Internal Credit Rating Practices of Indian Banks

Author(s): M. Jayadev
Source: Economic and Political Weekly, Vol. 41, No. 11, Money, Banking and Finance (Mar. 18-
24, 2006), pp. 1069-1078
Published by: Economic and Political Weekly
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 Internal Credit Rating Practices
of Indian Banks
The overarching goal of the second Basel accord is aligning the capital requirementsof-banks
with risk sensitivity. The accord einphasises the quantificationof capital requirementson the
basis of internal rating models. The internal credit rating models of banks are expected
to produce the probability of default and loss given default to estimate the capital requirementsof
credit risk. Thispaper presents an analysis of the currentstatus of internal credit ratingpractices
of Indian banks. The survey reveals that the componentsof internal rating systems, their
architecture,and operation differ substantiallyacross banks. The range of grades and
risks associated with each grade vary across banks analysed. This implies that lending decisions
may vary across banks. There are differences among the rating systems of various banks. This
paper presents a set of actions to improve the quality of internal rating models of Indian banks.
M JAYADEV

he initiativesfor global best practicesand bankingstan- otheremergingmarkets)suffersfrom several limitationssuch

dardsbeganwiththe constitutionof the BaselCommittee
in 1975.ThefirstBaselAccordof 1988(BaselI)emphasised
the importanceof minimumcapitaladequacyto addresscredit
riskby devisingthe standardisedapproach.Capitaladequacyis
definedas the ratio of capitalfunds and risk weightedassets.
Here the Basel Committeeadopteda portfolio approachfor
decidingrisk weightedassets. Each asset in the balancesheet
carriesa risk weight and sum total of these productsare called
as riskweightedassets.InIndia,theReserveBankof India(RBI)
has suggestedrisk weights of 0, 20, 50, 75, 100 and 125 per-
centagesfor varioustypes of assets. The rule is that a bank's
capitalshouldnot be less than 8 per cent (in Indiait is 9 per
cent)of its riskweightedassets.However,Basel I has a number
of limitations,particularlyits insensitivenessto theriskof specific
assets.It assumesa "one size fits all" approachby prescribing
a standardrisk capitalrequirementglobally.
Introduction
The New Basel CapitalAccord (Basel II) addressesthese
deficienciesandfocusesmoreon riskmanagementby suggesting
aninternalratingframeworkfor assessmentof capitaladequacy.
Basel IIemphasisesthe allocationof riskcapitalfor all the three
risks-creditrisk,marketrisk,and operationalrisksandhas also
suggesteda frameworkon indirectregulationby introducing
marketdiscipline.AlthoughBasel II is addressingthe capital
requirements of all these threerisks,the issues associatedwith
theestimationof riskcapitalforcreditriskarecomplexin nature
and need to be addressedcautiously. Basel II suggests two
frameworks:the standardisedapproachand the internalratings
based(IRB)approachfor quantificationof riskcapitalforcredit
risk. Underthe standardisedapproach,differentrisk weights
varyingfrom0 percentto 150percent aresuggestedfor various
categoriesof assets,whichareintimatelyrelatedwiththeexternal
ratingsof variouscategoriesof borrowers.
The applicabilityof externalratingsfor estimationof capital
requirements especiallyin the Indianmarket(also applicableto
as, shopping attitudeof borrowersfor better rating and the
presenceof a largequantumof externallyunratedborrowersin
banks'portfolios.Therefore,banksareexpectedto move to the
internalratings based approachfor the estimationof capital
requirements. Moreover,the thrustof Basel II is thatbankshave
to maketheircapitalrequirements morerisksensitivebyadopting
the IRB approach.The internalratingsystem of a.bankhas to
producetwo essentialcomponents,probabilityof default(PD)
and loss given default(LGD);a productof these two will give
expectedloss. In this context,the objectiveof this paperis to
analysethecurrentinternalcreditratingpracticesof Indianbanks
andto suggestmeasuresto improvethe qualityof theirinternal
creditratingmodels. which ultimatelyhelps in improvingthe
qualityof loanportfoliosof commercialbanks.SectionII of this
paperfocuseson architecture, design,andcomponentsof internal
ratingmodels;measuresto improvethequalityof internalrating
models are presentedin Section III.
This paperis basedon informationgatheredthrougha survey
questionnaire from19banksandcreditratingdocuments of six banks.
Thusoverall25 banksarecoveredin thisstudy.Theloanportfolios
of these banks,comprise75 per cent of the total loan portfolio
of scheduledcommercialbanks(excludingregionalruralbanks,
cooperativebanksand foreignbanks)of India (Table 1). The
questionnaire is focusedonvariousdimensionsof the architecture
anddesignof creditratingsystemsof banks.Ihavealso interviewed
a few senior bankersto know more about the credit decision
processesof variousbanksin ratingdifferenttypesof customers.
As the data was collected from the banksassumingconfiden-
tiality,theidentitiesof thebanksarenotdisclosedin theanalysis.
II
Surveyof Internal RatingPractices
Credit
What Is a Rating System?
As per Basel (2000):
An Internalratingrefersto a summaryindicatorof riskinherent
in an individualcredit.Ratingstypicallyembodyan assessment

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 of the risk of loss due to failure by given borrowerto pay as focused on evaluatingtheborrower'scapacityto repaythe working
promised, based on considerationof relevant counter party and capital loans. The models applied for termloans are modifications
facility characteristics.A rating system includes the conceptual of the rating models applied for working capital limits.
methodology,managementprocesses, andsystems thatplay a role
in the assignmentof a rating.
Is the BorrowerRatedor the LoanFacility?
The internalratingmodel of a bank tries to capture all the risks
faced by an entity andattemptsto quantify such risks in a scientific A rating structure can have three dimensions. Rating can be
manner.The model calibrates and communicates the risk asso- on the basis of the characteristics of the borrower or on the basis
ciated with a borrower or a facility. Ideally, rating systems in of specific details of the transaction, or alternatively rating can
a bankcomprise of rating methodology, rating processes, control, be a summary indication of risk that comprises both borrower
datacollection, IT systems, assignment of rating,ratingtransition and transaction characteristics. The quality of credit decisions
matrix, probability of default, and loss in the event of default. of a bank reflect in the type of rating dimension it has adopted.
As per the Basel norms [BCBS 2004], an internal credit rating If banks choose to rate both borrower-wise and transaction-wise
system should produce mainly two important variables, PD and ratingdimensions, a single exposure receives two types of ratings
LGD or recovery rates. Out of the 19 banks surveyed it-is found under these two dimensions.
that only nine banks have internal rating systems that give the The overwhelming majority of banks surveyed have explicitly
output of the transition matrix, six banks are able to generate adopted rating of borrowers and only four banks have ratings
probability of default, and four banks are getting the data on on both the dimensions. In the two-dimensional rating system
recovery rates. In all the other banks, the ratingsystem comprises thatincludes a borrowerand transactiongrade, transactiongrades
of only rating methodology and assignment of rating (Table 2). for different loans to the same borrower could differ. The source
Bank rating models are essentially focused on the rating of of these differences is primarily the collateral attached to the
borrowerstojudge theirability to pay loan interestandinstalments. transaction.For example, a borrower may take a working capital
Theoretically, internal credit rating models are an effective loan which is normally secured against the inventory and book
instrument in the hands of banks for loan origination, pricing
and monitoring. Ratings facilitate comparison among the large Table 1: Composition of Loan Portfolios of Banks
numberof borrowers being financed by the banks. Banks' credit Participatingin the Survey
(in per cent)
rating systems are significantly.different from those of credit
Name of Advances Proportion Proportion ProportionProportion
rating agencies in architecture and design, as well as in the uses Banks (in of Bills, of Term of Un- of Loans
to which credit ratings are put. Rs crore) Cash Credit Loans secured to Com-
and Over- Loans mercial
draftLoans Sector
Who Is Rated?
