3. To check continuously if the loan policy is
being adhered to
To identify problems in accounts, even at the
incipient stage
To assess the bank’s exposure to credit risk
To assess the bank’s future capital
requirements
4. To obtain and scrutinize the financial
statements of the borrowers periodically
To ensure compliance of covenants (sanction
terms) and notice violations immediately, if any
To periodically ensure that the security coverage
for the loans granted doesn’t get diluted
To notice payment defaults immediately
To identify genuine problems of the potential
borrowers and institute timely remedial action
5. Macro level
◦ Economic developments that may have an impact on the
industry
◦ Industry development that may have an impact on the
borrower
Borrower’s level
◦ Financial health of the borrower – over/ under borrowed?
◦ Borrower’s repayment record
◦ Quality/ condition/ value of security offered – primary &
collateral
◦ Completeness of documentation as per legal
requirements
◦ Adherence to loan covenants
6. Categories of sickness
◦ Sickness at birth
Project itself becomes infeasible due to faulty
assumptions or change in environment
◦ Induced sickness
Incompetence in management or willful default
◦ Genuine sickness
Circumstances beyond the borrower’s control
Happens in spite of the borrower’s sincere efforts to
avert the situation
7. Effect of financial distress
◦ Prolonged period of lack of profitability
◦ Decay in cash flows – not able to meet the current
liabilities/ high level of unrealizable receivables
◦ Providing inadequate depreciation to the fixed assets –
assets losing market value not getting reflected in the
balance sheet
◦ Rates of return from investments drop below the cost of
capital
Issues to be tackled
◦ What are the signals of financial distress?
◦ Can the banks detect the signs of distress early enough?
◦ Can financial distress be predicted?
8. Warning signs Endogenous(Originating) from the firm
Management Related
◦ Lack of technical expertise
◦ Failure to control cost
◦ Fraud
◦ Poor capacity utilization
Technology Related
◦ Wrong choice of technology
◦ Choice of obsolete process
Product related
◦ Over estimating demand
◦ Demand for product fails
◦ Improper pricing
Financial management related
◦ Underestimating the project cost
◦ Inadequate working capital
◦ Financial control are weak
9. Warning signs Exogenous(Originating Externally) to
the firm
1) At the project implementation stage
- Currency risk
- Upward revision of import duties or excise duty may
escalate the project cost
- Delay in the receipt of approval for the project from the
government
- Force major event
2) At the production stage
- Non availability of raw material
- Power cuts, transport bottlenecks
- technological changes
-force major events
10. Warning signs Exogenous(Originating Externally)
to the firm
3) At the sales/marketing stage
- reduction in demand
- withdrawal of degree of government protection
- price cutting by competitors
- availability of cheaper alternatives
- economic downturn
4) Financial Management
- Non availability of adequate credit from bank
- delay in release of adequate of funding by the
banks
11. Continuous irregularities in Cash Credit/ Overdraft
accounts – inability to maintain margin/ frequent
drawings exceeding the sanctioned limits/ periodical
interest debited remaining unrealized
Balance in CC account always at the maximum
Default/ delay in payment of installments in Term loan
accounts
Non-submission/ delay in submission / incorrect
submission of stock statements and other control
statements
Attempts to divert sales proceeds through accounts of
other banks
Downward trend in credit summations (sales turnover)
Frequent return of cheques/ bills
12. Decline in production/ sales/ profit
Rising level of inventories – slow moving of
finished goods
Large and longer outstanding in bills accounts
Large and longer outstanding of credit
documents negotiated through bank and
frequent return of the same
Failure to pay statutory liabilities
Diverting the bank’s finance – utilizing the funds
for purpose other than running the business
Non cooperation – not furnishing required
information/ delay in meeting payment
commitments etc.
