios incorporate the major funding and
market liquidity risks to which the bank is exposed. These include risks
associated with its business activities, products (including complex financial
instruments and off-balance sheet items) and funding sources. The defined

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scenarios should allow the bank to evaluate the potential adverse impact
these factors can have on its liquidity position. While historical events may
serve as a guide, a bank’s judgment also plays an important role in the
design of stress tests.
The bank should specifically take into account the link between reductions
in market liquidity and constraints on funding liquidity. This is particularly
important for banks with significant market share in, or heavy reliance
upon, specific funding markets. It should also consider the insights and
results of stress tests performed for various other risk types when stress
testing its liquidity position and consider possible interactions with these
other types of risk.
A bank should recognise that stress events may simultaneously give rise to
immediate liquidity needs in different currencies and multiple payment and
settlement systems. It should consider in the stress tests, the likely
behavioural response of other market participants to events of market
stress and the extent to which a common response might amplify market
movements and exacerbate market strain as also the likely impact of its
own behaviour on that of other market participants. The stress tests should
consider how the behaviour of counterparties (or their correspondents and
custodians) would affect the timing of cash flows, including on an intraday
basis.
Based on the type and severity of the scenario, a bank needs to
consider the appropriateness of a number of assumptions which are
relevant to its business. The bank’s choice of scenarios and related
assumptions should be well thought of, documented and reviewed
together with the stress test results. A bank should take a conservative
approach when setting stress testing assumptions.
Banks should conduct stress tests to assess the level of liquidity they should
hold, the extent and frequency of which should be commensurate with the
size of the bank and their specific business activities/liquidity for a period
over which it is expected to survive a crisis. Banks are encouraged to have
stress tests with various survival horizons in mind say one month or
less; two or three months; and six months or more, etc.

Use of Stress Test Results

Stress tests outcomes should be used to identify and quantify sources of
potential liquidity strain and to analyse possible impacts on the bank’s cash
flows, liquidity position, profitability and solvency. The results of stress
tests should be discussed thoroughly by ALCO. Remedial or mitigating
actions should be identified and taken to limit the bank’s exposures, to build
up a liquidity cushion and to adjust the liquidity profile to fit the risk
tolerance. The results should also play a key role in shaping the bank’s

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contingent funding planning and in determining the strategy and tactics to
deal with events of liquidity stress.
The stress test results and the action taken should be documented by banks
and made available to the Reserve Bank / Inspecting Officers as and when
required. If the stress test results indicate any vulnerability, these should be
reported to the Board and a plan of action charted out immediately. The
Department of Banking Supervision, Central Office, Reserve Bank of India
should also be kept informed immediately in such cases.

Contingency Funding Plan

A bank should formulate a contingency funding plan (CFP) for responding to
severe disruptions which might affect the bank’s ability to fund some or all
of its activities in a timely manner and at a reasonable cost. CFPs should
prepare the bank to manage a range of scenarios of severe liquidity stress
that include both bank specific and market-wide stress and should be
commensurate with a bank’s complexity, risk profile, scope of operations.
Contingency plans should contain details of available / potential contingency
funding sources and the amount / estimated amount which can be drawn
from these sources, clear escalation / prioritisation procedures detailing
when and how each of the actions can and should be activated and the lead
time needed to tap additional funds from each of the contingency sources.
With a view to diversify, banks may like to enter into contingency funding
agreements with different banks / types of banks (public sector, private
sector, foreign banks) for providing contingency funding lines and / or
reciprocal lines of credit (e.g. agreement to receive contingent funds in India
with a reciprocity agreement to provide funds at a cross border location or
vice versa). The CFP should also provide a framework with a high degree
of flexibility so that a bank can respond quickly in a variety of situations. The
CFP's design, plans and procedures should be closely integrated with
the bank’s ongoing analysis of liquidity risk and with the results of the
scenarios and assumptions used in stress tests. As such, the plan should
address issues over a range of different time horizons including intraday.
To facilitate timely response needed to manage disruptions, CFP should set
out a clear decision making process on what actions to take at what time,
who can take them, and what issues need to be escalated to more
senior levels in the bank. There should be explicit procedures for
effective internal coordination and communication across the bank’s
different business lines and locations. It should also address when and how
to contact external parties, such as supervisors, central banks, or payments
system operators. It is particularly important that in developing and
analysing CFPs and stress scenarios, the bank is aware of the
operational procedures needed to transfer liquidity and collateral across

297
different entities, business lines and jurisdictions and the restrictions that
govern such transfers like legal, regulatory and time zone constraints. CFPs
should contain clear policies and procedures that will enable the bank’s
management to make timely and well-informed decisions, execute
contingency measures swiftly and proficiently, and communicate effectively
to implement the plan efficiently, including:
• clear specification of roles and responsibilities, including the
authority to invoke the CFP. The establishment of a crisis team may
facilitate internal coordination and decision-making during a liquidity
crisis;
• names and contact details of members of the team responsible for
implementing the CFP and the locations of team members; and
• the designation of alternates for key roles.
Contingency plans must be tested regularly to ensure their effectiveness
and operational feasibility and should be reviewed by the Board at least on
an annual basis.

Overseas Operations of the Indian Banks’ Branches and Subsidiaries

A bank’s liquidity policy and procedures should provide detailed procedures
and guidelines for their overseas branches/subsidiaries to manage their
operational liquidity on an ongoing basis.
Management of operational liquidity or liquidity in the short-term is
expected to be delegated to local management as part of local treasury
function. For measuring and managing net funding requirements, a
statement on structural liquidity in respect of overseas operations may
be prepared on a daily basis and should be reported to the Reserve Bank on
monthly basis. This statement will replace the existing “Report on Structural
Liquidity” for overseas operations for branches/subsidiaries/joint ventures
which was furnished to the Reserve Bank on quarterly basis under DSB-0
returns (DSB-0-2). The format for structural liquidity statement for
overseas operations is furnished under Appendix–II (Part B-Liquidity
Return). While slotting the various items of assets and liabilities in structural
liquidity statement, banks may refer to the guidance for slotting the cash
flows in respect of structural liquidity statement (rupee) which is furnished
as Appendix IVA. The statement needs to be submitted country-wise. Banks
should also report figures in respect of subsidiaries/joint ventures in the
same format on a stand-alone basis. The tolerance limit prescribed for net
cumulative negative mismatches in case of domestic structural liquidity
statement i.e. 5%, 10%, 15%, 20% of the cumulative cash outflows in
respect of next day, 2-7 days, 8-14 days and 15-28 days bucket would also
be applicable for overseas operations (country-wise). The Statement on
Short Term Dynamic Liquidity is now required to be prepared in respect

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of bank’s overseas operations - both jurisdiction-wise and overall
overseas position (Refer Appendix III).
Some of the broad norms in respect of liquidity management are as follows:
i. Banks should not normally assume voluntary risk exposures
extending beyond a period of ten years.
ii. Banks should endeavour to broaden their base of long- term
resources and funding capabilities consistent with their long term
assets and commitments.
iii. The limits on maturity mismatches shall be established within
the following tolerance levels: (a) long term resources should not
fall below 70% of long term assets; and (b) long and medium term
resources together should not fall below 80% of the long and medium
term assets. These controls should be undertaken currency-wise, and
in respect of all such currencies which individually constitute 10% or
more of a bank’s consolidated overseas balance sheet. Netting of inter-
currency positions and maturity gaps is not allowed. For the purpose of
these limits, short term, medium term and long term are defined as
under:
Short-term: those maturing within 6 months
Medium-term: those maturing in 6 months and longer but within 3
years
Long-term: those maturing in 3 years and longer
iii. The monitoring system should be centralised in the International
Division (ID) of the bank for controlling the mismatch in asset-liability
structure of the overseas sector on a consolidated basis, currency-
wise. The ID of each bank may review the structural maturity mismatch
position at quarterly intervals and submit the review/s to the top
management of the bank.
Supervisory authorities in several foreign countries regulate the levels of
short term funding by banks. They either require banks generally to raise
long-term resources so as to reduce the levels of maturity mismatches or
stipulate prudential ceilings or tolerance limits on the maturity mismatches
permitted to them. In countries, where the mismatches in the maturity
structures are subject to regulatory or supervisory guidelines, those should
be controlled locally within the host country regulatory or prudential
parameters. Additionally, at the corporate level (i.e. in respect of the
overseas sector as a whole), the maturity mismatches should also be
controlled by bank’s management by establishing tolerance limits on the
global asset-liability structures and monitored in the aggregate.
Relevant control should be undertaken / exercised on a centralised basis.

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Maintenance of Liquidity – Centralisation Vs Decentralisation
Decentralization refers to the degree of financial autonomy of a bank’s
branches and subsidiaries relative to the central treasury of the banking
group. The fully decentralised model devolves the responsibility of funding
and liquidity management to the individual local entities which, in the
extreme, acts as a collection of autonomous entities under common
ownership. A decentralised approach sees local entities plan and raise
funding for their activities and manage the associated liquidity risks. They
source funding in host countries and meet any shortfalls autonomously by
accessing local sources in the host country. Central treasury has only a
limited role under such approach.
At the other end of the spectrum, the fully centralised model concentrates
funding and liquidity management at the central treasury at the group level.
The central treasury distributes funding around the organisation, monitors
compliance with strict centrally mandated mismatch limits and manages
pools of liquid assets. A bank’s foreign operations are not expected to fund
their own balance sheets independent of the rest of the group. The
centralised model is associated with extensive intra-group transfers
(internal markets) and depends heavily on forex swap markets.
A fully centralised model is rare in practice, as the daily operations of
a group’s branches and subsidiaries necessitate a minimum of
independence to manage local cash flows. This can be said of the
fully decentralized model as well.
In principle, the concept of (de)centralisation can be applied separately to
funding and liquidity management. A model of centralised funding but
decentralised liquidity management would see local entities obtaining
funding from the central treasury (with any surpluses redistributed or
invested via the treasury), perhaps at a predetermined rate, as a means of
managing the funding of assets according to locally determined limits
on maturity and currency mismatches and liquid asset requirements.
Conversely, local responsibility for determining and executing the funding
strategy could coexist with centrally mandated mismatch limits and with the
central treasury managing liquid assets.
Although decentralised funding strategy may lead to a higher cost for
banks, greater decentralization of funding may leave the banks less
exposed to intra-group contagion and contagion across jurisdictions. It
may also strengthen the local resolution regime. Evidence from the
global financial crisis also supports the view that banks pursuing a
more decentralised model were somewhat less affected by the
funding problems than those operating a more centralised funding
model.

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In case of centralised funding strategy, there may be possible
constraints on transferability of liquidity within the group, which may
be operational (connectivity of settlement systems) or due to internal
limits or policies of the group or legal or regulatory constraints imposed
by host jurisdictions (say capital requirements, large exposure limits,
ring fencing rules, etc). Moreover, in times of group-wide liquidity stress
or systemic (market) stress, there may not be much surplus liquidity in
other parts of the group for timely transfer of funds when necessary.
Also during times of stress if the functioning of forex swap markets gets
impaired, it would become very difficult to fund parts of the group. In
light of these drawbacks, centralized liquidity management should
aim at a better allocation of liquidity within the group. Nevertheless,
in the crisis management phase, all banks, regardless of their strategic
funding model, would seem to benefit from making tactical use of intra-
group transfers.
Indian banks should adopt decentralised model with some flexibility
allowed in the form of some regional centres/hubs that may fund/manage
liquidity for some jurisdictions/currencies keeping in view the constraints
on the transfer of liquidity across jurisdictions/entities. Such of those
banks which do not currently have this kind of decentralized approach
should put in place such approach within a period of six months from
the date of this circular. Regardless of the model, it is essential for
institutions with multiple platforms and legal entities to have a central
liquidity management oversight function. The group’s strategy and
policy documents should describe the structure for monitoring
institution-wide liquidity risk and for overseeing operating subsidiaries
and foreign branches. Assumptions regarding the transferability of funds
and collateral should be described in bank’s liquidity risk management
plans.

Maintenance of Liquidity – Overseas Branches of Indian Banks and

Branches of Foreign banks in India
The Reserve Bank of India expects banks to maintain adequate liquidity both
at the solo bank and consolidated level. Irrespective of the organisational
structure and degree of centralised or decentralized liquidity risk
management, a bank should actively monitor and control liquidity risks at
the level of individual legal entities, foreign branches and subsidiaries
and the group as a whole, incorporating processes that aggregate data in
order to develop a group-wide view of liquidity risk exposures and identify
constraints on the transfer of liquidity within the group. If the legal entities
including subsidiaries, joint ventures and associates are subject to a
regulatory oversight other than by the Reserve Bank, that regulatory

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regime will prevail. In case they are not subject to any such regulatory
oversight, banks should evolve and follow bank like regulatory liquidity
standards. Further, on a consolidated basis, the regulatory standards as
applicable for the Group should also be adhered to.
Indian banks’ branches and subsidiaries abroad are required to
manage liquidity according to the host or home country requirements,
whichever is more stringent. It is expected that Indian banks’ branches
and subsidiaries are self sufficient with respect to liquidity maintenance
and should be able to withstand a range of severe but plausible stress
test scenarios on their own within the framework laid down in
paragraphs 45 to 49 above. However, in case of extreme stress
situations, while Indian banks’ branches abroad may have to rely on
liquidity support from their Head Office, their subsidiaries should be
self reliant.
Similarly, foreign banks operating in India should also be self reliant with
respect to liquidity maintenance and management. In case of extreme
stress situation, parent entity/Head Office support may be relied upon.
However, the possible constraints with respect to transferability of
funds from the parent entity/Head Office, including possible time lag in
availability of funds may be taken into account while factoring this as a
source of funds in contingency funding plan. Banks may also take into
account a stress situation when funds may not be available to them in
case of market/group wide stress situation.

Liquidity Across Currencies

Banks should have a measurement, monitoring and control system for
liquidity positions in the major currencies in which they are active. For
assessing the liquidity mismatch in foreign currencies, as far as domestic
operations are concerned, banks are required to prepare Maturity and
Position (MAP) statements according to the extant instructions. These
statements have been reviewed and the reporting requirements have been
revised as given in Appendix II (Liquidity Return, Part A2). Guidance on
slotting various items of inflows and outflows is given in Appendix IVB.
In addition to assessing its aggregate foreign currency liquidity needs
and the acceptable mismatch in combination with its domestic currency
commitments, a bank should also undertake separate analysis of its strategy
for each major currency individually by taking into account the outcome of
stress testing.
The size of the foreign currency mismatches for the bank as a whole should
take into account: (a) the bank’s ability to raise funds in foreign currency
markets; (b) the likely extent of foreign currency back-up facilities
available in its domestic market; (c) the ability to transfer liquidity

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surplus from one currency to another, and across countries/jurisdictions
and legal entities and (d) the likely convertibility of currencies in which bank
is active, including the potential for impairment or complete closure of
foreign exchange swap markets for particular currency pairs.

Management Information System (MIS)

A bank should have a reliable MIS designed to provide timely and forward-
looking information on the liquidity position of the bank and the Group to
the Board and ALCO, both under normal and stress situations. The MIS
should cover liquidity positions in all currencies in which the bank conducts
its business – both on a subsidiary / branch basis (in all countries in which
the bank is active) and on an aggregate group basis. It should capture all
sources of liquidity risk, including contingent risks and those arising from
new activities, and have the ability to furnish more granular and time
sensitive information during stress events.
Liquidity risk reports should provide sufficient detail to enable management
to assess the sensitivity of the bank to changes in market conditions, its own
financial performance, and other important risk factors. It may include cash
flow projections, cash flow gaps, asset and funding concentrations; critical
assumptions used in cash flow projections, funding availability, compliance
to various regulatory and internal limits on liquidity risk management,
results of stress tests, key early warning or risk indicators, status of
contingent funding sources, or collateral usage, etc.

Reporting to the Reserve Bank of India

The existing liquidity reporting requirements have been reviewed. Banks will
have to submit the revised liquidity return to the Chief General Manager-
in-Charge, Department of Banking Supervision, Reserve Bank of India,
Central Office, World Trade Centre, Mumbai as detailed below.

Statement of Structural Liquidity: At present banks are furnishing

statement of structural liquidity for domestic currency at fortnightly interval
and statement of structural liquidity for overseas operations at quarterly
interval. In addition, statement for structural liquidity for the consolidated
bank under consolidated prudential returns (CPR) is prescribed at half yearly
intervals. However, under the revised requirements, this statement is
required to be reported in five parts viz. (i) ‘for domestic currency, Indian
operations’; (ii) ‘for foreign currency, Indian operations’; (iii) ‘for combined
Indian operations’; (iv) ‘for overseas operations’ and for (v) ‘consolidated
bank operations’. While statements at (i) to (iii) are required to be
submitted fortnightly, statements at (iv) and (v) are required to be
submitted at monthly and quarterly intervals, respectively. The Maturity

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and Position statement (MAP) submitted by the banks at monthly
intervals is discontinued as the same is now addressed by statement for
foreign currency, Indian operations. The periodicity in respect of each part
of the return is even in the Table 2 below:
Table 2
Sr. Name of the Liquidity Return 6 Time period by
Periodicity
No. (LR) which required
to be reported
Structural Liquidity Statement
(i) Part A1 - Statement of Fortnightly* within a week
Structural Liquidity – Domestic from the reporting
Currency, Indian Operations date
(ii) Part A2 – Statement of do do
Structural Liquidity – Foreign
Currency, Indian Operations
(iii) Part A3 – Statement of do do
Structural Liquidity –
Combined Indian Operations
(iv) Part B – Statement of Monthly# within 15 days
Structural Liquidity for from the reporting
Overseas Operations date
(v) Part C – Statement of Quarterly# within a month
Structural Liquidity – For from the reporting
Consolidated Bank Operations date
th
* Reporting dates will be 15 and last date of the month – in case these
dates are holidays, the reporting dates will be the previous working day.
# Reporting date will be the last working day of the month / quarter.
The formats of the returns are furnished as Appendix II. The return in the
revised format will be first required to be reported from the relevant
fortnight/month/quarter ending March 2003.

INTERNAL CONTROL
A bank should have appropriate internal controls, systems and procedures to
ensure adherence to liquidity risk management policies and procedure as
also adequacy of liquidity risk management functioning.
Management should ensure that an independent party regularly reviews and
evaluates the various components of the bank’s liquidity risk management
process. These reviews should assess the extent to which the bank’s liquidity
risk management complies with the regulatory/supervisory instructions as
well as its own policy. The independent review process should report key
issues requiring immediate attention, including instances of non compliance
to various guidance/limits for prompt corrective action consistent with the
Board approved.

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 Liquidity Return (LR)-2
Statement of Short-term Dynamic Liquidity
Name of the Bank:
Reporting Frequency: Monthly
Position as on:
A. Domestic Operations
(Amounts in Rupees crores)
A. Outflows Next 2-7 8- 14 15-28 29-90
day days days days days
1. Net increase in loans and advances
Net increase in investments:
i) Approved securities
ii) Money market instruments
(other than Treasury bills)
2. iii) Bonds/Debentures/shares

iv) Others
3. Inter-bank obligations
4. Off balance sheet items (Repos,
swaps, bills discounted, etc.)
5. Others
TOTAL OUTFLOWS
B. Inflows
1. Net cash position
2. Net increase in deposits (less CRR
obligations)
3. Interest on investments
4. Inter-bank claims
5. Refinance eligibility (Export credit)
6. Off-balance sheet items (Reverse
repos, swaps, bills discounted, etc.)
7. Others
TOTAL INFLOWS
C. Mismatch (B - A)
D. Cumulative mismatch
E. C as a % to total outflows

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 B. Overseas Operations (to be furnished jurisdiction wise as also
the overall overseas position)*
(Amounts in Rupees crores)
A. Outflows Next day 2-7 days 8- 14 15-28 29-90
days days days
1. Net increase in loans and advances
Net increase in investments:
i) Approved securities
ii) Money market instruments
2. (other than Treasury bills)
iii) Bonds/Debentures/shares
iv) Others
3. Inter-bank obligations
Off balance sheet items (Repos,
4. swaps, bills discounted, etc.)
5. Others
TOTAL OUTFLOWS
B. Inflows
1. Net cash position
Net increase in deposits (less CRR
2. obligations)
3. Interest on investments
4. Inter-bank claims
5. Refinance eligibility (Export credit)
Off-balance sheet items (Reverse
6. repos, swaps, bills discounted, etc.)
7. Others
TOTAL INFLOWS
C. Mismatch (B - A)
D. Cumulative mismatch
E. C as a % to total outflows
* converted into INR using relevant spot rates as published by FEDAI

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 Appendix IV A
Guidance for Slotting the Future Cash Flows of Banks in Liquidity Return 1,
Part A1
Heads of Accounts Classification into time buckets
A. Outflows
1. Capital, Reserves and Surplus Over 5 years bucket.
2. Demand Deposits (Current Savings Bank and Current Deposits may be
and Savings Bank Deposits) classified into volatile and core portions.
Savings Bank (10%) and Current (15%)
Deposits are generally withdrawable on
demand. This portion may be treated as
volatile. While volatile portion can be
placed in the Day 1, 2-7 days and 8-14 days
time buckets, depending upon the
experience and estimates of banks and the
core portion may be placed in over 1- 3
years bucket.
The above classification of Savings Bank
and Current Deposits is only a benchmark.
Banks which are better equipped to
estimate the behavioural pattern, roll-in
and roll-out, embedded options, etc. on
the basis of past data / empirical studies
could classify them in the appropriate
buckets, i.e. behavioural maturity instead of
contractual maturity, subject to the
approval of the Board / ALCO.
3. Term Deposits Respective maturity buckets. Banks which
are better equipped to estimate the
behavioural pattern, roll-in and roll-out,
embedded options, etc. on the basis of
past data / empirical studies could classify
the retail deposits in the appropriate
buckets on the basis of behavioural
maturity rather than residual maturity.
However, the wholesale deposits should be
shown under respective maturity buckets.
4. Certificates of Deposit, Respective maturity buckets. Where call
Borrowings and Bonds / put options are built into the issue
(including Sub- ordinated Debt) structure of any instrument/s, the call /
put date/s should be reckoned as the
maturity date/s and the amount should
be shown in the respective time buckets.

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5. Other Liabilities and Provisions
(i) Bills Payable (i) The core component which could
reasonably be estimated on the basis of
past data and behavioural pattern may be
shown under 'Over 1-3 years' time bucket.
The balance amount may be placed in Day
1, 2-7 days and 8-14 days buckets, as per
behavioural pattern.
(ii) Provisions other than for (ii) Respective buckets depending on the
loan loss and depreciation purpose.
in investments
(iii) Other Liabilities (iii) Respective maturity buckets. Items not
representing cash payables (i.e. income
received in advance, etc.) may be placed in
over 5 years bucket.
6. Export Refinance – Availed Respective maturity buckets of underlying
assets.
B. Inflows
1. Cash Day 1 bucket
2. Balances with RBI While the excess balance over the required
CRR / SLR may be shown under Day 1
bucket, the Statutory Balances may be
distributed amongst various time buckets
corresponding to the maturity profile of DTL
with a time-lag of 14 days.
3. Balances with other Banks
(i) Current Account (i) Non-withdrawable portion on account
of stipulations of minimum balances may
be shown under 'Over 1-3 years' bucket
and the remaining balances may be shown
under Day 1 bucket.
(ii) Money at Call and Short (ii) Respective maturity buckets.
Notice, Term Deposits and
other placements
4. Investments (Net of provisions)#
(i) Approved securities (i) Respective maturity buckets, excluding
the amount required to be reinvested to
maintain SLR corresponding to the DTL
profile in various time buckets.

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 (ii) Corporate debentures (ii) Respective maturity buckets.
and bonds, PSU bonds, CDs Investments classified as NPIs should be
and CPs, Redeemable shown under over 3-5 years bucket (sub-
preference shares, Units of standard) or over 5 years bucket (doubtful).
Mutual Funds (close ended),
etc.
(iii) Shares (iii) Listed shares (except strategic
investments) in 2-7days bucket, with a
haircut of 50%. Other shares in
'Over 5 years' bucket.
(iv) Units of Mutual Funds (iv) Day 1 bucket
(open ended)
(v) Investments in Subsidiaries (v) 'Over 5 years' bucket.
/ Joint Ventures

(vi) Securities in the Trading (vi) Day 1, 2-7 days, 8-14 days, 15-28 days
Book and 29-90 days according to defeasance
periods.
# Provisions may be netted from the gross investments provided
provisions are held security-wise. Otherwise provisions should be shown in
over 5 years bucket.
5. Advances (Performing)
(i) Bills Purchased and (i) Respective maturity buckets.
Discounted (including bills
under DUPN)
(ii) Cash Credit / Overdraft (ii) Banks should undertake a study of
(including TOD) and behavioural and seasonal pattern of
Demand Loan component of availments based on outstandings and the
Working Capital. core and volatile portion should be
identified. While the volatile portion could
be shown in the near- term maturity
buckets, the core portion may be shown
under 'Over 1-3 years' bucket.

(iii) Term Loans (iii) Interim cash flows may be shown

under respective maturity buckets.
6. NPAs (Net of provisions, interest suspense and claims received from ECGC / DICGC)

(i) Sub-standard (i) Over 3-5 years bucket.

(ii) Doubtful and Loss (ii) Over 5 years bucket.
7. Fixed Assets / Assets on lease 'Over 5 years' bucket / Interim cash flows
may be shown under respective maturity
buckets.

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8. Other Assets
(i) Intangible assets Intangible assets and assets not
representing cash receivables may be
shown in 'Over 5 years' bucket.