AllahabadBank 12544 53 47 11 43
Fundamentally credit rating should be applicable to all bor- AndhraBank 11513 59 41 12 49
rowers. Large banks are found to apply rating models only to Bankof Baroda 35348 62 38 13 40
Bankof India 42633 64 36 22 36
corporate accounts while small banks are rating all types of CanaraBank 40472 67 33 14 49
borrowers seeking a minimum credit limit. On an average, most CentralBank
banks are assigning credit ratings to the borrowers whose loan of India 23159 58 42 10 38
Development
requirements are more than Rs 2 lakh. Apart from corporate CreditBank 2488 47 53 10 65
customers the next important category is borrowers from small FederalBank 6218 61- 39 8 65
and medium level enterprises (SMEs) and the agriculturesector. GlobalTrustBank 3276 46 54 13 73
HDFCBank 11755 44 56 14 80
Large and medium sized banks are rating borrowers whose loan ICICIBank 53279 7 93 3 79
requirementsexceed Rs 20 lakh. These discrepancies may help IndianOverseas
borrowers to take advantage of rating arbitrage. For instance, a Bank 17447 65 35 9 40
borrower may be unrated (rating is not applicable) as per bank KarnatakaBank 3900 71 29 8 58
X-'s norms but the same borrower may be considered a rated OBC 15677 55 45 11 52
PunjabNational
borrower as per bank Y's norms. Some banks have different Bank 40228 59 41 7 42
models for different categories of borrowers. These categories State Bank
are formed mostly on the basis of loan limit requirement, and of India 137758- 59 41 14 46
size criteria (such as corporates and SMEs). State Bank
of Indore 5183 62 38 6 47
Seventeen of the surveyed banks are applying rating models State Bank
to corporate borrowers; out of them five are applying models of Travancore 9171 66 34 13 52
to borrowers whose loan requirements meet the minimum level Syndicate Bank 16305 56 44 23 37
The KarurVyasa
criteria. This limit varies from bank to bank (for example Rs 2 Bank 3344 46 54 8 54
lakh for one bank and Rs 5 crore for another bank). Thirteen The South Indian
banks are rating SME borrowers and six banks are concentrating Bank 3613 55 45 17 62
on rating agriculturalborrowers also. Although six banks have Uco Bank 15923 57 43 10 51
UnionBank
indicated the applicability of credit rating to retail loans also, of India 25515 66 34 10 48
discussions with the bankers reveal that certain retail loans such UTI 7180 46 54 11 76
as educational loans and loans against shares are sanctioned by VijayaBank 7891 55 45 6 45
Total 551821 55 45 12 50
following certain norms instead of applying a rigorous credit
rating methodology. Primarily,the rating models are more Source: StatisticalExhibitsRelatingto Banks in India,2002-03.

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 Figure: GradingScales of IndianBanks advanced uses of credit rating models for the estimation of loan
loss reserves, risk capital, profitability, for loan pricing analysis
GradingScales
and of ratings as inputs to formal credit portfolio risk manage-
X 8 . 7 7 ment. Different uses place different stresses on the rating system
X
0
6--- 4 and may have different implications for the. internal controls
4
4 2 t2
2
1 needed to maintain the systems integrity [Treacy and Carey
E
O C , I 1998]. For instance, if a bank intends to use credit rating for risk
6 7 8 9 10 11 capital requirement it should carefully estimate the capital re-
Numberof Grades quirement with proper validation and back testing of the model.

debts, whereas if it is a letter of credit it may not be secured if How Many Grades?
the marginimposed is less thanthe value of the credit. The survey
finds only one bank assigns ratings purely on transaction alone. A well functioning rating system differentiates risk within a
Ratingon a transactionbasis facilitatesan estimationof therecovery loan portfolio. Grades are an effective way of expressing dif-
rate, which is an essential output of an internal rating system. ferentiation of risk categorisation of the entire loan portfolio.
Interviews with bankers reveal that some banks are practising Differentiation of risk and pricing of loans are intimately related.
rating the transaction once the bbrrower is rated; also rating Banks with the greatestdegree of differentiation seems to be using
dimensions actually being used by the banks are not reflected ratings in loan pricing decisions. Differentiation of risk also
in the rating model. Banks which have systems to rate the facilitates portfolio credit risk management and helps in formu-
borrower may also implicitly rate the loan facilities belonging lation of exposure norms for each category. The survey inves-
to that borrower. It is also observed from the credit rating tigated the number of grades in the current rating structure, the
documents of select banks that certain risk parameters are ex- number of pass grades and grades used in the watch category by
clusively applied to specific types of loan transactions. For banks. Thirtyper cent of the banks surveyed have eight grades for
example, debt service coverage ratio, an important risk factor, the categorisation of borrowers (see the figure). The New Basel
is implicitly applied to rate the borrowers seeking term loan Accord [BCBS 2004] suggests that for rating corporates, a bank
requirements.The sophistication desired in this direction is more rating structureshould have a minimum of seven borrowergrades
clarity in rating dimensions, and more robust rating models to for non-default borrowers and one for those that have defaulted.
give an idea about the recovery rates of various facilities. To facilitate easy decision making banks may categorise some
grades as pass grades for which the loan facility will be sanctioned
'Point in Time' or 'Through the Cycle' Approach? at an acceptable risk premium. All the banks have at least two
and at most four categories which are not considered for granting
The banks I have surveyed rate the borrowers on the basis of of loan facility. A large number of grades on the rating scale
current conditions. This is called rating on the basis of point in is expensive to operate as the costs of additional information for
time. Whereas,under"throughthe cycle" approach,the borrower's fine grading of credit quality increases sharply [RBI 2002]. The
expected condition in a downside event is primarily considered frequency of legitimate disagreements about ratings is likely to
for rating. In this method, long-term conditions and financial be higher when rating systems have a large number of grades.
strategies adopted by the borrower may change the ratings. A bankcan initiate the risk grading activity on a relatively smaller
Through the cycle approach may be adopted to at least large- or narrowerscale and introducenew categories as the riskgradation
scale borrowers as this provides an idea on rating in an adverse improves.
