Pnb Project Report

8/13/2019 Pnb Project Report

1/59

Estimation of Loss Given Default at P

1.1 Banking industr

Bank is the main conflu

Government uses it to contro

and thereby influencing the i

deposit from the public and

parties for growth and deve

education, housing etc and

sectors as decided by the RB

gives loan at the higher rate

main source of the income fo

Banking in India has unde

Organized banking was acti

India in 1786. The Reserve

1995. The imperial bank of

Government to form State o

exercise to reduce the fragm

merging weaker banks with

in 1951 to 85 in 1969.

With the objective of reachi

of people, the government

enormous growth in the nu

enough to reach the weaker s

Major Banking Operat

The main operations of a ban

(i) Balancing Pro(ii) Management(iii) Creation of C

B

at a glance

nce that maintains and controls the flow

l the flow of money by managing Cash Reserve

nflation level. The function of the bank include

other institutions and then to direct as loans a

lopment of industries. It extends loans for th

as a part of social duty, some percentage o

I. The bank takes the deposit at the lower rate o

of interest. The difference in the transaction c

r the bank. This is known as Net Interest Margi

rgone starling changes in terms of growth a

ve in India since the establishment of the Ge

Bank of India (RBI) was established as a ce

India, the biggest Bank at that time, was take

wned STATE BANK OF INDIA (SBI). RBI

ntation in the Indian Banking Industry post ind

tronger banks. The total number of banks redu

g out to the masses and servicing credit needs

nationalized 14 large banks in 1969. This pe

ber of branches and Banks branch network

ection of the society in a vast country like IND

ons

k can be segregated into three main areas:

fitability with Liquidity Management

f Reserves

edit

1

of money.

Ratio (CRR)

accepting the

d advance to

e purpose of

agricultural

f interest and

onstitutes the

n.

nd structure.

eral Bank of

ntral bank in

over by the

nder took an

pendence by

ced from 566

f all sections

riod saw the

ecome wide

A.


2/59


Main Operations of

Balancing Profitability

Banks are commercial conce

return for payments in one

etc. Their objective is to m

business concerns is the de

maximization with certain ot

Banks in general have to p

liquidity. Therefore, they ha

Banks deal in other peoples

That is why, for banks un

important as profitability ma

Management of Reserv

Banks are expected to hold

which is known as cash res

B

a Bank

with Liquidity Management

rns which provide various financial services to

orm or another, such as interest, discount fees

ake profits. However, what distinguishes the

gree to which they have to balance the princ

her principles.

y much more attention in balancing the pro

e to devote considerable attention to liquidity

money, a substantial part of which is repayabl

like other business concerns liquidity mana

agement.

es

oluntarily a part of their deposits in the form

rves and the ratio of cash reserves to deposits

2

customers in

, commission

from other

iple of profit

itability with

management.

on demand.

ement is as

f ready cash

is known as


3/59


Cash Reserve Ratio (CRR).

the reserve ratio that all ban

lender of last resort, to suppl

banks are required to main

modern banking system is al

Creation of Credit

Unlike other financial institu

can create as well as transfer

or it can be said that every lthe concept of deposit multi

add to the money supply in t

way for changes in the econo

Structure of Bankin

Nationalized

Banks

SBI & its

subsidiaries

Foreig

Bank

Regional

ruralBanks

Public

sectorbanks

Scheduled commercial B

B

he Central Bank in every country is empowere

ks must maintain. The Central Bank also und

y reserves to banks in times of genuine difficult

tain a fraction of their deposit liabilities as

o known as the fractional reserve banking.

ions, banks are not merely financial intermedia

money. Banks are set to create deposits or cr

oan given by bank creates a deposit. This haslier or credit multiplier. The importance of this

e economy and hence, banks become responsi

mic activities.

Industry

Scheduled banks

New private

sector Banks

Old privatesector

Banks

Private

sectorBanks

n Urban

CooperativeBanks

Scheduled cooperativenks

3

to prescribe

rtakes as the

ies. Since the

reserves, the

ries but they

dit or money

given rose tois that banks

le in a major

State

cooperativeBanks

Banks


4/59


1.2 COMPANY PR

Punjab National Ba

VISION

"To be a Leading Global Ba

in the Indo-Gangetic Plains

under one roof"

MISSION

"Banking for the unbanked"

PUNJAB NATION

Established in 1895 at Laho

the first Indian bank to hav

Lala Lajpat Rai. Now its hea

along with 13 other banks

successful track record over

with 6001 branches across 7

Category Banking Servic

Sector Banking and Fina

Tag line The name you c

USP Punjab national ban

Financial Performa

The Banks business crosse

growth of 4.0 % . This has

employee increasing to Rs.1

Total deposits have touched

B

FILE

k (PNB)

nk with Pan India footprints and become a ho

providing entire range of financial products

L BANK

e, Punjab National Bank (PNB) has the distin

been started solely with Indian capital. It wa

dquarter is at Delhi. The bank was nationalized

. Today, PNB is a professionally managed

110 years. The bank has the largest branch net

4 cities and serves over 72 million customers.

s.

ce.

n bank upon.

k if one of big four banks of India.

ce (2012-2013)

d Rs.7.28 lakh crore as on March 31, 2013

ositive impact on productivity indicators with

.65 crore. Business per branch increased to Rs.

s.3.91 lakh crore recording Growth of 3.2 % .

4

sehold brand

and services

tion of being

s founded by

in July 1969

bank with a

ork In India,

registering a

business per

116.84 crore.

Net advances


5/59


are around Rs.3.08 lakh cr

showing an increase by 14.3

Capital & revenue are aroun

Business Parameters (Rs.

PARAMETERS

Total Business

Total Deposits

Net advances

Casa Deposit

Capital and Revenue

Source: Annual results 2013

Source: Annual result 2011

Bank has also done well in

in absolute terms. Net Intere

highest among all the Natio

Operating Profit of Rs. 10

during the FY13.

Profit Parameters (Rs. Cro

PARAMETERS

Operating Profit

Net Profit

Net Intt Income

Source: Annual results 2013

PARAMETER

Business per employee

Business per branch

B

re with growth 5.1 %. The Banks CASA

over the FY13.

32677 which show the growth of 17.5%.

rore)

Mar-13 Mar-12 Growth (%)

700285 673363 4.0

391560 379588 3.2

308725 293775 5.1

153344 134129 14.3

32677 27815 17.5

rofitability parameters viz. Operating profit an

t Income at over Rs.14875 crore during FY13

alized Banks. PNB is the first Nationalized

,000 crore. Earnings per share also increased

re)

Mar-13 Mar-12 Growth(%)

10907 10614 2.8

4748 4884 -2.8

14857 13414 10.8

Mar-13

11.65

Mar-12

11.32

116.84 116.03

5

eposits were

Net Income

has been the

ank to cross

to Rs.139.52


6/59


Organization struct

The bank has its corporate

which branches function. Th

to facili

CMD Chief Managing Dir

ED- Executive DirectorGM General Manager

AGM Assistant General M

DGM Deputy General Ma

GM(Credit)GM(NPA

weak accou

DGM

AGM

F

B

re: PNB

office at New Delhi and supervises 69 circle

delegation of powers is decentralized up to th

tate quick

ctor

anager

ager

Board ofDirector

CMD

ED

t)

GM(Retail &lending)

GM(Treasury)

DGM

AGM

UNCTIONAL

HEAD

AGM .......

DGM DGM

GM(Deposits)

6

offices under

branch level

decision

.......

GM(Audit)


7/59


Channels in PNB

PRODUCT AND

1. Savings Account2. Current Account3. Fixed Deposits Sche4. Credit Scheme5. Social Banking6. Corporate Banking

VARIOUS TYPES

1. Agriculture & Allied2. Industry

a. MSME Manub. Large Industr

CircleOffice(CO)

BranchOffice(BO)

LargeCorporateBranches

B

SERVICES

e

F LOAN PROVIDED BY PNB

Activity

acturing

CorporateOffice (HO)

CircleOffice(CO)

Mid

CorporateBranches

Retail HubSpecialized

Branches eg.Agriculture

CircleOffice(CO)

7


8/59


3. Retail Loans of whica. Housingb. Other Retail

4. Comm. Real estate5. Services and Others

AREAS OF CONC

Loss of Number One Dependence on high Uncontrollable growt Lead over the immed Lack of uniform gro

THE ACTION POI

OF CONCERN DIS

Focus on CASA: Smanagement services

opened

Retail credit especiallgrowth.