C. Off balance sheet items

1. Lines of Credit committed / available

(i) Lines of Credit committed (i) Day 1 bucket.

to/ from Institutions

(ii) Unavailed portion of Cash (ii) Banks should undertake a study of the
Credit/Overdraft/Demand behavioural and seasonal pattern of
loan component of Working potential availments in the accounts and
Capital limits (outflow) the amounts so arrived at may be shown
under relevant maturity buckets upto 12
months.
(iii) Export Refinance - (iii) Day 1 bucket.
Unavailed
(inflow)
2. Contingent Liabilities
Letters of Credit / Guarantees Devolvement of Letters of Credit /
(outflow) Guarantees, initially entails cash outflows.
Thus, historical trend analysis ought to be
conducted on the devolvements and the
amounts so arrived at in respect of
outstanding Letters of Credit / Guarantees
(net of margins) should be distributed
amongst various time buckets. The assets
created out of devolvements may be
shown under respective maturity buckets
on the basis of probable recovery dates.
3. Other Inflows / outflows
(i) Repos / Bills Rediscounted (i) Respective maturity buckets.
(DUPN) / CBLO / Swaps INR
/ USD, maturing forex
forward contracts/futures
etc. (outflow / inflow)
(ii) Interest payable / receivable (ii) Respective maturity buckets.
(outflow / inflow) - Accrued
interest which are
appearing in the books on
the reporting day

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 Note :
(i) Liability on account of event cash flows i.e. short fall in CRR balance on
reporting Fridays, wage settlement, capital expenditure, etc. which are
known to the banks and any other contingency may be shown under
respective maturity buckets. The event cash outflows, including
incremental SLR requirement should be reported against "Outflows -
Others".
(ii) All overdue liabilities may be placed in the Day 1, 2-7 days and 8-14
days buckets, based on behavioural estimates.

(iii) Interest and instalments from advances and investments, which are
overdue for less than one month, may be placed in Day 1, 2-7 days and 8-
14 days buckets, based on behavioural estimates. Further, interest and
instalments due (before classification as NPAs) may be placed in '29 days to
3 months bucket' if the earlier receivables remain uncollected.

D. Financing of Gap
In case the net cumulative negative mismatches during the Day 1, 2-7 days, 8-
14 days and 15- 28 days buckets exceed the prudential limit of 5 %, 10%, 15 %
and 20% of the cumulative cash outflows in the respective time buckets, the
bank may show by way of a foot note as to how it proposes to finance the
gap to bring the mismatch within the prescribed limits. The gap can be
financed from market borrowings (call/ term), Bills Rediscounting, Repos,
LAF and deployment of foreign currency resources after conversion into rupees
(unswapped foreign currency funds ), etc.

Appendix IV B
Guidance for Slotting the Future Cash Flows of Banks in Liquidity Return 1,
Part A 2
Heads of Accounts Classification into time buckets
A. Outflows
Merchant sales, Inter-bank As per the tenor of the contract-
1. sales, overseas sales, sales to RBI respective maturity buckets
2. Swaps, currency futures, etc Respective maturity buckets as per the pay-off
profile
3. LCs and Guarantees Historical trend analysis ought to be
conducted on the devolvement and the
amounts so arrived at in respect of
outstanding LCs/Guarantees (net of
margins) should be distributed amongst
4. Foreign currency deposit various
For time buckets.
demand deposit accounts, the
accounts such as FCNR (B), guidance for rupee outflows may be
EEFC,RFC, etc. followed.
For term deposits – respective maturity

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5. Overdrafts in Nostro accounts Day 1 bucket
6. Inter-bank borrowings Respective Maturity buckets
B. Inflows
1. Merchant purchases, inter-bank As per the tenor of the contract-
purchases, overseas purchases, respective maturity buckets
purchases from RBI.
2. Swaps, currency futures Respective maturity buckets as per the pay-
and options off profile
3. Nostro balance Day 1 bucket
4. Short term, long term Respective Maturity buckets.
investments and loans

Appendix V
List of Circulars consolidated/modified in the Guidelines
S.N Circular No. Date Relevant para Subject
o. of the circular
1. D.O No. DBOD. June 5, 1, 2, 3, Control Systems at
IBS/1163/C.212 1986 Annexure A and B Foreign Offices –
(SG)‐86 Asset Liability
Management
2. A.D (M.A Series) May 15, ‐ Amendments to the
Circular 1999 Exchange Control
No. 16 Manual
3. DBOD. No. February 1 to 5, 7 of the Asset‐Liability
BP.BC.8/21.04.098 10, circular and 1 to 6 of Management
/99 1999 the Annex. (ALM) System
4. DBS.BC. No. July 17, 1 to 3 Introduction of
OSMOS.2/33.01.0 1999 Second Tranche of
01.15/98‐99 DSB Returns
5. DBOD. No. BP. October 7, 13 of the Risk Management
(SC). BC. 1999 circular and 8.2 Systems in Banks
98/21.04.103/99 and 9.10 of the
Annex.
6. DBS.CO.FBC.BC.34 April 6, DSB (O) return II Report of the
/13.1 2000 Working Group on
2.001/1999‐2000 Supervision of
foreign branches of
Indian banks –
Implementation
7. DBOD.No.BP.520/ October 2.1, 2.2 , Guidance note on
21.04.103/2002‐0 12, Chapter 3 Market Risk
3 2002 Management

312
8. DBOD. No. BP. BC. February 30 Guidelines for
72/21.04.018/200 25, Consolidated
1‐02 2003 Accounting and
Other Quantitative
methods to
Facilitate
Consolidated
Supervision.
9. DBOD. No. BP. BC. March 6, ‐ Prudential Limits for
66/21.01.002/200 2007 Inter‐Bank Liabilities
6‐07

10. DBOD. No. BP.BC. June 26, ‐ Guidelines on Stress

101/21.04.103/20 2007 Testing
06‐07
11. DBOD. No. BP. BC. October ‐ Guidelines on
38/21.04.098/200 24, Asset‐Liability (ALM)
7‐08 2007 System –
Amendments
12. DBOD. No. BP.BC. July 01, 13.7 Master Circular –
11/21.06.001/201 2011 Prudential
1‐12 Guidelines on
Capital Adequacy
and Market
Discipline – CAF
13. DBOD. BP.BC. No. July 01, 3. 6 Master Circular –
16/21.04.018/201 2011 Disclosure in
1‐12 Financial Statements
– Notes to Accounts
14. IDMD.PCD.3/14.01 July 01, 3.1 Master Circular on
.01/ 2011 Call/Notice money
2011‐12 Market Operations

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 Chapter-6

INTEREST RATE RISK MANAGEMENT

INTRODUCTION
Interest rate risk is the risk where changes in market interest rates
might adversely affect a bank’s financial condition. The immediate impact of
changes in interest rates is on the Net Interest Income (NII). A long term
impact of changing interest rates is on the bank’s net worth as the
economic value of bank’s assets, liabilities and off-balance sheet positions
get affected due to variation in market interest rates. The interest rate risk
when viewed from these two perspectives is known as ‘earnings
perspective’ and ‘economic value’ perspective, respectively. Management
of interest rate risk aims at capturing the risks arising from the maturity and
repricing mismatches and is measured both from the earnings and
economic value perspective.

Earnings perspective involves analysing the impact of changes in interest

rates on accrual or reported earnings in the near term. This is measured by
measuring the changes in the Net Interest Income (NII) or Net Interest
Margin (NIM) i.e. the difference between the total interest income and the
total interest expense.

Economic Value perspective involves analysing the expected cash flows on

assets minus the expected cash flows on liabilities plus the net cash flows on
off-balance sheet items. It focuses on the risk to networth arising from all
repricing mismatches and other interest rate sensitive positions. The
economic value perspective identifies risk arising from long-term interest
rate gaps.
The management of Interest Rate Risk (IRR) is one of the critical
components of market risk management in banks. The regulatory
restrictions in the past had greatly reduced many of the risks in the banking
system. Deregulation of interest rates has, however, exposed them to the
adverse impacts of interest rate risk. The Net Interest Income (NII) or Net
Interest Margin (NIM) of banks is dependent on the movements of interest
rates. Any mismatches in the cash flows (fixed assets or liabilities) or
repricing dates (floating assets or liabilities), expose banks’ NII or NIM to
variations. The earning of assets and the cost of liabilities are now closely
related to market interest rate volatility.
Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market
Value of Equity (MVE) caused by unexpected changes in market interest
rates. Interest Rate Risk can take different forms

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1. Gap or Mismatch Risk
2. Basis Risk
3. Embedded Option Risk
4. Yield Curve Risk
5. Price Risk
6. Reinvestment Risk
7. Net Interest Position Risk

1. Gap or Mismatch Risk

A gap or mismatch risk arises from holding assets and liabilities and
off-balance sheet items with different principal amounts, maturity dates or
repricing dates, thereby creating exposure to unexpected changes in the
level of market interest rates.

2. Basis Risk
Market interest rates of various instruments seldom change by the
same degree during a given period of time. The risk that the interest rate of
different assets, liabilities and off-balance sheet items may change in
different magnitude is termed as basis risk. The degree of basis risk is fairly
high in respect of banks that create composite assets out of composite
liabilities. The Loan book in India is funded out of a composite liability
portfolio and is exposed to a considerable degree of basis risk. The basis risk
is quite visible in volatile interest rate scenarios. When the variation in
market interest rate causes the NII to expand, the banks have experienced
favourable basis shifts and if the interest rate movement causes the NII to
contract, the basis has moved against the banks.

3. Embedded Option Risk

Significant changes in market interest rates create another source
of risk to banks’ profitability by encouraging prepayment of cash
credit/demand loans/term loans and exercise of call/put options on
bonds/debentures and/or premature withdrawal of term deposits before
their stated maturities. The embedded option risk is becoming a reality in
India and is experienced in volatile situations. The faster and higher the
magnitude of changes in interest rate, the greater will be the embedded
option risk to the banks’ NII. Thus, banks should evolve scientific techniques
to estimate the probable embedded options and adjust the Gap statements
(Liquidity and Interest Rate Sensitivity) to realistically estimate the risk
profiles in their balance sheet. Banks should also endeavour for stipulating
appropriate penalties based on opportunity costs to stem the exercise of
options, which is always to the disadvantage of banks.

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4. Yield Curve Risk
In a floating interest rate scenario, banks may price their assets and
liabilities based on different benchmarks, i.e. TBs yields, fixed deposit rates,
call money rates, MIBOR, etc. In case the banks use two different
instruments maturing at different time horizon for pricing their assets and
liabilities, any non-parallel movements in yield curves would affect the NII.
The movements in yield curve are rather frequent when the economy
moves through business cycles. Thus, banks should evaluate the movement
in yield curves and the impact of that on the portfolio values and income.

5. Price Risk
Price risk occurs when assets are sold before their stated
maturities. In the financial market, bond prices and yields are inversely
related. The price risk is closely associated with the trading book, which is
created for making profit out of short-term movements in interest rates.
Banks which have an active trading book should, therefore, formulate
policies to limit the portfolio size, holding period, duration, defeasance
period, stop loss limits, marking to market, etc.

6. Reinvestment Risk
Uncertainty with regard to interest rate at which the future cash
flows could be reinvested is called reinvestment risk. Any mismatches in
cash flows would expose the banks to variations in NII as the market
interest rates move in different directions.

7. Net Interest Position Risk

The size of nonpaying liabilities is one of the significant factors
contributing towards profitability of banks. When banks have more earning
assets than paying liabilities, interest rate risk arises when the market
interest rates adjust downwards. Thus, banks with positive net interest
positions will experience a reduction in NII as the market interest rate
declines and increases when interest rate rises. Thus, large float is a natural
hedge against the variations in interest rates.

Measuring Interest Rate Risk

Before interest rate risk could be managed, they should be
identified and quantified. Unless the quantum of IRR inherent in the balance
sheet is identified, it is impossible to measure the degree of risks to which
banks are exposed. It is also equally impossible to develop effective risk
management strategies/hedging techniques without being able to
understand the correct risk position of banks. The IRR measurement system
should address all material sources of interest rate risk including gap or

316
mismatch, basis, embedded option, yield curve, price, reinvestment and net
interest position risks exposures. The IRR measurement system should also
take into account the specific characteristics of each individual interest rate
sensitive position and should capture in detail the full range of potential
movements in interest rates.
There are different techniques for measurement of interest rate risk,
ranging from the traditional Maturity Gap Analysis (to measure the interest
rate sensitivity of earnings), Duration (to measure interest rate sensitivity of
capital), Simulation and Value at Risk. While these methods highlight
different facets of interest rate risk, many banks use them in combination,
or use hybrid methods that combine features of all the techniques
Generally, the approach towards measurement and hedging of IRR
varies with the segmentation of the balance sheet. In a well functioning risk
management system, banks broadly position their balance sheet into
Trading and Investment or Banking Books. While the assets in the trading
book are held primarily for generating profit on short-term differences in
prices/yields, the banking book comprises assets and liabilities, which are
contracted basically on account of relationship or for steady income and
statutory obligations and are generally held till maturity. Thus, while the
price risk is the prime concern of banks in trading book, the earnings or
economic value changes are the main focus of banking book.

Trading Book
The top management of banks should lay down policies with regard
to volume, maximum maturity, holding period, duration, stop loss,
defeasance period, rating standards, etc. for classifying securities in the
trading book. While the securities held in the trading book should ideally be
marked to market on a daily basis, the potential price risk to changes in
market risk factors should be estimated through internally developed Value
at Risk (VaR) models. The VaR method is employed to assess potential loss
that could crystalise on trading position or portfolio due to variations in
market interest rates and prices, using a given confidence level, usually 95%
to 99%, within a defined period of time. The VaR method should incorporate
the market factors against which the market value of the trading position is
exposed. The top management should put in place bank-wide VaR exposure
limits to the trading portfolio (including forex and gold positions, derivative
products, etc.) which is then disaggregated across different desks and
departments. The loss making tolerance level should also be stipulated to
ensure that potential impact on earnings is managed within acceptable
limits. The potential loss in Present Value Basis Points should be matched by
the Middle Office on a daily basis vis-à-vis the prudential limits set by the
Board. The advantage of using VaR is that it is comparable across products,

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desks and Departments and it can be validated through ‘back testing’.
However, VaR models require the use of extensive historical data to
estimate future volatility. VaR model also may not give good results in
extreme volatile conditions or outlier events and stress test has to be
employed to complement VaR. The stress tests provide management a view
on the potential impact of large size market movements and also attempt to
estimate the size of potential losses due to stress events, which occur in the
’tails’ of the loss distribution. Banks may also undertake scenario analysis
with specific possible stress situations (recently experienced in some
countries) by linking hypothetical, simultaneous and related changes in
multiple risk factors present in the trading portfolio to determine the impact
of moves on the rest of the portfolio. VaR models could also be modified to
reflect liquidity risk differences observed across assets over time.
International banks are now estimating Liquidity adjusted Value at Risk
(LaVaR) by assuming variable time horizons based on position size and
relative turnover. In an environment where VaR is difficult to estimate for
lack of data, non-statistical concepts such as stop loss and gross/net
positions can be used.

Banking Book
The changes in market interest rates have earnings and economic
value impacts on the banks’ banking book. Thus, given the complexity and
range of balance sheet products, banks should have IRR measurement
systems that assess the effects of the rate changes on both earnings and
economic value. The variety of techniques ranges from simple maturity
(fixed rate) and repricing (floating rate) to static simulation, based on
current on-and-off-balance sheet positions, to highly sophisticated dynamic
modeling techniques that incorporate assumptions on behavioral pattern of
assets, liabilities and off-balance sheet items and can easily capture the full
range of exposures against basis risk, embedded option risk, yield curve risk,
etc.

1. Maturity Gap Analysis

The simplest analytical techniques for calculation of IRR exposure
begins with maturity Gap analysis that distributes interest rate sensitive
assets, liabilities and off-balance sheet positions into a certain number of
pre-defined time-bands according to their maturity (fixed rate) or time
remaining for their next repricing (floating rate). Those assets and liabilities
lacking definite repricing intervals (savings bank, cash credit, overdraft,
loans, export finance, refinance from RBI etc.) or actual maturities vary from
contractual maturities (embedded option in bonds with put/call options,
loans, cash credit/overdraft, time deposits, etc.) are assigned time-bands

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according to the judgment, empirical studies and past experiences of banks.
A number of time bands can be used while constructing a gap
report. Generally, most of the banks focus their attention on near-term
periods, viz. monthly, quarterly, half-yearly or one year. It is very difficult to
take a view on interest rate movements beyond a year. Banks with large
exposures in the short-term should test the sensitivity of their assets and
liabilities even at shorter intervals like overnight, 1-7 days, 8-14 days, etc.
In order to evaluate the earnings exposure, interest Rate Sensitive Assets
(RSAs) in each time band are netted with the interest Rate Sensitive
Liabilities (RSLs) to produce a repricing ‘Gap’ for that time band. The positive
Gap indicates that banks have more RSAs than RSLs. A positive or asset
sensitive Gap means that an increase in market interest rates could cause an
increase in NII. Conversely, a negative or liability sensitive Gap implies that
the banks’ NII could decline as a result of increase in market interest rates.
The negative gap indicates that banks have more RSLs than RSAs. The Gap is
used as a measure of interest rate sensitivity. The Positive or Negative Gap
is multiplied by the assumed interest rate changes to derive the Earnings at
Risk (EaR). The EaR method facilitates to estimate how much the earnings
might be impacted by an adverse movement in interest rates. The changes
in interest rate could be estimated on the basis of past trends, forecasting of
interest rates, etc. The banks should fix EaR which could be based on
last/current year’s income and a trigger point at which the line management
should adopt on-or off-balance sheet hedging strategies may be clearly
defined.
The Gap calculations can be augmented by information on the
average coupon on assets and liabilities in each time band and the same
could be used to calculate estimates of the level of NII from positions
maturing or due for repricing within a given time-band, which would then
provide a scale to assess the changes in income implied by the gap analysis.
The Gap calculations can be augmented by information on the average
coupon on assets and liabilities in each time band and the same could be
used to calculate estimates of the level of NII from positions maturing or
due for repricing within a given time-band, which would then provide a
scale to assess the changes in income implied by the gap analysis.
In case banks could realistically estimate the magnitude of changes in
market interest rates of various assets and liabilities (basis risk) and their
past behavioural pattern (embedded option risk), they could standardise the
gap by multiplying the individual assets and liabilities by how much they will
change for a given change in interest rate. Thus, one or several assumptions
of standardised gap seem more consistent with real world than the simple
gap method. With the Adjusted Gap, banks could realistically estimate the
EaR.

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 2. Duration Gap Analysis
Matching the duration of assets and liabilities, instead of matching
the maturity or repricing dates is the most effective way to protect the
economic values of banks from exposure to IRR than the simple gap model.
Duration gap model focuses on managing economic value of banks by
recognising the change in the market value of assets, liabilities and off-
balance sheet (OBS) items. When weighted assets and liabilities and OBS
duration are matched, market interest rate movements would have almost
same impact on assets, liabilities and OBS, thereby protecting the bank’s
total equity or net worth. Duration is a measure of the percentage change in
the economic value of a position that will occur given a small change in the
level of interest rates.
Measuring the duration gap is more complex than the simple gap
model. For approximation of duration of assets and liabilities, the simple
gap schedule can be used by applying weights to each time-band. The
weights are based on estimates of the duration of assets and liabilities and
OBS that fall into each time band. The weighted duration of assets and
liabilities and OBS provide a rough estimation of the changes in banks’
economic value to a given change in market interest rates. It is also possible
to give different weights and interest rates to assets, liabilities and OBS in
different time buckets to capture differences in coupons and maturities and
volatilities in interest rates along the yield curve.
In a more scientific way, banks can precisely estimate the economic
value changes to market interest rates by calculating the duration of each
asset, liability and OBS position and weigh each of them to arrive at the
weighted duration of assets, liabilities and OBS. Once the weighted duration
of assets and liabilities are estimated, the duration gap can be worked out
with the help of standard mathematical formulae. The Duration Gap
measure can be used to estimate the expected change in Market Value of
Equity (MVE) for a given change in market interest rate.
The difference between duration of assets (DA) and liabilities (DL)
is bank’s net duration. If the net duration is positive (DA>DL), a decrease in
market interest rates will increase the market value of equity of the bank.
When the duration gap is negative (DL> DA), the MVE increases when the
interest rate increases but decreases when the rate declines. Thus, the
Duration Gap shows the impact of the movements in market interest rates
on the MVE through influencing the market value of assets, liabilities and
OBS.
The attraction of duration analysis is that it provides a
comprehensive measure of IRR for the total portfolio. The duration analysis
also recognises the time value of money. Duration measure is additive so
that banks can match total assets and liabilities rather than matching

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individual accounts. However, Duration Gap analysis assumes parallel shifts
in yield curve. For this reason, it fails to recognise basis risk.

Simulation
Many of the international banks are now using balance sheet
simulation models to gauge the effect of market interest rate variations on
reported earnings/economic values over different time zones. Simulation
technique attempts to overcome the limitations of Gap and Duration
approaches by computer modelling the bank’s interest rate sensitivity. Such
modelling involves making assumptions about future path of interest rates,
shape of yield curve, changes in business activity, pricing and hedging
strategies, etc. The simulation involves detailed assessment of the potential
effects of changes in interest rate on earnings and economic value. The
simulation techniques involve detailed analysis of various components of
on-and off-balance sheet positions. Simulations can also incorporate more
varied and refined changes in the interest rate environment, ranging from
changes in the slope and shape of the yield curve and interest rate scenario
derived from Monte Carlo simulations.
The output of simulation can take a variety of forms, depending on
users’ need. Simulation can provide current and expected periodic gaps,
duration gaps, balance sheet and income statements, performance
measures, budget and financial reports. The simulation model provides an
effective tool for understanding the risk exposure under variety of interest
rate/balance sheet scenarios. This technique also plays an integral-planning
role in evaluating the effect of alternative business strategies on risk
exposures.
The simulation can be carried out under static and dynamic
environment. While the current on and off-balance sheet positions are
evaluated under static environment, the dynamic simulation builds in more
detailed assumptions about the future course of interest rates and the
unexpected changes in bank’s business activity. The usefulness of the
simulation technique depends on the structure of the model, validity of
assumption, technology support and technical expertise of banks. The
application of various techniques depends to a large extent on the quality of
data and the degree of automated system of operations. Thus, banks may
start with the gap or duration gap or simulation techniques on the basis of
availability of data, information technology and technical expertise. In any
case, as suggested by RBI in the guidelines on ALM System, banks should
start estimating the interest rate risk exposure with the help of Maturity
Gap approach. Once banks are comfortable with the Gap model, they can
progressively graduate into the sophisticated approaches.

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Rigidities and the remedial measures:
However, there are certain rigidities at micro level of banks and
also at the systemic level, which the banks have to address. At the micro
level, the banks have to strengthen their Management Information System
(MIS) and computer processing capabilities for accurate measurement of
interest rate risk in their banking books, which impact, in the short-term,
their net interest income (NII) or net interest margin (NIM) or “spread” and
in the long-term, the economic value of the bank.
At the systemic level, the rigidities are the following:
Most of the liabilities of banks, like deposits and borrowings are on fixed
interest rate basis while their assets like loans and advances are on
floating rate basis.
There is still some regulation in place on interest rates in the system, such as
savings bank deposit, export credit, refinances, etc.
There is no definite interest rate repricing dates for floating Prime Lending
Rate (PLR) based products like loans and advances, thereby placing them
in accurate time buckets for measurement of interest rate risk difficult.
The RBI has taken a number of measures to correct the systemic
rigidities, like introduction of:
· Floating rate deposits,
· Fixed rate lending,
· Tenor-linked PLR,
· Interest rate derivative products like Interest Rate Swaps (IRSs) and
Forward Rate Agreements (FRAs), and
· For pricing of rupee interest rate derivatives, banks have been allowed to
use interest rate implied in foreign exchange forward market, etc.
In order to align the Indian accounting standards with the
international best practices and taking into consideration the evolving
international developments, the norms for classification and valuation of
investments have been modified with effect from September 30, 2000.
Now, the entire investment portfolio is required to be classified under three
categories, viz., Held to Maturity, Available for Sale and Held for Trading.
While the securities ‘Held for Trading ‘and ‘Available for Sale ‘should be
marked to market periodically, the securities ‘Held to Maturity’, which
should not exceed 25% of the total investments need not be marked to
market.
The Narasimham Committee II on Banking Sector Reforms had
recommended that in order to capture market risk in the investment
portfolio, a risk-weight of 5% should be applied for Government and other
approved securities for the purpose of capital adequacy. The Reserve Bank
of India has prescribed 2.5% risk-weight for capital adequacy for market risk
on SLR and non-SLR securities, with effect from 31 March 2000 and 2001

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respectively, in addition to appropriate risk-weights for credit risk. It may be
mentioned here that the Basle Committee on Banking Supervision (BCBS) of
the Bank for International Settlements (BIS) has introduced capital charge
for market risk, inter alia, for the interest rate related instruments and
equity positions in the trading book and gold and forex position in both
trading and banking books. The banks in India are required to apply the
2.5% risk-weight for capital charge for market risk for the whole investment
portfolio and 100% risk-weight on open gold and forex position limits. In the
“New Capital Adequacy Framework” consultative paper, the BCBS
recognises the significance of interest rate risk in some banking books and
proposes to develop a capital charge for interest rate risk in the banking
book for banks where interest rate risks are significantly above average
(“outliers”).

RBI Guidelines on Banks’ Interest Rate Risk

1. Scope
Banks should compute their interest rate risk position in each currency
applying the Duration Gap Analysis (DGA) and Traditional Gap Analysis
(TGA) to the Rate Sensitive Assets (RSA)/ Rate Sensitive Liabilities (RSL)
items in that currency, where either the assets, or liabilities are 5 per cent
or more of the total of either the bank’s global assets or global liabilities.
The RSA and RSL include the rate sensitive off balance sheet asset and
liabilities. The interest rate risk position in all other residual currencies
should be computed separately on an aggregate basis.

2. Adoption of Earnings and Economic Value Approach

Interest rate risk is the risk where changes in market interest rates
affect a bank’s financial position. Changes in interest rates impact a bank’s
earnings (i.e. reported profits) through changes in its Net Interest Income
(NII). Changes in interest rates also impact a bank’s Market Value of
Equity (MVE) or Net Worth through changes in the economic value of its
rate sensitive assets, liabilities and off-balance sheet positions. The interest
rate risk, when viewed from these two perspectives, is known as ‘earnings
perspective’ and ‘economic value perspective’, respectively. Generally, the
former is measured using the TGA and the latter is measured using more
sophisticated DGA. Banks should carry out both the analyses.