situation and helps the bank in estimating the additional capital
requirementsduring serious conditions of recession. Through the Table 2: Components of InternalRating Systems of Banks
cycle approach may be suitable to long-term loans exceeding Components No of Banks
more than three years and the point in time approach may be
Ratingmethodology 18
adequatefor workingcapitalloans as these arefrequentlyreviewed. Ratingprocesses 16
Control 11
Data collection 9
What Are the Uses of a Credit Rating System? ITsystems 8
Assignmentof rating 16
An internal credit rating system provides many advantages to Quantificationof probabilityof default 6
banks. It guides the loan origination process, portfolio monitor- Data on recoveryrates 4
Ratingtransitionmatrix 9
ing, analysis of the adequacy of loan loss provisions, profitability
analysis, loan pricing, risk capital allocation and incentives for
employees. All the surveyed banks are using the credit rating Table 3: Uses of InternalRating Models
system for loan origination, portfolio monitoring and reporting Numberof Banks
to senior management. Fifteen banks are pricing loans on the Applications
basis of internalrating models (Table 3). None of the banks have Guidingthe loan originationprocess 19
linked employee incentives with the risk grading system. Only Portfoliomonitoring 19
Reportingto senior management 19
four banks are using the models for profitability analysis of
Analysisof the adequacy of loan loss provisions 3
customers and only one bank is using the model for estimation Profitability
analysis 4
of risk capital requirementsand comparing the regulatorycapital Loanpricing 15
Risk capitalallocation 1
requirementswith risk capital. In India ratings are applied Employeecompensation 0
essentiallyto price loans, as the banks are yet to explore the

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 Gradesintendedto captureheightenedadministrative attention of current ratio whereas other banks may not regard this item
arecalledwatchgrades.Promptandsystematictrackingis required as current liability.
on creditsgroupedin watchcategoriesin theassessmentof credit The standardway of using financial ratio analysis is to compare
risk.Outof the bankssurveyed,13 have watchcategorygrades firm level ratios with those of the same industry. But most credit
builtintothegradingsystemsandsix banksaresilentaboutthis. ratingmodels do not have this feature of comparison at all. Rating
Banksareexpectedto developcompleteratingdescriptionsand is a process involving judgment because the strength of financial
criteriafor theirassignment.Althoughmost Indianbankshave ratios may vary with various other characteristics of borrowers.
categorisedthe ratingstructureinto gradesthey have not de- Banks also give importance to the size of borrowers represented
scribedthe ratinggrades,only five out of the surveyedbanks by sales or total assets and net worth. Many firms which do not
have supplementedthe ratingsymbols with descriptions.One have access to capital market resources often have low assets
suchsurveyedbank'sratingdescriptionis presentedin Table4. or net worth. In contrast large firms have several alternative
financing avenues, more salable assets in case of a stress scenario
Who Assigns Rating? and firmly established market presence. For these reasons many
banks assign relatively risky grades to small firms although
The surveyrevealsthatratingis being assignedat the branch their financial characteristics suggest a more favourable rating.
level by a creditofficerin case of eightbanks,whereasfor seven Table 7 shows the financial risk factors considered by a few Asian
banksit is beingdoneby sanctioningauthoritiesincludingbranch
managers.In the case of fourbanks.creditratingis a centralised Table 4: Risk Description
function.If thecreditratingis a decentralisedfunction,thescope Grade Description
for subjectivityin understandingthe business, industryand
A++ Indicatesan exceptionallyhighpositionof strength,veryhighdegree
management riskfactorswouldvaryandultimatelyoverallrating of sustainability
may be either understated or overstated.Unless continuous A+ Indicatesa highdegree of strengthon a factoramongthe peer group,
trainingis impartedforcreditratingofficersworkingatbranches high sustainability
andotheradministrative units,theconsistencyof the application A Indicatesa moderatedegree of strengthwithpositive outlook
B+ Indicatesa moderatedegree of strengthwithsuitableor marginally
of the model would be doubtful. negative outlook
B Indicates weaknesses on a parameter in comparison to peers,
unstableoutlook
What Weights Are Assigned for Various Risks? C Indicatesa fundamentalweakness withregardto the factor,unlikely
to improveundernormalcircumstances.
The surveyenquiredaboutvariousriskfactorsconsideredby
banksin ratingthe borrowers.The overwhelmingmajorityof Source: Creditratingdocumentof a surveyed bank.
banksconsiderfinancialrisk as the primerisk factor;the rest
Table 5: Weights Assigned to Various Risks (no of Banks)
of the surveyedbanks may also considerfinancialrisk as an
importantrisk factor but they have not clearly indicatedthis. Weights Financial Business Risk IndustryRisk Management
Banksareassigningaround40 percent weightfor financialrisk (Per Cent) Risk Risk
factors.The otherprominentrisk factorsare managementrisk 0-20 0 4 9 9
andindustryrisk (Table5). Internationally,the best practiceis 20-40 10 9 5 8
40-60 4 1 0 1
thatindustryrisk factorsaccountfor 20 to 30 per cent of total 60-80 4 0 0 0
scoreandmanagementriskfactorsaccountfor 10 to 15 percent 18 14 14 18
of total score [Scott 2003].
Table 6: Financial Risk Factors Considered by Internal Credit
What Are the Risk Factors Considered? Rating Models
Financialriskfactors No of Banks
Financial risk: Analysis of financial statementsis centralto
appraisingborrowers'financialrisk.Financialriskis expressed Currentratio 16
Debt-equityratio(totalliabilityto total net worth) 16
by variousfinancialrisk parameterswhich are computedfrom, Growthrate or trendin sales 10
the financialstatementsof the obligor. These parametersare Growthrate or trendin net profits 11
expressedas ratiosbetweenthe two variablesof financialstate- Net profitmargin 14
ments.A widerangeof riskparameters arebeingusedin assessing Gross profitmargin 10
Operatingprofit 8
the financialrisk of the borrowers(Table 6). Almost all the 5
Operatingleverage
surveyedbanksareconsideringcurrentratioas theprimevariable Interestcoverage ratio 13
for ratingthe financialriskof borrowers.Currentratioindicates Debt-servicecoverage ratio 14
Cash flows 9
liquidityof the borrowerin meetingall currentobligations.The Financialleverage 6
second most prominent ratio is debt-equity ratio, which Asset turnoverratio 9
explainsthe relationshipbetween total outstandingliabilities Workingcapitalturnoverratio 7
and equity. This ratio indicates the solvency position of the Returnon net worth 6
borrowerin meetingcurrentand long-termliabilities.Among Returnon capitalemployed 13
Returnon assets ' 5
theprofitabilityratios,netprofitmargin,operatingprofitmargin, Stock turnoverratio 12
andreturnon capitalemployedaretheimportant ratios.Theexact Debtorsturnoverratio 11
definitionsof these ratiosarefoundto varyfrombankto bank. Asset coverage ratio 6
