External Ratings - Basel II


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Under the Basel II framework, Standardized Approach for Credit Risk allows consideration of External Credit Ratings for the calculation of risk weighted assets/capital charge. This presentation provides an overview of the approach as prescribed for Indian Banking Industry by RBI.

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External Ratings - Basel II

  1. 1. External Ratings under the Basel II framework Aditya Lathe
  2. 2. Basel II FrameworkPart A Calculation of Risk Weighted AssetsPart B • Mapping of Risk Weights to Rating Scales • Treatment of Off Balance Sheet Exposure External Ratings - General GuidelinesPart C
  3. 3. Basel II Framework: Introduction 
  4. 4. Basel II Framework : Indian Scenario  Pillar I: Min CRAR for Banks in India set at 9%. Banks encouraged to maintain Tier I CRAR of at least 6%.  Pillar II: Banks to establish Internal Capital Adequacy Assessment Process which shall be subject to rigorous Supervisory Review Process.  Pillar III: Public disclosures to enhance market transparency. Among others, capital structure, capital adequacy, composition of loan/credit portfolios by risk rating and detailed risk parameters for each risk-rating category, market risk in Trading Book, Interest rate risk in the Banking Book, Operational risk etc to be disclosed.  Banks in India to continue to have parallel run of Basel I & Basel II till March 31, 2013, subject to review, and ensure that their Basel II minimum capital requirement continues to be higher than the prudential floor of 80% of the minimum capital requirement computed as per Basel I framework for credit and market risks.
  5. 5. Basel II Framework: Risk Measurement Approaches Market Risk Standardized Approach Alternative Approach Operational Risk Basic Indicator Approach Standardized Approach Advanced Measurement Approach Credit Risk Standardized Approach Simple Approach Comprehensive Approach Foundation IRB Approach Advanced IRB Approach
  6. 6. Credit Risk Measurement: Indian Scenario  RBI mandate: All commercial banks in India required to adopt Comprehensive Approach under the Standardised Approach for measurement of Credit Risk.  Foreign banks operating in India and Indian banks having operational presence outside India migrated to this approach with effect from March 31, 2008. All other commercial banks migrated from March 31, 2009.  RBI timeline for eventual migration to more advanced approaches for Credit Risk measurement: Approach Earliest date for applying to RBI Likely date of approval by RBI IRB Approach (Both Foundation & Advanced) April 1, 2012 March 31, 2014
  7. 7. Credit Risk Measurement: Indian Scenario  Credit Risk: Standardized Approach - Measurement of credit risk supported by ratings assigned by eligible External Credit Rating Agencies (ECRAs)  Eligible ECRAs as recognized by RBI: Domestic Credit Rating Agencies Credit Analysis and Research Limited CRISIL Limited FITCH India ICRA Limited Brickworks Rating India Pvt Ltd. SMERA International Credit Rating Agencies Fitch Moodys Standard & Poor’s
  8. 8. Basel II FrameworkPart A Calculation of Risk Weighted AssetsPart B • Mapping of Risk Weights to Rating Scales • Treatment of Off Balance Sheet Exposure External Ratings - General GuidelinesPart C
  9. 9. Mapping of Risk Weights to Rating Scales Risk Weight for claims on:  Sovereigns - Domestic & Foreign  Public Sector Enterprises - Domestic & Foreign  Multilateral Agencies  Banks- Domestic & Foreign  Corporates - Domestic & Foreign  Primary Dealers (PDs), Asset Finance Companies (AFCs), NBFCs, Infrastructure Finance Companies (IFCs)  Retail portfolio  Loans secured by Residential Property (Housing Loans)  Commercial Real Estate, Capital Market Exposure  Non Performing Assets (NPAs)  Others
  10. 10. Claims on Sovereigns - Domestic Back to Index * Also applicable for exposure to RBI, DICGC, CGFTSI and loans under Agriculture Debt Waiver Scheme 2008 ** Also applicable for claims on ECGC Exposure Type Risk Weight All claims on GoI* 0% Claims guaranteed by GoI 0% Claims on State Govt. 0% Claims guaranteed by State Govt.** 20%
