risk management system in banks

P.K.MITRAGeneral Manager

Punjab National Bank Head Office, New Delhi

punjab national bank

…..the name you can BANK upon 2

Outline of the Presentation

Introduction to Risk Management and Overview of Basel II

Approaches to measure Credit Risk Credit Risk Management in Punjab National

Bank Benefits of moving to advanced approaches



Need for Risk Management

Globalization of Indian Economy Integration of global markets Competition from Foreign and Private Sector Banks

Need to shift from demand driven to supply driven limits Bank should determine appetite for borrower based on his

risk assessment Risk Based Lending

Improve and monitor portfolio quality



Basel Committee on Banking Supervision-BCBS

A committee of central bankers/ bank supervisors from major industrialized countries like Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States.

BCBS has no formal supranational authority nor legal force

However IMF , World Bank, International Rating Agencies, International Financial Institutions, etc use it as a benchmark for assessment of the banks/ banking system



Basel Accord – I (1988) Portfolio Approach – It focused primarily on credit risk and assets of

the banks were categorized into risk buckets with risk weights ranging from 0% to 150%.

Minimum Capital Requirement – 8% of risk weighted assets only for credit risk (9% by RBI)

Based on 1988 accord, RBI initiated various actions for the banks like classification of assets, provision norms, classification of asset class etc.

Particulars Risk WeightCash in hand, Balance with banks, Investment in government securities etc

0%

Money at call and short notices, Investment under government guaranteed securities, Advances to staff members etc

20%

Claim guaranteed by DICGC/ECGE 50%Advance to public against Housing Finance 75%Advances to corporates, claim on PSUs, SME and Retail exposure etc.

100%

Advances under consumer credit 125%Advances covered under Commercial real estate 150%



Need for a new frame-work

Financial innovations viz derivatives and securitisation etc. and growing complexity of transactions

Requirement of more flexible approaches as opposed to “one size fits all” Approach

Requirement of Risk sensitivity as opposed to a “broad- brush Approach”

In last 8-10 years banking sector worldwide has seen catastrophic losses which led to failure of some established banks like Bearing bank and Continental Illinois.



Banking Risks

Credit Risk Market Risk

Liquidity Interest rate Foreign exchange Commodities and Equity

Operational Risk



Credit Risk

Credit risk is defined 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 a 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.



Market risk

Market Risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes.

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 market and interest rate market, currency exchange rates and commodity prices”.



Liquidity risk: Liquidity risk occurs when Bank is not in a position to pay amounts due to its customers/counterparties or these are met by borrowing from the market at high cost.

Interest Rate Risk: The risk that changes in interest rates will adversely impact the revenues and balance sheet.

Forex risk -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.

Equity/Commodity risk – Risk that a bank may suffer losses as a result of adverse movements in equity/commodity prices during a period in which it has an open position.

Market risk



Operational Risk

Basel Committee on Banking Supervision defines the operational risk as

“Risk of direct or indirect loss resulting from inadequate or failed internal control processes, people, systems or from external events”

Such breakdowns can lead to financial losses through Error Fraud Failure to perform in a timely manner Cause the interest of the bank to be compromised like

exceeding authority, conducting business in an unethical or risky manner



Cause Definition

InternalProcesses

Losses from failed transactions, client accounts, settlements and every day business processes.

People Losses caused by an employee or involving employees (intentional or unintentional), or losses caused through the relationship or contact that a firm has with its clients, shareholders, third parties, or regulators.

Systems Losses arising from disruption of business or system failure due to unavailability of infrastructure or IT.

ExternalEvents

Losses from the actions of 3rd parties including external fraud, or damage to property or assets, or from change in regulations that would alter the firm’s ability to continue doing business.