Bankborrowingsto sales 3
For example.a bank may considerterm loan instalmentsdue Anyother (trendsin performance,securitycoverage) 2
withinone year as partof the currentliabilityfor the purpose

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banks,which reveals that the ratios consideredby the Indian Table 8: Qualitative Factors Considered in Analysing
banksare almostsimilarto many internationalbanks. Financial Statements
Thequalityof financialinformationis alsoessentialinanalysing FactorsConsidered No of Banks
financialratios.Manybanks are giving due importanceto the Boardstructure 10
qualificationsbeingmadeby auditorswhile analysingthe finan- Groupto whichthe companybelongs 11
cial statementsof a borrower.The surveyalso revealsthatbanks Chairmanof the company 11
to boardstructure,familygroup,andmanaging Managingdirectorof the company 10
assignimportance Statutoryauditorsof the company 11
directorof the company(Table 8) while ratingthe borrower. Importantqualificationsbeing made by the auditors 16
Industryrisk:Industryratingsarea criticalelementof anyinternal Disclosures accordingto USGAAP 8
Creditratingassigned by externalagencies such as
ratingsystem and a well designed risk ratingsystem should CRISIL,ICRA,CARE.etc 12
identifypotentialfutureproblemswithbusinessesthatmayappear
todayto be financiallysoundwithacceptablecreditrisk.Industry Table 9: Industry Risk Factors Considered by
ratingsare akinto assessinga healthyindividual'>geneticpre- Internal Rating Models
dispositionto contracta medicalcondition.It is "corporateDNA
testing",anassessmentof thefamilybackground of anapparently IndustryRisk Factors No of Banks
healthycompany[Scott2003].Forsettingportfoliolimits,industry Competition 17
risk ratingis essential.Competitivescenario of the industry, Technology 14
Brand 12
naturalandartificialbarriers,
governmentpoliciesandthegeneral Availabilityof substitutes 13
political environmentare factors generally consideredwhile Environmentalrisk 13
9
assessing the industryrisk (Table 9). Some banks are using Exportpotential
Accessibilityof inputs 13
businessriskandindustryrisk interchangeably whereas,others Marketingnetwork 15
have differentweights for them. The variablesconsideredfor Productcharacteristics 11
businessriskandindustryriskarealso varywidely (AppendixI Barriersto entryfor new players 13
Any other (specify) 5
andII) acrossbanks.Manybankshave not even conceptualised
industryrisk properly.The conceptof businessrisk is also not
clear in the observedcreditratingdocuments.Wide variations Table 10: Management Risk Factors Considered by Internal
areobservedin parameters consideredfor industryriskof select Rating Models
Indianbanks. ManagementRisk Factors No of Banks
Managementrisk: Under managementrisk, banksjudge the Professionalexperience of management 18
qualityof the borrower'smanagementand assigna riskweight Labourrelations 12
to this factor.Almost all banks are consideringprofessional Professionalqualificationsof management 14
Transgressions 8
experienceof managementandfinancialdisciplineof borrowers Submissionof monthly/quarterly and periodicstatements 14
as an importantfactorin assigningbetterratings(Table10).The Financialdisciplineof borrowers 16
professionalexperienceof managementindicatesits abilityto Relationshipwiththe bank 15
Corporategovernance 13
achievea higherlevel of financialperformancethroughoutthe
business cycle and its attitudein protectingthe interestsof
lenders.AppendixIII demonstratesmanagementrisk factors Table 11: Other Factors (Negative) Considered While Rating the
consideredby select banks.Like businessriskfactors,these are Borrowers
broadlywordedandit is difficultfor the raterto understand their OtherFactors No of Banks
real meaning,especially when a large numberof people are ExternalDiversionof Funds 13
involvedin the ratingprocessat differentbranchesof a bank. Delayed submissionof QIS and other FinancialStatements 15
In orderto improvethe utilityof these factorsfor creditrating, in Documentation
Irregularities 12
Defaulton Paymentof LCand other Guarantees 16
bankshaveto focus moreon continuoustrainingandmentoring. Dishonourof CommercialBanks 15
Otherriskfactors:Mostof thebanksareconsideringsomefactors in Operationsof the Account
Irregularities 16
as negativefactors(Table 11) while ratingthe borrowers.For Non-complianceto Termsand Conditions 14
Others 7
arrivingatthecomprehensive ratingorfinerating,marksrelating
Table 7: Benchmarking of Financial Criteria Used by Asian Banks
Criteria US Bankin Asian Market Asian Bank 1 Asian Bank2 Asian Bank3 Asian Bank4
Liquidity Quickratio Currentratio Currentratio Current/Quick ratio
Leverage Debt-to-Equityratio Debt-to-equity Debt-to-equity Debt-to-equity Equity-to-debt
Cash flow Interestcover EBITDAto total debt Cash flow/totaldebt EBITDAto interest EBITDAto interest Net workingcapitalto
Cashflow/debtandPayables expense expense interestEBITDAto
Cash flow/sales interestexpense
Profitability Pretaxreturnon average ROI,Net income/assets. ROAE ROAE ROE
capital Gross profitmargin Net profitmargin Net profitmargin Net income/sales
Efficiency Assets turnover, Inventory/sales Inventory/sales
Inventory/sales, Receivables/sales
Labour,production,
Sales growthrate
Growth Equitygrowthrate-
Sales growthrate
Size Capitalisation Sales
Source: Scott 2003.

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to thesefactorsaredeductedfromthetotalmarkscomputedfrom of internal ratings already know the agency grade for a given
all the other risk factors. borrower and have an idea of a borrower's likely position on
the internal scale. Obviously, if the agency rating is the sole
How Do Banks Arrive at the Overall criterion used in assigning internal grades to agency rated bor-
Credit Rating of Borrowers? rowers, ratedand unratedborrowerswithin a given internalgrade
might differ substantially in risk. In such circumstances the
Afterevaluatingthe borroweron variousrisk parametersa mapping is circular because borrowers are assigned internal
creditratingmodel producesan overall ratingof the borrower grades based on the agency rating, and the agency rating cor-
by aggregatingthe scores of variousrisk parameters.Most of responding to each internalgrade is inferredonly from such rating
thebanksareusingsimplearithmeticsummationof scoresarrived assignments [Treacy and Carey 1998]. The banks I surveyed show
atundervariousriskparameters or a weightedaverageapproach. that 10 out of 19 banks compare internal grading with that of
While aggregatingsome banksare consideringthe importance external rating agencies. The portion of rated advances in the
of thesize of thecompany.Forexample,two differentcompanies total loan portfolio and amount of loans under each risk grade
mayhavesimilardebt-equityratiosbuta companylargerin size is not available in the public domain. Therefore a view about
shall certainlyhave higher shock absorbingcapacitythan the the size of rated advances and composition of advances with
smallersize company.Once the scores are aggregatedbanks different risk grades is difficult to analyse. Hence, it is difficult
assign an equivalentrating.For example,one of the surveyed to judge the correctness of mappings at this stage.
banks'overall ratingmethodologyis presentedin Table 12.