  11. 11. Claims on Sovereigns - Foreign Back to Index  Claims denominated in domestic currency of the foreign sovereign, met out of the resources in the same currency raised in the jurisdiction of that sovereign to attract 0% risk weight. Rating AAA AA A BBB BB B Below B Unrated Risk Weight 0% 0% 20% 50% 100 % 100 % 150% 100%
  12. 12. Claims on PSEs & Multilateral Agencies Back to Index  Domestic PSE: Same Risk Weight as for Corporates  Foreign PSEs:  Claims on following multilateral agencies at flat rate of 20% Rating AAA AA A BBB BB Below BB Unrated Risk Weight 20% 20% 50% 100 % 100 % 150% 100% Bank for International Settlements International Monetary Fund World Bank Group Asian Development Bank African Development Bank European Bank for Reconstruction & Development Inter-American Development Bank European Investment Bank European Investment Fund Nordic Investment Bank Caribbean Development Bank Islamic Development Bank Council of Europe Development Bank
  13. 13. Claims on Banks - Domestic Back to Index  Banks incorporated in India & branches of foreign banks in India (All Scheduled Commercial Banks) Level of CRAR Investment within 10% limit Other claims 9% and above Higher of 100 % or the risk weight as per the rating of the instrument or counterparty, whichever is higher 20% 6% to <9% 150% 50% 3% to <6% 250% 100% 0% to <3% 350% 150% Negative 625% 625%
  14. 14. Claims on Banks - Foreign Back to Index  Exposures of Indian branches of foreign banks, guaranteed / counter-guaranteed by the overseas Head Offices or the bank’s branch in another country would amount to a claim on the parent foreign bank and would also attract the risk weights as above  However, claims on a bank denominated in 'domestic' foreign currency met out of the resources in the same currency raised in that jurisdiction, to be risk weighted at 20% provided the bank complies with the minimum CRAR prescribed by the concerned bank regulator Rating AAA AA A BB B BB B Below B Unrated Risk Weight 20% 20% 50% 50% 100% 100 % 150% 100%
  15. 15. Claims on Corporates - Domestic Back to Index  Long Term Claims (Contractual maturity of above 1 year)  Short Term Claims (Contractual maturity of 1 year and below) Where “+” or “-” notation is attached to the rating, the corresponding main rating category risk weight to be used.  Restructured / Re-scheduled Assets: Unrated standard / performing claims to be assigned a risk weight of 125% until satisfactory performance under the revised payment schedule has been established for 1 year from the date when the first payment of interest / principal falls due under the revised schedule. Rating AAA AA A BBB BB & Below Unrated Risk Weight 20% 30% 50% 100% 150% 100% Rating A1+ A1 A2 A3 A4 A5 Unrated Risk Weight 20% 30% 50% 100% 150% 150% 100%
  16. 16. Claims on Corporates: Foreign Back to Index  Claim on an unrated corporate cannot be given a risk weight preferential to that assigned to its sovereign of incorporation. Rating AAA AA A BBB BB Below BB Unrated Risk Weight 20% 20% 50% 100% 100% 150% 100%
  17. 17. Claims on PDs, AFCs, NBFCs, IFCs Back to Index  Same as Risk Weight for Corporates - Domestic
  18. 18. Claims on Retail portfolio Back to Index Qualifying Criteria for Retail:  Orientation Criterion - The exposure is to an individual person or persons or to a small business (where the total average annual turnover of last 3 years is less than Rs. 50 crs)  Product Criterion - The exposure is in the form of revolving credits and lines of credit (including overdrafts), term loans and leases (e.g. instalment loans and leases, student and educational loans) and small business facilities and commitments.  Granularity Criterion- Aggregate exposure to a single counterpart (or business group) does not exceed 0.2 % of the overall regulatory retail portfolio of the bank  Low value of individual exposures - The maximum aggregated retail exposure to a single counterpart does not exceed Rs. 5 crs Notable Exclusions:  Loans and Advances to bank’s own staff, fully covered by superannuation benefits and / or mortgage of flat/ house;  Consumer Credit, (including Personal Loans and credit card receivables)  Housing Loans Category All Exposure Risk Weight 75%
