P.K.Mitra General Manager Punjab National Bank Head Office, New Delhi

P.K.
MITRA
General Manager
Punjab National Bank
Head Office, New Delhi
Outline of the Presentation
Introduction to Risk Management and Overview

of Basel II
Approaches to measure Credit Risk
Credit Risk Management in Punjab National
Bank
Benefits of moving to advanced approaches
punjab national bank

..the name you can BANK upon
Need for Risk Management
Globalization of Indian Economy

Integration of global markets
Competition from Foreign and Private Sector Banks
Need to shift from demand driven to supply driven limits

Bank should determine appetite for borrower based on his
risk assessment
Risk Based Lending
Improve and monitor portfolio quality

Basel Committee on Banking SupervisionBCBS

A committee of central bankers/ bank supervisors from
major industrialized countries like Belgium, Canada,

France, Germany, Italy, Japan, Luxembourg, the
Netherlands, Spain, Sweden, Switzerland, United
Kingdom and United States.
BCBS has no formal supranational authority nor legal
force
However IMF , World Bank, International Rating
Agencies, International Financial Institutions, etc use it as
a benchmark for assessment of the banks/ banking system
Basel Accord I (1988)

Portfolio Approach It focused primarily on credit risk and assets of
the banks were categorized into risk buckets with risk weights ranging
from 0% to 150%.
Particulars
Cash in hand, Balance with banks, Investment in
government securities etc
Money at call and short notices, Investment under
government guaranteed securities, Advances to
staff members etc
Claim guaranteed by DICGC/ECGE
Advance to public against Housing Finance
Advances to corporates, claim on PSUs, SME
and Retail exposure etc.
Advances under consumer credit
Advances covered under Commercial real estate
Risk We ight
0%
20%
50%
75%
100%
125%
150%
Minimum Capital Requirement 8% of risk weighted assets only for
credit risk (9% by RBI)

Based on 1988 accord, RBI initiated various actions for the banks like
classification of assets, provision norms, classification of asset class
etc.
Need for a new frame-work

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

Requirement of more flexible approaches as opposed
to one size fits all Approach
Requirement of Risk sensitivity as opposed to a
broad- brush Approach
In last 8-10 years banking sector worldwide has seen
catastrophic losses which led to failure of some
established banks like Bearing bank and Continental
Illinois.

Banking Risks
Credit Risk
Market Risk
Liquidity
Interest rate
Foreign exchange
Commodities and Equity
Operational Risk

Credit Risk
Credit risk is defined as the possibility of losses

associated with diminution in the credit quality of
borrowers or counter-parties. In a banks portfolio,
losses stem from outright default due to inability or
unwillingness of a customer or counter-party to meet
commitments in relation to lending, trading, settlement
and other financial transactions.
Alternatively, losses result from reduction in portfolio
value arising from actual or perceived deterioration in
credit quality.
Market risk
Market Risk is the risk to the banks earnings and

capital due to changes in the market level of interest
rates or prices of securities, foreign exchange and
equities, as well as the volatilities of those changes.
The Bank for International Settlements (BIS) defines
market risk as the risk that the value of on or off
balance sheet positions will be adversely affected by
movements in equity market and interest rate market,
currency exchange rates and commodity prices.
Market risk
Liquidity risk: Liquidity risk occurs when Bank is not

in a position to pay amounts due to its
customers/counterparties or these are met by
borrowing from the market at high cost.
Interest Rate Risk: The risk that changes in interest
rates will adversely impact the revenues and balance
sheet.
Forex risk -Risk that a bank may suffer losses as a
result of adverse exchange rate movements during a
period in which it has an open position.
Equity/Commodity risk Risk that a bank may
suffer losses as a result of adverse movements in
equity/commodity prices during a period in which it
has an open position.punjab national bank
10
Operational Risk
Basel Committee on Banking Supervision defines the operational risk
as
Risk
of direct or indirect loss resulting from inadequate

or failed internal control processes, people, systems or
from external events
Such breakdowns can lead to financial losses through