Arrivingat overall ratingin this methodis simple and easy Ill
for implementation.However, banks may shift over to other the Qualityof InternalRating
Improving
sophisticatedmultivariate techniqueslikelogit/probitmodelsand Systems
discriminant analysis.Thesetechniqueswill combinethevarious
risk parametersand also producePD, an essential parameter Credit risk ratings are designed to reflect the quality of a credit
requiredunderinternalratingmodelsapproach.Altman's(1968, exposure and explicitly or implicitly the loss characteristics of
2002) Z scoremodelgainedpopularityamongthe multi-variant that exposure. A consistent and meaningful internal risk rating
techniques.Thomas(2000)suggestsvariousapproachesto arrive system is a useful source of differentiating the degree of credit
ata singlecreditscoreby aggregating multipleriskfactors.Though
risk in loans and other credit exposures. This consistency and
afewbanksmadeanattemptto applymultiplediscriminant meaning is rooted in the design of the risk rating system itself.
analysis
on select data on an experimentalbasis, there is no concrete
Considering the importance of a robust credit rating system, this
evidenceof use of these models in the creditdecisionprocess.
section outlines certain measures to improve the quality of credit
rating system. The section is heavily dependent on the minimum
How Frequently Ratings Are Reviewed? requirements of an internal rating based approach stipulated by
Basel Accord [BCBS 2004] and the guidance notes issued by
Review of rating is an essential componentof credit risk Federal Reserve (2003).
management.Reviews are multifold:monitoringby those who
assigntheinitialratingof a transaction,regularlyscheduledrating Definition of Default
reviewsfor select exposures,occasionalreviews,reviewat the
timeof renewalof loan,yearlyorhalfyearlyreview.Manybanks The generally acceptable accounting definition of default is
have agreedthatthey conductyearlyreviews of ratings(Table when the interest or principal installment on any credit exposure
12) and the next importantreview is at the time of renewalof is due for more than 90 days. Banks which are in the process
loan limits. A strongreview process also aims to identifyand of implementing advanced credit rating models are recognising
disciplinemanagerswho produceinaccurateratings.Sucha step thatdowngrading is also a default event. Harmonisationof default
providesstrongincentivesfor the individualsmost responsible definition would facilitate creation of data pool across banks.
for negotiatingwith the borrowerto assess risk properlyandto Consistency in identification of default is fundamental to any
thinkseriouslyaboutcreditissuesateachstageof creditdecision IRB system. In the Indian context, only from the year 2004
making.Ratingsshouldbe reviewedby an independentcredit onwards has the delinquency norm of 90 days been introduced.
riskmanagement or loanreviewoffice bothat the inceptionof a "The greening of assets" may be avoided, which would dilute
transactionandperiodically overthelifeof theloan.Suchreviewers the importanceof a rating system in a bank. In defining the default
shouldhave adequateexperienceand businessjudgmentcom- rating systems must also capture so-called "silent defaults" or
parableto thatof line managersresponsiblefor assigninginitial defaults when the loss on a facility was avoided by liquidating
risk grades.If a bankrelies on outsideconsultants,auditorsor
Table 12: Computation of OverallCredit Rating of a Borrower
otherthirdpartiesto performall or partof this reviewrole,such
individualsshouldhavea clearunderstanding of theinstitution's Scores Gradation Risk Nature
creditcultureandits ratingprocess,in additionto commensurate Morethan 90 1 Very Low
experienceand competencein makinga creditjudgment. Morethan 80 2 Low
Morethan 70 3 Moderatelylow
Morethan 60 4 Fair
Are Internal Ratings Mapped with External Ratings? Morethan 50 5 Mode rate
Morethan 40 6 High
Banksmay compareandmapthe internalratingsassignedby Morethan 30 7 Very high
them with the ratingsof creditratingagencies.This may lead Less than 30 8 Critical
to the problemof circularity[TreacyandCarey19981as raters Source: Creditratingdocumentof one of the surveyed banks.

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underlyingcollaterals[FederalReserve2003]. The ratingdefi- othercharacteristicsshouldnot influencethe obligorrating.In
nitionsandcriteriamustbe bothplausibleandintuitiveandmust the Indiansystem some banks are combiningthese two. For
resultina meaningfuldifferentiationof risk[BCBS2004].Rating examplein a 1 to 10 ratingsystem where risk increaseswith
systemsshouldbe flexible enoughto cope with all foreseeable thenumbergrade,a defaultedborrowerwitha fullycashsecured
typesof risks.Similarly,ratingsystemsshouldbe ableto handle transactionshouldbe ratedas 10 (lowest), regardlessof remote
alltypesof borrowersbelongingto variousbusinessesof different expectationof loss. Similarly,a borrowerwhose financialcon-
industries[KrahnenandWeber2001].Usefuloutputfromacredit dition warrantsthe highest investmentgrade ratingshould be
ratingsystemmay be expectedprovideddefaultdefinitionand ratedas one, even if the bank'stransactionsare subordinateto
time horizonare consistent. othercreditorsand unsecured.Since a ratingis assignedto the
obligorand not to the facility, separateexposuresto the same
Rating Philosophy obligormust be assignedto the single obligor ratinggrade.
Bank managementsshould clearly-articulatewhethertheir Loss Severity Ratings
internalratingsystemis "pointin time"or "throughthe cycle".
If the bankadoptsa point in time ratingsystem. obligorsare The two dimensionsof a qualifyingIRB system are quanti-
groupedby probabilityof defaultfrequencyover the next year. ficationof defaultriskof borrowerandriskof specifictransaction.
Alternatively,borrowersmaybe ratedon thebasisof overa wide Theorientationof firstdimensionis thattheratingof theborrower
rangeof possiblestressoutcomes,which is called throughthe is same irrespectiveof his exposureto batiktransactions.For
cycle ratingsystem.Choosingbetweenthesetwo systemsforms example,he maytakea partlysecuredworkingcapitalloan and
a ratingphilosophy.Point in time ratingschangefrom year to a fully securedtermloan froma bank.Regardlessof the nature
yearas the borrower'scircumstanceschange,includingchanges of the transactionunderthe firstdimension,the ratingwouldbe
dueto economicpossibilities.Sincetheeconomiccircumstances same. Underthe second dimension,the adjustmentof security
of many borrowersreflect the common impactof the general shouldreflecton the borrower'sgrade.The LGDestimateis the
economicenvironment,the transitionsin point in time ratings loss thebankis likelyto incurintheeventthattheobligordefaults,
willreflectthatsystematicinfluence.Merton's(1974)probability andis expressedas a percentageof exposureatthetimeof default.
of defaultpredictionis in line with the point in time approach LGD estimatescan be assignedeitherthroughthe use of a loss
of rating.Throughthe cycle ratingsystemsdo not estimatePD severityratingsystem or they can be directlyassignedto each
overthenextyear;instead,theyassignobligorsto multiplegroups facility.A bankmustestimatea long-runaverageLGDfor each
thatwouldbe expectedto sharea commondefaultfrequencyif facility. Since defaultsare likely to be clusteredduringtimes
the borrowersin themwereto experiencedistress,regardlessof of economicdistressandLGDs may be correlatedwith default
whetherthatdistressis in the next year.This ratingphilosophy rates,a time weightmay materiallyunderstateloss severityper
abstractsfromnear-termeconomicpossibilitiesandconsidersa occurrence.Moreover,for exposuresfor which LGD estimates
richerassessmentof the possibilities.Normallyexternalrating are volatile over the economic cycle, the bank must use LGD
agenciesfollowthephilosophyof throughthecycleratingapproach estimatesthatareappropriate for an economicdownturnif those
whereasbanks'internalratingmodelsarepointin time.Regard- aremoreconservativethanthe long run-average.LGDestimates
less of ratingphilosophy,the bankmanagementmustarticulate mustbe groundedin historicalrecoveryratesand,whereappli-
the implicationsof the bank'sratingsphilosophyfor its capital cable, must not be based solely on the collateral'sestimated
planningprocess.Capitalmanagementpolicy shouldbe articu- marketvalue.Estimatesof LGD mustbe basedon a minimum
lated accordingto ratingphilosophyto avoid capitalshortfalls data observationperiodthat should ideally cover at least one
on times of systematiceconomic stress. completeeconomiccycle but must,in any case, be not shorter
than a periodof seven years from at least one source [BCBS
Obligor Rating Granularity 2004].
