CRA Overview

NEW CREDIT RISK ASSESSMENT (CRA) MODELS AN OVERVIEW Background A review of Credit Risk assessment (CRA) Models for Non-Trading & Trading

Sectors was undertaken with the objective of making them Basel-II compliant and meeting the requirements of Internal Ratings Based (IRB) Approach. The New CRA Models are being released for Bank-wide Ba nk-wide implementation. 2. Salient Features of New CRA Models (a) Type of Models S. No. (i) (ii)

Exposure Level (FB + NFB Limits ) Over Rs. 5.00 crore Rs 0.25 crore to Rs. 5.00 crore

Non – Trading Sector Trading Sector (C&I , SSI , AGL) ( Trade & Services) Regular Model Regular Model Simplified Model Simplified Model

(b) Type of Ratings S. No. (i)

Model Regular Model

(ii)

Simplified Model

Type of Rating (i) Borrower Rating (ii) Facility Rating Borrower Rating

(c) Type of Risks Covered Cove red : (i) Borrower Rating S. No.

Risk Category

(i)

Financial Risk (FR)

(ii) (iii)

Qualitative Factors (-‘ve) Business & Industry Risk (BR & IR) /Business /Business Risk (for Trading Sector) Management Risk (MR)

(iv) (v)

(vi) (vii) (viii) (ix) (x)

Qualitative Parameter (External Rating) Total Borrower Rating based on the above Score Country Risk (CR) Final Borrower Rating after CR Financial Statement Quality Risk Score/Rating Transition Matrix

NEW CRA MODEL: OVERVIEW CREDIT RISK MANAGEMENT DEPT.

Maximum Score Regular Model Simplified Model Existing New Existing New Company Company Company Company 65 25 70 35 (65 x 0.39) (70/2) (-10) (-10) (-10) (-10) 20 30 20 40 (20 x 1.5) (20 x 2)

15 (+5)

45 ( 15 x 3) (+5)

10 (+5)

25 ( 10 x 2.5) (+ 5)

100

100

100

100

Excellent/Good/Satisfactory/Poo Excellent/Good/Satisfactory/Poorr Comments on Trend in Rating

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(ii) Facility Rating (Regular Model) S. No. Parameter (a) Risk Drivers for Loss Given Default (LGD)

(i)

Maximum Score

Current Ratio [Working Capital/ Non-Fund Based Facility (except Capex)] Or Project Debt/Equity[Term

Loan/Non-Fund

Based

6

Facility (for Capex)] (ii)

Nature of Charge

4

(iii)

Industry /(Trade- for Trading Sector) #

6

(iv)

Geography #

2

(v)

Unit Characteristics (a) Leverage/ Enforcement of Collateral-4 (b) Safety, Value & Existence of Assets-4

8

Macro-Economic Conditions (a) GDP Growth Rate : Impact of Business Cycle - 2 (b) Insolvency Legislation in the Jurisdiction-1 Jurisdiction-1 (c) Impact of Systemic/Legal Factors on Recovery-1 (d) Time Period for Recovery-1

5

(vii)

Total Security (Primary + Collateral)

60

(b)

Risk Drivers for Exposure at Default (EAD)

(i)

Nature of Commitment (Revolving/Non-Revolving)

1

(ii)

Credit Quality of Borrower @

5

(iii)

Tenor of Facility Total Score Facility Rating based on the above Score

(vi)

3 100

# No Scoring under under these two parameters for for AGL & Trade Segments due to nonavailability of relevant LGD Data; Score out of 92 to be normalised to 100 for these segments. @ Marks linked to Borrower Rating Score of the Unit.


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(d) New Rating Scales - Borrower Rating: 16 Rating Grades S. No. 1 2 3 4 5

Borrower Rating SB1 SB2 SB3 SB4 SB5

Range of Scores 94-100 90-93 86-89 81-85 76-80

6 7 8 9 10

SB6 SB7 SB8 SB9 SB10

70-75 64-69 57-63 50-56 45-49

11 12 13 14 15

SB11 SB12 SB13 SB14 SB15

40-44 35-39 30-34 25-29 <24

16

SB16

Risk Level

Comfort

Virtually Zero risk Lowest Risk Lower Risk Low Risk Moderate Risk with Adequate Cushion Moderate Risk

Virtually Absolute safety Highest safety Higher safety High safety Adequate safety

