Chapter 8 – Management of Banking and Financial Services, 2nd Edition

Chapter Eight


1. The need for banks to hold capital as a cushion against ‘UL’ will be dealt with in detail in the Chapter ‘Capital—Risk, Regulation and Adequacy’.

2. Note that the Z score described in the previous chapter attempts to measure the probability of default typically over a 1 year horizon.

3. Also defined simply as the value of the loan outstanding less the market (realizable) value of collateral held by the bank.

4. See Chapter on ‘The Lending Function’ for more on loan pricing.

5. Constantinos Stephanouand Juan Carlos Mendoza, ‘Credit Risk Measurement under Basel II: An Overview and Implementation Issues for Developing Countries’, World Bank Policy Research Working Paper 3556, Fig. 1 (2005): 7

6. Basel Committee on Banking Supervision, Principles for the Management of Credit Risk (September 2000): 1.

7. The grouping is as proposed by Peter Crosbie in ‘Modeling Default Risk’, published by KMV Corporation, Document no 999-0000-031, Revision 2.1.0 (1999):1–2.

8. See chapter on ‘The Lending Function’ for more on loan pricing.

9. A further particular instance of credit risk relates to the process of settling financial transactions. If one side of a transaction is settled but the other fails, a loss may be incurred that is equal to the principal amount of the trans action. Even if one party is simply late in settling, then the other party may incur a loss relating to missed investment opportunities. ‘Settlement risk’ (i.e., the risk that the completion or settlement of a financial transaction will fail to take place as expected) thus includes elements of liquidity, market, operational and reputation risk as well as credit risk. The level of risk is determined by the particular arrangements for settlement. Factors in such arrangements that have a bearing on credit risk include: the timing of the exchange of value, payment/settlement finality and the role of intermediaries and clearing houses.

10. Basel Committee on Banking Supervision, ‘Principles for the Management of Credit Risk’, (September 2000): 3–4.

11. We have seen in the previous chapter that in India, restructuring invariably involves ‘sacrifices’ on the part of banks.

12. Basically, the model works like this. Assume a lower return-to-risk asset is swapped for a higher return-to-risk asset. This improves the return of the overall portfolio with no addition to risk. The process of an asset being swapped out of a portfolio implies that the concentration of risk in the portfolio is being reduced, i.e., risk is being ‘diversified’. The reverse applies when an asset is swapped into the portfolio. Thus, the returns to risk increases for the low return asset and decreases for the high return asset, until the assets’ return to risk ratios converge. At this point, where further swaps that raise returns will also raise risk, the portfolio has reached its optimal level. (Source: Morton Glantz, ‘Managing Bank Risk’, Chapter 9, (Florida: Academic Press, 2003): 299–330.

13. Morton Glantz, ‘Managing Bank Risk’, Chapter 9, (Florida: Academic Press, 2005): 299–330.

14. Basel Committee on Banking Supervision, ‘Principles for the Management of Credit Risk’, (September 2000): 18.

15. We have seen earlier in this chapter that ELs are equal to the exposure times the percentage loss given the event of default times the probability of loss. Hence, actual losses would be the product of the first two factors alone.

16. Ibid., 22.

17. Ibid., 23.

18. Until Basel II formalized the use of PD, this concept was often called Expected Default Frequency (EDF)).

19. Please refer the previous chapter for a discussion on these models.

20. Table derived by author from presentation material by Michel Crouhy, ‘Credit Risk Assessment: A Comparative Study of Different Methods’, at seminar on ‘Global Risk Management Practices and Emerging Market's Particular Issues’ at Moscow, (15–16 June, 2004).

21. Ibid., 15.

22. Nikola A Tarashev, ‘An Empirical Evaluation of Structural Credit Risk Models’, BIS Working Papers no. 179, Bank for International Settlements, (July 2005): 5–8.

23. ‘Without recourse’ implies that the issuer of security or the investors will have no recourse to the originator if there is shortfall in asset value at the end of the tenure of the securitized asset. The issuer/investor will have to look solely at the cash flows from the securitized assets for their return.

24. For more on transfer of credit risk, please see the section on ‘Credit Derivatives’.

25. Ibid.


27. ISDA-The International Swaps and Derivatives Association.

28. A ‘swap’ is an agreement in which two parties (called counterparties) agree to exchange periodic payments. The amount of payments exchanged is based on a notional principal amount. A swap can be viewed as a package of forward contracts, with more liquidity and longer maturity than typical forward contracts.

29. The other settlement method is for the protection buyer to make physical delivery of a portfolio of specified deliverable obligations in return for payment of their face amount. Deliverable obligations may be the reference obligation or one of a broad class of obligations meeting certain specifications, such as any senior unsecured claim against the reference entity.

30. Called ‘risky debt’ because there is a possibility that the debt may not be repaid in full.

31. This is done through a complex method. The put buyer pays a premium for the right to sell to the put seller a specified reference asset and simultaneously enters into a swap in which the put seller pays the coupons on the reference asset and receives 3 or 6 month LIBOR plus a predetermined spread (the ‘strike spread’). The put seller makes an up-front payment of par for this combined package upon exercise.