Regardingretailexposures,ratingsystems must be oriented
A bankmustjustify the numberof obligorgradesused in its tobothborrowerandtransaction riskandmustcaptureallrelevant
rating system and the distributionof borrowersacross those borrowerandtransaction characteristics.
Banksmustassigneach
grades.The gradedefinitionmustincludebotha descriptionof exposurethatfalls withinthedefinitionof retailforIRBpurposes
thedegreeof defaultrisktypicalforborrowersassignedthegrade intoa particularpool. Banksmustdemonstratethatthis process
andthe criteriaused to distinguishthatlevel of creditrisk.The providesfor a meaningfuldifferentiationof risk.Foreach pool
modifiersused or numericgrades(+ or - to alphaor Al, A2) bankmust estimatePD, LGD, and EAD [BCBS 2004].
will only qualify as distinctgrades if the bankhas developed
completeratingdescriptionsandcriteriafortheirassignmentand
Multiple Ratings Systems
separatelyquantifiedPDsforthesemodifiedgrades(Basel2004).
If modifiers(such as plus or minus)are attachedwith ratings, A bank'ssize of the loan portfolioandcomplexityin product
banksshouldclarify whetherthese constitutea separategrade rangewillaffectthetypesandnumbersof ratingsystemsemployed.
ornot.Bankshoulddevelopadistinctratingdefinitionandcriteria Banksmaydevelopone riskratingsystemthatcanbe usedacross
for the modifiedgrade.If a bankhas diversecreditqualitythey the entirecommercialloan portfolio.Alternatively,a bankcan
may have a greaternumberof borrowergrades(Basel 2004). choosedifferentratingsystemsfor differenttypes of portfolios.
Eachobligorgradein turnmustbe associatedwitha single PD, A bankmayhave as manydifferentratingsystemsas necessary
The ratingof obligorsmust result in a rankingof obligorsby and as few as possible. The reasonsfor choosing the number
PD. Theborrowerratingshouldbe distinctfromtheloss severity of ratingsystemsshouldbe madetransparent. Forexample,two
ratingwhich is assignedto the facilityand collateralas well as differentrating systems are requiredto evaluate real estate

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companiesand companiesin manufacturing activity.Similarly Data Maintenance
the bankshouldnot divide the set of companiesinto too many
subsetsandconstructtoo manydifferentratingsystems.Certain Indianbankshavenotpaidmuchattentionto storingof default
companiesmayfall into morethanone ratingsystemandcreate dataon each type of loan by risk grade.Even if they havedone
a difficultyin backtestingdue to the relativelysmallernumber so, the data is availableon regulatorycategorisationloans but
of datapoints[KrahnenandWeber2001]. Banksmay combine not on the basis of riskgrades.Underregulatorycategorisation
ratingmodelsfor some loans and expertjudgmentsystemsfor also the normsfor categorisationof badloansis not uniformfor
others.The bankmust documentthe rationalefor assigninga the last six or seven years. Therefore,banks have to make a
borrowerto a ratingsystem.Howeverthe aimof use of multiple beginningin collectionandmaintenanceof differentloansas per
ratingsystemsshouldnot be to minimisecapitalrequirements loan performanceand grading.A bankmust collect and store
inappropriately [BCBS 2004]. data on key borrowerand facility characteristicsto provide
effective supportto its internalcredit risk measurementand
Informational Efficiency managementprocesses.Banksmustmaintainratinghistorieson
borrowersandrecognisedguarantors,the datesthe ratingswere
A ratingsystemshouldaccommodateall the availableinfor- assigned,the methodologyandkey datausedto derivethe rating
mationandsuchinformationshouldbe modelledcorrectlyin the andthe personor mode!responsiblefor rating.The identityof
rating.The currentcreditratingof a borrowershouldbe the best defaultedborrowersand facilities, the timing of default and
basisfor predictingtomorrow'srating.The ratingsystemshould circumstancesof such defaultsmust be retained.
cope with splittingbias. Splittingbias suggeststhatpresenting
an attributemore in detail may increasethe weight it receives. Validation Process
Creditofficersmayhavethe tendencyto ratequalitativecriteria
of a ratingsystem betterthan quantitativeones and they tend Banksmustimplementa processto ensuretheaccuracyof their
to changequalitativevariablesless thanquantitative[Krahnen ratingsystems. Banks must have a robustsystem in place to
and Weber2001]. validatetheaccuracyandconsistencyof ratingsystems,processes
andtheestimationof all relevantriskcomponents[BCBS2004].
Documentation of Rating Systems Ratingsystemaccuracyis acombinationof twothings- theactual
long-runaveragedefaultfrequencyfor each ratinggradeis not
Banksmustdocumentin writingtheirratingsystemsdesign significantlygreaterthanthe PD assignedto thatgradeandthe
andoperationaldetails.The documentationis an evidenceof the actualstress conditionloss ratesexperiencedon defaultedfa-
bank'scompliancewiththeminimumstandardsandmustaddress cilities are not significantlygreaterthan the LGD estimates
topics such as portfoliodifferentiation,ratingcriteria,respon- assigned to those facilities. A bank must demonstrateto its
sibilitiesof partiesthatrateborrowersand facilities,definition supervisorthattheinternalvalidationprocessenablesit to assess
of rating exceptions, parties that have authorityto approve the performanceof internalratingand risk estimationsystems
exceptions,frequencyof ratingreviews,andmanagementover- concisely and meaningfully.While doing validation,estimates
sightof the ratingprocess.Ratingcriteriaandproceduresmust of PDs, LGDs and EADs are likely to involve unpredictable
be periodicallyreviewedto determinewhethertheyremainfully errors.In orderto avoid over optimism,a bankmust addto its
applicableto the currentportfolioandto externalconditions.If estimatesa marginof conservatismthat is relatedto the likely
thebankemploysstatisticalmodelsin theratingprocessthebank rangeof errors.Wheremethodsand data are less satisfactory
must documenttheir methodologies[BCBS 2004]. andthelikelyrangeof errorsis larger,themarginof conservatism
must be larger[BCBS 2004].