Average Risk

Above Safety Threshold

Moderate Safety

Acceptable Risk (Risk Tolerance Threshold) Borderline risk High Risk Higher Risk Substantial risk Pre-Default Risk (extremely vulnerable to default) Default Grade

-

Level

Safety Threshold

Inadequate safety Low safety Lower safety Lowest safety Nil

(e) New Rating Scales - Facility Rating (Separate for each Fund Based / NonFund Based Facility): 16 Rating Grades S NO

FACILITY GRADES

RANGE OF SCORES

LGD LEVEL (Recovery Level)

RISK LEVEL

COMFORT LEVEL

1

FR1

94-100

Virtually Zero LGD

Virtually Zero Risk

2

FR2

87-93

Lowest Risk

3

FR3

80-86

Lower Risk

Higher Safety

4

FR4

73-79

Low Risk

High Safety

5

FR5

66-72

FR6 FR7 FR8

59-65 52-58 45-51

Moderate Risk with Adequate Cushion Moderate Risk Average Risk

Adequate Safety

6 7 8 9

FR9

38-44

Lowest LGD (Highest Recovery) Lower LGD (Higher Recovery) Very Low LGD (High Recovery) Low LGD (Adequate Recovery) Moderate LGD (Moderate recovery) Average LGD (Average Recovery)

Virtually Absolute Safety Highest Safety

10

FR10

31-37

11

FR11

24-30

12

FR12

17-23

13 14 15 16

FR13 FR14 FR15 FR16

11-16 5-10 1-4 0

LGD Tolerance Threshold (Recovery Tolerance Threshold) High LGD (Low recovery)

Higher LGD (Lower Recovery) Substantial LGD (Small recovery) Highest LGD (Minimal/zero recovery


Acceptable Risk (Risk Tolerance Threshold) High Risk

Moderate Safety Above Safety Threshold Safety Threshold

Low Safety

Higher Risk

Lower Safety

Substantial Risk

Lowest Safety

Highest Risk NIL

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(f) Mapping to Existing Borrower Rating Bands

S. No.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

(g)

New CRA Model

Existing CRA Model

Score

Grade

Grade

Score

94-100 90-93 86-89 81-85 76-80 70-75 64-69 57-63 50-56 45-49 40-44 35-39 30-34 25-29 < 24 -

SB1 SB2 SB3 SB4 SB5 SB6 SB7 SB8 SB9 SB10 SB11 SB12 SB13 SB14 SB15 SB16

SB1

>= 90

SB2

>=75

SB3 SB4

>=65 >=50

SB5 SB6

>=45 >35

SB7

>=25

SB8

<25

Qualitative Parameter (External Rating)

Solicited Rating by a recognized External Credit Rating Agency (ECRA) translates to additional Score. Following ECRAs recognised by RBI are considered for this purpose: S. No. Type 1 Domestic

ECRA (a) Credit Analysis & Research Limited;

(b) CRISIL Limited; (c) FITCH India; (d) ICRA Limited. 2

International

(a) FITCH; (b) Moodys; (c) Standard & Poor’s

RBI has clarified that “Cash Credit Exposures tend to be generally rolled over and also tend to be drawn on an average for a major portion of the sanctioned limits. Hence even though a cash credit exposure may be sanctioned for a period of one year or less, these exposures should be reckoned as Long Term Exposures and accordingly, the Long Term Ratings accorded by the chosen Credit Rating Agencies


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will be relevant.” The Scoring Bands for factoring External Rating (Long Term/Short Term) are as under:

Long

Short Term Rating

Term

CARE

CRISIL

FITCH

Standardised ICRA

Rating

Approach Risk Weight

Additional Score Under

New

CRA Models

AAA

PR1+

P1+

F1+

A1+

20%

5

AA

PR1

P1

F1

A1

30%

3.5

A

PR2

P2

F2

A2

50%

2

BBB

PR3

P3

F3

A3

100%

1

BB &

PR4

P4 &

B,C,D

A 4/

150%

below

& PR5

P5

A5

0

Multiple Ratings:

In case of borrowers having multiple ratings from recognised ECRAs, following procedure is to be followed: (i)

If there is only one ECRA rating for a particular claim, that rating would be used to determine scoring;

(ii)

If there are two ratings accorded by ECRAs which map into different risk weights, the rating corresponding to the higher risk weight would be taken cognisance of for scoring ;

(iii)

If there are three or more ratings accorded by ECRAs, with different risk weights, the ratings corresponding to the two lowest risk weights should be referred to and the rating corresponding to the higher of the two risk weights should be taken cognisance of for scoring.