Error
Fraud
Failure to perform in a timely manner
Cause the interest of the bank to be compromised like
exceeding authority, conducting business in an unethical
or risky manner
11
Examples of Operational Risk

Cause
Definition
Internal
Processes
Losses from failed transactions, client

settlements and every day business processes.
accounts,
People
Losses caused by an employee or involving employees

(intentional or unintentional), or losses caused through
the relationship or contact that a firm has with its clients,
shareholders, third parties, or regulators.
Systems
Losses arising from disruption of business or system

failure due to unavailability of infrastructure or IT.
External
Events
Losses from the actions of 3rd parties including external

fraud, or damage to property or assets, or from change in
regulations that would alter the firms ability to continue
doing business.
12
Approaches to measure different risk

under new accord
Approaches to measure Credit risk

Standardized approach
Internal ratings based (IRB) approach
Foundation
Advanced
Approaches to measure Operational risk
Basic Indicator Approach
The Standardised Approach
Advanced Measurement Approach
Approaches to measure Market risk
Standardised method
Internal Model
13

14
Approaches to Credit Risk

Management under Basel II
INCREASED
SOPHISTICATION
Banks use internal

estimations of PD,
loss given
default
(LGD) and exposure at
default
(EAD)
to
calculate risk weights
for exposure classes
Banks use internal estimations
of probability of default (PD) to
calculate risk weights for
exposure classes. Other risk
components are standardized.
ADVANCED
INTERNAL RATING
BASED
APPROACH
FOUNDATION
INTERNAL
RATING BASED
APPROACH
STANDARDISE Risk weights are assigned in slabs

according to the asset class or are based
D
on assessment by external credit
APPROACH assessment institutions
REDUCED CAPITAL
REQUIREMENT
15
Credit Risk: Standardised Approach
Risk weights are assigned in slabs of 0%, 20%, 50%,

100% & 150% on the basis of rating assigned by
ECAIs. For example -- Claims on Sovereigns (or
Central Bank) 0% to 150% risk weight on the basis
of country risk scores and at national discretion, a
lower risk weight may be applied.
Claims on Corporates will be risk weighted in the
range of 20-150% and unrated Corporates will be
assigned 100% risk weight.

16
Credit Risk: Standardised Approach

Ratings
RW for
foreign
Sovereign
AAA to
AA
0%
20%
BBB
50%
BB to B
100%
Below B
150%
Unrated
100%
RW for banks
RW for
Corporates
Rupee
Claim
Foreign
Currency
Claim
Scheduled
Banks
20%
20% AAA
50% AA
50%
100%
50%
150%
100%
150%
150%
150%
50%
100%
20%
Others
100%
RW as per RBI document.

17
Off Balance sheet items under

Standardised approach
The credit risk exposure attached to off-Balance Sheet items has to be first
calculated by multiplying the face value of each of the off-Balance Sheet items
by credit conversion factor (CCF). This will then have to be again multiplied by
the risk weights attributable to the relevant counter-party as specified in previous
slide.
Sr.
No.
1
Instruments
Direct credit substitutes e.g. general guarantees of

indebtedness (including standby L/Cs serving as
financial guarantees for loans and securities) and
acceptances
(including
endorsements
with
the
character of acceptance).
Certain transaction-related contingent items (e.g.
performance bonds, bid bonds, warranties and
standby L/Cs related to particular transactions).
Short-term self-liquidating trade-related contingencies
(such as documentary credits collateralised by the
underlying shipments) for both issuing bank and
confirming bank.
Credit
Conversion
Factor (% )
100
50
20
*** Above list is not exhaustive.