Wealth managementcoins to Insurance.

Monitoring of Irregul NPA reduction by o

accounts.

B

oans car loan, housing loan, personal loan etc

RN FOR PNB FOR CURRENT

position in Deposits, Net Profit and Return on

ost deposits to shore up the deposits base.

h in NPAs.

iate competitor getting reduced to Rs. 1115 cror

th in business of various Circles/Branches.

TS FOR THE CURRENT YEA

USSED ABOVE

stainable growth in savings Deposits by of

to the customers. Business value base curren

y the housing loans be marketed aggressively t

products sales be maximized offering full ra

ar Accounts be stepped up to prevent Slippages

ne on one meetings, immediately targeting fr

8

..

EAR

quity.

e.

AREAS

ering wealth

accounts be

o record high

ge e.g. Gold

.

shly slipped


9/59


CREDIT ADMINIS

Commercial lending organiz

Branches(MCB), Large Cor

after the proposal for all

HO/ED/CMD/MC/Board. C

enforce internal control and

and limits are reported in a

action. Authority to handle l

Loan proposals leother proposals a

Office.

MCB handle prop CAD at Head Of

ED, CMD, or M

ED has authoritapprove proposal

greater than Rs.1

RISK MANAGEM

The credit administration di

and technical feasibility o

associated with changes in

banks portfolio, losses stem

borrower or counter party to

other financial transactions.

PNB has an elaborate risk

structure at PNB involves

B

RATION DIVISION (CAD)

ation structure in PNB consists of branches,

porate Branches(LCB) and Head Office(HO).

type of loans which fall within the previe

edit proposal goes through different level of s

ther practices to ensure that exception to polici

timely manner to the appropriate level of ma

an proposals is distributed as detailed below:

ss than 35cr are dealt by MCB and LCB at thei

e reffered to Circle Office which are finally ha

osals between Rs.5 crore and Rs.25 crore.

fice prepares finals proposals which are then

as per the quantum of proposals.

to approve loan proposals less than Rs.75

s between Rs.75 crore and Rs.100 crore.

0 Crore need the approval of management com

NT DEPARTMENT (RMD)

ision is assisted by RMD and industry desk fo

credit proposals.Credit risk is the possi

he credit quality of the borrowers or counter

from outright default due to inability or unwi

honour commitments in relation to lending, s

management structure in place. Credit Risk

9

id Corporate

CAD looks

w of GMs-

anctioning to

es, procedure

nagement for

level and all

dled at Head

laced before

crore. CMD

ny proposal

mittee.

risk analysis

ility of loss

parties. In a

lingness of a

ttlement and

management


10/59


Integrated Risk MaIRMD frames policie

identifying, measurin

industry risks.

Circle Risk ManageRisk Management

responsibilities inclu

the credit portfolio

accounts through re

Committee in addres Risk Management

It is a sub-com

policies/procedures a

Credit Risk ManageIt is a top level fun

CGMs/GMs of Risk

RBI.

Credit Audit RevieIt independently cond

The risk management phil

high risk areas, emphasizing

striking a balance between

improving market share to m

The bank has robust credit

models on central server bas

for assessing credit risk ratin

has developed and placed on

banking. These processes h

B

agement Division (IRMD)

s related to credit risk and develops systems a

g and managing credit risks. It also monitors

ent Departments (CRMDs)

epartments at circle level are known as C

e monitoring and initiating steps to improve

f the Circle, tracking down the health of th

gular risk rating, besides assisting the resp

ing the issues on risk.ommittee (RMC)

ittee of Board with responsibility of

d managing all the risks.

ment Committee (CRMC)

tional committee headed by CMD and comp

Management, Credit, Treasury etc. as per the

Division (CARD)

ucts Loan Reviews/Audits.

sophy & policy of the bank focuses reducin

more on the promising industries, optimizing

the risk and the return on assets and stri

aximize shareholders value.

risk framework and has already placed cred

d system PNB TRAC, which provides a scie

g of a client. Taking a step further during the

central server score based rating models in re

ve helped the bank to achieve fast & accurat

10

d models for

and manages

RMD. Their

he quality of

e borrowers

ctive Credit

formulating

ises of EDs,

directives of

exposure to

the return by

ing towards

it risk rating

ntific method

ear, the bank

pect of retail

e delivery of


11/59


credit, bring uniformity in t

The analysis also involves a

RISK ANALYSIS

PNB has elaborate risk mana

appraisal of the loan propos

based in the patented intern

statistical analysis of data. T

TRAC, which provides facil

This credit risk rating captur

Financial evaluati Business or indus Management eval Conduct of accou

Various External Credit Age

1. CIBIL2. CARE3. FITCH4. ICRA

Factors determining credit ri

State of economy Wide swing in co Fluctuations in fo Trade restrictions Economic sanctio Government poli

B

he system and facilitate storage of data & ana

alyzing the projections for the future years.

gement structure, processes and procedures in

ls, RMD provides the risk ratings for the clie

al models of the PNB that have been develo

ese models are placed on central server based

ity to assess credit risk rating of a client.

s risk factors under four areas:

on (40%)

try evaluation (30%)

uation (20%)

nt (10%)

cies in India:

k:

mmodity prices

reign exchange rates and interest rates

ns

ies

11

lysis thereof.

lace. For the

t and project

ed based on

system PNB


12/59


CREDIT FACILITI

PNB provides different typ

convenience of the clients. D

FUND BASED FACILITI

Fund based facilities are t

borrowing party.

Overdraft

Overdraft accou

allowed against

shares and/or de

supply bills, cash

Demand loans

Demand loan wo

bullet repayment.

deposits, govern

companies, life i

of immovable pro

Cash credit adv

Cash credit acco

bank and is opera

overdraft has bee

to draw on accou

B

ES

s of credit facilities according to the bankin

ifferent types of facilities provided are classifie

S

ose that require immediate outlay of funds

t is treated as current accounts. Normally o

the Banks own deposit, government securit

entures of companies, life insurance policies,

incentive and duty drawbacks, personal securit

ld be a loan, which is payable on demand in

Normally, demand loans are allowed against th

ment securities, approved shares and/or d

surance policies, pledge of gold/silver orname

perty.

nces

nt is a drawing account against the credit g

ed in exactly the same way as a current accoun

sanctioned. In cash credit accounts the borro

t within the prescribed limit as and when requi

12

g norms and

below:

towards the

verdrafts are

ies approved

government

etc.

one shot i.e.

e banks own

bentures of

ts, mortgage

anted by the

on which an

er is allowed

ed.


13/59


Bill finance

Bill finance are

form of limits f

collection. Bills a

NON FUND BASED FACI

While fund based credit faci

fund based facilities basicall

to provide monetary compen

certain conditions are fulfillebank income. Income is in

income in case of fund based

Non fund based credit play

clients of banks prefer to ava

The facility dcost of such

facilities.