Examples of Operational Risk



Approaches to measure different risk under new accord

Approaches to measure Credit risk Standardized approach Internal ratings based (IRB) approach

Foundation Advanced

Approaches to measure Operational risk Basic Indicator Approach The Standardised Approach Advanced Measurement Approach

Approaches to measure Market risk Standardised method Internal Model





Approaches to Credit Risk Management under Basel II

INC

REA

SED

S

OP

HIS

TIC

ATIO

N

REDUCED CAPITAL REQUIREMENT

STANDARDISED

APPROACH

Risk weights are assigned in slabs according to the asset class or are based on assessment by external credit assessment institutions

FOUNDATION INTERNAL

RATING BASED APPROACH

Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.

ADVANCED INTERNAL RATING

BASED APPROACH

Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes



Risk weights are assigned in slabs of 0%, 20%, 50%, 100% & 150% on the basis of rating assigned by ECAIs. For example -- Claims on Sovereigns (or Central Bank) – 0% to 150% risk weight on the basis of country risk scores and at national discretion, a lower risk weight may be applied.

Claims on Corporates – will be risk weighted in the range of 20-150% and unrated Corporates will be assigned 100% risk weight.

Credit Risk: Standardised Approach



RatingsRW for foreign

Sovereign

RW for banksRW for

CorporatesRupee Claim

Foreign Currency

Claim

AAA to AA

0% Scheduled

Banks

20%

20% 20% AAA

50% AA

A 20% 50% 100%

BBB 50% 50% 150%

BB to B 100% 100% 150%

Below B 150% Others

100%

150% 150%

Unrated 100% 50% 100%

RW as per RBI document.

Credit Risk: Standardised Approach



Off Balance sheet items under Standardised approach

The credit risk exposure attached to off-Balance Sheet items has to be first calculated by multiplying the face value of each of the off-Balance Sheet items by ‘credit conversion factor’ (CCF). This will then have to be again multiplied by the risk weights attributable to the relevant counter-party as specified in previous slide.

Sr. No.

Instruments Credit Conversion Factor (%)

1 Direct credit substitutes e.g. general guarantees ofindebtedness (including standby L/Cs serving asfinancial guarantees for loans and securities) andacceptances (including endorsements with thecharacter of acceptance).

100

2 Certain transaction-related contingent items (e.g.performance bonds, bid bonds, warranties andstandby L/Cs related to particular transactions).

50

3 Short-term self-liquidating trade-related contingencies(such as documentary credits collateralised by theunderlying shipments) for both issuing bank andconfirming bank.

20

*** Above list is not exhaustive.



Credit Risk Mitigants under Standardised Approach

Eligible collaterals Cash or deposit with bank, Gold Securities issued by Central and State Governments Indira Vikas Patra, Kisan Vikas Patra and National Savings Life insurance policies ( up to surrender value) Debt securities rated by a recognised Credit Rating Agency having at least “BB”

rating when issued by public sector entities and at least “A” rating when issued by other entities.

Debt securities not rated by a recognised Credit Rating Agency where these are issued by a bank, listed on a recognised exchange and classified as senior debt

Equities included in main index. Mutual funds having publicly quoted daily prices. Irrevocable, unconditional guarantees issued by entities with a lower risk weight

than the counterparty.



Four Key Risk Elements in IRB Approach

Probability of Default (PD)

It measures the likelihood that the borrower will default over a given time-horizon.

Loss Given Default

(LGD)

It measures the proportion of the exposure that will be lost

if a default occurs.

Exposure at Default

(EAD)

It measures the amount of the facility that is likely to be drawn

if a default occurs .

Maturity

(M)

It measures the remaining economic maturity of the

exposure .




Probability of default measures the likelihood that the borrower will default over a given time-horizon i.e. What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as an year.

For estimation of PD, PNB already has Risk Rating System in place for the last 5 years and the history of default rates is being tracked since then.



Loss Given Default (LGD)

Loss Given Default is the credit loss incurred if an obligor of the bank defaults.