18
Credit Risk Mitigants under

Standardised Approach
Eligible collaterals
Cash or deposit with bank, Gold
Securities issued by Central and State Governments
Indira Vikas Patra, Kisan Vikas Patra and National Savings
Life insurance policies ( up to surrender value)
Debt securities rated by a recognised Credit Rating Agency having at least BB
rating when issued by public sector entities and at least A rating when issued
by other entities.
Debt securities not rated by a recognised Credit Rating Agency where these are
issued by a bank, listed on a recognised exchange and classified as senior debt
Equities included in main index.
Mutual funds having publicly quoted daily prices.
Irrevocable, unconditional guarantees issued by entities with a lower risk weight
than the counterparty.
19
Four Key Risk Elements in IRB Approach

Probability of Default
(PD)
It measures the likelihood
that the borrower will default
over a given time-horizon.
Loss Given Default

(LGD)
It measures the proportion of
the exposure that will be lost
if a default occurs.
Exposure at Default
(EAD)
It measures the amount of the
facility that is likely to be drawn
if a default occurs .
Maturity
(M)
It measures the remaining
economic maturity of the
exposure .

20
Probability of Default (PD)
Probability of default measures the likelihood that the

borrower will default over a given time-horizon i.e.
What is the likelihood that the counterparty will
default on its obligation either over the life of the
obligation or over some specified horizon, such as an
year.
For estimation of PD, PNB already has Risk Rating
System in place for the last 5 years and the history of
default rates is being tracked since then.

21
Loss Given Default (LGD)

Loss Given Default is the credit loss incurred if an obligor of
the bank defaults.
LGD = 1 Recovery Rate
where, Recovery = Present Value of { Cash flows received
from borrower after the date of default - Costs incurred by
the bank on recovery }
Recovery rate = Recovery (as calculated above)/ Exposure on
the date of default

22
Exposure at Default (EAD)
EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK

23
Maturity (M)
It measures the remaining economic maturity of the exposure.

Determines framework for comparing different exposures.
Principal & outstanding balance

Opening Date of Loan
Contractual date of Maturity of Loan
Contractual and Discount Rate of Interest
Freq. of int. payment per annum
Tenor/Maturity (Years)
Time Period
Cash
Present Value of
in years
flow
Cash Flow
(A)
(B)
(c)
1
900
825.69
2
900
757.51
3
10900
8416.80
Total ------------------------>
10000.00
27591.11
Economic Maturity =
10000.00
10000
01/01/2003
31/12/2006
9.00%
1
3
(A) x (c)
825.69
1515.02
25250.40
27591.11
= 2.76
Internal Rating Based Approach
Under the IRB approach, a bank estimates each borrowers

creditworthiness and the results are translated into estimates of a
potential future loss amount, which forms the basis of minimum
capital requirement.
Under this approach, the treatment of each exposure class (i.e.

corporate, bank, sovereign, retail & equity exposure) is based on
three main elements namely: Risk components
Risk weight functions
Minimum requirements
25
Internal Rating Based Approach
The underlying concepts and approaches prescribed in IRB have

been developed based on credit risk measurement techniques
being used by sophisticated banks for ascertaining their capital
requirements.
The Capital required is derived from an estimate of potential
losses for a credit portfolio over one year time horizon with
99.9% confidence level.
99.9% confidence level implies that there is only one chance in
1000 that the losses will be larger than the regulatory capital.
The credit risk on an asset, reflected in UL & EL, increases as PD,
LGD, EAD or M increases.
26
Foundation IRB Vs Advanced IRB

Approach
Foundation IRB Approach
Advanced IRB Approach
Values for Loss given default (LGD) and

Values for Loss given default (LGD)
exposure at default (EAD) are provided by and exposure at default (EAD) are
the regulatory authority.
determined by each bank through
internal modeling with a data of 5-7
years.
Assessment of values of credit mitigants is Banks may assess the value of its credit
done by the regulatory authority.
mitigants.
For retail exposure, there is no foundation
IRB (only advanced IRB where besides
PD, the bank concerned will have to
estimate LGD & EAD.)
Advanced IRB is applicable to retail

exposure also.

27
Expected Loss (EL)
Expected Loss is the banks cost of doing business. Expected

loss has to be provided for.
The Expected Loss (in currency amounts)
EL = PD * EAD * LGD
If expressed as a percentage figure of the EAD
EL = PD * LGD.
The bank should also proactively incorporate an expected loss
rate in the estimation
of the total spread to be charged on
the loan.
Expected loss is not a measure of risk as it is anticipated.