3. Earnings Perspective - TGA

The focus of the TGA is to measure the level of a bank’s exposure to interest
rate risk in terms of sensitivity of its NII to interest rate movements over the
horizon of analysis which is usually one year. It involves bucketing of all RSA
and RSL and off balance sheet items as per residual maturity/ re-pricing date

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in various time bands, as is being currently done (circular DBOD.BP.BC. 8/
21.04.098/ 99 dated February 10, 1999) and computing Earnings at Risk
(EaR) i.e. loss of income under different interest rate scenarios over a time
horizon of one year.

4. Economic Value Perspective – DGA

The focus of the DGA is to measure the level of a bank’s exposure to
interest rate risk in terms of sensitivity of Market Value of its equity (MVE)
to interest rate movements. The DGA involves bucketing of all RSA and RSL
as per residual maturity/ re-pricing dates in various time bands and
computing the Modified Duration Gap (MDG). The RSA and RSL include the
rate sensitive off balance sheet asset and liabilities. MDG can be used to
evaluate the impact on the MVE of the bank under different interest rate
scenarios.

4.1 Relationship between MDG and sensitivity of MVE to interest rate

changes
(i) MD of an asset or liability measures the approximate percentage
change in its value for a 100 basis point change in the rate of interest.
(ii) The MDG framework involves computation of Modified Duration of RSA
(MDA) and Modified Duration of RSL (MDL). MDA and MDL are the
weighted average of the Modified Duration (MD) of items of RSA and
RSL respectively. The MDG can be calculated with the help of the following
formula:

MDG=

Ideally, in the calculation of changes in MVE due to changes in the interest

rates, market values of RSA and RSL should be used. However, for the sake
of simplicity, banks may take the book values of the RSA and RSL
(both inclusive of notional value of rate sensitive off-balance sheet
items) as an approximation The MDG as defined above reflects the degree
of duration mismatch in the RSA and RSL in a bank’s balance sheet.
Specifically, larger this gap in absolute terms, the more exposed the
bank is to interest rate shocks.
(iii) The impact of changes in the interest rates on the MVE can be
evaluated by computing ΔE with the help of following formula
ΔE= ‐[MDG]*RSA* Δ I
In the above equations:
• Equity would mean Networth as defined in DBS Circular No.
DBS.CO.PPD.ROC. 12 /11.01.005/2007-08 dated April 7, 2008.

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• ‘ΔE’ stands for change in the value of equity
 ‘Δ i’ stands for change in interest rates in percentage points ( 1%
change to be written as 0.01)

(iv) Illustration:

A schematic hypothetical illustration for computation of MDG, and

for an interest rate shock of 200 basis points is given below:

4.2 Preparation of Interest Rate Sensitivity statement

4.2.1 Need for behavioural studies
In the Interest Rate Sensitivity (IRS) Statement as per format prescribed in
Appendix II, while RSA and RSL with fixed maturities are straightaway
classified in the relevant time buckets based on residual maturity/ re-
pricing dates, there could be an element of variance in the manner of
bucketing those items which do not have a fixed maturity or have
embedded optionality (i.e savings bank deposits, current account deposits
and mortgage loans etc.). This calls for behavioural studies to be
undertaken by banks in order to have a realistic assessment of the interest
rate sensitivity, an issue which has already been highlighted in the present
ALM guidelines. Banks should not only have an appropriate process to
conduct such behavioural studies in a consistent manner, but also have a
detailed framework to review these studies and their output periodically
(say annually). Banks may apply the results of the behavioural studies on a
consistent basis and the results may be reviewed/ revised once a year in
the first quarter of the financial year, if necessary. The behavioural
studies should be based on at least three years data. Banks may evolve a
suitable mechanism, supported by empirical studies and behavioural
analysis to estimate the future behaviour of assets and liabilities and off-
balance sheet items with respect to changes in market variables. Pending
such studies, banks may use the indicative framework for bucketing of
assets and liabilities, as furnished in Appendix I.

4.2.2 Introduction of additional time buckets

The past few years have seen banks’ foray into financing long-term assets
such as home loans, infrastructure projects, etc. Banks also have been
allowed to raise funds through long-term bonds with a minimum maturity
of five years to the extent of their exposure of residual maturity of more
than 5 years to the infrastructure sector. Hence, it has been decided to add
the following time buckets to the existing Statement of Interest Rate
Sensitivity viz; ‘over 5 years and up to 7 years’, ‘above 7 years and up to
10 years’ and ‘over 10 years and up to 15 years’ and ’over 15 years. The

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existing and revised time buckets for compiling the Statement of Interest
Rate Sensitivity, both under TGA and DGA, are given below:
Statement of Interest Rate Sensitivity – Time buckets

4.2.3 Grouping of assets and liabilities in time buckets

(i) Calculation of the MD of each individual rate sensitive asset, liability and
off-balance sheet position and taking their weighted average to derive the
MD of RSA and RSL would enhance the accuracy of calculation. However, it
may lead to an increase in volume and complexity of calculations. The
feasibility of this approach would depend on bank’s information
technology infrastructure (availability of core banking solution, MIS
capability), staff skills, size of the branch network, etc. Banks have therefore
been provided certain extent of flexibility in applying the proposed
framework. Those banks which are not equipped to compute the MD of
each individual rate sensitive asset, liability and off balance sheet position
may:
a) group RSA and RSL under the broad categories indicated in Appendix I
under various time buckets; and
b) compute Modified Duration (MD) of these categories of assets/ liabilities
and off balance sheet items using the suggested common maturity,
coupon and yield parameters indicated in Appendix I.
(ii) The Modified Duration Gap (MDG) computed from the above would be
simpler and may also lead to a cost- benefit advantage, in spite of
the approximations in the calculation of MD. However, banks which have
the capability to compute the MD of each item of RSA and RSL may do so
in order to improve the accuracy of measurement of interest rate risk.
(iii) Banks may compile the ALM statements and compute the MDG for
the Balance Sheet as a whole, which would be a combination of the
Banking and Trading books. Trading Book currently comprises securities
included under Held for Trading and Available for Sale categories and
specified derivative positions.

4.2.4 Treatment of positions in various currencies

As indicated in para 1, banks should separately compute their interest rate
risk position in each currency for the purpose of DGA where either the
assets, or liabilities are 5 per cent or more of the total of either the bank’s
global assets or global liabilities. The interest rate risk position in all other
residual currencies should be computed separately on an aggregate basis.
While reporting the above interest rate risk position in Part B of
Appendix II, the foreign currencies would be converted into Indian Rupees
using the relevant spot closing rates as published by FEDAI. MD of each
item or group of items of rate sensitive assets, liabilities and off-balance

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sheet items may be computed using the appropriate coupon and
appropriate foreign currency yield curve. For residual currencies, the
appropriate coupon and appropriate foreign currency yield curve of the
largest among the residual currencies may be used. In deciding on
coupon and yield curves, the principles behind the choice of coupons and
yield curve in Appendix I may be followed.

4.2.5 Treatment of Interest Rate Derivatives instruments

(i) Derivatives are converted into positions in the relevant underlying. The
amounts considered are the principal amount of the underlying or of
the notional underlying.
(ii) Interest Rate Swaps could be considered as a combination of a
short position and a long position. The notional of the fixed and floating leg
of an Interest Rate Swap could be shown in the respective maturity bucket
based on the maturity date for the fixed leg and the reset date for the
floating leg. Suppose, a bank receives 5- year fixed and pays floating
MIBOR, then the fixed leg of the swap could be shown as an asset in
the ‘5-7 year’ bucket and the floating leg would be shown as a liability in ’1-
28 days’ bucket. Similarly, a currency swap may be considered as a
combination of a short position in one currency and long position in
another currency. The two positions will be sensitive to the changes in the
respective interest rates. The notionals of the two currencies will be
bucketed as a short/long positions in the respective currency with relevant
maturity.
(iii) Interest Rate Futures (IRFs) and Forward Rate Agreements (FRAs)
could also be considered as a combination of a short position and long
position. For instance, a long position in a September three month FRA
(taken on June 1), can be bucketed as a short position in a bond with a
maturity of six months and a long position in a bond with a maturity of
three months. The amount to be shown in the Statement of interest rate
sensitivity is the notional of FRA. IRFs could also be considered as a
combination of a short position and a long position. For instance, a long
position in a September three month IRF (taken on June 1), can be
bucketed as a long position in a Government bond, with a maturity of six
months and a short position in Government bond with a maturity of three
months. The amount to be shown in the Statement of interest rate
sensitivity is the notional of IRF.
(iv)Interest Rate Options (wherever permitted) are considered according to
the delta equivalent amount of the underlying or of the notional underlying.

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4.2.6 Reporting format of the Statement of Interest Rate Sensitivity
Currently banks are reporting interest rate sensitivity as a part of DSB
returns which is based on the Traditional Gap Approach. The methodology
for compiling these statements stands revised to the extent specified in
these guidelines, viz; in relation to maturity buckets, methodology for
bucketing various items of RSA and RSL. In addition to extant reporting,
interest rate sensitivity as per DGA approach should be reported in the
formats stipulated in Appendix II on a quarterly basis with effect from June
30, 2011 till March 31, 2012 and on a monthly basis with effect from April
30, 2012. The quarterly returns may be submitted within 21 days from
the end of the quarter and monthly returns may be submitted within
15 days from the end of the month. The average yield and coupons on
assets / liabilities used for computation of modified duration may be
reported as per format stipulated in Appendix IIA.

4.3 Methodology for computing Modified Duration Gap

This framework is based on the utilization of book values of banking book
assets and liabilities for the purpose of computation of MD. However, banks
which have the capability to use market value of assets and liabilities of
banking book may do so. Market values of assets and liabilities may be
determined by discounted cash flow method. The step-by- step approach
for computing modified duration gap is as follows:
i) Identify variables such as principal amount, maturity date / re-
pricing date, coupon rate, yield, frequency and basis of interest
calculation for each item / category of RSA/RSL.
ii) Plot each item / category of RSA/RSL under the various time buckets.
For this purpose, the absolute notional amount of rate sensitive off-
balance sheet items in each time bucket should be included in RSA if
positive or included in RSL if negative.
iii) The mid-point of each time bucket may be taken as a proxy for the
maturity of all assets and liabilities in that time bucket, except for those
for which the bank is able to compute modified duration on individual
basis.
iv) Determine the coupon for computation of MD of RSAs and RSLs as
indicated in Appendix-I except for those for which the bank is able
to compute MD on individual basis.
v) Determine the yield curve for arriving at the yields based on current
market yields or current replacement cost or as specified in
Appendix I for each item / category of asset / liability/ off-balance
sheet item.
vi) Calculate the MD in each time band of each item/ category of
RSA/RSL using the maturity date, yield, coupon rate, frequency, yield

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 and basis for interest calculation.
vii) Calculate the MD of each item/category of RSA/RSL as weighted
average MD of each time band for that item.
viii) Calculate the weighted average MD of all RSA (MDA) and RSL (MDL) to
arrive at MDG and MDOE.

5. Risk management and control issues

As a step towards enhancing and fine-tuning the existing risk management
practices in banks, Guidance Notes on Credit Risk Management and Market
Risk Management were issued to banks on October 12, 2002, giving
indicative guidelines for effective credit risk and market risk management.
Additionally, banks may ensure that:

5.1 Each bank should set appropriate internal limits on Earnings at Risk (EaR)
and on the volatility in the Market Value of Equity with the approval of its
Board / Risk Management Committee of the Board by March 31, 2011.
These limits may be linked to MVE for DGA and the NII (for TGA). Further,
the Board / ALCO must also periodically review the above limits after
assessing various scenarios of interest rates and the resultant volatility of
earnings in terms of Net Interest Income and volatility in networth.

5.2 The institutionalised framework of the ALCO in banks must be

strengthened and the ALCO’s prior approval must be taken for deciding
upon yields, assumptions used / proposed to be used, bucketing,
behavioural studies, etc. for duration gap analysis. Banks must also
ensure that these are compliant with regulatory prescriptions.

5.3 It is also imperative that material assumptions made, if any, are

updated regularly to reflect the current market and operating environment.
Further, the process of developing material assumptions should be
formalized and reviewed periodically (say annually).

5.4 As prescribed in para 4.2 of Annex 10 of Master Circular dated July 1,

2010 on Prudential Guidelines on Capital Adequacy and Market Discipline-
Implementation of the New Capital Adequacy Framework, a level of
interest rate risk which generates a drop in the value of equity of more than
20% of MVE with an interest rate shock of 200 basis points, will be treated
as excessive and such banks would be required by RBI to take action as
indicated in the circular. It is clarified that the under this circular the
shock of 200 basis points will be applied to the entire balance sheet
including the trading book. This is considered appropriate considering the
illiquidity in various market segments and the trading book generally being

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smaller in relation to the entire balance sheet. Banks should monitor their
interest rate risk positions and take appropriate corrective action with
reference to the stipulations in para 5.1 for internal limits on volatility of
MVE i.e percentage variation in the MVE and the limits on individual gaps.
Any significant difference in the assessment of interest rate risk for the bank
under two scenarios – (i) the bank as a whole and (ii) separately for banking
and trading book with different shocks – and their implication for regulatory
capital would be considered under Supervisory Review and Evaluation
Process (SREP).

5.5 Banks should also measure their vulnerability to loss in stressed market
conditions, including the breakdown of key assumptions, and consider
these results when establishing and reviewing their limits and policies in
respect of Interest Rate Risk. The possible stress scenarios may include:
changes in the general level of interest rates, e.g. a change in the yield by
200 and 300 basis points or more in a year, changes in interest rates in
individual time bands to different relative levels (i.e. yield curve risk),
changes in volatility of market rates, and earlier withdrawal of the core
portion of current account and savings accounts deposits ( i.e. placement of
the core portion of savings deposits in the first time band as also in the 3 to
6 months bucket than in the 1 to 3 year bucket) etc.

5.6 Banks must adopt the practice of periodic model validation. Thus,
where internal models / software packages are being used, the integrity
and validation of data/ assumptions being used to generate the results, its
validation and functioning of the entire system of interest rate risk
management should be subjected to an independent audit either by an
experienced internal auditor or external auditor who is conversant with risk
management processes. The Audit Committee of the Board (ACB) would be
responsible to ensure suitability of auditors after a proper due diligence
process.

5.7 Banks should ensure documentation in respect of discount rates,

coupons; assumptions used/ roposed to be used, bucketing, behavioural
studies, validation process etc. All material assumptions, regardless of the
source, should be supported with analysis and documentation. Banks shall
ensure that sufficient documentation is made available at the time of
validation, internal audit, statutory audit and RBI inspection.

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 Appendix I
Guidelines on bucketing of various items of assets and liabilities in the
Interest
Rate Sensitivity Statement, along with the coupons and yields to be used
Sr. Heads of Rate sensitivity and time Revised Framework for
Accounts bucket as per extant bucketing of assets/
ALM liabilities/off balance
Guidelines for interest sheet items and computation
rate sensitivity of
statement Modified Duration
1. 2. 3. 4.
Liabilities
1. Capital- Non-sensitive. • Non-sensitive for TGA.
Equity shares • Not to be bucketed for DGA.
2. Reserves and Non-sensitive. • Non-sensitive for TGA.
Surplus • Not to be bucketed for DGA.
3. (i)Innovative • Sensitive.
Perpetual Debt • Bucketing as per residual
Instruments(IPDI) maturity/ re-pricing.
eligible for Tier I • Coupon rate: Contract rate.
status • Yield: Govt. of India yield for
(ii) Debt capital corresponding period with
Instruments appropriate mark up for rated
qualifying as bonds (corresponding to
Upper Tier II rating of the instrument)
Capital and Tier II published by FIMMDA.
bonds
(iii) Preference
shares eligible for
Tier I and Tier II
Capital
4(i) Current Deposits Non-sensitive. • Sensitive.
• Banks better equipped to
estimate the behavioral
pattern of current deposits
should classify them in the
appropriate buckets based on
behavioral maturity as per the
behavioural study. In
such cases to compute the
Modified Duration, banks must
use its relevant term deposit
rates as the discount rate,
coupon rate being zero.

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 • However, banks which have
notconducted the above
behavioral study may classify
15% of the current deposits as
volatile and place it in the first
time bucket (viz. 1-28 days) and
85% may be placed in the 1-3
years time bucket.
• Coupon Rate: Zero.
• Yield :
(i) As the mid-point of the
1- 28 days time bucket is 14
days, each bank could take its
14 days term deposit rate as
the yield to compute the MD
of the volatile portion.
(ii) As the mid-point of the
1- 3 years time bucket is 2
years, each bank could take its
2-year term deposit rate as the
discount rate to compute the
Modified Duration of the core
portion.
4(ii). Savings Bank Sensitive to the extent • Sensitive.
Deposits of interest paying (core) • Banks may estimate the
portion. This may be future behaviour / sensitivity
included in over 3-6 of savings bank deposits to
months bucket. changes in market variables,
The non-interest paying the sensitivity so estimated
portion may be shown in could be shown under
Non-sensitive bucket. appropriate time
Where banks can buckets. The existing savings
estimate the future bank rate may be used as
behaviour/sensitivity of coupon and the bank’s own
current/savings bank relevant term deposit rates
deposits to changes in must be used as the yield to
market variables, the compute the MD.
sensitivity so estimated
could be shown under
appropriate time buckets

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 • However, where banks have
not undertaken any behavioral
study they may include
core portion (say 90%) as rate
sensitive and include the same
in 1-3 years time bucket. The
volatile portion (10%) may be
placed in 1-28 days bucket.
• Coupon Rate: Existing
Savings Bank interest rate, i.e.
3.5 %.
• Yield:
(i) As the mid-point of the
1- 28 days time bucket is 14
days, each bank could take
its 14 days term deposit rate as
the yield to compute the MD of
the volatile portion.
(ii) As the mid-point of the 1-
3 years time bucket is 2 years,
each bank could take its 2-year
term deposit rate as the
discount rate to compute the
Modified Duration of the core
portion.
4(iii). Term deposits Sensitive and reprices on • Sensitive.
maturity. The amounts • Banks may study the
should be distributed to behavioural pattern of large
different buckets on the value fixed rate term deposits
basis of remaining term to arrive at the percentage of
to maturity. However, in deposits encashed/foreclosed
case of floating rate and renewed before maturity,
term deposits, the i.e the quantum on which the
amounts may be shown option is exercised. The
under the time bucket amount of deposits which are
when deposits estimated to be prone to pre-
contractually become mature withdrawal as per such
due for re-pricing. studies may be placed in the
corresponding maturity
buckets.

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 • The other fixed rate term
deposits may be distributed in
various time buckets on the
basis of remaining term to
maturity.
• In the case of floating rate
term deposits, the amounts may
be shown under the time bucket
when the deposits
contractually become due for re-
pricing.
• Coupon rate:
Banks may compute the average
coupon on the term deposits by
comparing the interest paid/
accrued during the relevant
accounting period on term
deposits to the monthly average
outstanding term deposits.
• Yield:
Each bank’s card interest rate for
deposits for the relevant term
may be used.
4(iv). Certificates of Sensitive and re-prices on • Sensitive and re-prices on
Deposit maturity. The amounts maturity.
should be distributed to • The amounts should be
different buckets on the distributed to different
basis of remaining term buckets on the basis of
to maturity. However, in remaining term to maturity.
case of floating rate term However, in case of floating rate
deposits, the amounts CDs, the amounts may be shown
may be shown under the under the time bucket when
time bucket when CDs contractually become due
deposits contractually for re-pricing.
become due for re-
pricing.
• Coupon rate: Calculated in a
similar manner as term deposits.
• Yield: Govt. of India yield for
corresponding period with
mark up for rated bonds
(corresponding to CD ratings of
the bank) published by FIMMDA
may be taken as yield.

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5. Borrowings Borrowings – Fixed
Sensitive and reprices on
maturity. The amounts
should be distributed to
different buckets on the
basis of remaining
maturity.
Borrowings – Floating
Sensitive and reprices
when interest rate is
reset. The amounts
should be distributed
to the appropriate
bucket with reference to
the repricing date.
Borrowings – Zero
Coupon Sensitive and
reprices on maturity.
The amounts should be
distributed to the
respective maturity
buckets.
5(i). Money at Call  The amounts should be
and Short Notice distributed to different buckets
on the basis of remaining
maturity/ re-pricing date.
 Overnight call money rate may
be taken as both the coupon
and yield.
5(ii). Inter-bank (Term) • The amounts should be
distributed to different buckets
on the basis of remaining
maturity/ re-pricing date.
• The coupon will be as per
actual rate for each inter- bank
term loan and yield may be
based on the FIMMDA-NSE
MIBOR curve, with appropriate
mark up as per rating of the Tier
II bonds of the bank.

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5(iii). Refinances Borrowings from RBI – • The amounts should be
upto 1 month bucket. distributed to different buckets
Refinances from other on the basis of remaining
agencies Fixed rate as per maturity in the case of fixed rate
respective maturity. refinances and re-pricing date
Floating rate reprices for floating rate refinances.
when interest rate is • The appropriate refinance rate
reset. of RBI, NHB, NABARD, etc. may
be used as the coupon and yield
may be based on the GOI
securities of corresponding
tenors.

5(iv). Others (specify) - -

6. Other Liabilities
and Provisions

i) Bills Payable Non-sensitive. • Non-sensitive.

ii) Inter-office Non-sensitive • Non-sensitive.

adjustment
iii) Provisions Non-sensitive. • Non- sensitive.

iv) Others Non-sensitive. • Non-sensitive.

7. Repos (Funds Reprices only on maturity • Sensitive.

borrowed) and should be distributed • The amounts should be
to the respective distributed to different buckets
maturity buckets. on the basis of remaining
maturity.
• The coupon will be as per
actual rate for each repo and
yield may be based on FIMMDA-
NSE MIBOR curve.

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8. Bills Re- Re-prices only on • Sensitive.
discounted maturity and should be • The amounts should be
(DUPN) distributed to the distributed to different buckets
respective maturity on the basis of remaining
buckets. maturity.
• Coupon rate: Appropriate
discount rate.
• Yield: FIMMDA- NSE MIBOR
curve may be used as the yield,
with appropriate mark up as per
rating of the Tier II bonds of the
bank.
9. Forex Swaps Re-prices only on • Sensitive.
(Buy/Sell) maturity and should be • Actual MD for each contract
distributed to the may be computed using the
respective maturity rupee implied rate through
buckets. forward premium/discount as
both coupon and discount rate.
10. Others - -
A. Total Liabilities

1. Cash Non - sensitive. • Non-sensitive.

2. Balances with Interest earning portion • Non-sensitive.

RBI may be shown in over 3 -
6 months bucket. The
balance amount is non-
sensitive.
3. Balances with
other banks

i) Current account i) Non-sensitive. • Non-sensitive.

ii) Money at Call ii) Sensitive on maturity. • Sensitive on maturity.

and Short Notice. The amounts should be • The amount should be
distributed to the plotted in the 1-28 days bucket.
respective maturity • The overnight call money rate
buckets. may be used as both coupon and
yield.

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iii) Term deposits Sensitive on maturity. • Sensitive.
and other The amounts should be • The amounts should be
placements distributed to the distributed to different time
respective maturity buckets on the basis of residual
buckets. maturity or residual period to
repricing, as relevant.
• Coupon rate: Relevant rate of
term deposit / placement.
• Yield: Term deposit rates of
the corresponding tenors of
the banks with whom deposits
are placed.
4. Investments Fixed rate/ zero coupon  Sensitive
(Performing) – sensitive on maturity.  For the purpose of bucketing
(including those Floating rate – sensitive and calculation of Modified
under reverse at next re-pricing date. Duration, investments may be
repos but classified into SLR and non-SLR
excluding repos) investments as indicated below:

i) SLR Fixed rate/ zero coupon • Sensitive.

investments – sensitive on maturity. • Actual Modified Duration of
Floating rate – sensitive each SLR security should be
at next repricing date. used.
• Yield: G-Sec yield curve
ii) Non-SLR Fixed rate/ zero coupon– • Sensitive (except equity which
investments sensitive on maturity. may be put in the non-sensitive
Floating rate – sensitive bucket).
at next repricing date. • Actual Modified Duration of
each Non-SLR security should be
used.
• Yield: FIMMDA benchmark
curve.
iiii) Re-capitalisation • Sensitive.
bonds • Actual Modified Duration of
each recapitalization bond may
be computed.
iv) Investments in • Non- sensitive.
SRs issued by
ARCs

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5. Advances • Sensitive.
(Performing) • The amounts should be
distributed to different time
buckets on the basis of residual
maturity or residual period to re-
pricing, as relevant.
 Banks may compute the
average coupon for the
advances portfolio by
comparing the interest income
during the relevant accounting
period from ‘standard’
advances to the monthly
average outstanding ‘standard’
advances.
 The average rating of the
advances portfolio may be
estimated by each bank to
arrive at the applicable yield.
One of the methods for
estimating the average rating
may be as follows:
Multiply the outstanding
advances in each bucket with the
internal rating scores to arrive at
the weighted average rating of
the advances in that bucket.
Thereafter, this rating may be
mapped to an external rating.
In case a major portion of the
bank's advances in a particular
time bucket happens to be
unrated, the bank may use the
rating scores of large advances/
rated advances in each bucket
(mapped with the rating of
external agency) for arriving at
weighted average rating for
the bucket. On the basis of the
average rating of each bucket,
the yield may be arrived at using
the FIMMDA yield curve for GoI
securities with appropriate mark-
up.