  19. 19. Claims on Loans secured by Residential Property Back to Index  Amount of Loan Risk Weight Upto Rs.30 Lakhs 50% Above Rs. 30 Lakhs but below Rs.75 Lakhs 75% Above Rs.75 Lakhs 125% Amount of Loan Risk Weight Upto Rs.75 Lakhs 100% Above Rs.75 Lakhs 125%
  20. 20. Claims on CRE & Capital Market Exposure Back to Index Commercial Real Estate:  The funding results in creation or acquisition of real estate (such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, and hotels)  The prospects for repayment depend primarily on cash flows generated by the asset. Prospect of recovery in event of default also depend primarily on the cash flows generated from the funded asset. Capital Market Exposure:  Direct investment in capital markets,  Advance against capital market instruments, or on clean basis to individuals for investment in capital market instruments  Advances for any other purpose where capital market instruments are taken as primary security. (For detailed guidelines, consult References) Category Risk Weight Commercial Real Estate 100% Capital Market Exposure 125%
  21. 21. Claims on Non Performing Assets Back to Index  For defining secured portion of NPA, eligible collateral will be the same as recognised for credit risk mitigation purposes (Cash, Gold, Securities issued by Central or State Govt, KVP, NSC, Life Insurance Policies, Debt securities rated by a Credit Rating Agency, Units of MFs). Other forms of collateral like land, buildings, plant, machinery, current assets, etc. not allowable for capital adequacy purposes. Unsecured portion of NPA, where specific provisions are Risk Weight Less than 20% of outstanding 150% At least 20% of outstanding 100% At least 50% of outstanding 50%
  22. 22. Claims on Others Back to Index Category Risk Weight High Risk Venture Capital Funds 150% Consumer Credit (Personal loans, credit card receivables) 125% Non-deposit Taking Systemically Important Non-Banking Financial Companies (NBFC-ND-SI), 100% All investments in the paid up equity of non-financial entities, which are not consolidated for capital purposes with the bank 125% Loans and advances to bank’s own staff which are fully covered by superannuation benefits and/or mortgage of flat/ house 20%
  23. 23. Treatment of Off Balance Sheet Exposure Back to Index Off Balance Sheet Exposure -Market Related -Non Market Related • Notional Exposure Credit Equivalent Exposure • Notional Exposure X CCF Risk Weighted Asset • CEE X Risk Weight
  24. 24. Off Balance Sheet Exposure- Non- Market related Back to Index Instrument CCF Direct credit substitutes and acceptances, where the risk of loss depends on the credit worthiness of the counterparty or the party against whom a potential claim is acquired (eg. standby L/Cs serving as financial guarantees for loans and securities, credit enhancements, liquidity facilities for securitisation transactions etc.) 100% Transaction-related contingent items (e.g. performance bonds, bid bonds, warranties, indemnities and standby letters of credit related to particular transaction). 50% Short-term self-liquidating trade letters of credit arising from the movement of goods for both issuing bank & confirming bank. (e.g. documentary credits collateralised by the underlying shipment) 20% Sale & repurchase agreements, and asset sales with recourse, where the credit risk remains with the bank. 100% Forward asset purchases, forward deposits and partly paid shares and securities, which represent commitments with certain drawdown. 100%
  25. 25. Off Balance Sheet Exposure- Non- Market related Back to Index Instrument CCF Lending of banks’ securities or posting of securities as collateral by banks, including instances where these arise out of repo style transactions 100% Note issuance facilities and underwriting facilities. 50% Commitments with certain drawdown 100% Other commitments (e.g., formal standby facilities and credit lines) with an original maturity of a) up to 1 year b) over 1 year. Commitments that are unconditionally cancellable at any time by the bank without prior notice or that effectively provide for automatic cancellation due to deterioration in a borrower’s credit worthiness 20% 50% 0% Take-out Finance in the books of taking-over institution (i) Unconditional take-out finance (ii) Conditional take-out finance 100% 50%