13. Workout procedure to be adopted by the banks to
ensure high recovery rates
◦ Intensify the collection process through letters/ telephone
calls/ personal visits/ inspections
◦ Build an appropriate team from internal or external
resources to enforce an effective monitoring system, which
may involve legal action
◦ Assess available alternative solutions taking into account
the costs involved – whether to go in for restructuring or
loan sales or legal action or write off
Banks basically have two choices for the workout
◦ Restructure the problem (Rehabilitation) for potentially
viable sick units within stipulated time frame – 3 to 6
months
◦ Liquidate the credit
14. Broad parameters for grant of relief
Term Loans
◦ Waiver of penal interest and additional charges, if
any during the intervening period
◦ Interest on term loan may be reduced, if necessary;
reduced interest rates are prospective
◦ Unpaid interest may be segregated and funded;
repayment schedule for the same may be fixed
(within 3 years normally); no interest to be charged
on unpaid interest
◦ Fresh term loans may be sanctioned for revival –
repayment period to be fixed between 5 to 7 years
15. Cash Credit
◦ Waiver of penal interest and additional charges, if
any during the intervening period
◦ Unpaid interest in Cash Credit account may be
segregated and funded; this funded loan, which is a
clean loan, can be extended as a term loan (FITL)
without interest – to be repaid within 3 to 5 years
◦ A part of working capital loan may be unsecured
without any primary security; this portion may be
converted as ‘working capital term loan (WCTL)’ to
be repaid in installments; interest on this loan may
be at a concessional rate
16. Cash losses
Even after rehabilitation, till the firm reaches the
break even period, the cash losses incurred by the
firm may be funded by banks
Additional loan assistance
Additional working capital loan may be granted for
carrying on the operations at a concessional
interest (comparable to prime lending rate – PLR)
Additional loan for meeting capital expenditure, if
any, may be granted as contingency assistance, at a
concessional rate
17. Start-up expenses & Margin for working capital
The ailing firm tends to have liquidity problems and hence to
ensure uninterrupted operations, the bank can fund for
making payments to the pressing creditors/ statutory
liabilities and to provide margin for WC loans; such payments
may be treated as part of the term loans for start –up
Promoters’ contribution
Fresh infusion of funds from the borrowers is required to
ensure their involvement – at least 20 to 30% of the total term
loan requirement should be contributed by the promoters
Concessions from other agencies
State Government – SLIIC/ SFCs/ SIDBI
Central Government – BIFR/ IDBI
18. Rights of the rehabilitating bank
◦ Right of Review - to reassess the facilities offered - for
example, to revise the interest rate upwards etc.
◦ Right of Recompense – to recoup the interest and other
monetary sacrifices, once the firm generates adequate
positive cash flows
Cases where rehabilitation should not be
considered
◦ If the firm’s sickness is due to the following, the bank
should not go in for rehabilitation but should take
efforts for recovery of the dues
Mismanagement
Willful default
Unauthorized diversion of funds
Dispute among partners/ promoters
19. Banks are subject to various inter dependant
risks, owing to the type of business they
transact
The Risk management in banks is considered
very much essential as they occupy an
eminent role in the nation’s economy
Risk management involves
◦ Risk identification
◦ Risk Measurement
◦ Risk monitoring
◦ Risk control
22. Asset-Liability risks are risks arising from
the dissimilar characteristics of assets and
liabilities of the bank
The dissimilar characteristics could be
related to
◦ Interest rate – mismatch in exposures to interest
rates of assets and liabilities
◦ liquidity – mismatch in maturity intermediation of
assets (inflows) and liabilities (outflows)
◦ Foreign exchange – mismatch between the foreign
exchange assets and liabilities
23. Variable in Variable in Variable in
long term short term short term
Difference between the interest earnings and interest costs of
a bank is its ‘spread’
Mismatch in reprising of assets and liabilities due to changes
in interest rates over a period of time exposes the spread of
banks to unexpected changes, giving rise to interest rate risk