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i) Bills Purchased (i) Sensitive on maturity. • Sensitive on maturity.
and Discounted • The average coupon and yield
(incl. Bills under for the advances portfolio, as
DUPN) computed above, may be used.
ii) Cash (ii) Sensitive only when  Sensitive on re-pricing/ date of
credit/Overdrafts PLR/Base Rate /risk next renewal, whichever is
(incl. TODs/Loans premium is changed. earlier. In the case of BPLR/Base
repayable on Each bank should foresee Rate– linked advances, banks
demand) the direction of interest may estimate the re-pricing date
rate movements of based on the past experience
funding options and and future forecast for the
capture the amounts in changes in their BPLR/Base
the respective maturity Rate.
buckets which coincide  The average coupon and yield
with the time taken by for the advances portfolio, as
banks to effect changes computed above, may be used.
in PLR/Base Rate in
response to changes in
market interest rates.
iii) Term Loans (iii) Sensitive only when • Sensitive on re-pricing/
PLR/Base Rate/risk maturity, whichever is earlier. In
premium is changed. the case of BPLR/Base Rate
Each bank should foresee linked advances, banks may
the direction of interest estimate the re-pricing date
rate movements of based on the past experience
funding options and and future forecast for the
capture the amounts in changes in their BPLR/Base Rate.
the respective maturity • The average coupon and yield
buckets which coincide for the advances portfolio, as
with the time taken by computed above, may be used.
banks to effect changes
in PLR/Base Rate in
response to changes in
market interest rates.
6. NPAs (Advances Sub-standard –over 3-5 • Sensitive.
and years bucket. • Sub-standard NPAs should be
Investments) * Doubtful and loss –over 5 slotted in the 1-3 years time
years bucket. bucket.
• Doubtful and Loss Assets –
should be slotted in the 3-5 years
time bucket.
• Coupon: The coupon rate will
be taken as zero.
• The yield curve prescribed by
FIMMDA for unrated exposures/
default category may be used as

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 yield.
7. Fixed Assets Non-sensitive. • Non-sensitive.
8. Other Assets
i) Inter-office Non-sensitive. • Non-sensitive.
ii) Leased Assets Sensitive on cash flows. • Sensitive on cash flows.
The amounts should be • The amounts should be
distributed to respective distributed to respective maturity
maturity buckets buckets corresponding to the
corresponding to the cash cash flow dates.
flow dates. • Yield curve prescribed by
FIMMDA for valuation of
corporate bonds as per the
average rating estimated for
leased assets to be used for
arriving at the yields.
• The average coupon for the
leased assets portfolio, as
computed for advances, may be
used.
iii) Others Non-sensitive. • Non-sensitive.
9. Reverse Repos Sensitive on maturity. • Sensitive. The amounts should
(Funds Lent) be distributed to different
buckets on the basis of
remaining maturity.
• The coupon will be as per
actual rate for each repo and
yield may be based on FIMMDA-
NSE MIBOR curve.
10. Forex Swaps Sensitive on maturity • Sensitive.
(Sell / Buy) • Actual MD for each contract
may be computed using the
rupee implied rate through
forward premium/discount may
be used as both coupon and
discount rate.
11. Bills Sensitive on maturity. • Overnight call money rate may
Rediscounted be used as both the yield and
(DUPN) coupon rates.
12. Others (specify) - -
B. Total Assets

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13. Other Products • Actual modified duration for
(Interest Rate each contract may be computed
Derivatives) using the contracted rate as
coupon and the relevant yield
curve for discounting factor.
Alternatively all interest rate
derivatives can also be dealt with
in the following manner:
i) FRAs Suitably classified. • Forward Rate Agreements
(FRAs) could also be considered
as a combination of a short
position and a long position. For
instance, a long position in a
September three month FRA
(taken on June 1), can be
bucketed as a short position in a
bond with a maturity of 6
months and a long position in a
bond with a maturity of 3
months. Accordingly a liability in
the 3-6 months bucket and an
asset in the 28 days to 3 months
bucket may be shown. The
amount to be reckoned for
computing interest rate
sensitivity is the notional value of
the FRA.
ii) Swaps Sensitive and should be • Interest Rate Swaps could be
distributed under considered as a combination of a
different buckets with short position and a long
reference to maturity. position. The notional of the
fixed and floating leg of an
Interest Rate Swap could be
shown in the respective maturity
bucket based on the maturity
date for the fixed leg and the
reset date for the floating leg.
Suppose, a bank receives 5-year
fixed and pays floating MIBOR,
then the fixed leg of the swap
could be shown as an asset in
the ‘5-7 year’ bucket and the
floating leg would be shown as a
liability in ’1-28 days’ bucket.

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 Similarly, a currency swap may
be considered as a combination
of a short position in one
currency and long position in
another currency. The two
positions will be sensitive to the
changes in the respective interest
rates. The notionals of the two
currencies will be bucketed as a
short/long positions in the
respective currency with relevant
maturity.
iii) Futures Suitably classified. • Interest Rate Futures (IRFs)
could also be considered as a
combination of a short position
and long position. For instance, a
long position in a September
three month IRF (taken on
June
1) Can be bucketed as a long
position in Government bond,
with a maturity of six months
and a short position in
Government bond with maturity
of three months. The amount to
be reckoned for computing
interest rate sensitivity is the
notional value of the IRF.
Net of provisions, interest suspense and claims received from ECGC/DICGC.
Note:
1. Wherever FIMMDA spreads are proposed to be used, the FIMMDA
Corporate Bond Spreads table may be used. The same can be
downloaded from the FIMMDA website (www.fimmda.org) or more
from the exact link at
http://www.fimmda.org/Products_and_Services/asp/spread_gilt.asp
2. Equity holding whether strategic or for investment purposes may be
treated as Non-sensitive and bucketed accordingly.

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 Chapter-7

FOREIGN EXCHANGE RISK

Introduction
The risk inherent in running open foreign exchange positions have been
heightened in the recent years by the pronounced volatility in forex rates,
thereby adding a new dimension to the risk profile of banks’ balance sheets.
Foreign Exchange Risk maybe defined as the risk that a bank may suffer
losses as a result of adverse exchange rate movements during a period in
which it has an open position, either spot or forward, or a combination of
the two, in an individual foreign currency. The banks are also exposed to
interest rate risk, which arises from the maturity mismatching of foreign
currency positions. Even in cases where spot and forward positions in
individual currencies are balanced, the maturity pattern of forward
transactions may produce mismatches. As a result, banks may suffer losses
as a result of changes in premia/discounts of the currencies concerned.
In the forex business, banks also face the risk of default of the
counterparties or settlement risk. While such type of risk crystallization does
not cause principal loss, banks may have to undertake fresh transactions in
the cash/spot market for replacing the failed transactions. Thus, banks may
incur replacement cost, which depends upon the currency rate movements.
Banks also face another risk called time zone risk or Herstatt risk which
arises out of time-lags in settlement of one currency in one centre and the
settlement of another currency in another time-zone. The forex transactions
with counterparties from another country also trigger sovereign or country
risk.

Types of exposure
Foreign exposure risk may broadly categorized into the following groups:
1. Transaction Exposure
2. Economic Exposure
3. Translation Exposure
4. Contingent exposure

1. Transaction Exposure
A firm has transaction exposure whenever it has contractual cash
flows (receivables and payables) whose values are subject to unanticipated
changes in exchange rates due to a contract being denominated in a foreign
currency. To realize the domestic value of its foreign-denominated cash
flows, the firm must exchange foreign currency for domestic currency.
As firms negotiate contracts with set prices and delivery dates in the face of

355
a volatile foreign exchange market with exchange rates constantly
fluctuating, the firms face a risk of changes in the exchange rate between
the foreign and domestic currency. It refers to the risk associated with the
change in the exchange rate between the time an enterprise initiates a
transaction and settles it.

2. Economic Exposure
A firm has economic exposure (also known as operating exposure)
to the degree that its market value is influenced by unexpected exchange
rate fluctuations. Such exchange rate adjustments can severely affect the
firm's market share position with regards to its competitors, the firm's
future cash flows, and ultimately the firm's value. Economic exposure can
affect the present value of future cash flows. Any transaction that exposes
the firm to foreign exchange risk also exposes the firm economically, but
economic exposure can be caused by other business activities and
investments which may not be mere international transactions, such as
future cash flows from fixed assets. A shift in exchange a rate that influences
the demand for a good in some country would also be an economic
exposure for a firm that sells that good.

3. Translation Exposure
A firm's translation exposure is the extent to which its financial
reporting is affected by exchange rate movements. As all firms generally
must prepare consolidated financial statements for reporting purposes, the
consolidation process for multinationals entails translating foreign assets
and liabilities or the financial statements of foreign subsidiary/subsidiaries
from foreign to domestic currency. While translation exposure may not
affect a firm's cash flows, it could have a significant impact on a firm's
reported earnings and therefore its stock price. Translation exposure is
distinguished from transaction risk as a result of income and losses from
various types of risk having different accounting treatments.

4. Contingent exposure
A firm has contingent exposure when bidding for foreign projects
or negotiating other contracts or foreign direct investments. Such an
exposure arises from the potential for a firm to suddenly face a
transactional or economic foreign exchange risk, contingent on the outcome
of some contract or negotiation. For example, a firm could be waiting for a
project bid to be accepted by a foreign business or government that if
accepted would result in an immediate receivable. While waiting, the firm
faces a contingent exposure from the uncertainty as to whether or not that
receivable will happen. If the bid is accepted and a receivable is paid the

356
firm then faces a transaction exposure, so a firm may prefer to manage
contingent exposures.

Forex Risk Management measures

The three important issues that need to be addressed in this regard are:
1. Nature and Magnitude of exchange risk
2. The strategy to be adopted for hedging or managing exchange risk.
3. The tools of managing exchange risk and their relative merits.

1. Nature and Magnitude of Risk

The first aspect of management of foreign exchange risk is to acknowledge
that such risk does exist and that it must be managed to avoid adverse
financial consequences. Many banks refrain from active management of
their foreign exchange exposure because they feel that financial forecasting
is outside their field of expertise or because they find it difficult to measure
currency exposure precisely. However not recognising a risk would not
make it go away. Nor is the inability to measure risk any excuse for not
managing it. Having recognized this fact the nature and magnitude of such
risk must now be identified.
The basic difficulty in measuring exposure comes from the fact that
available accounting information which provides the most reliable base to
calculate exposure (accounting or translation exposure) does not capture
the actual risk a bank faces, which depends on its future cash flows and
their associated risk profiles (economic exposure). Also there is the
distinction between the currency in which cash flows are denominated and
the currency that determines the size of the cash flows. For instance a
borrower selling jewellery in Europe may keep its records in Rupees, invoice
in Euros, and collect Euro cash flow, only to find that its revenue stream
behaves as if it were in U.S. dollars! This occurs because Euro-prices for the
exports might adjust to reflect world market prices which could be
determined in U.S. dollars.
Another dimension of exchange risk involves the element of time. In the
very short run, virtually all local currency prices for goods and services
(although not necessarily for financial assets) remain unchanged after an
unexpected exchange rate change. However, over a longer period of time,
prices and costs respond to price changes. It is therefore necessary to
determine the time frame within which the bank can react to (unexpected)
rate changes.
For a bank, being a financial entity, it is relatively easier to gauge the nature
as well as the measure of forex risk simply because all financial
assets/liabilities are denominated in a currency. A bank’s future cash
streams are more predictable than those of a non-financial firm. Its net

357
exposure, or position, completely encapsulates the measure of its exposure
to forex risk.
In order to manage forex risk some forex market relationships need to be
understood well. The first and most important of these is the covered
interest parity relationship. If there is free and unrestricted mobility of
capital, the interest differential between two currencies will equal the
forward premium/discount for either of the currency. This relationship must
hold under the assumptions; otherwise arbitrage opportunities will arise to
restore the relationship. However, in the case of Rupee, since it is not totally
convertible, this relationship does not hold exactly. Although interest rate
differentials are the driving factor for the Dollar premium against the Rupee,
it also is a factor of forward demand / supply factors. This brings in typical
complications to forward hedging which must be taken into account.
From the above it can easily be determined that a currency with a lower
interest rate will be at a premium to a currency with a higher interest rate.
The other relationships in the forex market are not as deterministic as the
covered interest parity, but needs to be recognised to manage forex
exposure because they are the theoretical tools used for predicting
exchange rate movements, essential to any hedging strategy particularly to
economic risk as opposed to accounting risk. The most important of these is
the Purchasing Power Parity relationship which says exchange rate changes
are determined by inflation differentials. The Uncovered Interest Parity
theory says that the forward exchange rate is the best and unbiased
predictor of future spot rates under risk neutrality. These relationships have
to be clearly understood for any meaningful forex risk management process.

2. Managing Forex Exposure

For a bank therefore the first major decision on forex risk management is
for the management to fix its open foreign exchange position. Although
typically this is a management decision, it could also be subject to
regulatory capital and could also be required to be in tune with the
regulatory environment that prevails. These open position limits have two
aspects, the Daylight limit and the Overnight limit. The daylight limit could
typically be substantially higher for two reasons, (a) It is easier to manage
exchange risk when the market is open and the bank is actively present in
the market and (b) the bank needs a higher limit to accommodate client
flows during business hours. Overnight position, being subject to more
uncertainty and therefore being more risky should be much lower.
Having decided on the overall open position limits, the next step is to
allocate these limits among different operating centres of the bank (in the
case of banks which hold positions at multiple centres). Within a centre
there could be a further allocation among different dealers. It must however

358
be ensured that the bank has a system to monitor the overall open position
limit for the bank on a real time basis.

3. Tools and Techniques for managing forex risk

There are various tools, often substitutes, available for hedging of foreign
exchange risk like over the counter forwards, futures, money market
instruments, options and the like. Most currency management instruments
enable the bank to take a long or a short position to hedge an opposite
short or long position. In equilibrium and in an efficient market the cost of
all will be the same, according to the fundamental relationships. Also tools
differ in that they hedge different risks. In particular, symmetric hedging
tools like futures cannot easily hedge contingent cash flows where risk is
non-linear: options may be better suited to the latter.
Foreign exchange forward contracts are the most common means of
hedging transactions in foreign currencies. However since they require
future performance, and if one party is unable to perform on the contract,
the hedge disappears, bringing in replacement risk which could be high. This
default risk also means that many banks may not have access to the forward
market to adequately hedge their exchange exposure. For such situations,
futures may be more suitable where available since they are exchange
traded and effectively minimise default risk. However, futures are
standardised and therefore may not be as versatile in terms of quantity and
tenor as over the counter forward contracts. This in turn gives rise to
assumption of basis risk.
Money market borrowing to invest in interest-bearing assets to offset a
foreign currency payment – also serves the same purpose as forward
contracts. This follows from the covered interest parity principle. Since the
carrying cost of a position is the same in either, the forex or the money
market hedging can also be done in either market. For instance, let us say a
bank has a short forward Dollar position. It can of course hedge the position
by buying forward Dollars. Alternatively it can borrow Rupees now, buy
Dollar with the proceeds, and place the Dollars in a forward deposit to meet
the short Dollar position on maturity. The Rupees received on the sale on
maturity are used to pay off the Rupee borrowing. The cost of this money
market hedge is the difference between the Rupee interest rate paid and
the US dollar interest rate earned. According to the interest rate parity
theorem, the interest differential equals the forward exchange premium,
the percentage by which the forward rate differs from the spot exchange
rate. So the cost of the money market hedge should be the same as the
forward or futures market hedge.
Currency options are another tool for managing forex risk. A foreign
exchange option is a contract for future delivery of a currency in exchange

359
for another, where the holder of the option has the right to buy (or sell) the
currency at an agreed price, the strike or exercise price, but is not required
to do so. The right to buy is a call; the right to sell, a put. For such a right he
pays a price called the option premium. The option seller receives the
premium and is obliged to make (or take) delivery at the agreed-upon price
if the buyer exercises his option. In some options, the instrument being
delivered is the currency itself; in others, a futures contract on the currency.
American options permit the holder to exercise at any time before the
expiration date; European options, only on the expiration date.
Futures and forwards are contracts in which two parties oblige themselves
to exchange something in the future. They are thus useful to hedge or
convert known currency or interest rate exposures. An option, in contrast,
gives one party the right but not the obligation to buy or sell an asset under
specified conditions while the other party assumes an obligation to sell or
buy that asset if that option is exercised. Options being non-linear
instruments are more difficult to price and therefore their risk profiles need
to be well understood before they can be used. For example it needs to be
understood that the value of a currency changes not just when exchange
rate changes (the event for which the bank usually hedges using
forwards/futures) but also if the underlying volatility of the currency pair
changes, a risk banks are not directly concerned with while hedging.

Treasury operations
The primary treasury operation of a bank is that of catering to customer
needs, both in the spot as well as forward market. This lands the bank with
net foreign exchange positions which it needs to manage on a real time
basis. If the bank needs to sell Dollars forward to an importer, the bank has
a short Dollar position. It can offset the position by buying matching forward
Dollars in the market in which case all risks apart from the profit element
are covered for the bank. However, it may be easier for the bank to
immediately cover the forex risk with a purchase of Dollars in the spot
market. Here again the exchange risk is fully covered except for the profit
element. However the bank now has a swap position. This is called a gap.
The bank has a gap risk which affects it if interest rates change affecting the
forward premia for Dollar. In the case of our domestic markets, in addition,
premia could also change due to forward demand/supply factors. However,
gap risks are easier to manage than exchange risks. So the bank can build up
gaps, subject to the management mandated gap limits, and do offsetting
swaps to reduce gap risks if it so desires periodically.
The bank’s treasury might also do transactions to take advantage of
disequilibrium situations, subject to such transactions being permissible. For
instance if the forward premium for 6 months is say 5% while the 6-month

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interest differential between Rupee and Dollar is say 4%, the bank can
receive in the forex market (buy spot, sell 6-month swap to earn 5%
annualized for 6 months) and finance the transaction by borrowing in the
money market (money market cost being 4% annualized for 6 months).
The bank can also do transactions to take advantage of expected interest
rate changes. It can then use either the money market route (mismatched
cash-flow maturities) or the forex market route (by running a gap risk). The
bank of course also trades on currency movements with a view to make
profits. Here the management must keep in place systems of stop loss
discipline, proper monitoring and evaluation of open positions, etc.

Risk Control Systems:

The management of the bank need to lay out clear and unambiguous
performance measurement criteria, accountability norms and financial
limits in its treasury operations. Management must specify in operational
terms the goals of exchange risk management. It must also clearly recognise
the risks of trading arising from open positions, credit risks, and operations
risks. The bank must also keep in place a system to independently evaluate
through marking to market the net positions taken. Marking to market
should ideally be based on objective market prices provided by an external
agency. All position limits should be made explicit and expressed in simple
terms for easy control.

RBI Guidelines to banks for Foreign Exchange Exposure Limits

The Foreign Exchange Exposure Limits of Authorised Dealers would be dual
in nature.
i. Net Overnight Open Position Limit (NOOPL) for calculation of capital
charge on forex risk
ii. Limit for positions involving Rupee as one of the currencies (NOP-INR)
for exchange rate management.
For banks incorporated in India , the exposure limits fixed by the Board
should be the aggregate for all branches including their overseas branches
and Off-shore Banking Units. For foreign banks, the limits will cover only
their branches in India.

i. Net Overnight Open Position Limit (NOOPL) for calculation of capital

charge on forex risk
NOOPL may be fixed by the boards of the respective banks and
communicated to the Reserve Bank immediately. However, such limits
should not exceed 25 percent of the total capital (Tier I and Tier II capital) of
the bank.
The Net Open position may be calculated as per the method given below:

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1. Calculation of the Net Open Position in a Single Currency
The open position must first be measured separately for each foreign
currency. The open position in a currency is the sum of (a) the net spot
position, (b) the net forward position and (c) the net options position.

a) Net Spot Position

The net spot position is the difference between foreign currency assets and
the liabilities in the balance sheet. This should include all accrued
income/expenses.

b) Net Forward Position

This represents the net of all amounts to be received less all amounts to be
paid in the future as a result of foreign exchange transactions, which have
been concluded. These transactions, which are recorded as off-balance
sheet items in the bank's books, would include:
spot transactions which are not yet settled; forward transactions;
Guarantees and similar commitments denominated in foreign
currencies which are certain to be called; Net future income/expenses
not yet accrued but already fully hedged (at the discretion of the
reporting bank); Net of amounts to be received/paid in respect of
currency futures, and the principal on currency futures/swaps.

• Net Options Position

The options position is the "delta-equivalent" spot currency position as
reflected in the authorized dealer's options risk management system, and
includes any delta hedges in place which have not already been included
under 1(a) or 1(b) (i) and (ii) above.

2. Calculation of the Overall Net Open Position

This involves measurement of risks inherent in a bank's mix of long and
short position in different currencies. It has been decided to adopt the
"shorthand method" which is accepted internationally for arriving at the
overall net open position. Banks may, therefore, calculate the overall net
open position as follows:
Calculate the net open position in each currency (paragraph 1 above).
ii. Calculate the net open position in gold.
iii. Convert the net position in various currencies and gold into Rupees in
terms of existing RBI / FEDAI Guidelines. All derivative transactions
including forward exchange contracts should be reported on the basis
of Present Value (PV) adjustment. Arrive at the sum of all the net short
positions.
iv. Arrive at the sum of all the net long positions.

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Overall net foreign exchange position is the higher of (iv) or (v). The overall
net foreign exchange position arrived at as above must be kept within the
limit approved by the bank’s Board.
Note: Authorised Dealer banks should report all derivative transactions
including forward exchange contracts on the basis of PV adjustment for the
purpose of calculation of the net open position. Authorised Dealer banks
may select their own yield curve for the purpose of PV adjustments. The
banks however should have an internal policy approved by its ALCO
regarding the yield curve/(s) to be used and apply it on a consistent basis.

3. Offshore exposures
For banks with overseas presence, the offshore exposures should be
calculated on a standalone basis as per the above method and should not be
netted with onshore exposures. The aggregate limit (on-shore + off-shore)
may be termed Net Overnight open Position (NOOP) and will be subjected
to capital charge. Accumulated surplus of foreign branches need not be
reckoned for calculation of open position. An illustrative example is as
follows:
If a bank has, let us say three foreign branches and the three branches have
open position as below-
Branch A: + Rs 15 crores
Branch B: + Rs 5 crores
Branch C: - Rs 12 crores
The open position for the overseas branches taken together would be Rs 20
crores.
1
4. Capital Requirement
1
Capital refers to Tier I capital as per instructions issued by Reserve Bank of
India (Department of Banking Operations and Development). As prescribed
by the Reserve Bank from time to time

5. Other Guidelines
i. ALCO / Internal Audit Committee of the Authorized Dealers should
monitor the utilization of and adherence to the limits.
ii. Authorized Dealers should also have a system in place to demonstrate,
whenever required, the various components of the NOOP as
prescribed in the guidelines for verification by the Reserve Bank.
iii. Transactions undertaken by Authorized Dealers till the end of business
day may be computed for calculation of Foreign Exchange Exposure
Limits. The transactions undertaken after the end of business day may
be taken into the positions for the next day. The end of day time may
be approved by the bank’s Board.

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Limit for positions involving Rupee as one of the currencies (NOP-INR) for
exchange rate management
a. NOP-INR may be prescribed to Authorised Dealers at the discretion
of the Reserve Bank of India depending on the market conditions.
b. The NOP-INR positions may be calculated by netting off the long &
short onshore positions (as arrived at by the short hand method) plus
the net INR positions of offshore branches.
c. Positions undertaken by banks in currency futures / options traded
in exchanges will not form part of the NOP-INR.
d. As regards option position, any excesses on account of large option
Greeks during volatile market closing / revaluations may be treated as
technical breaches. However, such breaches are to be monitored by
the banks with proper audit trail. Such breaches should also be
regularized and ratified by appropriate authorities (ALCO / Internal
Audit Committee).

B. Aggregate Gap Limits (AGL)

 AGL may be fixed by the boards of the respective banks and
communicated to the Reserve Bank immediately. However, such limits
should not exceed 6 times the total capital (Tier I and Tier II capital) of
the bank.
 However, Authorised Dealers which have instituted superior measures
such as tenor wise PV01 limits and VaR to aggregate foreign exchange
gap risks are allowed to fix their own PV01 and VaR limits based on
their capital, risk bearing capacity etc. in place of AGL and
communicate the same to the Reserve Bank. The procedure and
calculation of the limit should be clearly documented as an internal
policy and strictly adhered to.

RBI Guidelines on Foreign Exchange Derivatives

RBI in its master circular no 5/2013/14 dated 1 July 2013 on Risk
Management and inter-bank dealings has enumerated comprehensive
guidelines covering categories of persons who are permitted to access
the OTC foreign exchange market in India for managing exchange rate risks
as also the menu of permitted products that can be used for hedging
different categories of exchange rate exposures.

A) Persons resident in India (other than AD Category-I banks)

1) Contracted Exposures – The following products are permitted to be used:
• Forward Foreign Exchange Contracts
• Cross Currency Options (not involving the Rupee)
• Foreign Currency-INR Options

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• Foreign Currency-INR Swaps

2) Probable Exposures based on past performance - The following

products are permitted to be used:
• Forward Foreign Exchange Contracts
• Cross Currency Options (not involving the Rupee)
• Foreign Currency-INR Options

3) Special Dispensation – The following categories are permitted special

dispensation:
1
• Small and Medium Enterprises (SMEs) - Permitted to book forward
foreign exchange contracts without production of underlying
documents for hedging their direct /indirect exposure to foreign
exchange risk.
O Product: Forward Foreign Exchange Contracts
• Resident Individuals - To manage / hedge their foreign exchange
exposures arising out of actual or anticipated remittances, both inward
and outward, without production of underlying documents, up to a limit of
USD 100,000, based on self declaration.
O Product: Forward Foreign Exchange Contracts

B) Persons Resident outside India –

The following categories are permitted to hedge their contracted foreign
exchange exposures:
• Foreign Institutional Investors (FIIs)
• Persons having Foreign Direct Investment in India
• Non-resident Indians (NRIs)
For these categories, subject to terms and conditions enumerated later,
the following products are permitted:
• Forward Foreign Exchange Contracts
• Foreign Currency-INR Options

C) Authorised Dealers Category - I (AD Category-I) –

Hedging can be undertaken for the following purposes:
• Management of Assets and Liabilities
• Hedging of Gold Price Risk
Hedging of currency risk on Capital

1
SME as defined by the Rural Planning and Credit Department, Reserve
Bank of India vide circular
RPCD.PLNS. BC.No.63/06.02.31/2006-07 dated April 4, 2007.