A bank guaraof its client is

not show up a

For the lending banks, cost

than the cost of providing fu

Bank Guarantees

BG may be financi

issuing bank assume

However, issue of a

managerial ability o

which guarantee has

B

he advances against the inland bills are sanc

r purchase of bills or discount of bills or

re either payable on demand of after usage peri

ITIES

lities require immediate outlay of funds from t

include the promises made by banks in favor

sation on behalf of their client if certain situati

d. The non-fund based business is one of the mthe form of fees and commissions as compar

lending.

an important role in trade and commerce. T

il of the non-fund based facilities mainly becau

oes not require immediate outlay of funds and

funds tend to be lower than the cost of fund

tee(BG) or letter of credit(LOC) issued by a b

an off-balance sheet item in the books of clie

s debt or liability.

of providing non-fund based facilities is signi

d-based facilities.

l of performance in nature. In a financial g

s an usual credit risk which is the domain

performance guarantee involved technical co

a customer to ensure the performance of th

been drawn. Issuing banks responsibility agai

13

tioned in the

ills sent for

d.

e bank, non-

of third party

ns emerge or

in sources ofd to interest

e borrowing

e:

therefore the

based credit

nk on behalf

nts, hence do

icantly lower

uarantee, the

f the banks.

petency and

contract for

nst the BG is


14/59


absolute. So proper

responsibility of the i

Letter of credit

A document issued b

substitutes the bank

buyer to the seller, t

irrevocable, i.e. cann

beneficiary, the issui

BG in the sense that

to default, and for thplay only when the p

SWOT Analysis o

Strengths 1.

2.

3.

4. I

abo

5. I

Weakness 1.

2. I

3.

Opportunities 1. S

2.

3. I

Threats 1.

2.

3. S

B

appraisal needs to be done before issuing B

ssuing bank to honor its guarantee when invoke

y a bank that guarantees the payment of a cus

credit. It is an undertaking issued by bank on

o pay for the goods and services. All letters

ot be amended or canceled without prior agre

g bank and the confirming bank, if any. It is

in case of LOC, the issuing bank does not wait

seller to invoke the undertaking. While in Bincipal party (the buyer) has failed to pay its su

f PNB

iversified operations with 5100 branches.

trong I. T support with best fit approach.

chemes for small and medium scale businesses.

t is the second largest state-owned commercial ban

ut 5000 branches across 764 cities.

s 56,000+ workforce serves over 37 million custom

ess penetration in the urban areas.

adequate advertising and branding as compared to

egal issues regarding employees caused a bad name

mall scale business banking across India.

xpansion in other countries for international banki

stallation of more ATMs and better customers se

conomic crisis and economic fluctuations.

ighly competitive environment.

tringent Banking Norms by the RBI and the Govern

14

as it is the

.

omers draft;

behalf of the

of credit are

ement of the

ifferent from

for the buyer

, comes intopplier

in India with

rs.

ther banks.

of PNB.

g.

vices.

ments.


15/59


WORKING OF THE RIS

Risk Management is the pr

controls its risk exposure in

the Bank and are clearly und

Risk is inherent part of Ban

Bank for achieving financial

Specifically, integrated risk

To protect the Credit Risk Operational Market Risk

The Board oCommittee (

professionals

Management

mentioned ab

To protect fro

AREA OF THE PROJE

APPROACH

The project mainly focuses

estimation of LGD and effec

B

K MANAGEMENT DIVISION (RMD) AT

cess by which the Bank identifies, measures,

rder to ensure that risks are within the toleranc

rstood at relevant levels across the Bank.

ks business. Effective Risk Management is c

soundness.

anagement division at PNB has two important

bank against -

isk

Directors had constituted the Risk ManagemRMAC) which included IRMD officials

as its members. The Committee overse

functions of the Bank with focus on the

ve.

systemic risk.

T: STUDY OF RISK COMPONETS U

on study and analysis of different risk co

ive maturity of loans by PNB under IRB Appr

15

NB.

monitors and

e level set by

ritical to any

functions:

ent Advisorynd external

s the Risk

three risks

DER AIRB

ponents and

ach.


16/59


The aim of the study would

o What are the different cro How to calculated Risk uo Estimation of LGD

PURPOSE OF THE STU

Indian economy is witnessin

the rise of tide, all sectorssector. A very large number

Building hardware, Home

coming up.

Secondly, the supply chain

between small and large se

country: a segment that retai

Keeping in view the heterog

left out that are performing

are finding difficult to adjus

Most of the small enterpri

procurement led sectors such

.

B

e to know

dit risk

nder AIRB Approach

Y:

g a new state of buoyancy during last couple o

of economy are performing well and so is thof SMEs in sectors such as Engineering, Electri

Furnishing, Paints, Furniture, Industrial con

are increasingly getting organized necessita

tor thus giving rise of the genuine medium

s the flexibility of small scale and of large ente

eneity of the sector, a significant number of s

t below par or even struggling all together. Th

to the changed economic dynamics of new re

es in this segment belong to traditional and

as traditional textiles (handlooms), stationery e

16

f years. With

small scalecals, Plastics,

umables are

ting linkages

sector in the

rprises.

b-sectors are

ese segments

urgent India.

government

tc.


17/59


Most of the published resear

to the proprietary nature of

difference between bank lo

least the following peculiari

2000):

Bank loans are typically mo

clearly affect their recovery r

Banks usually more activ

Banks as private lender

tighter covenants, better re

characteristics are pretty mu

These differences are also a

estimating recovery rates. N

debt, that can be associated

the features of the privately

on corporate bonds report

seniority and security, but al

and Carvalho, 2006).

Altman et al. (2004) present

during the last three deca

probability of default of an

discuss the empirical eviden

the rest of this section

measurement in case of d

individual bank loan tran

measurement of bank loans

Edwards (1995) calculated

B

2.1 Literature Review

h deals with recoveries of bonds rather than ba

data for the latter. But data unavailability is

ns and bonds. The list of relevant differences

ties (Schuermann, 2001; Amihud, Garbad

e senior in the capital structure of the borrowe

ates.

ly monitor the evolving financial health of the

better control the agency costs of the borro

negotiation possibilities and closer monitori

h tight to the notion of relationship banking.

reason for somewhat different methodological

vertheless the fundamental characteristics of p

ith debt recovery rates turn out to be basicall

placed bank loans and related recovery rates.

hat recovery on individual bonds is affected

o by the industry conditions at the time of def

a detailed review of the way credit risk mode

es, treat the recovery rate and its relations

bligor. Altman et al. (2004) also summarize a

e on recovery rate calculation and RR PD re

e briefly summarize published research on

faulted bank loans, since our study focuse

sactions. One of the widely quoted studi

is the Asarnow and Edwards (1995) study.

loss in the eventof default (LIED) for 831 d

17

nk loans, due

ot the only

contains at

and Kahan,

rs, which can

bligor.

wers through

g. All these

pproaches in

blicly traded

the same as

o the studies

not only by

ult (Dermine

ls, developed

hip with the

d thoroughly

lationship. In

RR (LGD)

s strictly on

es on LGD

sarnow and

faulted C&I


18/59


19/59


One of the largest and more

enterprises was made by Sta

Davydenko, 2004). It consid

across banks within the sam

countries where banks resp

different lending practices.

collateral and target specifi

significantly (it is lower) fro

published papers Gupton (2

LGD and employed a datasestudied LGD for defaulted l

December 2003 in Australia

States and the United Kingd

any of the transition countrie

The most recent study on ba

(2006) who investigated LG

medium size firms in Banco

authors applied mortality a

empirically the determinants

the direct costs incurred by

recovery rate measured in t

studies in the field. More i

bank loans LGD rates pro

determinants of loan losses

such as size of the loan, coll

(firm).