Interest rate risk for a bank is zero, if all assets and liabilities
have perfectly matched reprising
Interest
income
Interest
costs
Spread
24. Inflows Outflows
Cash
reserves
Liquidity
Uncertainty Uncertainty Uncertainty Liquidity
in in in risk
Maturity characteristics of the liabilities differ from
that of the assets
Banks are vulnerable to liquidity risk owing to the
presence of demand liabilities on their books
Demand liabilities are matched largely by liquid
assets in the form of loans and advances,
generating large possibilities of liquidity risk
25. Exchange rate of currency A
versus reference currency
Changes in exchange rates of currency A (for
example $) against a reference currency (say
Rupee) cause changes in the value of net position
in reference currency terms
Mismatch gives rise to foreign exchange risk
Short
position in
currency A
Net position
value in
reference
currency
Net position
in currency A
Long
position in
currency A
26. Portfolio risks are risks connected with the
loan and investment portfolios of the banks
and they are viewed independent of the
liabilities
◦ Credit risk – It refers to the probability that a
borrower will fail to meet his obligations in
accordance with the agreed terms. In other words,
it is the possibility of losses associated with decline
of credit quality of the borrowers
◦ Market risk – It is the risk of losses in ‘on balance
sheet’ and ‘off balance sheet’ trading positions
arising out of movements in market prices of debt,
equity, foreign exchange and commodity markets
27. combined combined
with with
It is the most important risk faced by a bank given the
importance of loans in its portfolio
Probability of default is the most important source of this risk
In case of default, the value that can be recovered from the
exposure becomes critical
For example, in case the probability of default is high but the
loan is fully secured and can be recovered through sale of
securities, then credit risk is non- existent. This variable is
captured by ‘loss given default rate’
Exposure
at default
Probability
of default
Loss given
default
rate
Credit risk
28. affect resulting in
Market risk is applicable to the trading portfolio
of a bank (both ‘on balance sheet ‘ and ‘off
balance sheet’)
The focus is on changes in market prices of
trading instruments – interest rates, equity
prices, commodity prices and foreign exchange
rates
Risk factors:
Interest rates, equity
prices, commodity
prices & foreign
exchange rates
Variable of
interest:
Value of trading
portfolio
Market
risk
29. Operational Risk
◦ It is the risk of loss resulting from inadequate or failed
internal processes, people, and systems or from external
events
◦ It is given lot of importance by the regulators (apart from
credit and market risks, operational risk also is included in
the New Basel Accord 2003 for the purposes of capital
adequacy)
Solvency Risk
◦ It is a situation wherein losses are large enough to wipe out
the capital of a bank
◦ Since insolvency can arise from any of the aforementioned
risks faced by the banks, the management of capital
encompasses the management of all other risks
31. The level of solvency risk chosen by a bank helps it to place limits on
the credit, liquidity, market, interest rate, foreign exchange and
operational risks it assumes
The level of credit, liquidity, market, interest rate, foreign exchange
and operational risks assumed, in turn, determine the amount of
capital, bank needs in order to meet these risks
Level of liquidity
risk assumed
Level of foreign
exchange risk
assumed
Level of
operational
risk assumed
Level of market
risk assumed
Level of credit
risk assumed
Chosen
level of
solvency
risk
Level of
capital
required
Level of interest
rate risk assumed
32. Risk Measurement
Risk measurement consists of three steps
1. Identification of the basic risk factors and indices
2. Identification of a target variable (variable the bank
wishes to protect from risk – it can be market value,
earnings or cash flows depending on what is critical or
important for the bank)
(For example, in case of Interest rate risk
Risk factor – Interest rate
Target variables can be
1. Earnings perspective – net interest income or spread
2. Economic value perspective – net worth of the bank)
33. Once target variable is identified, the amount of
sensitivity of the target variable to the changes in the
basic factors is measured through an exposure map. The
exposure map will look like the following equation:
ΔVt = Delta × ΔPt
Where Vt is the value of the target variable at time t and
Pt is the value of risk factor at time t, and Delta is the
exposure of the target variable to the basic risk factor
3. Once the exposure map is ready, the next step involves
an assessment of the range and likelihood of possible
outcomes of the values of the basic risk factors and
thereby the values of target variables, which are the
estimates of risk
34. Mitigation
It is done by way of cost-benefit analysis
Tools for analysis are carefully chosen after analyzing their
usefulness to the situation - for example, a derivative contract
can be purchased to hedge against adverse stock price
movements
The analysis should accompany the strategy to
deal with the risk – no exposure, selective exposure or
magnified exposure
once the strategy is implemented, it can be
subject to evaluation and back testing
Performance evaluation feeds back into the risk
measurement process in order to improve the
efficiency of the process
35. Risk Measurement
• Enlisting basic risk factors and indices to measure them
• Determining exposure of target variables to risk factors
• Grasping range of likelihood of the possible outcomes
Tool Analysis
• Analyzing tools that can alter risk exposure and evaluating
risk-cost trade-off of each tool
Exposure measurement
• Selecting a strategy of no exposure, selective exposure or
magnified exposure
Performance evaluation
• Back testing the risk measurement model to evaluate its
performance
36. A concrete step was taken by RBI to manage
credit risk in banks, in the year 1998, by way of
introducing ‘Prudential norms for Asset
Classification, Income Recognition and
Provisioning’– initiated from Narasimham
Committee Recommendations of 1991and 1998
on financial sector reforms
RBI gave instructions to all banks to classify
assets (loans and advances) under certain
categories; it also includes leased assets
Loans which do not generate income to the
bank are to be classified as ‘Non-performing
Assets’ (NPA)
37. NPA is a loan where
◦ Interest and/or installment of principal remain overdue for a
period of more than 90 days in respect of term loans
◦ Account remains out of order in respect of overdraft/ cash
credit accounts for more than 90 days
◦ Bill remains overdue for a period of more than 90 days in
respect to bills purchased/ bills discounted accounts
◦ Interest and/or installment of principal remain overdue for two
crop seasons, in respect of crop loans granted for short
duration crops
◦ Interest and/or installment of principal remain overdue for one
crop season, in respect of crop loans granted for long duration
crops
◦ The amount of liquidity facility remains outstanding for more
than 90 days in respect of securitization transaction
◦ Derivative contracts, whose overdue receivables remain unpaid
for more than 90 days
38. Income recognition – income from NPA is not to be
recognized on accrual basis but is booked as income only
when it is actually received; hence
◦ Banks should not charge interest on any NPA
◦ Unrealized interest, if any, should be reversed or
provided for
◦ Unrealized finance charge component of finance
income in case of leased assets should be reversed
or provided for
◦ Interest realized on NPAs may be taken to income
account provided the credits in the accounts
towards interest are not out of fresh/additional
credit sanctioned to the borrower
39. Asset classification – NPAs are classified based on i)
period for which the asset has remained as NPA and ii) the
realizability of dues
The following are classification norms with effect from
31.03.2005
◦ i) Sub-standard asset – an asset, which has remained
NPA for a period of less than or equal to 12 months
◦ ii) Doubtful asset – an asset, which has remained in
the sub-standard category for a period of 12 months
◦ Iii) Loss asset – an asset which is considered
uncollectable and hence continuance as a bank asset
is not warranted
The assets, which are not classified as NPAs i.e. accounts which
are conducted well are called ‘Standard Assets’
40. Provisioning norms – adequate provision has
to made by the banks for their NPA accounts
◦ Loss assets
They have to be written-off or provision has to be
made for 100% of the outstanding amount
◦ Doubtful assets
Provision of 100% to the extent of loan not covered by
realizable security (unsecured portion)
Provision 25% to 100% for the portion of loans covered