365
The products and terms and conditions for each of the purposes are
enumerated later.

D) Reports
AD Category I banks are required to submit reports on derivative products,
as per the details given in this section.

A) Facilities for Persons Resident in India – Other than Authorised

Dealers Category – I
The facilities for persons resident in India (other than AD Cat I bank) are
elaborated under paragraphs A I and A II. Paragraph A I describes the
facilities and operational guidelines for the respective facility. In addition to
the operational guidelines under A I, the general instructions that are
applicable across all facilities for residents (other than AD Cat I banks) are
detailed under paragraph A II.

A I. Facilities and Operational Guidelines

The product/purpose wise facilities for persons resident in India
(other than AD Category I bank) are detailed under the following subheads:
1) Contracted Exposure
2) Probable Exposure
3) Special Dispensation

1) Contracted exposures
Product - i) Forward Foreign Exchange Contracts
Participants
Market-makers - AD Category-I banks
Users - Persons resident in India
Purpose
• To hedge exchange rate risk in respect of transactions for which sale
and /or purchase of foreign exchange is permitted under the FEMA
1999, or in terms of the rules/ regulations/directions/orders made or
issued there under.
• To hedge exchange rate risk in respect of the market value of overseas
direct investments (in equity and loan).
O Contracts covering overseas direct investment (ODI) can be
cancelled or rolled over on due dates. However, AD
Category I banks may permit rebooking only to the extent of 50
per cent of the cancelled contracts.
O If a hedge becomes naked in part or full owing to shrinking
of the market value of the ODI, the hedge may be allowed to
continue until maturity, if the customer so desires. Rollovers on

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 due date shall be permitted up to the extent of the market value
as on that date.
• To hedge exchange rate risk of transactions denominated in foreign
currency but settled in INR, including hedging the economic (currency
indexed) exposure of importers in respect of customs duty payable on
imports.
O Forward foreign exchange contracts covering such transactions
will be settled in cash on maturity.
O These contracts once cancelled, are not eligible to be rebooked.
O In the event of any change in the rate(s) of customs duties,
due to Government notifications subsequent to the date of the
forward contracts, importers may be allowed to cancel and/or
rebook the contracts before maturity.
Operational Guidelines, Terms and Conditions
General principles to be observed for forward foreign exchange contracts.
a) AD Category-I banks, through verification of documentary evidence,
should be satisfied about the genuineness of the underlying exposure,
irrespective of the transaction being a current or a capital account
transaction. Full particulars of contract should be marked on the
original documents under proper authentication and retained for
verification. Where it may not be possible to retain the original
documents, evidencing underlying exposures, AD Category- 1 banks
should retain a copy thereof. In either of the cases, before offering the
contract, the AD Category I bank should obtain an undertaking from
the customer and an annual certificate from the statutory auditor (for
details refer para A II for General Instructions). AD banks have to
evidence the underlying documents as stipulated so that existence of
underlying foreign currency exposure can be clearly established. No
hedging facility is to be provided to clients on the basis of undertaking
to produce original documents within specified dates and / or
declarations.
b) The maturity of the hedge should not exceed the maturity of the
underlying transaction. The currency of hedge and tenor, subject to
the above restrictions, are left to the customer.
c) Where the exact amount of the underlying transaction is not
ascertainable, the contract is booked on the basis of a reasonable
estimate.
d) Foreign currency loans/bonds will be eligible for hedge only after
final approval is accorded by the Reserve Bank, where such approval is
necessary or Loan Registration Number is allotted by the Reserve Bank.

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e) Global Depository Receipts (GDRs)/American Depository Receipts
(ADRs) will be eligible for hedge only after the issue price has been
finalized.
f) Balances in the Exchange Earner's Foreign Currency (EEFC) accounts
sold forward by the account holders shall remain earmarked for
delivery and such contracts shall not be cancelled. They are, however,
eligible for rollover, on maturity.
g) Forward contracts, involving the Rupee as one of the currencies,
booked by residents to hedge current account transactions, regardless
of the tenor, may be allowed to be cancelled and rebooked subject to
condition (i) below. This relaxation will not be available to
forward contracts booked on past performance basis without
documents as also forward contracts booked to hedge transactions
denominated (or indexed) in foreign currency but settled in INR.
Other forward contracts with Rupee as one of the currencies, booked
to cover underlying foreign currency exposures falling due within
one year can be cancelled and rebooked subject to condition (i) below.
h) All non-INR forward contracts can be rebooked on cancellation subject
to condition (i) below.
i) The facility of cancellation and rebooking should not be permitted
unless the corporate has submitted the exposure information as
prescribed in Annex I B.
j) Substitution of contracts for hedging trade transactions may be
permitted by an AD Category- I bank on being satisfied with the
circumstances under which such substitution has become necessary.
k) Forward contract(s) cancelled with one AD Category-I bank
can be rebooked with another AD Category-I bank, subject to
the following conditions:
(i) the switch is warranted by competitive rates on offer,
termination of banking relationship with the AD Category-I bank
with whom the contract was originally booked;
(ii) the cancellation and rebooking are done simultaneously
on the maturity date of the contract; and
(iii) the responsibility of ensuring that the original contract
has been cancelled rests with the AD Category-I bank who
undertakes rebooking of the contract.

Product - ii) Cross Currency Options (not involving Rupee) Participants

Market-makers - AD Category-I banks as approved for this purpose by
the Reserve Bank
Users – Persons resident in India

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Purpose –
• To hedge exchange rate risk arising out of trade transactions.
Operational Guidelines, Terms and Conditions
a. AD Category-I banks can only offer plain vanilla European options.
b. Customers can buy call or put options.
c. The contingent foreign exchange exposure arising out of
submission of a tender bid in foreign exchange is eligible for hedging
under this sub-head.
d. Importers and exporters having underlying unhedged foreign currency
exposures in respect of trade transactions, evidenced by documents
(firm order, Letter of Credit or actual shipment), may write plain
vanilla stand alone covered call and put options in cross currency and
receive premia subject to AD Category I banks satisfying that the
customers have sound risk management systems and have adopted AS
30 and AS 32. The pricing of the premium may be done in a
transparent manner. These options may not be combined with any
other derivative products.
e. These transactions may be freely booked and/ or cancelled subject to
verification of the underlying.
f. Guidelines applicable for cancellation and rebooking of cross currency
forward contracts are applicable to cross currency option contracts
also.
g. Cross currency options should be written by AD Category I banks on a
fully covered back-to-back basis. The cover transaction may be
undertaken with a bank outside India, an Off-shore Banking Unit
situated in a Special Economic Zone or an internationally recognized
option exchange or another AD Category - I bank in India. AD
Category - I banks desirous of writing options, should obtain a one-
time approval from the Chief General Manager, Reserve Bank of
India, Foreign Exchange Department, Forex Markets Division,
Central Office, Amar Building 5th Floor, Mumbai, 400001, before
undertaking the business.
h. Market participants may follow only ISDA documentation.

Product - iii) Foreign Currency - INR Options

Participants
Market-makers - AD Category-I banks, as approved for this purpose by the
Reserve Bank.
Users- Customers who have genuine foreign currency exposures in
accordance with Schedule I of Notification No. FEMA 25/2000-RB dated
May 3, 2000, as amended from time to time.

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Operational Guidelines, Terms and Conditions
6. AD Category-I banks having a minimum CRAR of 9 per cent, can offer
only plain vanilla European options on a back-to-back basis.
7. Customers can buy call or put options.
8. Option contracts cannot be used to hedge contingent exposures
(except for exposures arising out of submission of tender bids in
foreign exchange).
9. Importers and exporters having underlying unhedged foreign currency
exposures in respect of trade transactions, evidenced by documents
(firm order, Letter of Credit or actual shipment) may write plain
vanilla stand alone covered call and put options in foreign currency-
rupee and receive premia subject to AD Category I banks satisfying
that the customers have sound risk management systems and have
adopted AS 30 and AS 32. The pricing of the premium may be done in
a transparent manner. These options may not be combined with any
other derivative products.
10. All the conditions applicable for booking, rolling over and cancellation
of forward foreign exchange contracts would be applicable to option
contracts also.
11. AD Category I banks having adequate internal control, risk
monitoring/management systems, mark to market mechanism are
permitted to run a foreign currency–rupee options book subject to
prior approval from the Reserve Bank subject to the following
conditions. AD Category-I banks desirous of running a foreign
currency-rupee options book and fulfilling minimum eligibility criteria
listed below, may apply to the Reserve Bank with copies of approval
from the competent authority (Board/ Risk Committee/ ALCO),
detailed memorandum in this regard, specific approval of the
Board for the type of option writing and permissible limits. The
memorandum put up to the Board should clearly mention the
downside risks, among other matters.
12. Minimum Eligibility criteria
(i) Minimum net worth not less than Rs 300 crore
(ii) Minimum CRAR of 10 per cent
(iii) Net NPAs at reasonable levels (not more than 3 per cent of net
advances)
(iv) Continuous profitability for at least three years
13. The Reserve Bank will consider the application and accord a one time
approval at its discretion. AD Category I banks are expected to
manage the option portfolio within the risk management limits
already approved by the Reserve Bank.

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14. AD banks may quote the option premium in Rupees or as a
percentage of the Rupee/foreign currency notional.
15. Option contracts may be settled on maturity either by delivery on
spot basis or by net cash settlement in Rupees on spot basis as
specified in the contract. In case of unwinding of a transaction prior to
maturity, the contract may be cash settled based on the market value
of an identical offsetting option.
16. Market makers are allowed to hedge the ‘Delta’ of their option
portfolio by accessing the spot markets. Other ‘Greeks’ may be
hedged by entering into option transactions in the inter-bank market.
17. The ‘Delta’ of the option contract would form part of the overnight
open position. The ‘Delta’ equivalent as at the end of each maturity
shall be taken into account for the purpose of AGL. The residual
maturity (life) of each outstanding option contract can be taken as
the basis for the purpose of grouping under various maturity
buckets.
18. AD banks running an option book are permitted to initiate plain
vanilla cross currency option positions to cover risks arising out of
market making in foreign currency-rupee options.
19. Banks should put in place necessary systems for marking to market
the portfolio on a daily basis. FEDAI will publish daily a matrix of
polled implied volatility estimates, which market participants can use
for marking to market their portfolio.
20. The accounting framework for option contracts will be as per
FEDAI circular No.SPL-24/FC-Rupee Options/2003 dated May 29,
2003.Market participants may follow only ISDA documentation.

Product - iv) Foreign Currency-INR Swaps

Participants
Market-makers – AD Category-I banks in India.
Users - Persons resident in India, other than banks and financial
institutions, who have foreign currency or rupee liability
Purpose –
• To hedge/transform exchange rate and/or interest rate risk exposure
for those having long-term foreign currency borrowing or to transform
long-term INR borrowing into foreign exchange liability.
Operational Guidelines, Terms and Conditions
a. No swap transactions involving upfront payment of Rupees or its
equivalent in any form shall be undertaken.
b. The term “long-term exposure” means exposures with residual
maturity of one year or more.

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c. Swap transactions may be undertaken by AD Category-I banks a
intermediaries by matching the requirements of corporate
counterparties. While no limits are placed on the AD Category-I banks
for undertaking swaps to facilitate customers to hedge their exchange
rate risk exposures, limits have been put in place for swap
transactions facilitating customers to assume foreign exchange
liability, which result in supply of foreign exchange to the market.
While matched transactions may be undertaken without any limit, a
limit of USD 50 million is placed for net supply of foreign
exchange to the market on account of these swaps. Positions arising
out of cancellation of foreign currency-rupee swaps by customers
need not be reckoned within this cap.
d. With reference to the specified limits for swap transactions facilitating
customers to assume a foreign exchange liability, the limit will
be reinstated on account of cancellation/ maturity of the swap and on
amortization, up to the amounts amortized.
e. The above transactions, once cancelled, shall not be rebooked or re-
entered, by whichever mechanism or by whatever name called.
f. Where the Foreign Currency-INR swap is used to transform a long-
term INR borrowing into a foreign exchange liability, AD Category I
banks at the time of offering the Fcy-INR swap, are permitted to offer
a plain vanilla cross currency option (not involving the Rupee) at the
time of inception, to cap the currency risk. Before offering the
product, the maximum possible loss/worst downside, under various
scenarios is to be quantified and conveyed to the customer in the
term sheet.
g. AD Category-I banks should not offer leveraged swap structures.
Typically, in leveraged swap structures, a multiplicative factor other
than unity is attached to the benchmark rate(s), which alters the
payables or receivables vis-à-vis the situation in the absence of such a
factor.

v) Hedging of Loan Exposure - For resident entities with External

Commercial
Borrowings the following facilities are provided:
Products – Interest rate swap, Cross currency swap, Coupon swap, Cross
currency option, Interest rate cap or collar (purchases), Forward rate
agreement (FRA)
Participants
Market-makers –
o AD Category-I banks in India

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o Branch outside India of an Indian bank authorized to deal in
foreign exchange in India
o Offshore banking unit in a SEZ in India.
Users –
O Persons resident in India who have borrowed foreign exchange
in accordance with the provisions of Foreign Exchange Management
(Borrowing and Lending in Foreign Exchange) Regulations, 2000
Purpose –
• For hedging/transforming interest rate risk and currency risk on
foreign exchange loan, in the case of entities with external commercial
borrowing.
Operational Guidelines, Terms and Conditions.
a. The products, as detailed above should not involve the rupee under
any circumstances.
b. Final approval has been accorded or Loan Registration Number
allotted by the Reserve Bank for borrowing in foreign currency.
c. The notional principal amount of the product should not exceed the
outstanding amount of the foreign currency loan.
d. The maturity of the product should not exceed the unexpired
maturity of the underlying loan.
e. The contracts may be cancelled and rebooked.

2) Probable exposures based on past performance

Participants
Market-makers – AD Category-I banks in India.
Users – Importers and exporters of goods and services
Purpose
• To hedge currency risk on the basis of a declaration of an
exposure and based on past performance up to the average of the
previous three financial years’ (April to March) actual import/export
turnover or the previous year’s actual import/export turnover, whichever is
higher. Probable exposure based on past performance can be hedged only
in respect of trades in merchandise goods as well as services.
Products
• Forward foreign exchange contracts, cross currency options (not
involving the rupee) and foreign currency-rupee options
Operational Guidelines, Terms and Conditions
a. The contracts booked in aggregate, during the current financial year
(April-March) and outstanding at any point of time should not exceed
the eligible limit i.e. the average of the previous three financial years’
actual import/export t u r n o v e r or the previous year’s actual
import/export turnover, whichever is higher.

373
b. Contracts booked in excess of 75 per cent of the eligible limit will be
on deliverable basis and cannot be cancelled.
c. These limits shall be computed separately for import/export
transactions.
d. Higher limits will be permitted on a case-by-case basis on
application to the Reserve Bank.
e. Any contract booked without producing documentary evidence will
be marked off against this limit. These contracts once cancelled, are
not eligible to be rebooked/rolled over.
f. AD banks should permit their clients to use the past performance
facility only after satisfying themselves that the following conditions
are complied with:
i. An undertaking may be taken from the customer that
supporting documentary evidence will be produced before the
maturity of all the contracts booked.
ii. Importers and exporters should furnish a monthly
declaration to the AD Category-I banks regarding amounts booked
with other AD Category-I banks under this facility, as per Annex I
N. The declaration may be validated with the information shared
by banks under the consortium and multiple banking
arrangements, vide circular DBOD.No. BP. BC. 94/ 08.12.001/
2008-09 dated December 8, 2008.
iii. For an exporter customer to be eligible for this
facility, the aggregate of overdue bills shall not exceed 10 per cent
of the turnover.
iv. Aggregate outstanding contracts in excess of 50 per cent
of the eligible limit may be permitted by the AD bank on being
satisfied about the genuine requirements of their
customers after examination of the following documents:
¾ A certificate from the Statutory Auditor of the customer
that all guidelines have been adhered to while utilizing this
facility.
¾ A certificate of import/export turnover of the customer
during the past three years duly certified by their Statutory
Auditor in the format given in Annex I L.
g. The past performance limits once utilised are not be reinstated either
on cancellation or on maturity of the contracts.
h. AD Category–I banks must arrive at the past performance limits at the
beginning of every financial year. The drawing up of the audited
figures (previous year) may require some time at the commencement
of the financial year. However, if the statements are not

374
 submitted within a reasonable time, the facility should not be
provided till submission of audited figures.
i. AD Category-I banks must institute appropriate systems for validating
the past performance limits at pre-deal stage and not to rely only
upon the customer declaration. AD Category-I banks should also
assess the past transactions with the customers and the turnover
based on provisional balance sheets, etc.
j. The booking of contracts under past performance route should
be in alignment with booking of contracts against underlying, such as
type of hedge instruments generally used for underlying, tenor, etc.
k. AD Category I banks are required to submit a monthly report (as on
the last Friday of every month) on the limits granted and utilised by
their constituents under this facility as prescribed in Annex I J.

3) Special Dispensation
a) Small and Medium Enterprises (SMEs) Participants
Market-makers – AD Category-I.
2
Users – Small and Medium Enterprises (SMEs)
Purpose
¾ To hedge direct and / or indirect exposures of SMEs to foreign exchange
risk
Product
¾ Forward foreign exchange contracts
Operational Guidelines:
Small and Medium Enterprises (SMEs) having direct and / or indirect
exposures to foreign exchange risk are permitted to book / cancel / rebook /
roll over forward contracts without production of underlying documents
to manage their exposures effectively, subject to the following conditions:
a. Such contracts may be booked through AD Category – I banks with
whom the SMEs have credit facilities and the total forward contracts
booked should be in alignment with the credit facilities availed by
them for their foreign exchange requirements or their working capital
requirements or capital expenditure.
b. AD Category – I bank should carry out due diligence regarding “user
appropriateness” and “suitability” of the forward contracts to the
SME customers as per Para 8.3 of 'Comprehensive Guidelines on

2
SME as defined by the Rural Planning and Credit Department, Reserve
Bank of India vide circular
RPCD.PLNS. BC.No.63/06.02.31/2006-07 dated April 4, 2007. }

375
 Derivatives' issued vide DBOD.No.BP.BC. 86/21.04.157/2006-07 dated
April 20, 2007.
c. The SMEs availing this facility should furnish a declaration to the
AD Category – I bank regarding the amounts of forward contracts
already booked, if any, with other AD Category – I banks under this
facility.

b) Resident Individuals
Participants
Market-makers – AD Category-I banks
Users: Resident Individuals
Purpose: To manage / hedge their foreign exchange exposures arising out
of actual or anticipated remittances, both inward and outward, can book
forward contracts, without production of underlying documents, up to a
limit of USD 100,000, based on self declaration.
Product
¾ Forward foreign exchange contracts.
Operational Guidelines, Terms and Conditions
a. The contracts booked under this facility would normally be
on a deliverable basis. However, in case of mismatches in cash flows
or other exigencies, the contracts booked under this facility may be
allowed to be cancelled and re-booked. The notional value of the
outstanding contracts should not exceed USD 100,000 at any time.
b. The contracts may be permitted to be booked up to tenors of one
year only.
c. Such contracts may be booked through AD Category I banks with
whom the resident individual has banking relationship, on the
basis of an application-cum-declaration in the format given in
Annex I G. The AD Category – I banks should satisfy themselves that
the resident individuals understand the nature of risk inherent in
booking of forward contracts and should carry out due diligence
regarding “user appropriateness” and “suitability” of the forward
contracts to such customer.

A II. General Instructions for all forex derivative contracts entered by

Residents in India
While the guidelines indicated above govern specific foreign exchange
derivatives, certain general principles and safeguards for prudential
considerations that are applicable across the OTC foreign exchange
derivatives, are detailed below. In addition to the guidelines under the
specific foreign exchange derivative product, the general instructions should

376
be followed scrupulously by the users (residents in India other than AD
Category I banks) and the market makers (AD Category I banks).
¾ In case of all forex derivative transactions undertaken, AD banks must
take a declaration from the clients that the exposure is unhedged and has
not been hedged with another AD Category I bank. The corporates should
provide an annual certificate to the AD Category I bank certifying that the
derivative transactions are authorized and that the Board (or the
equivalent forum in case of partnership or proprietary firms) is aware of the
same.
¾ In the case of contracted exposure, AD Category I banks must obtain:
i) An undertaking from the customer that the same underlying
exposure has not been covered with any other AD Category I bank/s.
Where hedging of the same exposure is undertaken with more than
one AD Category I bank, the details of amounts already booked with
other AD Category I bank/s should be clearly indicated in the
declaration.
ii) An annual certificate from the statutory auditors that the contracts
outstanding at any point of time during the year did not exceed
the value of the underlying exposures.
¾ Derived foreign exchange exposures {except as detailed under
the sub- heading of foreign currency rupee swap in para iv (f)
above} are not permitted to be hedged.
¾ In any derivative contract, the notional amount should not exceed
the actual underlying exposure at any point in time. Similarly, the
tenor of the derivative products should not exceed the tenor of
the underlying exposure. The notional amount for the entire
transaction over its complete tenor must be calculated and the
underlying exposure being hedged must be commensurate with the
notional amount of the derivative contract.
¾ Only one hedge transaction can be booked against a particular
exposure/ part thereof for a given time period.
¾ The term sheet for the derivative transactions should necessarily
and clearly mention the following:
o the purpose for the transaction detailing how the product and
each of its components help the client in hedging
o the spot rate prevailing at the time of executing the transaction.
o the delta of the trade at the time of executing the transaction.
o whether the corporate follows AS-30 and AS-32 accounting
standards.
o Quantified maximum loss/ worst downside in various scenarios.

377
 ¾ AD Category I banks can offer only those products that they
can price independently. The pricing of all forex derivative
products should be locally demonstrable at all times.
¾ Zero Cost Structures or structures aimed at reduction in cost of
hedging are not permitted.
¾ The only instances where a customer can write options are
detailed under para A I, 1 (ii) d and para A I, 1 (iii) d above.
¾ The market-makers should carry out proper due diligence
regarding ‘user appropriateness’ and ‘suitability’ of products
before offering derivative products to users.
¾ The relevant provisions of comprehensive guidelines on
Derivatives issued vide DBOD.No.BP.BC. 86/21.04.157/2006-07
dated April 20, 2007 are also applicable to forex derivatives.
¾ Sharing of information on derivatives between banks is
mandatory and as detailed vide circular
DBOD.No.BP.BC.94/08.12.001/2008-09 dated December 8, 2008.

B) Facilities for Persons Resident Outside India

For persons resident outside India, only capital account transactions as
enumerated hereunder are permitted to be hedged. Transactions arising
out of trade in merchandise goods as well as services with residents
are not permitted to be hedged.
Participants
• Market-makers – In respect of FIIs, designated branches of AD
Category-I banks maintaining accounts of FIIs. In all other cases, AD
Category-I banks.
• Users – Foreign Institutional Investors (FII), Investors having Foreign
Direct Investments (FDI) and Non Resident Indians (NRIs).
The purpose, products and operational guidelines of each of the
users is detailed below:
a) FII related
Purpose
To hedge currency risk on the market value of entire investment in
equity and/or debt in India as on a particular date.
Products
Forward foreign exchange contracts with rupee as one of the currencies
and foreign currency rupee options
Operational Guidelines, Terms and Conditions
a. The eligibility for cover may be determined on the basis of the
declaration of the FII.
b. AD Category-I banks may undertake periodic reviews, at least at
quarterly intervals, on the basis of market price movements, fresh

378
 inflows, amounts repatriated and other relevant parameters to ensure
that the forward cover outstanding is supported by underlying
exposures.
c. If a hedge becomes naked in part or in full owing to shrinkage of
the market value of the portfolio, for reasons other than sale of
securities, the hedge may be allowed to continue till the original
maturity, if so desired.
d. The forward contracts, once cancelled cannot be rebooked except to
the extent of 2 per cent of the market value of the portfolio as at the
beginning of the financial year. The contracts may, however, be
rolled over on or before maturity.
e. The cost of hedge should be met out of repatriable funds and /or
inward remittance through normal banking channel.
f. All outward remittances incidental to the hedge are net of
applicable taxes.

b) FDI related
Purpose
• To hedge exchange rate risk on the market value of investments
made in India since January 1, 1993, subject to verification of the exposure
in India
• To hedge exchange rate risk on dividend receivable on the
investments in Indian companies
• To hedge exchange rate risk on proposed investment in India
Products
Forward foreign exchange contracts with rupee as one of the currencies
and foreign currency-rupee options.
Operational Guidelines, Terms and Conditions
a. In respect of forward contracts to hedge exchange rate risk on the
market value of investments made in India, forward contracts once
cancelled are not eligible to be rebooked. The contracts may, however,
be rolled over.
b. In respect of proposed foreign direct investments, following
conditions would apply:
(i) Forward sale contracts to hedge exchange rate risks arising out of
proposed investment in Indian companies may be allowed to be
booked only after ensuring that the overseas entities have
completed all the necessary formalities and obtained necessary
approvals (wherever applicable) for the investment.
(ii) The tenor of the forward contracts should not exceed six months at
a time beyond which permission of the Reserve Bank would be
required to continue with the contract.

379
 (iii) These contracts, if cancelled, shall not be eligible to be rebooked
for the same inflows.
(iv) Exchange gains, if any, on cancellation shall not be passed on to
the overseas investor.

c) NRI related
Purpose
• To hedge the exchange rate risk on the market value of
investment made under the portfolio scheme in accordance with provisions
of FERA, 1973 or under notifications issued there under or in accordance
with provisions of FEMA, 1999.
• To hedge the exchange rate risk on the amount of dividend due on
shares held in Indian companies
• To hedge the exchange rate risk on the amounts held in FCNR (B)
deposits.
• To hedge the exchange rate risk on balances held in NRE account.
Products
• For balances/amounts in NRE accounts-Forward foreign exchange
contracts with rupee as one of the currencies and foreign currency-rupee
options
• For balances in FCNR (B) accounts – Forward foreign exchange
contracts with rupee as one of the currencies, Cross currency (not involving
the rupee) forward contracts to convert the balances in one foreign
currency to other foreign currencies in which FCNR (B) deposits are
permitted to be maintained, at the option of the account holder and foreign
currency-rupee options.
Operational Guidelines, Terms and Conditions
The operational guidelines as outlined for FIIs would be applicable,
with the exception of the provision relating to rebooking of cancelled
contracts. All foreign exchange derivative contracts permissible for a
resident outside India other than a FII, once cancelled, are not eligible to
be rebooked.