B

recent studies that focus on loans to small and

dard & Poors Risk Solution Department (Fran

ers collateral as the key driver of recovery rate

e country and jurisdiction. Recovery rates also

nd to different bankruptcy regimes and codes

In France, for instance, banks demand hig

forms of collateral. The recovery rate in

recoveries in the UK and Germany. In one

005) applied LossCalc Moodys KMV mo

which included 1424 defaulted public and prioans, bonds and preferred stock for period Ja

, New Zealand, Canada, Europe, Latin Americ

m, with at least seven years of data in each. Th

s in the research is not reported.

nk loan LGD rates was published by Dermine

D characteristics for 374 corporate bank loans

Commercial Portuguese over the period 1995

nalysis to defaulted bank loan recovery rat

of recovery rates. Additionally they provided i

bank in recoveries on bad and doubtful loans.

heir study was 71%, which was in line with

portantly, they showed that the frequency d

ed to be bimodal and in their multivariate a

hey identified statistically significant explanat

ateral, industry sector, year dummies and age

19

edium sized

ks, Servigny,

, which vary

differ across

by adjusting

er levels of

rance differs

f the lately

el to predict

ate firms. Heuary 1981

a, the United

inclusion of

and Carvalho

to small and

2000. The

s and tested

formation on

The average

some earlier

istribution of

alysis of the

ory variables

f the obligor


20/59


2.2 RISK MANAGEM

Risk Management at PNB co

1) Credit Risk2) Market Risk3) Operational Risk

The Board of Directors ulti

Bank. It approves the bank

management infrastructure.convenes monthly to be cons

The Risk Management Divi

Risk Management Committe

policies and assists line man

The risk management philos

approach to understand, mea

of healthy asset portfolio.

emphasizing more on the

balance between the risk an

share to maximize sharehold

The Bank has robust credit

models on central server bas

credit risk rating of a clie

developed and placed on c

banking. These processes h

credit; bring uniformity in th

B

NT AT PNB

vers three main areas

mately responsible for the management of t

s risk appetite, risk policies and procedures

he Risk Management Committee is a Board Ctantly apprised of banks risk profile and vario

ion is independent from the line and reports

e. It review risk exposure versus approved limi

gement in risk reduction strategies.

ophy & policy of the Bank is an embodiment

sure and manage risk and aims at ensuring sus

his would entail in reducing exposure in hi

promising industries, optimizing the return

the return on assets and striving towards impr

rs value.

risk framework and has already placed cred

ed system which provides a scientific method

t. Taking a step further during the year, t

ntral server score based rating models in res

ve helped the Bank to achieve fast & accurat

system and facilitate storage of data & analysi

20

e risk at the

and the risk

mmittee thats risk issues.

irectly to the

ts, drafts risk

f the Banks

ained growth

h risk areas,

y striking a

oving market

it risk rating

for assessing

he Bank has

pect of retail

e delivery of

s thereof.


21/59


The Bank has in place

management functions, whi

risk viz. interest rate risk &

and monitoring the same. T

are being used effectively i

actively re-shuffled the portf

Despite high volatility of the

liquidity position remained c

on proactive basis to manacovering entire branch netw

and liabilities is being done

Credit Risk is the potenti

obligations on agreed terms.

commitments for one or the

bank. These losses could t

changes in portfolio value ar

that is short of default. Cre

operations linked closely

management is to minimize

assuming and maintaining cr

Credit risk consists of prima

but the outstanding loan bala

severity of loss defined by th

in the event of default. Th

B

well defined organizational structure for

h looks into the process of overall managem

liquidity risk and implements methodologies

ols like stress testing, duration, modified dura

managing risk in the Treasury operations.

lio to improve profitability within risk limits.

liquidity position in the system during the yea

omfortable. Asset liability management of the

ge any eventuality. With Core Banking Sork, the Asset Liability Management in respec

n daily basis.

2.2.1 CREDIT RISK

l that a bank borrower/counter party fails

There is always scope for the borrower to de

other reason resulting in crystallization of cre

ke the form outright default or alternatively,

ising from actual or perceived deterioration in

it risk is inherent to the business of lending

to market risk variables. The objective o

the risk and maximize banks risk adjusted rat

dit exposure within the acceptable parameters.

rily two components, viz. Quantity of risk, whi

nce as on the date of default and the Quality o

e Probability of Default & the recoveries that c

s credit risk is a combined outcome of Def

21

market risk

nt of market

or measuring

ion, VaR etc

he Bank has

r, the Banks

Bank is done

lution (CBS)of all assets

to meet the

ault from his

it risk to the

losses from

credit quality

funds to the

credit risk

of return by

ch is nothing

risk, viz. the

ould be made

ult Risk and


22/59


Exposure Risk. The element

Risk as well as Intrinsic Ris

risk as well as Default Risk.

evaluating credit risk that is

credit functions are handled

credit risk, default/migration

In general, Default is not a

dictates that, more often tha

gradually, which is otherwismigration.

Off balance sheet exposures

etc are classified in to three

risk and then translated into

up.

The management of credit ri

a) Measurement througb) Quantification througc) Pricing on a scientifid) Controlling through

Management.

The Committee permits ban

their capital requirements for

be to measure credit risk

assessments. The other alter

to the explicit approval of th

rating systems for credit risk.

B

s of Credit Risk are Portfolio risk comprising

and Transaction Risk comprising migration/do

At the transaction level, credit ratings are usefu

prevalent across the entire organization where

. Portfolio analysis help in identifying the co

statistics, recovery data, etc.

n abrupt process to happen suddenly and pa

not, borrowers credit worthiness and asset qu

e known as migration. Default is an extreme e

such as foreign exchange forward contracts, s

broad categories such as full Risk, Medium Ri

isk weighted assets through a conversion factor

k includes:

credit rating/scoring,

h estimate of expected loan losses,

basis, and

effective Loan Review Mechanism a

s a choice between two broad methodologies f

credit risk. One alternative, the Standardised A

in a standardised manner, supported by e

ative, the Internal Ratings-based Approach, wh

e banks supervisor, would allow banks to use

22

oncentration

wn gradation

l measures of

treasury and

centration of

t experience

ality declines

ent of credit

waps options

sk and Low

and summed

d Portfolio

r calculating

pproach, will

ternal credit

ich is subject

their internal


23/59


The following section sets o

book exposures. Exposures t

current treatment; however,

IV. Furthermore, the credit e

and OTC derivatives that ex

under the rules set forth . In

banks may use assessment

eligible for capital purpose

defined in paragraphs. Expos

CreditAAAto A

Assessment AA-

Risk Weight 0% 2

At national discretion, a lo

sovereign (or central bank)

funded19 in that currency.

authorities may also permi

currency exposures to this

purpose of risk weighting cl

risk scores assigned by Expo

its risk scores and subscribe

the risk scores published by

the consensus risk scores

Supported Export Credits.

score categories associated

scores will correspond to ris

ECA risk scores 0-1

Risk weight 0%

B

ut revisions to the 1988 Accord for risk weig

hat are not explicitly addressed in this section

exposures related to securitisation are dealt wi

uivalent amount of Securities Financing Trans

pose a bank to counterparty credit risk16 is to

determining the risk weights in the standardi

by external credit assessment institutions r

s by national supervisors in accordance wit

ures should be risk-weighted net of specific pro

+ to A- BBB+ to BB+ to B- Below B-

BBB-

% 50% 100% 150%

er risk weight may be applied to banks expo

of incorporation denominated in domestic

here this discretion is exercised, other nationa

their banks to apply the same risk weight

overeign (or central bank) funded in that cur

aims on sovereigns, supervisors may recognis

rt Credit Agencies (ECAs). To qualify, an ECA

o the OECD agreed methodology. Banks may

individual ECAs that are recognised by their

f ECAs participating in the Arrangement

1 The OECD agreed methodology establish

ith minimum export insurance premiums. Th

weight categories as detailed below.

2 3 4 to 6 7

20% 50% 100% 1

23

ting banking

ill retain the

th in Section

ctions (SFT)

be calculated

ed approach,

ecognised as

the criteria

visions.