32. ‘Negative carry’ is the loss in income due to investing funds obtained at higher cost in lower yielding investments to ensure liquidity.

33. Christian Bluhm, et al., ‘An Introduction to Credit Risk Modeling,’ Chapter 7, ‘Credit Derivatives’, ISBN 1-58488-326-X, Chapman&Hall/CRC (2003).

34. Basel Committee on Banking Supervision, ‘Consultative Paper: The Standardised Approach to Credit Risk’, (January 2001): 33–34.

35. An asset mismatch occurs when a credit protection contract refers to an instrument that is not the same as the exposure being hedged.

36. RBI, ‘Master Circular—Exposure Norms’, (July 2009).

37. Computation of the replacement cost value has been described in detail in the RBI's ‘Master Circular—Exposure Norms’ (1 July 2008).

38. As defined by the RBI under capital adequacy standards (please see chapter on ‘Capital—Risk, Regulation and Adequacy’) and as per published accounts at the end of the previous financial year. Exposures cannot be taken in anticipation of capital infusion at a future date.

39. ‘Infrastructure projects’ have been defined in Annexure I of the RBI Master circular on Exposure Norms dated 1 July 2009

40. RBI ‘Master Circular—Prudential Norms on Income Recognition, Asset Classification and Provisioning Pertaining to Advances’, (1 July 2009).

41. Any amount due to the bank under any credit facility is ‘overdue’ if it is not paid on the due date fixed by the bank.

42. An account should be treated as ‘out of order’ if the outstanding balance remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit/drawing power, but there are no credits continuously for 90 days as on the date of balance sheet or credits are not enough to cover the interest debited during the same period, these accounts should be treated as ‘out of order’.

43. ‘Liquidity facilities’ enable the securitization vehicles to assure investors of timely payments. These include smoothening of timing differences between payment of interest and principal on pooled assets and payments due to investors

44. Interest on advances against term deposits, NSCs, IVPs, KVPs and life policies may be taken to income account on the due date, provided adequate margin is available in the accounts. Fees and commissions earned by the banks as a result of renegotiations or rescheduling of outstanding debts should be recognized on an accrual basis over the period of time covered by the renegotiated or rescheduled extension of credit. If government guaranteed advances become NPAs, the interest on such advances should not be taken to income account unless the interest has been realized.

45. As defined in ‘AS 19—Leases’ issued by the Council of the Institute of Chartered Accountants of India (ICAI).

46. A ‘standard’ account is not an NPA. It carries normal business risks, the securities are sufficient to cover the advances made and the firm is currently meeting its interest and principal repayment obligations.

47. Unsecured exposure is defined as an exposure where the realizable value of the security, as assessed by the bank/ approved valuers/Reserve Bank's inspecting officers, is not more than 10 per cent, ab-initio, of the outstanding advances. ‘Exposure’ shall include all funded and non-funded exposures (including underwriting and similar commitments). ‘Security’ will mean tangible security properly discharged to the bank and will not include intangible securities like guarantees and comfort letters.

48. Considering that higher loan loss provisioning adds to the overall financial strength of the banks and the stability of the financial sector, banks are urged to voluntarily set apart provisions much above the minimum prudential levels as a desirable practice. RBI has been monitoring the accounting treatment of such floating provisions and issuing guidelines from time to time. At the G20 meet in London held in April 2009, the Group agreed to initiate several measures to strengthen the international frameworks for prudential regulation. The Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS) and Committee on Global Financial System (CGFS), along with various accounting bodies, would be working on the proposal to build buffers of capital and reserves in good times, so that the risk to financial stability can be mitigated when conditions worsen. The RBI proposes to issue fresh instructions based on the international recommendations.

49. RBI Master Circular quoted above, point 3.5.

50. Advances written off at Head Office, but may be still outstanding in the branch books.

51. SICA—Sick Industrial Companies Act—which has since been repealed.

52. Guidelines on ‘Securitization of Standard Assets’ issued by the RBI on 24 January, 2006.

53. Other banks/financial institutions/NBFCs can also buy loan assets from banks/FIs, as per the draft guidelines dated 12 April 2005 issued by the RBI titled ‘Draft Guidelines on Purchase/Sale of NPA’. The conditions for such proposed sale are similar to those described for SC/RC.

54. For the salient features of the Act relevant to banks, please refer ‘Annexure to RBI Guidelines to Banks/FIs on sale of SC/RC (created under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002) and related issues’, and for the salient features relevant to securitization and reconstruction companies, please refer to RBI, Notification dated 23 April 2003, ‘The Securitization Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003’, as well as subsequent notification and amendments. All the resources can be accessed at

56. Source: ICRA, ‘Update on Indian Structured Finance Market’, ICRA Rating Feature, (April 2009).

57. Draft Guidelines for Introduction of Credit Derivatives in India, the Reserve Bank of India, (26 March 2003).

58. Frank J Fabozzi, and Vinod Kothari, ‘Securitization: The Tool of Financial Transformation,’ Yale ICF Working Paper no. 07–07, downloaded from (31 March 2008)