C) Facilities for Authorised Dealers Category – I

1) Management of Assets and Liabilities
Users – AD Category-I banks
Purpose - Hedging of interest rate and currency risks of foreign
exchange asset- liability portfolio
Products - Interest Rate Swap, Currency Swap, and Forward Rate
Agreement, Foreign Currency-Rupee Options. AD banks may also purchase
call or put options to hedge their cross currency proprietary trading
positions,

380
Operational Guidelines, Terms and Conditions
The use of these instruments is subject to the following conditions:
a. An appropriate policy in this regard is approved by the Top
Management.
b. The value and maturity of the hedge should not exceed those of
the underlying.
c. No ‘stand alone’ transactions can be initiated. If a hedge becomes
naked, in part or full, owing to the shrinking of the value of portfolio,
it may be allowed to continue till the original maturity and should be
marked to market at regular intervals.
d. The net cash flows arising out of these transactions are booked
as income/ expenditure and reckoned toward foreign exchange
position, wherever applicable.

2) Hedging of Gold Price Risk

Users – (a) Banks authorised by the Reserve Bank to operate the Gold
Deposit Scheme
(b) Banks, which are allowed to enter into forward gold contracts in India in
terms of the guidelines issued by the Department of Banking Operations
and Development (including the positions arising out of inter-bank gold
deals).
Purpose – To hedge price risk of gold.
Products - Exchange-traded and over-the-counter hedging products
available overseas.
Operational Guidelines, Terms and Conditions
a. While using products involving options, it may be ensured that there is
no net receipt of premium, either direct or implied.
b. Authorised banks are permitted to enter into forward contracts with
their constituents (exporters of gold products, jewellery
manufacturers, trading houses, etc.) in respect of the underlying sale,
purchase and loan transactions in gold with them, subject to the
conditions specified by the Reserve Bank in this regard. The tenor
of such contracts should not exceed six months.

3) Hedging of currency risk on capital

Users – Foreign banks operating in India
Product – Forward foreign exchange contracts
Operational Guidelines, Terms and Conditions
i) Tier I capital
a. the capital funds should be available in India to meet local
regulatory and CRAR requirements and, hence, these should not
be parked in nostro accounts. Foreign currency funds accruing out

381
 of hedging should not be parked in Nostro accounts but should
remain swapped with banks in India at all times.
b. the forward contracts should be for tenors of one or more years
and may be rolled over on maturity. Rebooking of cancelled
hedges will require prior approval of the Reserve Bank.
ii) Tier II capital
a. Foreign banks are permitted to hedge their Tier II capital in the
form of Head Office borrowing as subordinated debt, by keeping it
swapped into rupees at all times in terms of
DBOD circular No.IBS.BC.65/23.10.015/2001-02 dated February
14, 2002.
b. Banks are not permitted to enter into foreign currency-rupee
swap transactions involving conversion of fixed rate rupee liabilities
in respect of Innovative Tier I/Tier II bonds into floating rate foreign
currency liabilities.

Annex I A
Cross- currency derivative transactions - statement for the half-year ended.
Product No. of transactions Notional principal amount in USD

Interest rate swaps

Currency swaps
Coupon swaps
Foreign currency
option
Interest rate caps
or collars Purchases)
Forward rate
agreement
Any other product
as permitted by
Reserve Bank from
time to time

382
 Annex I B
Information relating to exposures in foreign currency as on
Amount Hedged by the
NAME TRADE NON Corporate with banks as at
Of RELATED TRADE Quarter ended
the RELATED
Corpo Trade Exposures Eligible Short EXPOSURE Forward Foreign
rate outstanding at limit under Term S– Contracts Currency / Currency
Quarter ended Past Finance OUTSTAN (with INR
Performan Outstandi DING rupee as Options Swaps
ce basis ng one leg)

Exports* Imports Expor Impor Trade ECB/FCCB Pur Sale Call Put
** ts ts Credit cha
(Buyer's se
credit/
supplier's
credit)

* All Export bills sent on collection. Export bills purchased / discounted /

negotiated not to be included.
** To include LCs established / Bills under LCs to be retired / Import
collection bills outstanding.

Annex I C
Weekly report of Long Term Foreign Currency Rupee Swaps for the week
from to

Name of the Authorized Dealer Category-I bank:-

Date of Notional USD Custome FC to Amount Last Current
Transa Principal- equivale r INR/ covered in week’s Balance
ction Currency nt Name INR the market – balance
and to FC Purchase/
Amount Sale

383
 Annex I D
Rupee/Fcy Option transactions :
[For the week ended ]
I. Option Transaction Report

Sr. no Trade Client/ Notional Option Strike Maturity Premiu Purpose*

date C- party Call/ m
Name Put

*Mention balance sheet, trading or client related.

II. Option Positions Report

Notional Net Net Portfolio Net Portfolio
Currency Pair Outstanding Portfolio Gamma Vega
Delta
calls puts
USD-INR USD USD USD
EUR-INR EUR EUR EUR
JPY-INR JPY JPY JPY
(Similarly for other currency pairs)
Total Net Open Options Position (INR):
The total net open options position can be arrived using the methodology
prescribed in A.P. (DIR Series) Circular No. 92 dated April 4, 2003.

III. Change in Portfolio Delta Report

Change in USD-INR delta for a 0.25% change in spot ($-appreciation) in INR
terms =
Change in USD-INR delta for a 0.25% change in spot ($-depreciation) in INR
terms =
Similarly, Change in delta for a 0.25% change in spot (FCY appreciation &
depreciation separately) in INR terms for other currency pairs, such as
EUR-INR, JPY-INR etc.

384
IV. Strike Concentration Report
Maturity Buckets
Strike Price 1 week 2 weeks 1 month 2 months 3 months > 3 months

This report should be prepared for a range of 150 paise around current spot
level. Cumulative positions to be given.
All amounts in USD million. When the bank owns an option, the amount
should be shown as positive. When the bank has sold an option, the amount
should be shown as negative. All reports may be sent via e-mail by market-
makers to [email protected]. Reports may be prepared as of every
Friday and sent by the following Monday.

Annex I E
Statement – Details of Forward cover undertaken by FII clients
Month –
Part A – Details of forward cover (without rebooking) outstanding
Name of FII
Current Market Value (USD mio)
Eligibility Forward Contracts Forward Contracts Total
for Booked Cancelled forward
Forward During Cumulative During Cumulative cover
cover the month Total – Year the month total – Year outstanding
to Date to date

385
Part B – Details of transactions permitted to be cancelled and rebooked
Name of FII
Market Value as determined at start of year
Eligibility Forward Contracts Forward Contracts Total
for Booked Cancelled forward
Forward During Cumulative During Cumulative cover
cover the month Total – Year the month total – Year outstanding
to Date to date

Name of the AD Category – I bank:

Signature of the Authorised official:
Date:
Stamp:

Annex I F

386
 Annex I G

Application cum Declaration for booking of forward contracts up to USD

100,000 by Resident Individuals (To be completed by the applicant)
I. Details of the applicant
a. Name …………………………..
b. Address…………………………
c. Account No……………………..
d. PAN No………………………….
II. Details of the foreign exchange forward contracts required
1. Amount (Specify currency pair) ………………………………
2. Tenor ………………………………………………….
III. Notional value of forward contracts outstanding as on date ……….
IV. Details of actual / anticipated remittances
1. Amount:
2. Remittance Schedule:
3. Purpose:
Declaration
I, ………………. …………(Name of the applicant), hereby declare that the
total amount of foreign exchange forward contracts booked with the ---------
------ (designated branch) of ------------------(bank) in India is within the
limit of USD
100,000/- (US Dollar One lakh only) and certify that the forward contracts
are meant for undertaking permitted current and / or capital account
transactions. I also certify that I have not booked foreign exchange forward
contracts with any other bank / branch. I have understood the risks
inherent in booking of foreign exchange forward contracts.
Signature of the applicant
(Name)
Place:
Date:
Certificate by the Authorised Dealer Category – I bank
This is to certify that the customer …………(Name of the applicant) having
PAN No.……. has been maintaining an account ……..(no.) with us since ……..*
We certify that the customer meets the AML / KYC guidelines laid down by
RBI and confirm having carried out requisite suitability and appropriateness
test.
Name and designation of the authorised official:
Place:
Signature:
Date: Stamp and seal
* month / year

387
 Chapter-8

OPERATIONAL RISK MANAGEMENT

Introduction:
The bedrock of the entire risk management is operational risk.
Credit and market risk generally emanate from operational risk. Hence, to
nip any risk in the bud, operational risk management is essential.
Operational risk management is not an alien subject to the Indian Banking
Industry. Various internal control systems designed by banks in India are
traditionally deployed to deal with operational risk. Deregulation and
globalisation of financial services, together with the growing sophistication
of financial technology, are making the activities of banks more complex.
Developing banking practices suggests that risk other than credit, interest
rate and market risk can be substantial.
Operational risk, as defined by the Basel Committee Banking
Supervision (BCBS) is “The risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and systems or from
external events”. The definition excludes strategic and reputation risk for
the purpose of a minimum regulatory operational risk capital charge. The
Basel Committee has observed through various surveys that the current
measurement practice of operational risk by banks is relatively undefined in
nature. RBI defines Operational Risk, as “any risk, which is not categorised
as market or credit risk, or the risk of loss arising from various types of
human or technical errors”. It is also synonymous with settlement or
payments risk and business interruption, administrative and legal risks.
Operational risk can also be defined as an unexpected loss resulting from
human error, fraud, process failure, technology breakdown or external
factors.
Banks, in the past, had incurred huge losses due to operational
risks. Some of those are us under.
 The huge position built up by the rogue trader Nick Leeson in case of
Barings Bank was in some sense an operational risk management failure
which led to $1.5 billion losses that brought about liquidation of the
Bank in 1995.
 Bank of credit and commerce International (BCCI)s biggest loss ($10
billion to 17 billion) in history come to light on July 5, 1991 when
regulators in seven countries took control of its branch offices (BCCI
had made large loans to companies and individuals with improper
documents and monitoring mechanism. Besides, lax corporate
governance, manipulation by bank officers and failure of fundamental

388
 risk management structures were the primary reasons driving the
losses in the bank.
 UTI’s liquidity crunch that occurred in 2001 due to confinement of
investment decisions largely with the Chairman than to committee;
Portfolio concentration, large mobilisation of funds under US-64
Scheme from corporates as well without opportunities for investments.
 Banks incurred losses worth Rs. 70 crs. In bullion scam in Ahmedabad
during March, 2001 owing to their following the practice to deliver gold
against banker cheques (even issued by co-operative banks) instead of
established / permitted practice of ‘Deliver Vs Payments’.
 Co-operative Banks scam in March 2001 owing to their finances
extended to Ketan’s broking firms beyond their net worth / permitted
activities.
 Deregulation and globalisation of financial services, together with the
growing sophistication of financial technology are making the activities
of banks and thus their risk profiles (i.e., the level of risk across a bank’s
activities and / or risk categories) more complex. Developing banking
practices suggests that risk other than credit, interest rate and market
risk can be substantial.
 Highly automated technology – If not controlled, the greater use of
more highly automated technology has the potential to transform risks
from manual processing errors to system failure risks, as greater
reliance is placed on integrated systems.
 Emergence of E-Commerce – Growth of e-commerce brings with H
potential risks (e.g. internal and external fraud and system securities
issue) that are not yet fully understood.
 Emergence of banks acting as very large volume service providers
creates the need for continual maintenance of high-grade internal
controls and back-up system.
 Outsourcing – growing use of outsourcing arrangements and the and
the participation in clearing and settlement systems can mitigate some
risks but can also present significant other risks and banks.
 Large-scale acquisitions, mergers, de-mergers and consolidations test
the viability of new or newly integrated systems.
 Banks may engage in risk mitigation techniques (e.g. collateral,
derivates, netting arrangements and asset securitisations) to optimise
their exposure to market risk and credit risk, but which in turn may
produce other forms of risk (e.g. legal risk).

389
Components of Operational Risk:
There are found constituents of operational risk (based on the Basel
definitions mentioned above), namely people, process, technology systems
external events.

Organization

People System External events

Process

Figure-1. Showing various constituents of operational risk.

The four components or operational risk categories are further
clarified as follows.

People Risk:
This is perhaps the most dynamic of all sources of operational risk.
Internal controls are often blamed for operational breakdowns, whereas the
true cause of many operational losses can be traced to people failures
losses caused by intentional or unintentional behavior of employees, which
causes the interest of the bank to the compromised in some other way
(Managers, dealers, lending officers, other staff exceeding their authority or
conducting business in an unethical or risky manner).

Process Risk:
Financial institutions operate a myriad of processes to deliver their
products and services to the customers. As a result, process risk can arise at
any stage in the value chain and can result in losses that have been incurred
due to a deficiency in an existing procedure, or the absence of a procedure.

Systems Risk:
The growing independence of financial institutions on it systems is
a key source of operational risk, system risk arises due to various reasons
throughout the lifecycle of use of technology and other related system.

Determinants Operational Risk:

Before proceeding further, it would be appropriate to look at the
factors responsible for operational risks. few operational risks, which may

390
arise from a variety of reasons, which can broadly be classified in the
1
following broad categories .

1. Internal Environment
2. External Environment

1. Internal Environment
The following are the important factors effecting operational risk
managements in banks which emanate from internal environment;

Management:
 Lack of Management accountability, understanding, oversight, control
culture, critical policies and periodical review thereof.
 Inadequate or incomplete management information system. (MIS).
 Poor or incomprehensive corporate planning decisions.
 Wrong / delayed decisions.
 Lack of or inadequate risk management systems.
 In adequate risk focussed auditing systems, strategic planning and
manpower.

People (Staff):
 In competency, lack of knowledge, awareness of products / services
offered and laws of land related to bank business.
 Lack of succession planning / development of second line, contingency
planning.
 Demotivation, indiscipline wrong placement and / or recruitment
policy.
 Dislocation lexit / frequent turnover of key staff at key positions.
 Involvement in fraud, forgeries and embazzlement.
 Lack of opportunities / willingness for updating skills.
 Lack of health care and safety.

Systems:
 Outdated, untested, not in conformity with statutory and regulatory
requirements.
 Incapable to achieve business goals either in short, medium or long
term.
 Non-compliance.

1
Operational risk under New basel Accord by Rajesh and IBA Bulletin June
2004.

391
 Lack of user manuals and updation thereof.
 Programming error, model methodology error (basic errors in
assumptions, data etc.) mark to market error (wide variation between
model output and actual event.

Technology:
 Failure of computer systems, software, equipment, power or
telecommunication.
 Lack of backup and recovery procedures.
 Lack of periodic testing of business continuity plan (BCP) / Disaster
Recovery Plan (DRP).
 Absence of maintenance procedures.
 Poor control over IT infrastructure.
 Delay in technological and IT advancement.

Transaction:
 Execution error, settlement error, product complexity.

Control:
 Failure to obtain proper internal authorisation for exceeding limits.
 Volumes risk.
 Money laundering.
 Rogue trading
 Lack of appropriate control structure.

Loan Portfolio:
 Pitfalls in execution of security documents relating to advances –
inclusive of improper stamp duty, breach of legal provisions.
 Wrong loan decisions due to inadequate knowledge.
 Decision exceeding vested powers to the functionaries.

Commercial:
 Increased competition, better products or services with competitors.

Legal:
 Short fall in documentation for various transactions.
 Claims from customers, counter parties or third party service providers.

392
2. External Environments
The following are the important causative factors responsible for
operational risk in banks, emerging out off external environment such as
below:
 Events such as flood, fire, storms, earthquakes natural calamities,
explosion, riot, theft strike and terrorism.
 Unanticipating changes in external environment (other than macro
economic factors).
 Adverse political decisions and regulatory changes.

Reputation:
 Deterioration / erosion of image among customers, counter parties and
shareholders on account of poor service, staff behaviour, frauds
increased NPA’s etc. It is the risk that devalues the brand name and
image.

Severity of Operational Risks:

Banks, in the past, had incurred huge losses due to operational risks. A few
examples are us under
 The huge position built up by the rogue trader Nick Leeson in case of
Barings Bank was in some sense an operational risk management failure
which led to $1.5 billion losses that brought about liquidation of the
Bank in 1995. (A lack of internal check and balance exposed barings to
operational risk).
 Bank of credit and commerce International (BCCI)s biggest loss ($10
billion to 17 billion) in history come to light on July 5, 1991 when
regulators in seven countries took control of its branch offices (BCCI
had made large loans to companies and individuals with improper
documents and monitoring mechanism. Besides, lax corporate
governance, manipulation by bank officers and failure of fundamental
risk management structures were the primary reasons driving the
losses in the bank.
 UTI’s liquidity crunch that occurred in 2001 due to confinement of
investment decisions largely with the Chairman than to committee;
Portfolio concentration, large mobilisation of funds under US-64
Scheme from corporates as well without opportunities for investments.
 Penalty imposed on SBI during 2001-02 by the US Federal Reserve on
the issue of violation of Federal Deposit Insurance Corporation rules.
 Banks incurred losses worth Rs. 70 crs. In bullion scam in Ahmedabad
during March, 2001 owing to their following the practice to deliver gold
against banker cheques (even issued by co-operative banks) instead of
established / permitted practice of ‘Deliver Vs Payments’.

393
 Co-operative Banks scam in March 2001 owing to their finances
extended to Ketan’s broking firms beyond their net worth / permitted
activities.
 The Reserve Bank of India (RBI) on July 30, 2010 imposed a penalty of
Rs 5 lakh on private sector lender ICICI Bank for violating Know-Your
Customer (KYC) norms, and the same amount on Standard Chartered
Bank for not providing information on time about its foreign currency
loan facility.
 A fraud case reportedly involving Rs 400 crore came to light in the
financial year 2009-10 and Police arrested a senior official at a Citibank
branch in Gurgaon.

Need to Identify, manage and measure operational risk:

Identification, management and measurement of risks, with particular
reference to operational risks, are considered necessary for the Indian
banks, for the following reasons
 Rapid changes that are being experienced by banks world over,
inclusive of Indian banks, due to disintermediation, deregulation,
liberalisation and globalisation.
 Changing dynamics of financial markets owing to complexity / advent of
new technology, growth in business and transaction volumes, rapidly
changing systems and procedures.
 Emergence of new variety of transactions such as derivatives, intense
competition, increased frauds, increased size of banks such as barings
bank.
 To avert the instance of increased regulatory capital requirements
owing to poor / inadequate operational risk management policies.
Banks in due course have to gear up for the regime for better allocation
of capital for operational risk based on the approaches suggested by
Basel Committee.
 To satisfy the supervisor on operational risk management policies under
Risk Based Supervision (RBS). Supervisor (RBI) has now asked banks to
provide their assessment on operational risk related areas in a separate
Risk Profile Teplate (RPT) under RBS.
 To ensure that operating risk assessment and mitigation become an
integral part of bank’s policy through appropriate structure and declare
it, in due course, for better understanding of market participants as per
the third pillar Market Discipline Requirements under New Basel
Accord.

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 Limitation of the available insurance covers to take care of wide range
of visible / invisible, quantifiable / non-quantifiable operational risks.
Moreover cost is also a factor.
 Very high liverage of banks.
 To maintain / improve bank’s credit rating agencies, share holders value
and project a better image vis-à-vis competitors.
 Banks are ever-increasing emphasis on volumes to maintain their
margins. Thus, adequate operational risk management structure is
needed to safeguard the interests of employee / banks while handling
volumes.
 To enhance the confidence level of operating staff through appropriate
/ adequate operational risk management frame work. Such a structure
also facilitates faster examination of staff accountability in a more
transparent manner.
 Banks own limitation to frequently raise capital from the market / stake
holders inclusive of Government. This is more pronounced in case of
Indian Public Sector Banks.
 Ever-increasing cost of processing operational errors.
 Emphasis on out-sourcing of non-core banking activity thereby leading
to know / unknown type of risks.
 RBI has emphasized from time to time that the design of risk
management frame work should be oriented towards the bank’s own
requirements dictated by the size and complexity of business, risk
philosophy, market perception and the expected level of capital the
responsibility to manage various types of risk associated with business
of the bank.
RBI also acknowledges the importance of risks and say’s that
operational risk is emerging as an important feature of sound risk
management in the wake of phenomenal increase in volume of financial
transactions, high degree of structural changes and complex technological
support systems. RBI therefore desire that banks should (a) adopted proper
systems for measurement, monitoring and control of operational risk; (b)
devote the necessary resources to quantify the level of such risks and to
incorporate them in to their assessment of overall capital adequacy.

Step in Operational Risk Management:

Operational risk management comprises a host of activities
1. Identifying the risk
2. Predicting operational losses
3. Measuring the risk
4. Allocating capital to cover operational risk
5. Monitoring and management

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1. Identifying the risk:
Bank can prepare an indicative list of areas, relating to operational
risk based on checklist as referred by Baselt-II and the broad areas of events
that may happen in operational areas like Internal Fraud, External Fraud,
Employment practices and work place safety, clients, products and Business
practices, Damage to physical assets, Business Disruption and system
Failures and Execution, Delivery and process management. The broad areas
can again be subdivided in to different models.

2. Predicting Operational losses:

There are a large number of events that could potentially affect a
business. No analysis could ever consider all of them. A loss event has
several important aspects that should affect how operations managers try
to deal with them. These include

a) The likelihood of event occurring in a particular time period.

Event likelihood = No. of event occurrences in a future period
during representative historical times period / Length of the historical time
period.
For less frequent events, historical frequencies are less helpful and
hence we must rely on different approaches, which are either subjective or
the likely hood based upon our knowledge.

b) The impact on the Bank should the event occur:

The operational loss events may have three general types of
financial impact on the bank viz., direct (either through a reduction in
income or loss in value of Banks assets and liabilities) Indirect (as a result of
damage to Bank’s reputation or downstream effects on other loss events)
and opportunity costs (potential earnings foregone because of occurrence
of loss events).
 Event criticality – an approximate measure of the events risk = Event
likelihood X event impact.
 The time structure – How the event unfolds overtime.
The incidents involving extensive human mis-management can be
analyzed with detailed structure of the event i.e., how the events unfold
overtime. Making this event structure helps to answer the modalities,
prevention and minimization of length of impact as well as the mitigation
strategy.
Event uncertainty – how well can we predict the various aspects of the
events risk.

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 The probability of distributions of both frequency and impacts are
subject to uncertainty. For more frequent events one can generally
estimate more accurate risk figures.

3. Measuring the operational risk:

“One cannot manage what one cannot measure”. This implies that
measurement of risk is must for effective risk management. The regulatory
pressure has been made on banks and other financial institutions to
measure and manage operation risk. So banks need to quantify operational
risk, to manage it. But measuring operational risk, unlike credit risk and
market risk, is difficult. This is because operational risk in any organization
is unpredictable, and measuring risk, in a way, is to predict the
unpredictability.
There can be two approaches to measure operational risk:
 Based upon the pattern of the past behaviour of loss events and the
current context of the business environment, in terms of standard
parameters specified by the regulators.
 If we can’t predict the future (due to non-availability of standard
parameters or history data), we need to provide a certain percentage of
some risk indicators say gross profit as a premium for not able to
quantify the operational risk.

4. Capital Allocation for Operational Risk

The Basel Committee has put forward a framework consisting of three
options for calculating operational risk capital charges in a ‘continuum’ of
increasing sophistication and risk sensitivity. These are, in the order of their
increasing complexity, viz., (i) the Basic Indicator Approach (ii) the
Standardised Approach and (iii) Advanced Measurement Approaches.
Though the Reserve Bank proposes to allow banks to initially allow banks to
use the Basic Indicator Approach for computing regulatory capital for
operational risk, banks are expected to move along the range toward more
sophisticated approaches as they develop more sophisticated operational
risk management systems and practices which meet the prescribed
qualifying criteria.

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 Operational Risk Capital Charge Methodologies

Top down methodologies Bottom up methodologies

BIA SA IMA LDA SCA

2
Figure-2: Classification of quantification approaches to operational risk
Increased sophistication
BIA: Basic Indicator approach
SA: Standardized approach
IMA: Internet Measurement approach
LDA: Loss distribution approach
SCA: Score care approach

Top-Down Methodologies:
These methodologies focus on broader measures operational risk
at the bank level. A fixed expense or gross revenue is used as a proxy for
operational risk. But these approaches suffered by the lack of risk
sensitivity as a broad measure. Basel II has given two methodologies as
given below.
1. Basic indicator approach
2. Standardised approach

The Basic Indicator Approach:

Reserve Bank has proposed that, at the minimum, all banks in India
should adopt this approach while computing capital for operational risk
while implementing Basel II. Under basic indicator approach the required
capital is determined by multiplying a financial indicator, such as gross
income, by a fixed percentage. This approach is easy to implement and is
universal applicable to every bank regardless of its complexity or
sophistication. This approach is based on premise that there is some
3
percentage of unpredictibility in any kind of transaction and process .
KBIA = (GI d)n
Whereas,
KBIA = The capital charge under the basic indicator approach.
GI = Gross annual income, where positive, over the previous three years .

2
Basel II Quantification of Operational risks issues and concerns by D.P.
Dube, Bancon, 2004, Nov. 2004, IBA Publication.
3
Draft Guidance Note on management of operational risk by C.R.
Muralidharan, RBI Website March, 11, 2005.