Unrated

100%

sures to their

urrency and

l supervisory

to domestic

ency.For the

the country

must publish

hoose to use

upervisor, or

on Officially

es eight risk

se ECA risk

0%


24/59


25/59


Market Risk may be define

the market variables. It is th

adversely affected by move

rates and commodity prices.

to changes in the market le

and equities, as well as t

provides a comprehensive

managing liquidity, interest rrisk of a bank that needs to b

Scenario analysis and stress

problems in a given portfol

like economic/industry ove

have unfavorable effect on

stress testing. As the underl

the test should be reviewed

responsive and sensitive to t

a) Liquidity Risk:

Bank Deposits generally h

liquidity management nee

withdrawals. Liquidity is the

in liabilities and to fund the

claims. The cash flows are

behaviour of assets, liabilit

Funding Risk, Time Risk &

B

2.2.2 MARKET RISK

as the possibility of loss to bank caused by t

risk that the value of on-/off-balance sheet pos

ents in equity and interest rate markets, curre

Market risk is the risk to the banks earnings a

el of interest rates or prices of securities, fore

e volatilities, of those prices. Market Risk

and dynamic frame work for measuring, m

ate, foreign exchange and equity as well as coclosely integrated with the banks business str

testing is yet another tool used to assess area

io. Identification of future changes in econom

rturns, market risk events, liquidity conditions

banks portfolio is a condition precedent for

ing assumption keep changing from time to ti

periodically as market risk management syst

e happenings in the market.

ave a much shorter contractual maturity th

s to provide a cushion to cover anticip

ability to efficiently accommodate deposit as

loan growth and possible funding of the off-

placed in different time buckets based on

es and off-balance sheet items. Liquidity ris

all Risk

25

e changes in

itions will be

cy exchange

d capital due

ign exchange

Management

nitoring and

modity priceategy.

of potential

ic conditions

tc that could

carrying out

e, output of

m should be

n loans and

ated deposit

lso reduction

alance sheet

future likely

k consists of


26/59


b) Interest Rate Risk

Interest Rate Risk is the pote

to the vulnerability of an i

rates. Changes in interest ra

items and cash flow. Hence,

earnings, improve the capa

adequacy of the compensati

Management of interest rate

re-pricing mismatches andperspective.

Earnings perspective involve

or reported earnings in the n

Net Interest Income (NII) e

total interest expense.

In order to manage interest

their portfolios to the risk o

Duration of market value o

market interest rate. The dif

average duration for bank l

banks exposure to interest

uses the information contain

By reducing the size of the d

Economic Value perspectiv

minus expected cash out flo

B

ntial negative impact on the Net Interest Incom

stitutions financial condition to the moveme

e affect earnings, value of assets, liability off-

the objective of interest rate risk management i

bility, ability to absorb potential loss and t

n received for the risk taken and affect risk ret

risk aims at capturing the risks arising from the

is measured both from the earnings and ec

s analyzing the impact of changes in interest ra

ear term. This is measured by measuring the c

uivalent to the difference between total interes

ate risk, banks should begin evaluating the vu

fluctuations in market interest rates. One su

f a bank asset or liabilities to a percentage c

erence between the average duration for bank

iabilities is known as the duration gap, whi

ate risk. The Asset Liability Committee (ALC

d in the duration gap analysis to guide and fra

ration gap, banks can minimize the interest rat

involves analyzing the expected cash inflo

s on liabilities plus the net cash flows on off-

26

and it refers

nt in interest

alance sheet

s to maintain

o ensure the

urn trade-off.

maturity and

nomic value

es on accrual

hanges in the

t income and

lnerability of

h measure is

hange in the

ssets and the

h assess the

O) of a bank

e strategies.

risk.

ws on assets

balance sheet


27/59


items. The economic value p

gaps. The various types of in

There are different techniq

measure the interest rate se

sensitivity of capital, c) sim

risk. The approach towards

segmentation of banks bala

and Banking Book. While tr

profits on short term differeliabilities contracted basica

statutory obligations and are

Thus, while price risk is th

changes in the economic val

Value at Risk (VaR) is a m

techniques. It is a statistical

loss over a given time inte

level of say 95% or 99%.

future losses that may occur

event takes place. Till then it

As far as Trading Book is c

or internal models for provid

c) Forex Risk

Foreign exchange risk is th

exchange rate movement du

B

erspective identifies risk arising from long-ter

terest rate risks are detailed below:

ues such as a) the traditional Maturity Gap

sitivity, b) Duration Gap Analysis to measur

lation and d) Value at Risk for measurement o

measurement and hedging interest rate ris

ce sheet. Banks broadly divide the asset into

ding book comprises of assets held primarily

ces in prices/yields, the banking book consistsly on account of relationship or for steady

generally held till maturity/payment by counter

prime concern of banks in trading book, th

e are the main focus in banking book.

thod of assessing the market risk using stand

measure of risk exposure and measures the w

val under normal market conditions at a give

hus VaR is simply a distribution of probabl

on a portfolio. The actual result will not be kn

is a random variable whose outcome has been

ncerned, bank should be able to adopt standar

ing explicit capital charge for market risk.

e risk that a bank may suffer loss as a resu

ing a period in which it has an open position,

27

interest rate

Analysis to

interest rate

f interest rate

varies with

rading Book

or generating

of assets andincome and

party.

earnings or

ard statistical

orst expected

n confidence

outcome of

own until the

stimated.

ized method

lt of adverse

either spot or


28/59


forward or both in same for

in individual currencies are

produce mismatches. There

party and out of time lag in s

another currency in another t

arises from the maturity mis

indicates the risk that the b

these gap positions are to be

announced by FEDAI for the

Currency Risk is the possibil

of principal and return of the

this specific risk on the len

fluctuations to the borrower

converted in to credit risk.

By setting appropriates limit

as overnight limits for each

clear cut and well defined

office the risk element in for

d) Country Risk

This is the risk that arises d

in the recent years owing to

that a country will be unab

comprises of Transfer Risk

on external remittances; So

sovereign nation or takin

environment or legislative p

B

ign currency. Even in case where spot or for

balanced the maturity pattern of forward tran

s also a settlement risk arising out of default

ettlement of one currency in one centre and the

ime zone. Banks are also exposed to interest ra

atch of foreign currency position. The Value

nk is exposed due to uncovered position of

valued on daily basis at the prevalent forward

remaining maturities.

ity that exchange rate changes will alter the exp

lending or investment. At times, banks may tr

ing side by shifting the risk associated with

. However the risk does not get extinguished,

s-open position and gaps, stop-loss limits, Day

urrency, Individual Gap Limits and Aggregat

ivision of responsibilities between front, mid

ign exchange risk can be managed/monitored.

e to cross border transactions that are growing

conomic liberalization and globalization. It is t

le to service or repay debts to foreign lende

rising on account of possibility of losses due

vereign Risk associated with lending to gov

government guarantees; Political Risk w

ocess of country leads to government taking o

28

ard positions

sactions may

f the counter

settlement of

e risk, which

t Risk (VaR)

ismatch and

market rates

ected amount

to cope with

xchange rate

but only gets

Light as well

Gap Limits,

dle and back

dramatically

he possibility

s in time. It

o restrictions

rnment of a

hen political

ver the assets


29/59


of the financial entity (like n

manner that had been agre

borrower being a resident of

is booked; Currency Risk, a

amount of principal and retu

In the process there can be

but may not be paid or the

was not delivered the goods

As per the RBI guidance noshould reckon both fund an

branches, if any, while identi

advocates that bank should

example, exposures to a do

on a certain country may be

should be computed on a net

Netting may be considered

risk category and may be pe

RBI further suggests that b

move over to internal asse

31.3.2004, by which time t

should be able to identify

features that acknowledge t

rely solely on rating agenc

monitoring tool.

With regard to inter-bank e

country ratings of internati

B

tionalization, etc) and preventing discharge of

d to earlier; Cross border risk arising on a

a country other than the country where the cros

possibility that exchange rate change, will alter

n on the lending or investment.

situation in which seller (exporter) may deliv

uyer (importer) might have paid the money i

or one or the other reasons.

te on Country Risk Management published renon-fund exposures from their domestic as w

fying, measuring, monitoring and controlling c

also take into account indirect country risk

estic commercial borrower with large economi

considered as subject to indirect country risk.

basis, i.e. gross exposure minus collaterals, gua

for collaterals in/guarantees issued by countri

rmitted for banks dues payable to the respect

nks should eventually put in place appropria

sment of country risk within a prescribed p

e new capital accord would be implemented

he full dimensions of country risk as well a

e links between credit and market risks. Ban

ies or other external sources as their only

posures, the guidelines suggests that banks s

nal rating agencies and broadly classify the

29

iabilities in a

count of the

-border asset

the expected

er the goods,

advance but

cently, banksell as foreign

untry risk. It

xposure. For

dependence

he exposures

rantees etc.

s in a lower

ve countries.

e systems to

eriod say by

. The system

s incorporate

s should not

ountry risk-

ould use the

country risk


30/59


rating into six categories su

credit.