(h) Financial Statement Quality The credit analyst is to comment on the quality, adequacy and reliability of financial statements/information irrespective of the Risk Rating. This includes consideration of the size and capabilities of the accounting firm, compared to the complexities of the borrower and its financial statements. The comments on the quality of financial statements should include the quality of information provided to the Bank. The Quality is to be indicated as Excellent/Good/Satisfactory/Poor. This step is not NEW CRA MODEL: OVERVIEW CREDIT RISK MANAGEMENT DEPT.

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instrumental in improvement improvement of rating but is helpful in defining the best possible possible Borrower Rating. (i) Risk Score /Rating Transition Matrix

A major fluctuation in scores resulting in upgradation or deterioration in Rating by more than one stage, is to be commented upon. Upgradation in Rating only on account of higher score in parameters other than Financial Risk , is to be examined and commented upon. This provides an additional risk awareness tool for the Credit Analyst. (j) Country Risk (Applicable for borrowers having 25% or more cashflow or assets outside India)

Country risk is the risk that a borrower will not be able to service its obligations to pay because of cross-border restrictions on the convertibility or availability of a given currency. It is also an assessment of the political and economic risk of a country. Country Risk is assumed to exist when 25% or more of the borrower’s cashflow or assets assets are located outside India. Country Risk Ratings are circulated by Foreign Department (FD). Last FD Circular No. 070/2007-08 dated 27th July, 2007 indicates Risk category-wise category-wise list list of countries as on 31/03/2007. (k) Entry Barriers

(i)

Minimum Score ‘2’ under ‘Integrity ‘ parameter under ‘Management Risk’ ;

(ii)

Full Compliance with Environmental Regulations

(l) Hurdle Scores Regular Model Risk Types

New Company 10/25

Existing Company 30/70

New Company 15/35

Business & Industry Risk (B&IR) 12/20 [Business Risk (BR) for trade] Management Risk (MR) 8/15

16/30

10/20

20/40

22/45

5/10

13/25

Aggregate hurdle Score

45/100

48/100

45/100

48/100

ll Hurdle Grade#

SB10

SB10

SB10

SB10

Financial Risk (FR)

Existing Company 25/65

Simplified Model

# Score Range 45-49 corresponds to SB10. Hence as per New CRA Models SB10 is the new Hurdle Grade. NEW CRA MODEL: OVERVIEW CREDIT RISK MANAGEMENT DEPT.

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Under Facility Rating, if the score goes below the hurdle rate of FR10, the reasons

for low score are to be given. (m) Factoring Decimal Scores while while aggregating Score for Risk Grading

(i) Score upto 0. 4 to be ignored; (ii) Score of 0.5 or more to be rounded rounded off to the next next number.

(n) Reporting of Risk Score alongwith Rating:

Aggregate Risk Score is to be shown in brackets alongwith Borrower Rating in internal reporting within the Bank. (o) Frequency of Rating: Annual (p) Risk Assessment for New Units Activity Status Newly incorporated unit where the production/commercial production is yet to begin Newly incorporated unit where the audited financials relate to less than 12 months of commercial production. Newly incorporated unit where the audited financials reflect minimum 12 months of working after the start of commercial production.

Basis of Risk Assessment Projected Financials

Projected Financials

Audited Financials

For Rating purpose, a new unit refers to a newly incorporated Firm/Company which may continue to be regarded as new for a period of three years after the start of commercial production. However, in the case of Companies/Firms promoted by an established Group, a view regarding their status as new or otherwise would be taken by the CGM of the Circle/CAG/Mid-Corporate after one year’s performance. (q) General

(i)

For units units engaged in both ‘industrial’ & ‘trading’ activities, the Risk Rating will be done based on the predominant activity financed by the Bank and the relevant model used.

(ii) If data on a certain industry industry for ‘industry comparison’ in CRIS-INFAC or CMIE or any other published source is not available, the score would be normalised. In a Multi Division Company, the thrust of scoring under


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‘Industry Outlook’ would be limited to the industry being financed by the Bank.

(iii) Wherever a parameter is not applicable, the score would be normalised.