398
= 15% set by the committee, relating the industry – wide level of required
capital to the industry – wide level of the indicator.
n = Number of the previous three years for which gross income is positive.
Gross income = Net profit (+) provisions and contingencies (+) operating
expenses (schedule 16) (-) profit on sale of HTM investments (-) income
from insurance (-) extraordinary irregular item of income (+) loss on sale of
HTM investment.
Basic Indicator Approach A Hypothetical example
Gross income Average gross Capital
Year (in Cr.) income for 3  change for
years operational
Risk (in Cr.)
2002 1000 1200 15 180
2003 1200
2004 1400
In the above cases the capital is calculated.
KBIA = (GI )n
= 1200 × 15% = 180 × 3 = 4540 Cr.
Hence, this bank should allocate Rs. 540 Cr. as regulatory capital,
using Basic indicator approach.

Limitations:
The basis indicator approach is not based on scientific criteria and
also is too simple to be used for high – risk institutions like Banking. This
one-size-fit all approach will also not encourage the banks that are prudent
in their risk management.

The standardized approach:

In this approach, bank’s activities are divided into eight business
lines as shown in the table within each businessline, these are broad
indicators () specified, that reflect the size of volume of bank’s activities in
that area.
Table-2: Business lines given by Basel II.
Name of Business line Indicator  Factor
Corporate finance Gross income 18%
Trading and sales Gross income 18%
Retail banking Annual average assets 12%
Commercial banking Annual average assets 15%
Payment and settlement Annual settlement through put 18%
Agency services Gross income 15%
Retail Brokerage Gross income 12%
Asset management Total funds under management 12%
Source: www.bis.org.

399
 Some of there business lines may not be applicable to a particular
bank, as it depends upon how big the bank is, and how widespread is its
business. The total capital charge for operational risk is calculated as the
simple for operational risk is calculated as the simple summation of the
regulatory capital charges over the whole business lines. This equation can
be expressed as follows.
KTSA = I (G 1-8 × 1-8)
Whereas,
KTSA = The capital charge under the standardised approach.
G1 1-8 = The average annual level of gross income over the past three years.
-8 = a fixed percentage from 12 to 18.

Example: Suppose a bank’s business can be divided in five business lines

name, corporate finance, Retail banking, commercial banking agency service
and others having a correspondence indicator values i.e., the average
annual level of gross income over the past three year’s value as Rs. 250.00
Cr, Rs. 400.00 Cr. Rs. 300.00 Cr. Rs. 117.00 Cr and Rs. 133.00 Cr.
respectively.
So,
KtSA = I (G1-8 ×  1-8)
= 1 (Rs. 250.00 × 18%)
= Rs. 45.00 Cr. corporate finance.
This is shown clearly in Table.
Table-3: The standardised approach – A Hypothetical example
Business Lines Gross Average  Capital
Year Income Income % charge
for 3
years
2002 Corporate Finance 200.00 250.00 18 45
Retail Banking 300.00 400.00 12 48
Commercial Banking 300.00 300.00 15 45
Agency Services 100.00 117.00 15 18
Other’s 100.00 113.00 18 24
Total Gross income 1000.00
2003 Corporate Finance 250.00
Retail Banking 400.00
Commercial Banking 300.00
Agency Services 100.00
Other’s 150.00
Total Gross income 1200.00
2004 Corporate Finance 300.00
Retail Banking 500.00
Commercial Banking 300.00

400
 Agency Services 150.00
Other’s 150.00
Total Gross income 1400.00
For Retail Banking
KtSA = I (G1-8 × 1-8)
= 1 (400 × 12%)
= Rs. 48.00 Crs.
For Commercial Banking
KtSA = 1 (G1-8 × 1-8)
= 1 (300.00 × 15%)
= Rs. 45.00 Cr.
For agency service
KtSA = I (G1-8 × 1-8)
= 1 (117.00 × 15%)
= Rs. 18.00 Cr.
For others
KtSA = I (G1-8 × 1-8)
= 1 (113.00 × 18%)
= Rs. 24.00 Cr.
Total Capital charge = 45.00 + 48.00 + 45.00 + 18.00 + 24.00
+ 24.00
Rs. 180.00 Cr.
The operational risk capital requirement is Rs. 180.00 Cr. using standardised
method.
The Basel committee has also suggested that at national
discreation, banks can use Alternative Standardised Approach (ASA) for
calculating operational risk capital changes.

Limitations:
This approach, although is better than BIA in the sense that it
consider’s 8 parameters instead of one in case of Basic indicator Approach,
still it also suffers from the same problem of lack of scientific approach and
one-size-fits all nation.

Bottom-up Methodologies:
Internal Measurement Approach:
In this approach, there are same business lines as in the standardized
approach, but an extra dimention, loss types are introduced as given in
Table-4.
The required capital for IMA is calculated as follows:
 The bank would estimate unexpected loss amount (ELA) of each cell in
the metrix of business lines and event types (8 business lines, 7 loss

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 types = 56 cells). In stimating ELA, the bank would supply an Exposure
indicator (EI) for each business lines, and would estimate probability of
loss event (PE) and loss given event (LGE) for each business line and
event type combinations. The product of EI, PE and LGE produces the
ELA.
Table-4 Loss types given by Basel II
Sl. No. Loss types
1. Internal Fraud
2. External Fraud
3. Employment practice and work place safety
4. Clients, products and business practice
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery and process management
 The required capital for each business line and event type combination
would be calculated by multiplying the ELA and gama () factor. The
gamma factors may be different across business lines and event types,
but the same gamma factors will be applied across firms.
 It is also proposed to use Risk Profile Index (RPI) as an adjustment factor
to capture the differing risk profile of loss distribution of individual
banks. The overall capital charge for the bank is simple sum of all the
resulting products.
This can be expressed in the following formula.
4
Kij = Yij * El ij * PE ij * LGE ij = Yij * EL ij
= Y * El * PE * LGE
Whereas,
PE = The probability that operational risk event occurs over some future
horizon.
LEG = The average loss given that an event occurs.
EI = An exposure indicator that is intended to capture the scale of the bank
activities in a particular business line.
(i) = is the event type
(j) = j is combination
Kij = capital under Internal measurement approach
Where the parameter  (to be specified by banks and subject to
acceptance by supervisors) translates the estimate of expected loss (EL) for
business line in to capital charge.

4
Advanced operational risk measurement methodologies by RBI Guidelines,
RBI wib site March 11, 2005.

402
 Under the advanced measurement approaches (AMA), banks will
be permitted to choose their own methodology for assessing opertional risk,
so long as it is sufficiently comprehensive and systematic.

Internal Measurement Approach – The a bank is projecting advances of Rs.

27500 Cr. and other business lines of Rs. 42500 Cr. for the year 2005-06
under various segments and considering the past experience of PE
(Probability Estimation) LGE under each business lines as follows.  is
assumed as 3 (which management expects i.e., three times of expected
losses).
Table-5
Internal measurement approach – A Hypothetical example
PE Average LGE average Captial change
Business lines EI
for 3 years for 3 years K=*E1*PE*LGE
Corporate finance 7500 0.0025 0.50 28.13
Retail Banking 12500 0.0007 0.30 7.88
Commercial Banking 7500 0.0025 0.40 18.00
Agency Services 5000 0.0008 0.75 9.00
Others 37500 0.0003 0.50 16.88
Totalcapital required 79.80
Table-5 Internal Measurement Approach –A Hypo theatrical example.
[or Table –5 showing the calcution process of capital change under the
internal measurement Approach].
Hence, bank should allocate Rs. 79.80 as a regulating capital, using internal
measurement approach. [For different business line and different loss type
combination].

Limitation:
In this method we assumed there is a linear relationship between
expected loss and the unexpected loss. Also, it is assumed that the losses by
category will remain stable year after year, which does not happen in
reality.

Loss Distribution Approach:

In this approach the bank uses its history loss data to calculate the
regulating capital to be allocated. The loss distribution is plotted and the
value-at-Risk figure is calculated at a certain confidence level (d) for
operational losses over a fixed period (e.g. a year). This approach is most
straight forward for calculation of operational Risk because it is based on
the use of direct losses. This method differs from internal measurement
approaches in one important respect. If it aims to assess unexpected losses
directly rather than via media an assumption about the relationship

403
between expected loss and unexpected loss. That is internal measurement
approaches estimate a single parameter of the overall loss distribution,
expected loss and assume that the relationship between expected and
unexpected loss (essentially, the shape of the loss distribution) is fixed
regardless of level of the expected loss frequency, severity and scale – are
combined. In contrast, the loss distribution approaches allow this
distribution to vary with both the level of expected losses and with variation
in its components. Thus, there is no need for the determination of a
multiplication () factor under the approach. At present, several kinds of
LDA methods are being developed and no industry standard has emerged

Limitations:
The data collection is important for the assessment of operational
Risk among financial institutions. Moreover, Basel II’s recommendation of
collection of loss data for a period of 3 to 5 years has added fuel to the fire.
As LDA is completing based on history data, it requires the history data
available, which cannot be satisfied as of now as banks do not have loss
data available with them and they cannot use external data because, first,
external data is not representative data for a specific bank. And second,
external data are for only those events, which have been publicly reported,
would be above a certain (high) amount of loss.

Scorecard Approach:
In this approach an initial level of operational Risk capital is set,
then modified based on scorecards filled out by line personal at regular
intervals. Scorecard approach can be considered as the fore cast of
operational losses and events that cause them, based on the knowledge of
business experts. Scorecard approach is hence, a mix of, the quantitative
approaches followed by scenario analysis as an important qualitative
strategy appended for sophistication and robustness of measurement.

Limitation:
This approach is the most sophisticated among all the above-
mentioned approaches, but it works as add-on, not a complete approach in
its own i.e. it needs some statistical measurement of operational risk, up on
which this approach works. Reserve Bank of India suggests Indian banks to
adopt Basic Indicator Approach for measuring operational risk. After
developing the adequate skills in quantifying the operational risks RBI
suggest for migrate to the advanced measurement approach.

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6. Monitoring and Management
Monitoring Operational Risk:
An effective monitoring process is essential for adequately managing
operational risk. Regular monitoring activities can offer the advantage of
quickly detecting and correcting deficiencies in the policies, processes and
procedures for managing operational risk. Promptly detecting and
addressing these deficiencies can substantially reduce the potential
frequency and/or severity of a loss event.
In addition to monitoring operational loss events, banks should
identify appropriate indicators that provide early warning of an increased
risk of future losses. Such indicators (often referred to as early warning
indicators) should be forward-looking and could reflect potential sources of
operational risk such as rapid growth, the introduction of new products,
employee turnover, transaction breaks, system downtime, and so on. When
thresholds are directly linked to these indicators, an effective monitoring
process can help identify key material risks in a transparent manner and
enable the bank to act upon these risks appropriately.
The frequency of monitoring should reflect the risks involved and
the frequency and nature of changes in the operating environment.
Monitoring should be an integrated part of a bank’s activities. The results of
these monitoring activities should be included in regular management and
Board reports, as should compliance reviews performed by the internal
audit and/or risk management functions. Reports generated by and/or for
supervisory authorities may also inform this monitoring and should likewise
be reported internally to senior management and the Board, where
appropriate.
Senior management should receive regular reports from
appropriate areas such as business units, group functions, the operational
risk management unit and internal audit. The operational risk reports should
contain internal financial, operational, and compliance data, as well as
external market information about events and conditions that are relevant
to decision making. Reports should be distributed to appropriate levels of
management and to areas of the bank on which areas of concern may have
an impact. Reports should fully reflect any identified problem areas and
should motivate timely corrective action on outstanding issues. To ensure
the usefulness and reliability of these risks and audit reports, management
should regularly verify the timeliness, accuracy, and relevance of reporting
systems and internal controls in general. Management may also use reports
prepared by external sources (auditors, supervisors) to assess the usefulness
and reliability of internal reports. Reports should be analysed with a view to
improving existing risk management performance as well as developing new
risk management policies, procedures and practices.

405
Management information systems
Banks should implement a process to regularly monitor operational
risk profiles and material exposures to losses. There should be regular
reporting of pertinent information to senior management and the Board of
Directors that supports the proactive management of operational risk. In
general, the Board of Directors should receive sufficient higher-level
information to enable them to understand the bank’s overall operational
risk profile and focus on the material and strategic implications for the
business. Towards this end it would be relevant to identify all activities and
all loss events in a bank under well defined business lines.

Business Line Identification

Banks have different business and risk profiles. Hence the most intractable
problem banks face in assessing operational risk capital is due to this
diversity. The best way to get around this intractable problem in
computation is by specifying a range of operational risk multipliers for
specified distinct business lines. By specifying business lines, banks will be
able to crystallise the assessment processes to the underlying operational
risk and the regulatory framework. Thus, by specifying business lines, the
line managers will be aware of operational risk in their line of business.
Further, confusion and territorial overlap which may be linked to subsets of
the overall risk profile of a bank can be avoided.
For the purpose of operational risk management, the activities of a bank
may be divided into eight business lines identified in the New Capital
Adequacy Framework. Banks are required to align their business activities as
per these eight business lines. The various products launched by the banks
are to be mapped to the relevant business line. Bank must develop specific
policies for mapping a product or an activity to a business line and have the
same documented to indicate the criteria. The following are the eight
recommended business lines.
1. Corporate finance
2. Trading and sales
3. Retail banking
4. Commercial banking
5. Payment and settlement
6. Agency services
7. Asset management
8. Retail brokerage
The following are the principles to be followed for business line mapping:
(i) All activities must be mapped into the eight level - 1 business lines in a
mutually exclusive and jointly exhaustive manner.
(ii) Any banking or non banking activity which cannot be readily mapped

406
 into the business line framework, but which represents an ancillary
function to an activity included in the framework, must be allocated to
the business line it supports. If more than one business line is
supported through the ancillary activity, an objective mapping criteria
must be used.
(iii) The mapping of activities into business lines for operational risk
management must be consistent with the definitions of business lines
used for management of other risk categories, i.e. credit and market
risk. Any deviations from this principle must be clearly motivated and
documented.
(iv) The mapping process used must be clearly documented. In particular,
written business line definitions must be clear and detailed enough to
allow third parties to replicate the business line mapping.
Documentation must, among other things, clearly motivate any
exceptions or overrides and be kept on record.
(v) Processes must be in place to define the mapping of any new activities
or products.
(vi) Senior management is responsible for the mapping policy (which is
subject to the approval by the Board of Directors).
(vii) The mapping process to business lines must be subject to independent
review.

Operational Risk Loss events

Banks must meet the following data requirement for internally generating
operational risk measures.
§ The tracking of individual internal event data is an essential
prerequisite to the development and functioning of operational risk
measurement system. Internal loss data is crucial for tying a bank’s risk
estimates to its actual loss experience.
§ Internal loss data is most relevant when it is clearly linked to a bank’s
current business activities, technological process and risk management
procedures. Therefore, bank must have documented procedures for
assessing on-going relevance of historical loss data, including those
situations in which judgement overrides, scaling, or other adjustments
may be used, to what extent it may used and who is authorised to
make such decisions.
§ Bank’s internal loss data must be comprehensive in that it captures all
material activities and exposures from all appropriate sub-systems and
geographic locations. A bank must be able to justify that any activities
and exposures excluded would not have an impact on the overall risk
estimates. Bank may have appropriate de minimis gross loss threshold
for internal loss data collection, say Rs.10,000. The appropriate

407
 threshold may somewhat vary between banks but should broadly be
consistent with those used by peer banks provided the data captured
covers at least 95% of the bank's total loss due to operational risks.
§ Measuring Operational Risk requires both estimating the probability of
an operational loss event and the potential size of the loss. Operational
Risk assessment addresses the frequency of a particular operational
risk event occurring and the severity of the effect on business
objectives.
§ Banks must track individual internal loss data viz. actual loss, potential
loss, near misses, attempted frauds etc. and map the same into the
relevant level 1 categories defined in Annex 3. Bank must endeavour to
map the events to level 3.
§ Aside from information on gross loss amounts, bank should collect
information about the data of the event, any recoveries, as well as
some descriptive information about the cause/drivers of the loss
event. The level of descriptive information should be commensurate
with the size of the gross loss amount.
§ Bank must develop specific criteria for assigning loss data arising from
an event in a centralised function (e.g. information technology,
administration department etc.) or any activity that spans more than
one business line.
§ External loss data – bank may also collect external loss data to the
extent possible. External loss data should include data on actual loss
amounts, information on scale of business operations where the event
occurred, information on causes and circumstances of the loss events
or any other relevant information. Bank must develop systematic
process for determining the situations for which external data should
be used and the methodologies used to incorporate the data.
§ The loss data even collected must be analysed loss event category and
business line wise. Banks to look into the process and plug any
deficiencies in the process and take remedial steps to reduce such
events.

Controls / Mitigation of Operational Risk:

Although a framework of formal, written policies and procedures is
critical, it needs to be reinforced through a strong control culture that
promotes sound risk management practices. Both the Board of Directors
and senior management are responsible for establishing a strong internal
control culture in which control activities are an integral part of the regular
activities of a bank, since such integration enables quick responses to
changing conditions and avoids unnecessary costs.

408
 A system of effective internal controls is a critical component of
bank management and a foundation for the safe and sound operation of
banking organisations. Such a system can also help to ensure that the bank
will comply with laws and regulations as well as policies, plans, internal rules
and procedures, and decrease the risk of unexpected losses or damage to
the bank’s reputation. Internal control is a process effected by the Board of
Directors, senior management and all levels of personnel. It is not solely a
procedure or policy that is performed at a certain point in time, but rather it
is continually operating at all levels within the bank.
The internal control process, which historically has been a
mechanism for reducing instances of fraud, misappropriation and errors,
has become more extensive, addressing all the various risks faced by
banking organisations. It is now recognised that a sound internal control
process is critical to a bank’s ability to meet its established goals, and to
maintain its financial viability.
In varying degrees, internal control is the responsibility of everyone
in a bank. Almost all employees produce information used in the internal
control system or take other actions needed to effect control. An essential
element of a strong internal control system is the recognition by all
employees of the need to carry out their responsibilities effectively and to
communicate to the appropriate level of management any problems in
operations, instances of non-compliance with the code of conduct, or other
policy violations or illegal actions that are noticed. It is essential that all
personnel within the bank understand the importance of internal control
and are actively engaged in the process. While having a strong internal
control culture does not guarantee that an organisation will reach its goals,
the lack of such a culture provides greater opportunities for errors to go
undetected or for improprieties to occur.
An effective internal control system requires that
· an appropriate control structure is set up, with control activities
defined at every business level. These should include: top level reviews;
appropriate activity controls for different departments or divisions; physical
controls; checking for compliance with exposure limits and follow-up on
non-compliance; a system of approvals and authorisations; and, a system of
verification and reconciliation.
· there is appropriate segregation of duties and that personnel are
not assigned conflicting responsibilities. Areas of potential conflicts of
interest should be identified, minimised, and subject to careful,
independent monitoring.
· there are adequate and comprehensive internal financial,
operational and compliance data, as well as external market information
about events and conditions that are relevant to decision making.

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Information should be reliable, timely, accessible, and provided in a
consistent format.
· there are reliable information systems in place that cover all
significant activities of the bank. These systems, including those that hold
and use data in an electronic form, must be secure, monitored
independently and supported by adequate contingency arrangements.
· effective channels of communication to ensure that all staff fully
understand and adhere to policies and procedures affecting their duties and
responsibilities and that other relevant information is reaching the
appropriate personnel.
Adequate internal controls within banking organisations must be
supplemented by an effective internal audit function that independently
evaluates the control systems within the organisation. Internal audit is part
of the ongoing monitoring of the bank's system of internal controls and of
its internal capital assessment procedure, because internal audit provides
an independent assessment of the adequacy of, and compliance with, the
bank’s established policies and procedures.
Operational risk can be more pronounced where banks engage in
new activities or develop new products (particularly where these activities
or products are not consistent with the bank’s core business strategies),
enter unfamiliar markets, and/or engage in businesses that are
geographically distant from the head office. It is incumbent upon banks to
ensure that special attention is paid to internal control activities where such
conditions exist. In some instances, banks may decide to either retain a
certain level of operational risk or self-insure against that risk. Where this is
the case and the risk is material, the decision to retain or self-insure the risk
should be transparent within the organisation and should be consistent with
the bank’s overall business strategy and appetite for risk.
Banks should have policies, processes and procedures to control and/or
mitigate material operational risks. Banks should periodically review their
risk limitation and control strategies and should adjust their operational risk
profile accordingly using appropriate strategies, in light of their overall risk
appetite and profile.
§ For all material operational risks that have been identified, the bank
should decide whether to use appropriate procedures to control
and/or mitigate the risks, or bear the risks. For those risks that cannot
be controlled, the bank should decide whether to accept these risks,
reduce the level of business activity involved, or withdraw from this
activity completely. Control processes and procedures should be
established and banks should have a system in place for ensuring
compliance with a documented set of internal policies.
§ Some significant operational risks have low probabilities but

410
 potentially very large financial impact. Classification of operational loss
event into various risk categories based on frequency and severity
matrix prioritise the events to be controlled and tracked. Audit
benchmarks can be set for high loss events. Moreover, not all risk
events can be controlled (e.g., natural disasters). Risk mitigation tools
or programmes can be used to reduce the exposure to, or frequency
and/or severity of, such events. For example, insurance policies,
particularly those with prompt and certain pay-out features, can be
used to externalise the risk of “low frequency, high severity” losses
which may occur as a result of events such as third-party claims
resulting from errors and omissions, physical loss of securities,
employee or third-party fraud, and natural disasters.
§ However, banks should view risk mitigation tools as complementary to,
rather than a replacement for, thorough internal operational risk
control. Having mechanisms in place to quickly recognise and rectify
legitimate operational risk errors can greatly reduce exposures. Careful
consideration also needs to be given to the extent to which risk
mitigation tools such as insurance truly reduce risk, or transfer the risk
to another business sector or area, or even create a new risk (e.g. legal
or counterparty risk).
§ Investment in appropriate processing technology and information
technology security are also important for risk mitigation. However,
banks should be aware that increased automation could transform
high frequency-low severity losses into low frequency-high severity
losses. The latter may be associated with loss or extended disruption
of services caused by internal factors or by factors beyond the bank’s
immediate control (e.g., external events). Such problems may cause
serious difficulties for banks and could jeopardise an institution’s
ability to conduct key business activities. Banks should establish
disaster recovery and business continuity plans that address this risk.
§ Banks should also establish policies for managing risks associated with
outsourcing activities. Outsourcing of activities can reduce the
institution’s risk profile by transferring activities to others with greater
expertise and scale to manage the risks associated with specialised
business activities. However, a bank’s use of third parties does not
diminish the responsibility of management to ensure that the third-
party activity is conducted in a safe and sound manner and in
compliance with applicable laws. Outsourcing arrangements should be
based on robust contracts and/or service level agreements that ensure
a clear allocation of responsibilities between external service providers
and the outsourcing bank. Furthermore, banks need to manage
residual risks associated with outsourcing arrangements, including

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 disruption of services
§ Depending on the scale and nature of the activity, banks should
understand the potential impact on their operations and their
customers of any potential deficiencies in services provided by vendors
and other third-party or intra-group service providers, including both
operational breakdowns and the potential business failure or default
of the external parties. Banks to ensure that the expectations and
obligations of each party are clearly defined, understood and
enforceable. The extent of the external party’s liability and financial
ability to compensate the bank for errors, negligence, and other
operational failures should be explicitly considered as part of the risk
assessment. Banks should carry out an initial due diligence test and
monitor the activities of third party providers, especially those lacking
experience of the banking industry’s regulated environment, and
review this process (including re-evaluations of due diligence) on a
regular basis. For critical activities, the bank may need to consider
contingency plans, including the availability of alternative external
parties and the costs and resources required to switch external parties,
potentially on very short notice.
§ Banks should have in place contingency and business continuity plans
to ensure their ability to operate on an ongoing basis and limit losses in
the event of severe business disruption. These plans needs to be
stress-tested annually and the plans may be revised to appropriately
address any new or previously unaddressed parameters for these
plans. For reasons that may be beyond a bank’s control, a severe event
may result in the inability of the bank to fulfil some or all of its business
obligations, particularly where the bank’s physical, telecommunication,
or information technology infrastructures have been damaged or
made inaccessible. This can, in turn, result in significant financial losses
to the bank, as well as broader disruptions to the financial system
through channels such as the payments system. This potential requires
that banks establish disaster recovery and business continuity plans
that take into account different types of plausible scenarios to which
the bank may be vulnerable, commensurate with the size and
complexity of the bank’s operations.
Banks should periodically review their disaster recovery and business
continuity plans so that they are consistent with the bank’s current
operations and business strategies. Moreover, these plans should be tested
periodically to ensure that the bank would be able to execute the plans in
the unlikely event of a severe business disruption.

