Credit Risk Rating:

Credit Risk Ratings is a part of ongoing process for assessing and mitigating Credit Risk of the obligors,
rating involves the categorization of individual loans, based on credit analysis and local market conditions,
into a series of graduated categories of increasing risk. Risk ratings are most commonly applied to all loans.

A primary function of a risk rating model is to assist in the underwriting of new loans. Further, risk ratings
are useful for pricing loans and regulating the commercial portfolio exposure to maximum levels of risk.

CRR may vary as regards to comprehensiveness of the model based on subjective risk appetite of the
financial institutions, the more an FI wants to take risk the more comprehensive CRR is designed and vice
versa. A CRR can have risk categories ratings based on customer quality and are assigned numbers from
1 to 10 and may vary among FIs based on risk rating models.

Following is a sample risk rating model based on 6 risk categories:

Risk Parameters:

 Financial: Equity, Leverage, DSCR, ICR, Sales, Net Margins, Gross Margins, Current Ratios.
 Customer History & Track Record: Customer’s Repayment History, years in a particular
business, level of expertise in a business.
 Security: Level of Security I.e. Fixed Asset as security, CA as security, pledge or mortgage, lien on
shares etc.
 Cash flow Analysis: Cash generated from operations to repay financial obligation.
BASEL ACCORDS:

The Basel Accords are three series of banking regulations (Basel I, II, and III) set by the Basel Committee
on Bank Supervision (BCBS). The committee provides recommendations on banking regulations,
specifically, concerning capital risk, market risk, and operational risk. The accords ensure that financial
institutions have enough capital on account to absorb unexpected losses.

The BCBS describes its original aim as the enhancement of "financial stability by improving supervisory
knowhow and the quality of banking supervision worldwide.

BASEL I

Basel I is a set of international banking regulations put forth by the Basel Committee on Bank
Supervision (BCBS) that sets out the minimum capital requirements of financial institutions with the goal
of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount
(8%) of capital based on a percent of risk-weighted assets.

The Basel I classification system groups a bank's assets into five risk categories, classified as percentages:
0%, 10%, 20%, 50%, and 100%. A bank's assets are placed into a category based on the nature of the
debtor.

The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For
example, if a bank has risk-weighted assets of PKR 100 million, it is required to maintain capital of at least
PKR 8 million.

The tier 1 capital ratio is the ratio of a bank’s core tier 1 capital—that is, its equity capital and disclosed
reserves—to its total risk-weighted assets. Tier 1 capital is core capital and is comprised of a bank's
common stock, retained earnings, accumulated other comprehensive income (AOCI), noncumulative
perpetual preferred stock and any regulatory adjustments to those accounts.

Tier 2 capital is the secondary component of bank capital, in addition to Tier 1 capital, that makes up a
bank's required reserves. Tier 2 capital is designated as supplementary capital and is composed of items
such as revaluation reserves, undisclosed reserves, hybrid instruments, and subordinated term debt. In
the calculation of a bank's reserve requirements.

COOKE RATIO

The Cooke ratio is a way of calculating how much capital a bank has in relation to its risky assets. The 1988
accord requires internationally active banks in the G10 countries to hold capital for credit equal to, at
least, 8% of weighted assets. This is the Cooke ratio for credit risk. Weighted assets are the product of risk
weights (RW) by the value of the facility.
BASEL II

Basel II is a set of international banking regulations put forth by the Basel Committee on Bank Supervision,
which leveled the international regulation field with uniform rules and guidelines. Basel II expanded rules
for minimum capital requirements established under Basel I, the first international regulatory accord, and
provided framework for regulatory review, as well as set disclosure requirements for assessment of capital
adequacy of banks.

The main difference between Basel II and Basel I is that Basel II incorporates credit risk of assets held by
financial institutions to determine regulatory capital ratios. Basel II is a second international banking
regulatory accord that is based on three main pillars:

1. Minimal capital requirements,

2. Regulatory supervision
3. Market discipline

Minimum Capital Requirement

Basel II divides the eligible regulatory capital of a bank into three tiers. The higher the tier, the less
subordinated securities a bank is allowed to include in it. Each tier must be of a certain minimum
percentage of the total regulatory capital and is used as a numerator in the calculation of regulatory
capital ratios.

Regulatory supervision

Regulatory supervision is the second pillar of Basel II that provides the framework for national regulatory
bodies to deal with various types of risks, including systemic risk, liquidity risk, and legal risks.

Market discipline

The market discipline pillar provides various disclosure requirements for banks' risk exposures, risk
assessment processes, and capital adequacy, which are helpful for users of financial statements.
Maintenance of CAR as per regulatory bodies of countries.

BASEL III

Basel III is an international regulatory accord that introduced a set of reforms designed to improve the
regulation, supervision and risk management within the banking sector. The Basel Committee on Banking
Supervision published the first version of Basel III in late 2009, giving banks approximately three years to
satisfy all requirements. Largely in response to the credit crisis, banks are required to maintain
proper leverage ratios and meet certain minimum capital requirements.

Basel III is part of the continuous effort to enhance the banking regulatory framework. It builds on
the Basel I and Basel II documents, and seeks to improve the banking sector's ability to deal with financial
stress, improve risk management, and strengthen the banks' transparency. A focus of Basel III is to foster
greater resilience at the individual bank level in order to reduce the risk of system-wide shocks.
Capital Requirements as per SBP in Pakistan
All the existing locally incorporated banks are required to maintain MCR of Rs 10 billion. Branches of
foreign banks are required to maintain assigned capital (net of losses) of Rs. 3 billion (if operating with
5 branches or less), Rs. 6 billion (if operating with 6 - 50 branches) and Rs. 10 billion (if operating with
more than 50 branches). DFIs are required to maintain an MCR of Rs. 6 billion.

Similarly, for MFBs, the MCR has been set at Rs. 1,000 million, Rs. 500 million, Rs 400 million and Rs
300 million for operating at national level, provincial level, regional and district level respectively.

CAR requirements

CAR is a risk sensitive measure of assessing capital adequacy of Financial Institutions and is computed
as the ratio of Total Eligible Capital (TEC) to Total Risk Weighted Assets (TRWAs) which is currently set
at 10.25% and will be gradually increased to 12.5% by December 31, 2019 as per Basel III instructions
with the inclusion of capital conservation buffer for banks/ DFIs. For MFBs, the CAR requirement is 15%.