LGD = 1 – Recovery Rate

where, Recovery = Present Value of { Cash flows received from borrower after the date of default - Costs incurred by the bank on recovery }

Recovery rate = Recovery (as calculated above)/ Exposure on the date of default



Exposure at Default (EAD)

EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK

65

40

20

60

Sanctioned limits Loan outstanding Utilisation of unavailedlimit in event of default

Exposure at time ofdefault (EAD)

Maturity (M) It measures the remaining economic maturity of the exposure. Determines framework for comparing different exposures.

1000001/01/200331/12/2006

9.00%13

Time Period in years

Cash flow

Present Value of Cash Flow (A) x (c)

(A) (B) (c)1 900 825.69 825.692 900 757.51 1515.023 10900 8416.80 25250.40

Total ------------------------> 10000.00 27591.1127591.1110000.00

Principal & outstanding balanceOpening Date of LoanContractual date of Maturity of LoanContractual and Discount Rate of InterestFreq. of int. payment per annumTenor/Maturity (Years)

= 2.76Economic Maturity =



Internal Rating Based Approach

Under the IRB approach, a bank estimates each borrower’s creditworthiness and the results are translated into estimates of a potential future loss amount, which forms the basis of minimum capital requirement.

Under this approach, the treatment of each exposure class (i.e. corporate, bank, sovereign, retail & equity exposure) is based on three main elements namely: - Risk components Risk weight functions Minimum requirements



The underlying concepts and approaches prescribed in IRB have been developed based on credit risk measurement techniques being used by sophisticated banks for ascertaining their capital requirements.

The Capital required is derived from an estimate of potential losses for a credit portfolio over one year time horizon with 99.9% confidence level.

99.9% confidence level implies that there is only one chance in 1000 that the losses will be larger than the regulatory capital.

The credit risk on an asset, reflected in UL & EL, increases as PD, LGD, EAD or M increases.

Internal Rating Based Approach



Foundation IRB Vs Advanced IRB Approach

Foundation IRB Approach Advanced IRB Approach

Values for Loss given default (LGD) and exposure at default (EAD) are provided by the regulatory authority.

Values for Loss given default (LGD) and exposure at default (EAD) are determined by each bank through internal modeling with a data of 5-7 years.

Assessment of values of credit mitigants is done by the regulatory authority.

Banks may assess the value of its credit mitigants.

For retail exposure, there is no foundation IRB (only advanced IRB where besides PD, the bank concerned will have to estimate LGD & EAD.)

Advanced IRB is applicable to retail exposure also.



Expected Loss (EL)

Expected Loss is the bank’s cost of doing business. Expected loss has to be provided for.

The Expected Loss (in currency amounts)

EL = PD * EAD * LGD

If expressed as a percentage figure of the EAD

EL = PD * LGD. The bank should also proactively incorporate an expected loss

rate in the estimation of the total spread to be charged on the loan.

Expected loss is not a measure of risk as it is anticipated.



Unexpected Loss (UL)

Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value.

This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations.



Expected V/s Unexpected Losses

1.21%0.44%

1.41%1.96%

4.58%

7.53%

3.52%

0.27%

3.32%3.93%

2.30%2.21%

0.56%0.42%0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

1 2 3 4 5 6 7 8 9 10 11 12 13 14

Time (Year)

Lo

an lo

sses

Unexpected loss

Expected loss

EL Vs UL



Capital Requirement under IRB

Borrower

Internal Rating


Transaction

Collateral Maturity

Loss Given Default (LGD)

Maturity (M)

Capital Requirement

= Exposure at Default

X RiskWeight

X 9%

[LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)]

- PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5) * b (PD)



Standard normal distribution (N) applied to threshold and conservative value of systematic factor

= [LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)]

- PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5) * b (PD)

Inverse of the standard normal distribution (G) applied to PD to derive default threshold

Inverse of the standard normal distribution (G) applied to confidence level i.e. 99.9% to derive conservative value of systematic factor

Risk Weight function

Expected Loss (E.L.)