28
Unexpected Loss (UL)
Regardless of how prudent a bank is in managing its

day-to-day business activities, there are market
conditions that can cause uncertainty in the amount
of loss in portfolio value.
This uncertainty, or more appropriately the volatility
of loss, is the unexpected loss. Unexpected losses are
triggered by the occurrence of higher default rates as
a result of unexpected credit migrations.

29
EL Vs UL
Expected V/s Unexpected Losses
8.00%
7.53%
7.00%
Loan losses
6.00%
Unexpected loss
5.00%
4.58%
4.00%
3.93%
3.52%
3.00%
2.00%
1.41%
1.21%
1.00%
3.32%
2.21%
1.96%
Expected loss
0.44%
0.00%
1
2.30%
0.42%
0.27%
4
10
11
12
0.56%
13
14
Time (Year)

30
Capital Requirement under IRB

Borrower
Transaction
Internal Rating
Probability of
Default (PD)
Capital
Requirement
Exposure at
Default
Collateral
Maturity
Loss Given
Default (LGD)
Maturity
(M)
Risk
Weight
9%
[LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G

(0.999)]
- PD * LGD] * (1 - 1.5 x b(PD))^ -1 (1 + (M - 2.5) *
b (PD)
31
Risk Weight function

Standard normal
distribution (N)
applied to
threshold and
conservative value
of systematic factor
Inverse of the
standard normal
distribution (G)
applied to PD to
derive default
threshold
Inverse of the
standard normal
distribution (G)
applied to
confidence level i.e.
99.9% to derive
conservative value
of systematic factor
= [LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 *

G (0.999)]
- PD * LGD] * (1 - 1.5 x b(PD))^ -1 (1 + (M - 2.5)
* b (PD)
Expected
Asset
Maturity Smoothened
Loss (E.L.) Correlation
(regression)
Maturity
adjustment
32
Minimum Criteria for IRB Adv

Approach
To be eligible for IRB Approach a bank must demonstrate to its
supervisor that it meets certain minimum requirements at the
outset and on an on going basis. These include:
A robust rating system comprising all of the methods,
processes, controls and data collection and IT systems that
support the assessment of credit risk, the assignment of
internal risk ratings, and the quantification of default and loss
estimates.
Risk rating system operations which includes Coverage of
ratings, Integrity of rating process, overrides based on expert
judgement, Data maintenance and use of stress tests in
assessment of capital adequacy.
33
Minimum Criteria for IRB Adv

Approach
Corporate Governance and overseeing of risk management by

Board of Directors/Top Management
Use of Internal ratings and default and loss estimates in credit
approval, risk management processes, corporate governance
functions etc apart from using them in capital calculations
Risk quantification covering definition of default,
requirements specific to estimations of PD, LGD and EAD
Robust internal control systems for risk management and
validation of the models used, internal estimates of risk inputs
viz. PD, LGD and EAD etc.

34

35
Set Up for Management of Credit Risk

SYSTEM
&
MODELS
Migration Implementation Periodical Conducting

Analysis of Preventive portfolio
various
implementing and Default Monitoring
review
analysis
credit risk
System
Rate
models
Analysis.
(PMS)
INDUSTRY
ANALYSIS
GROUP
Preparation of
Liaison with external Monitoring industry
scenarios of various
agencies for
wise profile of the
industries
updating the industry
bank
profiles.
INDUSTRY
DESK
Developing
and
Approval of rating of borrowers falling under