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Operational Risk Management
Organizational set up and culture
Operational risk is intrinsic to a bank and should hence be an important
component of its enterprise wide risk management systems. The Board and
senior management should create an enabling organizational culture placing
high priority on effective operational risk management and adherence to
sound operating procedures. Successful implementation of risk
management process has to emanate from the top management with the
demonstration of strong commitment to integrate the same into the basic
operations and strategic decision making processes. Therefore, the Board
and senior management should promote an organizational culture for
management of operational risk.
It is recognised that the exact approach for operational risk management
chosen by an individual bank will depend on a range of factors, including
size and sophistication, nature and complexity of its activities. However,
despite these differences, clear strategies and oversight by the Board of
Directors and senior management; a strong operational risk culture, i.e the
combined set of individual and corporate values, attitudes, competencies
and behaviour that determine a bank's commitment to and style of
operational risk management; internal control culture (including clear lines
of responsibility and segregation of duties); effective internal reporting; and
contingency planning are all crucial elements of an effective operational risk
management framework.
Ideally, the organizational set-up for operational risk management should
include the following:
Ø Board of Directors
Ø Risk Management Committee of the Board
Ø Operational Risk Management Committee
Ø Operational Risk Management Department
Ø Operational Risk Managers
Ø Support Group for operational risk management
A typical organisation chart for supporting operational risk management
function could be as under

413
 ANNEX1

BOARD OF DIRECTORS
(Decide overall risk management policy and strategy)

RISK MANAGEMENT COMMITTEE Board Sub-Committee

including CEO and Heads of Credit, Market and Operational
Risk Management Committees
(Policy and Strategy for Integrated Risk Management)

CREDIT RISK MARKET RISK OPERATIONAL RISK

MANAGEMENT MANAGEMENT MANAGEMENT
COMMITTEE COMMITTEE COMMITTEE

Chief Risk Officer

Credit Risk Operational Risk Market Risk

Management Management Management
Department Department Department

Business Operational Operational Risk Department Heads

Risk Manager Management
Specialist

414
Board Responsibilities:
Board of Directors of a bank is primarily responsible for ensuring effective
management of the operational risks in banks. The Board would include
Committee of the Board to which the Board may delegate specific
operational risk management responsibilities:
- The Board of Directors should be aware of the major aspects of the
bank’s operational risks as a distinct risk category that should be
managed, and it should approve an appropriate operational risk
management framework for the bank and review it periodically.
- The Board of Directors should provide senior management with
clear guidance and direction.
- The Framework should be based on appropriate definition of
operational risk which clearly articulates what constitutes operational
risk in the bank and covers the bank’s appetite and tolerance for
operational risk. The framework should also articulate the key
processes the bank needs to have in place to manage operational risk.
- The Board of Directors should be responsible for establishing a
management structure capable of implementing the bank's
operational risk management framework. Since a significant aspect of
managing operational risk relates to the establishment of strong
internal controls, it is particularly important that the Board establishes
clear lines of management responsibility, accountability and reporting.
In addition, there should be separation of responsibilities and
reporting lines between operational risk control functions, business
lines and support functions in order to avoid conflicts of interest.
- Board shall review the framework regularly to ensure that the bank
is managing the operational risks arising from external market changes
and other environmental factors, as well as those operational risks
associated with new products, activities or systems. This review
process should also aim to assess industry best practice in operational
risk management appropriate for the bank’s activities, systems and
processes. If necessary, the Board should ensure that the operational
risk management framework is revised in light of this analysis, so that
material operational risks are captured within.
- Board should ensure that the bank has in place adequate internal
audit coverage to satisfy itself those policies and procedures have been
implemented effectively. The operational risk management framework
should be subjected to an effective and comprehensive internal audit
by operationally independent, appropriately trained and competent
staff not directly involved in the operational risk management process.
Though, in smaller banks, the internal audit function may be
responsible for developing the operational risk management

415
 programme, responsibility for day-to-day operational risk management
should be transferred elsewhere.

Senior Management Responsibilities

Senior management should have responsibility for implementing
the operational risk management framework approved by the Board of
Directors. The framework should be consistently implemented throughout
the whole banking organisation, and all levels of staff should understand
their responsibilities with respect to operational risk management. The
additional responsibilities that devolve on the senior management include
the following:
§ To translate operational risk management framework established by
the Board of Directors into specific policies, processes and procedures
that can be implemented and verified within the different business
units.
§ To clearly assign authority, responsibility and reporting relationships to
encourage and maintain this accountability, and ensure that the
necessary resources are available to manage operational risk
effectively.
§ To assess the appropriateness of the management oversight process in
light of the risks inherent in a business unit’s policy.
§ To ensure bank’s activities are conducted by qualified staff with the
necessary experience, technical capabilities and access to resources,
and that staff responsible for monitoring and enforcing compliance
with the institution’s risk policy have authority independent from the
units they oversee.
§ To ensure that the banks operational risk management policy has been
clearly communicated to staff at all levels.
§ To ensure that staff responsible for managing operational risk
communicate effectively with staff responsible for managing credit,
market, and other risks as well as with those in the bank who are
responsible for the procurement of external services such as insurance
purchasing and outsourcing agreements. Failure to do so could result
in significant gaps or overlaps in a bank’s overall risk management
programme.
§ To give particular attention to the quality of documentation controls
and transaction-handling practices. Policies, processes and procedures
related to advanced technologies supporting high transaction volumes,
in particular, should be well documented and disseminated to all
relevant personnel.
§ To ensure that the bank's HR policies are consistent with its appetite
for risk and are not aligned to rewarding staff who deviate from

416
 policies.
The broad indicative role of each organisational arm of the risk
management structure both at the corporate level and at the functional
level is indicated in brief in the Annex 1. These can be customised to the
actual requirements of each bank depending upon the size, risk profile, risk
appetite and level of sophistication.

Policy Requirements and Strategic Approach

The operational risk management framework provides the strategic
direction and ensures that an effective operational risk management and
measurement process is adopted throughout the institution. Each
institution's operational risk profile is unique and requires a tailored risk
management approach appropriate for the scale and materiality of the risk
present, and the size of the institution. There is no single framework that
would suit every institution; different approaches will be needed for
different institutions. In fact, many operational risk management techniques
continue to evolve rapidly to keep pace with new technologies, business
models and applications. The key elements in the Operational Risk
Management process include –
· Appropriate policies and procedures;
· Efforts to identify and measure operational risk
· Effective monitoring and reporting
· A sound system of internal controls; and
· Appropriate testing and verification of the Operational Risk
Framework.

Policy Requirement
Each bank must have policies and procedures that clearly describe
the major elements of the Operational Risk Management framework
including identifying, assessing, monitoring and controlling / mitigating
operational risk.
Operational Risk Management policies, processes, and procedures
should be documented and communicated to appropriate staff. The policies
and procedures should outline all aspects of the institution's Operational
Risk Management framework, including: -
· The roles and responsibilities of the independent bank-wide
Operational Risk Management function and line of business
management.
· A definition for operational risk, including the loss event types that will
be monitored.
· The capture and use of internal and external operational risk loss data
including data potential events (including the use of Scenario analysis).

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· The development and incorporation of business environment and
internal control factor assessments into the operational risk
framework.
· A description of the internally derived analytical framework that
quantifies the operational risk exposure of the institution.
· A discussion of qualitative factors and risk mitigants and how they are
incorporated into the operational risk framework.
· A discussion of the testing and verification processes and procedures.
· A discussion of other factors that affect the measurement of
operational risk.
· Provisions for the review and approval of significant policy and
procedural exceptions.
· Operational risk Limits, breach of limits and reporting levels.
· Regular reporting of critical risk issues facing the banks and its
control/mitigations to senior management and Board.
· Top-level reviews of the bank's progress towards the stated objectives.
· Checking for compliance with management controls.
· Provisions for review, treatment and resolution of non-compliance
issues.
· A system of documented approvals and authorisations to ensure
accountability at an appropriate level of management.
· Define the risk tolerance level for the bank and break it down to
appropriate limits, and
· Indicate the process to be adopted for immediate corrective action.
Given the vast advantages associated with effective Operational Risk
Management, it is imperative that the strategic approach of the risk
management function should be oriented towards:
· An emphasis on minimising and eventually eliminating losses and
customer dissatisfaction due to failures in processes.
· Focus on flaws in products and their design that can expose the
institution to losses due to fraud etc.
· Align business structures and incentive systems to minimize conflicts
between employees and the institution.
· Analyze the impact of failures in technology / systems and develop
mitigants to minimize the impact.
· Develop plans for external shocks that can adversely impact the
continuity in the institution’s operations.
The institution can decide upon the mitigants for minimizing operational
risks rationally, by looking at the costs of putting in mitigants as against the
benefit of reducing the operational losses.

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Operational Risk Management Committee
A. Key functions of Risk Management Committee of Board (RMCB)
· Approve operational risk policies and issues delegated to it by the
Board.
· Review profiles of operational risk throughout the organization
· Approve operational risk capital methodology and resulting attribution
· Set and approve expressions of risk appetite, within overall parameters
set by the Board.
· Re-enforce the culture and awareness of operational risk management
throughout the organization.

B. Key functions of Operational Risk Management Committee

The Operational Risk Management Committee is an executive committee. It
shall have as its principal objective the mitigation of operational risk within
the institution by the creation and maintenance of an explicit operational
risk management process. The committee will be presented with detailed
reviews of operational risk exposures across the bank. Its goals are to take a
cross-business view and assure that a proper understanding is reached and
actions are being taken to meet the stated goals and objectives of
operational risk management in the bank. The Committee may meet
quarterly, or more often as it determines is necessary. The meetings will
focus on all operational risk issues that the bank faces. Key roles of the
Committee are:
· Review the risk profile, understand future changes and threats, and
concur on areas of highest priority and related mitigation strategy.
· Assure adequate resources are being assigned to mitigate risks as
needed
· Communicate to business areas and staff components the importance
of operational risk management, and assure adequate participation
and cooperation
· Review and approve the development and implementation of
operational risk methodologies and tools, including assessments,
reporting, capital and loss event databases.
· Receive and review reports/presentations from the business lines and
other areas about their risk profile and mitigation programs
· To monitor and ensure that appropriate operational risk management
frameworks are in place
· To proactively review and mange potential risks which may arise from
regulatory changes/or changes in economic /political environment in
order to keep ahead
· To discuss and recommend suitable controls/mitigations for managing
operational risk

419
· To analyse frauds, potential losses, non compliance, breaches etc. and
recommend corrective measures to prevent recurrences
· To discuss any issues arising / directions in any one business
unit/product which may impact the risks of other business/products
· To continually promote risk awareness across all business units so that
complacency does not set in.

C. Key functions of Operational Risk Management Department (ORMD)

The ORMD is responsible for coordinating all the operational risk activities
of the Bank, working towards achievement of the stated goals and
objectives. Activities include building an understanding of the risk profile,
implementing tools related to operational risk management, and working
towards the goals of improved controls and lower risk. ORMD works with
the operational liaisons within the business units, staff areas and with the
corporate management staff. The group is organized within the Risk
Management function. Specific activities of the ORMD include:
· Risk Profile – ORMD will work with all areas of the bank and assemble
information to build an overall risk profile of the institution,
understand and communicate these risks, and analyze changes/trends
in the risk profile. ORMD will utilize the following four-pronged
approach to develop these profiles:
· Risk Indicators
· Self-Assessment
· Loss Database
· Capital Model
· Tools – ORMD is responsible for the purchase or development and
implementation of tools that the Bank will use in its operational risk
management program.
· Capital – ORMD is jointly responsible with the department involved in
capital management for development of a capital measurement
methodology for operational risks. It will also coordinate the assembly
of required inputs, documentation of assumptions, gaining consensus
with the business areas, and coordination with other areas of the bank
for the use of the results in the strategic planning, performance
measurement, cost benefit analysis, and pricing processes.
· Consolidation and Reporting of Data – ORMD will collect relevant
information from all areas of the bank, build a consolidated view of
operational risk, assemble summary management reports and
communicate the results to the risk committees or other interested
parties. Key information will include risk indicators, event data and
self-assessment results and related issues.

420
· Analysis of Data – ORMD is responsible to analyze the data on a
consolidated basis, on an individual basis and on a comparative basis.
· Best Practices – ORMD will identify best practices from within the bank
or from external sources and share these practices with management
and risk specialists across the Bank as beneficial. As part of this role,
they will participate in industry conferences surveys, keep up to date
on rules and regulations, monitor trends and practices in the industry,
and maintain a database/library of articles on the subject.
· Advice/Consultation – ORMD will be responsible for working with the
Risk Specialists and the businesses as a team to provide advice on how
to apply the operational risk management framework identify
operational risks and work on solving problems and improving the risk
profile of the Bank.
· Insurance – ORMD will work with the Bank’s insurance area to
determine optimal insurance limits and coverage to assure that the
insurance policies the bank purchases are cost beneficial and align with
the operational risk profiles of the Bank.
· Policies – ORMD will be responsible for drafting, presenting, updating
and interpreting, this Operational Risk Policy, and related detailed
policies and methodologies.
· Self-Assessment – ORMD will be responsible for facilitating periodic
self-assessments for the purpose of identifying and monitoring
operational risks.
· Coordination with Internal Audit –ORMD will work closely with
Internal Audit to plan assessments and concerns about risks in the
Bank. ORMD and Internal Audit will share information and coordinate
activities so as to minimize potential overlap of activities.

D. Key functions of Chief Risk Officer (CRO)

The CRO has supervisory responsibilities over the Operational Risk
Management Department as well as responsibility over market risk and
credit risk:
· Review Recommendations –The CRO will supervise the activities and
review and approve the recommendations of the ORMD before
submission to the Operational Risk Committee or Risk Management
Committee
· Assess interrelationships between Operational, and other risk types –
The CRO will facilitate the analysis of risks and interrelationships of
risks across market, credit and operational risks. The CRO will assure
communication between risk functions and that risk measures and
economic capital measures reflect any interrelationships.
· Create Awareness – The CRO will help assure that line and executive

421
 management maintains an ongoing understanding of operational risks
and participates in related risk management activities.

E. Key function of Operational Risk Management Specialists

The bank-wide support departments (e.g., Legal, Human Resources, and
Information Technology) shall assign a representative(s) to be designated as
Operational Risk Specialists. Their main responsibility is to work with ORMD
and the departments/businesses to identify, analyze, explain and mitigate
operational issues within their respective areas of expertise. They will also
act as verifiers for their related risks in the self assessment process. They
will accomplish this responsibility by involving themselves in the following:
· Committee Participation – The Operational Risk Management
Specialists shall be members of the committees and task forces related
to operational risk management, as applicable. They must be ready to
discuss operational issues and recommend mitigation strategies.
· Risk-Indicators – Assist in the development and review of appropriate
risk indicators, both on a bank-wide and business specific basis for
their area of specialty.
· Self-Assessment – Assist in the review of Self-Assessment results and
opine on the departmental/business assessment of risk types,
quantification and frequency.
· Loss Database – Assist in the timely identification and recording of
operational loss data and explanations.
· Gaps/Issues – Ensure that all operational risk issues are brought to the
attention of ORMD and the Department/business.
· Mitigation – Assist the department/business in the design and
implementation of risk mitigation strategies.

F. Key functions of Business Operational Risk Managers

It is expected that each business/ functional area will appoint a person
responsible to coordinate the management of operational risk. This
responsibility may be assigned to an existing job, be a full time position, or
even a team of people, as the size and complexity justify.
Business/Functional areas should determine how this should be organized
within their respective areas. Risk Managers will report to their respective
departments/businesses, but work closely with ORMD and with consistent
tools and risk management framework and policy. The Operational Risk
Management Committee will assure that these liaisons are appointed and
approve their selection. The key responsibilities of the liaisons are:
· Self-Assessments – Will help facilitate, partake and verify the results of
the self-assessment process.
· Risk Indicators – Design, collection, reporting, and data capture of risk

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 indicators and related reports. Liaisons will monitor results and help
work with their respective departments on identified issues. Resulting
information will be distributed to both the departments and ORMD on
a timely and accurate basis
· Loss Events – Coordinate collection, recording and data capture of loss
events within the businesses and regular reporting of these events, the
details, amounts
· Gaps/Issues – Responsible for the timely follow-up, documentation
and status of action plans, open issues (Internal Audit, External Audit,
Regulator and Inspector) and other initiatives waiting to be completed.
· Committee Participation – Must prepare to be called upon to attend
the Operational Risk Management Committee meetings, when
necessary, to discuss operational risk issues.
· Risk Mitigation – Responsible for consulting/advising the business
units on ways to mitigate risks. Work with business areas and
respective departments on risk analysis and mitigation.

G. Key functions of Department Heads

Business/Functional area heads are responsible for risk taking, related
controls and mitigation. They are ultimately responsible for implementation
of sound risk management practices and any resulting impact for
operational losses. To support this responsibility, they will have the
following responsibilities related to operational risk management.
· Risk Ownership – The department heads shall take ownership of the
risks faced in their departments/businesses.
· Understanding – Understanding the profile of operational risk facing
the area and monitoring changes in the business and risk profile.
Department Heads may be expected to present their risk profiles and
action plans to the Operational Risk Management Committee.
· Risk Indicators – Collection and Preparation of various risk indicator
reports
· Loss Events - Identification of loss events within the businesses and
regular reporting of these events, the details, amounts and
circumstances to ORMD on a complete and timely basis.
· Self-Assessment – Responsible for the periodic completion of self-
assessments

Risk Migration – The businesses are responsible for developing strategies

for the mitigation of risk where required (or managing those risks deemed
to be acceptable).

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 ANNEX 2
(Paragraph 7.3)
Mapping of Business Lines
Buisness
Unit Business line Activity Groups

Level 1 Level 2
Mergers and Acquisitions, Underwriting,
Corporate Privatisations, Securitisation, Research,
Corporate Debt (Government, High Yield) Equity,
Finance
Finance Syndications, IPO, Secondary Private
Placements.

Investment Sales
Banking
Fixed Income, equity, foreign exchanges,
Trading and Market Making commodities, credit, funding, own
sales
position securities lending and repos,
Proprietary brokerage, debt, prime brokerage.
Positions

Treasury

Retail lending and deposits, banking

Retail Banking
services, trust and estates

Private lending and deposits, banking

Retail Banking
Private Banking services, trust and estates, investment
advice.

Merchant/Commercial/Corporate
Card Services cards, private labels and retail.

Commercial Commercial Project finance, real estate, export

Banking Banking finance, trade finance, factoring, leasing,
Banking lends, guarantees, bills of exchange
Payment and Payments and collections, funds
Settlement External Clients transfer, clearing and settlement.

Escrow, Depository Receipts, Securities

Custody
Lending (Customers) Corporate actions
Agency Services
Corporate
Issuer and paying agents
Agency

Corporate Trust

424
 Discretionary
Fund Pooled, segregated, retail, institutional,
Management closed, open, private equity
Asset
Management Non -
Others Discretionary
Fund Pooled, segregated, retail, institutional,
closed, open
Management

Retail Retail Brokerage Execution and full service

Brokerage

ANNEX 3
(Paragraph 5.9)
Category (Level 1) Definition Category (Level 2) Category (Level 3)
Internal Fraud Lossess due To acts of Unauthorized Transactions not
a type intended to activity reported (intentional)
defraud,
Trans type Unauthorized
Misappropriate
(monetary loss)
property or Circumvent
regulations, the law or Mismarking of position
company policy, (intentional)
excluding diversity/
discrimination events, Theft and Fraud Fraud/credit fraud
which Involves at least /worthless deposits
one internal party.
Theft/ extortion/
embezzlement/ robbery
Misappropriation of assets

Malicious destruction
of assets
Forgery
Check kiting
Smuggling

Account take-over/
impersonation /etc.
Tax non-compliance/
evasion (willful)

Bribes/ kickbacks
Insider trading (not on
bank’s account)

425
External Fraud Lossess due To acts of Theft and Fraud Theft/ robbery
a type intended to
defraud, Forgery
Misappropriate Cheque Kiting
property or circumvent
Systems Security Hacking damage
the law, by a third
party. Theft of information

Employment Lossess Arising from Employee Relations Compensation, benefit,

Practices and acts inconsistent with termination issues
Workplace Safety employment, health or
safety Laws or
Organized labor activity
agreements, from
payment of personal
injury claims, or from Environmental General liability
diversity / safety (Workplace accidents - slip
discrimination events. & fall etc)

Workers compensation

Diversity and All discrimination types

discrimination

Clients, Products Lossess Arising from Suitability, Fiduciary breaches /

Practices An unintentional or Disclosure & guideline violations
Negligent Failure to Fiduciary Suitability / disclosure
Meet a professional issues (KYC etc)
obligation to specific
clients (including Retail consumer
fiduciary and Suitability disclosure violations
requirements), or from
the nature or design
of a product.
Breach of privacy
Aggressive sales

Account churning

Misuse of confidential
information
Lender Liability

426
 Improper Antitrust
Business
Improper trade / market
or Market Practices
practices

Market manipulation
Insider trading
Unlicensed activity
Money laundering
Product flaws Product defects
(unauthorized etc.)

Model errors
Selection, Failure to investigate
Sponsorship & client per guidelines
Exposure
Exceeding client exposure
limits

Disputes over
performance of advisory
Advisory activities activities

Damage to Losses Arising from loss Disasters and other Natural disaster losses
physical assets or damage to physical events
Assets from natural
Human losses from
disasters or other external sources
events
(terrorism, vandalism)

Business Losses arising from Systems Hardware

disruption & disruption of business
Software
system failures or system failures
Telecommunications
Utility outrage /
disruptions

Losses from failed Transaction Miscommunication

Execution, transcations Capture, Execution
Data entry, maintenance
Delivery & processing or process Maintenance
or loading error
Process management, from
Management relations with Missed deadline or
trade counterparties responsibility
and vendors
Model/ system
misoperation

427
 Accounting error/ entity
attribution error
Other task
misperformance
Delivery failure
Collateral
Monitoring management failure
And Reporting
Reference data
maintenance
Failed mandatory
reporting obligation

Inaccurate external report

(loss incurred)

Customer intake Client permissions

and documentation /disclaimers missing

Legal documents missing /

incomplete

Customer client Unapproved access given

Account to accounts
management Incorrect client records
(loss incurred)

Negligent loss damage of

Trade client assets
Counterparties
Non client counterparty
misperformance
Misc. non-client
counterparty disputes

Vendors & Suppliers Outsourcing

Vendor disputes

Reference:
1. International conference of capital measurement and capital standards
– A revised frame work, June 2004
2. www.erisk.com for BCCI failure
3. RBI’s Comments / feedback on Basel Discussion Paper April 2000
4. Basel-II and Quantification of Operational Risks Issues and concern by
D.P. Dube, Banoon 2004 Conference IBA Publication Nov. 2004
5. Operational risk under New basel Accord by Rajesh and IBA Bulletin
June 2004

428
6. Operational Risk under new Basel accord by Rajesh food IBA Bulletin,
June 2004
7. Draft Guidance Note on Management of Operational Risk RBI Wibe site
March, 11 2005
8. Measurement of operational risk – A primer, A.S. Rajeev Bancon 2004,
Conference, IBA Publication Nov. 2004.
9. Measuring and managing operational risk in Fls – Tools, Techniques
and other Resources by Dr. Christopher Lee Marshall – 2002.
10. BIS 2001, Basel Committee on Banking Supervision (2001) consultative
Document, the New Basel Capital accord htt://www.bis.org.
11. Basel II Quantification of Operational risks issues and concerns by D.P.
Dube, Bancon, 2004, Nov. 2004, IBA Publication
12. Draft Guidance Note on management of operational risk by C.R.
Muralidharan, RBI Website March, 11, 2005.
13. Advanced operational risk measurement methodologies by RBI
Guidelines, RBI wib site March 11, 2005.
14. Draft Guidance note on management of operational risk by C.R.
Muralidharan, RBI Guidelines, March 11, 2005, p. 54.
15. Basel Committee on Banking Supervision, Sound Practices for the
Management and Supervision of Operational Risk, February 2003
16. Basel Committee on Banking Supervision, International Convergence of
Capital Measurement and Capital Standards – A Revised Framework,
June 2004.
17. Basel Committee on Banking Supervision, Framework for Internal
Control Systems in Banking Organisations, September 1998

429
 Chapter-9

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Capital Measurement and Capital Standards – A Revised Framework,
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2001
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432
7. Basel Committee on Banking Supervision (1988) “International
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433
Circulars from RBI website:
26. DRAFT GUIDANCE NOTE ON MANAGEMENT OF OPERATIONAL RISK
1999
27. Guidance Notes on management of credit risk and market risk in
October 2002.
28. BCBS Paper entitled “An Explanatory Note on the Basel II IRB Risk
Weight Functions” October 2004
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Hedging Commodity Price Risk and Freight Risk Overseas July 2013
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Calculate Capital Requirement for Credit Risk July 2013
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Action taken on the recommendations June 2012 website www.rbi.org

List of master circulars referred

1. D.O.No.DBOD.IBS/1163/C.212 (SG)‐86; June 5, 1986;
Control Systems at Foreign Offices – Asset Liability Management
2. A.D (M.A Series) Circular No. 16; May 15, 1999;
Amendments to the Exchange Control Manual
3. DBOD.No.BP.BC.8/21.04.098/99; February 10, 1999;
Asset‐Liability Management (ALM) System
4. DBS.BC.No.OSMOS.2/33.01.001.15/98‐99; July 17, 1999;
Introduction of Second Tranche of DSB Returns
5. DBOD.No.BP.(SC).BC.98/21.04.103/99; October 7, 1999;
Risk Management Systems in Banks
6. DBS.CO.FBC.BC.34/13.12.001/1999‐2000; April 6, 2000;
Report of the Working Group on Supervision of foreign branches of
Indian banks – Implementation
7. DBOD.No.BP.520/21.04.103/2002‐03; October 12, 2002;
Guidance note on Market Risk Management
8. DBOD.No.BP.BC.72/21.04.018/2001‐02; February 25, 2003;
Guidelines for Consolidated Accounting and Other Quantitative
methods to Facilitate Consolidated Supervision.
9. DBOD.No.BP.BC.66/21.01.002/2006‐07; March 6, 2007;
Prudential Limits for Inter‐Bank Liabilities
10. DBOD.No.BP.BC.101/21.04.103/2006‐07; June 26, 2007;
Guidelines on Stress Testing
11. DBOD.No.BP.BC.38/21.04.098/2007‐08; October 24, 2007;
Guidelines on Asset‐Liability (ALM) System – Amendments

434
12. DBOD.No.BP.BC.11/21.06.001/2011‐12; July 01, 2011;
Master Circular – Prudential Guidelines on Capital Adequacy and
Market Discipline – NCAF
13. DBOD.BP.BC.No.16/21.04.018/2011‐12; July 01, 2011;
Master Circular – Disclosure in Financial Statements – Notes to
Accounts
14. IDMD.PCD.3/14.01.01/2011‐12; July 01, 2011;
Master Circular on Call/Notice money Market Operations
15 RBI No.2012-13/285DBOD.BP.No.56/21.04.098/2012-13;
November 7, 2012; Liquidity Risk Management by Banks
16 RBI/2010-11/263DBOD. No. BP.BC.59 / 21.04.098/ 2010-11;
November 4, 2010; Guidelines on Banks’ Asset Liability Management
Framework – Interest Rate Risk
17 DBOD. No. BP.BC.90 / 20.06.001/ 2006-07; April 27, 2007;
Standardised Approach measures credit risk

435