(iv) For a new unit, where where value statements for for some of the parameters appear to be out of place for scoring, the Credit Analyst would assess whether the unit has any plans to measure upto the levels indicated under those value statements and then score accordingly.

(v)

While Borrower Rating of a unit unit will remain unchanged for a period upto one year, the different facilities would be rated simultaneously with Borrower Rating or as and when the facility is sanctioned/reappraised. A unit would carry several different Facility Ratings e.g. if a unit is enjoying one Working Capital facility & two (say) Term Loan facilities, it will have one Borrower Rating & 3 Facility Ratings.

(vi) Borrower Rating would would not be assessed assessed each time a new new facility is sanctioned sanctioned to the unit within the year.

(vii) While working out the Facility Rating, the share of total security security against that facility will be worked out to score under Total Security (Primary + Collateral). 3. Facility Rating (i) Facility Rating Design

A Borrowing Company may be availing either one or more of Fund Based (FB) Facilities such as Working Capital (WC) /Term Loan (TL) or/and Non-Fund Based (NFB) Facilities like, Letters of Credit (L C)/Bank Guarantee (BG). All the facilities are to be rated separately viz., if a Borrowing Borrowing Company has has both WC & TL & two Bank Guarantee Facilities & three different L/C Facilities; in total, the Company would have one Borrower Rating & seven (i.e, 1+1+2 + 3 = 7) Facility Ratings. The pricing of loans, in future, will be linked to Facility Rating after building up adequate Loss Given Default (LGD) data base. For the present, pricing will continue to be linked to Borrower Rating only.


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(ii) Facility Hurdle Rate

All facilities are expected to meet the Facility Hurdle Rate of FR10. Reasons for not crossing this Hurdle Rate would need to be commented upon by the Credit Analyst. (iii) Loss Given Default (LGD)

Facility Rating would reflect the degree of severity of loss in the event of default on the obligation. Facility Rating Grade will thus translate to a LGD Scale, indicating loss percentage. The present Facility Rating Grades/Scales are empirically designed to reflect LGD levels. (iv) Collateral

The Collaterals are an important ingredient of Facility Rating design; their quality and depth affects the severity of LGD for any facility and hence the Facility Rating itself. As an element of risk (uncertainty) is involved, prudence is required in assessing the value of the collateral offered for obtaining credit facility. The security is thus to be valued as it would be in a distress scenario i.e, the extent of availability of proceeds (legal certainty) in the event of failure of the business.

Basel-II does not differentiate between Primary & Collateral Securities and all securities charged for a loan are designated designated as “Collaterals”. Thus, while while for for monitoring of Drawing Power (DP) or DP related issues in borrowal accounts, the securities charged would continue to be segregated into Primary and Collateral securities, however, for the purpose of risk assessment, all securities will be treated as collateral securities. (v) Scoring under Facility Rating Rating

Scoring under ‘Total Security ‘Parameter under Facility Rating R ating requires an in-depth look into types of Collaterals & Guarantees and their recognition and valuation as per Basel-II /RBI Document Document as discussed discussed in Bank’s Collateral Management Management Policy (please see para 5 below). This would necessitate detailed analysis of Collaterals/Guarantees to facilitate scoring.


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4. IRB Requirements under Basel-II Guidelines

Requirements for Risk Rating Design under Internal Ratings Based (IRB) Approach are detailed in Basel-II Document (International Convergence of Capital Measurement and Capital Standards) published in June, 2004, available on the Bank for International Settlement website www.bis.org. Extracts from the Document are enclosed (for reference and detailed study, if desired).

The following definitions are used in this context:

S. No.

Terminology

(i)

Probability

Definition

of The probability/risk/chance of a borrower defaulting

Default (PD)

(ii)

Loss

on the payment of the credit cr edit obligations.

Given The loss suffered in the event of a default of an

Default (LGD) (iii)

Exposure

exposure.

at The amount that is exposed to the t he default risk.

Default (EAD) (iv)

Expected Loss Part of the credit loss that happens in the normal course (EL)

of business due to default of exposures and the banks have to either make provisions for it or price it in the loans.

(v)

Unexpected

Part of credit loss that cannot be estimated or priced into

Loss (UL)

the product and hence the banks have to provide capital for it by risk-weighting r isk-weighting their assets.

Highlights of Basel requirements are as under:

(i)

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.

(ii)

A qualifying IRB rating system needs to have two separate and distinct dimensions: (a) the risk of borrower borrower default i.e, Borrower Rating and (b) transaction-specific transaction-specific factors i.e., Facility Rating.