HO powers

36

37
Implementing Standardised Approach
RBI has advised banks to start parallel run of

Standardized Approach of Credit Risk w.e.f.
01/04/2006
This require system for categorisation of assets as per
Basel II and for collating data of credit risk mitigation
techniques i.e. details of primary/collateral securities.
System should also be able to consolidate Risk
Weighted Assets and arrive at the required capital charge
for credit risk..
Bank has implemented the system and parallel run as
per RBI guidelines has since been started.
38
Implementing Foundation IRB approach
All eligible credit exposures beyond a threshold limit

of above Rs 20 lacs are risk rated through internal credit
risk rating models.
Default Rates for last five years generated. The default
rates are satisfactory and comparable with international
standards.
Migration of ratings analysed since last four years.
In addition to Default rating, Facility-rating is being
implemented.
39
Implementing Advanced IRB approach
Data requirements as well as features of application

tools for Risk Management finalized.
A data warehouse is being established which will have
application tools also.
The gaps in the existing systems for adoption of Basel
II are being identified.
Goal is to adopt IRB advanced approach by March
2010, subject to RBI approval.

40
Annual Average Default rates as at 31.03.2006

Rating
Large
Mid
Corporate (5 Corporate
years average
(3 year
DR) %
average DR)
%
Combined***
Three year
Average DR(%)
for 2004-06
Small Loan A/Cs

Two Yr. Average
DR(%) for 200506
AAA
0.00
0.00
0.00
0.00
AA
0.00
0.00
0.00
0.00
0.18
0.78
0.40
0.59
BB
0.64
0.88
0.77
0.90
0.91
4.03
2.35
1.96
6.44
8.16
6.40
3.60
14.96
12.82
13.21
11.93
1.91
2.06
1.72
1.25
Total
***Large & Mid Corporate

41
Validation of rating models

GINI Coefficient
GINI- COEFFICIENT
% CUMULATIVE DEFAULT
POPULATION
Ideal
100
90
80
70
60
50
40
30
20
10
0
AAA rating
Actual
B rating
C rating
BB rating
A rating
D rating
0
10
GINI Coefficient
=
0.63
AA rating
Random
20
30
40
50
60
70
80
90
100
% CUMULATIVE POPULATION

42
Probability of default of PNB Vs

Crisil
32.00%
28.00%
Probability of Default
24.00%
CRISI
L
20.00%
16.00%
Exponenti
al
fiiting
12.00%
8.00%
PNB
4.00%
0.00%
AAA
AA
BB
BB
Actual
0.03%
0.09%
0.40%
0.77%
2.35%
6.40%
13.21%
Exponential
0.04%
0.10%
0.28%
0.77%
2.14%
5.94%
16.47%
CRISIL
0.00%
0.00%
1.01%
3.47%
15.85%
30.30%
28.57%
Rating Grades
43
Comparative average annual default rate

(Up to 31.03.06)
PNB
AAA 0.00
AA 0.00
A 0.40
BB 0.77
B 2.35
C 6.40
D 13.21
S&P
AAA 0.00
AA 0.00
A 0.06
BBB 0.18
BB 1.06
B 5.20
C 19.79
Moody
Aaa 0.00
Aa 0.02
A 0.00
Baa 0.15
Ba 1.29
B 6.81
C 24.06
CRISIL
AAA 0.00
AA 0.00
A 1.01
BBB 3.47
BB 15.85
B 30.30
C 28.57

44
Impact of Basel II on Capital Requirement

Existing
Particulars
Total Capital (A)
12831.85
12831.85
(@ 9%)
8001.22
1075.90
0.00
9077.12
(@ 9%)
7813.69
1075.90
855.90
9745.49
12.72
11.85
88902.46
11954.44
0.00
100856.90
86818.76
11954.44
9510.03
108283.23
Min. Capital Requirement

Credit Risk
Market Risk
Operational Risk
Total Capital Required (B)
CRAR = [(A)/(B)]*0.09
Risk Weighted Assets
Credit Risk
Market Risk
Operational
Total Risk Weighted Assets
Standardised
Approach Basel II