However, banks may be al

countries. Banks may set c

capital (Tier I & II) with suit

etc. Banks were also advised

weekly basis before eventua

variety of internal and extern

rely solely on rating agencie

country risk. Banks are expetheir Annual Report by way

Always banks live with the

disasters. The recent happ

highlighted the potential loss

use of technology and incr

changes that contributed to s

not categorized as market o

failed internal processes, peo

this, internal control and inte

Risk education for familiari

reduce operational risk. In

Operational risk events are a

key to management of opera

B

ch as insignificant, low, moderate, high, very

lowed to adopt a more conservative categori

untry exposure limits in relation to the bank

able sub limits, if necessary, for products, bran

to set country exposure limits and monitor suc

lly switching over to real tie monitoring. Ban

al sources as a means to measure country risk a

s or other external sources as their only tool f

cted to disclose the Country Risk Managemef notes.

2.2.3 OPERATIONAL RISK

risks arising out of human error, financial frau

nings such as WTC tragedy, Barings deb

es on account of operational risk. Exponential

ase in global financial inter-linkages are the

ch risks. Operational risk, though defined as a

r credit risk, is the risk of loss arising from i

ple and systems or from external events. In ord

rnal audit systems are used as the primary mean

zing the complex operations at all levels of

surance cover is one which mitigates ope

ssociated with weak links in internal control pr

tional risk lies in the banks ability to assess i

30

high & off-

zation of the

s regulatory

hes, maturity

exposure on

s should use

d should not

r monitoring

t policies in

d and natural

cle etc. has

growth in the

two primary

y risk that is

nadequate or

er to mitigate

s.

taff can also

ational risk.

cedures. The

s process for


31/59


vulnerability and establish

unanticipated worst-case sce

Operational risk involves

leading to error, fraud, per

resulting in financial loss. Pu

would serve as an effective r

understanding of operationa

risk is often inter-wined with

Over a period of time, ma

sophisticated fashion than o

monitored and analysed. An

the result of operational ris

staff lapses. So far, scienti

Hence 20% charge on the C

subsequent data/feed-back; i

risk and computing capital

ultimate goals, what is to be

a phased manner and then ca

2.

The New Basel Accord, e

internationally active banks

capital requirements

B

controls as well as safeguards while p

arios.

reakdown in internal controls and corporat

ormance failure, compromise on the interest

tting in place proper corporate governance prac

sk management tool. Bank should strive to pro

l risk within the organization, especially sinc

market or credit risk and it is difficult to isolat

nagement of credit and market risks has ev

erational risk, as the former can be more eas

yet the root causes of all the financial scams

caused by breakdowns in internal control m

ic measurement of operational risk has not b

apital Funds is earmarked for operational risk

t was reduced to 12%. While measurement

charges as envisaged in the Basel proposals

one at present is to start implementing the Bas

refully plan in that direction.

3 Calculation of Credit Risk

pected to be implemented at year-end 2006,

o use more risk sensitive methods for calculati

31

roviding for

governance

of the bank

tices by itself

ote a shared

e operational

.

lved a more

ly measured,

nd losses are

chanism and

een evolved.

and based on

f operational

re to be the

l proposal in

will require

ng credit risk


32/59


As per the norms, there are t

1) Standardized Approa2) Internal Ratings Base

Standardized Approach

It refers to a set oII capital adequacy ru

Under this approachRating Agencies to q

In many countries thiin the initial phase of

Internal Ratings Based (IR

This approach has two parts

1. Advanced internal rat2. Foundation internal r

Advanced internal r

Under this apmodel to qua

B

o approaches of calculating credit risk are

h

d (IRB) Approach

credit risk measurement techniques proposed

les for banking institutions.

the banks are required to use ratings from E

antify required capital for credit risk.

s is the only approach the regulators are planni

Basel II Implementation.

) Approach

ing-based approach (A-IRB)

tings-based approach (F-IRB)

ating-based approach (A-IRB)

roach the banks are allowed to develop their o

tify required capital for credit risk.

32

under Basel

ternal Credit

g to approve

wn empirical


33/59


In this appro(probability o

Default) and

Weighted As

percentage of

Banks can usregulators.

Foundation internal rating Under this approach

to estimate the PD

clients

Banks are required tother parameters req

total required capital

Definitions of Default and

Default

By definition, a debt instrum

However, there is no stan

definitions may be used for

the following conditions are

A loan is placed on non-acc

A charge-off has already o

The obligor is more than 9

The obligor has filed bank

B

ach quantitative models are developed to est

f default), EAD (Exposure at Default), LGD

other parameters required for calculating the

set). Then total required capital is calculate

the estimated RWA.

e this approach only subject to approval fro

-based approach (F-IRB)the banks are allowed to develop their own em

(probability of default) for individual clients

o use regulator's prescribed LGD (Loss Given

ired for calculating the RWA (Risk Weighted

is calculated as a fixed percentage of the estima

oss

nt can experience a loss only if there has been

ard definition of what constitutes a defaul

different purposes. Typically a default occurs

met:

rual

curred

days past due

uptcy

33

imate the PD

(Loss Given

RWA (Risk

as a fixed

their local

pirical model

or groups of

Default) and

ssets). Then

ed RWA.

a default.

t. Different

when any of


34/59


The BIS reference definitio

many of these events:

A default is considered to h

more of the following events

(a) It is determined that th

interest, or fees) in full;

(b) A credit loss event assoc

specific provision, or distres

of principal, interest, or fees;(c) The obligor is past due m

(d) The obligor has filed for

The measured loss in the

exposure), will clearly depe

defaults under the definition

90 days past due on a loan p

This event would count as a

such events will under-esti

wont be included in the ban

2.4 C

There are four risk comp

sovereign exposures, which

1) Exposure At Defau2) Loss Given Default3) Probability Of Defa4) Maturity

B

of default for purposes of the New Basel A

ave occurred with regard to a particular obligo

has taken place.

obligor is unlikely to pay its debt obligatio

iated with any obligation of the obligor, such

sed restructuring involving the forgiveness or

ore than 90 days on any credit obligation; or

ankruptcy or similar protection from creditors.

event of default, and likewise the LGD (p

d on the definition of default adopted. Man

may result in no loss incurred. For example, a

yment and subsequently make good on all of it

efault but would result in full recovery. A ban

ate recovery rates since the exposure and 10

s loss data. The banks model will consequen

omponents of Credit Risk

nents within the IRB approach to corporat

uild off the structure of banks rating systems.

t

ult

34

cord reflects

when one or

s (principal,

s charge-off,

ostponement

ercentage of

instances of

firm may go

s obligations.

that ignores

0% recovery

ly yield an

, bank, and


35/59


2.4.1

Exposure at Default (E The EAD for funded e

approach.

Our bank has started c31.03.2004 and having

and above.

Calculation Of EAD [ Unde

EAD for non bund ba

= Undrawn Credit Li

EAD for fund based t

= (Amount withdrawn

By the borrower

2.4.2 P

Probability of defaultgiven time-horizon i.

its obligation either o

such as an year.

PNB already has Risof default rates is bei

for Mid Corporate.

PD using historical d

B

xposure at default (EAD)

D): It is a level of exposure to a borrower at the ti

posure will be provided by National Supervisor un

llection of LGD & EAD data for accounts defaul

outstanding balance of Rs. 20 lac (since changed

r A-IRB Approach ]

sed transactions

ne * Credit Conversion Factor

ransactions

+ (Undrawn Credit Line * Credit Conversion

obability of Default (PD)

measures the likelihood that the borrower will

. What is the likelihood that the counterparty

ver the life of the obligation or over some spec

Rating System in place for the last 7 years a

ng tracked since last 7 years for Large Corpor

here are several statistical techniques availabl

fault rate and our bank is working on them.