Maturity Smoothened (regression) Maturity adjustment

Asset Correlation



Minimum Criteria for IRB Adv Approach

To be eligible for IRB Approach a bank must demonstrate to its supervisor that it meets certain minimum requirements at the outset and on an on going basis. These include:

• A robust rating system comprising 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.

• Risk rating system operations which includes Coverage of ratings, Integrity of rating process, overrides based on expert judgement, Data maintenance and use of stress tests in assessment of capital adequacy.



Minimum Criteria for IRB Adv Approach

• Corporate Governance and overseeing of risk management by Board of Directors/Top Management

• Use of Internal ratings and default and loss estimates in credit approval, risk management processes, corporate governance functions etc apart from using them in capital calculations

• Risk quantification covering definition of default, requirements specific to estimations of PD, LGD and EAD

• Robust internal control systems for risk management and validation of the models used, internal estimates of risk inputs viz. PD, LGD and EAD etc.





Set Up for Management of Credit Risk

SYSTEM &

MODELS

Developing and

implementing credit risk

models

Periodical portfolio review

Migration Analysis

and Default Rate

Analysis.

Conducting various analysis

Implementation of Preventive Monitoring

System

(PMS)

INDUSTRY ANALYSIS

GROUP

Preparation of scenarios of various

industries

Liaison with external agencies for

updating the industry profiles.

Monitoring industry wise profile of the

bank

INDUSTRY DESK

Approval of rating of borrowers falling under HO powers





Implementing Standardised Approach

RBI has advised banks to start parallel run of “Standardized Approach of Credit Risk” w.e.f. 01/04/2006

This require system for categorisation of assets as per Basel II and for collating data of credit risk mitigation techniques i.e. details of primary/collateral securities.

System should also be able to consolidate Risk Weighted Assets and arrive at the required capital charge for credit risk..

Bank has implemented the system and parallel run as per RBI guidelines has since been started.



All eligible credit exposures beyond a threshold limit of above Rs 20 lacs are risk rated through internal credit risk rating models.

Default Rates for last five years generated. The default rates are satisfactory and comparable with international standards.

Migration of ratings analysed since last four years. In addition to Default rating, Facility-rating is being

implemented.

Implementing Foundation IRB approach



Data requirements as well as features of application tools for Risk Management finalized.

A data warehouse is being established which will have application tools also.

The gaps in the existing systems for adoption of Basel II are being identified.

Goal is to adopt IRB advanced approach by March 2010, subject to RBI approval.

Implementing Advanced IRB approach



Rating Large Corporate (5 years average

DR) %

Mid Corporate

(3 year average DR)

%

Combined*** Three year

Average DR(%) for 2004-06

Small Loan A/Cs

Two Yr. Average DR(%) for 2005-

06

AAA 0.00 0.00 0.00 0.00

AA 0.00 0.00 0.00 0.00

A 0.18 0.78 0.40 0.59

BB 0.64 0.88 0.77 0.90

B 0.91 4.03 2.35 1.96

C 6.44 8.16 6.40 3.60

D 14.96 12.82 13.21 11.93

Total 1.91 2.06 1.72 1.25

Annual Average Default rates as at 31.03.2006

***Large & Mid Corporate



Validation of rating modelsGINI Coefficient

GINI- COEFFICIENT

0

10

2030

40

50

60

7080

90

100

0 10 20 30 40 50 60 70 80 90 100

% CUMULATIVE POPULATION

% C

UM

UL

AT

IVE

DE

FA

UL

T

PO

PU

LA

TIO

N

X

YZ

Actual

Ideal

Random

D rating

A rating

BB rating

B rating

C rating

AA rating

AAA rating

GINI Coefficient = 0.63



Probability of default of PNB Vs Crisil

0.00%

4.00%

8.00%

12.00%

16.00%

20.00%

24.00%

28.00%

32.00%

Rating Grades

Prob

abili

ty o

f Def

ault

Actual 0.03% 0.09% 0.40% 0.77% 2.35% 6.40% 13.21%

Exponential 0.04% 0.10% 0.28% 0.77% 2.14% 5.94% 16.47%

CRISIL 0.00% 0.00% 1.01% 3.47% 15.85% 30.30% 28.57%

AAA AA A BB BB C D

CRISIL

PNB

Exponential

fiiting



Comparative average annual default rate (Up to 31.03.06)