  26. 26. Off Balance Sheet Exposure- Non Market related Back to Index Following transactions to be treated as claims on banks:  Guarantees issued by banks against the counter guarantees of other banks.  LCBD Cases: Rediscounting of documentary bills discounted by other banks, and bills discounted by banks which have been accepted by another bank
  27. 27. Off Balance Sheet Exposure- Market related Back to Index Market related off-balance sheet items  Interest Rate Contracts – single currency interest rate swaps, basis swaps, forward rate agreements, and interest rate futures;  Foreign Exchange Contracts - contracts involving gold, cross currency swaps, cross currency interest rate swaps, forward foreign exchange contracts, currency futures, currency options  Any other market related contracts specifically allowed by RBI which gives rise to credit risk. Does not include foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.
  28. 28. Off Balance Sheet Exposure- Market related Back to Index CCF Calculation: Current Exposure Method:  Credit Equivalent Amount = Current Credit Exposure + Potential Future Exposure  Current Credit Exposure is sum of positive mark-to-market value of contracts  Potential Future Exposure determined by multiplying notional principal amount of the contract with following CCF: Maturity CCF Interest Rate Contracts Exchange Rate Contracts & Gold 1 year or less 0.50% 2.00% Over 1 year to 5 years 1.00% 10.00% Over 5 years 3.00% 15.00%
  29. 29. Basel II FrameworkPart A Calculation of Risk Weighted AssetsPart B • Mapping of Risk Weights to Rating Scales • Treatment of Off Balance Sheet Exposure External Ratings - General GuidelinesPart C
  30. 30. External Ratings - General Guidelines Back to Index Publicly available ratings:  Only publically available credit assessments to be used. (i.e. rating must be published in an accessible form and included in the external credit rating agency’s transition matrix). Ratings made available only to the parties to a transaction are ineligible. Currently Valid ratings:  Only ratings currently in force and confirmed from the monthly bulletin of the concerned rating agency to be used. The rating agency should have reviewed the rating at least once during the previous 15 months.
  31. 31. External Ratings - General Guidelines Back to Index Unsolicited ratings:  Banks to use only solicited ratings. A rating is solicited only if the issuer of the instrument has requested the credit rating agency for the rating and has accepted the rating assigned by the agency. Cherry Picking  Banks not allowed to use one agency’s rating for one exposure, while using another agency’s rating for another exposure to the same counter-party, unless the respective exposures are rated by only one of the chosen credit rating agencies, whose ratings the bank has decided to use.
  32. 32. External Ratings - General Guidelines Back to Index Multiple Ratings:  In case of divergent ratings from two different ECRAs, rating with higher risk weight to be used.  In case of divergent ratings from three or more different ECRAs, ratings corresponding to the two lowest risk weights to be considered and the higher of those two risk weights to be applied. i.e., the second lowest risk weight. Double Counting of Credit Mitigants  To avoid double counting of credit enhancement factors, credit risk mitigation techniques should not be taken into account if the credit enhancement is already reflected in the rating.
  33. 33. External Ratings - General Guidelines Back to Index Application of Issue Rating to unrated claims  Sort-term ratings are issue-specific. Cannot be generalised to other short-term claims or long-term claims.  In cases where the Bank’s exposure is not a part of the rated exposure of the borrower, the long term rating of the rated exposure may be applied to the bank’s un- assessed claim if this claim ranks pari passu or senior to the specific rated exposure in all respects and the maturity of the un-assessed claim is not later than the maturity of the rated claim. Note: Substitution of Foreign currency ratings only for exposures in foreign currency.