Minimise the Error of Human Judgment
Back Testing
Undoubtedlytheratingprocessinvolvestheexerciseof human
judgmentwhileconsideringthe assignmentof ratingandweight Banksmustestablishinternaltolerancelimits for differences
given to each factor.Among the surveyed banks almost all of between expected and actual outcomes. The ex-ante default
themareusingjudgmentalratingmethodsfor ratingtheborrow- should not be significantlydifferentfrom the ex post default
ers on managementand industryrisk parameters.Different frequency.Back testing in creditrisk managementis difficult
individualsin the samebankmayunderstand certainriskparam- becauseof non-availabilityof marketpricesforloans.Thehistorical
etersdifferently.Thisis morepertinentwhileratingtheborrowers data on credit defaults is also limited. Therefore,pooling of
on industryriskand managementrisk.For example,almostall resourcesacrossdifferentbanksmay create a betterdatabase
thebanksareassigningweightstothecompetitionwhileassessing which facilitatesimprovedback testing.Back testingis a focal
the businessrisk.For the creditofficer at the branchlevel it is pointfor validatingrating,the needfor it yields some important
difficult to comprehendthe concept of competition.He may implicationsfor the design and use of ratings.
considerpurelylocalfactorsof a specificgeographicalareawhile
thefirmmayfacecompetitionfromnonlocalunitsandultimately Credit Risk Control
theborrowermayencountercompetition risksubstantially.
Unless
the bankprovidesrigoroustrainingto all usersof the model,the Banksmusthave independentcreditriskcontrolunitsthatare
of
degree objectivity will be very low in evaluatingbusinessand responsiblefor the design, implementationand performance of
industryrisk factors. The rating system should be identical their internalrating systems. The unit must be functionally
regardlessof the personwho rates.It shouldstandfor the test independentfrom the personnel and managementfunctions
of stationaritypropertyl[Krahnenand Weber2001]. responsiblefor originatingexposures.Areas of responsibility

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must include: (a) Testing and monitoring internal grade. Appendix I: Business Risk Factors
(b) Productionandanalysisof summaryreportsfromthe bank's BankX
ratingsystemto includehistoricaldefaultdatastoredby rating 1 Past commitmentswithrespect to net sales.
atthetimeof defaultandoneyearpriorto default,ratingmigration 2 Past commitmentwith respect to net profit.
3 Conductof the account
analysis and monitoring of trends in key rating criteria. 4 Complianceof terms and conditions
(c) Implementingproceduresto verifythatratingdefinitionsare 5 Incomevalue of the Bank(Interest,commission,exchange, etc, fromthe
account as percentage of total fund based limit)
consistentlyappliedacross departmentsand geographicareas. 6 Repaymentof installment(forterm loan)
(d) Reviewinganddocumentinganyratingchangesto the rating 7 Securitycoverage (collateral)
8 Trendanalysis
process,includingthe reasonsfor the changes. (e) Reviewing (a) Trendanalysis-variationin net currentassets
the ratingcriteriato evaluateif they remainpredictiveof risk. (b) Trendanalysis-variationin tangible net worth
Changesto the ratingprocess,criteriaor individualratingpa- (c) Trendanalysis-profitability
Bank Y
(net profit/netsales or receipt)
rametersmust be documentedand retainedfor supervisorsto 1 Marketposition/Current marketshare
review.A creditriskcontrolunitmustactivelyparticipatein the 2 Operatingefficiency
andvalidationof rating 3 Growth
development,selection,implementation 1 Marketposition/Current marketshare
models. Products
- Productrange (single productdependence or wide range of products)
- Consistencyof quality(approachtowardqualityassurance)
Corporate Governance - Supportservice facilities(abilityto provideservice after sales)
- Customisationof product(abilityto providecustomised products)
All materialaspectsof theratingandestimatingprocessesmust - Shelf life of product.
Prices
be approvedby thebank'sboardof directors.Thesepartiesmust - Pricingflexibility(flexibilityto increase prices in line withcosts)
processa generalunderstanding of the bank'sriskratingsystem _Brand equity
and detailedcomprehensionof its associatedmanagementre- - Bargainingpowerwithsuppliers(to controlcost of inputeffectively)
- Bargainingpowerwithbuyers (whethermonopolistic,etc)
ports.Seniormanagementmustalso have a good understanding Place (Selling/Marketing)
of the ratingsystem's design and operationand must approve - Distributionset-up
- Geographicaldiversityof markets(bothdomestic and international)
materialdifferencesbetweenestablishedprocedureand actual - Long-termcontracts/assuredoff take
practice.Managementmustalso ensureon anongoingbasis,that Promotion(based on needs/competition)
- Advertisingexpenditure(requiredas well as abilityto sustain)
the ratingsystemis being operatedproperly.Managementand - Otherpromotional ventures(whetherundertakenandwhetherbeneficial)
staffin thecreditcontrolfunctionmustmeetregularlyto discuss 2 Operatingefficiency
theperformance of theratingprocess,areasneedingimprovement Raw material
- Related riskand mitigation
and the statusof effortsto improvepreviouslyidentifieddefi- - Availabilityof rawmaterials
ciencies.Internalratingsmustbe anessentialpartof thereporting - Importcontent substitution(degree of indigenisation)
to these parties.Reportingmust includerisk profile by grade, - Managementof productprice volatility
Manufacturing and selling
migrationacrossgrades,estimationof the relevantparameters - Overallcost structureadvantage/disadvantage form
per grade, and comparisonof realised default rates against - Capacityutilisation
- Managementof operativecost (employee/energy/technology)
expectations.Reportingfrequenciesmay vary with the signifi- - Managementof selling costs.
canceandtypeof informationandthelevel of therecipient.Senior - Technologyadoption
- Locationadvantage.
managementmust providenotice to the boardof directorsfor
Others
anymaterialchangesorexceptionsfromestablishedpoliciesthat - Availabilityof utilities(power/water,etc)
will impactthe operationsof the bank's ratingsystem. - Adherenceto environmental/domestic/international regulation
- Foreignexchange earnings
- Workingcapitalmanagement
Internal and External Audit 3 Growth
- Increase of net sales over last year (per cent)
Markettestingis possiblefor externalratingsbut for internal - Increase of operatingprofitmarginover last year (per cent)
- Debtor'svelocity (months)
ratingsthereis noexternalcheck.Testingforneutralityof internal BankZ
ratingsis a serioustest of ratingmethodologyand ratingper- 1 Competition
- There is no competitionin the nearlyarea
formance.Internalauditoranequallyindependentfunctionmust - Competitionis existing but not a threat
reviewat least annuallythe bank'sratingsystemand its opera- - Companyhas to existamongstiffcompetition/faces insustaining
difficulty
tions, includingthe operationsof the credit functionand the growth
- Heavycompetitionleadingto insipidgrowth
estimationof PDs, andLGDs.Internalauditmustdocumentits 2 Locationaladvantage
findings. - Locatedin an area withhuge demand
- Locatedamong competitorsbut standingis long (> 10 years)
- Locatedamong competitorsbut witha standingof 5 to 10 years.