35

e of default.

er foundation

ted on or after

to Rs. 50 lac)

actor)

efault over a

ill default on

ified horizon,

d the history

te & 5 years

e to estimate


36/59


Calculation of PD:

When calculating the prob

guarantee, the system assig

either of the IRB approaches.

The PD calculation is depen

determine which rating to a

estimation is based on histo

The key element in PD esti

earlier defaults will automa

compare PDs across differen

and the definition of default

not very complex. The PD i

of defaults within the given t

Basel II requires banks to es

achieved by generating ye

according to his rating at the

minimum of five years is re

the PD estimation from year

B

bility of default, for each combination of

s a PD to every exposure that is calculated

. This PD is alter used to calculate the capital re

ent on the relevant rating. The system uses the

ssign to the single transaction. One possible

rical data, where estimates are made per each

ation is the definition of default. Definitions

tically produce higher PDs. Also, in order t

rating systems or for data pooling, both the rat

have to be identical. The calculation of the hi

self does not include a loss component but onl

ime period.

imate 1-year PDs based on long-term averages

rly pseudo-obligor pools, where each oblig

beginning of the year, and taking the average o

uired in Basel II). In this way there will be les

to year.

36

xposure and

according to

uirement.

ransaction to

ethod of PD

rating grade.

which trigger

o be able to

ing processes

torical PD is

y the number

. This can be

or is placed

f the pools (a

s variation in


37/59


The following steps are com

Analyse the credit ris Map the counterparty Determine the facilit

of Default for facilit

derivative.

The weighting takesderivative.

Once the probabilityvaluation of the loan

element of credit ri

the Jarrow-Turnbull

2.4

Subject to certain abanks to use their ow

corporate, sovereign

Since it directly affeIRB, proper collater

minimize losses to ba

Masurement and Estimatio

Loss Given Default i

LGD

B

only used:

k aspects of the counterparty / portfolio

to an internal risk grade which has an associate

specific PD. This last step will give a weight

ies that are subject to a guarantee or protecte

account of the PD of the guarantor or seller

of default has been estimated, the related cred

or bond is the next step. A popular approach t

sk analysis is the "reduced form" modeling

odel..

.3 Loss Given Default (LGD)

ditional minimum requirements, supervisors

n internal estimates of LGD for various asset cl

nd bank exposures.

cts your provisioning as well as capital requi

l should be taken and actual valuation shoul

nk in case of default.

n of LGD

the credit loss incurred if an obligor of the ban

1 Recovery Rate

37

d PD: and

d Probability

by a credit

of the credit

it spread and

o this critical

approach of

may permit

asses such as

ement under

d be used to

k defaults.


38/59


39/59


percentage recovery). Thes

observed early and are a ref

the result of a market transac

These prices reflect the in

include recoveries on both d

restructuring costs and uncer

for example, they are observ

default event. This price is

recovery.

Workout LGD

LGD observed over the cou

observed market LGD. Atte

the distressed asset. Measuri

LGD. The cash flows should

rate to apply. For example,

assets such as equity or warr

principle the correct rate w

obligor has defaulted, the b

accordingly, possibly at th

coupon rate (set ex ante of d

Implied Market LGD

An entirely different approa

credit spreads on the (much l

currently traded. Although t

credit risk arena, they are us

derivatives and as such are o

B

e prices have some desirable properties si

lection of market sentiment at that time. Afte

tion and hence less subject to debate about pro

estors expected recovery, suitably discount

iscounted principal and missed interest payme

tainty of that restructuring process.9

In the Mo

ed in the market one month after the first occ

therefore the markets expected present valu

se of a workout is a bit more complicated tha

tion needs to be paid to the timing of the cas

ng this timing will impact downstream estimat

be discounted, but it is by no means obvious w

the debt restructuring could result in the issu

ants, or less risky ones such as notes, bonds or

uld be for an asset of similar risk. Importa

ank is an investor in a defaulted asset and sh

banks hurdle rate. Inappropriate candidate

fault, so too low) and the risk-free (or Treasury

h one could take to obtain an estimate of LG

arger universe of) non-defaulted risky (e.g. cor

ese new methods have not yet fully migrated i

ed in the trading room for fixed income produ

ften used as a check against more conventiona

39

ce they are

all, they are

er valuation.

ed, and thus

ts as well as

dys dataset,

rrence of the

of eventual

the directly

h flows from

s of realized

hich discount

ance of risky

ven cash. In

tly, once the

ould value it

include the

) rate.

is to look at

orate) bonds

to the banks

ts and credit

credit rating


40/59


models. Moreover, some

parameter.

The spread above risk-free

demanded by investors. Ho

well as liquidity premiums.

to separately identify these t

Madan and Zhang (2001) an

B

redit portfolio models require credit spreads

(i.e. Treasury) bonds is an indicator of the

ever, this spread reflects EL, and thus both PD

Only recently have models been developed wh

o parameters from bond spreads (see, for inst

Unal, Madan and Guntay (2003).

40

as an input

isk premium

and LGD, as

ch allow one

ance, Bakshi,


41/59


3.1

The main objective of th

calculation of Different ris

Though the Risk Managem

entirely albeit concise mann

(LGD) for retail sector.

At this point of time, there is

each bank is in the process o

Although, I was offered many

unique topic and will provide

very important in the banking i

3

The report seeks to present

bank. The risks can be broad

Credit Risk Market Risk Operational risk

Within each of these br

comprehensively as possibl

components viz Probability

Default (LGD) and Maturity

B

BJECTIVE OF THE STUDY

study is to understand the concept, sign

components and estimation of LGD

nt area is very wide and elaborated, the proj

er. The project involves calculation of Loss

no bank in India which has fully adopted the B

implementing them

ther topics by my project guide, I chose this one b

e a lot of knowledge about the Basel norms, whic

dustry.

.2 SCOPE OF STUDY

a comprehensive picture of the various risk i

ly classified into three categories:

ad groups, an attempt has been made

e, the various sub groups. Credit risk entai

of Default (PD), Exposure at Default (EAD)

(M).

41

ificance and

ect covers it

iven Default

sel II norms,

cause it was a

have become

herent in the

to cover as

ls four main

, Loss given


42/59


3.

Secondary Sources o

Discussions with theSince I have never be

guide and other s

understanding the v

become even more i

available on Maturi

Discussions with vaInteraction with the

the departments coor

different departments

Discussions with othAlthough I was the

trainees helped me in

B

3 Data Collection Method

f Information

project guide and staff members -

en a student of risk management, interaction wi

aff members in the same department he

rious technicalities pertaining to my topic.

mportant than reading, because not much li

y.

ious other department heads.-

GM`s of different departments helped me in a

dinated with themselves and how Maturity wi

for their own purpose.

er trainees-

only one working on this topic, but discussi

solving various issues of data collection and an

42

th the project

lped me in

Interactions

erature was

alyzing how

ll be used by

n with other

alysis.


43/59


3.4Li

The data availability

The study is not veryare not approachable.

The study is being do

Due to the ongoingmodel or method will

will be required.

B

itation of the study:

s proprietary and not readily shared for dissemi

exhaustive and many concepts could not be co

ne keeping in mind the policies of the Head Of

rocess of globalization and increasing compe

suffice over a long period of time and constant

43

nation.

vered as they

ice.

ition, no one

up gradation


44/59


45/59


The flexibility to determine

motivation for a bank to

approach. The appropriate

knows about LGD generall

supervisors must be able to e

4.2 M

LGD is usually defined as th

has occurred, loss given defa

The loss of principal

The carrying costs of non

Workout expenses (co

measuring LGD for an instru

1) Market LGD: obseloan soon after the a

2) Workout LGD: Thand/or Collections pr

3) Implied Market LGusing a theoretical as

For defaulted bonds and loa

so long as a trade has actuall

this approach. The actual pr

thus be easily translated i

percentage recovery). Thes

B

LGD values tailored to a banks portfolio wi

ant to move from the foundation to the a

degree of flexibility depends, of course, on

and about differentiated LGDs in particular;

valuate what a bank knows.

easurement and Estimation of L

e ratio of losses to exposure at default. Once a

ult includes three types of losses:

-performing loans, e.g. interest income foregon

llections, legal, etc.) There are broadly th

ment:

ved from market prices of defaulted bonds

tual defaultset of estimated cash flows resulting from

cess, properly discounted, and the estimated e

D: LGDs derived from risky (but not defaulted

et pricing model.