  34. 34. External Ratings - General Guidelines Back to Index Higher weightage to unrated claims  In case an issuer has long-term/ short-term exposure with rating that has a risk weight of 150%, all unrated claims to also receive a 150% risk weight.  Short Term Claims: Unrated short term claim to attract a risk weight of at least one level higher than the risk weight applicable to the rated short term claim on that counter-party. (Eg. If a short-term rated facility attracts a 20% or 50% risk-weight, unrated short-term claims to the same counter-party cannot attract a risk weight lower than 30% or 100% respectively).
  35. 35. External Ratings - General Guidelines Back to Index Substitution of guarantor’s rating: Guaranteed portion of the counterparty exposure to be assigned risk weight of the guarantor, whereas the uncovered portion to retain the risk weight of the underlying counterparty. Substitution of risk weight is allowable in cases where available guarantee meets the following criteria:  Direct & Explicit: The guarantee must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures, so that extent of the cover is clearly defined and incontrovertible.  Irrevocable: The guarantee must be irrevocable; there must be no clause in the contract that would allow the protection provider unilaterally to cancel the cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the guaranteed exposure.  Unconditional: The guarantee must be unconditional; there should be no clause in the guarantee outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment due.
  36. 36. External Ratings - General Guidelines Back to Index Eligible Guarantors: (i) Sovereigns, sovereign entities (including BIS, IMF, European Central Bank and European Community as well as other mentioned Multilateral Agencies; banks and primary dealers with a lower risk weight than the counterparty (ii) other entities rated AA- or better. (including parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor). Rating of the guarantor should be an entity rating which has factored in all the liabilities and commitments (including guarantees) of the entity.  No adjustment permitted on account of guarantees in case of NPAs.
  37. 37. Capital Saving: Unconditional Cancellability Clause Back to Index  Undrawn portion of CC limit: Non market Off Balance Sheet exposure arises on account of maximum unused portion of the commitment that could be drawn during the remaining period to maturity.  Example: Sanctioned CC Limits: Rs. 100 crs Company Rating : A Facilities not unconditionally cancellable Details Amount (A) CCF (B) Risk Weight (C) RWA (A*B*C) Cash Credit Facility Rs. 100 crs - - - Drawn Portion Rs.60 crs NA 50% Rs.30 crs Undrawn Portion Rs.40 crs 20% 50% Rs.4 crs Total Rs.34 crs
  38. 38. Capital Saving: Project Sequencing Back to Index  Commitments with certain drawdown:  Example: Sanctioned Term Loan: Rs.1000 crs Drawdown Period : 3 Years (Bank’s explicit approval needed for each drawdown) Stage I : Amount- Rs.200 crs, Time period of execution-1 year Stage II : Amount- Rs.300 crs, Time period of execution- 1.5 years Stage III : Amount- Rs. 500 crs, Time period of execution- 2 years Company Rating : A Details Amount (A) CCF (B) Risk Weight (C) RWA (A*B*C) Term Loan Facility Rs. 1000 crs - - - Amount for Stage I Rs.200 crs - - - Drawn Portion Rs.150 crs NA 50% Rs.75 crs Undrawn Portion Rs.50 crs 20% 50% Rs.5 crs Total Rs.80 crs
  39. 39. Thank You
  40. 40. References Documents Consulted  International Convergence of Capital Measurement and Capital Standards – A Revised Framework (June 2006) (Source)  RBI Master Circular on Prudential Guidelines on Capital Adequacy and Market Discipline- Implementation of New Capital Adequacy Framework (July 2011) (Source)  RBI Guideline on Classification of Exposures as CRE (Sep 2009) (Source)  RBI Master Circular on Exposure Norms (July 2011) (Source)