by realizable security as under (secured portion)
Up to 1 year – 25%
1 to 3 years – 40%
More than 3 years – 100%
41. Provisioning norms
◦ Sub-standard assets
General provision of 15% on the total outstanding should be
made ( without making any allowance for ECGC Guarantee
cover and securities available)
The unsecured exposures would attract an additional
provision of 10% constituting to 25% of the outstanding
balance
◦ Standard assets
Direct advances to Agriculture, Small & Micro enterprises
sectors – 0.25%
Advances to commercial real estate sector – 1.00%
Advances to commercial real estate residential housing
sector – 0.75%
All other advances – 0.40%
42. Managing risks in banks is uniquely important
because their capital base is small relative to their
assets and liabilities; small % changes in assets or
liabilities can translate in to large % changes in
capital
ALM is concerned with management of risks
associated with the assets and liabilities of the bank
viz. interest rate risk, liquidity risk and foreign
exchange risk (currency risk)
ALM has been gaining a lot of importance as the
banks focus on mitigating the balance sheet
weaknesses
ALM techniques have been evolving over a period of
time
43. The ALM process rests on three pillars:
ALM information system
◦ Management Information system
◦ Information availability, accuracy and expediency
ALM Organization
◦ Structure and responsibilities
◦ Level of top management involvement
ALM process
◦ Deals with Risk parameters, Risk identification, Risk
measurement, Risk management, Risk policies and
tolerance – RBI guidelines primarily addresses
liquidity and interest rate risks
44. Information is the key to ALM process
Getting information in time is a difficult process,
considering the large network of branches
This problem can be addressed by following an
ABC approach i.e. analyzing the behaviour of asset
and liability products in top branches contributing
significant business to make rational assumptions
on other branches
The data and assumptions can be refined over a
period of time; experience helps banks to conduct
business within the ALM framework
Increased level of Computerization in banks is a
blessing in disguise in accessing data
45. Banks typically have an ALM committee (ALCO)
comprising of bank’s senior management
including CEO entrusted with the responsibility of
ALM
ALCO’s responsibility is to device strategies for
ALM, monitor and manage the interrelated risk
exposure on a daily basis
◦ Assess the probability of various liquidity shocks
◦ Assess the probability of various interest rate scenarios
and their impact on net income
◦ Position the bank to handle the above at minimum cost,
while achieving a reasonable profitability level
◦ Handle foreign exchange risks – derivatives market helps
46. Liquidity is to be tracked through maturity or cash
flow mismatches – a maturity liability will be a cash
outflow and a maturity asset will be a cash inflow
Use of a maturity ladder and calculation of cumulative
surplus or deficit of funds at selected maturity dates
is adopted as a standard tool
Assets and liabilities are grouped in to different
maturity profiles (time buckets) and presented for
decision making (1-14 days, 15-28 days, 29 days to
3 months, 3-6 months, 6-12 months, 1-2 years, 2-5
years and over 5 years)
Main focus should be on short-term mismatches (up
to 26 days). RBI’s instructions is to keep the
mismatches below 20% of the cash outflows in each
time bucket
47. Interest rate risk can be measured either from
i) earnings perspective (net interest income) or
ii) economic value perspective (net worth)
Methods used – Gap Analysis, Simulation and
Value at Risk
Mismatch between rate sensitive liabilities and
rate sensitive assets is measured and gaps are
identified in various buckets (up to 1 month, 1-3
months, 3 to 6 months, 6-12 months, 1-3 years,
3-5 years, over 5 years, non-sensitive)
The Gap reports indicate whether the institution
is in a position to benefit from rising interest
rates (positive Gap) or declining interest rate
(negative Gap)
48. Floating exchange rates and increased capital
flows across free economies contributes to
increase in volume of foreign exchange
transactions and the associated risks
If the liabilities in one currency exceed the
level of assets in the same currency mismatch
can add or erode value depending upon
currency movements
Currency risk can be avoided by reducing the
mismatches by adopting suitable strategies