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(iii)

A bank must articulate 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.

(iv)

The second dimension must reflect transaction-specific transaction-specific factors, such as collateral, seniority, product type, etc. For banks using the advanced approach, facility ratings must reflect exclusively Loss Given Default (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 their supervisor that it improves the relevance and precision of their estimates.

(v)

A bank must have a meaningful distribution of exposures across grades with no excessive concentrations, on both its borrower-rating and its facilityrating scales. To meet this objective, objective, a bank must have a minimum 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; supervisors may require banks, which lend to borrowers of diverse credit quality, to have a greater number of borrower grades.

(vi)

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.

(vii)

A bank must have have specific specific rating definitions, processes and criteria for assigning exposures to grades within a rating system. The rating definitions and criteria must be both plausible and intuitive and must result in a meaningful differentiation of risk.


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(vii)

To ensure ensure that banks are consistently 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.

(viii) A borrower rating must represent the bank’s assessment assessment of the borrower’s ability and willingness to contractually perform despite adverse economic conditions or the occurrence of unexpected events. 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.

(ix)

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.

(x)

A bank must have a credible track record record in the use of internal ratings information. 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 noncompliant with the three-year requirement.

5. Collaterals & Guarantees

Collateral Management Policy of the Bank has been put in place based on Basel-II /RBI Guidelines, vide Circular No. CPP/NJ/CIR/58 dated 21st September, 2007. This Policy is to be referred to for scoring under ‘Total Security’ Parameter under Facility Rating.


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Some features of the Policy are mentioned below: •

In addition to the general requirements for legal certainty, the legal mechanism by which the collateral is pledged or transferred must ensure that the Bank has the right to liquidate or take legal possession of the Collateral, in a timely manner, in the event of the default/insolvency /bankruptcy on the part of the counterparty or third party.

•

•

Collaterals are broadly classified as Financial and Non-Financial A guarantee (counter-guarantee) must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible. The guarantee must be irrevocable. There must be no clause in the contract that would allow the protection provider unilaterally to cancel the cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the guaranteed exposure.

•

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 make the payment(s) due.

6. Details of New CRA Models

Details of New CRA Models are enclosed, separately, for Non-Trading & Trading Sectors.


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RATING SYSTEM DESIGN AS PER INTERNAL RATINGS BASED (I RB) APPROACH UNDER BASEL-II

Extracts from Basel-II Document (International Convergence of Capital

Measurement and Capital Standards, June, 2004-Bank for International Settlement website: www.bis.org)

Rating System Design

(Para Number) 394. 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.

395. 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. middle market, and large corporate). If a bank chooses to use multiple systems, the rationale for assigning a borrower to a 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 minimize 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.

(i) Rating Dimensions : Standards for Corporate, Sovereign, and Bank Exposures

396. A qualifying IRB rating system must have two separate and distinct dimensions: (i) the risk of borrower default, and (ii) transaction-specific transaction-specific factors. 397. The first dimension must be oriented to the risk of borrower default. Separate exposures to the same borrower must be assigned to the same borrower grade,


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irrespective of any differences in the nature of each specific transaction . There are

two exceptions to this. Banks are not required to produce their own estimates of PD for certain equity exposures and certain exposures that fall within the Specialised Lending (SL) sub-class. 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. Secondly, when the treatment of associated guarantees to a facility may be reflected in an adjusted borrower grade. In either case, separate exposures may result in multiple grades for the same borrower. 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. 398. The second dimension must reflect transaction-specific factors, such as collateral, seniority, product type, etc. For foundation IRB banks, this requirement can be fulfilled by the existence of a facility dimension, which reflects both borrower and transaction-specific factors. For example, a rating dimension that reflects EL by incorporating both borrower strength (PD) and loss severity (LGD) considerations would qualify. Likewise a rating system that exclusively reflects LGD would qualify. Where a rating dimension reflects EL and does not separately quantify LGD, the supervisory estimates of LGD must be used.

399. For banks using the advanced approach, facility ratings must reflect exclusively 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 ortfolio as long as they can satisfy their supervisor that it improves the relevance and precision of their estimates. 400. Banks using the supervisory slotting criteria for the SL sub-class are exempt NEW CRA MODEL: OVERVIEW CREDIT RISK MANAGEMENT DEPT.