AAA 0.00 AAA 0.00 Aaa 0.00 AAA 0.00AA 0.00 AA 0.00 Aa 0.02 AA 0.00A 0.40 A 0.06 A 0.00 A 1.01

BB 0.77 BBB 0.18 Baa 0.15 BBB 3.47B 2.35 BB 1.06 Ba 1.29 BB 15.85C 6.40 B 5.20 B 6.81 B 30.30D 13.21 C 19.79 C 24.06 C 28.57

PNB S&P Moody CRISIL



Impact of Basel II on Capital Requirement

Particulars

Existing Standardised Approach -

Basel II

Total Capital (A) 12831.85 12831.85

Min. Capital Requirement (@ 9%) (@ 9%)Credit Risk 8001.22 7813.69Market Risk 1075.90 1075.90Operational Risk 0.00 855.90Total Capital Required (B) 9077.12 9745.49

CRAR = [(A)/(B)]*0.09 12.72 11.85

Risk Weighted Assets Credit Risk 88902.46 86818.76Market Risk 11954.44 11954.44Operational 0.00 9510.03Total Risk Weighted Assets 100856.90 108283.23



Road Map for Basel II Implementation

Approach RBI’s Indication Bank’s PreparednessCredit Risk

Standardized 31.03.08 Parallel run started w.e.f 1.4.06

IRB Foundation Not Indicated March 2009 (Subject to RBI approval)

IRB Advanced Not Indicated March 2010 (Subject to RBI approval)

Market RiskStandardized 31.03.06 Already implemented Internal RiskManagement Model Method Not Indicated March 2008 (Subject to RBI approval)

Operational Risk

Basic Indicator 31.03.08 Simple approach can be implemented immediately (Subject to RBI approval)

Standardized Not Indicated March 2009 (Subject to RBI approval) Advanced Not Indicated March 2010 (Subject to RBI approval)



Relief in Capital Charge Risk based Pricing – focus on identified business

areas. Competitive pricing in niche areas. Image/Prestige International recognition/benefits in dealing with

Foreign banks Risk Control

Benefits of moving to Advanced approaches



Banks must correctly classify the assets into Sovereign, Banks, Corporate, Retail and Equity asset classes.

Banks must have used data of at least 5 to 7 years in various models for estimation of various risk components (viz., PD, LGD, EAD and M).

Banks must have robust systems in place to evaluate the accuracy and consistency with regard to the system, processing and the estimation of PDs.

Banks must use proper credit risk mitigants in capital calculation. Banks must have a credible track record in the use of internal ratings

at least for the last 3 years. Banks must disclose in greater detail the rating process, risk factors, validation etc. of the rating system. Internal and External audit must review annually, the banks’ rating system including the quantification of internal ratings.

Areas requiring attention of Auditors



Banks must use appropriate risk weights against the asset classes. Banks must update the credit risk rating at least on annual basis. Banks must have adequately qualified and trained staff for rating

process. Banks must compute the default rates on regular basis and these

should be validate at regular intervals. Banks must have in place sound stress testing process for the

assessment of capital adequacy. Internal rating must be explicitly linked with the banks’ internal

assessment of capital adequacy in line with requirements of Pillar 2.

Areas requiring attention of Auditors



Thank you and Happy New YearThank you and Happy New YearThank you and Happy New YearThank you and Happy New Year

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