45
Road Map for Basel II Implementation

Approach
Credit Risk
Standardized
IRB Foundation
IRB Advanced
Market Risk
Standardized
Internal
Risk
Management
Model Method
RBIs Indication
31.03.08
Not Indicated
Not Indicated
31.03.06
Banks Preparedness
Parallel run started w.e.f 1.4.06
March 2009 (Subject to RBI approval)
Already implemented
Not Indicated
31.03.08
Not Indicated
Not Indicated
Simple approach can be implemented

immediately (Subject to RBI approval)
Operational Risk
Basic Indicator
Standardized
Advanced

46
Benefits of moving to Advanced approaches
Relief in Capital Charge

Risk based Pricing focus on identified business
areas. Competitive pricing in niche areas.
Image/Prestige
International recognition/benefits in dealing with
Foreign banks
Risk Control

47
Areas requiring attention of Auditors
Banks must correctly classify the assets into Sovereign, Banks,

Corporate, Retail and Equity asset classes.
Banks must have used data of at least 5 to 7 years in various models
for estimation of various risk components (viz., PD, LGD, EAD and
M).
Banks must have robust systems in place to evaluate the accuracy and
consistency with regard to the system, processing and the estimation
of PDs.
Banks must use proper credit risk mitigants in capital calculation.
Banks must have a credible track record in the use of internal ratings
at least for the last 3 years. Banks must disclose in greater detail the
rating process, risk factors, validation etc. of the rating system.
Internal and External audit must review annually, the banks rating
system including the quantification of internal ratings.

48
Areas requiring attention of Auditors
Banks must use appropriate risk weights against the asset classes.
Banks must update the credit risk rating at least on annual basis.
Banks must have adequately qualified and trained staff for rating
process.
Banks must compute the default rates on regular basis and these
should be validate at regular intervals.
Banks must have in place sound stress testing process for the
assessment of capital adequacy.
Internal rating must be explicitly linked with the banks internal
assessment of capital adequacy in line with requirements of Pillar
2.

49
Thank you and Happy New Year

50

P.K.Mitra General Manager Punjab National Bank Head Office, New Delhi

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P.K.

Outline of the Presentation

Introduction to Risk Management and Overview

punjab national bank

Need for Risk Management

Globalization of Indian Economy

Need to shift from demand driven to supply driven limits

Improve and monitor portfolio quality

punjab national bank

Basel Committee on Banking SupervisionBCBS

major industrialized countries like Belgium, Canada,

Basel Accord I (1988)

Minimum Capital Requirement 8% of risk weighted assets only for

credit risk (9% by RBI)

Need for a new frame-work

etc. and growing complexity of transactions

punjab national bank

punjab national bank

Credit risk is defined as the possibility of losses

Market Risk is the risk to the banks earnings and

Liquidity risk: Liquidity risk occurs when Bank is not

of direct or indirect loss resulting from inadequate

Such breakdowns can lead to financial losses through

Examples of Operational Risk

Losses from failed transactions, client

Losses caused by an employee or involving employees

Losses arising from disruption of business or system

Losses from the actions of 3rd parties including external

Approaches to measure different risk

Approaches to measure Credit risk

punjab national bank

Approaches to Credit Risk

Banks use internal

STANDARDISE Risk weights are assigned in slabs

Credit Risk: Standardised Approach

Risk weights are assigned in slabs of 0%, 20%, 50%,

punjab national bank

Credit Risk: Standardised Approach

RW as per RBI document.

Off Balance sheet items under

Direct credit substitutes e.g. general guarantees of

*** Above list is not exhaustive.

punjab national bank

Credit Risk Mitigants under

Four Key Risk Elements in IRB Approach

Loss Given Default

punjab national bank

Probability of Default (PD)

Probability of default measures the likelihood that the

punjab national bank

Loss Given Default (LGD)

punjab national bank

Exposure at Default (EAD)

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

punjab national bank

It measures the remaining economic maturity of the exposure.

Principal & outstanding balance

Internal Rating Based Approach

Under the IRB approach, a bank estimates each borrowers

Under this approach, the treatment of each exposure class (i.e.

Internal Rating Based Approach

The underlying concepts and approaches prescribed in IRB have

Foundation IRB Vs Advanced IRB