15

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 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 general corporate foundation or advanced approach for the SL subclass.

(ii) Rating Structure : Standards for Corporate, Sovereign, and Bank Exposures

403. A bank must have a meaningful distribution of exposures across grades with no excessive concentrations, on both its borrower-rating and its facilityrating scales.

404. 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; supervisors may require banks, which lend to borrowers of diverse credit quality, to have a greater number of borrower grades.

405. 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 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.

406. Banks with loan portfolios concentrated in a particular market segment and range of default risk must have enough grades within that range to avoid undue concentrations of borrowers in particular grades. Significant concentrations within a single grade or grades must be supported by convincing empirical evidence that the grade or grades cover reasonably


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narrow PD bands and that the default risk posed by all borrowers in a grade fall within that band.

407. 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.

408. 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.

(iii) Rating Criteria

410. A bank must have specific rating definitions, processes and criteria for assigning exposures to grades within a rating system. The rating definitions and criteria must be both plausible and intuitive and must result in a meaningful differentiation of risk.

•

The grade descriptions descriptions and criteria must must be sufficiently sufficiently detailed detailed to allow those charged with assigning ratings to consistently assign the same grade gr ade to borrowersor facilities posing similar risk. This consistency should exist across lines of business, departments and geographic locations. If rating criteria and procedures differ for different types of borrowers or facilities, the bank must monitor for possibleinconsistency, and must alter rating criteria to improve consistency when appropriate.

•

Written rating definitions 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 supervisors, 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


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facilities.

411. 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. (iv) Rating Assignment Horizon

414. Although the time horizon used used in PD estimation estimation is one year, banks are expected to use a longer time horizon in assigning ratings.

415. 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.

416. 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 Internal Ratings

444. 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


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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 supervisor.

445. 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 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 noncompliant with the three-year requirement. Definition of Default for PD Estimation as per Basel-II Document

452. A default is considered to have occurred with regard to a particular obligor when either or both of the two following events have taken place.

•

The bank considers that the obligor is unlikely to pay its credit obligations to the banking group in full, without recourse by the bank to actions such as realising security (if held).

•

The obligor is past due more than 90 days on any material credit obligation to the banking group. Overdrafts will be considered considered as being past past due once the customer has breached an advised limit or been advised of a limit smaller than current outstandings.

453. The elements to be taken as indications of unlikeliness to pay include: •

The bank puts the credit obligation on non-accrued status.


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•

The bank makes a charge-off or 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 credi-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 by the material forgiveness, or postponement, of principal, interest or (where relevant) fees.

•

The bank has filed for the obligor’s bankruptcy or a similar order in respect of the obligor’s credit obligation to the banking group.

•

The obligor 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.

Requirements specific to PD estimation

461. Banks must use information and techniques that take appropriate account of the long-run experience when estimating the average PD for each rating grade.

For example, banks banks may use use one or more of the three specific specific

techniques set out below: internal default experience, mapping to external data, and statistical default models.

462. Banks may have a primary technique and use others as a point of comparison and potential potential adjustment. Supervisors will will not be satisfied by mechanical application of a technique technique without without supporting analysis. analysis. Banks must recognise the importance of judgmental considerations in combining results of techniques and in making adjustments for limitations of techniques and information.

•

A bank 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 and the current rating system. Where only only limited data


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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 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.

•

Banks may associate or map their internal grades to the scale used by an external credit assessment institution or similar institution and then attribute the default rate observed for the external institution’s grades to the bank’s grades. Mappings must be based on a comparison of internal rating criteria to the criteria used by the external institution and on a comparison of the internal and external ratings of any common borrowers.

Biases or

inconsistencies inconsistencies in the mapping approach or underlying data must be avoided. The external institution’s criteria underlying the data used for quantification must be oriented to the risk of the borrower and not reflect transaction characteristics. The bank must document document the basis for for the mapping.

•

A bank is allowed to use a simple average of default-probability estimates for individual borrowers in a given grade, where such estimates are drawn from statistical default default prediction models. models. The bank’s use of default probability probability models for this purpose must meet the standards set in the document.

Requirements specific to own-LGD Estimates

468. A bank must estimate an LGD for each facility that aims to reflect economic downturn conditions conditions where necessary necessary to capture the the relevant risks. This LGD cannot be less than the long-run default-weighted average loss rate given default calculated based on the average economic loss of all observed defaults within within the data source for for that type of facility. In addition, a bank must take into account the potential for the LGD of the facility to be higher than the default-weighted average during a period when credit losses are substantially higher than average.