4.2.1 Market LGD

s which trade in the market, one may observe

y occurred. The rating agency recovery studies

ices are based on par = 100 (cents on the dol

to a recovery percentage (or LGD as 100

e prices have some desirable properties si

45

ll likely be a

vanced IRB

what a bank

consequently

D

default event

ree ways of

r marketable

the workout

posure

) bond prices

rices directly

are based on

lar) and can

minus the

ce they are


46/59


observed early and are a ref

the result of a market transac

These prices reflect the in

include recoveries on both d

restructuring costs and unce

for example, they are observ

default event. This price is

recovery.

LGD observed over the cou

observed market LGD. Atte

the distressed asset. Measuri

LGD. The cash flows should

rate to apply. For example,

assets such as equity or warrprinciple the correct rate w

obligor has defaulted, the b

accordingly, possibly at th

coupon rate (set ex ante of d

An entirely different approacredit spreads on the (much l

currently traded. Although t

credit risk arena, they are us

derivatives and as such are o

B

lection of market sentiment at that time. Afte

tion and hence less subject to debate about pro

estors expected recovery, suitably discount

iscounted principal and missed interest payme

rtainty of that restructuring process.In the Mo

ed in the market one month after the first occ

therefore the markets expected present valu

4.2.2 Workout LGD

se of a workout is a bit more complicated tha

tion needs to be paid to the timing of the cas

ng this timing will impact downstream estimat

be discounted, but it is by no means obvious w

the debt restructuring could result in the issu

ants, or less risky ones such as notes, bonds oruld be for an asset of similar risk. Importa

ank is an investor in a defaulted asset and sh

banks hurdle rate. Inappropriate candidate

fault, so too low) and the risk-free (or Treasury

4.2.3 Implied Market LGD

h one could take to obtain an estimate of LGarger universe of) non-defaulted risky (e.g. cor

ese new methods have not yet fully migrated i

ed in the trading room for fixed income produ

ften used as a check against more conventiona

46

all, they are

er valuation.

ed, and thus

ts as well as

dys dataset,

rrence of the

of eventual

the directly

h flows from

s of realized

hich discount

ance of risky

ven cash. Intly, once the

ould value it

include the

) rate.

is to look atorate) bonds

to the banks

ts and credit

credit rating


47/59


models. Moreover, some

parameter.

The spread above risk-free

demanded by investors. Ho

well as liquidity premiums.

to separately identify these t

Madan and Zhang (2001) an

(2003) find that on average,

the physical recovery rate

and Kishore (1996).

LGD is weighting that rep

occurs. It is derived within

security that applies to the tr

Calculation of LGD is furthe

Historical LGD: It is the lo

taking into account time valu

Economic LGD: It is the los

into account time value of m

Here we calculated workou

discounting there are issues

available, viz., funding rate,

rate, opportunity cost of fund

B

redit portfolio models require credit spreads

(i.e. Treasury) bonds is an indicator of the

ever, this spread reflects EL, and thus both PD

Only recently have models been developed wh

o parameters from bond spreads (see, for inst

Unal, Madan and Guntay (2003). Unal, Mada

recovery rates obtained in this way lie systema

s (their terminology) as implied by studies su

4.3Calculation of LGD:

esents the proportion of EAD that will be l

a Credit Risk Model by taking account of any

nsaction/facility and the degree of subordinatio

r classified into two types based on time value

ss incurred in the account in the event of de

e of money

s incurred in the account in the event of defaul

ney.

t LGD after discounting for time value of

regarding the rate to be used. There are va

distress loans rate, contract rate, current comp

s, cost of capital etc.

47

as an input

isk premium

and LGD, as

ch allow one

ance, Bakshi,

n and Guntay

tically below

h as Altman

st if default

collateral or

n of facility

f money.

aults without

s after taking

oney. While

rious options

rable market


48/59


4.4 Defa

Punjab National Bank consi

payment has been missed f

capital adequacy rules.

Translating this recommend

By the national banking sect

Rating worse than or equal t

As no data have been availab

Pnb decided to apply the dis

This approach asks for calc

related to each specific loan.

Therefore we decided to take

.

4.5 STEP

Step 1: Cleaning of Data

To start with, the first

collecting the data, initially t

the CBS system. The followi

1. The account should haveMarch 31, 2011.

2. The data set should inclu Sol ID Customer ID Name Account Number Account Open Date

B

ult and loan recovery measureme

er a bank borrower (an obligor) as being in d

or more than 90 days as is recommended by

tion into loan credit rating system, as enforced

r regulator5, it would mean that every obligor

C is shifted into the recovery process.

le on the market price of loans as at the default

ounted cash flow approach to calculate recover

lation of the present value of actually recover

the average interest rate.

IN CALCULATION OF LGD

job in hand was to collect data from CBS

he logic was explained and then the data was e

ng logic has been applied:

been classified as NPA and should be a closed

e the following data points:

48

nt

fault when a

the Basel II

ith a

date,

y rates.

d cash flows

system. For

xtracted from

account as at


49/59


NPA Date Closure Date Outstanding as at NPA D Limit Scheme Code Transaction Date Transaction Particulars Transaction Type

Transaction Amount

The last four particulars perta

format:

This file was in the *.TXT f

utilization.

B

ate

ined to a separate file. The data was received in

rmat and it needed to be converted and cleans

49

the following

d for further


50/59


Step 2: Data Cleaned

The data was received in the

After conversion, the proces

sequential format and remov

Step 3: Data Sorting

This was the most impo

the project was dependent. It

under valuate or over valuat

project and consumed maxi

understanding of Credit func

logical functions could be hi

Derecognized Interes Recorded Interest Excess Recovery Reversal of Bank Ch

B

above format and it needed to be converted int

of data cleaning began, which meant aligning

ng anomaly, if any.

tant part of the exercise and on its accuracy; t

s reason being that, any relevant transaction, if l

the final LGD. Hence, this was the most tedio

um time and effort for final outcome. It requ

ion, operating CBS, and NPA norms. Some of

hlighted as treatment of:

rges, Interest

50

o Excel files.

the data in a

he success of

eft out, could

us part of the

ired in depth

the important


51/59


After completion of task, the

For operational efficienc

platform, which mechanized

system would pick eligible fi

it was our job to pick the re

logic:

Y If the

Null If the transa

F If the

N If the

Our main objective here

recovery from the customer

bank charges and recorded

included in our calculation p

B

final outcome looked as below:

, we got a computer program me prepared (on

the above steps. On account of this, once the m

les and merge relevant transactions with them.

levant transactions. For that purpose, we used

transaction was to be used

tion was to be ignored

LGD was 100% prima facie

account was outside the purview of our samp

was to pick only those transactions which d

and ignore any other credit transaction. Sim

interest, post crystallization of NPA amount

rpose.

51

isual Basic)

acro was run,

fter merger,

he following

le

picted actual

ilarly, all the

, were to be


52/59


Step 4: Calculations

Net Present Value for each a

Next steps are relatively si

average LGD for the entire

Pooling was done and LGD

Step 5: Result Sheet

B

count was calculated.

mple and the only task remains is to calcul

ircle.

as modified to 0 or 100, upgraded accounts w

52

ate weighted

re added.


53/59


We have included in our sa

circle. The sample consists o

in default. needed for the cal

Consists of 7085 A/C (Appr

The dataset with all the requ

2005 to 2011 and were clos

process takes on

Average 2-3 years before the

Average recovery period is 2

All the data used in the sam

the risk management divisio

We observe that

the series of 7085 default cas

bad loans were defaulted fro

B

Pnb Project Report

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