Conclusion - No locationaladvantage
3 Commoditiestraded
The componentsof internalratingsystems,theirarchitecture - ' Tradedcommoditieshaveconsistentdemandwithnoseasonalfluctuation
- Demandfluctuationwould not impactthe growth
andoperationdiffersubstantiallyacrossthe surveyedbanks.The -Demand fluctuationresults in constant revisionaccordingto market
rangeof gradesandrisksassociatedwitheachgradevaryacross trend
thebanksanalysed.Thisimpliesthatlendingdecisionsmayvary - Highfluctuationon demand leadingto poor growth
4 Marketperception
acrossthebanks.Therearedifferencesamongtheratingsystems - Cash and carrybusiness leadingto constant cash flow
of variousbanks.No single ratingsystem is best for all banks. - Availablecreditfromsuppliermatchesextensionof creditto customers.
- Largelydependent on creditsales withsatisfactoryrealisation
Buildingan internalratingsystemandimplementingit success- - Largelydependent on creditsales but realisationis poor
fullyto get thedesiredresultis a complextaskin abankingentity.

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 Appendix II: Industry Risk Parameters In this process human judgment plays central role and a variety
BankX of possible uses of ratingscan influence the ratingdecisions. Thus
scenario dealt by is favourable.
I Present industry/activity banks have to design carefully controls and internal review
2 Technology/activityis provenfor medium-term.
3 Demandof the productis increasing. procedures for the effective implementation of internal rating
of rawmaterial/products(traders)is adequate.
4 Availability systems. Internal rating systems promote a credit culture in the
does not depend on the vagaries of nature.
5 Industry/activity organisation. It should hold managers accountable for credit
6 The productshave established markets.
7 Qualityof productis satisfactory. quality. The banks should consider critically the culture factor
8 Productrange/mixis satisfactory. in designing rating systems.
9 Threatof substitute/competitorsto the product/sis not there. Internal rating systems are expected to operate dynamically.
10 Firmis not assembler or traderof unbrandeditems. As ratings are assigned, quantified and used, estimates will be
Bank Y
1 Industrycharacteristics comparedwith actual results, data will be maintainedand updated
- Importanceto economy (in terms of industry size/contributionto to support oversight and validation efforts and for better future
production/exports/employmentgeneration/forwardand backward estimates. Rating systems with appropriate data and oversight
linkages) feedback mechanisms foster a learning environment that pro-
- Cyclicality(impactof cyclicalfluctuationson industryperformance)
- Sensitivityof the industryto governmentpolicies (duties/pricecontrols motes integrity in the rating system as well as continuing refine-
and licensingor environmentalnorms) ment. Internal rating systems need the support and oversight of
- Growthpotential/outlookof the industry(best estimate of next five
the board and senior management to ensure that the various
years' average annualgrowthper cent)
2 Competitiveforces components fit together seamlessly and those incentives to make
- Extentof competitionamong domestic/international players the system rigorousextend across line, risk management and other
- Threatsof imports/substitute/unorganised sector
- Technologyrisk(doesindustryrequireconstantlychangingtechnology control groups. In the absence of strong supportand involvement
or R&D/rateof obsolescence of technology) of board and senior management, rating systems are unlikely to
- Barriersto entryfornew players(interimsof technology,highcost, long provide accurate and consistent risk estimates during both good
gestation perod) and bad times. 1[3
- Bargainingpower of buyerindustries
- Bargainingpower of supplierindustry
- Internationalcompetitiveness Email: jayadev@iiml.ac.in
- Fluctuationand demand-supplygap
3 Industryfinancials
- Retumon capitalemployed- ROCE(threeyearsindustry averagepercent) Note
- Operatingmargins(three years industryaverage per cent)
- Earningstability [This paperis partof the researchreportentitled 'Basel-II and CreditRisk'
submittedto the IndianInstituteof Banking and Finance, Mumbai.Author
wishes to express gratitudeto the anonymous referee and to Joshy Jacob
Appendix III:Management Risk Factors for their useful comments on this paper.]
BankX 1 A PD is based on an ex-ante point of view. It states thata companywithin
1 Managementis an established playerfor more than five years. PD 0.7 per cent has a 7 in a 1,000 chance to be default within a given
2 Have good reputationand trackrecord.
3 Have satisfactoryrelationswiththe bankfor more than three years. time period. We know from research on capital markets that testing
4 Business is not managed by one or two persons. expectationsis always tricky. In orderto relate (ex-ante) expectationsof
5 Managementis financiallyable to withstandcompetition. (ex-post)observeddata,we haveto assumethatthe structureof theproblem
6 Borrowersnot dealing in perishablegoods. underconsiderationremains constant from the date where expectations
7 Futuregrowthpotentialis high. are formed to the date where observationsare taken. This assumptionis
8 Borrowersare not dependent on limitedsuppliers. called the stationarityassumption.
9 Business is not cyclicalor there are no cyclicalearnings.
10 Borrowersnot dependent on limitedcustomers.
11 Marketshare is satisfactoryand acceptable. References
12 Distributionset-up is satisfactory.
Bank Y Altman, I Edward (1968): 'Financial Ratios, Discriminant Analysis and
Compulsoryparameters/trackrecords Predictionof CorporateBankruptcy',Journalof Finance,23, ppl89-209.
1 No of years of experience in industry - (2002): Bankruptcy,Credit Risk and High YieldJunk Bonds, Blackwell
2 Qualityof managementpersonnel Publishers.
3 Percentageof actual sales achieved to projectionsmade last year. Basel (2000): Rangeof Practice in Banks' InternalRatingsSystems,January.
4 Percentage of net profitachieved to projectionsmade last years. BCBS (2004):InternationalConvergenceof CapitalMeasurementandCapital
5 Percentage of actual net workingcapitalto projectionsmade last year.
6 Paymentrecordto bankers/institutions Standards, Basel Committee on Banking Supervision, June.
Otherrelevantparameters Federal Reserve (2003): 'Draft SupervisoryGuidance on InternalRatings
1 Groupsupport Based Systems for CorporateCredit', July 1.
2 Managementsuccession Krahnen Jan Peiter, Martin Weber (2001): 'Generally Accepted
3 Corporategovernance Rating Principles: A Primer', Journal of Banking and Finance, 25,
4 Credibility pp 3-23.
BankZ Merton,R C (1974): 'On the Pricingof CorporateDebt: The Risk Structure
Managementquality: of InterestRates', Journal of Finance, 29, pp 449-70.
1 Managementexperience
- The promotershave been in the tradeformorethan a decade and are RBI (2002): 'Guidance Note on Credit Risk Management',Reserve Bank
well experienced of India, October.
- The promotersare inthe tradeforover fiveyears, butless than10 years Scott, Roman (2003): 'Credit Risk Management for Emerging Markets:
- Promotersare in the tradefor less than five years Lessons fromthe Asian Crisis', in GordianGaeta(ed), Frontiersin Credit
- Managementis totallynew in venture Risk, John Wiley and Sons (Asia), Singapore.
2 Succession planning Thomas, Lyn C (2000): 'A Survey of Credit and Behavioural Scoring:
- Familybusiness and no cause forconcern
- Promotersare young and have familyback up ForecastingFinancialRiskof LendingtoCustomers',InternationalJournal
- Promotersare old but succession by familymembers is expected of Forecasting, No 16, pp 149-72.
- Promotersare old and no back up for succession Treacy, William F, MarkS Carey (1998): 'CreditRisk Rating at Large US
Banks', Federal Reserve Bulletin, November, pp 897-921.

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