469. 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


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provider. Cases where there there is a significant significant degree of dependence dependence must be addressed in a conservative manner.

470. LGD estimates must be grounded in historical recovery rates and, when applicable, must not solely be based on the collateral’s estimated market value. His requirement requirement recognises the potential inability inability of banks to gain both control of their collateral and liquidate it expeditiously.

471. Recognising the principle that realised losses can at times systematically exceed expected levels, the LGD assigned to a defaulted asset should reflect the possibility that the bank would have to recognise additional, unexpected losses during during the recovery period. For each defaulted asset, the bank bank must also construct its best estimate of the expected loss on that asset based on current economic circumstances and facility status.

472. 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. source. If the available observation period spans a longer period for any source, and the data are relevant, this longer period must be used. Requirements specific to own-EAD Estimates

474. EAD for an on-balance sheet or off-balance sheet item is defined as the expected gross exposure of of the facility upon default of the obligor. For onbalance 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 specified in the foundation approach. Advanced approach banks must must have established procedures in place for the estimation of EAD for offbalance sheet items. These must specify specify the estimates of EAD to be used used for each facility type. Banks estimates of EAD should reflect the possibility possibility of additional drawings by the borrower up to t o and after the time a default event is triggered.

475. Advanced approach banks must assign an estimate of EAD for each facility. It must be an estimate of he long-run default-weighted average EAD for


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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 reasonably be expected expected between the default frequency and the magnitude of EAD, the EAD estimate must incorporate a larger margin of conservatism. 476. 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 credible internal analysis by the bank. Across facility facility types, a bank must review is estimates of EAD when material new information comes to light and a least on an annual basis.

477. Banks must also have adequate systems and procedures in place to monitor facility amounts, current outstandings against committed lines and changes in outstandings per borrower and per grade.

478. 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. Guarantees

480. When a bank uses is own estimates of LGD, it may reflect the risk-mitigating effect of guarantees through an adjustment to PD or LGD 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.

481. In all cases, both the borrower and all recognised guarantors must be assigned a borrower rating at the outset and on an ongoing basis.

483. 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.


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507. Definition of Eligibility of Commercial Real Estate (CRE) and Residential Real Estate (RRE) Collateral •

Collateral 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 borrower to repay the debt from other sources. sources. As such, repayment of the facility is not materially dependent on any cash flow generated by the underlying CRE/RRE serving as collateral; and

•

Additionally, the value of the collateral pledged must not be materially dependent on the performance of the borrower.

509 Operational requirements for Eligible CRE/RRE .

•

Legal enforceability:

Any claim on a collateral taken must be legally 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 establishing the claim have been fulfilled). 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. •

Objective market value of collateral : The collateral collateral must be valued 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.

•

Frequent revaluation: The bank is expected expected to monitor monitor the value of the

collateral on a frequent basis basis and at a minimum once every year. More frequent monitoring is suggested where the market is subject to significant changes in conditions. 510 Additional collateral management requirements are as follows: .

•

The types of CRE and RRE collateral accepted by the bank and lending policies (advance rates) when this type of collateral is taken must be clearly documented.


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•

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.

511. Requirements for recognition of financial receivables Definition:

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. 521 Requirements for recognition of other collateral .

Supervisors may allow for recognition of the credit risk mitigating effect of certain other physical physical collateral. Each supervisor will determine which, if any, collateral types in its jurisdiction 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. Supervisors will seek to ensure ensure that the amount amount a bank receives receives when collateral is realised does does not deviate significantly from these market prices.

522. In order for a given bank to receive recognition for additional physical collateral, it must meet all the standards in paragraphs 509 and 510, subject to the following modifications.


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• First Claim : only first liens on, or charges over, collateral are permissible. As such, the bank must have priority over all other lenders to the realised proceeds of the collateral.

• 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 “fashion-sensitive” collateral to ensure that valuations are appropriately adjusted downward of fashion, or model-year, obsolescence as well as physical obsolescence or deterioration.

• In cases of inventories (e.g. raw materials, work-in-process, finished finished goods, dealers’ inventories of autos) and equipment, the periodic revaluation process must include physical inspection of the collateral.

Akhilesh/Mydoc/ CRA General/CRA Overview (171007)


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CRA Overview

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